Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 6

Last week… 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

Last week… 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

One application of this: choosing a remedy for property rights violations 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?

Calabresi and Melamed Transaction costs high… Transaction costs low… 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”

High transaction costs  damages Low transaction costs  injunctive relief “Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy. On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases.” (Cooter and Ulen) Cooter and Ulen point out that this is how things are typically done in certain types of disputes “Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy.” On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases. But, in the first case – where transaction costs are high, so bargaining is likely to fail – a liability rule is only efficient when the court is able to correctly calculate the amount of damages (Damages get the injurer to internalize his externality – he pays the cost that he imposes on the injurer – but if damages are calculated wrong, he pays the wrong cost, and so he won’t behave efficiently) On the other hand, injunctive relief is efficient any time the court can determine who values the right more, regardless of its absolute level (If the court assigns the right to the correct party, no bargaining is necessary) This leads Cooter and Ulen to a different interpretation of efficient remedies in the case of high transaction costs:

A different view of the high-transaction-costs case… “When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely. Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more.” (Cooter and Ulen) This leads them to a different interpretation of efficient remedies in the high-transaction-costs case: When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely. Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more. For example: suppose the court knows that a good night’s sleep is worth exactly $200 to me. Then it can protect this right be damages; then you’ll only have a party if having the party is worth more than $200 to you, since that’s what you’d have to pay me; and this is exactly what’s efficient. On the other hand, suppose the court has no idea what a good night’s sleep is worth to me, but knows it’s worth more to me than having a party is to you. The court can’t use damages, since it won’t know how much damages to assess; but it can give me an injunction against noise, and then you won’t be able to have the party, which is efficient in this case.

Third remedy: inalienability Inalienability: when an entitlement is not transferable or saleable As the title of the paper suggests, Calabresi and Melamed also talk about a third type of protection for entitlements: inalienability This is when an entitlement is not transferable or sellable For example, I an entitled to not be a slave, and I am not allowed to give away or sell that right Similarly, you can’t give away or sell your right to vote (We can think of this as the case of owning a historical landmark: it is your property, but it may be unalienable, in that you cannot sell it to someone who would put it to a different use.) Inalienability is a bit of a funny case The word might resonate as being a positive one – think of the well-known line from the Declaration of Independence, that all men are endowed with “certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness” But in our context, inalienability seems more negative Everything we’ve done so far – in particular, Coase – has assumed that the way to get efficient outcomes it to allow people to trade rights with each other, in order to get them owned by whoever values them the most I own two kidneys; some kidney patient needs one; if my second kidney is worth more to him than to me, why shouldn’t I be allowed to sell it to him? In some cases, we can defend inalienability by talking about externalities If giving away a particular right imposed a large externality on others, maybe it makes sense not to allow it In other cases, it seems to be more a case of paternalism that is, the government thinking it knows what is good for you In the kidney case, it may have nothing to do with the kidney itself, but the incentives for other behavior we might acknowledge that me having two kidneys is inefficient; but if we allowed the sale and trade of kidneys, then murder rates might go up, because everyone was always carrying around hundreds of thousands of dollars worth of organs But inalienability is not that common – thinking about remedies usually comes down to comparing injunctive relief to damages

How do we design an efficient property law system? what can be privately owned? what can an owner do? how are property rights established? what remedies are given? We’ve now addressed the fourth question, remedies We move next to the first: what things can be privately owned?

Public versus 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 You may recall from micro a discussion of Public and Private Goods. Private Goods tend to be characterized by two properties: Rivalrous – one person’s consumption of a private good precludes another person’s enjoyment of its benefits if I eat an apple, you won’t be able to eat that same apple Excludable – it’s technologically possible to prevent others from consuming it It shouldn’t be too hard for me to prevent you from eating it. Public Goods tend to be characterized by the opposite of these two properties: Nonrivalrous – one person’s consumption of a public good does not impact others’ enjoyment of it Nonexcludable – hard to prevent people from taking advantage The cleanest example of a public good is defense against a nuclear attack It’s very hard for me to defend myself from a nuclear attack in a way that doesn’t also protect you a bit and you being safe from nuclear attack doesn’t impact my enjoyment of this privilege. Other public goods are urban infrastructure (bridges and roads) (although roads may become somewhat rivalrous when there is congestion); parks, clean air, the ocean, large fireworks displays, and so on.

Public versus Private Goods When private goods are owned publicly, they tend to be overutilized/overexploited A principle you may remember from intermediate micro: When private goods are owned publicly, they tend to be overutilized, or overexploited. This is the point of the classic paper by Hardin on the syllabus, the tragedy of the commons His example: a large common area where everyone is permitted to graze their cattle Since it’s public, nobody considers the cost their herd imposes on the grass So the grass on the commons gets wiped out by overgrazing Similar problems with overhunting, or overfishing, in unregulated public land Another example of this is congestion on busy roads Most roads are provided publicly (no toll, free to use) When there’s lots of traffic, roads become rivalrous – the more people on the road, the less utility I get from driving on them – so they take on one of the characteristics of a private good But when people are deciding whether or not to drive, they tend not to consider the externality that their choice to drive has on other drivers; so the roads get overused (Some cities are looking at ways to solve this problem with congestion pricing – charging people to use the roads during peak hours, so that people internalize this externality.)

