Econ 522 – Lecture 6 (Sept 25 2007)

Recall the four key questions we said that any system of property law must address:

  • What things can be privately owned?
  • What can (and can’t) an owner do with his property?
  • How are property rights established?
  • What remedies are given when property rights are violated?

We’ve addressed question 4, remedies, looking at the effects of Injunctive Relief and Damages, and considering the circumstances under which each of these are likely to be more efficient. And we’ve talked a bit about question 2, what an owner can or can’t do with his property, in the context of nuisance law.

Now we turn to the question of what can be privately owned.

You may recall from micro a discussion of Public and Private Goods.

Private Goods tend to be characterized by two properties:

  • Rivalry, that is, one person’s consumption of a private good precludes another person’s enjoyment of its benefits
  • Excludability – it’s technologically possible to prevent others from consuming it

Good example is an apple. If you eat my apple, I can’t eat it; but it shouldn’t be too hard for me to prevent you from eating it.

Public Goods tend to be characterized by the opposite of these two properties:

  • Nonrivalrous – one person’s consumption of a public good does not impact others’ enjoyment of it
  • Nonexcludable – hard to prevent people from taking advantage

The cleanest example of a public good is defense against a nuclear attack. It’s very hard for me to defend myself from a nuclear attack in a way that doesn’t also protect you a bit; and you being safe from nuclear attack doesn’t impact my enjoyment of this privilege.

Other public goods are urban infrastructure (bridges and roads), although roads may become somewhat rivalrous when there is congestion; parks, clean air, the ocean, large fireworks displays, and so on.

This brings us to a very simple rule: it is generally efficient for private goods to be privately owned, and public goods to be publicly owned.

When private goods are owned publicly, they tend to be overutilized, or overexploited. Suppose the University decided that even though apples are a private good, it would purchase a lot of them and make them freely available to anyone who wanted them. Well, since they were free, people might tend to grab an apple even when they don’t really feel like one; since there’s no cost, people would take too many apples, and the University might run out. This is the classic “tragedy of the commons” – a good that is publicly owned, that is, a resource that everyone has rights to use, but which is rivalrous and gives private benefit, will likely be overused and run out. (The classic paper on the tragedy of the commons, by Hardin, is on the syllabus – his example is that of a common area where everyone is permitted to graze their cattle; leading to people building herds which are too large, and therefore wiping out the grass on the commons.)

(Another example of this is congestion on busy roads. Most roads are provided publicly; when there’s lots of traffic, roads become rivalrous – the more people on the road, the less utility I get from driving on them – so they take on one of the characteristics of a private good. But when people are deciding whether or not to drive, they tend not to consider the externality that their choice to drive has on other drivers; so the roads get overused. Some cities are looking at ways to solve this problem with congestion pricing – charging people to use the roads during peak hours, so that people internalize this externality.)

The problem when public goods are privately owned is the opposite: they will tend to be underprovided. Going back to an example we’ve already discussed: suppose a town wants to build a park, but has to pay for it with voluntary donations. People weigh their donations only against their private gain from the park, ignoring the positive effect it has on everyone else; so people will donate very little, and a nice park will not be built in this way. This is exactly the free-rider problem we talked about earlier.

(Example: 100 people, each with utility 10 sqrt( Park ) + $, where Park is the sum of everyones’ donations. Anyone’s first-order condition establishes that when contributions are voluntary, they will total exactly 25, giving everyone an average utility of 10 sqrt (25) – 25/100 = 49.75. On the other hand, if everyone agreed to contribute $1 each, a park of quality 100 would be built, leading everyone to utility of 10 sqrt( 100 ) – 1 = 99. So obviously, the bigger park is Pareto-superior, even though only the small one could be built through voluntary private contributions.)

This leads us back to our earlier example, that a market in clean air could overcome the externality between the brewery and the beer drinker living next door. This worked well when there was just a single beer drinker, since he was the only one affected by the smoke. When there are lots of consumers, pollution becomes a “public bad” – a bad version of a public good. Then even if each one could individually negotiate with the brewer to pollute less, the private gains from doing that are less than the total gains, so even a free market in clean air will generally not lead to efficiency.

