The First Homework in up on the Website Due Thursday, February 19 at 1 P.M. SHARP

Econ 522 – Lecture 6 (Feb 5 2008)

The first homework in up on the website – due Thursday, February 19 at 1 p.m. SHARP

Also, since the HW questions are a bit different from the types of questions I tend to ask on exams, I’ve also posted a few sample exam questions on property law – two from past exams, two old homework problems that “feel more like” exam questions – for when you guys start to review for the first midterm

In the last three lectures, we posed four questions for property law to address, and took a crack at answering each of them:

What things can be privately owned?
Efficiency suggests private goods should be privately owned, to avoid the tragedy of the commons
and public goods should be publicly provided or regulated, so they will be supplied at the efficient level (to avoid underprovision due to freeriding)

What can (and can’t) an owner do with his property?
Maximum liberty – can do anything you want that doesn’t cause an externality (infringe on others’ rights/property)
When two parties’ rights conflict – as with the rancher and the farmer – Coase suggests whose rights prevail doesn’t matter for efficiency, as long as the rights are tradable and there are no transaction costs

How are property rights established?
Other than whaling and Pierson v. Post, we haven’t said much about this, but we’ll come back to it soon

What remedies are given when property rights are violated?
Discussed this Tuesday – mostly, comparing injunctive relief (property rules) to damages (liability rules)
Calabresi and Melamed: property rules (injunctions) are more efficient when transaction costs are low; liability rules (damages) are more efficient when transaction costs are high
Cooter and Ulen: efficient rule depends on what type of information is more readily available

For the next three lectures, we’ll discuss applications – looking both at how the law is actually designed, and at whether there is an economic rationale for it.

To start, I want to introduce one more important idea from game theory, which is the idea of sequential rationality in dynamic games.

A dynamic game is a game in which one player moves first, then the other player, after seeing what his opponent did, moves second.

Dynamic games are generally presented via a game tree, where each node of the tree represents a situation where someone has to make a decision

Example: suppose there is one firm already operating as a monopolist in some market, and another firm is considering entering
If he does enter, than the incumbent firm has two choice: he can play nice, ensuring that both firms end up making money; or he can start a price war, ensuring that both firms end up losing money
We can represent the game this way:

A strategy in this type of game is a plan of what to do at each juncture
So even if firm 1 doesn’t enter, we need to know what firm 2 planned to do if he did enter
We can also represent this game with a payoff matrix:

Firm 2’s Action:
Accommodate / Fight
Firm 1’s Action: / Enter / 10, 10 / -10, -10
Don’t Enter / 0, 30 / 0, 30

And we can circle each firm’s best-response to each action by the other
We find there are two (pure-strategy) Nash equilibria: (Enter, Accommodate), and (Don’t Enter, Fight).

However, (Don’t Enter, Fight)isn’t that believable as a prediction
Firm 1 has no incentive to enter if he believes firm 2 really would fight
But would it really make sense for firm 2 to fight if it got to that point?
We say that “fight” here is not a credible threat, since once firm 1 had entered, firm 2 would actually be better off accommodating

When we look at dynamic games like this, we’ll look for a stronger type of equilibrium: Subgame Perfect Equilibrium

Basically, this is when players don’t just play best-responses in the game as a whole, but also at every branch of the game tree.

And the way we find subgame perfect equilibria is by backward induction

(DO IT)

The key assumption here is common knowledge of rationality
The players know each others’ payoff functions, everyone is rational, everyone knows everyone is rational, everyone knows everyone knows everyone is rational, and so on
If you’re playing a game like this against someone who’s crazy, it’s hard to know what would happen
And in fact, a “crazy” player – someone who doesn’t always do what’s best for them – might do better than a “rational” player
Because if I’m crazy and I’m firm 2, you might believe that I’ll actually fight if you enter; so you might choose not to enter
But if you know I’m rational, then you’re better off entering, since you know that once you enter, I won’t want to fight
(Literature on repeated games with reputation, where your actions in the early stages may partly be to try to convince opponents that you’re not a rational player, and therefore that they shouldn’t try to take advantage of you in later stages.)

But for us, we’ll stick to the assumption of rationality – I know that if I move first, my opponent will do whatever is in his best interest

This is referred to as sequential rationality – since the players are assumed to be rational at each stage of the game

Now, back to property law

The first application we’ll consider 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 – whether it’s a technological innovation, or 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 an example
There’s 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 it
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
We can write the game tree this way:

If we do backward induction, we find that 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 one way to solve this problem
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 – the new SPE is now innovation.)

A key thing to remember: monopoly is inefficient!
Monopoly pricing always involves a deadweight loss, since a monopolist maximizes profits by setting price higher than marginal costs
For example, suppose demand for the new drug is Q = 100 – P (DRAW IT)
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.
That is, patents solve the dynamic inefficiency – not enough drugs being developed – by introducing a static inefficiency – monopoly pricing once the drug has been developed

(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, most 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.
There have been a number of proposals to try to make them available cheaply (at cost) in developing countries, but the challenge is how to do that without undermining profits in the U.S. and Europe)

A little bit of history

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
To be approved, a patent application must satisfy three 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 both for 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.

Another way to think of breadth is to suppose that a new product might require two distinct innovations: one “pioneering invention” that is worth little on its own, and then the subsequent development of an application, which can be sold profitably
The question then is, does a patent on the original invention also cover the application?
Or would separate patents be required for the pioneering invention and the application?
(A similar question can be asked of whether an improvement to an existing product is patentable. The question can also be asked in other configurations.)

