Econ 522Economics of Law

Dan Quint

Fall 2011

Lecture 11

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Contract = legally binding promise Allow for cooperation/trade when transactions aren’t instantaneous First purpose of contract law: enable cooperation

What promises should be enforced? Bargain theory: those given as part of a bargain

Three elements: offer, acceptance, consideration Efficiency: any promise both promisor and promisee wanted to be

enforceable

Information Asymmetric/private info can prevent trade; contract law can help Second purpose: encourage efficient disclosure of information

Contract law: the story so far

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May become efficient/necessary to break a promise

When should a contract be breached? Breach of contract is efficient when

cost to perform > benefit of performance to promisee Breach is in promisor’s interest when

cost to perform > promisor’s liability from breach Expectation damages: liability from breach = benefit to promisee Leads to breach exactly when it’s efficient Think of this as “designing the law to internalize an externality” Third purpose of contract law: obtain optimal commitment to performance

Contract law: the story so far

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Reliance

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Reliance

You expect an airplane to arrive in spring – you might… Sign up for flying lessons Build yourself a hangar Buy a helmet and goggles

Reliance – investments which depend on performance Reliance increases the value of performance to promisee Reliance increases the social cost of breach

The fourth purpose of contract law is to secure optimal reliance

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When is reliance efficient?

When social benefit of reliance > social cost of reliance

Social benefit is increased benefit to promisee (Value of airplane + hangar) – (Value of airplane without hangar) Value is only realized if the promise is performed

Social cost is cost borne by promisee Cost occurs whether or not promise is performed

Reliance is efficient if

Increase in value of

performance

Cost ofinvestment>Probability of

performanceX

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How should reliance figure into damages?

Expectation damages = expected benefit from performance

If reliance investments increase the anticipated benefit…

should they increase the damages I owe you in the event of breach?

Can we design damages to get efficient reliance, in addition to efficient breach?

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You’re buying an airplane from me Price is $350,000, to be paid on delivery Airplane alone gives you benefit of $500,000 Building a hangar costs $75,000 Airplane with hangar gives you benefit of $600,000

Without hangar, expectation damages = $150,000

If you build a hangar and I fail to deliver plane, do I owe… $150,000? (Value of original promise) $250,000? (Value of performance after your investment) $225,000? (Value of original promise, plus reimburse you for investment

you made) Some other amount?

Reliance and damages:example

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

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The only way to guarantee efficient breach is if damages included the added benefit from reliance Once you’ve made investment, you anticipate benefit of $250,000

from performance If damages are anything less than that, I’ll breach too often (If damages exclude the added benefit, then I’m back to imposing

an externality when I choose to breach the contract)

So what happens to the incentive for reliance investments if damages will increase to include this added benefit?

To get efficient breach…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000

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If you don’t build hangar, your payoff will be… $150,000 if I deliver the plane ($500,000 – $350,000) $150,000 if I breach and pay expectation damages

If you build hangar, your payoff will be… $175,000 if I deliver the plane ($600,000 – $350,000 – $75,000) $175,000 if I breach and pay (higher) expectation damages

So if expectation damages include the increased value of performance due to reliance investments… You’ll invest whenever (increase in benefit) > (cost) In this case, you’ll invest (because $100,000 > $75,000)

If exp damages includebenefit from reliance…

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

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If expectation damages include increased value of performance, you’ll invest for sure

Is this efficient? Reliance is efficient if

(increase in benefit) X (probability of performance) > (cost)

$100,000 X (probability of performance) > $75,000 Only efficient if probability of performance > ¾ If probability of performance < ¾, reliance is inefficient, but happens

anyway

Overreliance!

If exp damages includebenefit from reliance…

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

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Better example:continuous investment

xy 600

Investment in hangar

Additionalvalue ofplane

$100

$10,

000

$40,

000

$160

,000

$640

,000

Tarp and rope - $6,000 benefit

Plywood frame, canvas roof - $60,000

Metal poles, rigid roof - $120,000

Functional heating - $240,000

Designer hangar with Starbucks - $480,000

Price of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x

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Let p be probability of breach

Three questions What is the efficient level of reliance?

What will promisee do if expectation damages include anticipated benefit from reliance?

What will promisee do if expectation damages exclude anticipated benefit from reliance?

Three questionsPrice of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x

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Let p be probability of breach

Three questions What is the efficient level of reliance?

x = $90,000 (1 – p)2

What will promisee do if expectation damages include anticipated benefit from reliance?

x = $90,000

What will promisee do if expectation damages exclude anticipated benefit from reliance?

x = $90,000 (1 – p)2

Three questionsPrice of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x

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Overreliance

If reliance investments increase the damages you’ll receive in the event of breach, you’ll over-rely You’ll rely if

Efficient to rely if

So if damages increase when you make reliance investments, we’re sure to get overreliance!

(Your investment imposes an externality on me)

Increasein benefit

Cost ofinvestment>Prob. of

perform.X Increasein damages

Prob. of breachX+

Increasein benefit

Cost ofinvestment>Prob. of

perform.X

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Reliance and breach

Just showed: if damages include added benefit from reliance, promisee will invest more than efficient amount

But if damages exclude added benefit… Then promisor’s liability < promisee’s benefit from performance Which means: promisor will breach more often than efficient

“Paradox of compensation” Single “price” (damages owed) sets multiple incentives… …impossible to set them all efficiently!

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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 do?

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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

So what do we do?

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1850s England Hadley ran flour mill, crankshaft broke Baxendale’s firm hired to transport

broken 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

Foreseeable reliance: Hadley v Baxendale

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1850s England Hadley ran flour mill, crankshaft broke Baxendale’s firm hired to transport

broken 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

Foreseeable reliance: Hadley v Baxendale

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Default Rules

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

Default rules: rules applied by courts to fill gaps

Default rules

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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

Default rules

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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 be?

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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

What should default rules be?

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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 rules

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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 rules

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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 rules

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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 rules

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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

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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”

Default rules: a different view

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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: Hadley v Baxendale

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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 examples

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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

Penalty defaults: other examples

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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.”

When to use penalty defaults?