Public versus Private Goods When private goods are owned publicly, they tend to be overutilized/overexploited When public goods are privately owned, they tend to be underprovided/undersupplied One the other hand, when public goods are privately owned, they face the opposite problem: they will be underprovided suppose a town wants to build a park, but has to pay for it with voluntary donations people weigh their donations only against their private gain from the park, ignoring the positive effect it has on everyone else so people will donate very little, and a nice park will not be built in this way this is exactly the free-rider problem we talked about earlier when we were considering bargaining Example: 100 people, each with utility 10 sqrt( Park ) + $, where Park is the sum of everyones’ contributions. When each person decides how much to contribute, he maximizes 10sqrt(X+x) – x, where X is what everyone else contributed Solving the problem establishes that when contributions are voluntary, X+x=25 – total contributions will be 25, giving everyone an average utility of 10 sqrt (25) – 25/100 = 49.75 On the other hand, suppose everyone agreed to contribute $1 each; a park of quality 100 would be built, leading everyone to utility of 10 sqrt( 100 ) – 1 = 99 So obviously, the bigger park is Pareto-superior, even though only the small one could be built through voluntary private contributions.) Recall our earlier story of a hops farmer and a brewery When there was a single hops farmer, he could negotiate with the brewery to reduce pollution and breathe cleaner air But if the dirty air affects lots of people, it becomes a “public bad” – and if each person tries to negotiate separately with the brewery to reduce pollution, they will reduce it less than efficiency would suggest.

Public versus Private Goods 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 Which brings us to the general rule proposed by Cooter and Ulen: Efficiency suggests that private goods should be privately owned, and public goods should be publicly provided or regulated Private ownership of private goods avoids overuse, and allows trade, leading to efficient allocations (Coase) Public provision of public goods avoids undersupply This also gives us another interpretation of the Demsetz example we did last week, of the development of property rights to land among Native Americans What makes the case interesting is that land can be either a public or a private good, depending on the circumstances. National forests can be thought of as a public good they’re a good thing ecologically, they’re pretty to drive by and hike in, I can enjoy them even if other people are enjoying them, and it’s hard to exclude other people from getting their benefits. On the other hand, 900 square feet in the middle of a city is a private good if I build an apartment there and live in it, that precludes you doing the same; and as long as I get a door with a decent lock, I can keep you out. Demsetz’s observation was that property rights over land developed among Native Americans as the fur trade became more important economically We can interpret this in terms of public and private goods.

Public versus Private Goods 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 Before the fur trade, land was pretty much a public good There was no shortage of animals, so hunting grounds were not particularly rivalrous – I could hunt on your land, and still leave enough game for you to hunt the next day With the emergence of the fur trade came stronger incentives for hunting Fur-bearing animals became more valuable, so were hunted more, so became scarce, so the land became a rivalrous good – the more I hunted, the less luck you would have hunting on the same land So the emergence of the fur trade led to a sort of transition of land from being a public to a private good Efficiency would then suggest that at the same time, it should go from being publicly owned (everyone could hunt on it) to being privately owned (one family might have exclusive rights to hunt in a particular area) Which is pretty much what happened So the general principle is, private goods should be owned privately, and public goods should be publicly provided/regulated The book mentions the move in the 1990s toward deregulation/privitization as an example of correcting a situation of private goods being publicly supplied services that did not involve externalities, and could therefore be supplied by private industry, but for historical reasons were being run by the government in the 1990s, there was a big movement to dismantle or sell off government monopolies on trains, planes, and other services worldwide.

A different view: transaction costs 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 Cooter and Ulen also point out that in many cases, either type of ownership, public or private, will involve some transaction costs, and the case can be made for one or the other by considering the magnitude of these costs (In fact, we can think of public goods as goods where costs of privately transacting are too high – enforcement costs are high because the good is nonexcludable, or bargaining costs are high because so many people are affected) Consider again the example of clean air If there are lots of consumers affected by pollution from a factory, injunctive relief is unlikely to work well, since transaction costs tend to be high when there are lots of parties affected However, there are still two possible ways to maintain clean air One way is to grant property owners the right to clean air, but protected by damages; so that a factory, if it felt it worthwhile, could choose to pollute and pay damages Alternatively, clean air could be viewed as a public good, and regulated by a government agency We can argue for the efficiency of one system or the other by comparing the magnitude of these transaction costs In the case of damages, the transaction cost here would be the legal cost of these lawsuits, or pretrial negotiations, including the cost to the court of calculating damages In the case of regulation, this would involve the administrative costs of setting up and running a government agency to regulate air quality, and could run the risk of the level of pollution not being the one that is socially optimal Whichever costs would be lower, suggests which system would be more efficient

what can be privately owned? what can an owner do? how are property rights established? what remedies are given? So that gives a general answer to the question, What can be privately owned? Efficiency says, private goods should be privately owned, public goods should not. The next question, How do I establish rights to something? we’ve seen a couple examples of this already: in whaling, and foxes (Pierson v Post) there isn’t really a general theory behind it – we can see it as an extension of the question of what can be owned we will come back to this and talk about it through some more applications Which leaves us with the question, what can an owner do with his property?

