1 George Mason School of Law Contracts I III. Bargaining Gains F.H. Buckley [email protected].

1

George Mason School of Law

Contracts I

III. Bargaining Gains

F.H. Buckley

[email protected]

mailto:[email protected]

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

2

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

4

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

5


So what do we do about that? Maybe it’s not so bad after all… Government solution A Coasian solution

6


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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Let the state enforce cooperation environmental laws taxation and national defense Boston Commons

8


A Coasian solution Just how bad is the transaction cost

problem? Qu. What if transaction costs were zero? Contractarianism

9

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


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12

Such contracts do get made, and they disappoint Fraud Duress Mistake Unconscionability?



The contract that should have been made and wasn’t made

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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

16

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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The seller tells you it’s a beaut

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The seller knows which kind of car he has but you can’t tell them apart

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What would you pay for one?

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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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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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Illegal contracts Eg. Divorce waivers, security interests in

consumer goods

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Illegal contracts Transaction cost barriers

Information processing problems Too many parties Emergencies Agent misbehavior

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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.

33

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

41

0

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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43

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

50

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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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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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 numbers: First, second, third

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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

61



I3

Time 1 I2

I1 100

50 A I2 I1

0

50

100 Time 2

B

B is not optimal

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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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69

Relies Doesn’t Rely

Performs

Doesn’t Perform

David

Ebenezer

Four possibilities

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Performs

Doesn’t Perform

David

Ebenezer

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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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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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


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


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


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


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


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

81


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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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

84

Where David is on Ebenezer’s performance

B100, 100 100

I200

50

E150, 50

0 100 150



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

85

B100, 100 100

I200

50

E150, 50

0 100 150



Ino-reliance

Goetz and Scott, 89 Yale L.J. 1261 (1980)86

87


Performs

Doesn’t Perform

David

Ebenezer

To Review…

88


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

89


Performs

David spends $100 now, $100

later

Doesn’t Perform

David

Ebenezer

Scenario II: David Relies and Ebenezer Performs

90


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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PerformsDavid spends

$50 now, $150 later

Doesn’t Perform

David

Ebenezer

Scenario IV: David doesn’t rely and Ebenezer performs

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PerformsBeneficial Reliance

Doesn’t Perform

David

Ebenezer

Modeling the Bargaining Game

93


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

99

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

101

Mums

Mary Roses

Rotating Bess’s diagram I

Roses

Mums

Bess

102

Mums

Mary Roses

Rotating Bess’s diagram II

RosesMums

B

ess

103

Rotating Bess’s diagram III

Mums

Mary Roses

Mums

Bess

Roses

104

Rotating Bess’s diagram IV

Mums

Mary Roses

Mums

Bess

Roses

105

Rotating Bess’s diagram V

0

0

Mums Roses Bess

Mums Mary

Roses

106

Mary

Edgeworth Box Function: Bargaining from endowment point A

0

Bess

A

0

107


Mary

Bess

A

0

0

Rosesbess

Mumsmary Mumsbess

Rosesmary

108


Mary

Bess

A

0

0

The Edgeworth Box Function permits us to define Efficiency Standards

Pareto-superiority

Pareto-optimality

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110

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)

112

Are all bargaining gains exploited at F?The bargaining “lens” shrinks through bargaining

Mary

Bess

A

B

C

D

E

F

113

The bargaining “lens” shrinks through bargaining

Mary

Bess

A

B

C

D

E

F

G

113

114

Pareto OptimalityAt G no further Pareto-superior transformations are possible

Mary

Bess

A

B

C

D

E

F

G

114

115

The Contract CurveG is a point of tangency of the two sets of indifference curves

Mary

Bess

A

B

C

D

E

F

G

115

116

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?

118

Greed is good!

Michael Douglas as Gordon Gecko in Wall Street (1987)


119

OMG!!!!

Closing booksAsh tray

suspenders

222 Broadway

120


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?

124

There is apparently no word for “promise” in Tonganese


125

“I intend to do x, but if I change my mind, well, then was then, now is now.”


126

In such a place, is promising intelligible?

1 George Mason School of Law Contracts I III. Bargaining Gains F.H. Buckley [email protected].

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Transcript of 1 George Mason School of Law Contracts I III. Bargaining Gains F.H. Buckley [email protected].