E351 Law and Economics
IU Spring 2006 Midterm examination 1 Prof. Alexeev
Part A (20 points). Write an essay (2-3 pages) on one of the following two topics.
A.1. Free markets in the presence of externalities may lead to consistently inefficient outcomes. Describe the standard pre-Coase prescriptions for dealing with negative externalities and explain their main shortcomings. State the main insights that Coase made with respect to externalities. Formulate the Coase theorem for the case of zero transaction costs and its corollary for high transaction costs. What is the normative implication of the Coase theorem for structuring property law?
A.2. Discuss why property law may need to treat information differently from other types of property. Also, justify from the economic efficiency point of view any two of the four differences between patents and copyright summarized in the following table (rows marked (1) through (4)):
FEATURES / COPYRIGHT / PATENTS(1) Breadth / Narrow / Relatively broad
(2) Length / Life of author + 70 years / 20 years
(3) How easy to obtain / Easy / Difficult
(4) Exceptions / Several / None
Part B (30 points). Short answers (approximately one half of a blue book page or less per answer). Answer any two of the following three questions.
B.1. What is the necessity exception in property law? From which general rule does it provide an exception? Why does this exception exist? How is it connected with the Coase or Hobbes theorems?
B.2. What is the social benefit of a patent for an invention? Why does the present value of this benefit increase at a decreasing rate with an increase in the length of the patent’s term? Make sure to explain two reasons for this.
B.3. Under a typical estray statute in the US, the finder of abandoned or lost property that exceeds a given value may have to report the find to the court. The court would then advertise the find. The finder becomes owner only if the original owner did not claim the property within a certain period of time. What are the social costs and benefits of this rule?
Part C (30 points). Solve the following two problems.
C.1. (20 points) Suppose the annual monopoly profit resulting from obtaining a patent for discovery of drug X is equal to 35 and the dead-weight loss is 10. Suppose also that anybody could, within a relatively short period of time, discover X at a cost of 40, but the exact timing of a successful discovery is uncertain. Let interest rate be zero.
(i) Assume that the patent duration is 5 years. If any company that decides to develop the drug is equally likely to develop it first, how many drug companies would join the race to obtain the patent? (Assume that drug companies are risk-neutral.)
(ii) What would be the total (gross) social cost of the patent system?
(iii) How would your answers to (i) and (ii) change if the patent duration were shortened to four years?
(iv) Assuming that drug X is (socially) worth discovering, what is the optimal patent length in whole years?
C.2. (10 points) A railroad owned by B runs a train that produces sparks that occasionally cause fire that burns crops of a farmer whose farm is located along the railroad. The farm’s expected damage from the fire is 300. The railroad makes 500 of profit, not taking into account the damage to the farm.
Suppose that there are two alternative property rights rules that could be used:
Rule 1. Railroad owes compensatory damages to the farmer (the damages are always estimated correctly and no negotiations are involved if the damages are paid).
Rule 2. The railroad is enjoined from causing fires to the farm. That is, if a fire occurs and the farmer complains, the railroad owner, B, would go to jail.
(i) What is the socially efficient outcome in this situation?
(ii) Will B run his train under each rule if (a) transaction costs of negotiation between the farmers and B are zero? What if (b) the cost of negotiations is 250?
Part D (20 points). Solve the following problem.
D.1. A rancher and a farmer have neighboring plots of land with no fence between them. The rancher earns 30 from his cattle. However, if the rancher’s cattle stray onto the farmer’s property, the farmer incurs losses. The amount of these losses depends on the frequency and size of cattle incursions on the farmer’s land, which, in turn, depend on the rancher’s effort to control his cattle. Specifically, the farmer’s loss is (20-8E), where E is the rancher’s effort to control his cattle. The cost of this effort to the rancher (i.e., his disutility of effort) is 2E2.
(1) What is the socially efficient amount of rancher’s effort to control cattle?
(2) Suppose no negotiations are possible. If the rancher is not liable for damage caused to the farmer, what effort will he undertake? If the rancher is liable for the true amount of damage to the farmer’s property, what effort will he undertake?
(3) Suppose now that the transaction costs of negotiations between the farmer and the rancher are zero. Also, instead of paying damages to the farmer, the rancher has to pay a fine to the government equal to the damage his cattle causes. Finally, suppose that the rancher can build a fence at the cost of 15 to himself that would prevent his cattle from straying onto the farmer’s property even if the rancher exerts no effort to control his cattle. (a) What will be the outcome in this case? (b) Is this a socially efficient outcome?
(Usually, the values of X that maximize or minimize function F(X) can be found by solving for X the equation dF/dX=0. Also, recall that d(aX2)/dX=2aX and d(bX)/dX=b, where a and b are constants.)