What can an owner do with his property? 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 This leaves us with the question of, what can an owner do with his property? which we’ve already discussed some in the context of nuisance law Efficiency suggests that anything that makes me better off, and doesn’t affect anyone else, is efficient And so efficiency suggests the principle of maximum liberty maximum liberty suggests that owners can do anything with their property that does not interfere with other peoples’ property or rights that is, you can do anything you like with your property as long as it doesn’t impose an externality on anyone else once one person’s actions begin to affect another, we run into what we’ve already been looking at – nuisance law In the textbook, they make the case that the common law approximates the rule of maximum liberty, although I’m a bit skeptical Legislatures may pass laws that impose further restrictions on what people can do with their property In general, these laws are only efficient if the behavior they are restricting causes an externality.

So, what does an efficient property law system look like? 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

Up next: applications But first: an experiment

Experiment: Coasian bargaining 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 threat points are common knowledge (nametags) Take 2: private information (each player knows his threat point, but not his opponent’s)

Experiment: Coasian bargaining 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

Why did we do this? 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 But… does this really happen? Ward Farnsworth (1999), Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside The Cathedral 20 nuisance cases: no bargaining after judgment “In almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining… Frequently the parties were not on speaking terms... …The second recurring obstacle involves the parties’ disinclination to think of the rights at stake… as readily commensurable with cash.” In the case where transaction costs are low, however, injunctive relief is assumed to be more efficient because it is cheaper for the court to implement and because, by making property rights clear, it is more likely to encourage negotiations Calabresi and Melamed defend injunctions as being optimal by assuming that the parties will privately negotiate after the court rules Cooter and Ulen (on their website) mention a paper by Ward Farnsworth, examining whether this occurs.[1]  Quoting: Farnsworth "examines twenty nuisance cases and finds no bargaining after judgment in any of them; nor did the parties’ lawyers believe that bargaining would have occurred if judgment had been given to the loser. Farnsworth asked the lawyers why they though that no bargaining occurred after judgment.  The lawyers cited two impediments to post-judgment bargaining. "First, in almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining.  The parties in these cases often thought that their adversaries were behaving in ways that were unreasonable, discourteous, and unneighborly.  Frequently the parties were not on speaking terms by the time the case was over (sometimes much earlier).  ...  The second recurring obstacle involves the parties’ disinclination to think of the rights at stake in these cases as readily commensurable with cash."   [1] Ward Farnsworth, “Do Parties to Nuisance Cases Bargain After Judgment?  A Glimpse Inside the Cathedral,” 66 U. Chi. L. Rev. 373 (1999). 

Sequential Rationality

But first: dynamic games and sequential rationality 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 this can work to either player’s advantage player 2 can gain by knowing his opponent’s move or, player 1 can gain by being committed to his action before his opponent

Dynamic games FIRM 1 (entrant) FIRM 2 (incumbent) Enter Don’t Enter (0, 30) Accommodate Fight (10, 10) (-10, -10) Like with static games, we need to specify the players, the actions, and the payoffs But now, what actions one player chooses among may depend on the action another player took And which action a player chooses can similarly depend on what other players have already done Dynamic games are generally presented via a game tree, where each node of the tree represents a situation where someone has to make a decision Example: suppose there is one firm already operating as a monopolist in some market, and another firm is considering entering If he does enter, than the incumbent firm has two choice: he can play nice, ensuring that both firms end up making money; or he can start a price war, ensuring that both firms end up losing money (If Firm 2 had to choose an action in either case, then his strategies would be more complicated, such as, “Accommodate if Firm 1 enters, and do X if Firm 1 does not enter”) 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”

We can put payoffs from this game into a payoff matrix… Firm 2’s Action Accommodate Fight 10, 10 -10, -10 Enter Firm 1’s Action 0, 30 0, 30 Don’t Enter We can look for equilibria like in static games: by circling best-responses to each strategy If Firm 1 believes Firm 2 will Accommodate, he chooses between Enter (10) and Don’t Enter (0) – his best response is Enter If Firm 1 believes Firm 2 will Fight, he chooses between Enter (-10) and Don’t Enter (0) – best response is Don’t Enter If 2 believes 1 will Enter, he chooses between Accommodate (10) and Fight (-10) – best response is Accommodate If 2 believes 1 will Not Enter, he gets 30 from either – so either one is a best response We find two equilibria: 1 Enters and 2 Accomodates, and 1 Does Not Enter and 2 plays Fight (or would play Fight if 1 entered) The question: are both of these reasonable? Think about the equilibrium (Don’t Enter, Fight) Firm 1 has no incentive to enter if he believes firm 2 really would fight But if firm 1 entered, firm 2 would not actually want to fight We say that “fight” here is not a credible threat, since once firm 1 had entered, firm 2 would actually be better off accommodating In a dynamic game, firm 1 might believe that if he enters, firm 2 might then choose to accommodate, since that’s in his best interest This is what’s called sequential rationality We can look for equilibria like before we find two: (Enter, Accommodate), and (Don’t Enter, Fight) question: are both equilibria plausible? sequential rationality 25 25

