Coase (with help from Grossman and Hart), transaction costs and IP

One of the seminal notions in modern economics is transaction costs. As formulated by the Noble laureate Ronald Coase, the concept was brought to bear on the simple, yet powerful question that Coase posed in his classic 1937 paper, “The Nature of the Firm.” He asked why some kinds of activities and transactions are governed by market forces while others are in effect dictated by fiat within the framework of a company. By extension, he asked why some things were done by the company but others were left to third parties by way of contract. It turns out that for some kinds of transactions, it is simply too costly to negotiate and enforce an agreement. Hence, the existence of the firm, which by dictate can set various relationships between it and its employees.

The Economist recently provided a useful introduction to Coase’s thought (“Coase Call: the theory of the firm”). Because of the centrality of Coase in this Kat's law school days (Richard Posner was the genius in residence, but it was Coase and his notion of transaction costs that cut across much that we learned), this Kat gave special attention to the article. In so doing, he was struck by the different manner by which IP may play a role.

More particularly, one of the most salient spin-offs of Coase's approach was developed by Sanford Grossman and Oliver Hart (co-winner of the 2016 Nobel Prize for Economics) in their influential 1986 article, "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration". One way to view their discussion is to ask the question: when should I contract with a supplier for a good or service and when should I vertically integrate it by acquisition. In addressing this question, what this Kat found interesting is how they treat IP matters from a quite different approach.

Let’s start with the distinction between so-called spot market/low-costs and long-term/more complex agreements. Think of the former in terms of engaging a taxi: one side provides the service and the other pays a specified amount. No written agreement is needed and any dissatisfaction is dealt with by eschewing the services of that driver in the future. To the contrary is an arrangement intended to be carried out over a period of time, such as a patent or trademark license. Here, a written agreement is called for. The problem is that the very complexity of such an agreement means that not everything can be specified. Some agreements are by their nature incomplete.

In this context, as Grossman and Hart note, property rights confer upon the owner of an asset what is termed "residual rights of control." The owner of the asset is entitled to the use and fruits of the asset except to the extent that he has agreed by contract to place a limit on those rights. The example given is taken from the publishing world, but not from the usual perspective of the author-publisher relationship. Rather, Grossman and Hart focus on the relationship between the publisher and the printer, writing as follows:

"Consider, for example, a contract between a publisher and a printer for a particular number of copies of a book. If the contract has no provision for an additional print run but the publisher receives some new information that makes it profitable for another run, then it is obvious that the right to decide whether or not to have the run belongs to the owner of the printing press. This is the simplest possible illustration of our assumption that the owner of an asset has the residual rights of control of that asset, that is, the right to control all aspects of the asset that have not been explicitly given away by contract."

Thus, while the author and publisher may provide by contract in greater or lesser detail the circumstances in which the publisher may publish the work on the basis of copyright, there are also physical assets involved, the ownership of which provides control over their use by their owner, unless the parties otherwise reach agreement to the contrary.

Second, take the customer list. Any discussion of trade secrets will point out that a customer list is a potentially valuable asset for the party that generates it as part of its business activities. Grossman and Hart consider the insurance industry and the issue of how to align the incentives of an insurance company and its independent agents in determining who should own this list. Against this backdrop, The Economist summarizes their discussion as follows:

"…[T]he party that brings the most to any venture in terms of “non-contractible” effort should own the key assets, which in this case is the client list. So the agent ought to own the list wherever policy renewals are sensitive to sales effort, as in the case of car insurance, for which people tend to shop around more. The agent would keep the residual rights [i.e., the customer list] and be rewarded for the effort to find the right sort of client."

Grossman and Hart go on to describe when this may not be the case, depending upon what kind of insurance policy is involved (e.g., life insurance). There, given that the first sale of the policy is crucial, the on-going role of the agent is less important and it may well make more sense for the insurance company to acquire the agent. Here, it is more appropriate that the company be the owner of the customer list (although the question of how to then incentivize the employee becomes front and center).

The upshot is that attention needs to be paid to the circumstances in which it will be in the company's interest acquire the residual, non-physical assets of another (here, the customer list) in a manner which makes sense for both sides, while also finding at least a partial solution of how to incentivize the party that foregoes control/ownership of the customer list asset to continue to perform in a productive manner.

Perhaps the ultimate take-away is that the moment that we treat IP as a property right, its treatment within the fertile world of legal-economic scholarship can sometimes take us in unexpected directions, expanding our understanding of how IP rights function within the wider context.

Photo at upper right courtesy of Coase-Sandor Institute for Law and Economics, University of Chicago Law School