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Eastern Economic Journal, Volume XVII, No. 2,April-June 1991

The Chicago Intellectual PropertyRights Tradition and theReconciliation of Coase and Hayek

Laurence Moss*

In thispaper I trace a fairly ontinuous line of argument about the institutionalmechanisms bywhich intellectual property is produced and maintained in an advanced, commercial economy.1 Thebetter part of the economic thinking n thissubject owes directly to an approach topolicy analysisadvocated by Ronald Coase.2 Coase's ideas influenced a number of talented economists especially afterhis arrival at the Law School in 1964. I speak of a "Chicago intellectualproperty rightstradition"notonly because of the splendid bouquet of ideas at the law school proper, but also because of thecross-fertilization that took place between the lawyers and several economists on the Chicago economics faculty.3The enigma of intellectualpropertycan be summarized quite simplythisway: Since commerciallyvaluable information an be kept proprietary only for limitedperiods of time,how is it thatsomanyindividuals and businesses are atwork producing this informationeach day? Somehow theymustbenefit from producing valuable information,either by the lead time advantage they gain overcompetitors before this information ecomes generally available to other firmsor else by somehowkeeping this information frombeing utilized by other competing firms.Surely, other firmsmust bediscouraged from copying or at least copying without permission from the original information "owner."How do information-producers stablish theirproprietary interests in the firstplace? How do theyprotect their intellectual harvests from would-be poachers who wish to free-ride on the first informationproducer's often costly investments?4To appreciate the contribution of the"Chicago tradition,"toward theunravelingof thispuzzle, Ihave organized my discussion in three main parts. In Part I, I emphasize Aaron Director's role both ininauguratinga field of research in law and economics at Chicago and in pioneering a particularmethodology foraccomplishing that task.Director and his students literally aved theway forCoaseand the celebrated property-rights pproach topolicy analysis.5As I demonstrate in Part II, Coase's students, especially Harold Demsetz and Steven Cheung,applied Coase's thesis to the problem of the production and profitable distribution of businessinformation.6he Coase group broke new ground. They systematically pplied amethod which theycalled "comparative institution analysis" to the problem of intellectual property.7I also survey dmund Kitch's work,which utilizes the basic logicof theChicago human capitalapproach inorder to reach a surprisingresult about the effectiveness f the division of knowledge andthe organization of work within large business organizations.8Finally, inPart III I show that thepropertyrights pproach applied to intellectualpropertyhelps usreconcile FriedrichA. Hayek's celebrated appreciation of thepricingsystem s amechanism forquicklyand effectively utilizing commercially valuable economic information with another of Coase's pioneeringessays, namely, theone about thenature of thefirm.9o some extent thefirm xists to retard thediffusionof commercially valuable informationwhile, at the same time,effectively nd "selfishly"utilizing that informationforbusiness gain.Whereas Hayek argued that,once property rightsare

*Babson College, Wellesley, MA 02157.

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146 EASTERN ECONOMIC JOURNAL

established, information smost effectively tilized via thepricing system,theChicago traditionstandsfortheproposition that theattenuation of theprice system an, insome cases, facilitateboth the reationand utilization of commercially valuable information. o the best of my knowledge, this proposedreconciliationofCoase andHayek isoriginal and has not been offeredbefore.10

THE CHICAGO LAW SCHOOL APPROACHOrigins

As a rule, law school faculties do not employ professional economists to teach economics.11 Duringthe 1930s,Chicago's Law School violated this rule and actually hired a professional economist.HenrySimons was hired to teach economic principles to law students.12 Simons's interest in preservingcompetition as amethod of social regulation informedmost of his policy prescriptions and providedfertile oil fortherooting f theChicago lawapproach.13Simons's untimely death in 1946 led to the appointment of a successor economist, AaronDirector.14With Director we have the initiation f a genuinelynovel and influential aw and economicsresearch program at Chicago. In a team-taught antitrust seminar with the distinguished lawyer, EdwardLevi,Director encouraged the lawstudents to inquiremore deeply intowhat, at firstglance, appeared tobe suspicious, "exclusionary," business practices.15 Rather than stigmatize what they do not understandas "anticompetitive," lawyers should study suspicious business practices in order to discover the functionthey lay in modern commercial setting.Levi would analyze the rhetorical methods the courts use to characterize and therefore distinguishlawful from unlawful behavior. Director, on the other hand, warned the law students to be skepticalabout the court's rhetoric. Instead of semantic hairsplitting, lawyers should ask how an unlawfulbusiness practice could possibly enhance business profits.16 In the cases where the condemned businesspractice is not profitable nor likely to produce profits in the future, the lawyer is put into theembarrassing position of arguing that businessmen violate the antitrust lawsby doing things thataretruly nprofitable. Such a conclusion strains all credulitysince itwas thegreed of businessmen that thelawwas designed toregulate inthefirstplaceIn other cases, where the condemned business practice enhances business profits, Director appliedthe tools of economic analysis and found that the national product was increased along with thebusiness profits. This meant that the condemnation of the business practice under the antitrust lawsmight serve to restrict market opportunities and diminish national wealth?once again, a disturbingresult.17

Director's great contribution was to show the students that, in the absence of transaction costconsiderations, so-called exclusionary practices were unprofitable to the businessman. In the presenceof transaction costs, condemned business practices were profitable and helped achieve the importantpublic policy objective ofwealth creation.lfi

