Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 8

1  Second homework due next Thursday (Oct 10)  First midterm October 23  Interesting talk this Thursday  Jonathan Gruber, MIT, will be giving the Weisbrod Lecture:  “Health Care Reform: What It Is, Why It’s Necessary, How It Works”  This Thursday 10/3, 3:45 p.m., Union South Marquee Theater Logistics

2 (old exam question, question by Alex Tabarrok at Marginal Revolution blog) In Virginia, the common law has long held that if a neighbor’s tree encroaches on your yard you may cut the branches as they cross the property line, but any damage the tree does to your property is your problem. Your neighbor can even sue if your pruning kills the tree. In 2007, the Virginia Supreme Court overruled this 70-year- old precedent, making it your neighbor’s duty to prune or cut down the tree if it is a “nuisance.” Which is better: the new rule or the old? What would the Coase Theorem say about the two rules? Discussion question

3 Sequential Rationality

4  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 Dynamic games and sequential rationality

55  Now change the game so that player 1 moves first  Player 1 goes somewhere  Player 2 learns what 1 did, then decides where to go Let’s go back to a game we’ve seen – the Battle of the Sexes 6, 30, 0 3, 6 BallgameOpera Ballgame Opera Player 2 Player 1

6 Dynamic games are typically shown as “game trees” PLAYER 1 BallgameOpera PLAYER 2 BallgameOpera (6, 3)(0, 0)  A strategy is one player’s plan for what to do at each decision point he/she acts at  Player 1: “Ballgame” or “Opera”  Player 2’s strategy is more complicated – can depend on P1’s choice Ballgame (0, 0)(3, 6) Opera PLAYER 2

77  Player 2 has four options  “Go to the ballgame no matter what”  “Go to the ballgame if P1 went to the ballgame, otherwise opera”  “Opera if P1 went to the ballgame, otherwise ballgame”  “Opera no matter what” We can expand the matrix to accommodate Player 2’s additional options 6, 3 0, 03, 6 Ballgame, Ballgame Ballgame Opera Player 2 Player 1 0, 0 3, 6 Ballgame, Opera Opera, Ballgame Opera, Opera

88  Three equilibria:  1 goes to ballgame, 2 plays “ballgame no matter what”  1 goes to ballgame, 2 plays “do what 1 did”  1 goes to opera, 2 plays “opera no matter what”  Are all of these “reasonable”? We can solve this game for equilibrium in the “usual” way 6, 3 0, 03, 6 Ballgame, Ballgame Ballgame Opera Player 2 Player 1 0, 0 3, 6 Ballgame, Opera Opera, Ballgame Opera, Opera

9  Consider the equilibrium where  player 2 plans to go to the opera no matter what  player 1 therefore goes to the opera  Player 1 might wonder…  “Suppose I changed my mind and went to the ballgame.  Once I’m there, player 2 has to choose between sticking to the plan, going to the opera, and getting 0…  …versus following me to the ballgame and getting 3.  If player 2 is rational and I go to the ballgame, she should follow me there, and I’ll end up with a payoff of 6!” Are all these equilibria “reasonable”?

10  Sequential rationality is when a player can count on the other players to behave rationally from that point forward  Similar to “dynamic consistency” (macro)  When an equilibrium satisfies sequential rationality, we call it a Subgame-Perfect Equilibrium  Players play best-responses both in the game as a whole, and in each “subgame,” or part of the game  Rules out the opera-opera equilibrium: in the subgame where P1 had already gone to the ballgame, P2 wasn’t playing a best-response  In fact, P2 only has one strategy that is sequentially rational: do whatever player 1 did! Sequential rationality

11 Subgame Perfect Equilibria are found by Backward Induction PLAYER 1 BallgameOpera PLAYER 2 BallgameOpera (6, 3)(0, 0)  Start at the “bottom,” solve for what P2 would do at each point  If P2 is rational and P1 knows it, P1 can infer what payoff he would get from each move  Now figure out what P1 would do, given those payoffs Ballgame (0, 0)(3, 6) Opera PLAYER 2