Dynamic games 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 FIRM 1 (entrant) FIRM 2 (incumbent) Enter Don’t Enter In dynamic games, we don’t just look for Nash equilibria: we look for a subset of Nash equilibria, called Subgame Perfect Equilibria Nash equilibrium was when every player played a best-response in the game as a whole, given the actions of the other players Subgame-perfect equilibrium is where every player plays a best-response in the game as a whole, and also in every branch of the game tree – even those that aren’t reached In the entry example, we said there were two Nash equilibria: (Enter, Accommodate), and (Don’t Enter, Fight) In the equilibrium (Don’t Enter, Fight), Fight is a best-response to Don’t Enter BUT Fight is not a best-response in branch of the game tree, once Firm 1 has already entered So (Don’t Enter, Fight) is an equilibrium, but not a subgame perfect equilibrium We look for subgame perfect equilibria by backward induction We begin at the last point in the tree where anyone takes an action… (0, 30) Accommodate Fight (10, 10) (-10, -10)

The key assumption behind subgame perfect equilibrium: common knowledge of rationality 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 here is common knowledge of rationality The players know each others’ payoff functions, everyone is rational, everyone knows everyone is rational, everyone knows everyone knows everyone is rational, and so on If you’re playing a game like this against someone who’s crazy, it’s hard to know what would happen And in fact, a “crazy” player – someone who doesn’t always do what’s best for them – might do better than a “rational” player Because if I’m crazy and I’m firm 2, you might believe that I’ll actually fight if you enter; so you might choose not to enter But if you know I’m rational, then you’re better off entering, since you know that once you enter, I won’t want to fight (Literature on repeated games with reputation, where your actions in the early stages may partly be to try to convince opponents that you’re not a rational player, and therefore that they shouldn’t try to take advantage of you in later stages.) But for us, we’ll stick to the assumption of rationality – I know that if I move first, my opponent will do whatever is in his best interest This is referred to as sequential rationality – since the players are assumed to be rational at each stage of the game

WILL ONLY GET TO HERE, AT MOST

Applications of Property Law

Intellectual Property 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 The first application we’ll consider is a non-obvious answer to the question, what can be privately owned? And this is the area of information and intellectual property Intellectual property is a broad term for ways that an individual, or a firm, (or a university) can claim ownership of information. There are four areas we’ll look at within information economics: patents; copyright; trademark; trade secrets patents copyright trademark trade secrets

Information: costly to generate, easy to imitate up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each Information: costly to generate, easy to imitate 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 The general “problem” with information is that it tends to be expensive to create, but then very cheap to disseminate once it’s been created That is, once an idea has been developed – whether it’s a technological innovation, or a song, a piece of software, or a catchy logo for a company – it is very easy to imitate or share This means that without some sort of intervention, it may be impossible for whoever developed the idea to recoup the costs – time, effort, and actual money invested – in coming up with the idea And this means that there may not be sufficient incentive to come up with ideas in the first place To see how this works, consider an example There’s a firm that has some idea for a totally new and innovative product It’s a good idea: it’s a product that will be valuable to a large number of people But it’s an idea that will take a large amount of money to develop; and it’s also an idea that, once it’s out there, will be easy for other firms to imitate (A good example of this is a new drug A huge amount of money goes into researching drugs, finding one that’s effective, testing for safety and for side effects, and so on But once a drug is released, it may be very easy for other firms to reverse-engineer it, figure out how to make it relatively cheaply, and compete with the firm that developed it. So now suppose a firm is deciding whether to make the initial investment in developing a new drug The drug will cost $1,000 to develop Monopoly profits in the market would be $2500, but if two firms are competing, then price competition would drive down profits to $250 each Only one firm has the capability to develop the drug; they move first, deciding whether or not to develop it; and then another firm moves second and decides whether to imitate it

Information: costly to generate, easy to imitate up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each Information: costly to generate, easy to imitate FIRM 1 (innovator) Innovate Don’t FIRM 2 (imitator) (0, 0) Imitate Don’t (-750, 250) (1500, 0) We can model this example as a dynamic game, and write the game tree this way: Firm 1 moves first, and chooses to innovate or not to Firm 2 moves second, and chooses whether or not to imitate firm 1’s product If firm 1 innovates and earns monopoly profits, it earns $2500, minus the up-front cost of innovation ($1000), = $1500 If firm 1 innovates and both firms enter the market, duopoly profits are $250 each, but firm 1 paid the up-front cost of $1000 to innovate If firm 1 doesn’t innovate, firm 2 has nothing to imitate, and both earn 0 profits We can solve the game by backward induction… 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)

