Economics of Contract Law

Agency Game I Give me $100 and Ill 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 PerformBreach Player 1 Contract150, 500, 200 Dont Contract100, 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 PerformBreach Player 1 Contract150, 50125, 25 Dont Contract100, 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 1 st 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 2 nd Purpose of Contract Law is to encourage efficient disclosure of information [ ] $2500 (your guess as to value of car to me) Suppose you offer $3000 [ ] $1500 (your revised guess as to value of car to me) You will end up paying $3000 for a car thats 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 Its 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 3 rd Purpose of Contract Law is to secure optimal commitment to performing.

Optimal Performance If promisors cost of performing > promisees benefit from performing, then breach is efficient If promisors cost of performing < promisees 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 3 rd Purpose of Contract Law is to secure optimal commitment to performing.

Actual Performance Decision: If promisors cost of performing > promisors liability for breaching, then he will breach If promisors cost of performing < promisors liability for breaching, then he will perform Perfect Expectations Damages Promisors liability = promisees benefit from performance Restores promisee to position he would have enjoyed if promise had been kept 3 rd 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? D E = $1000 What if D = $6000 Buyer BuyDont Buy Painter Perform600, Breach5600, , , 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 D E Buyer purchases frame for $50 which raises value of painting to $1200 Buyer RelyDont Rely Painter Perform600, , 400 Breach4400, , 400 Whether painter performs or not, reliance makes you better off But, is reliance efficient?

4 th Purpose of Contract Law is to secure optimal reliance. p = probability of performance V = increase in value of performance due to reliance c = 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 its efficient, then youll 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 4 th 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 weeks 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 5 th 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 couldve 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 Prisoners Dilemma One-shot game: DS is to cheat Repeated game: Cooperative outcome is Pareto Optimal Endgame Problem 6 th 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 Dealers 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