Post on 26-Mar-2015
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George Mason School of Law
Contracts I
III. Bargaining Gains
F.H. Buckley
fbuckley@gmu.edu
Today
1. Problems of PD Games 2. Solutions to PD Problems3. Coasian bargains and trust4. Modeling Bargaining gains:
a. Detrimental and Beneficial Relianceb. Edgeworth Box Function
5. Defining Efficiency Criteria
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3
Cooperate Defect
Cooperate 3, 3 -1, 4
Defect 4, -1 0, 0
Player 2
Player 1
Getting to Cooperation in PD games
Two kinds of PD problems
Sins of commission Overfishing Excessive pollution Tragedy of the commons
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Two kinds of PD problems
Sins of omission Failure to exploit bargaining gains
Eg. Dueling, arms race
Failure to contribute to public goods (where beneficiaries can’t be excluded) E.g., free riding on defense, taxes
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Getting to Cooperation in PD games
So what do we do about that? Maybe it’s not so bad after all… Government solution A Coasian solution
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Getting to Cooperation in PD games
Maybe it’s not so bad after all… De minimis non curat lex Eleanor Ostrom on the private provision
of public goods E.g., wikipedia
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Getting to Cooperation in PD games
Let the state enforce cooperation environmental laws taxation and national defense Boston Commons
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Getting to Cooperation in PD games
A Coasian solution Just how bad is the transaction cost
problem? Qu. What if transaction costs were zero? Contractarianism
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Enforceable Contracts: Two Problems
The contract which was made and shouldn’t have been made
The contract that should have been made and wasn’t made
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Enforceable Contracts
The contract which was made and shouldn’t have been made
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Enforceable Contracts
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Such contracts do get made, and they disappoint Fraud Duress Mistake Unconscionability?
Enforceable Contracts
The contract which was made and shouldn’t have been made
The contract that should have been made and wasn’t made
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Getting to Cooperation in PD games
A Coasian solution What if bargaining is impossible?
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What if one can’t bargain:The “Market for Lemons”
Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970)
Trust in promises without contracts
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Let’s say you want to buy a 1956 Ford…
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Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
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Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller tells you it’s a beaut
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Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart
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Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart
What would you pay for one?
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Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart
The trick: Seller’s willingness to sell is a signal Akerlof, The Market for Lemons, 84 Q.J. Econ.
488 (1970)
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Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart
Question: Is the seller satisfied with this result?
So why do lemons markets exist?
Craigslist ad: 1956 Ford Fairlane - Date: 2013-08-25, $18,000 Looking to sell
my ALL ORIGINAL 1956 ford fairlane. Mint condition with original paint and all. Super low miles. Serious inquiries only. 301-641-xxxx. As is.
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Craigslist on the subject of lemons
Offers to ship a vehicle are virtually 100% fraudulent Never use Western Union or wire transfer to pay for
goods - only a scammer will ask for this, and any funds sent will be lost
Do not buy vehicles sight-unseen, regardless of low price. The vehicle does not exist, and any money you send will be lost.
Stories about divorcees or departing servicemen needing to sell quickly at a low price are generally fraudulent
If a deal sounds too good to be true, it probably is!
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So why do lemons markets exist?
Sometimes one doesn’t need a warranty. The sale is the contract.
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Contract Law as a solution
Suppose that the defector is penalized through sanctions so that the incentive to defect disappears.
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Cooperate Defect
Cooperate 3, 3 2, 0
Defect 0, 2 0, 0
Player 2
Player 1
Contract Law as a solution
So why do people fail to contract?
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So why do people fail to contract?
Illegal contracts Eg. Divorce waivers, security interests in
consumer goods
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So why do people fail to contract?
Illegal contracts Transaction cost barriers
Information processing problems Too many parties Emergencies Agent misbehavior
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So why do people fail to contract?
Illegal contracts Transaction cost barriers Rule of Law Problems
Imperfect enforcement in corrupt countries or countries with inefficient enforcement mechanisms
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Hobbes on Bare PromisesHobbes, Leviathan 14.18 (1651)
If a covenant be made wherein neither of the parties perform presently, but trust one another, in the condition of mere nature (which is a condition of war of every man against every man) upon any reasonable suspicion, it is void…
For he that performeth first hath no assurance the other will perform after, because the bonds of words are too weak to bridle men's ambition, avarice, anger, and other passions, without the fear of some coercive power; which in the condition of mere nature, where all men are equal, and judges of the justness of their own fears, cannot possibly be supposed. And therefore he which performeth first doth but betray himself to his enemy.
