LEB Slide Set 7b Economic Optimization of Contract Law and Economics Bounded Rationality Matti Rudanko

2 Basics of Contract Planning The bounded rationality of parties opportunism asymmetric information various degrees of risk aversion risk seeking / risk averse / risk neutral LEB Slde set 7b

3 Influence of Risk Aversion Rates Legal rules are often based on risk neutrality e.g. P(100 %) x $ 1 M = P(10 %) x $ 10 M risk seeking: P(100 %) x $ 1 M < P(10 %) x $ 10 risk averse: P(100 %) x $ 1 M > P(10 %) x $ 10 M risk premium may vary LEB Slde set 7b

4 “The Efficient Risk bearer” In the contract, the party capable of bearing a risk at least cost, should be charged with that risk even legal rules should be incentives to efficient liability (risk) bearing costs from damages and protection against them planning contracts / legislations: should negligence be a prerequisite of liability (the incentive effect) possibilities of getting prepared for risks: insurance etc. costs of settlement LEB Slde set 7b

5 The Efficient Contract An efficient contract transfers resources to efficient use with minimal transaction costs the Coasian theorem (by the economist Ronald Coase) no contracting disruptions (duress, undue influence, fraud, errors etc.): the perfect contract Efficient incentives are achieved by structuring the contract legal and other sanctions are decisive LEB Slde set 7b

6 The Optimum Scope of Binding Effect… … is an incentive to the performance of an efficient but not an inefficient contract … is achieved best by finding a proper structure of legal sanctions: right of rescission of the contract damages, liquidated damages reduction of price right to retain one’s own performance etc. LEB Slde set 7b

7 Economic Values of Contract Expectation value / interest the added value from the contract to a party the so-called commitment rationality is protected productivity Reliance value/interest the value to a party of committing herself to the contract (e.g. investments, costs) protection of risk taking rationality protectiveness LEB Slde set 7b

8 Efficient Expectation Interest A B C D E A the potential value added to the creditor; B = p/100 x A (p is the probability coefficient for its realization) C investments by the creditor; D = p/100 x C E (B - D) the efficient expectation interest LEB Slde set 7b

9 An Efficient Breach of Contract I LEB Slde set 7b Is it efficient to break an inefficient contract? E.g.: A has promised to sell to B goods at a price of $ x. C offers A $ (x+y) for the goods. A concludes the contract with C (breaking his contract with B). Legal evaluation: A has to compensate to B the expectation value e.g. z (i.a. B:s lost profit)

10 An Efficient Breach of ContractII A, B and C are entitled to their expectation value each total efficiency? If y > z, A’s breach of contract is an efficient one B’s right to the added value represented by C’s contract ? The external effects of a breach of contract ? To be internalized in the expectation value ? Total evaluation: LEB Slde set 7b

11 The external effects of a breach of contract The costs of the enforcement of liability (litigation costs) costs to third persons general drawbacks / advantages influence on employment rates environmental influence contracting morals LEB Slde set 7b

12 Efficient validity and morals A’s economic expectation value is negative however, B’s contractual breach is not efficient A’s values should be internalized as expectation values, or, as an alternative, the reliance value (e.g. A’s contracting costs) should be compensated moral aspect and the protection of immaterial (personal, cultural, spritual values) E.g., A buys an article of B at an overprice for emotional etc.values: LEB Slde set 7b

13 Contract Risk Management Types of Risks Credit risk financing risk country risk GOODS RISKS party risks delivery risk quality risk quantity risk risk of delay safekeeping and care risk transport risks PAYMENT RISKS risk of delay banking risk currency risk risks of payment modes LEB Slde set 7b