This article is a part of the Free to Choose Symposium symposium.
Christopher Sprigman is Professor of Law at the University of Virginia
Christopher J. Buccafusco is Assistant Professor of Law at Chicago-Kent College of Law
In our second post, we want to discuss some of the implications of the study (the details of which we described in our first post). One of the consistent concerns about BL&E in this symposium is about the too-quick jump from data to policy. We should emphasize that we think more work needs to be done to support these potential policy suggestions, but, importantly,we think that the answers to the policy issues rest fundamentally on empirical questions.
As we noted in the previous post, our research supports the idea that creators of new works will value them substantially more than will either mere owners or would-be purchasers of the works. These valuation anomalies are likely to create sub-optimal transaction levels in IP markets. The higher transaction and negotiation costs associated with bridging a large bargaining gap are particularly troubling in the IP context where efficient transfer of rights proves crucial. In both the copyright and patent contexts, initial rights-holders (usually authors in the case of copyright and inventors in patent) often are not particularly well positioned to exploit their work. Given the gap between initial entitlement and effective commercial exploitation, an efficient IP law must provide a smooth transition between the initial rights-holder and the eventual transferee or licensee. In this post, we want to suggest two possible solutions to the transaction costs problems – one based on private contracting and another based on changes to legal entitlements.
One possibility is that private parties may already be dealing with some of these issues by using royalty contracts. The running royalty – i.e., an arrangement where periodic payments are made according to some percentage of sales or revenues – is a way of effectively “agreeing to disagree” over the value of a creative work. In cases where an author or inventor believes that the work is likely to produce substantially more revenue than the purchaser, use of a running royalty may allow both parties to structure a deal that matches their expectations and that reduces inefficiencies caused by optimism or regret aversion. We should emphasize that we cannot be sure how effective running royalties will be at mitigating endowment effects. Surprisingly little empirical research has been performed on the negotiation of royalties, so it is difficult for us to predict how endowment effects will affect royalty bargaining. It is possible, as we have noted, that royalties might reduce the effects of optimism by allowing the parties to move forward without resolving their differences regarding the likely return on the transaction. But it also seems plausible that the substantial differences in estimates of likely success will continue to hinder parties’ ability to agree on an acceptable split of the profits – the seller’s inaccurately high estimate of the likelihood of the work’s success may feed into a conviction that he deserves a more advantageous split of projected revenues. Indeed, these questions present another level of complexity: in many IP contexts the royalty rate will not be subject to bargaining, because it will be set by industry norms. Again, it is difficult to predict in settings where bargaining is impossible or unlikely whether the inability to bargain and the strength of norms will undermine endowment effects. Inability to bargain may result in an exercise of buy-side market power that partially or wholly offsets endowment effects. Or, it may simply result in a negotiation failure.
Even if the use of running royalties can play a role in mitigating endowment effects, it is very unlikely to be a complete answer to the problem of valuation. Running royalties are expensive to negotiate, implement, and administer. They involve the necessity of ongoing monitoring and periodic payments. As a result, running royalties are appropriate only for transactions that are valuable enough to bear the transaction costs of the running royalty arrangement.
Accordingly, it is worth looking to the possibility of restructuring legal entitlements to debias creators. Our results suggest two good reasons to consider debiasing. First, valuation anomalies proceeding from overoptimism present a better case for debiasing than instances in which the creators have idiosyncratically high valuations that are not driven by a mistake regarding likely market outcomes. Overoptimism can’t be dismissed as just an idiosyncratic preference – it is, rather, an information imperfection, or perhaps a failure to respond to information. In either case, it’s an error. Second – and importantly – our results suggest that the very old and continuing debate about the value of property rules vs. liability rules in IP has been incomplete. IP law is presently structured around property rules. But if the wide disparities between valuations that we found in our study characterize a range of IP transactions, then parties seeking to license or otherwise transfer ownership of creative works will face substantial negotiation costs arising from the need to bridge wide differences in valuation.
Thus far the law’s preference for property rules is based primarily on a presumption, driven mostly by theory and ideology rather than data, that markets and arms-length negotiations will allocate rights more efficiently than the alternative; that is, a legal regime based in liability rules, in which users are free to take, and in which the price of use is set not primarily via private negotiation but by a legislature, court, or government agency. (of course, there will still likely be considerable bargaining in the shadow of liability rules).
Our study undercuts that presumption. While liability rules require non-market price setting, which is beset by its own costs and is likely to lead to misallocation in some cases (although these concerns can easily be overblown, as parties often negotiate in the shadow of a liability rule), IP’s strong property rules may sometimes lead to significant pricing anomalies that hinder transactions and impose separate inefficiencies that liability rules may not create. The valuation spreads that we have identified add a significant and previously unrecognized premium to the transaction costs associated with IP bargaining. The gaps that we report may result in substantially higher costs of bargaining and, accordingly, fewer otherwise valuable transactions taking place.
When considering the respective costs and benefits of property and liability rules, it is important to remember that the inefficiencies created by property rules are neither different in kind nor necessarily less severe than those created by liability rules. Worse, property rules generate inefficiencies that are systematic in one direction—overvaluation and failed bargains—whereas the errors created in valuation under liability rules are more likely to by distributed symmetrically on both sides of the optimal price (that is, non-market pricing is as likely to produce under-valuation as over-valuation). If this is right, then symmetrical mispricing may not create substantial ex ante disincentives to engage in the creation of new works, for even if the creator understands that mispricing is likely under a liability rule, there is an equal chance of either over- or undercompensation.
Accordingly, if IP law’s preference for strong property rules is to be sustained, it must rest not on the basis of presumptions and ideologies but rather on evidence about the costs and associated inefficiencies of negotiation versus non-market pricing. These are empirical questions, and the answers may vary for different types of creativity and different markets. To make a start, we need more studies inquiring into whether pricing anomalies attend IP markets in a variety of circumstances, how large the valuation gaps are likely to be, and what can be done to shrink them.