Judge Robert Bork, reflecting on his experiences in the Director-Levi course, stated that the courseprovided himwithnothing less thana "newway of looking t theworld."19Milton Friedman emphasizedthe success Director had in pointing students to a new source of data for economists to investigate?thebusiness practices discussed in the antitrust case law decisions.20 Finally, Judge Richard Posnercommented that Director actually succeeded in giving economists a new job to do?to prove thepresence or absence of business conspiracy through the actual effects the suspicious behavior had in themarket.21Director called attention to thepublic policy errors thatoccurwhen legal analysis isapplied tobusiness behavior without the benefit of economic analysis. Director advocated the merger of legalstudies with economic analysis, and that merger is now regarded as the hallmark of the law andeconomics approach.Director's studentsresponded tohis challenge bypublishinga spate of articles,several ofwhich areconsidered to be landmarks in the law and economics literature that emerged from the Chicago Law


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RECONCILIATION OF COASE AND HAYEK 147

School program. In addition to Bork, other veterans of the Director-Levi seminar include John S.McGee, Lester Telser, Gary Becker and Ward S. Bowman, Jr.22

Coase and Policy Analysis:When Coase came to theChicago Law School he enthusiasticallyassumed the responsibilitiesofeditor of theJournalofLaw andEconomics (JLE).23Under Coase's direction, theJLE became themainresearch outlet for the law and economics movement, a status that has remained an important part ofthat journal's success for nearly three decades.Coase's remarkable paper, "The Problem of Social Cost," appeared in the JLE in 1960 but hadalready setoffa lively nd far-reachingdebate about policy among the economics faculty tChicago.24The publication of the paper naturally publicized that debate and encouraged other commentary.

Despite the many qualifications, extensions and refutations, what is commonly referred to as the "Coasetheorem" has remained intact.My concern in this section iswith a narrower aspect of Coase's thesis, namely, those features of hisargument thatwere directed against the policy analysis ofA.C. Pigou.25The Pigouvian approachprovided a simple recipe fordirectgovernment regulationof theeconomy thatmany economistswereall too quick and eager to copy.26 Pigou's recipe consisted of calling for government regulation whenevertheprivatelyperceived cost of an activity id not include theentire "social costs" of thatactivity. gain,a simple example will serve to illustrate the Pigouvian approach.Consider the case of the six o'clock "Bolt Express." emitting sparks as it breezes byMrs. O'Leary'soutdoor laundry ine and creatingabout $40 amonth indamages toher laundry. fwe also learnthat therailroad owners net only $20 a month in profits, then we have a situation that makes the national

product of this economy lower than it otherwise might be. It occurred to Pigou and many economistsafterhim thata scientifically mposed (monthly) taxof $40 on the railroad owners,which accrues eachtime the six o'clock "Bolt Express" roared by Mrs. O'Leary's wash, would set matters right.27 The taxquickly educates the railroad owners about the true (marginal) costs of theiractivity. y confrontingrailroad ownerswith the true,"social cost" of theactivity, heywould be ina more precise position todecide whether torun that train t all. Since thetaxhas eliminated theprofits n the sixo'clock run,therailroad owners will stop running the six o'clock "Bolt Express." Now Mrs. O'Leary's laundry is savedfrom any further damage. Government intervention, especially if such intervention were not tooexpensive to administer, has helped increase the national product.Coase demonstrated that this reasoning led to false conclusions about resource allocation. Pigouwas correct in concentrating on the maximization of national output as the correct policy objective. Hewas also correct in focusing economists' attention on the problem of "economic damage" and trying toattach a dollar figureto thatdamage. Pigou erred incalling fordirectgovernmentregulation in the formof a tax when alternative, perhaps more effective, social arrangements are possible. Let us examinePigou's errors inmore detail.

Suppose Mrs. O'Leary, at only a minor expense, could hang her wash after the six o'clock morningtrainhad passed herbackyard clothesline and that suchan alteration inhernormal,daily routinewouldbe a minor inconvenience. So minor that a smallmonthly payment of $5 from the railroad would bemore than sufficient to compensate her for accommodating her wash schedule to the time-schedule ofthe railroad. The Pigouvian tax system, as described above, if implemented, would now lower nationaloutput below what itmight otherwise have been. Rather than direct government regulation, perhaps weneed onlyhave had a (less expensive) local court declare thatMrs. O'Leary has a "legal right"not tohave her laundry amaged (or threatenedwithdamage) by theearlymorning sixo'clock "Bolt Express."The railroad company, confronted by the court's decision, must now "purchase" Mrs. O'Leary'sconsent.28 The railroad might secure her voluntary consent and in this way obtain the right to run a trainby her house. If the costs of negotiating and enforcing such an agreement were small enough, such acontractual arrangement would emerge, and the value of the economic product would expand.The Coase theorem emerged from the observation that, under certain, special circumstances, it


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would not make a difference in terms of the allocation of resources and the size of the subsequent,national produce, whether or not Mrs. O'Leary were awarded the right not to have her laundry invadedby escaping sparks or, in the alternative, the railroad owners were providedwith the right fway andallowed to emit those sparks. If itwere the railroad owners who won the lawsuit, then itwould be Mrs.O'Leary who might have to make an offer to the railroad company to stop running the six o'clockexpress. Coase explained that, as long as the costs of transacting business between the parties weresmall, private negotiation would succeed inmaximizing national wealth. Private negotiation about theuse of property rightsrequires,first f all,well-defined propertyrights tructures.This surprising and now celebrated result that is a matter of indifference to an economist as towhich of the twoparties ina damage-dispute isdeclared tobe liable fordamages, derivedmostly (asCoase explained) from the simplifying ssumption that the transactioncosts of arrivingat agreementsabout resource use are negligible. In a world where accountants must perform audits and lawyers chargeforpreparing contracts, it ften does make a dramatic differencewhich of twodisputingpartieswins alawsuit. In fact,Coase explained that,from the economic point of view, it is best ifthe judge decidesagainst the party who can avoid the damage at the lowest cost. Indeed, as Coase's survey of privatenuisance actions revealed, judges often did decide cases in precisely this way.29

