Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 10

1  Midterm on Wednesday  Office hours tomorrow  Me (Soc Sci 7428) 9:30-11:30 a.m.  Fran (Soc Sci 6443) 12:30-2:30 p.m. Logistics

2  Why do we need contracts?  To get cooperation/trade when transactions aren’t instantaneous  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 Last week…

3 Breach

4  A contract is just a promise  The idea here is that we want some promises to be legally binding  This means there has to be some legal consequence for breaking such a promise  Breach of contract is when the promisor fails to live up to his promise  Just like property rights are meaningless unless there is a remedy when they are violated…  …contract law is meaningless unless there is a penalty for breach  So, what happens when a contract is breached? So…

5 Why does the penalty for breach matter?  If penalty is too weak, contract law has no bite, and we’re back to our original problem  But sometimes, circumstances change, and breach of contract becomes desirable  Example: I promise to sell you a painting

6 Why does the penalty for breach matter?  If penalty is too weak, contract law has no bite, and we’re back to our original problem  But sometimes, circumstances change, and breach of contract becomes desirable  Example: I promise to sell you a painting  Example: I promise to build you a plane  If penalty for breach is too severe, I’ll have to honor these promises even when this is inefficient  Can we design the law so that we only get breach of contract when it’s efficient?

7 When is breach efficient?  Breach is efficient if social benefit of breach > social cost of breach  Social cost of breach is that promisee doesn’t get the benefit from the promise  Social benefit of breach is that promisor doesn’t have to incur the cost of delivering (performing)  So breach is efficient if promisor’s cost to perform > promisee’s benefit from performance

8 Efficient Breach Promisor’s Cost Promisee’s Benefit  Efficient to Breach  Promisor’s Cost Promisee’s Benefit  Efficient to Perform  Efficiency:

9 When do we expect breach to happen?  Promisor weighs private cost of performance vs breach  Whatever the penalty for breach, if it’s cheaper to perform, promisor will perform; if it’s cheaper to breach, he’ll breach  That is, we expect breach to occur whenever promisor’s cost to perform > penalty for breach

10 Efficient Breach 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  What will actually happen (incentives of promisor): Efficiency:

11 So how do we get efficient breach? Promisor’s Cost Promisee’s Benefit  Efficient to Breach  Promisor’s Cost Promisor’s Liability  Promisor will Breach  What will actually happen (incentives of promisor): Efficiency: Promisor’s Liability for Breach Promisee’s Benefit from Performance  So if we design the law such that the promisor will breach exactly when breach is efficient

12 Efficient breach  When liability from breach = promisee’s benefit from performance, we get breach exactly when it’s efficient  So for efficiency, when a promisor breaches a contract, we want him to owe a penalty exactly equal to the benefit the promisee expected to receive  This is called expectation damages  Expectation damages: if I promise you something that has value of $100 to you, and then I break my promise, I owe you $100  This way,  if it costs me more than $100 to keep my promise, I’ll break it, which is efficient  if it costs me less than $100 to keep my promise, I’ll keep it, which is efficient

13  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

14  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 

15  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 

16  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

17  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  (You get a payoff of $500,000 if I build the plane, and a benefit of $500,000 if I don’t.)  So I choose efficiently when deciding whether to perform or breach Another way to think about expectation damages: eliminating an externality

18 Reliance

19 Reliance  Reliance – investments made by promisee, to increase the value of performance  The fourth purpose of contract law is to secure optimal reliance

20 When is reliance efficient?  When social benefit of reliance > social cost of reliance  Social benefit is increased benefit to promisee when promise is performed  Social cost is cost borne by promisee, whether or not promise is performed  So reliance is efficient as long as (probability of performance) X (increase in value) > (cost)

21 Efficient reliance  Efficiency: reliance is efficient as long as (probability of performance) X (increase in value) > (cost)  We said expectation damages = expected benefit from performance  Should expectation damages include increase in benefit due to reliance?  If yes: promisee will rely as long as (increase in value) > (cost)  So if yes, promisee will overrely  (Another way to think about this: there’s some chance I’ll have to breach  If your reliance increases my liability, then it increases the expected damages I’ll owe, which makes me worse off  If your reliance imposes a negative externality, you’ll do it more than the efficient amount)

22  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

23  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

24  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

25  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?

26  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?

27  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?

28  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

29  Default rules  What principles should we use to address contingencies not considered in a contract?  Paper by Ayres and Gertner on syllabus Up next