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Economics and Law
Computer Laboratory > Course material 2007-08 > Economics and Law

Economics and Law

Lecturers: Prof Ross Anderson, Mr Nicholas Bohm and Dr Richard Clayton
Taken by: Part IB



At one level, this course provides a bridge between the professional practice and ethics course in part 1a and the courses in business and e-commerce in part 2. But that is not all.

Economic arguments are starting to appear in a surprising number of areas of computer science. Economics deals with mechanisms whereby global equilibria emerge from the behaviour of large numbers of agents who optimise their utility locally. Economic arguments and techniques are starting to be used by computer scientists to tackle problems from network congestion, through resource allocation in distributed operating systems, to security. As systems become ever larger, these techniques are likely to become more important. (I got roped into teaching this course because of my interest in the interaction between economics and information security.)

Useful though economic arguments and explanations may be, however, there are many reasons why market mechanisms may fail, or yield an equilibrium that is far from the social optimum. Law deals with rules developed to remedy this. As the Internet has changed from a research tool to a public utility over the past ten years, legal questions have become increasingly important to computer scientists.

Game theory

We use game theory as a natural entry point into economics for the computer scientist. Game theory deals with such fundamental issues as whether people cooperate or fight to achieve their goals.

One of the classic puzzles in game theory is the Prisoner's dilemma. Two crooks are arrested and questioned separately about a robbery. The police tell each of them that if he confesses, he will go free while his partner will get 10 years for the robbery. If he keeps quiet and his partner confesses, it will be the other way round. If both confess, they will get five years; while if neither confesses, they will get a year each for possessing a firearm. Here, the optimal strategy from the prisoners' collective viewpoint is for both to keep quiet, but if they cannot both trust the other then the optimal strategy for each individual is to confess.

This is typical of many problems encountered in real life. Resolving them is easier where the games are not isolated, but are part of a series. Then one might, for example, have a strategy of tit for tat - if you cooperate with me this round, I'll return the favour next time; but if you stab me in the back, I'll retaliate. There has been a lot of study of such strategies; they are important not just in economics, but also in fields such as evolutionary biology where the evolution of strategies is believed to be the foundation for much social behaviour in animals.

At the level of routine economic analysis, game theory provides useful tools for understanding monopoly and oligopoly behaviour. For example, suppose that it costs $250 to fly a passenger from Boston to London and back, and only two airlines comnpete on the route. How will they set prices? Will they collude and charge $500 each, making a healthy profit, or will they compete for market share and charge $300 or even $255? What sort of strategies are available, and what sort of equilibria might emerge? Given the small number of firms in the typical IT market sector, understanding such issues is important for the working computer professional.

There are many books and web pages, such as Game Theory .net and the Stanford Encyclopaedia of Philosphy. (Of particular interest to computer scientists is the work of Robert Axelrod, one of the pioneers of the evolution of cooperation, who initiated regular tournaments of interated prisoner's dilemma which contributed to the development of genetic programming ideas. The 20th anniversary competition was won by computer scientists from Southampton.)

Classical economics

I will then spend about two lectures developing the classical view of economics: that under certain assumptions, markets provide an optimal way of allocating resources. This view had its roots in Adam Smith's Wealth of Nations and was further developed by writers such as Ricardo and Jevons to provide an explanation of the forces driving the industrial revolution. We'll explore concepts such as comparative advantage, marginal utility, opportunity cost and exchange, so that you get at least a rough idea of what's `under the hood'.

We will then look briefly at a number of the ways in which classical economic models fail, including the criticisms of Keynes and the fact that efficiency, welfare and justice do not always coincide.

There is a huge literature on basic economics. Cambridge economics students cut their teeth on Varian's textbook, `Intermediate Microeconomics', of which your college library should have many copies. You might look at chapters 1-6 and 14-16 to begin with. For an entirely different perspective, try JK Galbraith's `History of Economics'. A very convenient online reference is the History of Economic Thought website. With the collapse of the Soviet Union and the growth of anti-globalisation protests, trade is perhaps the most controversial topic nowadays: the consensus view of economists is probably well represented by Steven Suranovic's notes.

Information economics

Of even greater interest to computer scientists are some more modern criticisms of the classical approach that fall within the realm of microeconomics rather than macroeconomics or social theory.

Information goods and services markets tend to be characterised by high fixed costs, low marginal costs and increasing returns to scale, together with lock-in effects, all of which tend to lead to monopoly or oligopoly. In many markets, there are also network effects: the more people use a given service, the more value it is to each user. So products may take a long time to reach critical mass, then take off very rapidly (as happened with faxes in 1985-88 and email ten years later). Network effects can reinforce a tendency to monopoly.

We will look at a number of other ways in which information goods and services markets can deviate from the classical ideal. These include asymmetric information, where one party to a contract knows more than the other. For example, people applying for health insurance typically know more about their health than the insurance company does, and this leads to adverse selection effects whereby sick people buy more cover. (Attitudes to risk in general are well known to be perverse; see John Adams on Cars, Cholera and Cows.)

The strategies used by monopolies to maximise their revenue are important, both as a practical foundation for later work on e-commerce and as a theoretical underpinning for understanding regulation. These include marget segmentation, price differentiation and bundling. Why, for example, does Microsoft prefer to sell Office as a single product rather than as separate word processor, spreadsheet and other programs?

By far the best book on this is Shapiro and Varian's `Information Rules'. Varian's textbook also has some useful material, especially in chapters 32-36. As for online resources, there are many: the Information Economy page at Berkeley is a reasonable place to start.

