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George Mason School of Law

Contracts I

Bargaining Gains

F.H. Buckleyfbuckley@gmu.edu

Next Day Montesquieu

John Stuart Mill, On Liberty

Scott 480-501

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Up to now

Let’s assume that societal wealth has something to do with national happiness

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Up to now

And does contract enforceability have something to do with societal wealth?

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Where does contract law come in?

What is the relationship between enforceable promises and wealth?

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Cooperate Defect

Cooperate Jointcooperation

Player 1: sucker’s payoff

DefectPlayer 2: Sucker’s payoff

Jointdefection

Player 2

Player 1

Bargains as a Prisoner Dilemma game

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Cooperate Defect

Cooperate

Defect 0

Player 2

Defection dominates for both Players

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Contract Law as a solution

Suppose that the defector is penalized through legal sanctions so that the incentive to defect disappears.

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Why Enforce Contracts:An Economic Analysis of Bargaining Gains

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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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The Commodities: Dollars in Two Time Periods

Dollars in Time 2

Dollars in Time 1

•A

X*

Y*

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Two different time preferences(Which is right?)

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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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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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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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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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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

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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

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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

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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

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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 32

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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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

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 spending $100 in period 1

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B100, 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 David spends 100 in period 1 and now has nothing left to spend in period 2

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B100, 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 be had the promise been performed?

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B100, 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 Expectation Interest is CB, or $100

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B100, 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 the promise not been made, or had he not relied?

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B100, 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: 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

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Fool me once…: Non-reliance: Ebenezer breaches: No harm, no foul

Time 1 I1

100 50 B I1

0 50

100 Time 2

Now David spends only 50 in period 1

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 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)46

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Enforceable Contracts provide the gains

associated with beneficial reliance

Now: How parties gain from contracting

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“If one person does not lose, the other does not gain.”

St. Augustine

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Modeling a Bargain: Mums and Roses

0

Mum

s

Roses

50

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

Bess

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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

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Are these attractive moral standards?

Paretian man is not an altruist He takes no interest in the other person

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Are these attractive moral standards?

What’s so good about altruism?

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Are these attractive moral standards?Here’s an altruist…

Gericault, Portrait(Envy)

Is a complete lack of empathy an attractive quality for bargainers?

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Are these attractive moral standards?The bourgeoisie … has pitilessly torn asunder the motley feudal ties … and has left remaining no other nexus between man and man than naked self-interest, than callous “cash payment.” It has drowned the most heavenly ecstasies of religious fervour, of chivalrous enthusiasm, of philistine sentimentalism, in the icy water of egotistical calculation.

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Further Readings

Goetz and Scott, Enforcing Promises: An Examination of the Basis of Contract, 89 Yale LJ 1261 (1980)

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Contract Law in the State of NatureIII.State of Nature.ppt

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