• We consider an Entry Game, a sequential game played between a potential Entrant and an Incumbent

• A sequence of play: Entrant moves first, Incumbent moves second

• Note: the magnitude of the payoffs don't really matter, only their relative sizes

  • Hence, my simple numbers

• This game is depicted in “Extensive form” or a game tree

• Each player faces at least one “decision node” (solid, colored by player)

  • Entrant chooses between Enter or Stay Out at node E.1
  • Incumbent chooses between Accommodate or Fight at I.1
  • Game ends at any “terminal node” (hollow), and each player earns payoffs (Entrant, Incumbent)

• Entrant has 2 pure strategies:

  1. Stay Out at E.1
  2. Enter at E.1

• Incumbent has 2 pure strategies:

  1. Accommodate at I.1
  2. Fight at I.1

• Note Incumbent's strategy only comes into play if Entrant plays Enter and the game reaches node I.1

• Backward induction: to determine the outcome of the game, start with the last-mover (i.e. decision nodes just before terminal nodes) and work to the beginning

• A process of considering “sequential rationality”:

“If I play X, my opponent will respond with Y; given their response, do I really want to play X?”

• What is that mover's best choice to maximize their payoff?

• We start at I.1 where Incumbent can:
  • Accommodate to earn 1
  • Fight to earn 0

• Incumbent will Accommodate if game reaches I.1

• Incumbent will Accommodate if game reaches I.1

• Given this, what will Entrant do at E.1?

  • Stay Out to earn 1
  • Enter, knowing Incumbent will Accommodate, and so will earn 2

• Entrant will Enter at E.1

• Continue until we've reached the initial node (beginning)

• We have the outcome:

• Some textbooks call this a “rollback equilibrium”
  • more technical name: subgame perfect Nash equilibrium

• Any game in extensive form can also be depicted in “normal” or “strategic” form (a payoff matrix)

• Note, if Entrant plays Stay Out, doesn't matter what Incumbent plays, payoffs are the same

• Solve this for Nash Equilibria...

• Two Nash Equilibria:

1. (Enter, Accommodate)
2. (Stay Out, Fight)

• But remember, we ignored the sequential nature of this game in normal form

  • Which Nash equilibrium is sequentially rational?

• New solution concept: subgame perfect Nash equilibrium (SPNE)

• Subgame: any portion of a full game beginning at one node and continuing until all terminal nodes

  • i.e. any decision node starts a subgame containing all the "branches" of that decision node

• Every full game is itself a subgame

• How many subgames does this game have?

1. Subgame initiated at decision node E.1 (i.e. the full game)
2. Subgame initiated at decision node I.1

• Consider each subgame as a game itself and ignore the “history” of play that got a to that subgame

  • What is optimal to play in that subgame?

• Consider a set of strategies that is optimal for all players in every subgame it reaches

• That is a subgame perfect Nash equilibrium

• Recall our two Nash Equilibria from normal form:

1. (Enter, Accommodate)
2. (Stay Out, Fight)

• Recall our two Nash Equilibria from normal form:

1. (Enter, Accommodate)
2. (Stay Out, Fight)

• Consider the second set of strategies, where Incumbent chooses to Fight at node I.1

• What if for some reason, Incumbent is playing this strategy, and Entrant unexpectedly plays Enter?

• It's not rational for Incumbent to play Fight if the game reaches I.1!

  • Would want to switch to Accommodate!

• Incumbent playing Fight at I.1 is not a Nash Equilibrium in this subgame!

• Thus, Nash Equilibrium (Stay Out, Fight) is not sequentially rational

  • It is still a Nash equilibrium!

• Only (Enter, Accommodate) is a Subgame Perfect Nash Equilibrium (SPNE)

• These strategy profiles for each player constitute a Nash equilibrium in every possible subgame!

• Simple connection: rollback equilibrium is always SPNE!

• Suppose before the game started, Incumbent announced to Entrant

“if you Enter, I will Fight!”

• This threat is not credible because playing Fight in response to Enter is not rational!

• The strategy is not Subgame Perfect!

• Recall the 4 questions any property system must answer:

1. What can be privately owned?

2. What can (and can't) an owner do with her property?

3. How are property rights established?

4. What remedies are available when property rights are violated?

• If left to own devices, acts like a monopoly

• Creates inefficiency

  • Restrict output to \(q_M\) where \(MR(q)=MC(q)\)
  • Mark up price to consumers' max WTP at \(p_M\)
  • Small consumer surplus
  • Generates DWL

• But now consider a second firm, with same \(MC(q)=c\) but no fixed costs \(f\)!

  • Doesn't have to invest in R&D, just copy the first firm!

