Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2012 Lecture 6

2. Announcements • HW1 due at 11:59 p.m. tomorrow night on Learn@UW • ESA event tomorrow,6 p.m. in Grainger 5120

3. Announcements • HW1 due at 11:59 p.m. tomorrow night on Learn@UW • ESA event tomorrow,6 p.m. in Grainger 5120 • Low-cost LSAT course throughUW Law (March 3-18) http://www.prelaw.wisc.edu/ • Info session for Washington DC Semester in International Affairs today at 4, 206 Ingraham

4. Our story so far on property law… • Coase • Absent transaction costs, if property rights are complete and tradable, we’ll get efficiency through voluntary negotiation • 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

5. One application of this: choosing a remedy for property rights violations • Injunctive relief: court clarifies right, bars future violation; violations are punished as crimes (but right is tradable) • 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?

6. 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”

7. How do we design an efficient property law system? what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

8. 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

9. Public versus Private Goods • When private goods are owned publicly, they tend to be overutilized/overexploited

10. 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

11. 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

12. 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

13. A different view: transaction costs • 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

14. what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

15. What can an owner do with his property? • 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

16. 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? • Maximum liberty • How are property rights established? • (More examples to come) • What remedies are given? • Injunctions when transaction costs are low; damages when transaction costs are high

17. Up next: applicationsBut first: an experiment

18. Experiment: Coasian bargaining • Round 1 (full information) • Ten people, five of them have a poker chip to start • Each person is given a personal value for a poker chip • At the end of the round, that’s how much you can trade in a chip for • Purple chip is worth that number, red chip is worth 2 x your number • So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it • Each person can only sell back one chip • Your number is on your nametag (common knowledge)

19. Experiment: Coasian bargaining • Round 2 (private information) • Ten people, five of them have a poker chip to start • Each person is given a personal value for a poker chip • At the end of the round, that’s how much you can trade in a chip for • Purple chip is worth that number, red chip is worth 2 x your number • So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it • Each person can only sell back one chip • Only you know your number

20. Experiment: Coasian bargaining • Round 3 (uncertainty) • Six people, three poker chips • Value of each chip is determined by a die roll • If seller keeps the chip, it’s worth 2 x roll of the die • If new buyer buys chip, it’s worth 3 x roll of the die • No contingent trades – buyer must pay cash • Nobody sees the die roll until the end

21. Experiment: Coasian bargaining • Round 4 (asymmetric information) • Six people, three poker chips • Value of each chip is determined by a die roll • If seller keeps the chip, it’s worth 2 x roll of the die • If new buyer buys chip, it’s worth 3 x roll of the die • No contingent trades – buyer must pay cash • Seller sees the die roll initially, buyer does not

22. Why did we do this? • 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? • Last week: paper by Farnsworth showing no bargaining after 20 nuisance cases • Just saw examples of various transaction costs: private information, uncertainty, asymmetric information

23. SequentialRationality

24. Dynamic games and sequential rationality • 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

25. Dynamic games FIRM 1 (entrant) FIRM 2 (incumbent) Enter Don’t Enter (0, 30) Accommodate Fight (10, 10) (-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”

26. We can put payoffs from this game into a payoff matrix… Firm 2’s Action Accommodate Fight 10, 10 -10, -10 Enter Firm 1’s Action 0, 30 0, 30 Don’t Enter • We can look for equilibria like before • we find two: (Enter, Accommodate), and (Don’t Enter, Fight) • question: are both equilibria plausible? • sequential rationality 25

27. 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) Enter Don’t Enter (0, 30) Accommodate Fight (10, 10) (-10, -10)

28. 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

29. An Example of Dynamic Games: Innovation(probably won’t get to this)

30. up-front investment: 1,000monopoly profits: 2,500duopoly profits: 450 each Information: costly to generate, easy to imitate • 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

31. up-front investment: 1,000monopoly profits: 2,500duopoly profits: 450 each Information: costly to generate,easy to imitate FIRM 1 (innovator) Innovate Don’t FIRM 2 (imitator) (0, 0) Imitate Don’t (-550, 450) (1500, 0) • Solve the game by backward induction: • Subgame perfect equilibrium: firm 2 plays Imitate, firm 1 playsDon’t Innovate, drug is never discovered • (Both firms earn 0 profits, consumers don’t get the drug)

32. up-front investment: 1,000monopoly profits: 2,500duopoly profits: 450 each One way to solve the problem:intellectual property • 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 FIRM 1 (innovator) Innovate Don’t FIRM 2 (imitator) (0, 0) Imitate Don’t (-550, 450) (1500, 0) 450 – P

33. up-front investment: 1,000monopoly profits: 2,500duopoly profits: 450 each Comparing the two outcomes FIRM 1 (innovator) FIRM 2 (imitator) Without patents: • Drug never discovered • With patents: • Drug gets discovered • But… Innovate Don’t (0, 0) Imitate Don’t (-550, 450) (1500, 0) FIRM 1 (innovator) FIRM 2 (imitator) Innovate Don’t (0, 0) Imitate Don’t (-550, 450 – P) (1500, 0)

34. up-front investment: 1,000monopoly profits: 2,500duopoly profits: 450 each Patents solve one inefficiencyby introducing another • 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… Monopoly Duopoly CS1,250 Net Surplus = 2,750 CS4,050 Net Surplus = 3,950 P= 50 Profit2,500 DWL1,250 P = 100 – Q DWL50 P= 10 Profit 450 x 2 Q= 50 Q= 90