Dan Quint
Fall 2010
Lecture 7

On Monday…
 Established properties of an efficient property law system



Private goods are privately owned, public goods are not
Owners have maximum liberty over how they use their property
Injunctive relief used when transaction costs are low, damages used when transaction costs high
 We also gave some thought to “testing Coase”


Farnsworth: no bargaining after judgment in lawsuits he studied, due to animosity and unwillingness to equate utility to price
In-class experiment: can UW undergrads allocate poker chips efficiently?
1

Our experiment…
 Take 1: Full Information (values on nametags) starting allocation
12
10
10
8
8
6
6
4
4
2 red chip purple chip purple chip purple chip purple chip
32 efficient allocation red chip purple chip purple chip purple chip purple chip
60 actual final allocation red chip purple chip purple chip purple chip fraction of potential gains realized purple chip
56 86%
2

Our experiment…
 Take 2: Private Information (values hidden) starting allocation
8
6
6
4
10
8
4
3
3
2 red chip purple chip purple chip purple chip purple chip
24 efficient allocation red chip purple chip purple chip purple chip purple chip
48 actual final allocation purple chip purple chip red chip purple chip purple chip fraction of potential gains realized
40 67%
3

Our experiment…
 Take 3: Uncertainty starting allocation
3 X die roll
(actually 3)
2 X die roll
(actually 2) chip
2 efficient allocation chip
3
 Take 4: Adverse Selection starting allocation efficient allocation
3 X die roll
(actually 15)
2 X die roll
(actually 10) chip chip
10 15 actual final allocation chip fraction of potential gains realized
3 100% actual final allocation fraction of potential gains realized chip
10 0%
4

Our experiment…
 So…



With full information, 87% of gains realized
With private information, 67%
With uncertainty, 100%
 With adverse selection, 0%
 Comparing the last two cases…


Seller’s value was 2 X die roll, buyer’s value was 3 X die roll
If nobody knows die roll, no problem – they can trade based on the expected value
 But if seller knows die roll, problem
5

Adverse Selection
 In the last round, seller knew die roll had come up 5
 Seller says, “the die says 5; the chip is worth 10 to me and 15 to you; I’ll sell it to you for 11”
 Buyer thinks, “ what type of person would sell for 11?”



Certainly not a guy who had rolled a 6
Possibly a guy who rolled a 5…
…or a 4, 3, 2, or 1



Expected value conditional on seller willing to sell at 11 = 3 X 3 = 9
If he can’t trust seller to be honest, buyer not willing to pay 11
Same problem at most prices
– trade breaks down
 Best case: trade only at low prices, realize 29% of gains
 Akerloff (1970), “The Market for Lemons: Quality
Uncertainty and the Market Mechanism”
6

Sequential
Rationality
7

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
8

Dynamic games
FIRM 2
(incumbent)
Enter
FIRM 1 (entrant)
Don’t 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”
9

We can put payoffs from this game into a payoff matrix…
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
 firm 1 asks, “once I’ve entered, would he really choose to fight?”

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 2
(incumbent)
Enter
FIRM 1 (entrant)
Don’t Enter
(0, 30)
Accommodate
(10, 10)
Fight
(-10, -10)
11

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 he 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
12

Applications of
Property Law
13

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
14

Information: costly to generate, up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each easy to imitate
 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
15

Information: costly to generate, up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each easy to imitate
FIRM 2 (imitator)
FIRM 1 (innovator)
Innovate Don’t
(0, 0)
Imitate Don’t
(-750, 250) (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)
16

Patents: one way to solve the problem up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each
 Patent: legal monopoly
 Other firms prohibited from imitating Firm 1’s discovery
FIRM 2 (imitator)
FIRM 1 (innovator)
Innovate Don’t
(0, 0)
Imitate Don’t
(-750, 250)
250 – P
(1500, 0)
 Subgame perfect equilibrium: firm 2 does not imitate; firm 1 innovates, drug gets developed 17

Comparing the two outcomes up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each
FIRM 2 (imitator)
Without patents:
 Drug never discovered
Imitate
(-750, 250)
FIRM 1 (innovator)
Innovate Don’t
(0, 0)
Don’t
(1500, 0)
FIRM 1 (innovator)
 With patents:


Drug gets discovered
But…
FIRM 2 (imitator)
Imitate
Innovate Don’t
Don’t
(0, 0)
(-750, 250 – P ) (1500, 0)
18

BUT… patents solve one inefficiency by introducing another
 Without patents, inefficient outcome: drug not developed
 With patents, different inefficiency: monopoly!
CS
P * = 50
Profit P = 100 – Q
DWL
Q * = 50
 Once the drug has been found, the original incentive problem is solved, but the new inefficiency remains…
19

Solving one inefficiency by introducing another
Duopoly
Price of Drug
Demand for Drug
(Q = 100 – P)
Industry Profits
(net of up-front investment)
Consumer Surplus
$5.28
94.72
$250 + $250
– $1,000 =
–$500
$4,486
Total Surplus $3,986 up-front investment: 1,000 monopoly profits: 2,500 duopoly profits: 250 each
Monopoly
$50
50
$2,500
– $1,000 =
$1,500
$1,250
$2,750
No entry infinity
0
0
0
0
 Monopoly outcome is more efficient than noentry…
 …but still less inefficient than competition
20

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
21

Two variables in patent law: how broad patents are, and how long they last
 Patent breadth
22

Two variables in patent law: how broad patents are, and how long they last
 Patent breadth
23

Two variables in patent law: how broad patents are, and how long they last
 Patent breadth
24

Two variables in patent law: how broad patents are, and how long they last
 Patent breadth
25

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?
26

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
27

patents copyrights trademarks trade secrets
28

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
29

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
30

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
31

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
32

patents copyrights trademarks trade secrets
33

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
34

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
 Generic names cannot be trademarked
35

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”
36 http://online.wsj.com/article/SB10001424052748704285104575492650336813506.html

Trademarks and trademark dilution
37

patents copyrights trademarks trade secrets
38

Trade Secrets
 Protection against misappropriation
 But plaintiff must show…
 Valid trade secret


Acquired illegally
Reasonable steps taken to protect it
39

patents copyrights trademarks trade secrets
40