Econ 522 economics of law
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Econ 522 Economics of Law. Dan Quint Fall 2009 Lecture 10. Logistics. Office hours between now and midterm: Me: Monday 1:30-3:30 Chao: today 1:00-3:00, Monday 10:00-1:30 Midterm #1 Tuesday, in class No contract law. Tuesday…. Why do we need contracts? What promises should be enforced?

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Econ 522 Economics of Law

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Econ 522 economics of law

Econ 522Economics of Law

Dan Quint

Fall 2009

Lecture 10


Logistics

Logistics

  • Office hours between now and midterm:

    • Me: Monday 1:30-3:30

    • Chao: today 1:00-3:00, Monday 10:00-1:30

  • Midterm #1 Tuesday, in class

    • No contract law


Tuesday

Tuesday…

  • Why do we need contracts?

  • What promises should be enforced?

    • Bargain Theory of Contracts

    • Efficiency

  • First purpose of contract law: enable cooperation

  • Second purpose of contract law: encourage efficient disclosure of information

  • Third purpose of contract law: secure optimal commitment to performance (efficient breach)

  • Fourth purpose of contract law: secure optimal reliance


Econ 522 economics of law

Efficient Breach


Efficient breach

Efficient Breach

Efficiency:

>

Promisor’sCost

Promisee’sBenefit

Efficient to Breach

<

Promisor’sCost

Promisee’sBenefit

Efficient to Perform

Self-Interest (incentives of promisor):

>

Promisor’sCost

Promisor’s Liability

Promisor will Breach

<

Promisor’sCost

Promisor’sLiability

Promisor will Perform


Example of efficient breach

Value to you = $500,000

Price = $350,000

Example of efficient breach

  • I build airplanes

  • You value one of my planes at $500,000

  • You agree to buy one for $350,000, and pay up front

  • After you pay, price of materials goes up


Example of efficient breach1

Value to you = $500,000

Price = $350,000

Example of efficient breach

>

Promisor’sCost

Promisee’sBenefit

Efficient to Breach

  • Promisee’s benefit = $500,000

    • If it costs me less than $500,000 to build plane, efficient to build it

    • If it costs me more than $500,000, efficient to breach


Example of efficient breach2

Value to you = $500,000

Price = $350,000

Example of efficient breach

>

Promisor’sCost

Promisor’sLiability

Promisor will Breach

  • Liability is just to return your money

    • If my costs rise to $400,000, performance is still efficient, but I’ll choose to breach

  • Liability is $1,000,000

    • If costs rise to $700,000, performance is inefficient, but I’d rather perform than breach

  • Liability = promisee’s benefit ($500,000)

    • I’ll perform when performance is efficient, breach when breach is efficient


But so what can t we just coase back to efficiency

Value to you = $500,000

Price = $350,000

But so what? Can’t we just“Coase” back to efficiency?

  • Liability is $350,000, my costs rise to $400,000

    • I’ll breach original contract, but we can renegotiate to higher price

    • But I might try to do that even if my costs don’t go up…

  • Liability is $1,000,000, my costs rise to $700,000

    • Rather than performing, I can offer you money to let me cancel contract

    • But my threat point is very low – you can demand a lot of money

    • If I realize that might happen, maybe I’m afraid to sign original contract

  • Expectation damages avoid these problems


Another way to think about expectation damages eliminating an externality

Another way to think about expectation damages: eliminating an externality

  • If I breach contract, I impose externality on you

    • You’re $500,000 worse off

  • If I have to pay you $500,000, then I internalize the externality

    • Now my action no longer affects your well-being

    • So I choose efficiently when deciding whether to perform or breach


Econ 522 economics of law

Reliance


Next reliance

Next: Reliance

  • Reliance: investments you make to increase your benefit from performance

  • Increases my liability if I breach

  • If expectation damages include added benefit due to reliance, leads to more than efficient level of reliance

    • There’s some chance I’ll need to breach the contract

    • Your reliance investments increase my liability from breach, so they impose a negative externality

    • Activities which impose negative externality happen too much

    • Overreliance


Reliance and damages example

Reliance and Damages: example

  • Reliance increases your benefit from my promise

    • Airplane gives you benefit of $500,000

    • Costs $75,000 to build a hangar

    • Airplane with hangar gives you benefit of $600,000

  • Suppose price is $350,000, to be paid on delivery

    • Expectation damages restore you to well-being you expected to have from performance

    • Without a hangar, if I breach, I owe you $150,000

    • If you build a hangar and I breach, do I owe you $250,000?


Reliance and damages example1

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000

Reliance and damages:example

  • Cost of building plane: maybe $250,000, maybe $700,000

  • Clearly, you’ll choose to build the hangar

  • But, is that efficient?

You build hangar

You don’t

You get

I get

You get

I get

Costsstay low

600 - 75 - 350 = 175

350 - 250 =100

500 - 350 =150

350 - 250 =100

Costsrise

- 75 + 250 =175

-250

150

-150


Reliance and damages example2

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000

Reliance and damages:example

  • Let p be probability my costs go up

  • Combined expected payoffs if you rely:

    (1 – p) (175 + 100) + p (175 – 250)

    = 275 (1 – p) – 75 p = 275 – 350 p

  • Combined expected payoffs if you don’t rely:

    (1 – p) (150 + 100) + p (150 – 150)

    = 250 (1 – p) = 250 – 250 p

  • Which is bigger?