Pigou's earlier tax-the-harm approach embodies an important, analytic error. The tax levied on theperpetrators of the damage-producing activity (that is, the owners of the railroad) results in taxrevenues thatare not therebyredistributed to thevictim (that is,Mrs. O'Leary). Thus, the victim isfaced with an extreme choice of either permittingthe activityof her neighbor (the six o'clock "BoltExpress") or else trying to ban the activity altogether. The range of intermediate solutions, such asletting he harmfulactivity ontinue,but only for while and up toa point are eliminatedby thepatternof the government intervention Pigou recommended. The Pigouvian approach to the problem ofwelfare economics was, Coase argued, "defective." It was defective because the Pigouvian approachfailed to consider the opportunities that are foregone when direct government regulation, such as a tax,isused rather than,say, the clarificationofpropertyrights y thejudges.30Coase's message was simple: Economists should apply the idea of opportunity cost as consistentlyin thearea of normativepolicy analysis as it isapplied to the study f thefirm inthemarket place. Thetypicalbusiness organization compares one intended application of resourceswith what theycouldproduce when productively employed elsewhere either within the firm r elsewhere in the economy.These calculations are based on market prices and, as Coase explained:

The main advantage of the pricing system is that it leads to the employment of factors inplaces where thevalue of the product yielded isgreatest and does so at less cost than alternative systems. . . .3lBy analogy thepolicy analyst should stop comparing currentmarket outcomes to the so-called ideal ofperfect competition since the ideal of perfect competition is,as itsname suggests,an ideal and not arealistic alternative. By definition and not by analysis, the current market outcome always appears to beinadequate, warranting the interventionist solution. A more fruitful approach would be to start with asituation thatactually captures business practices as theyexist and then examine theproposed policychange in order to decide whether the new situation would be, on balance, better or worse than thecurrent situation. As Coase explained, the practical value of this approach would be that "conclusionsfor policy would [finally] have some relevance to the actual situation."32

APPLICATION OF THE APPROACH TO INTELLECTUAL PROPERTYDemsetz and Cheung

Harold Demsetz joined theChicago economics department in 1963.He applied Coase's generalline of reasoning to several importantproblems inmodern economics, includingtheproblem of theproduction and maintenance of commercially valuable business information.33 Demsetz underscoredthe point that property rights structures were a necessary precondition in order that markets could


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function to internalize (i.e., eliminate) troublesome externalities. The internalization of externalitieswould allow competitive market structures to maximize national product. It was the maximization ofnational product that remained forDemsetz (as ithad forboth Coase and Pigou) the overridingobjective of economic policy analysis.34A primary function of property rights is that of guiding incentives to achieve a greater internalization ofexternalities. Every cost and benefit associated with social interdependencies is a potential externality.One condition is necessary tomake costs and benefits externalities. The cost of a transaction in the rightsbetween the parties (internalization) must exceed the gains from internalization. In general, transactioncosts can be large relative to gains because of "natural" difficulties in trading or they can be large becauseof legal reasons.15

In otherwords, iftransactionscostswere too high, itwould make the adequate definitionof propertyrights impossible,and individualsmight simplyfail to internalize the externalities, losingout inwhatmight otherwise be mutually advantageous exchanges. These insightsare nicely illustratedby theproblem of theproduction and maintenance of intellectualproperty.Consider thepeculiar problemsassociated with the financing of technological innovation.The firstproblem has todo with the fact thatmost successful innovations re emphaticallynot theresultof a flash of genius and springout fullygrown fromthe recesses of an inquiringgenius' brain.Rather, the innovations are a product of hard work and excruciating mental effort.36 At the start, there isthepreliminary,basic research that,among other things, emonstrates the logical possibilityof somequality or effect that subsequentlymay be determined to have commercial value. Then comes theprocess of inventing ith all itspitfallsand varied experimentation.Finally, theprocess of developingthe invention is long and treacherous. Rendering the invention fit for customer use includes manufacturing, demonstrating that the invention is reasonably safe to use and also acquiring the numerous,regulatory permissions now required by themodern welfare state.37 ach milestone along thewayproduces ideas, data, recipes, formulas nd results that re difficult okeep out of the reach ofpoachersand other free riders.38Demsetz explained why the financing of commercially valuable informationwould not be aproblem in a world without transaction costs. In such an imaginary world, the costless negotiation andenforcement of contracts would make itpossible for investors to enter into contracts with would-be freeriders. Each free-rider, lacking the incentive tomisrepresent his (subjective) offer price wouldimmediatelyvolunteer topay his fair share of the (discounted expected value) of these investments nknowledge production.3g But the private transaction costs of preventing the uncompensated diffusion ofbusiness information is quite substantial as Kenneth Arrow realized in 1962.4UArrow's celebrated statement of the problem immediately became the standard textbook rationalefor declaring that government intervention is needed to support inventive effort. Arrow insisted that thesystem of perfect competition invariably leads to a nonoptimal allocation of resources. By encouragingthe rapid and speedy diffusion of commercially valuable information, otential investorscan avoidcommittingresources in these areas since anything theyproduce of value is quickly exploited bynonpaying free-riders.Arrow acknowledged that thepatent system, ycreatingpropertyrights n"inventions,"does helprestore business incentives in the later stages of technological innovation, but what about the earlystages?41 rrow suggested that it is the incompleteness of propertyrights thatcreates the allocativeinefficiency:

