Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 7
Last week…
 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 tried “testing Coase” through an experiment


Can UW undergrads reallocate poker chips efficiently?
(Cost me $162)
1
Our experiment…
 Take 1: Full Information (values on nametags)
starting
allocation
efficient
allocation
actual final
allocation
12
red chip
red chip
10
purple chip
purple chip
10
purple chip
purple chip
8
red chip
8
6
fraction of potential
gains realized
purple chip
purple chip
purple chip
purple chip
purple chip
6
4
purple chip
4
purple chip
2
purple chip
32
60
58
26/28 = 93%
2
Our experiment…
 Take 2: Private Information (values hidden)
starting
allocation
efficient
allocation
actual final
allocation
10
red chip
purple chip
8
purple chip
red chip
8
purple chip
purple chip
6
red chip
6
4
fraction of potential
gains realized
purple chip
purple chip
purple chip
purple chip
purple chip
4
3
purple chip
3
purple chip
2
purple chip
24
48
44
20/24 = 83%
3
Our experiment…
 Take 3: Uncertainty



All three chips got sold, at price of $8 each
Rolled 1, 2, and 4, so two buyers lost money…
…but we did achieve 100% of gains from trade
 Take 4: Asymmetric Information




Rolled 3, 6, 6
Two of the chips (the 3 and one 6) got sold
60% of the gains from trade were realized
(And even that surprised me!)
4
Conclusion
 Coase works pretty well, except under asymmetric info

Full info: 93% of gains achieved

Private info: 83%

Uncertainty: 100%

Asymmetric info: 60%
5
Comparing pure uncertainty to asymmetric
information
 Consider a seller in the last two cases

Your value = 2 x die roll, EV = $7.00
 If you know nothing…


Trade at some price between $7 and $10.50
Expected payoff might be $8 or $9
 If you know value exactly…


Asymmetric information might stop you from being able to sell
If so, expected payoff is $7
 So information has negative value!
6
Discussion question
(old exam question, question by Alex Tabarrok at Marginal Revolution blog)
In Virginia, the common law has long held that if a
neighbor’s tree encroaches on your yard you may cut the
branches as they cross the property line, but any damage
the tree does to your property is your problem. Your
neighbor can even sue if your pruning kills the tree.
In 2007, the Virginia Supreme Court overruled this 70-yearold precedent, making it your neighbor’s duty to prune or
cut down the tree if it is a “nuisance.”
Which is better: the new rule or the old? What would the
Coase Theorem say about the two rules?
7
Applications of
Property Law
8
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
9
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
10
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)
11
up-front investment: 1,000
monopoly profits: 2,500
duopoly profits: 450 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
(-550, 450)
Don’t
(1500, 0)
450 – P
 Subgame perfect equilibrium: firm 2 does not imitate;
firm 1 innovates, drug gets developed
12
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)
13
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…
14
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
15
Patent breadth
 Narrow patents might allow us each to patent own invention
 Broad patents might not

“Winner-take-all” race to be first
16
Patent breadth
 Does a patent on the “pioneering invention” cover the
application as well?
 Can you patent an improvement to an existing product?
17
Patent length
 Patent length




Need to last long enough for firms to recover up-front investment…
…But the longer patents last, the longer we have DWL from
monopoly
(Example from textbook: drug price drops from $15 to $1 per pill
when patent expires)
Tradeoff between ex-post inefficiency and ex-ante incentive provision
 U.S.: all patents last 20 years


Jeff Bezos (founder of Amazon) once suggested software patents
should last just 3 years
Germany: full-term patents for major inventions, 3 year “petty
patents” for minor ones, annual renewal fees
18
Do the details matter?
 Coase: without transaction costs, initial allocation of rights
irrelevant for efficiency
 But transaction costs may be high



Uncertainty on whether a patent is valid
Uncertainty of outcome of research
Many parties
19
Do the details matter?
 Coase: without transaction costs, initial allocation of rights
irrelevant for efficiency
 But transaction costs may be high



Uncertainty on whether a patent is valid
Uncertainty of outcome of research
Many parties
20
Do the details matter?
 Coase: without transaction costs, initial allocation of rights
irrelevant for efficiency
 But transaction costs may be high



Uncertainty on whether a patent is valid
Uncertainty of outcome of research
Many parties
21
Alternatives to patents for encouraging
innovation
 government purchase of drug patents
 prizes

Google $30 million prize for landing a rover on the moon
 direct government funding of research

~25% of research spending in U.S. is funded by government
22
patents
copyrights
trademarks
trade secrets
23
Copyright
 Property rights over original expressions

writing, music, other artistic creations
 Creations like this 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
24
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
25
Copyright
 Retelling of Gone With The Wind, from point of view of a
slave on Scarlett’s plantation, published in 2001



Margaret Mitchell’s estate sued to halt publication
Eventually settled out of court
Was there really any harm?
26
Copyright
 Retelling of Gone With The Wind, from point of view of a
slave on Scarlett’s plantation, published in 2001



Margaret Mitchell’s estate sued to halt publication
Eventually settled out of court
Was there really any harm?
27
patents
copyrights
trademarks
trade secrets
28
Trademarks
 Reduce confusion over who made a product
 Allow companies to build reputation for quality
 Don’t expire, unless abandoned
 Generic names can’t be trademarked
29
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”
http://online.wsj.com/article/SB10001424052748704285104575492650336813506.html
30
Trademark dilution
31
patents
copyrights
trademarks
trade secrets
32
Trade Secrets
 Protection against misappropriation
 But plaintiff must show…



Valid trade secret
Acquired illegally
Reasonable steps taken to protect it
33
patents
copyrights
trademarks
trade secrets
34