Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 14.

Econ 522Economics of Law

Dan Quint

Spring 2011

Lecture 14

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Contracts as promises First purpose: facilitate cooperation Second purpose: encourage efficient disclosure of information

Breach of contract Third purpose: secure efficient commitment to performance

Reliance Fourth purpose: secure efficient reliance

Default rules Fifth purpose: reduce transaction costs via efficient default rules C&U: apply rule parties would have wanted (Typically means allocating each risk to efficient bearer of that risk) Ayres and Gertner: penalty defaults

Before Spring Break…

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Regulations/immutable rules Ways to get out of a contract

Formation defenses Incompetence Dire constraints (duress and necessity) Adhesion, unconscionability Fraud, frustration of purpose, mutual mistake Generally: situations where assumptions of Coase Theorem fail

Performance excuses Impossibility; allocating a loss to the efficient bearer of that risk

Remedies for breach of contract Court-ordered damages of various types Party-specified damages (but: penalty damages not always enforced) Specific Performance

Before Spring Break…

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Effects of different remedies on…decision to perform or breachdecision to sign or not signinvestment in performinginvestment in reliance

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Remedies and breach

Expectation Damages

0-500,000250,000Total

150,000150,000150,000You get

-150,000-650,000100,000I get

Costs High – Breach

Costs High –

Perform

Costs Low –

Perform

Specific Performance

0-500,000250,000Total

400,000150,000150,000You get

-400,000-650,000100,000I get

CostsHigh –

Renegotiate

Costs High –

Perform

Costs Low –

Perform

Transaction costs low either leads to efficient breach, but seller prefers “weaker” remedy Transaction costs high S.P. leads to ineff. performance

Plane worth $500,000 to youPrice $350,000Cost: either $250,000 or $1,000,000

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Opportunity cost damages, or reliance damages Inefficient breach when transaction costs are high Renegotiate contract to get efficient performance when transaction

costs are low Like nuisance law: any remedy leads to efficient breach with low

TC But only expectation damages do when TC are high

Unfortunate contingency and fortunate contingency

Remedies and breach

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Specific Performance If costs stay low, I get $350,000 - $250,000 = $100,000 profit If costs rise, I take $400,000 loss Am I willing to sign this contract?

Even expectation damages face this problem Expectation damages: costs stay low, same $100,000 profit Costs rise, $150,000 loss If probability of high costs is ½, I won’t sign contract

Expectation damages lead to efficient breach, but may not lead to efficient signing Suggests expectation damages might be good default rule,

but not good mandatory rule

Efficient signing

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If reliance investments increase damages you receive, we get overreliance To get efficient reliance, we need to exclude gains from reliance in

calculation of expectation damages

But then promisor’s liability < promisee’s benefit, leading to inefficient breach

With low transaction costs, fix this through renegotiation

But what about unobservable actions the promisor needs to take, to make breach less likely? Investment in performance

Did example of reliance a few days ago

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Some investment I can make to reduce likelihood that breach becomes necessary

Suppose probability of breach is initially ½…

but for every $27,726 I invest, I cut the probability in half Invest nothing probability of breach is 1/2 Invest $27,726 probability is 1/4 Invest $55,452 probability is 1/8 Any investment z probability is .5 * (.5) z / 27,726

Wrote it this way so p = .5 e – z / 40,000

Investment in performance(continuing with airplane example)

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Suppose you’ve built a $90,000 hangar Increases value of performance by $180,000… …so value of performance is $150,000 + $180,000 = $330,000 Probability of breach = .5 e – z/40,000

Let D = damages I owe if I breach

Same questions as before: What is efficient level of investment in performance?

How much will I choose to invest in performance?


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Suppose you’ve built a $90,000 hangar Increases value of performance by $180,000… …so value of performance is $150,000 + $180,000 = $330,000 Probability of breach = .5 e – z/40,000

Let D = damages I owe if I breach

Same questions as before: What is efficient level of investment in performance?

Enough to reduce probability of breach to 40,000/430,000

How much will I choose to invest in performance?

Enough to reduce probability of breach to 40,000/(100,000 + D)


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What is the efficient level of investment in performance? Enough so that p(z) = 40,000/430,000

What will promisor do under various rules for damages? Enough so that p(z) = 40,000/(100,000 + D)

So if D = 330,000, efficient investment in performance D = 330,000 is promisee’s benefit, including reliance So expectation damages, with benefit of reliance, leads to

efficient investment in performance If D < 330,000, too little investment in performance If D > 330,000, too much Makes sense – think about externalities

What do these results mean?

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Paradox of compensation

• Inefficient breach

• Underinvestment in performance

• Efficient reliance

• Efficient breach

• Efficient investment in performance

• Over-reliance

Expectation damages exclude benefit from reliance investments

Expectation damages include benefit from reliance investments

Is there a way to get efficient behavior by both parties?

