Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 10

1  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 Logistics

2  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 Tuesday…

3 Efficient Breach

4 Promisor’s Cost Promisee’s Benefit  Efficient to Breach  Promisor’s Cost Promisee’s Benefit  Efficient to Perform  Promisor’s Cost Promisor’s Liability  Promisor will Breach  Promisor’s Cost Promisor’s Liability  Promisor will Perform  Self-Interest (incentives of promisor): Efficiency:

5  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 breach Value to you = $500,000 Price = $350,000

6  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 breach Value to you = $500,000 Price = $350,000 Promisor’s Cost Promisee’s Benefit  Efficient to Breach 

7  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 Example of efficient breach Value to you = $500,000 Price = $350,000 Promisor’s Cost Promisor’s Liability  Promisor will Breach 

8  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 But so what? Can’t we just “Coase” back to efficiency? Value to you = $500,000 Price = $350,000

9  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 Another way to think about expectation damages: eliminating an externality

10 Reliance

11  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 Next: Reliance

12  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: example

13  Cost of building plane: maybe $250,000, maybe $700,000  Clearly, you’ll choose to build the hangar  But, is that efficient? Reliance and damages: example Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600, = 175 Costs rise = = = = 175 Costs stay low I getYou getI getYou get You don’tYou build hangar

14  Let p be probability my costs go up  Combined expected payoffs if you rely: (1 – p) ( ) + p (175 – 250) = 275 (1 – p) – 75 p = 275 – 350 p  Combined expected payoffs if you don’t rely: (1 – p) ( ) + 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, it’s not  But you’re going to rely either way! Reliance and damages: example Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000

15  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) What do we learn?

16  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?

17  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?

18  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 Foreseeable reliance: Hadley v Baxendale

19 Default Rules

20  Gaps: risks or circumstances that aren’t specifically addressed in a contract  Default rules: rules applied by courts to fill gaps Default rules

21  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

22  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?

23  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?

24  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

25  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

26  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

27 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?

28  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

29  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

30  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

31  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

32  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

33  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?

34  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 Default rules versus regulations