... if the seller can retain property rights in the use of the information, this would be no problem, butgiven incomplete appropriability, the potential buyer will base his decision topurchase information on lessthan optimal criteria.42

Arrow concluded that 'Tor optimal allocation to invention itwould be necessary for the government orsome other agency not governed by profit-and-loss criteria to finance research and invention."43There is no doubt thatArrow simply leapt from the litanyof insightful tatements about the


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difficulties f appropriating the value of commerciallyvaluable information, nder competitive conditions, to the amazing policy conclusion that a government subsidy program is required. Arrow'sconclusion is, t best, a leap of faith r, perhaps, an expressionof lack of faith inmarket alternatives togovernment intervention. In 1969, Demsetz questioned the logical coherence of Arrow's policyanalysis.44Demsetz appealed to economists to avoid the "nirvana approach." What was the point ofcomparing the current, actual, everyday world of business practice to some fanciful, ideal world ofcostless exchange and thenconcluding that the realworld of commercial life s"defective." Possibly theonly rationale for such an approach is a cynical one; namely, just about any form of governmentintervention an be shown tobe superior to existingbusiness practice.Arrow is,perhaps, unwittinglylendinghis support to thosewho use the abstractmodel of perfect competition as a foil to justify hecontinued funding of large-scale, government intervention in commercial life.Demsetz called for the immediate adoption of the "comparative institution approach."45 Economists should judge existingmarket institutions ut only afterconsideringwhat alternative institutionswould emerge in their absence. The comparison is not between existing, commercial practice and someideal, unobtainable, abstract world of perfect competition but, rather, between existing commercialpractice and what would otherwise arise ifwe limitedexisting practice by legal rules and sanctionsaccording to certain practical, administrative criteria. Such a comparison might, on occasion, strengthenthe case for a government intervention and on other occasions weaken it.Consider, for example, StevenCheung's defense of the creation of property rights in inventions by a patent office.46In an article published in Economic Inquiry in 1982, Cheung summarized several well-knownarguments against the patent system, as follows:

... ithas been argued that an idea is a "public" good, amenable to concurrent usages, and for that reasonany patent protection which allows a fee to be charged for itsuse will "inefficiently" inhibit its usefulnessand diffusion. Other arguments are that patents create monopoly rights, encourage wasteful duplication ofresearch effort, or promote a rush to invent. By similar reasoning, a popular thesis asserts that patentprotection leads to the dissipation of economic rents.47

Cheung reminded us, however, that the abolition of thepatent systemwill not bringon the regimeofperfect competition.Without a patent system,not all inventions ill be speedily expedited. Instead, theabolition of patentingwill induce certain investorsto relymore heavilyon the law of trade secrecy toprotect their inventions.48The creation and maintenance of secrecydepends on establishing carefullydefined relationshipsbetween employers and employees usually enhanced byway of explicitlydrafted,nondisclosure, privatecontracts.These contractsare explicitlydesigned to limitthemobility of the laborerby prohibiting thesortsof jobs he or she can accept should thepresent job situationnot last.These contractsdepend onthe availabilityof swift nd (relatively) inexpensive, udicial enforcement; otherwise theywill not beeffective. It was clear that Cheung took it for granted that, in the absence of the patent system, suchagreements would be enforced by the courts.4y Based on this, he concluded that a regime ofnondisclosure and thewidespread duplication of investmentin commercially valuable informationwould come into existence if the patent system were to be abolished. Such a surge in trade secrecy wouldresult in an allocation of inventive effort far inferior towhat we now have with the patent system, itself.50

Cheung opted for the patent system over trade secrecy. The system of patent examination and theissuingof limited,exclusive rights to inventions is nearly always superior to the sortof hoarding ofinformation that would be set inmotion should the patent system ever be abolished. In Cheung's words:... if the patent system were to be eliminated, the "undesirable" effects attributed to itwould emergeelsewhere in aggravated form. In other words, economists, [that is, economists following Pigou or,perhaps, Arrow] tend to overlook the crucial question: What would an inventor or innovator do if therewere not patent protection?51

Cheung's article is an interesting and convincing extension of the Coase-Demsetz property-rights


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approach topolicy problems. It isbased on the critical assumption that, in the absence of thepatentsystem, the courts would be willing to enforce privately negotiated employee-employer covenantsnot-to-compete and related non-disclosure agreements. How sympathetic are the courts to enforcingsuch contracts? If judges were unwilling to enforce trade secrecy agreements because they seemviolative of basic rights to move from one job to another, what alternative market institutions mightemerge to facilitate trade.52 The answer to these questions can be answered by carefully considering thehuman capital approach in economics.