When private goods are privately owned, the owner weighs the cost and benefit of consuming the good; and the ability to trade should lead to private goods being owned by whoever values them the most. And the government can provide public goods, paying for them out of taxes; or regulate public bads, in a way that avoids the free-rider problem and externalities and leads to efficiency.

Which leads us to the conclusion that, in general, private goods should be privately owned, but public goods should be publicly provided or regulated.

This also gives us another interpretation of the Demsetz example we did last week, of the development of property rights to land among Native Americans. What makes the case interesting is that land can be either a public or a private good, depending on the circumstances.

National forests can be thought of as a public good – they’re a good thing ecologically, they’re pretty to drive by and hike in, I can enjoy them even if other people are enjoying them, and it’s hard to exclude other people from getting their benefits.

On the other hand, 900 square feet in the middle of a city is a private good – if I build an apartment there and live in it, that precludes you doing the same; and as long as I get a door with a decent lock, I can keep you out.

Demsetz’s observation was that property rights over land developed among Native Americans as the fur trade became more important economically. Interpret this in terms of public and private goods.

Before the fur trade, land was pretty much a public good. Since there was no shortage of animals, hunting grounds were not particularly rivalrous – I could hunt on your land, and still leave enough game for you to hunt the next day. But with the emergence of the fur trade, and stronger incentives for hunting, fur-bearing animals became a valuable and scarce resource, and so the land became a rivalrous good – the more I hunted, the less luck you would have hunting on the same land. So we can see the emergence of the fur trade leading to a sort of transition of land from being a public to a private good; efficiency would then suggest that at the same time, it would go from being publicly owned (everyone could hunt on it) to being privately owned (one family might have exclusive rights to hunt in a particular area).

So the general principle is, private goods should be owned privately, public goods should be publicly provided/regulated. The book mentions the 1990s move toward deregulation/privitization as an example of correcting a situation of private goods being publicly supplied – services that did not involve externalities, and could therefore be supplied by private industry, but for historical reasons were being run by the government. This led to the dismantling or selling of government monopolies on trains, planes, and other services worldwide.

They also point out that in many cases, either type of ownership, public or private, will involve some transaction costs, and the case can be made for one or the other by considering the magnitude of these costs. Consider again the example of clean air. If there are lots of consumers affected by pollution from a factory, injunctive relief is unlikely to work well, since transaction costs tend to be high when there are lots of parties affected. However, there are still two possible ways to maintain clean air. One way is to grant property owners the right to clean air, but protected by damages; so that a factory, if it felt it worthwhile, could choose to pollute and pay damages. The transaction cost here would be the legal cost of these lawsuits, or pretrial negotiations. Alternatively, clean air could be viewed as a public good, and regulated by a government agency. This would involve administrative costs, and could run the risk of the level of pollution not being the one that is socially optimal. We can argue for the efficiency of one system or the other by comparing the magnitude of these transaction costs.

So that gives a general answer to the question, What can be privately owned? The question, How do I establish rights to something?, we have discussed in the context of a couple of examples; there isn’t really a general theory behind it, since it can be seen just as an extension of the question of what can be owned. (We’ll come back to it through some applications, though.)

This leaves us with the question of, what can an owner do with his property? (which we’ve already discussed some in the context of nuisance law) The principle laid out briefly in the textbook is the principle of maximum liberty, in which owners can do anything with their property that does not interfere with other peoples’ property or rights, that is, that doesn’t impose an externality on anyone else. (They make the case that the common law approximates this.) Of course, legislatures may pass laws that impose further restrictions on what people can do with their property. But in general, these laws are only efficient if the behavior they are restricting causes an externality.

That wraps up what we want to say about property law in the abstract, that is, the broad principles we want a property law system to adhere to. Next, we’ll see how these work by examining a number of applications.

The first application is a non-obvious answer to the question, What can be privately owned? And this is the area of information and intellectual property. Intellectual property is a broad term for ways that an individual, or a firm, (or a university) can claim ownership of information.

There are four areas we’ll look at within information economics:

  • patents
  • copyright
  • trademark
  • trade secrets

The general “problem” with information is that it tends to be expensive to create, but then very cheap to disseminate once it’s been created. That is, once an idea has been developed – be it a technological innovation, a song, a piece of software, or a catchy logo for a company – it is very easy to imitate or share. This means that without some sort of intervention, it may be impossible for whoever developed the idea to recoup the costs – time, effort, and actual money invested – in coming up with the idea. And this means that there may not be sufficient incentive to come up with ideas in the first place.

