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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

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
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
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 = $600,000Reliance 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 = $600,000Reliance 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
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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