Patents: one way to solve the problem up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each Patents: one way to solve the problem 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 FIRM 1 (innovator) Innovate Don’t FIRM 2 (imitator) (0, 0) Imitate A patent is one way to solve this problem A patent is basically a legal monopoly – a patent prevents the second firm from imitating the first firm’s product, allowing the first firm to function as a monopolist for a predetermined amount of time In the U.S., patents last 20 years from the time of application. So if the firm’s invention were be protected by a patent, the firm can count on receiving several years of monopoly profits; which may be enough to cause them to innovate in the first place. (Modify the game tree by imposing a large penalty on the imitating firm – the new SPE is now innovation.) Don’t (-750, 250 – P) (1500, 0)

BUT… patents solve one inefficiency by introducing another 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… CS P* = 50 Profit DWL A key thing to remember: monopoly is inefficient! Monopoly pricing always involves a deadweight loss, since a monopolist maximizes profits by setting price higher than marginal costs For example, suppose demand for the new drug is Q = 100 – P (DRAW IT) Suppose the monopolist has 0 marginal costs; then he sets monopoly price at 50, sells to half the market, gets profit of 2500 and generates consumer surplus of 1250 But there’s a deadweight loss of 1250 – if the drug were sold for free, it would generate total surplus of 5000 (all of it going to consumers in this case) But if the drug were going to be sold free, or cheaply, it might never have been developed in the first place So patents trade off one sort of inefficiency for another. That is, patents solve the dynamic inefficiency – not enough drugs being developed – by introducing a static inefficiency – monopoly pricing once the drug has been developed (Of course, once the innovation has occurred, the incentive problem has been solved, and the inefficiency from the monopoly remains, and can sometimes look pretty undesirable. There’s been lots of talk in recent years about the cost of AIDS drugs, most which are protected by patents. The manufacturers are pricing them high, to maximize their profits or, arguably, to recoup the investments they made to develop the drugs in the first place But it’s hard to not notice that pills which can be produced at a marginal cost of pennies are priced high enough that they are not available to much of the developing world. There have been a number of proposals to try to make them available cheaply (at cost) in developing countries, but the challenge is how to do that without undermining profits in the U.S. and Europe) P = 100 – Q Q* = 50

Patents: a bit of history 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 A little bit of history The power of Congress to legislate both patents and copyrights was actually written into the Constitution The first patent law was passed in 1790, and has been updated several times since At present, patents last for 20 years from the date of application To be approved, a patent application must satisfy three conditions they must be for something which is novel (new), non-obvious, and has practical utility (basically, is commercializable) Applications are reviewed by the patent office, which handles a huge volume and is therefore sometimes criticized for granting patents too easily In particular, in recent years, there’s been criticism that the “non-obvious” test had not been applied Amazon, for instance, was granted a patent on “one-click purchasing”, which many thought was an obvious extension of online shopping. A patentholder who feels his patent has been violated can sue both for damages already done and for an injunction, stopping the violator from future violations Thus, patents are protected both by injunctive and damages relief Patentholders are also free to license their patents to others, that is, to allow others to use them for a fee (called a royalty). When you apply for a patent, the details of your innovation go into the public record, so in some industries, firms choose not to patent new inventions, instead choosing to keep them secret.

Two variables in patent law: how broad patents are, and how long they last Patent breadth There are two important degrees of freedom in patent law: how broad a patent is, and how long it lasts The question of breadth can be thought of in a couple of different ways. First, suppose two different firms are developing distinct, but similar, products A broad patent on one of the products might cover both Thus, in a world with broad patents, the two firms might engage in a race – both try hard to develop the product very quickly, since whoever applies for the patent first will get all the gains from both products On the other hand, a narrow patent on one product might not cover the other; in which case, the firms might develop the products slower (and less expensively), knowing that both products will exist and that neither one will really have a true monopoly So the breadth of patents affects the intensity of the research effort. Another way to think of breadth is to suppose that a new product might require two distinct innovations: one “pioneering invention” that is worth little on its own, and then the subsequent development of an application, which can be sold profitably The question then is, does a patent on the original invention also cover the application? Or would separate patents be required for the pioneering invention and the application? (A similar question can be asked of whether an improvement to an existing product is patentable. The question can also be asked in other configurations.) Courts have sometimes held that an improvement with great commercial value does not infringe on a pioneering invention that had little standalone value Such rulings, of course, increase the incentives to invest in applications and improvements to existing technologies, and decrease the incentives to engage in fundamental research On the other hand, when patents on pioneering inventions are held to be broad, this encourages fundamental research but discourages new firms from attempting to commercialize existing (but unexploited) technologies Which of these is preferable depends on the details of a particular industry.

