1. Econ 522 Economics of Law
Dan Quint
Fall 2013
Lecture 11

2. Reminders
Homework 2 due tomorrow at midnight

3. Contract Law
Before we start talking about what an efficient contract law system would look like,
we’ll discuss an early legal theory of contract law: the Bargain Theory

4. Looking back The question we’ve posed:
Suppose we set up the rules, and then everyone does what’s best for them under those rules.
What rules do we set up, if we want efficient outcomes?
A couple of the ideas we’ve seen so far
Coase: initial rules don’t matter if no transaction costs
“More complicated” rules (such as more extensive property rights) lead to more efficient use of a resource, but also higher costs
Injunctive relief when transaction costs low, damages when high

5. So far, we haven’t worried about the details of trade
When two parties want to reallocate rights…
I want to buy your used car
Or you want to “buy” my permission to have a noisy party
Or neighbors want to pay a factory to pollute less
…we’ve assumed they can do so…
…subject (possibly) to there being some transaction costs

6. Timing of transactions
Some transactions happen all at once
I hand you a check for $3500, you hand me the keys to your car
There might be search costs and bargaining costs…
…but no enforcement costs
But some don’t
Neighbors pay the factory to pollute less going forward
Need to make sure factory sticks to the agreement
What if technology changes and factory wants to start polluting more again?

7. Lots of transactions are like this
I’m flying to Florida for Spring Break
I hire someone to paint my house…
…or fix my car
I ask you not to have a party on a particular night
We’re doing an in-class experiment, you want to buy a poker chip from someone but don’t have any cash
I’m flying to Florida for Spring Break
If I were going to literally exchange money for a flight to Daytona Beach, I’d show up for the flight with a pile of $20 bills
And hand them to the gate agent as I boarded the plane? How would I know it was going to take off?
Hand them over as I was getting off the plane? How would the airline trust that I had the money?
Maybe the stewardess could come around in the middle of the flight and collect everyone’s money?
In fact, of course, I pay for the flight weeks in advance
Which means i’m not literally buying a flight
At the time, I was buying a promise of a flight
That is, I give someone (Expedia) money
and in return, they promise to fly me to Florida
now… what happens if they don’t?
Or, I hire someone to paint my house
If I wait till the end to pay him, how will he know I’ll pay?
If I pay him at the beginning, how will I know he’ll show up?
I could pay him each day for that day’s work
But if a half-painted house is worthless to me, he could threaten to quit in the middle, and I might have to agree to pay him more

8. This is what contracts are for
A contract is a promise…
…which is legally binding
Point of contracts: to enable trade when transactions aren’t concluded immediately
In the experiment we just did, suppose you had a 10, but no cash?
Someone has a 4, and a chip
How do you buy the chip from them?
Promise to give them $6 after you trade in the chip for money?
Should they believe you?
Fundamentally, contracts are simply promises
And they solve the problem of how to achieve cooperation or trade when transactions don’t occur all at one time
by giving a way to make a promise legally enforceable
That is, I can promise the painter I’ll pay him once the house is done, and he’ll know this promise is good
Then he can paint my house, knowing he’ll get paid in the end
There are lots of settings where this is what we do
So contracts are legally binding promises, which allow for trade in situations where transactions don’t take place all at once

9. Example: the agency (trust) game
Player 1 (you)
Trust me
Don’t
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(0, 200)
A simple example of a situation where legally binding promises are valuable: the agency, or trust, game
Suppose I have an opportunity to make a valuable investment, but I don’t have any money
You have some money, but don’t have access to the investment on your own
You could give me your money, I could invest it for you, and then we could split the proceeds
if you lent me $100, I could invest it, double our money, and promise to give you back $150 and keep $50 for myself.
But without contract law, there’s no way for you to be sure, once I’ve doubled your money, that I’ll choose to give you back your share
We can draw this as a simple game tree:
This is a classic example of an agency game
There’s some surplus we can achieve together, but it requires you to trust me
But if we look at my incentives here once you’ve given me the money, I have no reason to give you your money back
Since you anticipate this problem, you refuse to trust me, so we miss out on this great opportunity.
The important thing to note here:
It’s not just that you’re worse off because you can’t trust me; I’m worse off too
My inability to commit to returning your money causes me to miss out on the investment as well.
So we’d both be better off if there was some way I could commit to returning your money
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

