CONTRACTS – Terms And Conditions October 17, 2006

CONTRACTS – Terms And Conditions October 17, 2006 COLOUR CODE FOR GRAPHS Marginal Cost Curve for Agent (firm, individual) under a strict liability rule Marginal Cost Curve for Agent (firm, individual) under a no liability rule Marginal Cost Curve for Agent (firm, individual) under a negotiated contract that follows the Theoem of Coase Demand Curve for the Agent’s output Marginal Revenue Curve

CONTRACTS – Terms And Conditions October 17, 2006 COLOUR CODE FOR GRAPHS (con’t) Average Cost Curve for Agent (firm, individual) with no transaction costs Average Cost Curve for Agent (firm, individual) with transaction costs Profit of Agent (firm, individual) Portion of profit traded in exchange for property rights Portion of profit lost due to a trade in property rights Portion of profit lost due to transaction costs

CONTRACTS – Terms And Conditions October 17, 2006 Review of Coase Theorem Exceptions To Coase Theorem Transaction Costs - October 17, 2006 »Rules that reduce transaction costs Asymmetric Information – October 24, 2006 »Rules that compensate for market failure Empty Core - October 31, 2006

CONTRACTS – Terms And Conditions October 17, 2006 Review The Theorem Of Coase

CONTRACTS – Terms And Conditions. Agent 2 has theexclusive use to itsproperty rights Agent 1 creates a harmful nuisance that hurts Agent 2 economically.

CONTRACTS – Terms And Conditions While cooperation between the agents determines when optimal use or the most efficient use of an asset will occur, what determines what that level of efficiency will be? Technology

CONTRACTS – Terms And Conditions Social surplus increases under the contract. No party can be worse off. Agent 1 S D P a1a1 PMPM PMC SMC CMC

CONTRACTS – Terms And Conditions Social surplus is improved to the most efficient or optimal amount irregardless of which agent has the property rights. Agent 2 S D P a1a1 PMPM PMC SMC CMC

CONTRACTS – Terms And Conditions Theorem of Coase What rule applies makes no difference to the optimal level of efficiency. It is the cooperation of the parties that makes the difference. (Cooter, p. 87)

CONTRACTS – Terms And Conditions Agent 2 S D P a1a1 PMPM Agent 1 S a1a1 CMC Maximum Joint Social Surplus

CONTRACTS – Terms And Conditions Theorem of Coase (continued) Productive or allocated transfer of surplus leads to a more efficient use of the asset Redistributive transfer of surplus causes no change to the efficient use of the asset Distribution of the social surplus varies in accordance with which agent has the property rights.

CONTRACTS – Terms And Conditions Theorem of Coase (continued): The improvement in social surplus involves the elimination of incompatible uses through bargaining. LEAST COST PRINCIPLE applies as the next example shows.

CONTRACTS – Terms And Conditions

Theorem of Coase (continued): If it is cheaper for the farmer to build a fence around his property, than for the rancher to hire a rustler, than the fence will be built. Note the LEAST COST PRINCIPLE is a corollary of the Theorem of Coase in these examples.

CONTRACTS – Terms And Conditions Set of Cost Minimizers Set of Profit Maximizers

CONTRACTS – Terms And Conditions Theorem of Coase (continued): Note the application of the “cheaper” technology reconciled a “incompatible use” with a compatible use. Efficiency requires limiting the use to the party that values the property most – higher utility or higher profits - efficiency rule (Cooter – p. 88)

CONTRACTS – Terms And Conditions The elimination of incompatible uses through bargaining underlies much of the theory behind urban geography and urban planning Former Irwin Toy factory - Toronto

CONTRACTS – Terms And Conditions Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 MC 1 P PC PMPM LATC

CONTRACTS – Terms And Conditions Theorem of Coase (continued): Property rights may be traded for a price. Each Agent does not have an incentive to defect

CONTRACTS – Terms And Conditions Nash Equilibria Prisoners dilemna works against a collusive duopoly Prisoners dilemna could be “solved” in a collusive externality agency P.O.E N.E P.O.E and N. E

CONTRACTS – Terms And Conditions Nash Equilibria Cournot Duopoly Negative Externality Axes a2a2 E Iso-Profit Curve For Agent 1 Iso-Profit Curve For Agent 2

CONTRACTS – Terms And Conditions October 17, 2006 Coase Theorem Short Run

CONTRACTS – Terms And Conditions Short Run Why the Theorem of Coase might be true in the short run, but not the long run (See Cooter, p. 90, for a fuller explanation)

CONTRACTS – Terms And Conditions Short Run Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S S = MC 1 D P a1a1 MC 1 SATC P PC PMPM LATC

CONTRACTS – Terms And Conditions Strict Liability Rule. Agent 2 has theexclusive use to itsproperty rights Agent 1 creates a harmful nuisance that hurts Agent 2 economically.

