Econ 522 Economics of Law Dan Quint Spring 2012 Lecture 14

1  If you haven’t gotten your first midterm back, see Fran  HW3 (contract law) due this Thursday Reminders:

2  …finished up reasons to not enforce a contract  Fraud, failure to disclose, frustration of purpose, mutual mistake  (NOT unilateral mistake, and why)  Vague terms, adhesion, unconscionability  …discussed remedies for breach of contract  Expectation damages, reliance damages, opportunity cost damages  Specific performance  …looked at Peevyhouse v Garland Coal  Garland failed to perform promised cleanup work after strip-mining  Court awarded objectively-measured damages…  …even though Peevyhouses had rejected similar terms in contract Last Wednesday, we…

3  Remedy for breach could be written directly into contract  However, common law courts don’t always enforce remedy terms  Liquidated damages – party-specified damages that reasonably approximate actual harm done by breach  Penalty damages – damages greater than actual harm done  Civil law courts are generally willing to enforce penalty damages  But common law courts often do not Party-designed remedies

4  Peevyhouse v Garland Coal  Peevyhouses only wanted farm strip-mined if it would be restored to original condition after  Suppose coal extracted worth $70,000  Garland paid $25,000 for rights to mine it  Restoration work would cost $30,000  Diminution of value was $300  So liquidated damages would be $300  Suppose Peevyhouses got $40,000 of disutility from land being left in poor condition Penalty Damages Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000

5 Liquidated damages Peevyhouses SignDon’t Garland Coal Restore propertyDon’t, pay damages (25,000, 15,000)(-14,700, 44,700) (0, 0)  If damages limited to liquidated damages…  Peevyhouses shouldn’t believe restorative work will get done  So Peevyhouses better off refusing to sign  Even though mining and restoring Pareto-dominates Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000

6 Penalty damages Peevyhouses SignDon’t Garland Coal Restore propertyDon’t, pay penalty (25,000, 15,000)(25,000, 5,000) (0, 0) Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000  If penalty clauses in contracts enforceable…  Write contract with $40,000 penalty for leaving land unrestored  Now restoration work would get done, so Peevyhouses willing to sign  But if courts won’t enforce penalty damages, this won’t work

7  Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus  I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late  Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time  Either way, you get $150,000 if house is late, $200,000 if on time  Courts generally enforce bonus clauses, so no problem! Penalty clauses

8  Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus  I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late  Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time  Either way, you get $150,000 if house is late, $200,000 if on time  Courts generally enforce bonus clauses, so no problem!  Similarly, Peevyhouse example  Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is not restored  Equivalently, get $65,000 for mining rights, pay $40,000 bonus if restoration is completed  But, if intent of contract is too transparent, still might not be enforced Penalty clauses

9 Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

10 Remedies and breach Expectation Damages 0-500,000250,000Total 150,000 You get -150, ,000100,000I get Costs High – Breach Costs High – Perform Costs Low – Perform Specific Performance 0-500,000250,000Total 400,000150,000 You get -400, ,000100,000I get Costs High – Renegotiate Costs High – Perform Costs Low – Perform  Transaction costs low  either leads to efficient breach, but seller prefers “weaker” remedy  Transaction costs high  S.P. leads to ineff. performance Plane worth $500,000 to you Price $350,000 Cost: either $250,000 or $1,000,000 –650,000 + ½ (500,000) 150,000 + ½ (500,000)

11  Opportunity cost damages, or reliance damages  Inefficient breach when transaction costs are high  Renegotiate contract to get efficient performance when transaction costs are low  Like nuisance law: any remedy leads to efficient breach with low TC  But only expectation damages do when TC are high  Unfortunate contingency and fortunate contingency Remedies and breach

12  Specific Performance  If costs stay low, I get $350,000 - $250,000 = $100,000 profit  If costs rise, I take $400,000 loss  Am I willing to sign this contract?  Even expectation damages face this problem  Expectation damages: costs stay low, same $100,000 profit  Costs rise, $150,000 loss  If probability of high costs is ½, I won’t sign contract  Expectation damages lead to efficient breach, but may not lead to efficient signing Efficient signing

13  If reliance investments increase the damages you receive, we expect to get overreliance  To get efficient reliance, need to exclude gains from reliance in calculation of expectation damages  But then promisor’s liability < promisee’s benefit, leading to inefficient breach  With low transaction costs, fix this through renegotiation  But what about unobservable actions the promisor needs to take, to make breach less likely?  Investment in performance Reliance – did example a few days ago

14  Some investment I can make to reduce likelihood that breach becomes necessary  Suppose probability of breach is initially ½… but for every $27,726 I invest, I cut the probability in half  Invest nothing  probability of breach is 1/2  Invest $27,726  probability is 1/4  Invest $55,452  probability is 1/8  Any investment z  probability is.5 * (.5) z / 27,726  Wrote it this way so p =.5 e – z / 40,000 Investment in performance

15  Suppose you’ve built a $90,000 hangar  Increases value of performance by $180,000…  …so value of performance is $150,000 + $180,000 = $330,000  Probability of breach =.5 e – z/40,000  Let D = damages I owe if I breach  Same questions as before:  What is efficient level of investment in performance?  How much will I choose to invest in performance? Investment in performance (continuing with airplane example)