10. (One solution: reputation)
(One powerful way around this problem is to rely on reputation
If this is a situation we find ourselves in over and over, it becomes valuable to me to be looked at as someone who is trustworthy; that way, you can keep investing your money with me, and we both do better
So if the game is to be repeated many times, we may be able to cooperate even when we could not in a one-shot game
This is part of the success of eBay – realizing that making sellers’ reputations public would give people a strong incentive to behave well
However, many interactions are fundamentally “one-shot” – this is the only time I expect to deal with a person, and the incentives to maintain a good reputation may be too small.)

11. Another solution: legally binding promises
Player 1 (you)
Trust me
Don’t
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(125, 25)
What contract law does is give us a way to make a promise legally binding,
which allows us to change this game into one that has a cooperative solution
Suppose we can sign a contract, under which I am punished if I run off with all the money
The punishment doesn’t have to be too severe – it just has to be bad enough that I’d rather share the gains rather than face the punishment
Suppose that the punishment is that a court steps in and forces me to give you back your $150, and charges each of us an additional $25 fee for doing so
This changes the game to:
Now there is a way for us to cooperate
After the investment, I’m better off giving you back your share of the money
So now you have a reason to trust me, and we get the benefit of the investment.
Like before (with intellectual property), we’ve changed the game so that now, instead of only a “bad” equilibrium where we don’t cooperate, it has a “good” equilibrium where we cooperate
So that’s the first purpose of contract law
To allow for efficient trade in situations where this requires some sort of commitment ability, that is, some way to make a promise credible
Now we get cooperation (and efficiency)
Purpose of contract law: to allow trade in situations where this requires credible promises

12. Contract: a legally binding promise
Point of contracts: to enable trade when transactions aren’t concluded immediately
Obvious question: which promises should be legally binding, and which should not?

13. What types of promises should be enforced by the law?
“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 $ 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.”
this raises a number of different questions, first among them, exactly what types of promises should be enforced by the law? The textbook motivates the question with three examples
In a little while, we’ll start developing a theory of what contract law should look like for efficiency. But first…

14. The Bargain Theory of Contracts
Before we start talking about what an efficient contract law system would look like,
we’ll discuss an early legal theory of contract law: the Bargain Theory

15. The bargain theory of contracts
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
One of the early theories of contract law was developed in the late 1800s and early 1900s: the bargain theory of contracts. The bargain theory determined what promises would be held to be legally binding. The theory was:
A promise should be enforced if it was given in a bargain, otherwise it should not.
A bargain was taken to have three elements – that is, at its core, there are three things that must be present for a bargain to have occurred, and therefore for a promise to be enforceable under this theory:
offer; acceptance; consideration
“Offer” and “acceptance” are pretty clear
One of us approaches the other and offers some deal – “I’ll give you $1000 for that old car.”
The other decides to accept
Of course, this is done differently in different situations
When you walk into a store and see price tags on goods, each of those is an offer to sell you that good at a given price
In an art auction, every time you raise your hand or nod to the auctioneer, you are making an offer to buy the piece up for sale; at some point, when there are no other bidders, the auctioneer accepts your offer
In most states, buying land requires a written contract, which functions as both offer and acceptance.

16. What is consideration? 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
On to consideration…
We refer to the person who gives a promise as the promisor, and the person who receives it as the promisee
In a bargain, both sides must be giving up something
So the promisee must be giving something to the promisor to induce the promise
It could be money – I give you $25 in exchange for the promise to give me a way to kill grasshoppers
It could be goods or services – you give me a car, or paint my house, in exchange for the promise of payment later
It could be another promise – a farmer promises to deliver a certain amount of wheat on a certain date, and a wholesaler promises to pay a certain amount at that time
“Money-for-a-promise”, “goods-for-a-promise,” “service-for-a-promise”, “promise-for-a-promise” all refer to different types of bargains we could reach.
The key is that both of us are giving up something
Bargains involve reciprocal inducement
the promisee gives something to the promisor to induce the promise
and the promisor gives the promise to induce the promisee to give up that thing
Consideration is the legal term for the thing the promisee gives the promisor to induce the promise.
So the payment of $25, given to induce the promise of a way to kill grasshoppers, is consideration
Giving up the car, or painting the house, is consideration for the promise of payment
And the promise of crops is consideration for the promise of payment.
Under the bargain theory of contracts, a promise becomes enforceable once consideration is given, that is, once the promisee gives something to the promisor in exchange for the promise.

