A transaction costs framework is developed to explain the choice between licensing arrangements and employment contracts in R&D. Innovations are nonrivalrous and difficult to protect with patents, and the combination of these properties generates adverse selection, moral hazard, and causes problems of theft when transferred from inventor to firm. By identifying conditions in which these forces vary, predictions about which contract form minimizes the costs of measurement and contract enforcement are derived. The framework also provides insight into why firms in several industries have converted from mostly in-house research to licensing arrangements with independent inventors. Evidence from the Pharmaceutical industry is also presented.
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