Talked About Particular Sources of Transaction Costs

Econ 522 – Lecture 5 (Sept 16 2008)

Last lecture, we…  recapped Coase  talked about particular sources of transaction costs  introduced the two primary means of enforcing a right – injunctive relief and damages  and saw that in the absence of transaction costs, either one will lead to efficiency through private negotiations  saw Calabresi and Melamed’s rule: o when transaction costs are high, damages will be more efficient o when transaction costs are low, injunctions will be more efficient  To recap why: consider the farmer and the rancher again o Recall that there are three possible ways to deal with the damage the rancher’s herd does to the farmer’s crops: the rancher can fence in his herd, the farmer can fence in his crops, or they can just live with the damage being done o If transaction costs are low, they’ll always do whichever one is cheapest; who starts off with the entitlement, and how it’s protected, will matter for distribution, but not for efficiency o If transaction costs are high, we rule out bargaining o If the farmer has an entitlement to no damage protected by damages and transaction costs are too high to reach a private agreement, the rancher can do two things: he can fence in his herd, or he can pay for the damage it does. We assume he’ll do whichever is cheaper. o If the farmer has an entitlement to no damage protected by an injunction, the rancher can only do one thing: build the fence. o So when the rancher’s fence is cheaper than the damage it prevents, an injunction and a damages rule lead to the same outcome o But when the rancher’s fence is more expensive than the damage it prevents, an injunction forces him to build it anyway – less efficient  We also mentioned Cooter and Ulen’s take – when transaction costs are high, the efficient rule depends on what information is more readily available o Injunctions are better when the court knows who values a right more, but not the absolute amount (since damages would be difficult to calculate correctly, but the right can just be allocated efficiently to begin with) o Damages are better when the court knows how much one party values a right, but not who values it more – since damages can be calculated accurately, so the other party can choose whether it’s worth it to violate the entitlement or not So that was last week. We also mentioned 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. 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 – we’ll come back to it (briefly).

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:  Rivalrous – one one person’s consumption of a private good precludes another person’s enjoyment of its benefits  Excludable – 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. You may remember from intermediate micro: When private goods are owned publicly, they tend to be overutilized, or overexploited.  This is the point of the classic paper by Hardin on the syllabus, the tragedy of the commons  His example: a large common area where everyone is permitted to graze their cattle  Since it’s public, nobody considers the cost their herd imposes on the grass  So the grass on the commons gets wiped out by overgrazing

(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.)

One the other hand, when public goods are privately owned, they face the opposite problem: they will be underprovided  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 when we were considering bargaining  Example: 100 people, each with utility 10 sqrt( Park ) + $, where Park is the sum of everyones’ contributions. o When each person decides how much to contribute, he maximizes 10sqrt(X+x) – x, where X is what everyone else contributed o Solving the problem establishes that when contributions are voluntary, X+x=25 – total contributions will be 25, giving everyone an average utility of 10 sqrt (25) – 25/100 = 49.75 o On the other hand, suppose 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.)

 Recall our earlier story of a hops farmer and a brewery. When there was a single hops farmer, he could negotiate with the brewery to reduce pollution and breathe cleaner air. But if the dirty air affects lots of people, it becomes a “public bad” – and if each person tries to negotiate separately with the brewery to reduce pollution, they will reduce it less than efficiency would suggest. Which brings us to the general rule proposed by Cooter and Ulen:  Efficiency suggests that private goods should be privately owned, and public goods should be publicly provided or regulated  Private ownership of private goods avoids overuse, and allows trade, leading to efficient allocations (Coase)  Public provision of public goods avoids undersupply

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. We can interpret this in terms of public and private goods.

 Before the fur trade, land was pretty much a public good o There was no shortage of animals, so hunting grounds were not particularly rivalrous – I could hunt on your land, and still leave enough game for you to hunt the next day  With the emergence of the fur trade came stronger incentives for hunting o Fur-bearing animals became a valuable, so were hunted more, so became scarce, so the land became a rivalrous good – the more I hunted, the less luck you would have hunting on the same land  So the emergence of the fur trade led 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 should 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)  Which is pretty much what happened 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 next 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. In general, though, 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 in practice, by examining a number of applications.

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

Dynamic games are generally presented via a game tree. Suppose there is one firm already in a particular market, and another firm is considering entering. If he does enter, than the incumbent firm can either 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:

(10, 10) Accomodate Firm 2 Enter Fight (-10, -10) Firm 1

Don’t Enter (0, 30)

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 did enter. We can 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

There are two (pure-strategy) Nash equilibria: (Enter, Accommodate), and (Don’t Enter, Fight). However, (Don’t Enter, Fight) doesn’t make that much sense. 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? Not a “Credible Threat”, since once firm 1 had entered, firm 2 would prefer to accommodate.

We use a stronger type of equilibrium in this type of game: 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.

Backward induction.

Key assumption here is rationality – the players know each others’ payoff functions, everyone is rational, everyone knows everyone is rational, and so on. If you’re up against someone who’s crazy, who knows what will happen – it might turn out better for them! 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. 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: (-750,250) Enter Firm 2 Innovate Don’t (1500,0) Firm 1

Don’t Innovate (0, 0)

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. 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 is often uncertain – that is, if you make an investment in research or in developing a product, it is often uncertain how successful you will be. 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 due, 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 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 firm – based in Canada, I think – 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; 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 don’t think that’s atypical.) 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 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. Google recently announced a $30 million prize for a private citizen landing a rover on the moon. Similar prizes have been offered by governments, and by private foundations, to encourage innovation in particular directions.

And finally, government (or a private foundation) can simply give grants to subsidize research directly – which they do – reducing the need for ex-post incentives.