Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 10

1  First midterm Wednesday, in class  HW2 solutions at end of lecture Reminders

2 Contract Law

3  Some transactions don’t occur all at once  I’m flying to Boston for Thanksgiving…  …or I hire someone to paint my house… Why do we need contracts?

4  Some transactions don’t occur all at once  I’m flying to Boston for Thanksgiving…  …or I hire someone to paint my house…  …or you can get $10 for a purple poker chip, but don’t have any cash on you right now to buy it from someone with a lower number  A contract is a promise…  …which enables trade when transactions aren’t concluded immediately Why do we need contracts?

5  Subgame perfect equilibrium: I’ll keep all the money; so you don’t trust me  Inefficient outcome (100 < 200)  And we’re both worse off Example: the agency (trust) game Player 1 (you) Trust meDon’t Player 2 (me) Share profitsKeep all the money (150, 50)(0, 200) (100, 0)

6 (One solution: reputation)

7  Now we get cooperation (and efficiency)  Purpose of contract law: to allow trade in situations where this requires credible promises Another solution: legally binding promises Player 1 (you) Trust meDon’t Player 2 (me) Share profitsKeep all the money (150, 50)(125, 25) (100, 0)

8  “The rich uncle of a struggling college student learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world.”  “One neighbor offers to sell a used car to another for $1000. The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back yard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac.”  “A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,” mails $25 and receives in the mail two wooden blocks with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and pay $500 in punitive damages.” So… what types of promises should be enforced by the law?

9 The Bargain Theory of Contracts

10  Developed in the late 1800s/early 1900s  A promise should be enforced if it was given as part of a bargain, otherwise it should not  Bargains were taken to have three elements  Offer  Acceptance  Consideration The bargain theory of contracts

11  Promisor: person who gives a promise  Promisee: person who receives it  In a bargain, both sides must give up something  reciprocal inducement  Consideration is what the promisee gives to the promisor, in exchange for the promise  Under the bargain theory, a contract becomes enforceable once consideration is given What is consideration?

12  Promisor: person who gives a promise  Promisee: person who receives it  In a bargain, both sides must give up something  reciprocal inducement  Consideration is what the promisee gives to the promisor, in exchange for the promise  Under the bargain theory, a contract becomes enforceable once consideration is given What is consideration?

13  Hamer v Sidway (NY Appeals Ct, 1891)  Uncle offered nephew $5,000 to give up drinking and smoking until his 21 st birthday, then refused to pay “The promisee [previously] used tobacco, occasionally drank liquor, and he had a legal right to do so. That right he abandoned for a period of years upon the strength of the promise… We need not speculate on the effort which may have been required to give up the use of these stimulants. It is sufficient that he restricted his lawful freedom of action within certain prescribed limits upon the faith of his uncle’s agreement, and now, having fully performed the conditions imposed, it is of no moment whether such performance actually proved a benefit to the promisor, and the court will not inquire into it.” The bargain theory does not distinguish between fair and unfair bargains

14  Expectation damages  the amount of benefit the promisee could reasonably expect from performance of the promise  meant to make the promisee as well of as he would have been, had the promise been fulfilled Under the bargain theory, what is the remedy?

15 Problems with the bargain theory  Not that accurate a description of what modern courts actually do  Not always efficient  Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable

16 Problems with the bargain theory  Not that accurate a description of what modern courts actually do  Not always efficient  Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable  Does enforce certain promises that maybe should not be enforced

17 What does efficiency say about what promises should be enforced?

18 What promises should be enforced?  In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was made  different from wanting it to actually be enforced

19 What promises should be enforced?  In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was made  different from wanting it to actually be enforced  The first purpose of contract law is to enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions  or, enable people to convert games with inefficient equilibria into games with efficient equilibria

20 What promises should be enforced?  In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was made  different from wanting it to actually be enforced  The first purpose of contract law is to enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions  or, enable people to convert games with inefficient equilibria into games with efficient equilibria

21 So now we know…  What promises should be enforceable?  For efficiency: enforce those which both promisor and promisee wanted to be enforceable when they were made  One purpose of contract law  Enable cooperation by changing a game to have a cooperative solution  Contract law can serve a number of other purposes as well

22 Information  Private/asymmetric information can hinder trade  Car example (George Akerloff, “The Market for Lemons”)

23 Information  Private/asymmetric information can hinder trade  Car example (George Akerloff, “The Market for Lemons”)

24 Information  Private/asymmetric information can hinder trade  Car example (George Akerloff, “The Market for Lemons”)  Contract law could help  You could offer me a legally binding warranty  Or, contract law could impose on you an obligation to tell me what you know about the condition of the car  Forcing you to share information is efficient, since it makes us more likely to trade  The second purpose of contract law is to encourage the efficient disclosure of information within the contractual relationship.

25 Breach

26  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…

27 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

28 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?

29 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

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

31 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

32 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:

33 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

34 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

35  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

36  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 

37  Liability is just to return your money  What if my costs rise to $400,000?  Performance is still efficient, but I’ll choose to breach  Liability is $1,000,000  What if my costs rise to $700,000?  Performance is now 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 

38  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

39  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