Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 6

1  HW1 online, due next Friday (2/19)  Pretty long – don’t wait till last minute to start!  If you can’t attend section, can hand in to my mailbox (Social Sciences), or by  First midterm Wednesday 2/24 Logistics

2  Coase: in the absence of transaction costs, if property rights are complete and tradeable, voluntary negotiations will lead to efficiency  So initial allocation of rights doesn’t matter for efficiency if there are no transaction costs  But if there are transaction costs, the initial allocation of rights does impact efficiency  Sources of transaction costs  Search costs, bargaining costs, enforcement costs  What to do about transaction costs  Normative Coase: design law to minimize transaction costs  Normative Hobbes: design law to minimize harm done by failures in bargaining Last week…

3  How to choose between two normative approaches?  When transaction costs are low and information costs high, design law to minimize transaction costs  What transaction costs are high and information costs are low, design law to allocate rights efficiently  Application of this: choosing a remedy (Calabresi/Melamed)  When transaction costs are low, use injunctions (property rules)  When transaction costs are high, use damages (liability rules)  C&U: this is what actually happens in many settings Last week…

4 what can be privately owned? what can an owner do? how are property rights established? what remedies are given? That answered first of four questions we need to address

5 Public versus Private Goods Private Goods  rivalrous – one’s consumption precludes another  excludable – technologically possible to prevent consumption  example: apple Public Goods  non-rivalrous  non-excludable  examples: defense against nuclear attack  infrastructure (roads, bridges)  parks, clean air, large fireworks displays

6  When private goods are owned publicly, they tend to be overutilized/overexploited Public versus Private Goods

7  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied Public versus Private Goods

8  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied  Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated Public versus Private Goods

9  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied  Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated Public versus Private Goods

10  Clean air  Large number of people affected  transaction costs high  injunctive relief unlikely to work well  Still two options  One: give property owners right to clean air, protected by damages  Two: public regulation  Argue for one or the other by comparing costs of each  Damages: costs are legal cost of lawsuits or pretrial negotiations  Regulation: administrative costs, error costs if level is not chosen correctly A different view: transaction costs

11 what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

12  Priniciple of maximum liberty  Owners can do whatever they like with their property, provided it does not interfere with other’ property or rights  That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else What can an owner do with his property?

13  What things can be privately owned?  Private goods are privately owned, public goods are publicly provided  What can owners do with their property?  Maximum liberty  How are property rights established?  (Examples to come)  What remedies are given?  Injunctions when transaction costs are low; damages when transaction costs are high So, what does an efficient property law system look like?

14 Up next: applications

15  Game theory we’ve seen so far: static games  “everything happens at once”  (nobody observes another player’s move before deciding how to act)  Dynamic games  one player moves first  second player learns what first player did, and then moves But first: dynamic games and sequential rationality

16 Dynamic games FIRM 1 (entrant) EnterDon’t Enter FIRM 2 (incumbent) AccommodateFight (10, 10)(-10, -10) (0, 30)  A strategy is one player’s plan for what to do at each decision point he/she acts at  In this case: player 1’s possible strategies are “enter” and “don’t”, player 2’s are “accommodate” and “fight”

17  We can look for equilibria like before  we find two: (Enter, Accommodate), and (Don’t Enter, Fight)  question: are both equilibria plausible?  sequential rationality We can put payoffs from this game into a payoff matrix… 10, 10-10, -10 0, 30 AccommodateFight Enter Don’t Enter Firm 2’s Action Firm 1’s Action

18 Dynamic games FIRM 1 (entrant) EnterDon’t Enter FIRM 2 (incumbent) AccommodateFight (10, 10)(-10, -10) (0, 30)  In dynamic games, we look for Subgame Perfect Equilibria  players play best-responses in the game as a whole, but also in every branch of the game tree  We find Subgame Perfect Equilibria by backward induction  start at the bottom of the game tree and work our way up

19  Firm 1 knows firm 2 is rational  So he knows that if he enters, firm 2 will do the rational thing – accommodate  So we enters, counting on firm 2 to accommodate  This is the idea of sequential rationality – the assumption that, whatever I do, I can count on the players moving after me to behave rationally in their own best interest The key assumption behind subgame perfect equilibrium: common knowledge of rationality

20 Back to… Property Law

21  Intellectual property: broad term for ways that an individual, or a firm, can claim ownership of information  Patents – cover products, commercial processes  Copyrights – written ideas (books, music, computer programs)  Trademarks – brand names, logos  Trade Secrets Intellectual Property

