Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 7

1  Established some more properties of an efficient property law system (Calabresi and Melamed)  Injunctive relief used when transaction costs are low, damages used when transaction costs high  Inalienability may make sense for goods with substantial externalities  We tried “testing Coase” through an experiment  Can UW undergrads reallocate poker chips efficiently?  (Cost me $133) Monday…

2  Take 1: Full Information (values on nametags) Our experiment… 24/28 = 86% purple chip red chip8 purple chip 10 purple chip 10 red chip12 fraction of potential gains realized actual final allocation efficient allocation starting allocation red chip

3  Take 2: Private Information (values hidden) Our experiment… 18/24 = 75% purple chip red chip6 purple chip 8 red chippurple chip8 red chip10 fraction of potential gains realized actual final allocation efficient allocation starting allocation

4  Take 3: Uncertainty  Two of three chips got sold, at prices around $8  Rolled three 1s, so buyers lost money, but trade was still efficient…  …and we achieved two-thirds of gains from trade  Take 4: Asymmetric Information  Rolled 5, 3, and 2  Two of the chips (the 5 and the 2) got sold  70% of the gains from trade were realized  (And even that surprised me!)  But the buyer of the 2 lost money Our experiment…

5  Coase works reasonably well, but not perfectly  Full info: 86% of gains achieved  Private info: 75%  Uncertainty: 67%  Asymmetric info: 70% Conclusion

6  Consider a seller in the last two cases  Your value = 2 x die roll, EV = $7.00  If you know nothing…  Trade at some price between $7 and $10.50  Expected payoff might be $8 or $9  If you know value exactly…  Asymmetric information might stop you from being able to sell  If so, expected payoff is $7  So information has negative value! Comparing pure uncertainty to asymmetric information

7 (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

8 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?

9  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?

10 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?

11  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

12  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

13  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

14  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

15 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:

16  “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

17  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

18 “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

19 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

20  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?

21 Sequential Rationality

22  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 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  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 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  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 Applications of Property Law

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  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?

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  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

42 patents copyrights trademarks trade secrets

43  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

44  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

45  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

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 patents copyrights trademarks trade secrets

48 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

49 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”

50 Trademark dilution

51 patents copyrights trademarks trade secrets

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

53 patents copyrights trademarks trade secrets