16  Suppose you’ve built a $90,000 hangar  Increases value of performance by $180,000…  …so value of performance is $150,000 + $180,000 = $330,000  Probability of breach =.5 e – z/40,000  Let D = damages I owe if I breach  Same questions as before:  What is efficient level of investment in performance? Enough to reduce probability of breach to 40,000/430,000  How much will I choose to invest in performance? Enough to reduce probability of breach to 40,000/(100,000 + D) Investment in performance (continuing with airplane example)

17  What is the efficient level of investment in performance?  Enough so that p(z) = 40,000/430,000  What will promisor do under various rules for damages?  Enough so that p(z) = 40,000/(100,000 + D)  So if D = 330,000, efficient investment in performance  D = 330,000 is promisee’s benefit, including reliance  So expectation damages, with benefit of reliance, leads to efficient investment in performance  If D < 330,000, too little investment in performance  If D > 330,000, too much  Makes sense – think about externalities What do these results mean?

18 Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

19 Paradox of compensation Inefficient breach Underinvestment in performance Efficient reliance Efficient breach Efficient investment in performance Over-reliance Expectation damages exclude benefit from reliance investments Expectation damages include benefit from reliance investments  Is there a way to get efficient behavior by both parties?

20  Have expectation damages include benefit from reliance…  …but only up to the efficient level of reliance, not beyond  That is, have damages reward efficient reliance investments, but not overreliance  Promisee has no incentive to over-rely  efficient reliance  Promisor still bears full cost of breach  efficient performance  Problem: this requires court to calculate efficient level of reliance after the fact We already saw one possible solution

21  The problem:  Damages promisor pays should include gain from reliance if we want to get efficient performance  Damages promisee receives should exclude gain from reliance if we want to get efficient reliance  Solution: make damages promisor pays different from damages promisee receives!  How do we do this? Need a third party Another clever (but unrealistic) solution

22  You (promisee) and I (promisor) offer Bob this deal:  If you rely and I breach,  I pay Bob value of promise with reliance (airplane plus hangar)  Bob pays you value of promise without reliance (airplane alone)  Bob keeps the difference  You receive damages without benefit from reliance; I pay damages with benefit from reliance “Anti-insurance”

23  You (promisee) and I (promisor) offer Bob this deal:  If you rely and I breach,  I pay Bob value of promise with reliance (airplane plus hangar)  Bob pays you value of promise without reliance (airplane alone)  Bob keeps the difference  You receive damages without benefit from reliance; I pay damages with benefit from reliance  Offer the deal to two people, make them pay up front for it “Anti-insurance”

24  Foreseeable reliance  Include benefits reliance that promisor could have reasonably anticipated Reminder: what do courts actually do?

25 Another experiment: is trust a problem?

26  Player A starts with $10  Chooses how much of it to give to player B  That money is tripled  Player B has $10, plus 3x whatever A gave him/her  Chooses how much (if any) to give back to player A  So for example…  if player A decides to send $3…  then A has $7 left, and B has $19…  and then B can send back to A any amount from 0 to $19  if A sends $9, B has $37, A has $1 plus whatever B sends back A two-player game, similar to the investment/agency game

27  We’ll try the game four different ways:  Anonymously – A and B don’t know who each other are  Privately – A and B don’t interact, but will learn who each other are after the game  Face to face – A and B know who each other are, and can discuss the game before playing, but their actions remain private  Publicly – A and B play out loud in front of the class A two-player game, similar to the investment/agency game

28 Repeated interactions

29 Repeated games

30 Repeated games Player 1 (you) Trust meDon’t Player 2 (me) Share profitsKeep all the money (150, 50)(0, 200) (100, 0)  Suppose we’ll play the game over and over  After each game, 10% chance relationship ends, 90% chance we play at least once more…

31  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

32  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

33  Diamond dealers in New York (Friedman) “…people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one” “Parties to a contract agree in advance to arbitration; if… one of them refuses to accept the arbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted.” Repeated games and reputation

34  The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions  The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts  Law assigns legal duties to certain long-term relationships  Bank has fiduciary duty to depositors  McDonalds franchisee has certain duties to franchisor Repeated games and reputation

35  Suppose we’ll play agency game 60 times  $50 x 60 = $3,000 > $200, so cooperation seems like no problem  But…  In game #60, reputation has no value to me  Last time we’re going to interact  So I have no reason not to keep all the money  So you have no reason to trust me  But if we weren’t going to cooperate in game #60, then in game #59… Repeated games and the endgame problem

36  Endgame problem: once there’s a definite end to our relationship, no reason to trust each other  Example: collapse of communism in late 1980s  Communism believed to be much less efficient than capitalism  But fall of communism led to decrease in growth  Under communism, lots of production relied on gray market  Transactions weren’t protected by law, so they relied on long-term relationships  Fall of communism upset these relationships Repeated games and the endgame problem

37 One other bit I like from Friedman

38 Friedman on premarital sex

39 Friedman on premarital sex

40  Purposes for contract law:  Encourage cooperation  Encourage efficient disclosure of information  Secure optimal commitment to performance  Secure efficient reliance  Provide efficient default rules and regulations  Foster enduring relationships  Wednesday, we begin tort law That’s it for contract law End of material on second midterm