Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 6 Logistics HW2 (Property Law) online, due 5 p.m. Thurs Feb 24 Midterms will be Wed March 2 and Wed March 30 1 Our story so far on property law… Coase: in the absence of transaction costs, if property rights are complete and tradable, voluntary negotiations will lead to efficiency We can solve externalities by expanding property rights and allowing trade Demsetz: property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization Fur trade increased overhunting and therefore value of private property rights Domestication of the dog decreased the cost of maintaining private property 2 Our story so far on property law… 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 3 One application of this: choosing a remedy for property rights violations Injunctive relief: court clarifies right, bars future violation (punishable as a crime) 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? 4 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” 5 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? 6 Public versus Private Goods Private Goods rivalrous – one’s consumption precludes another Public Goods non-rivalrous non-excludable excludable – technologically possible to prevent consumption examples: defense against nuclear attack example: apple infrastructure (roads, bridges) parks, clean air, large fireworks displays 7 Public versus Private Goods When private goods are owned publicly, they tend to be overutilized/overexploited 8 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 9 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 10 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 11 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 12 what can be privately owned? what can an owner do? how are property rights established? what remedies are given? 13 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 14 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? (Examples to come) What remedies are given? Injunctions when transaction costs are low; damages when transaction costs are high 15 Up next: applications But first: an experiment 16 Experiment: Coasian bargaining Each person given a personal value for a poker chip Amount you can sell it back to me for (real money) Purple chip is worth your number, red chip is worth 2 x your number Each person can only sell back one chip Take 1: buyer’s and seller’s values are common knowledge (nametags) Take 2: private information (each player knows his threat point, but not his opponent’s) 17 Experiment: Coasian bargaining Take 3: uncertainty If seller keeps chip, it’s worth 2 x die roll ($2-$12, EV $7) If buyer gets chip, it’s worth 3 x die roll ($3-$18, EV $10.50) Can’t sell for conditional price – deal must be done before die roll is revealed Take 4: asymmetric information Values are same as above… …but seller knows value of die roll, buyer doesn’t 18 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? Monday: paper by Farnsworth showing no bargaining after 20 nuisance cases Just saw examples of various transaction costs: private information, uncertainty, asymmetric information 19 Sequential Rationality 20 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 21 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” 22 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 23 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) 24 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 25 Applications of Property Law 26 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 27 Information: costly to generate, easy to imitate up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 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 $250 each 28 Information: costly to generate, easy to imitate up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each FIRM 1 (innovator) Don’t Innovate FIRM 2 (imitator) (0, 0) Imitate (-750, 250) 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) 29 up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 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 (-750, 250 – P) Don’t (1500, 0) Subgame perfect equilibrium: firm 2 does not imitate; firm 1 30 innovates, drug gets developed BUT… patents solve one inefficiency by introducing another Without patents, inefficient outcome: drug not developed With patents, different inefficiency: monopoly! CS P* = 50 P = 100 – Q Profit DWL Q* = 50 Once the drug has been found, the original incentive problem is solved, but the new inefficiency remains… 31