Econ 522 Economics of Law Dan Quint Spring 2012 Lecture 6

Econ 522Economics of Law

Dan Quint

Spring 2012

Lecture 6

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HW1 due at 11:59 p.m. tomorrow night on Learn@UW

ESA event tomorrow,6 p.m. in Grainger 5120

Announcements

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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

Announcements

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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

Our story so far on property law…

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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?

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


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


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Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated


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Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated


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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? (More 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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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)

Experiment: Coasian bargaining

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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


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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


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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


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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? Last week: 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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An Example of Dynamic Games: Innovation

(probably won’t get to this)

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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 $450 each

Information: costly to generate, easy to imitate

up-front investment: 1,000monopoly profits: 2,500duopoly profits: 450 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

(-550, 450) (1500, 0)

(0, 0)


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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

One way to solve the problem:intellectual property

FIRM 1 (innovator)

Innovate Don’t

FIRM 2 (imitator)

Imitate Don’t

(-550, 450) (1500, 0)

(0, 0)


450 – P

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Comparing the two outcomes

FIRM 1 (innovator)

Innovate Don’tFIRM 2 (imitator)

Imitate Don’t

(-550, 450) (1500, 0)

(0, 0)


FIRM 1 (innovator)

Innovate Don’tFIRM 2 (imitator)

Imitate Don’t

(-550, 450 – P) (1500, 0)

(0, 0)

Without patents: Drug never

discovered

With patents: Drug gets

discovered But…

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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…

Patents solve one inefficiencyby introducing another

CS1,250

Profit2,500

P = 50

P = 100 – Q

Q = 50

DWL1,250

CS4,050

Profit 450 x 2P = 10

Q = 90

DWL50

Monopoly Duopoly


Net Surplus = 2,750 Net Surplus = 3,950

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Econ 522 Economics of Law Dan Quint Spring 2012 Lecture 6