To see how this works, consider a firm that has some idea for a totally new and innovative product. It’s a good idea, it’s a product that will be valuable to a large number of people. But it’s an idea that will take a large amount of money to develop; and it’s also an idea that, once it’s out there, will be easy for other firms to imitate.

(A good example of this is a new drug. A huge amount of money goes into researching drugs, finding one that’s effective, testing for safety and for side effects, and so on. But once a drug is released, it may be very easy for other firms to reverse-engineer it, figure out how to make it relatively cheaply, and compete with the firm that developed it.)

So now suppose a firm is deciding whether to make the initial investment in developing a new drug. They move first, and then another firm moves second and decides whether to imitate. Suppose monopoly profits in the market would be $2500, the drug costs $1000 to develop, but that with two firms, price competition would drive down profits to $250 each. So we can write the game tree this way:

The only subgame perfect equilibrium is for the second firm to enter if the first develops the product; and therefore, for the firm not to develop the product.

A patent is basically a legal monopoly – a patent prevents the second firm from imitating the first firm’s product, allowing the first firm to function as a monopolist for a predetermined amount of time. (In the U.S., patents last 20 years from the time of application.) So if the firm’s invention were be protected by a patent, the firm can count on receiving several years of monopoly profits; which may be enough to cause them to innovate in the first place. (Modify the game tree by imposing a large penalty on the imitating firm – SPE is now innovation.)

Key thing to notice: monopoly is inefficient! Monopoly pricing always involves a deadweight loss, since a monopolist maximizes profits by limiting supply by setting price higher than marginal costs. For example, suppose demand for the new drug is
Q = 100 – P. Suppose the monopolist has 0 marginal costs; then he sets monopoly price at 50, sells to half the market, gets profit of 2500 and generates consumer surplus of 1250. But there’s a deadweight loss of 1250 – if the drug were sold for free, it would generate total surplus of 5000 (all of it going to consumers in this case). But if the drug were going to be sold free, or cheaply, it might never have been developed in the first place. So patents trade off one sort of inefficiency for another.

(Of course, once the innovation has occurred, the incentive problem has been solved, and the inefficiency from the monopoly remains, and can sometimes look pretty undesirable. There’s been lots of talk in recent years about the cost of AIDS drugs, which are protected by patents. The manufacturers are pricing them high, to maximize their profits or, arguably, to recoup the investments they made to develop the drugs in the first place; but it’s hard to not notice that pills which can be produced at a marginal cost of pennies are priced high enough that they are not available to much of the developing world.)

The power of Congress to legislate both patents and copyrights was actually written into the Constitution. The first patent law was passed in 1790, and has been updated several times since. At present, patents last for 20 years from the date of application. Patent applications must satisfy certain conditions: they must be for something which is novel (new), non-obvious, and has practical utility (basically, is commercializable). Applications are reviewed by the patent office, which handles a huge volume and is therefore sometimes criticized for granting patents too easily. In particular, in recent years, there’s been criticism that the “non-obvious” test had not been applied – Amazon, for instance, was granted a patent on “one-click purchasing”, which many thought was an obvious extension of online shopping.

A patentholder who feels his patent has been violated can sue for both damages already done and for an injunction, stopping the violator from future violations. Thus, patents are protected both by injunctive and damages relief. Patentholders are also free to license their patents to others, that is, to allow others to use them for a fee (called a royalty).

When you apply for a patent, the details of your innovation go into the public record, so in some industries, firms choose not to patent new inventions, instead choosing to keep them secret.

There are two important degrees of freedom in patent law: how broad a patent is, and how long it lasts. The question of breadth can be thought of in a couple of different ways.

First, suppose two different firms are developing distinct, but similar, products. A broad patent on one of the products might cover both. Thus, in a world with broad patents, the two firms might engage in a race – both try hard to develop the product very quickly, since whoever applies for the patent first will get all the gains from both products. On the other hand, a narrow patent on one product might not cover the other; in which case, the firms might develop the products slower (and less expensively), knowing that both products will exist and that neither one will really have a true monopoly. So the breadth of patents affects the intensity of the research effort.