Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 7

1  Established properties of an efficient property law system  Private goods are privately owned, public goods are not  Owners have maximum liberty over how they use their property  Injunctive relief used when transaction costs are low, damages used when transaction costs high  We also gave some thought to “testing Coase”  Farnsworth: no bargaining after judgment in lawsuits he studied, due to animosity and unwillingness to equate utility to price  In-class experiment: can UW undergrads allocate poker chips efficiently? On Monday…

2  Take 1: Full Information (values on nametags) Our experiment… 86% purple chip red chip8 purple chip 10 purple chip 10 red chip 12 fraction of potential gains realized actual final allocation efficient allocation starting allocation

3  Take 2: Private Information (values hidden) Our experiment… 67% purple chip red chippurple chipred chip6 purple chip8 8 red chip10 fraction of potential gains realized actual final allocation efficient allocation starting allocation

4  Take 3: Uncertainty  Take 4: Adverse Selection Our experiment… 100%332 chip 2 X die roll (actually 2) chip 3 X die roll (actually 3) fraction of potential gains realized actual final allocation efficient allocation starting allocation 0% chip 2 X die roll (actually 10) chip 3 X die roll (actually 15) fraction of potential gains realized actual final allocation efficient allocation starting allocation

5  So…  With full information, 87% of gains realized  With private information, 67%  With uncertainty, 100%  With adverse selection, 0%  Comparing the last two cases…  Seller’s value was 2 X die roll, buyer’s value was 3 X die roll  If nobody knows die roll, no problem – they can trade based on the expected value  But if seller knows die roll, problem Our experiment…

6  In the last round, seller knew die roll had come up 5  Seller says, “the die says 5; the chip is worth 10 to me and 15 to you; I’ll sell it to you for 11”  Buyer thinks, “what type of person would sell for 11?”  Certainly not a guy who had rolled a 6  Possibly a guy who rolled a 5…  …or a 4, 3, 2, or 1  Expected value conditional on seller willing to sell at 11 = 3 X 3 = 9  If he can’t trust seller to be honest, buyer not willing to pay 11  Same problem at most prices – trade breaks down  Best case: trade only at low prices, realize 29% of gains  Akerloff (1970), “The Market for Lemons: Quality Uncertainty and the Market Mechanism” Adverse Selection

7 Sequential Rationality

8  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

9 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”

10  We can look for equilibria like before  we find two: (Enter, Accommodate), and (Don’t Enter, Fight)  question: are both equilibria plausible?  sequential rationality  firm 1 asks, “once I’ve entered, would he really choose to fight?” 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

11 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

12  Firm 1 knows firm 2 is rational  So he knows that if he enters, firm 2 will do the rational thing – accommodate  So he 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

13 Applications of Property Law

14  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

15  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

16  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

17  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)(1500, 0) (0, 0) up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each 250 – P

18 Comparing the two outcomes 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 FIRM 1 (innovator) InnovateDon’t FIRM 2 (imitator) ImitateDon’t (-750, 250 – P)(1500, 0) (0, 0) Without patents:  Drug never discovered  With patents:  Drug gets discovered  But…

19  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

20 Solving one inefficiency by introducing another up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each 0$2,750$3,986Total Surplus 0$1,250$4,486Consumer Surplus 0 $2,500 – $1,000 = $1,500 $250 + $250 – $1,000 = –$500 Industry Profits (net of up-front investment) Demand for Drug (Q = 100 – P) infinity$50$5.28Price of Drug No entryMonopolyDuopoly  Monopoly outcome is more efficient than no-entry…  …but still less inefficient than competition

21  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

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

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

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

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

26  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

27  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

28 patents copyrights trademarks trade secrets

29  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

30  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

31  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

32  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

33 patents copyrights trademarks trade secrets

34 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

35 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  Generic names cannot be trademarked

36 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”

37 Trademarks and trademark dilution

38 patents copyrights trademarks trade secrets

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

40 patents copyrights trademarks trade secrets