• If by itself, could maximize profits at \(p_m\)

  • But so long as it can charge \(p<AC(q)\) of the first firm, can capture the market and push the first firm out of business

• Fixed costs of $1,000 for R&D

• Monopoly profits of $2,500

• Second firm can imitate for free, duopoly profits would be $450 each

• Fixed costs of $1,000 for R&D

• Monopoly profits of $2,500

• Second firm can imitate for free, duopoly profits would be $450 each

• A sequential game where Innovator goes first

• SPNE: {Don't, Imitate}

  • Lose valuable innovation

• Note: Copycat could promise not to Imitate, but it would not be a credible promise!

• Suppose instead, Innovator can obtain a patent and sue Copycat (whether for damages or injunction) for infringement
  • Copycat would suffer some penalty P

• Suppose instead, Innovator can obtain a patent and sue Copycat (whether for damages or injunction) for infringement

  • Copycat would suffer some penalty P

• If P>450, Copycat chooses Don't

• SPNE becomes {Innovate, Don't}

• But now we're back to the outcome where the Innovator becomes a monopoly!

• We’re trading off one inefficiency for another

  • Without patents: no innovation
  • With patents: monopoly

• Intellectual property (IP): ways that individual/s (or firm) can claim ownership of information

• Patents over products, commercial processes

• Copyrights over expressions

• Trademarks over brand names, logos

• Trade secrets

• Patent grants the holder the exclusive rights to prevent others from producing and selling a product for a limited time

• Patent grants the holder

“the right to exclude others from making, using, offering for sale, or selling the invention throughout the U.S. or importing the invention into the U.S”

• Lasts only for a limited time
  • 20 years from date of application
  • Optional 20 year renewal

35 U.S.C. § 154

• Apply to government Patent and Trademark Office (PTO)

• For application to be approved, invention must be:

  1. Novel
  2. Non-obvious
  3. Have practical utility

35 U.S.C. § 101-103

• Patent requires detailed instructions and figures for how to produce the product

• Upon expiration, invention enters the public domain, where all at liberty to use

• Cannot patent “laws of nature, natural phenomena, and abstract ideas”

• Patents are property rights

  • Can be sold or gifted to others
  • Can be licensed to others (others can produce/sell/use product in exchange for a royalty fee)
  • Holder can choose not to exercise rights

• Use/sale of product without consent of patent-holder constitutes infringement

  • Patent-holder can sue for damages & injunction against future use

• “Letters Patent” by English Crown (esp. 17^th C.—18^th C.)

• 1623 Statute of Monopolies

• Patent Act of 1790 (U.S.)

• Patents are managed by government bureaucrats
  • Underpaid, overworked
  • Lot of bad patents getting through

• Individuals have been allowed to patent a wide variety of things, often extremely broad and vague

• “Weak” patents: many of these would not hold up in court

  • But requires going to court to determine; the average patent lawsuit costs $2-5 million

• Makes Coasian bargaining too difficult

• Unclear who owns property rights (what is the valid breadth of a vague patent?)

• Raises transaction costs of production

  • Some products, especially in tech sector, touch upon hundreds of patents!

• Patent pools: multiple firms with their own patents reach an agreement to cross-license their patents

  • Effectively all firms in the pool can use all the accumulated patents for a fee

• Reduces transaction costs...if you're in the patent pool

  • Market power, oligopoly

• Submarine patent: individual takes out a patent on something extremely broad, doesn’t enforce it for many years (“stays under the surface”), until a producer comes along (thinking the idea is not patented)

• Non-practicing entity (NPE) aka Patent troll: buys up patents not with intention to produce anything, but only to sue individuals and firms for infringement

• Tragedy of the anti-commons: too many holders of right to exclude others, blocks productive action
  • Symmetric to tragedy of the commons (not enough holders of right to exclude others)!

• Copyright grants the holder the exclusive rights to prevent others from publishing and selling a particular expressive work for a limited time

• Copyright grants the holder

“the exclusive rights to reproduce the [work]...to prepare derivative works...to distribute to the public by sale or other transfer of ownership, or by rental, lease, or lending,...to perform,...to display publicly”

17 U.S.C. § 106

• Since the Copyright Act of 1976, copyright is automatic

“in original works of authorship fixed in any tangible medium of expression, now known or later developed”

• Applies to “literary works, musical works, dramatic works, choreographs, pictorial, graphic, and sculptural works, motion pictures, sound recordings, and architecture”

17 U.S.C. § 102

• Copyright lasts for

“a term consisting of the life of the author and 70 years after the author’s death.”

• Afterwards, works enter the public domain where all are at liberty to use

17 U.S.C. § 302

• One legal defense against infringement (unique to copyright): “fair use”

“for purposes such as criticism, comment, news reporting, teaching (including multiple copies for classroom use), scholarship, or research”

17 U.S.C. § 107

• Copyright Act of 1790 creates federal copyright in U.S.