CONTRACTS – Terms And Conditions Short Run Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S S = MC 1 D P a1a1 MC 1 SATC P PC PMPM LATC Strict Liability Rule

CONTRACTS – Terms And Conditions Strict Liability Rule - Short Run Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S S = MC 2 D P a1a1 MC 2 SATC P PC PMPM LATC Strict Liability Rule

CONTRACTS – Terms And Conditions Short Run - Strict Liability Rule PRINCIPAL Agent 1 Offers a Bribe or a Transfer Payment To Agent 2 AGENT Agent 2 promises to endure the pollution in exchange for the payment which makes it better off promise payment

CONTRACTS – Terms And Conditions Short Run - Strict Liability Rule Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S S = MC 1 D P a1a1 MC 1 SATC P PC PMPM LATC Strict Liability Rule

CONTRACTS – Terms And Conditions Short Run - Strict Liability Rule Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S S = MC 2 D P a1a1 MC 2 SATC P PC PMPM LATC Strict Liability Rule

CONTRACTS – Terms And Conditions Short Run - No Liability Rule. Agent 2 loses theexclusive use to itsproperty rights toprotect it againstpollution Agent 1 creates a harmful nuisance that hurts Agent 2 economically.

CONTRACTS – Terms And Conditions Short Run Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S S = MC 1 D P a1a1 MC 1 SATC P PC PMPM LATC No Liability Rule

CONTRACTS – Terms And Conditions Short Run Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S S = MC 2 D P a1a1 MC 2 SATC P PC PMPM LATC No Liability Rule

CONTRACTS – Terms And Conditions No Liability Rule PRINCIPAL Agent 2 Offers a Bribe or a Transfer Payment To Agent 1 AGENT Agent 1 promises to cutback production or incur the expense of pollution abatement promise payment

CONTRACTS – Terms And Conditions Short Run - No Liability Rule Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S S = MC 1 D P a1a1 MC 1 SATC P PC PMPM LATC No Liability Rule

CONTRACTS – Terms And Conditions Short Run - No Liability Rule Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S S = MC 2 D P a1a1 MC 2 SATC P PC PMPM LATC No Liability Rule

CONTRACTS – Terms And Conditions Exceptions to the Theorem of Coase Transaction Costs - Fees

CONTRACTS – Terms And Conditions Transaction Costs Rules that reduce transaction costs Default rules are developed by courts to reduce transaction costs. For example, if A 1 knows how much it will have to pay A 2 for breach of contract, it will not incur the cost of consulting a lawyer or losing in court (paying the legal fees of the winner) (Cooter – p. 267)

CONTRACTS – Terms And Conditions Transaction Costs – Legal Fees What are transaction costs? Fees paid to lawyers to draft a contract

CONTRACTS – Terms And Conditions Transaction Costs – Legal Fees When bargaining costs are low, the efficient use of assets or resources results from private negotiation irregardless of what the legal rules are When bargaining costs are high, the efficient use of assets or resources results from which legal rules is chosen (Cooter – p. 89)

CONTRACTS – Terms And Conditions Transaction Costs – Legal Fees Which legal rule should be chosen in this case? Choose the legal rule that favours the party that “most values” the asset or resource. This is an application of the NORMATIVE HOBBES THEOREM (Cooter – p. 98)

CONTRACTS – Terms And Conditions Strict Liability Rule – Short Run Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S S = MC 1 D P a1a1 MC 1 SATC P PC PMPM SATC + TC LATC Transaction Costs

CONTRACTS – Terms And Conditions Strict Liability Rule – Long Run Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 P PC PMPM LATC Strict Liability Rule

CONTRACTS – Terms And Conditions No Liability Rule – Long Run Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S D P a1a1 MC 2 P PC PMPMPMPM LATC No Liability Rule MC 2

CONTRACTS – Terms And Conditions Transaction Costs – Legal Fees Cournot Duopoly Negative Externality Axes a2a2 E Iso-Profit Curve For Agent 1 Iso-Profit Curve For Agent 2

CONTRACTS – Terms And Conditions Transaction Costs – Legal Fees Prisoners dilemna works against a collusive duopoly P.O.E N.E Prisoners dilemna works against negative externalities under the exceptions to the Theorem of Coase N.E P.O.E

CONTRACTS – Terms And Conditions Exceptions to the Theorem of Coase Transaction Costs - Enforcement