17. What is consideration? 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
Going back to the examples at the beginning
When the rich uncle promised his nephew a trip around the world, no consideration was given – the nephew did not give him anything to induce the promise
So under the bargain theory, the promise is not enforceable
Promises of gifts are generally not enforceable under the bargain theory, since the promisee is not giving anything as inducement, and therefore the promise is not part of a bargain
In the example of the disputed car, although consideration was given, the conditions of offer and acceptance were not met, since the seller was offering one thing and the buyer was accepting another
In Cooter and Ulen’s words, “Without a meeting of the minds, there is no offer and no acceptance, just a failure to communicate.”
In the third example, the seller offered a method for killing grasshoppers, the buyer accepted the offer, and the payment of $25 acted as consideration; so under the bargain theory, this was a valid promise, and therefore enforceable.

18. The bargain theory does not distinguish between fair and unfair bargains
Hamer v Sidway (NY Appeals Ct, 1891)
Uncle offered nephew $5,000 to give up drinking and smoking until his 21st 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
That is, even a bargain that is extremely one-sided is considered enforceable under the bargain theory
One example of a court’s refusal to examine whether a bargain was “fair,” and focus only on whether consideration was given
An 1891 case, Hamer v Sidway (New York Court of Appeals)
An uncle promised his nephew $5,000 to give up drinking and smoking until his 21st birthday
When the nephew turned 21, he refused to pay; the nephew sued. The court wrote:
So under the bargain theory, the court should not take a stand on whether a bargain was fair, just whether a bargain occurred.
Which makes sense – it would be difficult, and costly, to enforce a theory that required the court to only enforce fair bargains, since the court would have to calculate the value of the contract to each party and determine what was “fair.”
Modern courts, however, do sometimes refuse to enforce bargains that are completely one-sided. This is the doctrine of “unconscionability”, which we’ll come back to later.

19. Under the bargain theory, what is the remedy?
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, if the promise had been fulfilled
Having answered the question of which promises should be enforceable, the bargain theory also addresses the question of what the remedy should be when an enforceable promise is broken
Since the promisor agreed to the bargain, he owes it to the promisee to make him as well off as had the promise been fulfilled
Since the promise was not kept, however, it is sometimes impossible to calculate exactly what the benefits would be
Under the bargain theory, a promisor who breaches a promise owes the promisee expectation damages – the amount of benefit that the promisee could reasonably expect from the performance of the promise
This still leaves a lot of ambiguity sometimes
With the rich uncle and the college student, the benefit of the trip to the student would depend on the length of the trip, the route, and the quality of accommodations, which were not specified in the contract
The value to the farmer of a means of killing grasshoppers depends on the value of the crop that ended up being destroyed by them.

20. 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
Besides ambiguity, there are also other problems with the bargain theory
First of all, it turns out not to be an accurate description of how courts actually behave, that is, which promises they tend to enforce
And second, it turns out not to be a good description of how efficiency-minded courts should behave
There are instances in which, at the time a promise is being made, both the promisor and promisee want the promise to be enforceable
The bargain theory says that such a promise is not enforceable unless it arises as part of a bargain
But such a promise may represent a Pareto-improvement, and therefore, an efficient legal system may need to enforce such promises.
An example of this
Suppose I’m looking to buy a car, and I test-drive one, like it, but decide to look at a couple others as well
In order to get me to seriously consider the car, the seller might offer it to me at a particular price, and give me a week to decide – allowing me to test-drive a couple other cars, but keeping his in mind as an option
I’d like for this offer to be enforceable – I don’t want to come back a week later and find that he’s changed his mind, or that, knowing I’m ready to buy, he’s raising his price
And he wants this offer to be enforceable – he knows that I’ll only take the offer seriously if I think it’s enforceable, and he wants me to take it seriously
So this is an instance where both sides want the promise to be binding; but because consideration was not given, the bargain theory would not enforce it.