Becker and theChicago Human Capital ApproachAt firstglance, the human capital approach, which became a distinctiveresearch program at theChicago economics department during the 1960s,seems toowe little o the lineof research underwayattheChicago Law School Instead, theanalysisof human capital and themarket institutionsleading to its

productionmaintenance and diffusionseems tobe an insulardevelopment entirelywithinChicago'seconomics department, although drawing inspirationand doctrinal support froma long list fwritersdating back several centuries.^ It is truethatChicago economist Frank H. Knight's repeated emphasison treating factors of production as essentially alike and subject to improvement through investmentmay have been the immediate catalyst for thedevelopment of the human capital approach among theChicago faculty.54uite obviously, individuals do investresources in improvingtheirown jobmarketskills by going to college and obtaining professional degrees and then qualifying for licenses.But,despite this and other, often-cited "anticipations" of the human capital approach, in 1961 itwasChicago economist, T.W. Schultz, that sounded the call55Schultz argued that therewere importantmarket phenomena thatsimplycould not be adequatelyexplained without a more carefully crafted concept of human capital. As Schultz remarked, "the mostdistinctive feature of our economic system is the growth in human capital."56

It remained forGary Becker toextend theongoing, actual researchprogramon theproblem of theproduction and maintenance of human capital to the workplace situation and the contract betweenemployer and employee.57 Becker's great contribution was to recognize that on-the-job training was asimportant, ifnot more important, to the evolution of commercial institutions than formal, professionalschooling.The economic problem was to explain how this training was financed in a world where the courtsare hostile toagreements thatrestrictmobilityof labor.Stated quite simply, hy shouldAjax Industries,Inc. train a manager about how to use new techniques in, say, glassmaking if, after acquiring these skillsand knowledge, themanager could quit his job and go work fora competitorfirm t a higherwage?Becker's answer was entirely consistent with the competitive model of labor market equilibrium. The(marginal) employers and (marginal) employees are reasonably informed bout what thisknowledgeand skillwillmean in terms f theirfuture income.The employees therefore gree towork for less thanthe market value of their marginal product, and in exchange for such "bargain wages," the employersimplicitlygree tofinance thison-the-job training. hat we have, infact, s n implicit ontract inwhichemployees are paid a "discounted," marginal product discounted by the cost to the employer of theon-the-job training that is supplied.58Consider still one more example: Suppose company A was established by a scientist-entrepreneurwho had discovered a new formula for a delicious soft drink. Assume, further, that the process cannotbe reverse engineered in the usual manner from a sample of the final product purchased on the openmarket.59 As this entrepreneur begins to scale-up for wide, regional, market sales, he might find itnecessary to share that formula with other employees. In order to insure his market power at the time hehires these employees, he negotiates so-called trade secrecy agreements and various covenants not tocompete. The employees now acquire on-the-job training that will not be easily transferable to acompetitor firm. In exchange for this evident decrease in their job mobility, theymust be paid apremium wage.60There are definite advantages to paying premium wages. High wages cut down on employee


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turnover and help encourage a more enthusiastic and cooperative workforce.61 On the other hand,paying employees awage inexcess of themarginal productivity lso serves to reduce the returnsfromthe new invention that would otherwise be available to the investor/entrepreneur. "Golden-handcuffs"are effective nd legal,but theymay be tooexpensive touse because any singleemployee or smallgroupof employees can strategically hold out" fora remunerationpackage thatwill appropriatemost of therents that might, under a patent system, accrue to the original investor-scientist.62Curiously, Becker's distinction between information described as "basic research" and theinformation described as "on-the-job training" goes directly to the heart of the matter. On-the-job

training can be "financed" through a competitively determined wage rate that is somewhat less than aworker's current, opportunity wage. This is because the workers are not slaves and, therefore, aworker's skills cannot be used without a worker's willing participation and consent. Thus, theproduction of this sort of knowledge results mostly in "internalities" and not in the troublesome"externalities" that concerned Coase and Demsetz.61

Basic research, unlike on-the-job training, can be copied and used without the participation of theperson or persons originally possessing it.Creations of this sort produce externalities that cannot easilybe internalized, nd so it isbasic research thatmay need public subsidies and not on-the-job training.Becker explained:

The difference between investment in training and in research and development can be put very simply.Without patents or secrecy, firms incompetitive industries may have difficulty establishing property rightsin innovations and these innovations may become fair game for all comers. Patent systems try to establishthese rights so that incentives can be provided to invest in research. Property rights in skills on the otherhand are automatically vested, for a skill cannot be used without permission of the person possessing it.The property right of a worker in his skills is the source of his incentive to invest in training by accepting areduced wage during the training period and explains why an analogy with unowned innovations ismisleading.64Becker suggested (anticipating Cheung's position) that, if the patent systemwere abolished,business secrecy would become much more important.

Kitch and Organizational DesignIn a 1980 article entitled "The Law and Economics ofRights inValuable Information,"EdmundKitch argued that the courts are extremely reluctant to enforce contracts in which employers try to

prevent former employees from taking jobs with competitors as a way of protecting investments inintellectual property.65 Judicial attitudes on these matters date back to at least the 18th century whenthe Settlement Act and common law apprentice practices came under attack from Adam Smith andothermembers of the classical liberal school.66 In the 19th and 20th centuries, these attitudeswerereinforcedby the revoltagainst slavery.Contracts that intendto restrict themobility of labormust bereasonable, or else they will be declared void as a matter of public policy.67Kitch hypothesized that, in this legal climate, itwould be far cheaper and more reliable ifemployers could divide and subdivide theknowledgewithin thefirmso thatno single employee hasenough of it to "hold up" the owners of the business for higher wages or benefits.6* To appreciate Kitch'spoint,consider thefollowing arable: Suppose a firmhas a strongbox illedwith jewelswhich is fasteneddown but left nattended ina public area. Inorder toprevent the theft f thejewels, theowners of thefirm do not entrust the combination lock sequence to any one, single individual. Instead, severalindividuals each memorize one digit, and still another individualhas a listshowing the sequence inwhich each of the aforementioned individuals shouldgo to the lock and registerhis number.Ifthese several individualswere kept fromcommunicatingwith each otherby, say,separating themin the largefirm, ven staggeringtheir lunchhours, then thedeparture of anyone individual,or evenseveral, will not lead to a looting of the firm's precious jewels. A large, vertically integrated firm can bethought of as an ingenious, organizational innovation designed to keep the company jewels from leavingtheorganization and becoming public information. ach departmentwithin thefirm as a bitor piece of


