1. Professor Jonathan Masur The Law & Economics of Information

2. Contact Information jmasur@uchicago.edu (773) 702-5188 Office #405

3. Class 1 – July 18, 2016 Information, Property, and Incentives to Innovate

4. Information Knowledge about the world – Information about individuals and their interests – Information about the world at large (for instance, scholarly research) Innovations – New artistic creations (books, movies) – New innovations (iPhones, computers, new pharmaceutical drugs)

5. Information as Public Good Knowledge, ideas, and creative are public goods, like parks.

6. IP as Public Good A public good is: – Non-rivalrous: we can all use it – Non-excludable: I can’t stop you from using it Ideas and creative works are public goods – We can all read Harry Potter or use iPhones at the same time – Once the work or idea is posted somewhere, I can’t stop you from using it Society will tend to produce too few public goods – If no one can capture the full value of the good, no one has the proper incentives to produce it

7. IP as Public Good Basically a collective action problem – Collectively, we’d all be better off if we had more public goods – But no one of us has the incentives to produce them – And it’s hard to coordinate I can’t write a contract with every other Harry Potter reader in the world – Without the means to coordinate, the public good goes unproduced

8. Public Goods and Free-Riding The problem is free-riding – Company A expends resources to invent something – Company B copies the invention and sells the same thing, but without expending the same resources to invent

9. Public Goods and Free-Riding The problem is that if Company B doesn’t have to expend resources on information (research & development), it can undersell Company A

10. Public Goods and Free-Riding Suppose it costs Company A $1 million to invent a pharmaceutical drug – Each individual pill costs $1 to manufacture – Company A expects to sell 1 million pills – Company A will have to sell the pills at $2/pill to recoup its costs: ($1 million + $1/pill x 1 million pills)/1 million pills = $2/pill But if Company B can just copy Company A’s invention, it can sell the pills for $1/pill – That’s what it costs to manufacture each pill

11. Public Goods and Free-Riding Another way of saying this: – Each company has to sell at “average cost,” not “marginal cost” – Marginal cost is what it costs to produce one more pill: $1 dollar – Average cost is what it costs to produce each pill, if you include the initial R&D costs For Company A, average cost = $2/pill because they spent $1 million on R&D For Company B, average cost = marginal cost = $1/pill because there is no initial R&D cost

12. Public Goods and Free-Riding The result: – Company A sells for $2/pill – Company B sells for $1/pill What consumer would ever buy from Company A? – That means that Company A will never recoup its initial research and development costs – If Company A is thinking ahead, that means it will never try to invent the drug in the first place (because it will just lose money) As a result, the drug will never exist, and consumers will never benefit from it

13. IP and Free-Riding The same issue exists with respect to copyright for creative works. It costs money to make a movie. No incentive to create it if another company can sell it for less.

14. Public Goods Solutions Two typical solutions to the public good problem: 1.Have government produce the good a)It’s often the government that builds parks, roads, etc. b)And sure enough, we see government doing a lot of R&D to produce inventions c)DARPA, NIH, NSF, etc. d)But do you want to consume movies made by the government? 2.Propertize the public good a)Give someone ownership of the park and let them charge admission b)Give someone ownership of the idea

15. Intellectual Property In the United States, we use both solutions Some information-production is government-funded and paid for through taxes – Direct government research; government grants; public universities; etc. But most of the information production is done privately and becomes subject to property rights – Person who creates or discovers information owns the right to control it – Will internalize all the costs and benefits of producing that information – Will lead to efficient levels of information production This is Intellectual Property (IP)

16. What is Intellectual Property (IP)? 1.Patents: property over inventions or ways of performing useful processes – The airplane, a method for making rubber, the email feature on a smartphone

17. What is Intellectual Property (IP)? 2. Copyrights: property over artistic or literary works – Books, movies, songs, video recordings

18. What is Intellectual Property (IP)? 3. Trademarks: property over commercial brands and symbols – Names and symbols of companies and products

19. What is Intellectual Property (IP)? 4. Trade Secrets: inventions and processes that are kept secret – Secret formulas, ways of doing business, computer code

20. IP and Free-Riding IP solves the free-riding problem – If Company A gets a patent on the drug, it can block Company B from selling it – Company A can then charge a price that will allow it to recoup its costs without fear of being undersold by Company B Much more on the prices charged by IP owners later today and tomorrow – This will lead Company A to do more research, create more drugs IP => greater creation and innovation

21. How to Test the Effects of IP? Well-understood theoretically – Harder to get at empirically – Requires asking the counterfactual question: how much creation & innovation would there be if the laws were different? – Counterfactuals are hard to investigate because they don’t exist! Even when the law has changed, hard to isolate the effect – Suppose U.S. changes its patent law. Innovation increases. – Was the legal change cause or effect? – Or neither? Was there some separate (exogenous) change in the world that caused the increase?