Courts have sometimes held that an improvement with great commercial value does not infringe on a pioneering invention that had little standalone value
Such rulings, of course, increase the incentives to invest in applications and improvements to existing technologies, and decrease the incentives to engage in fundamental research
On the other hand, when patents on pioneering inventions are held to be broad, this encourages fundamental research but discourages new firms from attempting to commercialize existing (but unexploited) technologies
Which of these is preferable depends on the details of a particular industry.

As always, there is Coase – in a world without transaction costs, the initial allocation of rights should not matter for efficiency – if the patent as initially granted is inefficient, firms should be able to bargain around it
(That is, as long as the initial grant of the patent gives the inventor enough surplus to overcome the initial incentive problem, Coase suggests we should be able to negotiate around any further inefficiencies.)
However, there are several impediments to this.

Patent law is often ambiguous
Until a patent has been tested in court, its breadth (and even whether or not it is valid) are often uncertain
So firms may not know what their threat points are, and therefore may find it hard to reach an agreement

Research itself is often uncertain
That is, if you make an investment in research or in developing a product, it is often unpredictable whether you’ll be successful
Consider the extreme case where a significant investment will lead only to a small probability of a discovery, but the discovery will be extremely valuable if it occurs
If the big discovery may infringe on an existing patent, it’s very hard to bargain around this problem beforehand – hard to agree on how likely the discovery is to be made, how valuable it will be, and so on
But it’s also risky to make the investment, knowing that you may still have to share your profits with the other patentholder if the discovery occurs.

In some areas, there is a sense that there are too many existing patents, and that it’s very difficult to innovate without infringing on existing patents
In biotech, many new projects require techniques, or even ingredients, that are patented; so there is a problem of “royalty stacking”, that is, having to pay multiple monopolists for rights to their good in order to do anything new
(The textbook mentions a Congressional act, and a Supreme Court ruling, meant to address this problem and encourage the development of new drugs and generic alternatives to existing ones.)

On the flip side, I have a friend who does microchip design, who told me that the conventional wisdom in chip design is, “Never ever try to find out what patents exist – just design the chip the way you want to, and deal with the patents later.”
This is because any design is likely to infringe on lots of patents
Their owners have to decide to sue you for it to matter
If they do, you may only be liable for damages
But if they can prove you knew about the patent beforehand, the penalty may be more severe
So you’re better off pleading ignorance, which is easier when you actually are ignorant!

The problem of research being risky also leads to the problem of “submarine patents”
There’s a significant lag (multiple years) between applying for a patent and it being granted; and the details of the application aren’t made public until the patent is granted
So someone could develop a product that infringes on a patent that hadn’t been granted yet!
For this reason, in many areas, patents are only valid if you can show that you were actively trying to commercialize the innovation, not just waiting around hoping someone else would do the work and then sue them for infringement
(This is what happened in a well-publicized case with Blackberry a couple years ago. Some Canadian firm which had no real business other than buying other peoples’ patents, claimed to have a patent that Blackberry was infringing on, and tried to get an injunction to shut down Blackberry unless they agreed to a huge settlement. In most patent cases, a preliminary injunction is granted – that is, the injunction is issued in advance of the case actually going to court. In this case, the injunction was denied, and the case subsequently went away.)

Of course, even when low transaction costs would lead to cooperative outcomes, this can sometimes be a problem in other ways
Often times, firms doing similar research are also competitors in the market; so attempts to cooperate (through joint research projects or in other ways) may be viewed suspiciously by antitrust authorities.
(A paper I wrote last year was on patent pools - … Much of the interest in patent pools stems from the need to figure out how they should be viewed by antitrust regulators.)

There is also the question of how long a patent should last
Obviously, patents must last long enough for firms to be able to recover their investment costs, in order to give sufficient incentives for innovation
But since monopolies are inefficient, having patents last too long is bad – once the patent expires, competition will drive down the price of the product, eliminating the deadweight loss.
(When drug patents expire, for example, competing firms can begin selling generic versions of the same drug – the book gives an example where the price per pill dropped immediately from $15 to $1, and I think that’s pretty typical.)
So the optimal length is a tradeoff between maintaining ex-post inefficiency versus creating a sufficient incentive for innovation.

Clearly, the optimal level is likely to vary across different industries
In the U.S., all patents last the same amount of time, 20 years
Jeff Bezos, the founder of Amazon, proposed that, since innovation occurs so fast in the software industry, software patents should expire after 3 years
In Germany, there are two different types of patents: full-term patents, which are granted for major inventions; and petty patents, granted for minor inventions and improvements, which last 3 years
In addition, in Germany, patentholders must pay an annual fee to continue the patent, which starts out cheap but escalates over time
In the U.S., patents used to be renewable under certain conditions – I believe now they are not.)

Of course, a patent system is not the only way to encourage innovation; and given the inefficiency inherent in a monopoly, there may be other ways to do it better
One proposal with drug patents has been that when a particularly valuable drug is invented, the government should buy the patent, and then allow multiple firms to produce the drug, leading to lower pricing and higher overall welfare
Since the government could pay the fair value (say, the discounted present value of expected monopoly profits) to the firm, there is no problem of incentives
The question then becomes how to correctly calculate the economic value of the patent itself
(One proposal was to let the market decide – hold an auction for the patent, with the understanding that once the auction was complete, a coin would be flipped; with a high probability, the government would buy the patent at that price, but with some probability, the winner of the auction would buy the patent
This way, a decent estimate of “fair value” could be obtained, and the deadweight loss associated with monopoly could still be eliminated “most of the time”.)

Another way to give incentives for innovation is through prizes