Recht und Ökonomie (Law and Economics) LVA-Nr.: WS 2011/12 (7) Contract Law (Vertragsrecht) 1 of 20 Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre

2 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 1. 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 correct incentives to fulfil the contract

3 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 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

4 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 3. Breach or Re-Negotiation Suppose S & B contract for 100 washing machines per month for 35,000 Daily cost of equipment (sunk cost) 15,000 Opportunity cost 25,000 (value of sales in best alternative use of equipment) B could re-negotiate contract for a new price of less than 35,000 (but more than 25,000) post-contractual opportunistic negotiations

5 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 4. Incompleteness and Contract Law Reliance on 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

6 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 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

7 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 6. Efficient Contract Laws Reduce transaction costs Economise on information costs imperfect vs asymmetric information Lead to only efficient contract breaches cf. penalty Imply efficient reliance avoid opportunistic re-negotiation Involve risk minimisation precautions to avoid risk cost-minimising risk bearing

8 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 7. Asymmetric Information Consider used car market for, say, 100 cars 50 plums and 50 lemons Sellers know the quality of car, buyers do not Plums would be offered for 6,000, lemons for 3,000 Willingness to pay: 7,200 and 3,600, resp. WtP with no information on quality: 5,400 Only lemons would be offered >> no contract

9 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 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 – A. S. Company will go out of business due to adverse selection (and not unbiased selection)

10 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 8. Adverse Selection 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) Only high risk people will take out insurance Solutions: mandatory insurance (e. g. Europe) health plan by firms (e. g. US, also Europe)

11 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 9. Moral Hazard (M.H.) Example: Bicycle Insurance Assume probability of theft (also) depends on action – care – taken by owners (type of locks) If no insurance is available: maximum care MC of taking care = MB of taking care With insurance: level of care is reduced – 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, …

12 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 9. Adverse Selection and Moral Hazard (A.S. & M.H.) 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

13 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 9. Signalling Car example: warranty on used cars Quality of workers: years of school attended diploma (sheepskin effect) additional qualifications voluntary work … Objective: reduce asymmetry in information (at low cost!)

14 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 10. Incentives and Asymmetric Information Which contract ensures that someone does what I want her/him to do for me? aka Principal – Agent – Problem Consider four types of contracts: rent wage labour take-it-or-leave-it sharecropping

15 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 11. Rent Agent pays fixed amount to principal Agent gets all the surplus beyond rent Maximum output produced >> efficient utility maximizing for agent but: agent also bears all the risk if she 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

16 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 12. Wage Labour Principal 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) unless: piece work

17 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 13. Take-it-or-leave-it Agent (worker) is paid the full amount if s/he chooses the optimum effort level – and zero otherwise Outcome: agent chooses this optimal level thus >> efficient With asymmetric information: agent bears all the risk (if payment is based on output) effort cannot be observed (payment based on input)

18 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 14. Sharecropping Principal (landowner) and agent each get some fixed proportion of total output Since agent gets only a fraction of output s/he will equalize this fraction of marginal product to the marginal cost Leads to an inefficient level of effort (output) Introducing risk aversion of actors leads to optimum output since both P. & A. bear risk

19 of 20 Recht und Ökonomie WS 2011/12Contract Law (Vertragsrecht)Prof. Dr. Friedrich Schneider 15. 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