Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 6.

Econ 522Economics of Law

Dan Quint

Spring 2011

Lecture 6

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HW2 (Property Law) online, due 5 p.m. Thurs Feb 24

Midterms will be Wed March 2 and Wed March 30

Logistics

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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

Our story so far on property law…

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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

Our story so far on property law…

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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?

One application of this: choosing a remedy for property rights violations

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Calabresi and Melamed

Transaction costs high…

difficult for parties to reassign rights through negotiations

injunction would force injurer to prevent harm himself

damages rule allows injurer to prevent harm or pay for it, whichever is cheaper

when transaction costs are high, damages rule is typically more efficient “liability rule”

Transaction costs low…

easy for parties to reassign rights

injunctions cheaper for court to implement (doesn’t need to calculate damage done)

when transaction costs are low, injunctive relief is typically more efficient “property rule”

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what can be privately owned?

what can an owner do?

how are property rights established?

what remedies are given?

How do we design an efficient property law system?

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Public versus Private Goods

Private Goods

rivalrous – one’s consumption precludes another

excludable – technologically possible to prevent consumption

example: apple

Public Goods

non-rivalrous

non-excludable

examples: defense against nuclear attack

infrastructure (roads, bridges)

parks, clean air, large fireworks displays

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When private goods are owned publicly, they tend to be overutilized/overexploited

Public versus Private Goods

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When private goods are owned publicly, they tend to be overutilized/overexploited

When public goods are privately owned, they tend to be underprovided/undersupplied

Public versus Private Goods

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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

Public versus Private Goods

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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

Public versus Private Goods

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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

A different view: transaction costs

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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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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

What can an owner do with his property?

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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

So, what does an efficient property law system look like?

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Up next: applicationsBut first: an experiment

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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)

Experiment: Coasian bargaining

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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

Experiment: Coasian bargaining

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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

Why did we do this?

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SequentialRationality

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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

Dynamic games and sequential rationality

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Dynamic games

FIRM 1 (entrant)

Enter Don’t EnterFIRM 2(incumbent)

Accommodate Fight

(10, 10) (-10, -10)

(0, 30)

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 look for equilibria like before we find two: (Enter, Accommodate), and (Don’t Enter, Fight) question: are both equilibria plausible? sequential rationality

We can put payoffs from this game into a payoff matrix…

10, 10 -10, -10

0, 30 0, 30

Accommodate Fight

Enter

Don’t Enter

Firm 2’s ActionF

irm 1

’s A

ctio

n

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Dynamic games

FIRM 1 (entrant)

Enter Don’t EnterFIRM 2(incumbent)

Accommodate Fight

(10, 10) (-10, -10)

(0, 30)

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

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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

The key assumption behind subgame perfect equilibrium: common knowledge of rationality

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Applications ofProperty Law

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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

Intellectual Property

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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

Information: costly to generate, easy to imitate

up-front investment: 1,000monopoly profits: 2,500duopoly profits: 250 each

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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)

Information: costly to generate,easy to imitate

FIRM 1 (innovator)

Innovate Don’t

FIRM 2 (imitator)

Imitate Don’t

(-750, 250) (1500, 0)

(0, 0)

up-front investment: 1,000monopoly profits: 2,500duopoly profits: 250 each

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Patent: legal monopoly Other firms prohibited from imitating Firm 1’s discovery

Subgame perfect equilibrium: firm 2 does not imitate; firm 1 innovates, drug gets developed

Patents: one way to solvethe problem

FIRM 1 (innovator)

Innovate Don’t

FIRM 2 (imitator)

Imitate Don’t

(-750, 250 – P) (1500, 0)

(0, 0)

up-front investment: 1,000monopoly profits: 2,500duopoly profits: 250 each

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Without patents, inefficient outcome: drug not developed With patents, different inefficiency: monopoly!

Once the drug has been found, the original incentive problem is solved, but the new inefficiency remains…

BUT… patents solve one inefficiency by introducing another

CS

Profit

P* = 50

P = 100 – Q

Q* = 50

DWL