Two variables in patent law: how broad patents are, and how long they last Patent breadth As always, there is Coase – in a world without transaction costs, the initial allocation of rights should not matter for efficiency – if the patent as initially granted is inefficient, firms should be able to bargain around it (That is, as long as the initial grant of the patent gives the inventor enough surplus to overcome the initial incentive problem, Coase suggests we should be able to negotiate around any further inefficiencies.) However, there are several impediments to this. Patent law is often ambiguous Until a patent has been tested in court, its breadth (and even whether or not it is valid) are often uncertain So firms may not know what their threat points are, and therefore may find it hard to reach an agreement Research itself is often uncertain That is, if you make an investment in research or in developing a product, it is often unpredictable whether you’ll be successful Consider the extreme case where a significant investment will lead only to a small probability of a discovery, but the discovery will be extremely valuable if it occurs If the big discovery may infringe on an existing patent, it’s very hard to bargain around this problem beforehand – hard to agree on how likely the discovery is to be made, how valuable it will be, and so on But it’s also risky to make the investment, knowing that you may still have to share your profits with the other patentholder if the discovery occurs.

Two variables in patent law: how broad patents are, and how long they last Patent breadth In some areas, there is a sense that there are too many existing patents, and that it’s very difficult to innovate without infringing on existing patents In biotech, many new projects require techniques, or even ingredients, that are patented; so there is a problem of “royalty stacking”, that is, having to pay multiple monopolists for rights to their good in order to do anything new (The textbook mentions a Congressional act, and a Supreme Court ruling, meant to address this problem and encourage the development of new drugs and generic alternatives to existing ones.) On the flip side, I have a friend who does microchip design, who told me that the conventional wisdom in chip design is, “Never ever try to find out what patents exist – just design the chip the way you want to, and deal with the patents later.” This is because any design is likely to infringe on lots of patents Their owners have to decide to sue you for it to matter If they do, you may only be liable for damages But if they can prove you knew about the patent beforehand, the penalty may be more severe So you’re better off pleading ignorance, which is easier when you actually are ignorant!

Two variables in patent law: how broad patents are, and how long they last Patent breadth research being risky also leads to the problem of “submarine patents” There’s a significant lag (multiple years) between applying for a patent and it being granted; and the details of the application aren’t made public until the patent is granted So someone could develop a product that infringes on a patent that hadn’t been granted yet! For this reason, in many areas, patents are only valid if you can show that you were actively trying to commercialize the innovation, not just waiting around hoping someone else would do the work and then sue them for infringement (This is what happened in a well-publicized case with Blackberry a couple years ago. Some Canadian firm which had no real business other than buying other peoples’ patents, claimed to have a patent that Blackberry was infringing on, and tried to get an injunction to shut down Blackberry unless they agreed to a huge settlement. In most patent cases, a preliminary injunction is granted – that is, the injunction is issued in advance of the case actually going to court. In this case, the injunction was denied, and the case subsequently went away.) Of course, even when low transaction costs would lead to cooperative outcomes, this can sometimes be a problem in other ways Often times, firms doing similar research are also competitors in the market; so attempts to cooperate (through joint research projects or in other ways) may be viewed suspiciously by antitrust authorities. (A paper I wrote last year was on patent pools - … Much of the interest in patent pools stems from the need to figure out how they should be viewed by antitrust regulators.)

Two variables in patent law: how broad patents are, and how long they last Patent breadth Patent length tradeoff: how long to maintain ex-post inefficiency (monopoly) to create enough incentive for innovation? There is also the question of how long a patent should last Obviously, patents must last long enough for firms to be able to recover their investment costs, in order to give sufficient incentives for innovation But since monopolies are inefficient, having patents last too long is bad – once the patent expires, competition will drive down the price of the product, eliminating the deadweight loss. (When drug patents expire, for example, competing firms can begin selling generic versions of the same drug – the book gives an example where the price per pill dropped immediately from $15 to $1, and I think that’s pretty typical.) So the optimal length is a tradeoff between maintaining ex-post inefficiency versus creating a sufficient incentive for innovation. Clearly, the optimal level is likely to vary across different industries In the U.S., all patents last the same amount of time, 20 years Jeff Bezos, the founder of Amazon, proposed that, since innovation occurs so fast in the software industry, software patents should expire after 3 years In Germany, there are two different types of patents: full-term patents, which are granted for major inventions; and petty patents, granted for minor inventions and improvements, which last 3 years In addition, in Germany, patentholders must pay an annual fee to continue the patent, which starts out cheap but escalates over time In the U.S., patents used to be renewable under certain conditions – I believe now they are not.)

