EEP 143 Lecture 4 OutlineNews (from Kevin Perkins) Private Goods: The competitive market is efficient price = marginal cost: Why is that efficient?From last class: Price DiscriminationEx ante vs. ex post incentivesEx ante vs. ex post incentivesEx ante vs. ex post incentivesAlternatives to IP protectionSimple “idea” modelSimple “idea” modelNet Present Value (“NPV”)Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV)Net Present Value (NPV)Notation on Consumer SurplusNotation on Consumer SurplusInformation Goods: the market doesn’t work (What is the price with free entry?) (What is the price with intellectual property?Alternatives to IPRs: PrizesTargeted PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: PrizesAlternatives to IPRs: ContestsAlternatives to IPRs: ContestsVickrey Auction: Vickrey Auction: Vickrey Auction: Vickrey Auction: Vickrey Auction: Contests: Choosing among IdeasConclusionWhat does IP do?EEP143Lecture4Wright07EEP 143Lecture 4Outline• Briefly: More on public goods, monopoly and price discrimination• Ex ante versus ex post views of incentives and intellectual property rights (“IPRs”)• Alternatives to IP protectionEEP143Lecture4Wright07News (from Kevin Perkins)House Expected to Vote on Contentious Patent Reform Bill FridayWASHINGTON (AP) -- The House this week is planning to take up a contentious patent reform bill that seeks to curtail infringement lawsuits that have resulted in large damage awards against companies such as Microsoft Corp.The House bill, sponsored by Reps. Howard Berman, D-Calif., and Lamar Smith, R-Texas, would increase the information available to patent examiners and set up a process to re-evaluate patents after they are granted.Supporters argue such post-grant reviews would help weed out patents for minor innovations and overly broad patents by allowing companies to challenge them without having to go through litigation.The House Judiciary Committee unanimously approved the legislation in July, and the Senate Judiciary Committee has approved a similar bill.EEP143Lecture4Wright07-pClocksDemand curveMarginal costPrivate Goods: The competitive market is efficientprice = marginal cost: Why is that efficient?What if a template must be developed?EEP143Lecture4Wright07From last class:Price Discrimination• What is price discrimination?• Who gains from perfect price discrimination?• Who gains from imperfect price discrimination?• Is imperfect price discrimination always bad?Example?• We’ll revisit these important questions later in the courseEEP143Lecture4Wright07knowledge that “DNA is a double helix”software digital musicWhat do these have in common?EEP143Lecture4Wright07• High cost to create• Zero (or low) cost to distribute to users• High cost to control access and use • Are these advantages or disadvantages?EEP143Lecture4Wright07• So far, discussion has considered efficiency of use of an existing innovation, an “ex post” perspective:– Assumes the invention has been madeEEP143Lecture4Wright07Ex ante vs. ex post incentives• In general, opponents of IP emphasize the cost of limiting access to existing inventions.• (examples?)• In general, American and British economists stress the inventive effects of IP for future inventionsEEP143Lecture4Wright07Ex ante vs. ex post incentives• There is also a European tradition: inventor has a moral right to her invention• Many lawyers view the patent grant as an exchange of monopoly right for disclosure of the innovation and how to make itEEP143Lecture4Wright07Ex ante vs. ex post incentives• Ex ante, IP decentralizes innovation incentives– No negotiation before inventing– No grant application– “users” rather than taxpayers pay• (cf. Dutch art market support)EEP143Lecture4Wright07Many lawyers, some economists assume IPRs are the correct means of rewarding invention• Here, 1. Start by modeling the problem2. See if IPRs are the solutionEEP143Lecture4Wright07Alternatives to IP protection• Outline:– Introduce/Refresh the Net Present Value Concept– Some notation in Consumer Surplus– First Alternative: Prizes• Pros and Cons– Second Alternative: Contests• Vickrey Auction• Pros and ConsEEP143Lecture4Wright07Simple “idea” model• Idea is a pair (v,c) where:– c is initial cost of developing the idea into an invention– v is the per-period consumer surplus given competitive pricingEEP143Lecture4Wright07Simple “idea” model•What if v is received annually for many periods?– Evaluate in present dollars using the “net present value” of the inventionEEP143Lecture4Wright07Net Present Value (“NPV”)• NPV is a standard concept for evaluating business projects that will yield different cash flows in future periods• In essence NPV evaluates the future cash flows 1. net of initial investment costs and 2. taking into account the opportunity costs of funds investedEEP143Lecture4Wright07Net Present Value (NPV)• Example:– I want to invest $200 in a project that I know will yield $100 at year’s end (t=1), $90 at the end of next year (t=2) and $80 in t=3– What is the NPV?EEP143Lecture4Wright07Net Present Value (NPV)• First of all, what is the current value of $1 if it is received one year from now? – How much must put it in savings now to have a dollar in a year’s time? (assume the interest rate is 10%)– Answer: $(1/1.1)• So, what is the NPV of the project?23100 90 80200(1 0.1) (1 0.1) (1 0.1)NPV =+ + −++ +EEP143Lecture4Wright07Net Present Value (NPV)• In a more general form:•Where:– vtis the cash flow at the end of time t– c is the investment costs incurred at t=0– r is the interest rate– τ is the length at which the investment will yield cash flows (total time of periods)1(1 )tttvNPV crτ==−+∑EEP143Lecture4Wright07Net Present Value (NPV)• Assume Ctis the same for all time periods• Special case: τÆ∞ :• Since:cvrNPV −=111(1 )ttVr∞==+∑EEP143Lecture4Wright07Net Present Value (NPV)• To check, set• Then calculate (1+r)V, term by term, and subtract V, term by term, to get rV=1. 11(1 )ttVr∞==+∑EEP143Lecture4Wright07Net Present Value (NPV)• Here we make few notational simplifications. • First, we will assume that vtis the