Econ 522
Economics of Law
Dan Quint
Fall 2012
Lecture 7
Monday…
 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)
1
Our experiment…
 Take 1: Full Information (values on nametags)
starting
allocation
efficient
allocation
actual final
allocation
12
red chip
purple chip
10
purple chip
purple chip
10
purple chip
purple chip
purple chip
red chip
purple chip
purple chip
60
56
8
red chip
8
6
fraction of potential
gains realized
purple chip
6
4
purple chip
4
purple chip
2
purple chip
32
24/28 = 86%
2
Our experiment…
 Take 2: Private Information (values hidden)
starting
allocation
efficient
allocation
actual final
allocation
10
red chip
purple chip
8
purple chip
red chip
8
purple chip
purple chip
6
red chip
6
4
fraction of potential
gains realized
purple chip
purple chip
purple chip
purple chip
4
3
purple chip
3
purple chip
2
purple chip
24
purple chip
48
42
18/24 = 75%
3
Our experiment…
 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
4
Conclusion
 Coase works reasonably well, but not perfectly

Full info: 86% of gains achieved

Private info: 75%

Uncertainty: 67%

Asymmetric info: 70%
5
Comparing pure uncertainty to asymmetric
information
 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!
6
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?
7
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?
8
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
9
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?
10
Fugitive property
 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”?)
Hammonds
Central KY
11
Two principles for establishing ownership
 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
12
First Possession versus Tied Ownership
 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
Firm 2
Firm 1

Slow
Fast
Slow
45, 45
20, 50
Fast
50, 20
25, 25
13
First Possession versus Tied Ownership
 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
2
but, difficulty of establishing andFirm
verifying
ownership rights
Firm 1

Slow
Fast
Slow
45, 45
45, 25
Fast
25, 45
25, 25
14
This brings us to the following tradeoff:
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.
15
We’ve already seen two examples of this
 “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
16
Another nice historical example: the
Homestead Act of 1862
 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
17
Friedman on the Homestead Act of 1862
“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 1890. 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.
18
Friedman on the Homestead Act of 1862
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.”
19
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?

(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
20
Sequential
Rationality
21
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
22
Dynamic games
FIRM 1 (entrant)
FIRM 2
(incumbent)
Don’t Enter
Enter
(0, 30)
Accommodate
(10, 10)
Fight
(-10, -10)
 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”
23
We can put payoffs from this game into a
payoff matrix…
Firm 1’s Action
Firm 2’s Action
Accommodate
Fight
Enter
10, 10
-10, -10
Don’t Enter
0, 30
0, 30
 We can look for equilibria like before
 we find two: (Enter, Accommodate), and (Don’t Enter, Fight)
 question: are both equilibria plausible?
 sequential rationality
24
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)
Don’t Enter
Enter
(0, 30)
Accommodate
(10, 10)
Fight
(-10, -10)
25
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
26
Applications of
Property Law
27
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
28
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
29
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)
30
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
31
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)
32
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…
33
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
34
Patent breadth
 Narrow patents might allow us each to patent own invention
 Broad patents might not

“Winner-take-all” race to be first
35
Patent breadth
 Does a patent on the “pioneering invention” cover the
application as well?
 Can you patent an improvement to an existing product?
36
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
37
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
38
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
39
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
40
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
41
patents
copyrights
trademarks
trade secrets
42
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
43
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
44
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?
45
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?
46
patents
copyrights
trademarks
trade secrets
47
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
48
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
49
Trademark dilution
50
patents
copyrights
trademarks
trade secrets
51
Trade Secrets
 Protection against misappropriation
 But plaintiff must show…



Valid trade secret
Acquired illegally
Reasonable steps taken to protect it
52
patents
copyrights
trademarks
trade secrets
53