Two variables in patent law: how broad patents are, and how long they last 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 Of course, a patent system is not the only way to encourage innovation; and given the inefficiency inherent in a monopoly, there may be other ways to do it better One proposal with drug patents has been that when a particularly valuable drug is invented, the government should buy the patent, and then allow multiple firms to produce the drug, leading to lower pricing and higher overall welfare Since the government could pay the fair value (say, the discounted present value of expected monopoly profits) to the firm, there is no problem of incentives The question then becomes how to correctly calculate the economic value of the patent itself (One proposal was to let the market decide – hold an auction for the patent, with the understanding that once the auction was complete, a coin would be flipped; with a high probability, the government would buy the patent at that price, but with some probability, the winner of the auction would buy the patent This way, a decent estimate of “fair value” could be obtained, and the deadweight loss associated with monopoly could still be eliminated “most of the time”.) Another way to give incentives for innovation is through prizes A couple years ago, Google announced a $30 million prize for any private citizen landing a rover on the moon Similar prizes have been offered by governments, and by private foundations, to encourage innovation in particular directions And finally, government (or a private foundation) can simply give grants to subsidize research directly – which they do – reducing the need for ex-post incentives.

patents copyrights trademarks trade secrets

Copyright 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 Copyrights are property rights over “original expressions” – writing, music, or other artistic creations Creations like this tend to fit the definition of a public good nonrivalrous – one more person reading a book, or listening to a song, or using a piece of software, doesn’t impose any costs on the creator or on other users nonexcludable – this isn’t quite as literally true; but technology has made it very cheap, often free, to copy and share music or software, so in some instances it’s very difficult to prevent people from accessing it (This has become more dramatically true in the last decade – once something is available digitally, it’s very hard to limit access to it.) So it is natural to think of creations like these in terms of public goods As with any public good, if they are privately supplied, we would expect them to be undersupplied That is, without any specific sort of reward system, creators could not capture the full social benefit of their creations, and so the free market would likely produce an inefficiently low level of “original expressions.” However, there are several possible ways to remedy this problem: Have the government subsidize it, that is, have it publicly supplied This happens with scientific research, since scientific knowledge can also be thought of as a public good; and it happens with art Another is for these activities to be paid for with charitable donations This is implicitly what happens with shareware – you download it for free, but are asked to pay for it voluntarily if you use it (Of course there’s the usual freerider problem.) And a lot of art is supported by private foundations and donations. Finally, the creator of a song, or of a computer program, can be given legal rights to it, which make it illegal for others to disseminate it, so that in order to use it legally, people have to buy it from the creator (or from someone else who pays fees to the creator) This last one is the case of copyright – exclusive legal rights to written material.

Copyright 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 law is less rigid than patent law Patents serve as injunctions against any unauthorized use of the idea But copyright law allows for certain exceptions For example, a few lectures ago, I handed out Xerox copies of the amputated leg story The article was copyrighted, but I wasn’t breaking the law by handing out copies, because educational use is recognized as “fair use” of copyrighted material, and is therefore exempt Similarly, small selections from a book can legally be quoted in reviews, or used in satires, and pieces of songs can be sampled in other songs. On the other hand, copyrights last much longer than patents the lifetime of a copyright has been extended several times in the U.S., copyrights currently expire 70 years after the death of the creator Unlike patents, you don’t have to apply for a copyright – it automatically applies to anything you’ve written or created.

Copyright 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 Copyrights are generally more narrow than patents In theory, they cover only the specific text, not the general idea, of a creation Although this line is sometimes a bit vague In 2001, Alice Randall published the book “The Wind Done Gone,” which was meant as a retelling of “Gone With The Wind” from the point of view of a slave on Scarlett’s plantation The estate of Margaret Mitchell sued the book’s publisher; an injunction was initially issued, halting publication, but was later overturned; in the end, a settlement was reached. In this case, though, even if the book did violate the copyright, it’s hard to see any financial damage to Mitchell’s estate That is, it’s hard to imagine there are many people who would see an “unauthorized parody” as a substitute for the original; hard to imagine a lot of people who planned to buy a copy of Gone With The Wind, then read the parody and felt they no longer needed to. In my own opinion, copyright holders sometimes defend their copyright aggressively as a reflex, without giving much thought to whether the activity they’re opposing actually hurts their interests Lots of book publishers were opposed to Google Book Search, which would allow people to search the text of books, but would only return the relevant paragraph, not the whole work Again, it’s hard to imagine that searching for a phrase or an idea, and finding it contained in a book you didn’t know about, would make you less likely to buy that book; yet the publishers felt some instinctive need to oppose the idea (Google Book Search is now mostly limited to books in the public domain, that is, works whose copyrights have expired or which are not protected by copyright for other reasons.) A similar argument could be made about the well-publicized RIAA lawsuits against music downloaders (There is little doubt that unlicensed copying of music does violate copyright; there is less clarity that treating potential customers as criminals is the best long-term strategy for the music and movie industries.)