22. How to Test the Effects of IP? Solution: – Look for natural experiments – Situations in which two jurisdictions have similar laws, then one changes – Use this change in one and only one to isolate the effect of IP Hard to do in patent law – Patent rules are largely uniform across the world – But differences exist in copyright law that can be exploited – Petra Moser study on copyright in Italian opera

23. Copyright and Opera

24. The Downside to IP All of this is the good news. IP creates incentives to produce more inventions and creative works. – Call this the “dynamic efficiency” rationale for IP But there is a very significant downside to IP as well – Granting an IP right makes the right-holder a monopolist Only JK Rowling can sell copies of Harry Potter Only Pfizer can make Viagra – This allows the rights-holder to raise the price Remember: this is precisely the point of IP! – But that will squeeze some consumers out of the market

25. A Competitive Firm Prices at Cost Price Quantity

26. Monopolist Pricing A monopolist is trying to maximize total profit – Total profit = (price – marginal cost) × quantity – But quantity declines as price increases – We’re using a linear demand curve – For our demand curve, quantity = - price + a a is just a constant – So, Total profit = (price – marginal cost) × (-price + a) – Total profit = - price 2 + (price × marginal cost) + (a × price) – a × marginal cost

27. Monopolist Pricing Now we need to maximize total revenue Maximization: take derivative, set = 0 Total profit = - price 2 + (price × marginal cost) + (a × price) – a × marginal cost d(Total profit)/d(Price) = -2(price) + mc + a Set derivative = 0: 0 = -2(price) + mc + a Price = (mc + a)/2

28. Monopolist Pricing Another way of saying the same thing: Monopolist sets marginal revenue = marginal cost – Meaning: it doesn’t want to lose money by selling an additional unit (if marginal revenue – marginal cost < 0) – We could calculate marginal revenue in much the same way Bottom line: a monopolist is going to set a higher price than a firm in a competitive market

29. Monopolist Sets a Higher Price Price Quantity

30. Higher Profits, But Deadweight Loss Price Quantity

31. Monopolist Pricing This higher price leads to producer surplus It also produces “deadweight loss” – Deadweight loss is inefficiency caused when a transaction that would be beneficial to both parties doesn’t occur – There are people who want to buy the patented or copyrighted good for more than its marginal cost – Those would be efficient transactions because they would make both producer and consumer better off – But they won’t happen because the price of the good is too high

32. Higher Profits, But Deadweight Loss Price Quantity

33. Monopolist Pricing The amount of surplus that is lost is the deadweight loss If the monopoly price of the good is substantially higher than the marginal cost, deadweight loss can be substantial – This is a severe economic negative – Called a “static inefficiency” – in equilibrium, people who want to buy a good cannot purchase it This deadweight loss represents the main downside of IP – In designing an IP system, must strike a balance between dynamic efficiency (incentives to innovate and create) and static inefficiency (deadweight loss)

34. Empirical Measures of Deadweight Loss Challenging to empirically examine the degree of deadweight loss – Have to know how many people would consume the product if the price were different One way to investigate empirically is to look at availability of products incorporating ideas that are protected or not protected by property rights – Lapse in protection can lead to wider dissemination, reduced deadweight loss – When copyright on a book lapses, what is the result?

35. Empirical Measures of Deadweight Loss

36. IP Design The existence of deadweight loss means that we don’t just want to give IP rights for everything – Every time someone acquires IP, there will be monopoly pricing and thus deadweight loss – We want to be judicious in where we award IP Theory: award IP rights only where necessary to incentivize innovation – IP comes with a cost (deadweight loss) – Make sure that the benefit (innovation) outweighs that cost

37. IP Design Theory: award IP rights only where necessary to incentivize innovation Remember, the original problem with IP was free-riding: – Company A creates, then Company B free-rides off of that creation, takes the idea, copies it, and undersells Company A – The fact that Company B doesn’t have to expend resources in creating is what causes the problem This allows Company B to undersell Company A

38. IP Design Because of this, we care about two separate costs: 1.The original cost of creating/inventing a)The higher this cost, the greater the free-riding problem b)But if creation is easy/cheap, we may not need IP 2.The cost of copying a)The lower this cost, the greater the free-riding problem b)But if copying is very costly, we may not need IP

39. High Creation Costs? Some types of IP are very costly to create.

40. Low Creation Costs? Others might be much less expensive.

41. High Copying Costs? Some forms of IP are hard to copy.

42. High Copying Costs? Others are much cheaper.