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Contract Law as a solutionLeviathan
Promising as a Problem of Trust
Promisor wants to persuade promisee to trust him
To do so, promisor must be able to make a credible commitment not to defect
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Promising as a Problem of Trust
Promisor wants to persuade promisee to trust him
Corruption weakens trust
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Corruption and the rule of law
Deputy Mayor of MoscowVladimir Resin sporting a $360,000 wristwatch
Less corruption, more wealth
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Country corruption and NYC parking tickets for UN diplomats
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Source: Raymond Fishman and Edward Miguel, Corruption, Norms and Legal Enforcement: Evidence from Diplomatic Parking Tickets, 115 Journal of Political Economy 1020 (2007)
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Modeling Bargaining Gains
Indifference Curves The Budget Line Consumer Choice Beneficial Reliance The Edgeworth Box Function Pareto-Superiority and Pareto-
Optimality
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Two dimensional Commodity Space:Every point represents a combination of the two commodities
X axis
Y axis
Commodity x
Commodity y
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0
Two dimensional Commodity Space:Every point represents a combination of the two commodities
X axis
Y axis
•A
X*
Y*
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0
The Commodities: Dollars in Two Time Periods
Dollars in Time 2
Dollars in Time 1
•A
X*
Y*
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Dollars in Time 1
0
Dollars in Time 2
Commodity space: Dollars consumed in two time periods
More of both
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The Budget Line: Allocating $100 between two periods
Dollars in Time 1
100
0
100
Dollars in Time 2
The budget line in red represents every trade-off of $100 in two periods
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Two different time preferences(Which is right?)
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The Budget Line: Allocating $100 between two periods
Dollars in Time 1
100
0
100
Dollars in Time 2
Grasshoppers
Ants
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Indifference Curves: Preferences about Consumption
Dollars in Time 1
0
Dollars in Time 2
An indifference curve represents a set of trade-offs to which the subject is indifferent
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Subject is willing to give up $BC in Time 2 for $AB in Time 1
Dollars in Time 1
0
Dollars in Time 2
BC
A
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A C: Subject is willing to give up $BC in Time 2 for $AB in
Time 1
Dollars in Time 1
0
Dollars in Time 2
BC
A
= “is indifferent to”
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Indifference Curves: Preferences about Consumption
Dollars in Time 1
0
Dollars in Time 2
Convexity (curve bends inward) assumes decreasing marginal
utility
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Decreasing marginal utility: We’ll always want more, but will enjoy each new scoop less and less
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Indifference Curves: Preferences about Consumption
Dollars in Time 1
0
Dollars in Time 2
One is better off the further one gets from the origin
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Dollars in Time 1
0 Dollars in Time 2
More is better:I2 > I1
I1
I2
More is better
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Dollars in Time 1
0 Dollars in Time 2
Ordinal Utility: We can’t say how much better I2 is than I1
I1
I2
I3
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Ordinal Utility: We can’t say how much better I2 is than I1
Ordinal numbers: First, second, third
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Ordinal Utility: We can’t say how much better I2 is than I1
Ordinal numbers: First, second, third
Cardinal numbers: 1,2, 3
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Consumption Decision:Uncle Ebenezer gives David $100
I3
Time 1 I2
I1 100
I2 I1
0
100 Time 2
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Consumption Decision:David has $100 and is best off at A
Maximization subject to the constraint of the Budget Line
I3
Time 1 I2
I1 100
50 A I2 I1
0
50
100 Time 2
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Consumption Decision:David has $100 and is best off at A
Maximization subject to the constraint of the Budget Line
I3
Time 1 I2
I1 100
50 A I2 I1
0
50
100 Time 2
B
B is not optimal
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Consumption Decision:David has $100 and is best off at A
Maximization subject to the constraint of the Budget Line
I3
Time 1 I2
I1 100
50 A I2 I1
0
50
100 Time 2
C
B
C is not feasible
B is not optimal
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Ebenezer gives David another $100: The Shift to a New Budget Line
200 I200
100 A50, 50
50
I100
0 100 63
A new Consumption Decision
B 100, 100
100 I200 A50, 50
50
I100
IDR
0 50 100
Time 1
Time 2
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A new Consumption Decision
B 100, 100
100 I200 A50, 50
50
I100
IDR
0 50 100
Time 1
Time 2
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We didn’t have to end up at 100,100. I just like round numbers …
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What happens when the donor promises to give in the future?
Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period
What Should David Do?
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What happens when the donor promises to give in the future?
Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period
David’s election: to rely or not to rely on the promise in the first period
But now Uncle Ebenezer comes along:David’s election
t0 Ebenezer makes promise
t1 David relies doesn’t rely
t2 Ebenezer performs doesn’t perform performs doesn’t perform
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Relies Doesn’t Rely
Performs
Doesn’t Perform
David
Ebenezer
Four possibilities
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Relies Doesn’t Rely
Performs
Doesn’t Perform
David
Ebenezer
The good scenario: David relies and Ebenezer performs
The good scenario: David relies and Ebenezer performs
B 100, 100
100 I200 A50, 50
50
I100
0 50 100 200
200 Reliance by David means he spends $100 of his own money in period 1 in the expectation he’ll get another $100 in period 2
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The good scenario: David relies and Ebenezer performs
B 100, 100
100 I200 A50, 50
50
I100
0 50 100 200
200
Because Ebenezer performs, David has another $100 to spend in period 2
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Relies Doesn’t Rely
Performs
Doesn’t Perform
David
Ebenezer
A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
B 100, 100
I100 I DR
0 50 100
A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
C 100,0 D
A50, 50 50
Time 1David spends 100 in period 1 and because Ebenezer breaches David has nothing left to spend in period 2
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B 100, 100
I100 I DR
0 50 100
A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
C 100,0 D
A50, 50 50
Time 1What do we need to give David to make him as well off as he would have been had the promise been performed?
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B 100, 100
I100 I DR
0 50 100
A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
C 100,0 D
A50, 50 50
Time 1The Expectation Interest is CB, or $100
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B 100, 100
I100 I DR
0 50 100
A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
C 100,0 D
A50, 50 50
Time 1
What do we need to give David to make him as well off as he would have been had he not relied?
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B 100, 100
I100 I DR
0 50 100
A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
C 100,0 D
A50, 50 50
Time 1
The Reliance Interest is CD, or about $25
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Fool me once…: Non-reliance: What does David do if he assumes Ebenezer will breach?
Time 1 I1
100 50 B I1
0 50
100 Time 2
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Fool me once…: Non-reliance: David assumes Ebenezer will breach
Time 1 I1
100 50 B I1
0 50
100 Time 2
Now David spends only $50 in period 1, and has $50 left over for period 2
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Relies Doesn’t Rely
Performs
Doesn’t Perform
David
Ebenezer
David doesn’t rely and Ebenezer doesn’t perform
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But now suppose Ebenezer performs
Time 1 I1
100 50 B I1
0 50
100 Time 2
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Relies Doesn’t Rely
Performs
Doesn’t Perform
David
Ebenezer
David doesn’t rely, Ebenezer performs
100
I200
50
E150, 50
0 100 150
Loss of Beneficial Reliance:
David doesn’t rely and Ebenezer performs
Ino-reliance
Goetz and Scott, 89 Yale L.J. 1261 (1980)
David spends only 50 in period 1
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Where David is on Ebenezer’s performance
B100, 100 100
I200
50
E150, 50
0 100 150
Loss of Beneficial Reliance:
David doesn’t rely and Ebenezer performs
Ino-reliance
Goetz and Scott, 89 Yale L.J. 1261 (1980)
David spends only 50 in period 1
Where David would have been had he relied
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B100, 100 100
I200
50
E150, 50
0 100 150
Loss of Beneficial Reliance:
David doesn’t rely and Ebenezer performs
Ino-reliance
Goetz and Scott, 89 Yale L.J. 1261 (1980)86
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Relies Doesn’t Rely
Performs
Doesn’t Perform
David
Ebenezer
To Review…
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Relies Doesn’t Rely
Performs
Doesn’t Perform
David spends $50 now, $50 later
(No Harm, No Foul)
David
Ebenezer
Scenario I: David doesn’t rely and Ebenezer doesn’t perform
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Relies Doesn’t Rely
Performs
David spends $100 now, $100
later
Doesn’t Perform
David
Ebenezer
Scenario II: David Relies and Ebenezer Performs
90
Relies Doesn’t Rely
Performs
Doesn’t Perform
David spends $100 now, 0 later
(Detrimental Reliance)
David
Ebenezer
Scenario III: David relies and Ebenezer breaches
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Relies Doesn’t Rely
PerformsDavid spends
$50 now, $150 later
Doesn’t Perform
David
Ebenezer
Scenario IV: David doesn’t rely and Ebenezer performs
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Relies Doesn’t Rely
PerformsBeneficial Reliance
Doesn’t Perform
David
Ebenezer
Modeling the Bargaining Game
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Relies Doesn’t Rely
PerformsBeneficial Reliance
Loss of Beneficial Reliance
Doesn’t Perform
David
Ebenezer
The problem of trust
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Enforceable Contracts provide the gains
associated with beneficial reliance
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David is better off because he relied and Ebenezer is
better off because he had a charitable motive
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How are two people made better off when they
exchange goods?