Copyright 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 (Commenting on the lengthening of copyright life, Cooter and Ulen comment that technology has made it easier to avoid paying copyright royalties, and that the lengthening of copyright therefore “allows creators a longer time to recoup their just royalties.” I wince at the use of the word “just” They seem to be implying that intellectual property protection is somehow the natural state of the world, or a moral imperative, that these rights are somehow inherent and deserved People forget sometimes that the protection of intellectual property is artificial, a man-made legal creation Copyright holders lobby for strengthening copyright law because that’s in their own financial interest, just like patentholders lobby for stronger patent protection because it’s in their interest There may be many good reasons for an author to have certain exclusive rights to their own work, but these rights are a calculated invention, not a natural or moral entitlement.) Separate from that, one could wonder whether the royalties received between, say, year 40 and year 70 after your own death really enter into one’s calculations when deciding how much time to invest in writing a book or a song so if we see copyrights, like patents, as existing mainly to give an incentive for creation, it may be hard to argue there’s an added benefit in having them last this long

patents copyrights trademarks trade secrets

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 Probably less controversial than patents and copyrights are trademarks This is protection for brand names, as well as distinctive commercial symbols such as McDonald’s golden arches and Nike’s swoosh Trademark protection prevents competitors from putting the same mark on their products; thus, it helps establish who a product is made by, allowing consumers to rely on a firm’s or a product’s reputation for quality To put it another way, when competing products are indistinguishable from each other, or when producers deliberately make it unclear whose product is whose, producers don’t have much incentive to make better products, since they won’t be rewarded with higher sales By certifying the identity of a particular brand of product, trademarks give firms more of an incentive to create higher-quality goods; and they give consumers less uncertainty about the goods they’re buying. Unlike other forms of intellectual property, trademarks last forever, unless they are abandoned Makes some sense – unlike patents and copyrights, there doesn’t seem to be the same tradeoff of long-term incentives versus short-term inefficiency.

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 – for example, nobody can trademark the word “camera”, and sue anyone else who advertises a product called a camera Sometimes, this goes in the other direction: occasionally, a brand-name product is so successful that their name becomes synonymous with the product “Kleenex,” “Xerox,” “Scotch tape,” and “Band-Aid” are all commonly used to refer to generic products The name “Aspirin” was once the name of acetacylicilic acid sold by the Sterling Drug Company; in 1921, a federal court ruled that the name had become the common word for the drug, and other companies were allowed to start using the term “aspirin.” (Bayer currently holds a trademark on the word “aspirin” in Mexico and Canada, where nobody else can sell a product with that name.) The book also talks about a program by Coca-Cola, which employs 25 “investigators” who order Coke all over the place and analyze what they’re given, in an effort to ensure that people don’t start using the term to refer to any generic soda and destroy the trademark

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 Protected against infringement and also dilution In 1989, when Toyota introduced the Lexus name (L-E-X-U-S), they were sued by Lexis (L-E-X-I-S), a company that provides searches of legal sources (now Lexis-Nexis, which those of you who go to law school will get to know quite well) The court ruled for the car company, saying they were not infringing. The first time I taught this class, I stumbled on an article that for the second time in a year, Toyota was suing a porn star who’s adopted the stage name “Lexus” Taken together, these seem to suggest that Toyota believes that: you are unlikely to mistake a luxury car for an online legal search but you might mistake a luxury car for gay porn Of course, this isn’t really what they’re claiming Obviously, trademark law prohibits someone else from selling a soft drink called Coca-Cola Less obviously, it also prohibits someone else from selling, say, a clothing line or a sandwich meat called Coca-Cola The legal doctrine here is “dilution of the distinctive quality of a mark or trade name,” which can be claimed even in “the absence of competition between the parties or the absence of confusion as to the source of goods or services.” That is, once you’ve established a brand name, people can’t use it in a way that hurts its image, even if it doesn’t create genuine confusion about whose products are whose. The economic argument for trademark protection seemed pretty clear – reduce buyer uncertainty, increase seller incentives to maintain a reputation for quality The argument against trademark dilution is a bit harder – seems more to be protecting vested interest But I thought it was interesting

patents copyrights trademarks trade secrets

Trade Secrets Protection against misappropriation But plaintiff must show… Valid trade secret Acquired illegally Reasonable steps taken to protect it The final type of legal protection for information is the protection of trade secrets A trade secret is any information "used in one's business" that gives its owner "an opportunity to obtain an advantage over competitors who do not know or use it." For instance, the exact formula for Coca-Cola or for the Big Mac “special sauce” are supposedly closely-guarded trade secrets In order to charge someone with misappropriating a trade secret, I have to show three things: One, that it is a valid trade secret, that is, that it is commercially valuable, and that it was not already commonly known throughout the industry. Two, that they acquired it illegally. Buying my product and reverse-engineering how I built it is not illegal. However, breaking into my lab and stealing my notes is. Three, that I took reasonable steps to protect it. Trade secrets behave like property – they can be transferred or sold The protection does not expire, as long as the secret remains a secret Trade secret protection is limited, however Suppose my firm hires an engineer to work on a secret project, and I have him sign a non-disclosure agreement, agreeing not to disclose my secrets After a while, he quits, and begins working for my competitor If he reveals my secrets to them, I can sue him for breach of contract But if my competitor did not know about the contract, I have no recourse against them, and now they have my secret. (Nondisclosure agreements tend to be difficult to enforce. Particularly in Silicon Valley, where people change jobs very frequently, trade secret protection is not felt to be particularly effective. Silicon Valley vs 128 Corridor. Kozmo/Urbanfetch)

patents copyrights trademarks trade secrets

Wednesday… Methods of public ownership How are property rights established, verified, lost Exceptions and limitations to property rights