CONTRACTS – Terms And Conditions Transaction Costs - Enforcement What are transaction costs? Enforcement Fees » Fees paid to lawyers to go to court to enforce a broken contract and obtain remedies for their clients

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement Formation Of Contracts Principal Makes An Offer To An Agent Agent Accepts The Offer Performance Of The Contract Agent Sends A Signal to the Principal

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement When A 1 sues A 2 in court, A 2 will either argue (a)there never was a contract in the first place (b)there was a contract, but A 1 failed to perform its part of the contract What usually happens is some external change in A 2 circumstances makes A 2 's position under the contract Pareto inferior, so that A 2 wants out

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement INCAPACITY Under 18 Undischarged Bankrupt Agent is not a utility or profit maximizer LEGAL DEFENCE ECONOMIC ANALYSIS INCOMPETENCE Mental illness The competent A 1 can protect the interests of incompetent A 2 at least cost, so an “efficient” rule of contract assigns liability to A 1 (Cooter – p. 268)

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement DURESS The Agent’s income compatibility constraint is restricted or challenged in some way LEGAL DEFENCE ECONOMIC ANALYSIS COERCION A promise extracted by A 1 from A 2 by a threat reduces social surplus, so the “efficient” rule of contract declares such a promise unenforceable (Cooter p. 271) Constraint: A 1 threatens A 2 if A 2 does not sign the contract

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement The Agent’s income compatibility constraint is restricted or challenged in some way LEGAL DEFENCE ECONOMIC ANALYSIS NECESSITY Cooter agrees, in part, with Adam Smith's argument about why prices have to be higher (within reason) (Cooter - pp ) Constraint: A 1 extracts a “gouging” price due to A 2 's need

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement Opportunistic types took advantage of the need and would sell a bottle for $ or more! What did Smith recommend – let the market rule. Okay to make a dollar (or pound) off someone’s suffering – as long as the conduct is not fraudulent

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement The Agent’s income compatibility constraint is restricted or challenged in some way LEGAL DEFENCE ECONOMIC ANALYSIS IMPOSSIBILITY The “efficient” rule of contract assigns liability to the party who, at least cost, can bear the risk that performance becomes impossible (Cooter - p. 275) Constraint: The contract cannot be performed

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement Who is this party? Cooter calls this party the “efficient” risk bearer Posner calls this party the “superior” risk bearer Posner extends the “least cost principle” to a theory that most contrcts create implied insurance – some party is bearing the risk of loss (Posner, s. 4.5)

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement The Agent’s income compatibility constraint is restricted or challenged in some way LEGAL DEFENCE ECONOMIC ANALYSIS ILLEGALITY Transaction costs due to unenforceability apply

CONTRACTS – Terms And Conditions Exceptions to the Theorem of Coase Asymmetric Information

CONTRACTS – Terms And Conditions Asymmetry Of Information In the Cournot duopoly example, what happens if both duopolists have identical costs, but only one of the agents knows this?

CONTRACTS – Terms And Conditions Asymmetry Of Information The uninformed agent would have to guess on the rival’s costs. What if the uninformed agent “guesses wrong” and overestimates the rival’s costs?

CONTRACTS – Terms And Conditions Asymmetry of Information - Nash Equilibria Cournot Duopoly – Perfect Information Cournot Duopoly – Asymmetric Information Axes a2a2 E Iso-Profit Curve For Agent 1 Iso-Profit Curve For Agent 2 a1a1

CONTRACTS – Terms And Conditions Asymmetry Of Information The uninformed agent will “mistakenly” increase its production levels in the “wrong expectation” that its rival is cutting back. The “rival” will in fact cut back to save money. The “Nash equilibrium” moves to the right reflecting more production and lower social surplus.

CONTRACTS – Terms And Conditions Asymmetry of Information - Nash Equilibria Cournot Duopoly – Perfect Information Cournot Duopoly – Asymmetric Information Axes a2a2 E Iso-Profit Curve For Agent 1 Iso-Profit Curve For Agent 2 a1a1

CONTRACTS – Terms And Conditions Asymmetry Of Information What if the uninformed agent “guesses wrong” and underestimates the rival’s costs? In effect, the uninformed agent “believes” its costs are higher, so it cuts back The “informed agent” will expand its production Nash equilibrium moves to the left

CONTRACTS – Terms And Conditions Asymmetry of Information - Nash Equilibria Cournot Duopoly – Perfect Information Cournot Duopoly – Asymmetric Information Axes a2a2 E Iso-Profit Curve For Agent 1 Iso-Profit Curve For Agent 2 a1a1

