Law and Economics-Charles W. Upton Relying on Contracts

Two Principles Break contracts if and only if the benefits from breach exceed the costs of the breach. Don’t over rely on a contract.

Relying on Contracts The General Rule Rely if and only if (Probability of Performance) x (Gains from Relying) > (Probability of Breach) x (Extra Costs Imposed by Relying)

Relying on Contracts The Opportunity An Entrepreneur offers an investor a chance to go into a business deal for $1,000. If the deal works out (and it will if the entrepreneur works at it), each will make $500. It is possible that another opportunity will come along. If the Entrepreneur takes that, the first deal will fail but the Entrepreneur will make $1,500 It is also possible that the Entrepreneur will simply take the investor’s $1,000.

Relying on Contracts The Payoff Matrix

Relying on Contracts The Payoff Matrix

Relying on Contracts The Payoff Matrix

Relying on Contracts The Payoff Matrix The entrepreneur makes $500 from the investment if he performs, but loses $1,500 from the forgone opportunity.

Relying on Contracts The Payoff Matrix

Relying on Contracts The Payoff Matrix So what is the right strategy?

Relying on Contracts The Payoff Matrix Without legal sanctions, the entrepreneur will always steal the money. Ergo no investment.

Relying on Contracts The Payoff Matrix We modify with perfect expectation damages.

Relying on Contracts The Payoff Matrix Now crime does not pay. But it does pay to walk away if the opportunity arises.

Relying on Contracts The Payoff Matrix Now it does not pay to steal. But it does pay to walk away if the opportunity arises. When we add in the $1,500 from the opportunity, the net gain to the entrepreneur is now $1,000

Relying on Contracts Moral Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity.

Relying on Contracts Moral Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity. But there is more to the story: the tale of the investor.

Relying on Contracts Moral Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity. But there is more to the story: the tale of the investor. The investor is indifferent between the entrepreneur performing and not performing. He will invest even if there is a 100% chance of the other opportunity coming along.

Relying on Contracts Moral Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity. But there is more to the story: the tale of the investor. The investor is indifferent between the entrepreneur performing and not performing. He will invest even if there is a 100% chance of the other opportunity coming along. This seems wasteful

Relying on Contracts The Payoff Matrix Another aspect. Lets focus on the payoff matrix without expectation damages.

Relying on Contracts The Payoff Matrix

Relying on Contracts Might He invest Too Much? Suppose the investor can put another $1,000 in the project and if successful, earn another $100. Should he do so?

Relying on Contracts The Payoff Matrix

Relying on Contracts How to Analyze Compute the expected gains from the two possible investments. The investor should invest if the expected gains are positive. Those gains depend on the probability p of no new opportunity arising

Relying on Contracts If it works out Gains from a $1000 investment = $1000 Gains from a $2000 investment = $1100

Relying on Contracts If it doesn’t works out Losses from a $1000 investment = $0 Losses from a $2000 investment = $- 1000

Relying on Contracts The $1000 Investment Losses from a $1000 investment = $0 Gains from a $1000 investment = $1000

Relying on Contracts The $1000 Investment Losses from a $1000 investment = $0 Gains from a $1000 investment = $1000 Expected gain = p($1000) + (1-p)($0)= p($1000)

Relying on Contracts The $2,000 Investment Losses from a $2000 investment = $ Gains from a $2000 investment = $1100

Relying on Contracts The $2,000 Investment Losses from a $2000 investment = $ Gains from a $2000 investment = $1100 Expected gain = p($1100) + (1-p)(-$1000)= p($2100)-$1000

Relying on Contracts You do the Math Expected gains from a $1000 investment 1000p Expected gains from a $2000 investment 2100p

Relying on Contracts You do the Math Expected gains from a $1000 investment 1000p Expected gains from a $2000 investment 2100p – 1000 Do the $2000 only if 2100p – 1000 > 1000p P>0.91

Relying on Contracts Might He invest Too Much? Suppose the investor can put another $1,000 in the project and if successful, earn another $100. Should he do so? If he gets perfect expectation damages, there is no risk in his doing so.

Relying on Contracts The Solution Tell the investor that he cannot just blindly invest the extra $1,000. He will not get damages if he over-relied (that is, he will not get his last $1,000 unless there was less than a 9% chance of the new project coming along).

Relying on Contracts Other Over Reliance You eat the obviously damaged box of Healthy Cookies. You get ill

Relying on Contracts Other Over Reliance You eat the obviously damaged box of Healthy Cookies. You get ill Tough. You over- relied.

Relying on Contracts Other Over Reliance You take the box of Healthy Cookies to the manager who tells you not to worry. You eat them. You get sick.

Relying on Contracts Other Over Reliance You take the box of Healthy Cookies to the manager who tells you not to worry. You eat them. You get sick. Tough. You over- relied.

Relying on Contracts Other Over Reliance You rely on my promise of the easy way to get an “A” in this course and don’t study. You fail.

Relying on Contracts Other Over Reliance You rely on my promise of the easy way to get an “A” in this course and don’t study. You fail. Tough. You over- relied.

Relying on Contracts End ©2004 Charles W. Upton