12 Subgame Perfect Equilibria are found by Backward Induction PLAYER 1 BallgameOpera PLAYER 2 BallgameOpera (6, 3)(0, 0)  This game has a unique subgame-perfect equilibrium  Player 1 plays Ballgame  Player 2 plays Ballgame if 1 plays Ballgame, Opera if 1 plays Opera  “Most” dynamic games have just one SPE Ballgame (0, 0)(3, 6) Opera PLAYER 2

13  Battle of the sexes: moving first is good  You know your partner will accommodate whatever you do…  …so you get your first choice  Some games: being able to “commit” to a decision, while your opponent still has to decide, can be good!  (Another example: entry game)  Scissors-paper-rock: moving first is terrible  You always lose  Some games: reacting to your opponent’s move is good! Moving first can be good or bad, depending on the game

14  Key assumption: common knowledge of rationality  Player 1 knows player 2 is rational…  …so whatever he does, she’ll do what’s best for her…  …so player 1 can confidently go to the ballgame  This is the key to sequential rationality  The assumption that, whatever happens first, players will continue to act rationally in their own best interest  Which means we can “solve the game” from the end, and figure out the beginning players’ optimal moves  (Backward induction has been used to solve checkers, and will eventually solve chess!) When we look at dynamic games, we’ll always look only at subgame-perfect equilibrium

15 patents copyrights trademarks trade secrets Intellectual Property

16  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

17  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 $450 each Information: costly to generate, easy to imitate up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 450 each

18  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 (-550, 450)(1500, 0) (0, 0) up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 450 each

19  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 (-550, 450)(1500, 0) (0, 0) up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 450 each 450 – P

20 Comparing the two outcomes FIRM 1 (innovator) InnovateDon’t FIRM 2 (imitator) ImitateDon’t (-550, 450)(1500, 0) (0, 0) up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 450 each FIRM 1 (innovator) InnovateDon’t FIRM 2 (imitator) ImitateDon’t (-550, 450 – P)(1500, 0) (0, 0) Without patents:  Drug never discovered  With patents:  Drug gets discovered  But…

21  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… Patents solve one inefficiency by introducing another CS 1,250 Profit 2,500 P = 50 P = 100 – Q Q = 50 DWL 1,250 CS 4,050 Profit 450 x 2 P = 10 Q = 90 DWL 50 MonopolyDuopoly up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 450 each Net Surplus = 2,750Net Surplus = 3,950

22  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

23  Narrow patents might allow us each to patent own invention  Broad patents might not  “Winner-take-all” race to be first Patent breadth

24  Does a patent on the “pioneering invention” cover the application as well?  Can you patent an improvement to an existing product? Patent breadth

25  Patent length  Need to last long enough for firms to recover up-front investment…  …But the longer patents last, the longer we have DWL from monopoly  (Example from textbook: drug price drops from $15 to $1 per pill when patent expires)  Tradeoff between ex-post inefficiency and ex-ante incentive provision  U.S.: all patents last 20 years  Jeff Bezos (founder of Amazon) once suggested software patents should last just 3 years  Germany: full-term patents for major inventions, 3 year “petty patents” for minor ones, annual renewal fees Patent length

26 Marginal Revolution (blog): “Patent Policy on the Back of a Napkin” “Patent Policy on the Back of a Napkin” (Marginal Revolution) New York Times last fall  “Last year, for the first time, spending by Apple and Google on patent lawsuits and unusually big-dollar patent purchases exceeded spending on research and development of new products”  (“The Patent, Used as a Sword”, 10/7/2012)

27  Coase: without transaction costs, initial allocation of rights irrelevant for efficiency  But transaction costs may be high  Uncertainty on whether a patent is valid  Uncertainty of outcome of research  Many parties Do the details matter?