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Have expectation damages include benefit from reliance…

…but only up to the efficient level of reliance, not beyond

That is, have damages reward efficient reliance investments, but not overreliance Promisee has no incentive to over-rely efficient reliance Promisor still bears full cost of breach efficient performance

Problem: this requires court to calculate efficient level of reliance after the fact

We already saw one possible solution

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The problem: Damages promisor pays should include gain from reliance if we

want to get efficient performance Damages promisee receives should exclude gain from reliance if

we want to get efficient reliance

Solution: make damages promisor pays different from damages promisee receives! How do we do this? Need a third party

Another clever (but unrealistic) solution

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You (promisee) and I (promisor) offer Bob this deal:

If you rely and I breach, I pay Bob value of promise with reliance (airplane plus hangar) Bob pays you value of promise without reliance (airplane alone) Bob keeps the difference

You receive damages without benefit from reliance; I pay damages with benefit from reliance

“Anti-insurance”

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You (promisee) and I (promisor) offer Bob this deal:

If you rely and I breach, I pay Bob value of promise with reliance (airplane plus hangar) Bob pays you value of promise without reliance (airplane alone) Bob keeps the difference

You receive damages without benefit from reliance;I pay damages with benefit from reliance

Offer the deal to two people, make them pay up front for it

“Anti-insurance”

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Foreseeable reliance

Include benefits reliance that promisor could have reasonably anticipated

Reminder: what do courts actually do?

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Another experiment:is trust a problem?

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Player A starts with $10 Chooses how much of it to give to player B That money is tripled

Player B has $10, plus 3x whatever A gave him/her Chooses how much (if any) to give back to player A

So for example… if player A decides to send $3… then A has $7 left, and B has $19… and then B can send back to A any amount from 0 to $19 if A sends $9, B has $37, A has $1 plus whatever B sends back

A two-player game, similar to the investment/agency game

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We’ll try the game four different ways:

Anonymously – A and B don’t know who each other are

Privately – A and B don’t interact, but will learn who each other are after the game

Face to face – A and B know who each other are, and can discuss the game before playing, but their actions remain private

Publicly – A and B play out loud in front of the class

A two-player game, similar to the investment/agency game

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Repeatedinteractions

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Repeated games

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Repeated games

Player 1 (you)

Trust me Don’t

Player 2 (me)

Share profits Keep all the money

(150, 50) (0, 200)

(100, 0)

Suppose we’ll play the game over and over After each game, 10% chance relationship ends, 90% chance we

play at least once more…

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Suppose you’ve chosen to trust me

Keep all the money: I get $200 today, nothing ever again

Share profits: I get $50 today, $50 tomorrow, $50 day after…

Value of relationship =

Since this is more than $200, we can get cooperation

Repeated games

50 29.509.50 39.50 ... 5009.1

50

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Suppose you’ve chosen to trust me

Keep all the money: I get $200 today, nothing ever again

Share profits: I get $50 today, $50 tomorrow, $50 day after…

Value of relationship =

Since this is more than $200, we can get cooperation

Repeated games

50 29.509.50 39.50 ... 5009.1

50

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Diamond dealers in New York (Friedman)

“…people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one”

“Parties to a contract agree in advance to arbitration;if… one of them refuses to accept the arbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted.”

Repeated games and reputation

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The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions

The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts

Law assigns legal duties to certain long-term relationships Bank has fiduciary duty to depositors McDonalds franchisee has certain duties to franchisor

Repeated games and reputation

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Suppose we’ll play agency game 60 times $50 x 60 = $3,000 > $200, so cooperation seems like no problem But…

In game #60, reputation has no value to me Last time we’re going to interact So I have no reason not to keep all the money So you have no reason to trust me

But if we weren’t going to cooperate in game #60, then in game #59…

Repeated games and the endgame problem

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Endgame problem: once there’s a definite end to our relationship, no reason to trust each other

Example: collapse of communism in late 1980s Communism believed to be much less efficient than capitalism But fall of communism led to decrease in growth Under communism, lots of production relied on gray market Transactions weren’t protected by law, so they relied on long-term

relationships Fall of communism upset these relationships

Repeated games and the endgame problem

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One other bitI like from Friedman

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Friedman on premarital sex

Under traditional common law, a jilted bride could sue for breach of promise to marry

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Friedman on premarital sex

Under traditional common law, a jilted bride could sue for breach of promise to marry

Between 1935 and 1945, lawsuits for breach of promise to marry stopped being recognized in many states

Diamond engagement rings became common in 1930s, peaked in 1950s, since declined

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Purposes for contract law: Encourage cooperation Encourage efficient disclosure of information Secure optimal commitment to performance Secure efficient reliance Provide efficient default rules and regulations Foster enduring relationships

Wednesday, we begin tort law

That’s it for contract law

End of material on second midterm

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Overall very good

Mean 87, std dev 8 Most points lost on question 1

Not assigning letter grades till after final

Second exam typically harder than first

First Midterm

A-G Q-ZH-P

Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 14.

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Transcript of Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 14.