Econ 522
Economics of Law
Dan Quint
Fall 2013
Lecture 8
Logistics
 Second homework due next Thursday (Oct 10)
 First midterm October 23
 Interesting talk this Thursday



Jonathan Gruber, MIT, will be giving the Weisbrod Lecture:
“Health Care Reform: What It Is, Why It’s Necessary, How It Works”
This Thursday 10/3, 3:45 p.m., Union South Marquee Theater
1
Discussion question
(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-yearold 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?
2
Sequential
Rationality
3
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
4
Let’s go back to a game we’ve seen – the
Battle of the Sexes
Player 1
Player 2
Ballgame
Opera
Ballgame
6, 3
0, 0
Opera
0, 0
3, 6
 Now change the game so that player 1 moves first
 Player 1 goes somewhere
 Player 2 learns what 1 did, then decides where to go
5
Dynamic games are typically shown as
“game trees”
PLAYER 1
Ballgame
Opera
PLAYER 2
Ballgame
(6, 3)
PLAYER 2
Opera
(0, 0)
Ballgame
(0, 0)
Opera
(3, 6)
 A strategy is one player’s plan for what to do at each decision
point he/she acts at


Player 1: “Ballgame” or “Opera”
Player 2’s strategy is more complicated – can depend on P1’s choice
6
We can expand the matrix to accommodate
Player 2’s additional options
Player 1
Player 2
Ballgame,
Ballgame
Ballgame,
Opera
Opera,
Ballgame
Opera,
Opera
Ballgame
6, 3
6, 3
0, 0
0, 0
Opera
0, 0
3, 6
0, 0
3, 6
 Player 2 has four options




“Go to the ballgame no matter what”
“Go to the ballgame if P1 went to the ballgame, otherwise opera”
“Opera if P1 went to the ballgame, otherwise ballgame”
“Opera no matter what”
7
We can solve this game for equilibrium in
the “usual” way
Player 1
Player 2
Ballgame,
Ballgame
Ballgame,
Opera
Opera,
Ballgame
Opera,
Opera
Ballgame
6, 3
6, 3
0, 0
0, 0
Opera
0, 0
3, 6
0, 0
3, 6
 Three equilibria:
 1 goes to ballgame, 2 plays “ballgame no matter what”
 1 goes to ballgame, 2 plays “do what 1 did”
 1 goes to opera, 2 plays “opera no matter what”
 Are all of these “reasonable”?
8
Are all these equilibria “reasonable”?
 Consider the equilibrium where


player 2 plans to go to the opera no matter what
player 1 therefore goes to the opera
 Player 1 might wonder…




“Suppose I changed my mind and went to the ballgame.
Once I’m there, player 2 has to choose between sticking to the plan,
going to the opera, and getting 0…
…versus following me to the ballgame and getting 3.
If player 2 is rational and I go to the ballgame, she should follow me
there, and I’ll end up with a payoff of 6!”
9
Sequential rationality
 Sequential rationality is when a player can count on the
other players to behave rationally from that point forward

Similar to “dynamic consistency” (macro)
 When an equilibrium satisfies sequential rationality, we call
it a Subgame-Perfect Equilibrium



Players play best-responses both in the game as a whole, and in
each “subgame,” or part of the game
Rules out the opera-opera equilibrium: in the subgame where P1 had
already gone to the ballgame, P2 wasn’t playing a best-response
In fact, P2 only has one strategy that is sequentially rational: do
whatever player 1 did!
10
Subgame Perfect Equilibria are found by
Backward Induction
PLAYER 1
Ballgame
Opera
PLAYER 2
Ballgame
(6, 3)
PLAYER 2
Opera
(0, 0)
Ballgame
(0, 0)
Opera
(3, 6)
 Start at the “bottom,” solve for what P2 would do at each point
 If P2 is rational and P1 knows it, P1 can infer what payoff he
would get from each move
 Now figure out what P1 would do, given those payoffs
11
Subgame Perfect Equilibria are found by
Backward Induction
PLAYER 1
Ballgame
Opera
PLAYER 2
Ballgame
(6, 3)
PLAYER 2
Opera
(0, 0)
Ballgame
(0, 0)
Opera
(3, 6)
 This game has a unique subgame-perfect equilibrium


Player 1 plays Ballgame
Player 2 plays Ballgame if 1 plays Ballgame, Opera if 1 plays Opera
 “Most” dynamic games have just one SPE
12
Moving first can be good or bad, depending
on the game
 Battle of the sexes: moving first is good




You know your partner will accommodate whatever you do…
…so you get your first choice
Some games: being able to “commit” to a decision, while your
opponent still has to decide, can be good!
(Another example: entry game)
 Scissors-paper-rock: moving first is terrible


You always lose
Some games: reacting to your opponent’s move is good!
13
When we look at dynamic games, we’ll always
look only at subgame-perfect equilibrium
 Key assumption: common knowledge of rationality



Player 1 knows player 2 is rational…
…so whatever he does, she’ll do what’s best for her…
…so player 1 can confidently go to the ballgame
 This is the key to sequential rationality