    275 – 350 p > 250 – 250 p

    « 25 > 100 p « p < ¼

  • So if p < ¼, reliance is efficient; if p > ¼, it’s not

  • But you’re going to rely either way!


What do we learn

What do we learn?

  • When probability of breach is low, more reliance tends to be efficient

  • When probability of breach is high, less reliance tends to be efficient

  • If expectation damages include increased benefit from reliance, we sometimes get overreliance

  • (OTOH, if expectation damages exclude increased benefit from reliance, liability < benefit, so inefficient breach)


So what do we do

So what do we do?

  • Cooter and Ulen: include only efficient reliance

    • Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount

    • So promisee rewarded for efficient reliance, not for overreliance


So what do we do1

So what do we do?

  • Cooter and Ulen: include only efficient reliance

    • Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount

    • So promisee rewarded for efficient reliance, not for overreliance

  • Actual courts: include only foreseeable reliance

    • That is, if promisor could reasonably expect promisee to rely that much


Foreseeable reliance hadley v baxendale

Foreseeable reliance: Hadley v Baxendale

  • 1850s England

    • Hadley owned gristmill, mill shaft broke

    • Baxendale’s firm hired to transport shaft for repair

    • Baxendale shipped by boat instead of train, making it a week late

    • Hadley sued for the week’s lost profits

  • “The shipper assumed that Hadley, like most millers, kept a spare shaft. …Hadley did not inform him of the special urgency in getting the shaft repaired.”

    • Court listed several circumstances where broken shaft would not force mill to shut down

    • Ruled lost profits not foreseeable  Baxendale didn’t have to pay


Econ 522 economics of law

Default Rules


Default rules

Default rules

  • Gaps: risks or circumstances that aren’t specifically addressed in a contract

  • Default rules: rules applied by courts to fill gaps


Default rules1

Default rules

  • Gaps: risks or circumstances that aren’t specifically addressed in a contract

  • Default rules: rules applied by courts to fill gaps

  • Writing something into a contract vs leaving a gap

    • Allocating a loss (ex post)

    • Versus allocating a risk (ex ante), before it becomes a loss


What should default rules be

What should default rules be?

  • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue

  • This will be whatever rule is efficient


What should default rules be1

What should default rules be?

  • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue

  • This will be whatever rule is efficient

  • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules

    • Do this by imputing the terms the parties would have chosen if they had addressed this contingency


Default rules2

Default rules

  • Don’t want ambiguity in the law

  • So default rule can’t vary with every case

  • Majoritarian default rule: the terms that most parties would have agreed to

    • In cases where this rule is not efficient, parties can still override it in the contract

  • Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate


Default rules3

Default rules

  • Example: probability ½, the cost of construction will increase by $2,000

    • Construction company can hedge this risk for $400

    • Family can’t do anything about it

  • Price goes up – who pays for it?


Default rules4

Default rules

  • Example: probability ½, the cost of construction will increase by $2,000

    • Construction company can hedge this risk for $400

    • Family can’t do anything about it

  • Price goes up – who pays for it?

    • Construction company is efficient bearer of this risk

    • So efficient contract would allocate this risk to construction company

    • Should prices be adjusted to compensate?


Default rules5

Default rules

  • Example: probability ½, the cost of construction will increase by $2,000

    • Construction company can hedge this risk for $400

    • Family can’t do anything about it

  • Price goes up – who pays for it?

    • Construction company is efficient bearer of this risk

    • So efficient contract would allocate this risk to constructioncompany

    • Should prices be adjusted to compensate?


Default rules6

Default rules

  • So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases

    • Most contracts can leave this gap, save on transaction costs

    • In cases where this rule is inefficient, parties can contract around it


Default rules a different view

Default rules: a different view

  • Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules”

  • Sometimes better to make default rule something the parties would not have wanted

    • To give incentive to address an issue rather than leave a gap

    • Or to give one party incentive to disclose information

    • “Penalty default”


Penalty defaults hadley v baxendale

Penalty defaults: Hadley v Baxendale

  • Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk

  • If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent

  • So Hadley might hide this information, which is inefficient

    • Ayres and Gertner: Ruling in Hadley was a good one, not because it was efficient, but because it was inefficient…

    • …but in a way that created incentive for disclosing information


Penalty defaults other examples

Penalty defaults: other examples

  • Real estate brokers and “earnest money”

    • Broker knows more about real estate law

    • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this


Penalty defaults other examples1

Penalty defaults: other examples

  • Real estate brokers and “earnest money”

    • Broker knows more about real estate law

    • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this

  • Courts will impute missing price of a good, but not quantity

    • Forces parties to explicitly contract on quantity, rather than leave it for court to decide


When to use penalty defaults

When to use penalty defaults?

  • Look at why the parties left a gap in contract

    • Because of transaction costs  use efficient rule

    • For strategic reasons  penalty default may be more efficient

  • Similar logic in a Supreme Court dissent by Justice Scalia

    • Congress passed a RICO law without statute of limitations

    • Majority decided on 4 years – what they thought legislature would have chosen

    • Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…”

    • “Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.”


Default rules versus regulations

Default rules versus regulations

  • Default rules can be contracted around

  • Some rules cannot – immutable rules, or mandatory rules, or regulations

  • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations.

    • Coase: if individuals are rational and there are no transaction costs, private negotiations lead to efficiency

    • So additional regulations would just get in the way

    • So regulations only make sense when people are not rational, or when there are transaction costs/market failures


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