1. Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 6

2. 1  HW2 (Property Law) online, due 5 p.m. Thurs Feb 24  Midterms will be Wed March 2 and Wed March 30 Logistics

3. 2  Coase: in the absence of transaction costs, if property rights are complete and tradable, voluntary negotiations will lead to efficiency  We can solve externalities by expanding property rights and allowing trade  Demsetz: property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization  Fur trade increased overhunting and therefore value of private property rights  Domestication of the dog decreased the cost of maintaining private property Our story so far on property law…

4. 3  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…

5. 4  Injunctive relief: court clarifies right, bars future violation (punishable as a crime)  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

6. 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”

7. 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?

8. 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

9. 8  When private goods are owned publicly, they tend to be overutilized/overexploited Public versus Private Goods

10. 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

11. 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

12. 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

13. 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

14. 13 what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

15. 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?

16. 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?  (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?

17. 16 Up next: applications But first: an experiment

18. 17  Each person given a personal value for a poker chip  Amount you can sell it back to me for (real money)  Purple chip is worth your number, red chip is worth 2 x your number  Each person can only sell back one chip  Take 1: buyer’s and seller’s values are common knowledge (nametags)  Take 2: private information (each player knows his threat point, but not his opponent’s) Experiment: Coasian bargaining

19. 18  Take 3: uncertainty  If seller keeps chip, it’s worth 2 x die roll ($2-$12, EV $7)  If buyer gets chip, it’s worth 3 x die roll ($3-$18, EV $10.50)  Can’t sell for conditional price – deal must be done before die roll is revealed  Take 4: asymmetric information  Values are same as above…  …but seller knows value of die roll, buyer doesn’t Experiment: Coasian bargaining

20. 19  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?  Monday: 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?

21. 20 Sequential Rationality

22. 21  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

23. 22 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”

24. 23  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

25. 24 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

26. 25  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

27. 26 Applications of Property Law

28. 27  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

29. 28  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

30. 29  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

31. 30  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

32. 31  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