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Econ 522 Economics of Law

This lecture discusses the concept of efficient breach in contract law, where breach becomes desirable in certain circumstances. It explores the importance of the penalty for breach and how it affects the efficiency of contracts.

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Econ 522 Economics of Law

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  1. Econ 522Economics of Law Dan Quint Spring 2010 Lecture 10

  2. Logistics • Midterm on Wednesday • Office hours tomorrow • Me (Soc Sci 7428) 9:30-11:30 a.m. • Fran (Soc Sci 6443) 12:30-2:30 p.m.

  3. Last week… • Why do we need contracts? • To get cooperation/trade when transactions aren’t instantaneous • 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

  4. Breach

  5. So… • A contract is just a promise • The idea here is that we want some promises to be legally binding • This means there has to be some legal consequence for breaking such a promise • Breach of contract is when the promisor fails to live up to his promise • Just like property rights are meaningless unless there is a remedy when they are violated… • …contract law is meaningless unless there is a penalty for breach • So, what happens when a contract is breached?

  6. Why does the penalty for breach matter? • If penalty is too weak, contract law has no bite, and we’re back to our original problem • But sometimes, circumstances change, and breach of contract becomes desirable • Example: I promise to sell you a painting

  7. Why does the penalty for breach matter? • If penalty is too weak, contract law has no bite, and we’re back to our original problem • But sometimes, circumstances change, and breach of contract becomes desirable • Example: I promise to sell you a painting • Example: I promise to build you a plane • If penalty for breach is too severe, I’ll have to honor these promises even when this is inefficient • Can we design the law so that we only get breach of contract when it’s efficient?

  8. When is breach efficient? • Breach is efficient if social benefit of breach > social cost of breach • Social cost of breach is that promisee doesn’t get the benefit from the promise • Social benefit of breach is that promisor doesn’t have to incur the cost of delivering (performing) • So breach is efficient if promisor’s cost to perform > promisee’s benefit from performance

  9. Efficient Breach Efficiency: > Promisor’sCost Promisee’sBenefit Efficient to Breach  < Promisor’sCost Promisee’sBenefit Efficient to Perform 

  10. When do we expect breach to happen? • Promisor weighs private cost of performance vs breach • Whatever the penalty for breach, if it’s cheaper to perform, promisor will perform; if it’s cheaper to breach, he’ll breach • That is, we expect breach to occur whenever promisor’s cost to perform > penalty for breach

  11. Efficient Breach Efficiency: > Promisor’sCost Promisee’sBenefit Efficient to Breach  < Promisor’sCost Promisee’sBenefit Efficient to Perform  What will actually happen (incentives of promisor): > Promisor’sCost Promisor’s Liability Promisor will Breach  < Promisor’sCost Promisor’sLiability Promisor will Perform 

  12. So how do we get efficient breach? Efficiency: > Promisor’sCost Promisee’sBenefit Efficient to Breach  What will actually happen (incentives of promisor): > Promisor’sCost Promisor’s Liability Promisor will Breach  So if we design the law such that = Promisor’sLiabilityfor Breach Promisee’sBenefit fromPerformance the promisor will breach exactly when breach is efficient

  13. Efficient breach • When liability from breach = promisee’s benefit from performance, we get breach exactly when it’s efficient • So for efficiency, when a promisor breaches a contract, we want him to owe a penalty exactly equal to the benefit the promisee expected to receive • This is called expectation damages • Expectation damages: if I promise you something that has value of $100 to you, and then I break my promise, I owe you $100 • This way, • if it costs me more than $100 to keep my promise, I’ll break it, which is efficient • if it costs me less than $100 to keep my promise, I’ll keep it, which is efficient

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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 • (You get a payoff of $500,000 if I build the plane, and a benefit of $500,000 if I don’t.) • So I choose efficiently when deciding whether to perform or breach

  19. Reliance

  20. Reliance • Reliance – investments made by promisee, to increase the value of performance • The fourth purpose of contract law is to secure optimal reliance

  21. When is reliance efficient? • When social benefit of reliance > social cost of reliance • Social benefit is increased benefit to promisee when promise is performed • Social cost is cost borne by promisee, whether or not promise is performed • So reliance is efficient as long as(probability of performance) X (increase in value) > (cost)

  22. Efficient reliance • Efficiency: reliance is efficient as long as(probability of performance) X (increase in value) > (cost) • We said expectation damages = expected benefit from performance • Should expectation damages include increase in benefit due to reliance? • If yes: promisee will rely as long as (increase in value) > (cost) • So if yes, promisee will overrely • (Another way to think about this: there’s some chance I’ll have to breach • If your reliance increases my liability, then it increases the expected damages I’ll owe, which makes me worse off • If your reliance imposes a negative externality, you’ll do it more than the efficient amount)

  23. 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?

  24. 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

  25. 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!

  26. 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)

  27. 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

  28. 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

  29. 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

  30. Up next • Default rules • What principles should we use to address contingencies not considered in a contract? • Paper by Ayres and Gertner on syllabus

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