Econ 522 Economics of Law Dan Quint Spring 2012 Lecture 6

1  HW1 due at 11:59 p.m. tomorrow night on  ESA event tomorrow, 6 p.m. in Grainger 5120 Announcements

2  HW1 due at 11:59 p.m. tomorrow night on  ESA event tomorrow, 6 p.m. in Grainger 5120  Low-cost LSAT course through UW Law (March 3-18)  Info session for Washington DC Semester in International Affairs today at 4, 206 Ingraham Announcements

3  Coase  Absent transaction costs, if property rights are complete and tradable, we’ll get efficiency through voluntary negotiation  Two normative approaches to the law:  Normative Coase: aim to minimize transaction costs  Normative Hobbes: aim to allocate rights efficiently (or minimize the need for bargaining/trade)  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 Our story so far on property law…

4  Injunctive relief: court clarifies right, bars future violation; violations are punished as crimes (but right is tradable)  Damages: court determines how much harm was done by violation, awards payment to injuree  Coase: should be equally efficient if there are no transaction costs  But in “real world”, which is more efficient? One application of this: choosing a remedy for property rights violations

5 Calabresi and Melamed Transaction costs high…  difficult for parties to reassign rights through negotiations  injunction would force injurer to prevent harm himself  damages rule allows injurer to prevent harm or pay for it, whichever is cheaper  when transaction costs are high, damages rule is typically more efficient  “liability rule” Transaction costs low…  easy for parties to reassign rights  injunctions cheaper for court to implement (doesn’t need to calculate damage done)  when transaction costs are low, injunctive relief is typically more efficient  “property rule”

6 what can be privately owned? what can an owner do? how are property rights established? what remedies are given? How do we design an efficient property law system?

7 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

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

10  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

11  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

12  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

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

14  Principle 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?

15  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?  (More 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?

16 Up next: applications But first: an experiment

17  Round 1 (full information)  Ten people, five of them have a poker chip to start  Each person is given a personal value for a poker chip  At the end of the round, that’s how much you can trade in a chip for  Purple chip is worth that number, red chip is worth 2 x your number  So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it  Each person can only sell back one chip  Your number is on your nametag (common knowledge) Experiment: Coasian bargaining

18  Round 2 (private information)  Ten people, five of them have a poker chip to start  Each person is given a personal value for a poker chip  At the end of the round, that’s how much you can trade in a chip for  Purple chip is worth that number, red chip is worth 2 x your number  So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it  Each person can only sell back one chip  Only you know your number Experiment: Coasian bargaining

19  Round 3 (uncertainty)  Six people, three poker chips  Value of each chip is determined by a die roll  If seller keeps the chip, it’s worth 2 x roll of the die  If new buyer buys chip, it’s worth 3 x roll of the die  No contingent trades – buyer must pay cash  Nobody sees the die roll until the end Experiment: Coasian bargaining

20  Round 4 (asymmetric information)  Six people, three poker chips  Value of each chip is determined by a die roll  If seller keeps the chip, it’s worth 2 x roll of the die  If new buyer buys chip, it’s worth 3 x roll of the die  No contingent trades – buyer must pay cash  Seller sees the die roll initially, buyer does not Experiment: Coasian bargaining

21  Coase relies on parties being able to negotiate privately if the right is not assigned efficiently  Low-TC case: injunctions more efficient, assuming bargaining works if “wrong” party is awarded the right  How well does this work?  Last week: paper by Farnsworth showing no bargaining after 20 nuisance cases  Just saw examples of various transaction costs: private information, uncertainty, asymmetric information Why did we do this?

22 Sequential Rationality

23  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

24 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”

25  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

26 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

27  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

28 An Example of Dynamic Games: Innovation (probably won’t get to this)

29  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

30  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

31  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 One way to solve the problem: intellectual property 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

32 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…

33  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