Economics of Contract Law

Agency Game I Give me $100 and I’ll turn it into $200 and share

the gain with you Do you trust me? No! Player 2 has DS to breach

Solutions? Reputation in a repeated game Contract law

Player 2

Perform Breach

Player 1Contract 150, 50 0, 200

Don’t Contract 100, 0 100, 0

Agency Game II Suppose we sign a contract in which I am

punished if I run off with the money Court forces me to pay you $150 and charges each of us

an additional $25 fee for doing so

Player 2

Perform Breach

Player 1Contract 150, 50 125, 25

Don’t Contract 100, 0 100, 0

1st Purpose of Contract Law is to enable people to cooperate

Requires a way to make a promise credible (some sort of commitment)

Example 1

The rich uncle of a struggling college student learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world.

Example 2

One neighbor offers to sell a used car to another for $1000. The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back yard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac.

Example 3

A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,” mails $25 and receives in the mail two wooden blocks with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and to pay $500 in punitive damages.

Bargain Theory of Contracts I A promise should be enforced if it was given in a

bargain, otherwise it should not. Offer Acceptance Consideration

Rich uncle: no consideration offered Disputed car: no “meeting of the minds” Grasshopper killer: enforceable bargain

Promisor: person who gives a promise

Promisee: person who receives it

“reciprocal inducement”

How do you enforce a gift promise?

Bargain Theory of Contracts II What should the remedy be for broken promises?

Expectations damages: amount promisee could reasonably expect from performance

Problems with the Bargain Theory Requires all promises to have consideration

Car shopping and a “firm offer” Requires that all bargains be enforced

Grasshopper killer?

Economic efficiency requires enforcing a promise that both parties want enforced.

Economic Theory of Contract

Rich uncle: both want the promise enforced Disputed car: no cooperative surplus Grasshopper killer: enforce the promise to discourage

deceit by promisor

1st Purpose of Contract Law is to enable people to cooperate

Used car market You value my car 50% more than I do Asymmetric information exists No mechanics

2nd Purpose of Contract Law is to encourage efficient disclosure of information

[0---------------------------5000]$2500

(your guess as to value of car to me) Suppose you offer $3000

[0-------------------3000]$1500

(your revised guess as to value of car to me)

You will end up paying $3000 for a car that’s only worth $2250 to you

What should be the remedy for efficient breach?

Painting sale You value my unfinished painting at $1000 We agree on a sale price of $600 upfront Crazy cousin makes $5000 offer It’s efficient for me to breach contract with you:

Cost of performance > benefit you will get from the painting

Airplane sale You value my plane at $500,000 We agree on a sale price of $350,000 Before construction begins, price of metal rises and raises my

cost to $1,000,000

3rd Purpose of Contract Law is to secure optimal commitment to performing.

Optimal Performance If promisor’s cost of performing > promisee’s benefit from

performing, then breach is efficient If promisor’s cost of performing < promisee’s benefit from

performing, then performance is efficient

Choice of remedy is critical If penalty for breach is too severe, the promisor will have

to perform, even though breach may be efficient If penalty for breach is too weak, the promisor will breach

when efficiency requires performance

3rd Purpose of Contract Law is to secure optimal commitment to performing.

Actual Performance Decision: If promisor’s cost of performing > promisor’s liability for

breaching, then he will breach If promisor’s cost of performing < promisor’s liability for

breaching, then he will perform

Perfect Expectations Damages Promisor’s liability = promisee’s benefit from performance Restores promisee to position he would have enjoyed if

promise had been kept

3rd Purpose of Contract Law is to secure optimal commitment to performing.

Painting Sale I You value my unfinished painting at $1000 We agree on a sale price of $600 upfront Crazy cousin makes $5000 offer

What are Expectation Damages? DE = $1000 What if D = $6000

Buyer

Buy Don’t Buy

PainterPerform 600, 400 ------

Breach 5600, - 600 ------4600, 400-400, 5400

Painter performs though breach is efficient

Painter breaches and it is efficient

Painting Sale II You value my unfinished painting at $1000 We agree on a sale price of $600 upfront Crazy cousin makes $5000 offer Assume simple DE

Buyer purchases frame for $50 which raises value of painting to $1200

Buyer

Rely Don’t Rely

PainterPerform 600, 550 600, 400

Breach 4400, 550 4600, 400

Whether painter performs or not, reliance makes you better off

But, is reliance efficient?

4th Purpose of Contract Law is to secure optimal reliance.

p = probability of performance∆V = increase in value of performance due to reliancec = cost of reliance

If Expected Gain from Reliance > Cost of Reliance then Reliance is efficient

If p(∆V) > C then reliance is efficient

Painter ex: ∆V = 200 c = 50

p* = 0.25

When the probability of performance is high, more reliance tends to be efficient

Warning: if my damages cover your benefit whether or not it’s efficient, then you’ll always spend on reliance (over-reliance)

Solution: Perfection Expectations Damages damages needed to restore the promisee had the

promise been kept, and had he relied the optimal amount

Foreseeability Doctrine “Reasonably expected” reliance

4th Purpose of Contract Law is to secure optimal reliance.

Hadley v Baxendale (1854) Hadley ran a mill and crankshaft broke Baxendale was to deliver it to engineers

Delayed one week (used boat rather than rail) Hadley sued for week’s worth of lost profits Court ruled lost profits were not foreseeable

Gaps: contract is silent about risks Inadvertent gaps: not foreseeable Deliberate gaps: remote risks

Default rules Compute hypothetical bargain

Who can bear risk at lowest cost? Adjust price of the contract

5th Purpose of Contract Law is to minimize transaction costs of negotiating contracts by supplying efficient default rules

Cost of allocating a risk > Expected cost of allocating a loss leave gap

Cost of allocating a risk < Expected cost of allocating a loss fill gap

McGuire v Wabash McGuires hire Wabash to build new house Price of copper rises by $2000 and contract is silent McGuires refuse to pay extra $2000

Suppose Wabash knows that copper costs could rise by $2000 with p = 0.50 Expected cost = (0.50)(2000) = $1000 Suppose Wabash could’ve hedged risk for $400

Hypothetical bargain Who is the low cost bearer of risk? If risk was foreseeable, Wabash would charge extra $700

McGuires pays $700 Wabash absorbs $1300 loss

Wabash

Perfect Contracts and Market Failures Perfect Contract

All risks is efficiently allocated All relevant information is communicated All resources allocated to those who value it the most

Individual Irrationality Incompetence Dire constraints

Necessity Duress

Transactions Costs Spillovers Asymmetric information Monopoly

Exceptions to perfect contracts

Coffee shop and the forgotten wallet

Prisoner’s Dilemma One-shot game: DS is to cheat Repeated game: Cooperative outcome is Pareto Optimal

Endgame Problem

6th Purpose of Contract Law is to foster enduring relationships, which solve the problem of cooperation with less reliance on the courts to enforce contracts

“tit-for-tat” strategy

NY Diamond Dealer’s Club“Rarely will buyers leave saying they bought the wrong goods at too high a price. Our goal is to make them eager to come back. We offer a source which provides a competitive edge, all of which translates directly into increased profits.”

Peevyhouse v Garland Coal (1962) Peevyhouse owned farm in Oklahoma Garland contracted to strip-mine coal

Contract specified that Garland would take steps to restore land to previous condition

Garland breached Peevyhouse sued for $25,000 Restorative costs were estimated to be $29,000 at trial Garland showed that “diminished value” of farm was only $300

Original jury awarded $5000 to Peevyhouse OK Supreme Court reduced damages to $300

Efficient breach? Dissent: specific performance was warranted, otherwise no

formation would have occurred