CONTRACTS – Terms And Conditions Asymmetry of Information – Search Costs and Disclosure Laidlaw v. Organ

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Kronman applies the Least Cost Principle to derive the most “efficient” disclosure rule for contracts. Kronman, A., "Mistake, Disclosure, Information and the Law of Contracts", (1978) 7 Journal of Legal Studies 1

CONTRACTS – Terms And Conditions Asymmetry Of Information – Search Costs Productive or allocative information is information that, if disclosed, leads to a more efficient use of the asset Redistributive information is information that, if disclosed, causes no change to the efficient use of the asset (Cooter, pp. 281 – 282)

CONTRACTS – Terms And Conditions Asymmetry Of Information - Search Costs Market failure due to moral hazard LEGAL DEFENCE ECONOMIC ANALYSIS MISTAKE Assumptions upon which the contract was made MISREPRESENTATION Inducing one of the parties to enter the contract Transaction costs due to search costs apply

CONTRACTS – Terms And Conditions Asymmetry Of Information - Search Costs Innocent Misrepresentation Negligent Misrepresentation Fraudulent Misrepresentation

CONTRACTS – Terms And Conditions Asymmetry Of Information - Search Costs Mutual Mistake With mutual mistake both parties have the same fundamental misunderstanding about the nature of the contract. In cases of mutual mistake, both parties may be excused from the contract (Kronman, p. 5)

CONTRACTS – Terms And Conditions Asymmetry Of Information - Search Costs Unilateral Mistake Unilateral mistake goes to a mistaken assumption by one of the parties upon which the contract was made

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Laidlaw, a wholesaler of tobacco, cannot move its supply due to the British bolockade of New Orleans This depresses the price Organ knows that the blockade is about to end

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Organ negotiates a contract with Laidlaw’s agent at a price favourable to a quick resale profit without making any illegal misrepresentation to the agent After the news becomes public, Laidlaw refuses to deliver the tobacco to Organ unless he agrees to pay a higher price Organ sues Laidlaw for delivery and wins Laidlaw appeals to the U.S. Supreme Court

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Chief Justice Marshall grants Laidlaw’s appeal, but only in so far as Laidlaw gets a right to a new trial in New Orleans

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Marshall emphasizes his opinion that Laidlaw is not likely to win at trial The contract was complete Any “after the fact” economic disadvantage to Laidlaw is not relevant unless there had been a misrepresentation, breach of trust or express proviso in the contract

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure What is the most efficient contract rule? The agent who acquires relevant productive information at least cost or at a cost lower than that possible for the agent not in possession of the information – should disclose. If that agent does not disclose, it should be liable.

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure The agent who acquires relevant productive information at greater cost or at the same cost as possible for the agent not in possession of the information – need not disclose The agent should not be liable if it does not disclose

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure The agent who acquires relevant redistributive information irregardless of cost – need not disclose. If that agent does not disclose, it should not be liable.

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Based on the foregoing analysis, Kronman and Cooter believe the outcome in Laidlaw was inefficient. (Cooter, p. 283)

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure What happens if an express disclosure clause appears in a contract involving purely redistributive information? In 1987, Aivazian and McCabe concluded that the disclosure rule is best left as a matter of contract, not a matter of rigid common law or statute law.

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Provided that the way relevant contractual information arises is common knowledge to the agents, they will contract on this. If the relevant sources of information are themselves asymmetric, then resort must be made to a transactions cost approach. Aivazian, V. and McCabe, P., "The Duty of Disclosure in Contractual Relations", Law and Economics Workshop, December, 1987

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure What is the most efficient contract rule if information is mixed? (For example both productive and redistributive information?)

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Does all economic relevant information fall under the categories of productive information or redistributive information or both?

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure What if a home seller deliberately witholds information that the house he or she is selling is infested with termites? The efficiency rule would require disclosure, but the common law rule would not require disclosure. Why?

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure Common law is predicated on the principle of “caveat emptor” Why? Justice Joseph Story – On Supreme Court with Marshall at the time Laidlaw v. Organ was decided. Would later defend the decision on the basis of “caveat emptor” – buyer beware

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure The analysis of Justice Story’s views on caveat emptor and disclosure were incorporated into Canadian and English law in Smith v. Hughes by Lord Chief Justice Cockburn A painting of the Lord Chief Justice presiding at the perjury trial of Arthur Orton

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure The Canadian courts give greater latitude to the possessor of productive information than those who follow Kronman’s “efficient disclosure rule” provided the possessor does not misrepresent the facts upon which a contract is formed.

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure act/Musy-1995/musy1.htmhttp:// act/Musy-1995/musy1.htm htm