  • Covers “books, maps, and charts”
  • 14 year terms, with optional 14 year renewal
  • authors must both register & declare on their works if they want copyright protection

• Almost verbatim 1710 Statute of Anne

• Copyright-holders have rights over derivative works

• But most media (books, music, films) need to borrow from originals!

• Copyright Term Extension Act (CTEA) of 1998 aka the “Sonny Bono Act” extended copyright from author’s life + 50 years to (current) author’s life + 70 years

• More controversially, it retroactively extended this duration to works about to expire in 1998

  • “The Mickey Mouse Protection Act”
  • Enormous lobbying by Disney

• Orphan works: many works are out of print, but still technically copyrighted, nobody knows who the owner is (and too afraid to publish)

• Music, movies, and books produced in 1923-1946 (first 23 years affected by Sunny Bono Act), <6% available today

• Trade secrets, trademarks are longstanding concepts in common law

• Patent & copyright are entirely statutory creations, not common law

  • Legislature creates artificial scarcity, barriers to entry, & monopoly power

• Is copying the same thing as theft?

• Moral/deontological arguments

• IPR are natural rights

• Extension of Lockean self-ownership and “mixing your labor” with nature

• Should be entitled to profit off of your own ideas

• Natural rights arguments — IP violates natural rights

• Unlike real property, ideas are not scarce

• Restricts what private persons are able to do with their property

• Nobody has a right to guaranteed profits

• Utilitarian arguments — IP doesn’t boost innovation much, and may actively reduce it

• IP is mostly rent-seeking

• Innovation & creation occurs despite or without IP

• Many valuable things exist but are not patentable or copyrightable

  • Examples: jokes, recipes, the news, government reports, fashion

• Many valuable things exist (for-profit & non-profit) but don’t rely on patents or copyright

  • Open source software
  • Creative commons

• Reasons other than IP that innovators and artists produce

• Not-maximizing profits

  • intrinsic motivation, creativity, altruism

• Profit-maximizing alternatives to IP

  • reputation, speaking fees, merchandising
  • trade secrets, first mover advantage

• Trade secrets

• Prizes

  • Longitude
  • Google X prize

• Government R&D subsidies

  • grants for scientific research

• Crowdfunding?

• Patent buyouts (Kremer)

• A trademark or tradename grants protection for a word, phrase, symbol, or design which identifies a particular seller of goods or services, distinct from other sellers

• Prohibits sellers from using marks that are “confusingly similar” to protected marks, this constitutes infringement

  • Is basically fraud

• Trademarks last indefinitely, so long as the mark is being used in commerce

• Allows companies to securely invest in reputation and quality

  • Consumers can easily identify quality based on seller's brand name

• If others could use same markings, consumers can't tell the difference between sellers, lose incentive to invest in high quality goods

• Can't trademark generic names (“camera”, “app”)

• Sometimes the reverse happens: a brand name becomes so dominant, people refer to a whole product category by it

  • Examples: Kleenex, Xerox, Band-Aid, Google
  • Story of Aspirin (acetacylicilic acid); Coca-Cola investigators

• Unregistered trademarks^TM or service marks^SM

  • “Common law trademark rights” emerge automatically from use of a distinguishing mark in commerce, enforceable in court

• Registered trademarks®

  • Can register with PTO for extra protection
  • Lasts 10 years with optional 10 year renewal

• Can sue for “dilution of the distinctive quality of a mark or trade name” even in “absence of competition between the parties or the absence of confusion as to the source of goods or services.”

• Less clear economic argument

  • Do we really think consumers can't tell the difference between Coca-Cola the soft drink and an auto-parts store calling itself “Coca-Cola”?

• Trade secret is any information “used in one's business” that gives its owner “an opportunity to obtain an advantage over competitors who do not know or use it.”
  • formula, device, process, or piece of information
  • valuable only so long as others don’t know it

• Plaintiff can sue Defendant for ”misappropriation” (basically, theft) of a trade secret if can demonstrate:
  1. It is a valid trade secret
  2. The Defendant acquired it illegally
  3. Plaintiff took reasonable steps to protect it

• Unlike normal property rights, possessor of trade secrets must continually make efforts to keep them secret!

• If they leave their “secrets” lying around, they lose claim to them

  • Kind of like adverse possession in property

• Strategic choice by firms/inventors to use trade secrets vs. patents

• Tradeoff of indefinite secrecy vs. guaranteed temporary monopoly

  • Patents require public disclosure of secrets, once they expire, firm loses competitive advantage

• Non-disclosure agreements

  • Suppose B works for A, who has her sign an NDA
  • B then leaves to work for competitor, C, and reveals A's secrets to C
  • A can sue B for breach of contract (our next unit)
  • But A has no recourse against party C, if C had no reasonable way of knowing about the NDA

• NDAs tend to be very difficult to enforce