Econ 522 Economics of Law Dan Quint Fall 2015 Lecture 7

1  HW2 is online, due Thursday 10/15 at midnight  First midterm is Monday 10/19 in class  Sample problems online from past exams Announcements

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 what can be privately owned? what can an owner do? how are property rights established? what remedies are given? What would an efficient property law system look like?

4  Hammonds v. Central Kentucky Natural Gas Co.  Central Kentucky leased land lying above natural gas deposits  Geological dome lay partly under Hammonds’ land  Central Kentucky drilled down and extracted the gas  Hammonds sued, claiming some of the gas was his  (Anybody see “There Will Be Blood”?) Fugitive property HammondsCentral KY

5  First Possession  nobody owns fugitive property until someone possesses it  first to “capture” a resource owns it  Central Kentucky would own all the gas  Tied Ownership  ownership of fugitive property tied to something else (here, surface)  so ownership already determined before resource is extracted  Hammonds would own some of the gas, since under his land  principle of accession – a new thing is owned by the owner of the proximate or prominent property Two principles for establishing ownership

6  First Possession  simpler to apply – easy to determine who possessed property first  incentive to invest too much to early in order to establish ownership  example: $100 of gas, two companies drilling fast or slow  drilling slowly costs $5, drilling fast costs $25  drill same speed  each gets half the gas, one drills fast  75/25 First Possession versus Tied Ownership 45, 4520, 50 50, 2025, 25 SlowFast Slow Fast Firm 2 Firm 1

7  First Possession  simpler to apply – easy to determine who possessed property first  incentive to invest too much to early in order to establish ownership  Tied Ownership  encourages efficient use of the resource  but, difficulty of establishing and verifying ownership rights First Possession versus Tied Ownership 45, 4545, 25 25, 4525, 25 SlowFast Slow Fast Firm 2 Firm 1

8 Rules that link ownership to possession have the advantage of being easy to administer, and the disadvantage of providing incentives for uneconomic investment in possessory acts. Rules that allow ownership without possession have the advantage of avoiding preemptive investment and the disadvantage of being costly to administer. This brings us to the following tradeoff:

9  “Fast fish/loose fish” and “the guy who kills a fox, owns it” are examples of a first possession rule  You can’t own a resource until you physically possess it  “Iron holds the whale” and “the guy chasing a fox owns it” are examples of a tied ownership rule  You can establish ownership of something before you actually possess it  (A harpoon, or chasing a fox, gives you a right to it)  More complicated/costly to enforce  “if the first seeing, starting, or pursuing such animals… should afford the basis of actions against others for intercepting and killing them, it would prove a fertile source of quarrels and litigation”  But avoids incentive to poach someone else’s resource We’ve already seen two examples of this

10  Meant to encourage settlement of the Western U.S.  Citizens could acquire 160 acres of land for free, provided  head of a family or 21 years old  “for the purpose of actual cultivation, and not… for the use or benefit of someone else”  had to live on the claim for 6 months and make “suitable” improvements  Basically a first possession rule for land – by living on the land, you gained ownership of it  Friedman: caused people to spend inefficiently much to gain ownership of the land Another nice historical example: the Homestead Act of 1862

11 “The year is 1862; the piece of land we are considering is… too far from railroads, feed stores, and other people to be cultivated at a profit. …The efficient rule would be to start farming the land the first year that doing so becomes profitable, say But if you set out to homestead the land in 1890, you will get an unpleasant surprise: someone else is already there. …If you want to get the land you will have to come early. By farming it at a loss for a few years you can acquire the right to farm it thereafter at a profit. Friedman on the Homestead Act of 1862

12 How early will you have to come? Assume the value of the land in 1890 is going to be $20,000, representing the present value of the profit that can be made by farming it from then on. Further assume that the loss from farming it earlier than that is $1,000 a year. If you try to homestead it in 1880, you again find the land already taken. Someone who homesteads in 1880 pays $10,000 in losses for $20,000 in real estate – not as good as getting it for free, but still an attractive deal. …The land will be claimed about 1870, just early enough so that the losses in the early years balance the later gains. It follows that the effect of the Homestead Act was to wipe out, in costs of premature farming, a large part of the land value of the United States.” Friedman on the Homestead Act of 1862

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?  (Tradeoff between first possession and tied ownership; 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?

14  Next up: some applications of property law  But first, one more tool… Next up

15 Sequential Rationality

16  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

17  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

18 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

19  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

20  Three equilibria:  1 goes to ballgame, 2 plays “ballgame no matter what”  1 goes to ballgame, 2 plays “go wherever 1 went”  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

21  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”?

22  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

23 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

24 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

25  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

26  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 in 2007 – it’s a draw – and will eventually solve chess…) When we look at dynamic games, we’ll always look only at subgame-perfect equilibrium

27 patents copyrights trademarks trade secrets Intellectual Property

28  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  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 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

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

34  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

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

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

37  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

38 Marginal Revolution (blog): “Patent Policy on the Back of a Napkin” “Patent Policy on the Back of a Napkin” (Marginal Revolution) New York Times a couple years ago  “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)

39  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?

40  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?

41  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?

42  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

43 patents copyrights trademarks trade secrets

44  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

45  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

46  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

47  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

48 patents copyrights trademarks trade secrets

49 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

50 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”

51 Trademarks – another example  In court papers, the oil behemoth effectively argues that it owns the exclusive right to put two X’s next to each other.  Deadline notes, “This double-cross brawl may come as a surprise to Dos Equis…”  An FX spokesperson called the suit “entirely meritless” and said, “We are confident that viewers won’t tune into FXX looking for gas or motor oil and drivers won’t pull up to an Exxon pump station expecting to get ‘It’s Always Sunny in Philadelphia.’” source:

52 Trademark dilution

53 patents copyrights trademarks trade secrets

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

55 patents copyrights trademarks trade secrets