Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 9

1  Office hours between now and midterm:  Me: Tomorrow 1:30-3:30, Monday 1:30-3:30  Chao: Thursday 1:00-3:00, Monday 10:00-1:30  Midterm #1 next Tuesday, in class  No contract law Logistics

2  Last week – finished property law  Handout – two cool examples  This week – we start contract law  But first – a digression (true story) that illustrates some of the principles from both Plan

3  Uncertainty about rights makes bargaining hard  Negotiating with lots of parties is hard  When transaction costs are high, “damages” are better than “injunctions”  But also… what is a ticket? So last Thursday, I’m flying from Boston to Montreal…

4 Contract Law

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  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 Problems with the bargain theory

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 Efficient breach  Example: I’m an artist  You expect to value my painting at $1,000, agree to buy it for $600  My rich cousin comes to town, offers me $5,000 for it  Efficient for him to get it, but I’ve already promised it to you

26 Efficient breach  Example: I’m an artist  You expect to value my painting at $1,000, agree to buy it for $600  My rich cousin comes to town, offers me $5,000 for it  Efficient for him to get it, but I’ve already promised it to you  Breach is efficient when promisor’s cost of performing is greater than promisee’s benefit from performance

27 Efficient breach  Example: I’m an artist  You expect to value my painting at $1,000, agree to buy it for $600  My rich cousin comes to town, offers me $5,000 for it  Efficient for him to get it, but I’ve already promised it to you  Breach is efficient when promisor’s cost of performing is greater than promisee’s benefit from performance  Question: how do we get breach only when it’s efficient?

28 Remedies and efficient breach  Breach is efficient when promisor’s cost of performing is greater than promisee’s benefit from performance  Self-interest: promisor will breach when cost of performing is greater than liability from breach  So when liability from breach = promisee’s benefit, promisor will choose to breach exactly when it’s efficient  Setting liability = benefit is exactly expectation damages  (This causes promisor to internalize the externality he causes by breaching the contract – so there is no externality, and he acts efficiently)

29 This brings us to…  The third purpose of contract law is to secure optimal commitment to performing.  Expectation damages lead to efficient breach (breach of contract only when it is efficient).

30 Reliance  Reliance – investments made by promisee, to increase the value of performance  The fourth purpose of contract law is to secure optimal reliance

31 Efficient reliance  Efficiency: reliance is efficient as long as (probability of performance) X (increase in value) > (cost)  We said expectation damages = expected benefit from performance  Should expectation damages include increase in benefit due to reliance?  If yes: promisee will rely as long as (increase in value) > (cost)  So if yes, promisee will overrely  Thursday: examples of efficient breach and reliance, and paper by Ayres and Gertner