The assumption that, whatever happens first, players will continue
to act rationally in their own best interest
Which means we can “solve the game” from the end, and figure
out the beginning players’ optimal moves
(Backward induction has been used to solve checkers, and will
eventually solve chess!)
14
Intellectual Property
patents
copyrights
trademarks
trade secrets
15
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
16
Information: costly to generate,
easy to imitate
up-front investment: 1,000
monopoly profits: 2,500
duopoly profits: 450 each
 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
17
Information: costly to generate,
easy to imitate
up-front investment: 1,000
monopoly profits: 2,500
duopoly profits: 450 each
FIRM 1 (innovator)
Don’t
Innovate
FIRM 2 (imitator)
(0, 0)
Imitate
(-550, 450)
Don’t
(1500, 0)
 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)
18
up-front investment: 1,000
monopoly profits: 2,500
duopoly profits: 450 each
Patents: one way to solve
the problem
 Patent: legal monopoly

Other firms prohibited from imitating Firm 1’s discovery
FIRM 1 (innovator)
Don’t
Innovate
FIRM 2 (imitator)
(0, 0)
Imitate
(-550, 450)
Don’t
(1500, 0)
450 – P
 Subgame perfect equilibrium: firm 2 does not imitate;
firm 1 innovates, drug gets developed
19
Comparing the two outcomes
up-front investment: 1,000
monopoly profits: 2,500
duopoly profits: 450 each
FIRM 1 (innovator)
FIRM 2 (imitator)
Innovate
Don’t
Without patents:

Drug never
discovered
(0, 0)
Imitate
(-550, 450)
Don’t
(1500, 0)
FIRM 1 (innovator)
 With patents:


Drug gets
discovered
But…
FIRM 2 (imitator)
Innovate
Don’t
(0, 0)
Imitate
(-550, 450 – P)
Don’t
(1500, 0)
20
Patents solve one inefficiency
by introducing another
up-front investment: 1,000
monopoly profits: 2,500
duopoly profits: 450 each
 Without patents, inefficient outcome: drug not developed
 With patents, different inefficiency: monopoly!
Monopoly
Net Surplus = 2,750
P = 50
Duopoly
Net Surplus = 3,950
CS
1,250
Profit
2,500
CS
4,050
P = 100 – Q
DWL
1,250
Q = 50
P = 10
Profit 450 x 2
DWL
50
Q = 90
 Once the drug has been found, the original incentive
problem is solved, but the new inefficiency remains…
21
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
22
Patent breadth
 Narrow patents might allow us each to patent own invention
 Broad patents might not

“Winner-take-all” race to be first
23
Patent breadth
 Does a patent on the “pioneering invention” cover the
application as well?
 Can you patent an improvement to an existing product?
24
Patent length
 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
25
Marginal Revolution (blog):
“Patent Policy on the Back of a Napkin”
“Patent Policy on the Back of a Napkin”
(Marginal Revolution)
New York Times last fall
 “Last year, for the first time,
spending by Apple and Google
on patent lawsuits and unusually
big-dollar patent purchases
exceeded spending on research
and development of new
products”
 (“The Patent, Used as a Sword”,
10/7/2012)
26
Do the details matter?
 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
27
Do the details matter?
 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
28
Do the details matter?
 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
29
Alternatives to patents for encouraging
innovation
 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
30
patents
copyrights
trademarks
trade secrets
31
Copyright
 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
32
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
33
Copyright
 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?
34
Copyright
 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?
35
patents
copyrights
trademarks
trade secrets
36
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
37
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 topgrossing 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”
http://online.wsj.com/article/SB10001424052748704285104575492650336813506.html
38
Trademark dilution
39
patents
copyrights
trademarks
trade secrets
40
Trade Secrets
 Protection against misappropriation
 But plaintiff must show…



Valid trade secret
Acquired illegally
Reasonable steps taken to protect it
41
patents
copyrights
trademarks
trade secrets
42
How do you establish, verify,
or give up property rights?
(probably won’t get to this)
43
When should resources become privately
owned?
 We already saw two doctrines for how ownership rights are
determined – First Possession and Tied Ownership
 Next question: when should a resource become privately
owned?



Cost of private ownership: owners must take steps to make the
resource excludable – boundary maintenance
Cost of public ownership: congestion and overuse
An economically rational society will privatize a resource at the
point in time where boundary maintenance costs less than the
waste from overuse of the resource.
44
When should resources become privately
owned?
 We already saw two doctrines for how ownership rights are
determined – First Possession and Tied Ownership
 Next question: when should a resource become privately
owned?



Cost of private ownership: owners must take steps to make the
resource excludable – boundary maintenance
Cost of public ownership: congestion and overuse
An economically rational society will privatize a resource at the
point in time where boundary maintenance costs less than the
waste from overuse of the resource.


(either because congestion got worse…
or because boundary maintenance became cheaper)
45
How do you give up (or lose) property
rights?
 Adverse Possession (“squatter’s rights”)



If you occupy someone else’s property for long enough, you
become the legal owner, provided:
1. the occupation was adverse to the owner’s interests, and
2. the owner did not object or take legal action
46
How do you give up (or lose) property
rights?
 Adverse Possession (“squatter’s rights”)





If you occupy someone else’s property for long enough, you
become the legal owner, provided:
1. the occupation was adverse to the owner’s interests, and
2. the owner did not object or take legal action
Pro: clear up uncertainty over time; allow land to be put to use
Con: owners must incur monitoring costs to protect property
47
How do you give up (or lose) property
rights?
 Adverse Possession (“squatter’s rights”)





If you occupy someone else’s property for long enough, you
become the legal owner, provided:
1. the occupation was adverse to the owner’s interests, and
2. the owner did not object or take legal action
Pro: clear up uncertainty over time; allow land to be put to use
Con: owners must incur monitoring costs to protect property
 Estray statutes – laws governing lost and found property
48