Econ 522
Economics of Law
Dan Quint
Fall 2010
Lecture 6
Last week…
 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
1
Last week…
 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
2
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?
3
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”
4
High transaction costs  damages
Low transaction costs  injunctive relief
“Private bargaining is unlikely to succeed in disputes
involving a large number of geographically dispersed
strangers because communication costs are high,
monitoring is costly, and strategic behavior is likely to
occur. Large numbers of land owners are typically affected
by nuisances, such as air pollution or the stench from a
feedlot. In these cases, damages are the preferred
remedy.
On the other hand, property disputes generally involve a
small number of parties who live near each other and
can monitor each others’ behavior easily after reaching a
deal; so injunctive relief is usually used in these cases.”
(Cooter and Ulen) 5
A different view of the high-transaction-costs
case…
“When transaction costs preclude bargaining, the court
should protect a right by an injunctive remedy if it knows
which party values the right relatively more and it does not
know how much either party values it absolutely.
Conversely, the court should protect a right by a damages
remedy if it knows how much one of the parties values the
right absolutely and it does not know which party values it
relatively more.”
(Cooter and Ulen)
6
Third remedy: inalienability
 Inalienability: when an entitlement is not transferable or
saleable
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
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
9
Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
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
11
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
12
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
13
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
14
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
15
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
16
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
17
Up next: applications
But first: an experiment
18
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 threat points are common
knowledge (nametags)
 Take 2: private information (each player knows his threat
point, but not his opponent’s)
19
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
20
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
 But… does this really happen?


Ward Farnsworth (1999), Do Parties to Nuisance Cases Bargain
After Judgment? A Glimpse Inside The Cathedral
20 nuisance cases: no bargaining after judgment
“In almost every case the lawyers said that acrimony between
the parties was an important obstacle to bargaining…
Frequently the parties were not on speaking terms...
…The second recurring obstacle involves the parties’
disinclination to think of the rights at stake… as readily
21
commensurable with cash.”
Sequential
Rationality
22
But first: 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
23
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”
24
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
25
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)
26
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
27
WILL ONLY GET TO HERE, AT MOST
28
Applications of
Property Law
29
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
30
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
31
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)
32
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
33
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…
34
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
35
Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
36
Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
37
Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
38
Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
39
Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
 Patent length

tradeoff: how long to maintain ex-post inefficiency (monopoly) to
create enough incentive for innovation?
40
Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
 Patent length

tradeoff: how long to maintain ex-post inefficiency (monopoly) to
create enough incentive for innovation?
 Alternatives to patents



government purchase of drug patents
prizes
direct government funding of research
41
patents
copyrights
trademarks
trade secrets
42
Copyright
 Property rights over original expressions

writing, music, other artistic creations
 These 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
44
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
45
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
46
patents
copyrights
trademarks
trade secrets
47
Trademarks
 Trademarks do not expire, as long as they’re not
“abandoned”

No trade-off between long-term incentives (innovation) and shortterm inefficiency (monopoly) – little apparent downside
48
Trademarks
 Trademarks do not expire, as long as they’re not
“abandoned”

No trade-off between long-term incentives (innovation) and shortterm inefficiency (monopoly) – little apparent downside
49
Trademarks
 Trademarks do not expire, as long as they’re not
“abandoned”

No trade-off between long-term incentives (innovation) and shortterm inefficiency (monopoly) – little apparent downside
 Protected against infringement and also 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
Wednesday…
 Methods of public ownership
 How are property rights established, verified, lost
 Exceptions and limitations to property rights
54