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thefinalcombination,but no one individualor department and certainlyno small group of employeescan easilymake offtogetherwith theentire company jewels.69The knowledge has become, so to speak, "institutionalized" within the firm, and in this way, unlessthefirm isacquired outrightbya takeoveror such, the basic research is largely rotected fromcopyingby others. Certainly, in the absence of a patent system, we might expect trade secrecy to become moreprevalent in business. But if the courts were reluctant to enforce employer-employee agreements, asKitch maintains, then the large,vertically integrated irmmight, by itself, ecome the leastcostlyway ofhelping the creators of intellectual property produce and maintain the fruits of their intellectualharvests.

If commercially valuable information were carefully folded into the various departments andoperating procedures of the business organization and not centralized inany single location, then thelikelihood of itsbecoming rapidlydiffused among free riders is significantly essened. The practicaleffect of such a structure is an increase on the return on intellectual property and, by implication, theencouragement of its continued production.

The existence of the large, hierarchical corporation and the tight-lipped "corporation man" may,indeed, be one spontaneously evolved market response to the enigma of intellectual property. Anotherresponsewas analyzed byFeinstein and Stein (F&S) in1988.70F&S coined the phrase, "internal redundancy," by which they meant the "practice of assigningemployees topartially overlapping tasks."71 his apparent duplication of effort snot irrationalwhenviewed in its proper context. If the firm were concerned that project managers may leave and take the

projects with them, then "redundancy" may be a cost-effective method of deterring the untimelydiffusionof intellectualproperty. In thewords ofF&S, "A researcher will be less tempted to strike uton his own ifthere isa chance that theproject he isworking on or the skills he has acquired will beduplicated by someone else."72 The authors place their work in a line of descent from Coase's 1937article on the analysis of thefirm.73My intentionhere is to show that these authors pursue a line ofargument thatmay be properly housed in the broader Chicago intellectualproperty rightstradition.What is studied are the noninterventionist alternatives to so-called "market failures." F&S, along withKitch, demonstrate the rich insights rovided by thisapproach.In my view, the research program is a viable one and, at this writing, remains in its early stages ofdevelopment.

RECONCILIATION OF COASE AND HAYEKCreation and Retarded Diffusion of Intellectual Property

Knowledge about theChicago intellectual property rights traditioncan help us reconcile twoimportant views of the market system that have always

seemed todefy

reconciliation. On the one handthere isFriedrichA. Hayek's classic 1945paper on "The Use ofKnowledge inSociety,"which presentsthe case for thepricing system in termsof how itencourages an efficient tilization of the availableinformation nsociety.74he knowledge isutilized,notbyfirstbecoming centralized inbureaus and thenpublished in encyclopedias and the like, but, rather,by creating private (financial) incentives forindividuals to acquire fragmentedbits and pieces of thatknowledge and then utilize thatknowledgemost effectively for their own personal advantage. The result is a complicated and coordinatedproduction structure that accomplishes much more than any single, individual actor could ever haveimagined. If the economic problem were, as Hayek supposes, one of utilizing information that is alreadyin the world, then the pricing system has everything to recommend it, and Hayek's view is correct. Alltransactions should be conducted by way of arm's-length, bargained-for contracts, and prices areformed for well-defined products and services.

Why, then, do we observe business firms? A business firm is, in a profound sense, a substitutemechanism for thepricingmechanism. This was the thesis of an article byRonald Coase published in1937 and entitled "The Nature of the Firm."75 According toCoase, a firm is established to avoid certain


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costs identifiedwith thepricing system. hese costs must surely include those of transactingbusinessthrough written contracts between otherwise, unrelated individuals. As Coase and subsequent writersexplained, these costs are diminished when hierarchical relationships are substituted for contract.76These hierarchical relationships between employers and employees constitute the business firm.However, there are also costs that arisewhen the pricingmechanism is limited and individuals arebrought together inbusiness organizations.The outside check ofmarket competition isdone awaywith,and the employermust relymore heavilyon the loyalty, edication and honesty of his employees.77According toCoase, theoptimal size of theorganization isobtained when:

... at themargin, the costs of organizing within the firm will be equal either to the costs of organizing inanother firm or to the costs involved in leaving the transaction tobe "organized" by the price mechanism.The same lineof thinking scarried over in itch's recentwork.According toKitch:

There is an optimal number of markets inan industry.Too few markets will raise the internal informationcost problems for firms, toomany markets will erode the net value of the information theygenerate.79It is verydifficultto profitably rrange for both theproduction and maintenance of intellectualpropertyby relying exclusivelyon theprice system,especially under the labormarket conditions inwhich courts frown on restrictive agreements between employers and employees, except under the most

egregious circumstances. The reluctance of the courts make trade secrecy a rather unreliable methodfor appropriating the returns on investment in intellectual property.80 The price system, which isextremely effective at utilizing information that is already in existence would bankrupt those who createintellectualproperty if llowed tooperate unimpeded. A Hayekian pricemechanism that facilitates theduplication and diffusionof already created informationresults in too fewresources being devoted totheproduction and maintenance of intellectualproperty inthefirstplace.Potential information producers do have at least one other alternative. They can utilize the newinformation o theirpersonal advantage byestablishinga business firm. Coasean world dominated byfirms that have been established to economize on certain costs associated with the use of thepricemechanism can also be a world able to account for investments in the production and maintenance ofintellectualproperty.The vertically integratedfirm isa burden on economic lifewhen we ask, for thepresent moment, how information already in the world can be most advantageously utilized.81 Theintegrated firm becomes valuable to modern, economic life when we ask how individuals can beencouraged tobring commerciallyvaluable information ntotheworld in thefirstplace. The Chicagolaw tradition, with its emphasis on comparative institution analysis, has furnished us with a coherent andunconventional understanding of market institutions.

ConclusionThe Chicago intellectualproperty rights tradition offersa rich and suggestive interpretation fmarket institutions as alternatives to direct government tax and subsidy schemes. By making particularlegal and other institutions a serious subject for investigation, Chicago economists have enriched ourunderstandingof thediversityof themarket process. They have also pointed theway towarda morerealistic appraisal of the role of government in the economy. I have tried to show how this approach nowencourages a viable research program and, in addition, can be used to reconcile Coase (1937) andHayek (1945).

NOTES1. An early version of this paper was presented to a joint session of the History of Economics Society and theAmerican Economic Association on "The Chicago School." My thanks to the Babson Board of Research for acourse release in the Spring of 1990 and Professors Ingrid Rima, Richard Gonce and Warren Samuels for theirthoughtful criticisms. The usual disclaimers apply.


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2. See R.H. Coase, "The Problem of Social Cost," Journal of Law and Economics, 3(October 1960):l-44; in idem.,The Firm theMarket and theLaw, (Chicago: University of Chicago, 1988), pp. 95-156.3. The "cross-fertilization" claim is supported by strong testimonial evidence, see E.W. Kitch, "The Fire of Truth:A Remembrance of Law and Economics at Chicago, 1932-1970/' Journal of Law and Economics, 26(April1983): 163?232; especially G. Becker's recollections, p. 185.4. Many law schools offer specialized courses in intellectual property. A typical list of subjects includes patentsystems, copyright laws, trade secrets, trademarks and so on. For a leading case book on these topics, see P.Goldstein, Copyright, Patent, Trademark and Related State Doctrines, 2d. ed. (Mineola, New York: FoundationPress, 1981).5. Kitch, "The Fire of Truth," pp. 179-182.6. The relevant writings are, Harold Demsetz, "Information and Efficiency: Another Viewpoint," Journal of Lawand Economics (March 1969) in idem., Efficiency, Competition and Policy: The Organization ofEconomic Activity,2 vols. (Blackwell, 1982)2:3-24; and S.N.S. Cheung, "Property Rights inTrade Secrets," Economic Inquiry,20(January 1982):40-43.7. Cf. Coase, "The Problem of Social Cost," inThe Firm, p. 153-156.8. E.W. Kitch, "The Law and Economics of Rights inValuable Information," Journal of Legal Studies (December1980):683-723.9. R.H. Coase, "The Nature of theFirm," Economica, 4(November 1937); in idem., The Firm, pp. 33-55.10. F.A. Hayek's "On theUse ofKnowledge inSociety "American Economic Review, 35(September 1945):519-30.1find it curious that Hayek, himself, was not engaged by Coase's conceptual challenge. At other places, Hayektreated the firmas consisting of a collection of investment projects and limited in its ability to borrow loanablefunds; see L.S. Moss and K. Vaughn, "Hayek's Ricardo Effect: A Second Look," History of Political Economy,18(Winter 986):545:565.11. Kitch, "The Fire of Truth," pp. 163-232.12. Ibid.13. Kitch, ed., "The Fire of Truth," pp. 175-177; cf. H. Simons, Economic Policy for a Free Society (Chicago:

University of Chicago Press, 1948).14. Ibid.15. Ibid.16. Ibid., see also R.H. Bork, The Antitrust Paradox: A Policy at War with Itself (New York: Basic Books, 1978), pp.1-11.17. Ibid.18. Bork recommends that the "only goal" of the antitrust laws should be the welfare of consumers. To the extentthat business investment is directed to satisfying themost urgent demands of consumers as translated throughmarket prices, the maximization of wealth and consumer welfare are compatible. See Bork, The AntitrustParadox, p. 405.19. Kitch, "The Fire of Truth," p. 201.20. Ibid., p. 203.21. Ibid., pp. 207-208.22. J.S.McGee, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics, 1(1958);K. Elzinga, "Predatory Pricing: The Case of theGunpowder Trust," Journal of Law and Economics, 13(1970);W.S. Bowman, Patent and Antitrust Law (Chicago, 1973).23. Coase stated, "... When I came to theUniversity of Chicago, I regarded my role as that of Saint Paul toAaronDirector's Christ.... He got the doctrine going, and what I had to do was bring it to the gentiles. And I don'tthink Iwould have ever come to theUniversity of Chicago had itnot been for the existence of the Journal of Lawand Economics ...," inKitch, ed., "The Fire of Truth," p. 192.24. Ibid., pp. 220-222.25. A.C. Pigou, The Economics ofWelfare (London: Macmillan, 1950).26. Nearly every modern economics text contains a section on "taxing-the-harm." For Coase's critique, see his"Problem of Social Cost" in idem, The Firm, pp. 133-153.27. Ibid.28. It is customary to speak of "bribing" Mrs. O'Leary; however, this language makes a mockery of the judicialdecision since, quite obviously, judges do not exist to promote bribery or itsequivalent.29. Coase, "The Problem of Social Cost," in idem, The Firm, pp. 119-133.30. Ibid., pp. 133-156.31. Ibid., p. 150.32. Ibid., p. 154.33. Kitch, "The Fire of Truth," p. 191.34. H. Demsetz, "Toward a Theory of Property Rights," American Economic Review (May 1967), in idem,OwnershipControl and theFirm: The Organization ofEconomic Activity; 2 vols. (Blackwell, 1988), p. 105.35. Ibid.