22  Example: new drug  Requires investment of $1,000 to discover  Monopoly profits would be $2,500  Once drug has been discovered, another firm could also begin to sell it  Duopoly profits would be $250 each Information: costly to generate, easy to imitate up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each

23  Solve the game by backward induction:  Subgame perfect equilibrium: firm 2 plays Imitate, firm 1 plays Don’t Innovate, drug is never discovered  (Both firms earn 0 profits, consumers don’t get the drug) Information: costly to generate, easy to imitate FIRM 1 (innovator) InnovateDon’t FIRM 2 (imitator) ImitateDon’t (-750, 250)(1500, 0) (0, 0) up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each

24  Patent: legal monopoly  Other firms prohibited from imitating Firm 1’s discovery  Subgame perfect equilibrium: firm 2 does not imitate; firm 1 innovates, drug gets developed Patents: one way to solve the problem FIRM 1 (innovator) InnovateDon’t FIRM 2 (imitator) ImitateDon’t (-750, 250 – P)(1500, 0) (0, 0) up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each

25  Without patents, inefficient outcome: drug not developed  With patents, different inefficiency: monopoly!  Once the drug has been found, the original incentive problem is solved, but the new inefficiency remains… BUT… patents solve one inefficiency by introducing another CS Profit P * = 50 P = 100 – Q Q * = 50 DWL

26  First U.S. patent law passed in 1790  Patents currently last 20 years from date of application  For a patent application to be approved, invention must be:  novel (new)  non-obvious  have practical utility (basically, be commercializable)  Patentholder whose patent has been infringed can sue for both damages and an injunction against future violations  Patents are property – can be sold or licensed to others Patents: a bit of history

27  Patent breadth Two variables in patent law: how broad patents are, and how long they last

28  Patent breadth Two variables in patent law: how broad patents are, and how long they last

29  Patent breadth Two variables in patent law: how broad patents are, and how long they last

30  Patent breadth Two variables in patent law: how broad patents are, and how long they last

31  Patent breadth  Patent length  tradeoff: how long to maintain ex-post inefficiency (monopoly) to create enough incentive for innovation? Two variables in patent law: how broad patents are, and how long they last

32  Patent breadth  Patent length  tradeoff: how long to maintain ex-post inefficiency (monopoly) to create enough incentive for innovation?  Alternatives to patents  government purchase of drug patents  prizes  direct government funding of research Two variables in patent law: how broad patents are, and how long they last

33 patents copyrights trademarks trade secrets

34  Property rights over original expressions  writing, music, other artistic creations  These tend to fit definition of public goods  nonrivalrous  nonexcludable  so private supply would lead to undersupply  Several possible solutions  government subsidies  charitable donations  legal rights to creations – copyrights Copyright

35  Copyright law less rigid than patent law  Unlike patent law, allows for certain exceptions  Copyrights last much longer than patents  Current U.S. law: copyright expires 70 years after creator’s death  No application process  Copyright law automatically applies to anything you’ve written/created Copyright

36  Copyright law less rigid than patent law  Unlike patent law, allows for certain exceptions  Copyrights last much longer than patents  Current U.S. law: copyright expires 70 years after creator’s death  No application process  Copyright law automatically applies to anything you’ve written/created  Copyrights more narrow than patents  Cover exact text, not general idea Copyright

37  Copyright law less rigid than patent law  Unlike patent law, allows for certain exceptions  Copyrights last much longer than patents  Current U.S. law: copyright expires 70 years after creator’s death  No application process  Copyright law automatically applies to anything you’ve written/created  Copyrights more narrow than patents  Cover exact text, not general idea Copyright

38 patents copyrights trademarks trade secrets

39 Trademarks  Trademarks do not expire, as long as they’re not “abandoned”  No trade-off between long-term incentives (innovation) and short- term inefficiency (monopoly) – little apparent downside

40 Trademarks  Trademarks do not expire, as long as they’re not “abandoned”  No trade-off between long-term incentives (innovation) and short- term inefficiency (monopoly) – little apparent downside

41  Trademarks do not expire, as long as they’re not “abandoned”  No trade-off between long-term incentives (innovation) and short- term inefficiency (monopoly) – little apparent downside  Protected against infringement and also dilution Trademarks

42 patents copyrights trademarks trade secrets

43  Protection against misappropriation  But plaintiff must show…  Valid trade secret  Acquired illegally  Reasonable steps taken to protect it Trade Secrets

44 patents copyrights trademarks trade secrets

45  Methods of public ownership  How are property rights established, verified, lost  Exceptions and limitations to property rights Wednesday…