28  Coase: without transaction costs, initial allocation of rights irrelevant for efficiency  But transaction costs may be high  Uncertainty on whether a patent is valid  Uncertainty of outcome of research  Many parties Do the details matter?

29  Coase: without transaction costs, initial allocation of rights irrelevant for efficiency  But transaction costs may be high  Uncertainty on whether a patent is valid  Uncertainty of outcome of research  Many parties Do the details matter?

30  government purchase of drug patents  prizes  Google $30 million prize for landing a rover on the moon  direct government funding of research  ~25% of research spending in U.S. is funded by government Alternatives to patents for encouraging innovation

31 patents copyrights trademarks trade secrets

32  Property rights over original expressions  writing, music, other artistic creations  Creations like this 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

33  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

34  Retelling of Gone With The Wind, from point of view of a slave on Scarlett’s plantation, published in 2001  Margaret Mitchell’s estate sued to halt publication  Eventually settled out of court  Was there really any harm? Copyright

35  Retelling of Gone With The Wind, from point of view of a slave on Scarlett’s plantation, published in 2001  Margaret Mitchell’s estate sued to halt publication  Eventually settled out of court  Was there really any harm? Copyright

36 patents copyrights trademarks trade secrets

37 Trademarks  Reduce confusion over who made a product  Allow companies to build reputation for quality  Don’t expire, unless abandoned  Generic names can’t be trademarked

38 Trademarks – example  WSJ article 9/17/2010: “Lars Johnson Has Goats On His Roof and a Stable of Lawyers To Prove It”  Restaurant in Sister Bay WI put goats on roof to attract customers  “The restaurant is one of the top- grossing in Wisconsin, and I’m sure the goats have helped.”  Suing restaurant in Georgia  “Defendant has willfully continued to offer food services from buildings with goats on the roof”

39 Trademark dilution

40 patents copyrights trademarks trade secrets

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

42 patents copyrights trademarks trade secrets

43 How do you establish, verify, or give up property rights? (probably won’t get to this)

44  We already saw two doctrines for how ownership rights are determined – First Possession and Tied Ownership  Next question: when should a resource become privately owned?  Cost of private ownership: owners must take steps to make the resource excludable – boundary maintenance  Cost of public ownership: congestion and overuse  An economically rational society will privatize a resource at the point in time where boundary maintenance costs less than the waste from overuse of the resource. When should resources become privately owned?

45  We already saw two doctrines for how ownership rights are determined – First Possession and Tied Ownership  Next question: when should a resource become privately owned?  Cost of private ownership: owners must take steps to make the resource excludable – boundary maintenance  Cost of public ownership: congestion and overuse  An economically rational society will privatize a resource at the point in time where boundary maintenance costs less than the waste from overuse of the resource.  (either because congestion got worse…  or because boundary maintenance became cheaper) When should resources become privately owned?

46  Adverse Possession (“squatter’s rights”)  If you occupy someone else’s property for long enough, you become the legal owner, provided:  1. the occupation was adverse to the owner’s interests, and  2. the owner did not object or take legal action How do you give up (or lose) property rights?

47  Adverse Possession (“squatter’s rights”)  If you occupy someone else’s property for long enough, you become the legal owner, provided:  1. the occupation was adverse to the owner’s interests, and  2. the owner did not object or take legal action  Pro: clear up uncertainty over time; allow land to be put to use  Con: owners must incur monitoring costs to protect property How do you give up (or lose) property rights?

48  Adverse Possession (“squatter’s rights”)  If you occupy someone else’s property for long enough, you become the legal owner, provided:  1. the occupation was adverse to the owner’s interests, and  2. the owner did not object or take legal action  Pro: clear up uncertainty over time; allow land to be put to use  Con: owners must incur monitoring costs to protect property  Estray statutes – laws governing lost and found property How do you give up (or lose) property rights?