Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 6
Logistics
 HW1 online, due next Friday (2/19)
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
Pretty long – don’t wait till last minute to start!
If you can’t attend section, can hand in to my mailbox (Social
Sciences), or by email
 First midterm Wednesday 2/24
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Last week…
 Coase: in the absence of transaction costs, if property
rights are complete and tradeable, voluntary negotiations
will lead to efficiency
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So initial allocation of rights doesn’t matter for efficiency if there are
no transaction costs
But if there are transaction costs, the initial allocation of rights does
impact efficiency
 Sources of transaction costs
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Search costs, bargaining costs, enforcement costs
 What to do about transaction costs
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Normative Coase: design law to minimize transaction costs
Normative Hobbes: design law to minimize harm done by failures in
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bargaining
Last week…
 How to choose between two normative approaches?
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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
 Application of this: choosing a remedy (Calabresi/Melamed)
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When transaction costs are low, use injunctions (property rules)
When transaction costs are high, use damages (liability rules)
C&U: this is what actually happens in many settings
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That answered first of four questions we
need to address
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
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rivalrous – one’s consumption
precludes another
Public Goods
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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
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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
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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
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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?
 Priniciple 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?
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Maximum liberty
 How are property rights established?
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(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
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But first: dynamic games and sequential
rationality
 Game theory we’ve seen so far: static games

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“everything happens at once”
(nobody observes another player’s move before deciding how to act)
 Dynamic games
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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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Back to…
Property Law
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Intellectual Property
 Intellectual property: broad term for ways that an individual,
or a firm, can claim ownership of information

Patents – cover products, commercial processes
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Copyrights – written ideas (books, music, computer programs)
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Trademarks – brand names, logos

Trade Secrets
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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
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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)
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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
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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…
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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:
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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
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Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
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Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
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Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
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Two variables in patent law: how broad
patents are, and how long they last
 Patent breadth
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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?
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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
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government purchase of drug patents
prizes
direct government funding of research
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patents
copyrights
trademarks
trade secrets
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Copyright
 Property rights over original expressions

writing, music, other artistic creations
 These tend to fit definition of public goods
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nonrivalrous
nonexcludable
so private supply would lead to undersupply
 Several possible solutions
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government subsidies
charitable donations
legal rights to creations – copyrights
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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
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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
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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
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patents
copyrights
trademarks
trade secrets
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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
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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
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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
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patents
copyrights
trademarks
trade secrets
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Trade Secrets
 Protection against misappropriation
 But plaintiff must show…



Valid trade secret
Acquired illegally
Reasonable steps taken to protect it
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patents
copyrights
trademarks
trade secrets
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Wednesday…
 Methods of public ownership
 How are property rights established, verified, lost
 Exceptions and limitations to property rights
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