Final Examination in Property

Professor Perritt

Spring, 2005

Model Answer

 

Question II

 

The Coase Theorem assumes zero transaction costs and postulates that, in such a world, parties will bargain to allocate resources and distribute entitlements so that the most efficient allocation of resources results, from a societal standpoint.  The Coase Theorem does not take into account distributive justice.

Societal benefit is best served if the lowest cost producer produces the product.  That might be either Alexander or Barbara, or it might be some third party.  In any event, society is better served if someone produces the product rather than no one.

 

The Coase Theorem says that Alexander and Barbara will bargain and reach a deal with respect to Alexander’s RAP tool.  Because Alexander thinks the tool is worth only $1 million, and Barbara thinks it is worth $2 million, there is a substantial settlement range between $1 million and $2 million.  Barbara rationally should be willing to pay anything less than $2 million, after she deducts her costs, and Alexander will be willing to accept anything over $1 million which will make him better off than if he gets himself organized and markets his tool himself.  Their relationship is not very multidimensional, but it does have more than just the price dimension.  Each is concerned that the other may use the RAP-tool idea to undercut their plans.  They can mitigate this danger by reaching agreement not only on price but also on the other dimension.  In other words, they will negotiate a deal where Barbara agrees, at the outset of negotiations, not to use any ideas disclosed to her by Alexander in the negotiations unless they reach agreement.  Alexander will agree not to use his RAP-tool idea in competition with Barbara, assuming they reach agreement. 

 

There also are conceivably other dimensions to the relationship, because the preference function of both Barbara and Alexander might be richer than has been suggested so far.  For example, Alexander might want, in addition to money, the fame of having produced this important tool for law students and practicing lawyers.  If Barbara is a good negotiator, she will sense this part of Alexander’s preference function and offer to put his name on the product or otherwise to identify it with him.  Likewise, Barbara may desire the non-monetary sense of accomplishment that comes from a bold, successful entrepreneurial effort that would be much appreciated by the legal profession.  If Alexander is a good enough negotiator to sense this, he will seek terms of the deal that fulfill this desire on Barbara’s part.

 

There are, however, a number of transaction costs that are likely to frustrate this deal or distort its terms, resulting in a misallocation of resources.

First, is the difficulty that both Barbara and Alexander may have in enforcing their deal.  They can, presumably, through practical means eliminate the possibility that Alexander will take the money and not transfer his knowledge for the RAP-tool to Barbara, possibly through some kind of escrow arrangement.  On the other hand, in the complete absence of law, they will not be able to enforce the other aspects of their bargain.  Barbara may promise not to run off with Alexander’s idea before they reach a deal but Alexander has no remedy except some sort of physical self-help.  Likewise, in the absence of law, Barbara will be unable to enforce Alexander’s promise not to use the RAP idea, which he already knows and will not lose, given the non-rival nature of information, once they reach a deal and Barbara begins to invest money and effort in developing and marketing the RAP tool. 

 

Additionally, they will face at least some negotiation costs—the time and trouble of bargaining, and the possible need to hire advisors to guide their negotiations.

 

They also likely face information costs; in other words, neither has perfect information.  Alexander may be held back because he doesn’t know anything about what others in the marketplace might be willing to offer him, so he cannot evaluate whether Barbara is offering him a fair and competitive price.  Barbara doesn’t know to whom else Alexander may have disclosed the idea.  Alexander doesn’t know as much as Barbara about costs of production and marketing. Alexander, more than Barbara, would have to expend time and money to find out more about the demand, including price and number of customers, the cost of producing and bringing to market.

 

Probably the most important transaction cost is the possibility of free riding.  I already have identified the two most threatening instances of free riding—that Barbara will steal Alexander’s idea, and that he will continue to use it even if he sells it to Barbara.  But that does not exhaust the free riding possibilities.  Each is likely to be concerned that others, “third parties,” may acquire sufficient knowledge of the idea that they will compete against both Barbara and Alexander.  The magnitude of this third-party free-riding risk depends on how easy it is to determine the content of the RAP-tool idea once a product is in the marketplace, and the time it would take and the financial investment for a third party free rider to get up to speed from both a design, production, and marketing standpoint to undercut Barbara and/or Alexander.  That produces another information cost, because in trying to protect themselves against this source of free riding, they would need to acquire additional information about these two aspects of cost and ease of third party free riding.

 

The law cannot effectively deal with all of these transaction costs.  It can do almost nothing to reduce the cost of negotiation, for example.  It might be able to do a little to adjust the asymmetry of knowledge, for example by giving an entitlement to Alexander which would tend to force Barbara to disclose to him more of what she knows about the demand and the cost function for production in marketing. 

 

But the most important thing law can do is to make contracts enforceable so that both Barbara and Alexander can make their own deal, secure in the knowledge that if the other party breaches, they have a remedy either through damages or an injunction.  But that may not be enough because it is hard for Barbara and Alexander to protect themselves against third party free riders through contract.  The third parties would not be parties to the contract and therefore would have no liability even if they violated terms that Alexander and Barbara sought to impose on them. 

 

That suggests some kind of intellectual property protection.  One clear possibility is something akin to trade secret law as it now exists.  The law could impose a fiduciary-like obligation on Barbara not to exploit Alexander’s idea once it is disclosed to her in the negotiations unless they reach a deal.  Similarly, the law could impose an obligation on Alexander not to disclose or use the idea in a way that undercuts any deal that he strikes with Barbara.  Even more significantly, the law could impose an obligation on third parties not to use illegal means, such as espionage to acquire the idea from either Barbara or Alexander. 

Somewhat broader rights could result from patent-like or copyright-like protection.  That would give either Barbara or Alexander or both a somewhat stronger protection against third parties.  Patent would be the strongest, patent protects against even completely independent creation and exploitation of an idea once the inventor of the idea has patented it.   Copyright only protects against copying and other specific types of conduct.  Patent is interesting in this regard because patent-like protection would give an entitlement to Alexander (assuming he applies for and qualifies for a patent under the proposed legal regime) that would protect him even against independent development of a RAP tool by Barbara.  Absent this kind of protection Barbara might be better off economically if she either steals or independently develops a RAP tool.  As long as it costs her less than $1 million to steal it or to develop it independently, she is better off doing that than meeting Alexander’s reservation price. 

 

One other social cost should be mentioned in the absence of legal protection against third party free riding.  If Barbara or Alexander or anyone else who exploits this idea is worried about free riding, they are likely to design the product with technical features to make it more difficult for someone else to appropriate the product, such as copy protection or restrictions on use that diminish the products utility.  Conversely, if they are more confident that their risks of free riding are minimized by the operation of law, they are more likely to design a product that maximizes its utility to consumers without special features that may get in the consumer’s way.