Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 7

1  Established properties of an efficient property law system  Private goods are privately owned, public goods are not  Owners have maximum liberty over how they use their property  Injunctive relief used when transaction costs are low, damages used when transaction costs high  We also gave some thought to “testing Coase”  In-class experiment: can UW undergrads allocate poker chips efficiently?  (Cost me $118) Last Wednesday…

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

3  Take 2: Private Information (values hidden) Our experiment… 20/24 = 83% purple chip red chip6 purple chip 8 8 red chip 10 fraction of potential gains realized actual final allocation efficient allocation starting allocation

4  Take 3: Uncertainty  Take 4: Adverse Selection Our experiment… 100%12 8 chip 2 X die roll (actually 8) chip 3 X die roll (actually 12) fraction of potential gains realized actual final allocation efficient allocation starting allocation 100%664 chip 2 X die roll (actually 4) chip 3 X die roll (actually 6) fraction of potential gains realized actual final allocation efficient allocation starting allocation

5  So…  Coase seems to work pretty well  My guess: if we redid the asymmetric information case a bunch of times, we wouldn’t get trade very often  Comparing “uncertainty” to “asymmetric info”…  Seller’s value was 2 X die roll, buyer’s value was 3 X die roll  If nobody knows die roll, no problem – they can trade based on the expected value  But if seller knows die roll, problem  In strategic settings, information can have negative value – the seller could be worse off for having information! Our experiment…

6 Sequential Rationality

7  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

8 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”

99  We can look for equilibria like before  we find two: (Enter, Accommodate), and (Don’t Enter, Fight)  question: are both equilibria plausible?  sequential rationality  firm 1 asks, “once I’ve entered, would he really choose to fight?” We can put payoffs from this game into a payoff matrix… 10, 10-10, -10 0, 30 AccommodateFight Enter Don’t Enter Firm 2’s Action Firm 1’s Action

10 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

11  Firm 1 knows firm 2 is rational  So he knows that if he enters, firm 2 will do the rational thing – accommodate  So he enters, counting on firm 2 to accommodate  This is the idea of sequential rationality – the assumption that, whatever I do, I can count on the players moving after me to behave rationally in their own best interest The key assumption behind subgame perfect equilibrium: common knowledge of rationality

12 Applications of Property Law

13  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

14  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

15  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

16  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

17 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…

18  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

19  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

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

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

22  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

23  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?

24  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?

25  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?

26  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

27 patents copyrights trademarks trade secrets

28  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

29  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

30  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

31  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

32 patents copyrights trademarks trade secrets

33 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

34 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”

35 Trademark dilution

36 patents copyrights trademarks trade secrets

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

38 patents copyrights trademarks trade secrets