Auction theory

A lot of current work in auction theory spills over between economics and computer science. Auctions have been around since at least the times of ancient Greece; they have long been the traditional way of selling art, livestock and much else. A lot of money was invested during the dotcom boom on the premise that technology would so lower the transaction costs associated with auctions that they would become the dominat means of doing business in many sectors. Ebay grew from nothing to blue-chip status in a few years; and the UK government made billions from auctioning off spectrum for third-generation mobile phones.

A surprising number of things can go wrong with auctions. The British government's success was not replicated everywhere else; in a number of countries, phone companies managed to rig the auctions and get bandwidth cheaply. Often this didn't require any overt criminal behaviour; the rules of the auctions were such that players could signal to each other, during the bidding process, which blocks they were interested in. The resulting tacit collusion meant that the taxpayers in many places got much less than expected. (The UK government's adviser, Paul Klemperer, has some interesting papers on what people did wrong - see especially `What Really Matters in Auction Design' for the practicalities. For a proof of the Revenue Equivalence Theorem, see his Guide to the Literature, and for its applications see Why Every Economist Should Learn Some Auction Theory.)

At the theoretical end of things, there has been a huge surge of interest among computer science researchers in the design of combinatorial auctions. A combinatorial auction is one in which you can bid for combinations of objects: `I'll give you $100 for lots 1 and 4 and 7, or I'll give you $80 for lots 3 and 4 and 7'. Finding an optimal allocation in such an auction is not merely an NP-complete problem, but is close to many engineering problems of practical interest - such as finding a low-cost route across a network. (For more detail and links, see the notes of a course at Berkeley by Christos Papadimitriou.)

Introduction to law

There will be two talks on legal topics. The first, by Nicholas Bohm of the Law Society's Electronic Law Committee, will cover the basics. (His notes are here.) As the syllabus puts it, these are: contract and tort; copyright and patent; liabilities and remedies; competition law; choice of law and jurisdiction. The gloss on that is: what do you have do do online in order to incur liability, or to impose it on someone else; and where can you be pursued, or pursue them, through the courts once you have done so? A standard introductory text is "Learning the Law" by Glanville Williams and ATH Smith.

The second talk, by Richard Clayton of FIPR, looks at more technology-specific aspects of law and regulation. (His notes are here.) There are a number of EU directives which affect how you can do business on the net, covering subjects that range from distance selling, electronic commerce, data protection and electronic signatures to copyright; and there are a number of particular issues relating to their UK implementation. There are also some specific UK laws, such as the Regulation of Investigatory Powers Act, that one might have to watch out for. One of the best-regarded cyber-law courses is that taught at Berkeley by Pam Samuelson (who deals mostly with US law issues); her course notes are here.

Intellectual property

The course title `economics and law' also refers to the academic discipline whose subject matter centres on copyright, patent, and related topics such as database rights. This will be the topic of the final lecture.

Intellectual property is increasingly seen as the foundation of prosperity in the information age, but is increasingly controversial. Powerful lobby groups, such as Hollywood and the music industry, have pushed for increased legal protection in ways that have brought them into conflict with the computer industry and with liberties groups. There is a nice primer on the economics of intellectual property here; for further analysis of the economic effects, see papers by Scotchmer, especially ``The Law and Economics of Reverse Engineering''. You might also be interested in a talk given at the Computer Lab in 2002 by Richard Stallman; he's giving another talk this term.

A paper that has caused much controversy is The Effect of File Sharing on Record Sales: An Empirical Analysis by Felix Oberholzer and Koleman Strumpf. This shows that file-sharing has little effect on CD sales and may even help promote sales of the most popular CDs. It thus rather undermines the music industry's case.

Even within Cambridge University, there has been controversy at a plan by the previous Vice-Chancellor to assume ownership of almost all intellectual property rights generated by faculty and research students. Academics at the Computer Lab and elsewhere organised resistance to these plans; there is a lot more material linked from here. (In the end the current VC managed to grab our patent rights but left us, for now, with our copyrights and 85% of the patent royalties.

A recent major development was the EU IPR Enforcement Directive; in its original form it would have had some drastic effects on the competitive landscape for computer and communications companies. It was toned down by the European Parliament but the Commission are trying once more to pass the measures the Parliament rejected, such as criminalisation of patent infringement. Such IP enforcement measures may interact with `Trusted Computing', which in turn raises a number of policy issues described in a recent position paper by the German government. (The Germans managed to bully the Trusted Computing Group into being less hostile to small technology business.)

So `economics and law' is a highly topical subject for people in our trade.

Supervisions, Books and Past Exam Questions

This course was created in 2002-3 by amalgamating and extending some of the basic material in the part 2 E-commerce and Business studies courses. Exam questions since 2003 are here, while some previous relevant Tripos questions are here, here, and here. In addition to this, see the revision questions in Varian's textbook, chapters 1-6, 14-17, 24-25, 27-28 and 32-36, and the problems in its companion volume `Workouts in Intermediate Microeconomics'.

One word of warning: many part 1b students may never have studied a humanties subject since GCSE. It is a different task from learning a programming language; it is not sufficient to acquire proficiency at a small core of manipulative techniques, and figure out the rest when needed. Breadth matters. You should spend at least half of the study time you allocate to this subject on general reading. There are many introductory texts on economics and on law; your college library is probably a good place to start.