Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre Recht und Ökonomie (Law and Economics) LVA-Nr.: WS 2012/13 (6) Contract Law (Vertragsrecht) WS 2012/131 of 21Law and Economics

1. Contract  Contract: agreement that regulates an exchange that is mutually beneficial. –Contracts to give or to make. –Replicable goods or ‘specific’ goods.  General problems: –breach of contract; –information may be asymmetric (one party knows more); –correct incentives to fulfil the contract. WS 2012/132 of 21Law and Economics

2. Incompleteness of Contracts  Complete contingent contract (hypothetical)  Incompleteness: Costs of specification: –ex ante, e. g. lawyers fees. –ex post, conflict resolution.  Minimise cost by comparing: –ex ante cost (usually certain) to –ex post cost, usually with presumed probability assumption: many contracts concluded. WS 2012/133 of 21Law and Economics

3. Breach or Re-Negotiation  Suppose seller (S) and buyer (B) contract for 100 washing machines per month for €  ‘Daily’ cost of equipment (sunk cost) € sunk costs = incurred costs that cannot be recovered.  Opportunity cost € (value of best alternative use of the equipment).  Buyer could re-negotiate contract for a new price of less than € (but more than € ).  Post-contractual opportunistic negotiations. WS 2012/134 of 21Law and Economics

4. Incompleteness and Contract Law  Reliance on contract law (C. L.) to resolve unexpected (unlikely) occurrences.  Only major or contract specific terms have to be contained in the contract.  Plus some clause: “ … contract is to be governed by the laws of…”  Contract law thus: –serves as ‘default option’; –reduces transaction costs through provision of (efficient) enforcement mechanisms. WS 2012/135 of 21Law and Economics

5. Inefficient Contract Laws  Breach of contract reduces profits (welfare).  Possible solution: penalty  –e.g.: “ … delay of delivery (finishing construction, …) leads to a penalty of € … per day (week, …)”; –recovers profits foregone by buyer.  Seller can choose to deliver on time or with delay to maximise his profits  optimal solution for both.  Poor enforcement mechanisms (may) lead to reduced economic activities, reducing welfare.  Uncertain debt recovery (or payment) will lead to request for securities, increases cost. WS 2012/136 of 21Law and Economics

6. Efficient Contract Laws  Reduce transaction costs.  Economise on information costs. –Imperfect versus asymmetric information.  Lead to only efficient contract breaches. –Penalty.  Imply efficient reliance. –Avoid opportunistic re-negotiation.  Involve risk minimisation: –precautions to avoid risk; –cost-minimising risk bearing. WS 2012/137 of 21Law and Economics

7. Asymmetric Information  Problem: one party in a transaction has more or better information compared to other party  can take advantage of other party’s lack of knowledge  market failure (?)  Causes general problems:  Adverse selection.  Moral hazard.  Principal-Agent-Problem WS 2012/138 of 21Law and Economics

7. Asymmetric Information (cont.)  Example: consider used car market.  With 100 cars: 50 ‚plums‘ and 50 ‚lemons‘.  Sellers know the quality of car, buyers do not (  asymmetric information).  ‚Plums‘ would be offered for € 6.000, ‚lemons‘ for €  Willingness-to-pay (WTP): € and € 3.600, respectively.  WTP with no information on quality: €  Result: only ‚lemons‘ would be offered  no contract. WS 2012/139 of 21Law and Economics

8. Adverse Selection Example 1: Bicycle Insurance.  Assume regional differences in theft rates.  Insurance company offers insurance based on average theft rate.  Only people in areas with high theft rates will take out insurance  adverse selection (A. S.).  Result: company will go out of business due to adverse selection (and not due to unbiased selection). WS 2012/1310 of 21Law and Economics

8. Adverse Selection (cont.) Example 2: Health Insurance.  Insurance company bases rates on average occurrence of health problems.  Individuals know their health status (better), insurance companies do not (or know it less than individuals).  Result: Only high risk people will take out insurance.  Solutions to avoid A. S.: –mandatory insurance (e. g. Europe); –‘health plan’ by firms (e. g. US, also Europe). WS 2012/1311 of 21Law and Economics