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How are two people made better off when they
exchange goods?
After the bargain, same horse, same cow
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Modeling a Bargain: Two Commodities: Mums and Roses
0
Mums
Roses
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Modeling a Bargain: Two Bargainers: Mary and Bess
0
Mums
Roses
Good Queen Mary “Bloody” Bess
100
Mums
Mary Roses
Two bargainers
Mums
Bess Roses
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Mums
Mary Roses
Rotating Bess’s diagram I
Roses
Mums
Bess
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Mums
Mary Roses
Rotating Bess’s diagram II
RosesMums
B
ess
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Rotating Bess’s diagram III
Mums
Mary Roses
Mums
Bess
Roses
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Rotating Bess’s diagram IV
Mums
Mary Roses
Mums
Bess
Roses
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Rotating Bess’s diagram V
0
0
Mums Roses Bess
Mums Mary
Roses
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Mary
Edgeworth Box Function: Bargaining from endowment point A
0
Bess
A
0
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Edgeworth Box Function: Bargaining from endowment point A
Mary
Bess
A
0
0
Rosesbess
Mumsmary Mumsbess
Rosesmary
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Edgeworth Box Function: Bargaining from endowment point A
Mary
Bess
A
0
0
The Edgeworth Box Function permits us to define Efficiency Standards
Pareto-superiority
Pareto-optimality
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Efficiency (Paretian) standardsVilfredo Pareto (1848-1923)
Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off
Pareto-optimality: No further Pareto-superior transformations are possible
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Pareto-SuperiorityB and C as Pareto-superior to A
D and E as Pareto-inferior
Mary
Bess
A
B
C
D
E
Coleman, 8 Hofstra L.Rev. 905 (1980)
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Are all bargaining gains exploited at F?The bargaining “lens” shrinks through bargaining
Mary
Bess
A
B
C
D
E
F
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The bargaining “lens” shrinks through bargaining
Mary
Bess
A
B
C
D
E
F
G
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Pareto OptimalityAt G no further Pareto-superior transformations are possible
Mary
Bess
A
B
C
D
E
F
G
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The Contract CurveG is a point of tangency of the two sets of indifference curves
Mary
Bess
A
B
C
D
E
F
G
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Mary
The Contract Curve All possible Pareto-optimal contracts at the points of tangency
Bess
A
B
C
D
E
FG
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Efficiency (Paretian) standardsVilfredo Pareto (1848-1923)
• Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off
• Pareto-optimality: No further Pareto-superior transformations are possible
Are Paretian standards morally attractive?
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Greed is good!
Michael Douglas as Gordon Gecko in Wall Street (1987)
Are Paretian standards morally attractive?
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OMG!!!!
Closing booksAsh tray
suspenders
222 Broadway
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Are Paretian standards morally attractive?
Paretian man is not an altruist He takes no interest in the other person
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Varieties of altruism: Charity
Madonna buys a pump for the poor
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Varities of altruism: Envy
Gericault, Portrait
Tonga: Where people don’t promise
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The Queen of Tonga with the Queen Mother at the Coronation, 1953
Could promising exist without promissory institutions?
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There is apparently no word for “promise” in Tonganese
Could promising exist without promissory institutions?
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“I intend to do x, but if I change my mind, well, then was then, now is now.”
Could promising exist without promissory institutions?
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In such a place, is promising intelligible?