Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 6
Announcements
 HW1 due at 11:59 p.m. tomorrow
night on Learn@UW
 ESA event tomorrow,
6 p.m. in Grainger 5120
1
Announcements
 HW1 due at 11:59 p.m. tomorrow
night on Learn@UW
 ESA event tomorrow,
6 p.m. in Grainger 5120
 Low-cost LSAT course through
UW Law (March 3-18)
http://www.prelaw.wisc.edu/
 Info session for Washington DC
Semester in International Affairs
today at 4, 206 Ingraham
2
Our story so far on property law…
 Coase

Absent transaction costs, if property rights are complete and
tradable, we’ll get efficiency through voluntary negotiation
 Two normative approaches to the law:


Normative Coase: aim to minimize transaction costs
Normative Hobbes: aim to allocate rights efficiently (or minimize
the need for bargaining/trade)
 How to choose between two normative approaches?


When transaction costs are low and information costs high, design
law to minimize transaction costs
What transaction costs are high and information costs are low,
design law to allocate rights efficiently
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One application of this: choosing a remedy
for property rights violations
 Injunctive relief: court clarifies right, bars future violation;
violations are punished as crimes (but right is tradable)
 Damages: court determines how much harm was done by
violation, awards payment to injuree
 Coase: should be equally efficient if there are no transaction
costs
 But in “real world”, which is more efficient?
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Calabresi and Melamed
Transaction costs high…
Transaction costs low…

difficult for parties to reassign
rights through negotiations

easy for parties to reassign
rights

injunction would force injurer to
prevent harm himself


damages rule allows injurer to
prevent harm or pay for it,
whichever is cheaper
injunctions cheaper for court
to implement (doesn’t need to
calculate damage done)

when transaction costs are
low, injunctive relief is
typically more efficient

when transaction costs are
high, damages rule is
typically more efficient

“liability rule”

“property rule”
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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?
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Public versus Private Goods
Private Goods



rivalrous – one’s consumption
precludes another
excludable – technologically
possible to prevent
consumption
example: apple
Public Goods

non-rivalrous

non-excludable

examples



defense against nuclear
attack
infrastructure (roads, bridges)
parks, clean air, large
fireworks displays
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Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
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Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
 When public goods are privately owned, they tend to be
underprovided/undersupplied
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Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
 When public goods are privately owned, they tend to be
underprovided/undersupplied
 Efficiency suggests private goods should be privately
owned, and public goods should be publicly
provided/regulated
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Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
 When public goods are privately owned, they tend to be
underprovided/undersupplied
 Efficiency suggests private goods should be privately
owned, and public goods should be publicly
provided/regulated
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A different view: transaction costs
 Clean air




Large number of people affected  transaction costs high
 injunctive relief unlikely to work well
Still two options
One: give property owners right to clean air, protected by damages
Two: public regulation
 Argue for one or the other by comparing costs of each


Damages: costs are legal cost of lawsuits or pretrial negotiations
Regulation: administrative costs, error costs if level is not chosen
correctly
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what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
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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
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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?

(More examples to come)
 What remedies are given?

Injunctions when transaction costs are low; damages when
transaction costs are high
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Up next: applications
But first: an experiment
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Experiment: Coasian bargaining
 Round 1 (full information)




Ten people, five of them have a poker chip to start
Each person is given a personal value for a poker chip
At the end of the round, that’s how much you can trade in a chip for
Purple chip is worth that number, red chip is worth 2 x your number



So if your number is 6 and you end up with a purple chip, I’ll give you
$6 for it; if you end up with a red chip, I’ll give you $12 for it
Each person can only sell back one chip
Your number is on your nametag (common knowledge)
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Experiment: Coasian bargaining
 Round 2 (private information)




Ten people, five of them have a poker chip to start
Each person is given a personal value for a poker chip
At the end of the round, that’s how much you can trade in a chip for
Purple chip is worth that number, red chip is worth 2 x your number



So if your number is 6 and you end up with a purple chip, I’ll give you
$6 for it; if you end up with a red chip, I’ll give you $12 for it
Each person can only sell back one chip
Only you know your number
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Experiment: Coasian bargaining
 Round 3 (uncertainty)






Six people, three poker chips
Value of each chip is determined by a die roll
If seller keeps the chip, it’s worth 2 x roll of the die
If new buyer buys chip, it’s worth 3 x roll of the die
No contingent trades – buyer must pay cash
Nobody sees the die roll until the end
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Experiment: Coasian bargaining
 Round 4 (asymmetric information)






Six people, three poker chips
Value of each chip is determined by a die roll
If seller keeps the chip, it’s worth 2 x roll of the die
If new buyer buys chip, it’s worth 3 x roll of the die
No contingent trades – buyer must pay cash
Seller sees the die roll initially, buyer does not
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Why did we do this?
 Coase relies on parties being able to negotiate privately if
the right is not assigned efficiently

Low-TC case: injunctions more efficient, assuming bargaining works
if “wrong” party is awarded the right
 How well does this work?


Last week: paper by Farnsworth showing no bargaining after 20
nuisance cases
Just saw examples of various transaction costs: private information,
uncertainty, asymmetric information
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Sequential
Rationality
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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
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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”
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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
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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)
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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
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An Example of Dynamic
Games: Innovation
(probably won’t get to this)
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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
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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)
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One way to solve the problem:
intellectual property
up-front investment: 1,000
monopoly profits: 2,500
duopoly profits: 450 each
 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
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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)
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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…
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