9. Moral Hazard Example: Bicycle Insurance.  Assume probability of theft (also) depends on action, that is care taken by owners (e.g. type of locks).  If no insurance is available: maximum care  –Marginal Costs (MC) of taking care = Marginal Benefit (MB) of taking care.  With insurance: level of care is reduced (change of behaviour)  moral hazard (M. H.). –Holds also for health insurance, fire insurance,...  Solutions: –deductibles: no full coverage; –try to observe level of care: rates differ for smokers, houses with sprinkler systems, … WS 2012/1312 of 21Law and Economics

9.1. Adverse Selection and Moral Hazard  Adverse Selection is due to ‘hidden information’: –one side of the market cannot observe quality.  Moral Hazard is due to ‘hidden action’: –one side of the market cannot observe care.  Lack of information causes inefficiency.  Government action may alleviate the problem only in case of hidden information. –Compulsory insurance. WS 2012/1313 of 21Law and Economics

10. Signalling  Car example: seller knows more (  signal to buyer):  warranty on used cars;  reputation of seller.  Quality of workers: employee knows more (  signal to employer): –years of school attended; –diploma (‘sheepskin effect’); –additional qualifications; –voluntary work; –…  Objective: reduce the asymmetry in information (at low cost!). WS 2012/1314 of 21Law and Economics

11. Incentives and Asymmetric Information  Which contract ensures that someone does what I want her/him to do for me?  Also known as ‘Principal–Agent–Problem’: a principal hires one (or more) agent(s), to pursue principal's interests.  Problem: performance of agent(s) not perfectly observable  information asymmetry  incentive scheme / contract?  Examples: employer and employee; owner and manager of company. WS 2012/1315 of 21Law and Economics

11. Incentives and Asymmetric Information (cont.)  Consider four types of contracts: (1)Rent; (2)wage labour; (3)take-it-or-leave-it; (4)Sharecropping. WS2012/1316 of 21Law and Economics

11.1. Rent  Agent (hirer) pays fixed amount to principal (landowner).  Agent gets all the surplus beyond rent.  Maximum output produced  efficient. –Utility maximizing for agent.  But: agent also bears all the risk.  If agent is more risk averse than the owner the result will be inefficient.  Agent would be willing to give up some income for a reduction in risk. WS 2012/1317 of 21Law and Economics

11.2. Wage Labour  Principal (employer) pays to agent (worker) a constant amount per unit of effort.  Utility maximizing agent chooses his effort such that marginal product of effort equals marginal cost of effort  efficient.  With asymmetric information: effort cannot be observed by principal (only hours can be observed). Unless: piece work. WS 2012/1318 of 21Law and Economics

11.3. Take-it-or-leave-it  Agent (worker) is paid the full amount if he/she chooses the optimum effort level – and zero otherwise.  Outcome: agent chooses this optimal level  efficient.  With asymmetric information: –agent bears all the risk (if payment is based on output); or –effort cannot be observed (payment based on input). WS 2012/1319 of 21Law and Economics

11.4. Sharecropping  Principal (landowner) and agent each get some fixed proportion of total output.  Since agent gets only a fraction of output he/she will equalize this fraction of marginal product (MP) to the marginal cost (MC).  Leads to an inefficient level of effort (output).  Introducing risk aversion of actors leads to optimum output since both (principal and agent) bear risk. WS 2012/1320 of 21Law and Economics

12. Conclusions  Results of ‘simple’ economic models may change if one adds: –asymmetry of information; –risk (uncertainty) considerations (risk neutral, risk averse, or risk loving); –behavioural insights (how are decisions actually made?).  If one wants to arrive at recommendations for the concrete design of contracts (more) advanced economic analysis may be required. WS 2012/1321 of 21Law and Economics