36. P.F. Drucker, Innovation and Entrepreneurship: Practice and Principles (Harper and Row, 1985), pp. 137-138.


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37. Cf. P. Asch, Consumer Safety Regulation Putting a Price on Life and Limb, (Oxford: 1988).38. R.M. Milgrim, ed., Protecting and Profiting from Trade Secrets 1979 (Practicing Law Institute, 1979).39. Demsetz, "Information and Efficiency," in idem,Efficiency, pp. 12-13.40. KJ. Arrow, "Economic Welfare and the Allocation of Resources for Invention," in idem, Essays in theTheory ofRisk-Brearing (Chicago: Markham, 1971), pp. 144-165.41. Ibid., p. 154.42. Ibid., p. 152.43. Ibid., p. 160.44. Demsetz, "Information and Efficiency," in idem, Efficiency, pp. 3-24.45. Ibid., p. 3.46. S.N.S. Cheung, "Property Rights inTrade Secrets," Economic Inquiry, 20(January 1982):40-53.47. Ibid., p. 40.48. Ibid.49. Ibid., p. 43.50. Ibid., pp. 44-45.51. Ibid., p. 40.52. At one place, Cheung refers to "labor laws [that] restrain the right to contract between employers andemployees," but concludes that these laws only make employment contracts more costly to enforce; ibid., p. 47.53. See B.F. Kiker, "The Historical Roots of the Concept of Human Capital," Journal of Political Economy,74(October 1966); and J.R. Walsh, "Capital Concept Applied toMan," Quarterly Journal of Economics,49(1935):255-285.54. F.H. Knight, Risk, Uncertainty, and Profit, London School of Economics and Political Science Reprint (Boston,1933), p. 159.55. T.W. Schultz, "Investment inHuman Capital," American Economic Review, 51(March 1961)1-17.56. Ibid., p. 16.57. G. Becker, Human Capital: A Theoretical and Empirical Analysis with Special Reference toEducation (New York,1964).58. Ibid., p. 8-29.59. Suppose the secret is the specific sequence ofmixing including temperatures and speed of mixing. In this case,there is no easy way to reverse engineer a process based on an examination of the final product. Cf.W. Casey andL. Moss, Intellectual Property Rights

and Biotechnology," Idea, 27(1987):251-268.60. Becker, Human Capital, pp. 20-21.61. This was one of the principal reasons Henry Ford gave fordeparting from industry standards and institutingwhathe called the "five dollar a day minimum wage" in the automobile industry.62. Kitch, "The Law and Economics. ... p. 708.63. Becker, Human Capital, p. 18.64. Ibid.65. Kitch, "The Law and Economics," p. 705.66. A. Smithy Wealth ofNations, 2 vois (Oxford, ed., 1976), 1:138.67. D.J. Aspelund and C.E. Eriksen, Employee Noncompetition Law (New York: Clark Boardman, 1989); seeespecially ch. 2 and 3.68. Kitch, "The Law and Economics," p. 705; cf.W.L. Casey, J.E. Marthinsen and L.S. Moss, "Trade Secrecy and

Patenting: Complementary or Substitutable Activities?" (Unpublished MS), Babson College (October, 1978).69. Ibid.70. J.S. Feinstein and J. Stein, "Employee Opportunism and Redundancy inFirms," Journal of Economic Behaviorand Organization, 10(1988):401-414.71. Ibid., p. 402.72. Ibid.73. Ibid., pp. 402^103. F&S name O.E. Williamson, Markets and Hierarchies (Free Press, 1975) an immediatepredecessor of this approach. Williamson emphasized the opportunism that exists within the firm but stated thatvertical integration is a rational response trying to conduct business in a low-trust culture. See O.E. Williamson,"The Vertical Integration of Production: Market Failure Considerations," in idem, Economic Organization:Firms, Markets and Policy Control (New York: 1986), p. 98.74. Hayek, "The Use ofKnowledge."75. Coase, "The Nature of the Firm," in idem, The Firm, pp. 33-55.76. Ibid., cf. A. Alchian and H. Demsetz, "Production, Information Costs, and Economic Organization," AmericanEconomic Review, 62(1972); inDemsetz, Ownership Control and theFirm, (Blackwell, 1988), pp. 119-143.77. O.E. Williamson, Markets and Hierarchies (Free Press, 1975).78. Coase, "The Nature of the Firm," in idem, The Firm, p. 55.79. Kitch, "The Law and Economics," p. 720.80. Ibid.81. Hayek, "The Use of Knowledge."

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