21. 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
Another example: a rich alumnus promises a large donation to his university, to finance a new building
But it will take him time to liquidate some assets to actually deliver the donation
The university would like to begin construction immediately
And the alumnus, who wants the university to use the money optimally, also wants the university to begin to put the money to use immediately
But since the promise is not enforceable, the university can’t begin construction until the donation arrives
Again, both sides want the promise to be enforceable; but because a gift lacks consideration, the bargain theory would not enforce it.
The bargain theory also demands enforcement of certain promises that on many other grounds should not be enforced
So next, we’ll put aside the bargain theory and consider what efficiency would require of contract law.

22. For efficiency, what promises should be enforced?
In the two examples we just saw – buying a used car, and the rich alumnus – both sides wanted the contract to be enforceable
This suggests that both sides think the contract being enforceable makes them better off
Neither of these contracts seem to impose any externalities on anyone else
So the enforceability of these contracts would appear to be a Pareto-improvement, that is, make the two sides better off without making anyone worse off
And therefore, efficiency suggests they should be enforceable.
And this illustrates a more general principle:
In general, economic efficiency requires enforcing a promise if the promisor and the promisee both wanted enforceability when it was made.

23. 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
In general, economic efficiency requires enforcing a promise if the promisor and the promisee both wanted enforceability when it was made.
Go back to the example we did at the beginning, you trusting me to make an investment with your money
Suppose I promise to share the gains of the investment with you
You want the contract to be enforceable: it’s the only way you’ll get your money back
And I want the contract to be enforceable: it’s the only way I can get you to trust me with your money, which is good for both of us
So we both want my promise to be enforceable; efficiency then suggests that it should be
(Note the important distinction here between wanting the contract to be enforceable and wanting it to actually be enforced.
At the time I make the promise, I want it to be enforceable – I want us both to live in a place and time whose laws would hold me to my promise
Because if not, you won’t trust me, and won’t give me the money
Once you’ve given me the money, though, I’d rather the contract not actually be enforced – I’d still be better off if I could keep all the money
Hence, the wording of the principle above: efficiency requires enforcing a promise if both sides wanted it to be enforceable when it was made.)

24. 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
There are lots of other situations that are variations on this agency game
I gave the example of an investment opportunity
It could have simply been a Pareto-improving trade: I have a good you want, but we’re far apart, and so you have to trust me with your money before I ship you the good
It could be an insurance policy: I choose to buy insurance, trusting that if my house burns down, the insurance company will pay for it
I could simply be putting my money in the bank, trusting I can get it out later
In all these cases, lack of enforceable contracts might lead us to forego a profitable exchange of some sort.
This brings us to Cooter and Ulen’s first (of many) proclamations about the purposes of contract law:
The first purpose of contract law is to enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions.
Clearly, in the example we did, cooperation is more efficient than no cooperation, since the combined payoffs are higher
Thus, in this case, cooperation is efficient.
(If cooperation were not efficient, we would not have tried.)
Thus, we could rephrase this by saying that contract law enables people to convert games with inefficient solutions (equilibria) into games with efficient solutions

25. 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
Also note that without enforceable contracts, it is my ability to run off with your money that causes cooperation to break down
In usual choice theory, more options always make you better off
When a restaurant adds items to its menu, you should be at least as well off – if you don’t like the new items, you don’t order them
But in a strategic setting, more options can make you worse off, since they change what other people expect you to do
Enforceable contracts give me a way to limit my own options – in this case, to take away my ability to run off with your money
In this case, limiting my options gives you a reason to trust me, and therefore makes me better off as well.
(Slightly off topic, but as an example of how “foreclosing (ruling out) an opportunity” can be beneficial, the book quotes Sun Tzu’s The Art of War:
“When your army has crossed the border [into hostile territory], you should burn your boats and bridges, in order to make it clear to everybody that you have no hankering after home.”
By taking away your option of retreating, you make it clear that you’re serious about fighting.)

26. 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
So now we have an initial idea of which promises should be enforceable
Those which both the promisor and the promisee want to be enforceable when the promise is made
And we know one purpose of contract law: to enable cooperation by changing a game to have a cooperative solution
However, there are a number of other purposes that contract law can serve.

27. Information Private/asymmetric information can hinder trade
Car example (George Akerloff, “The Market for Lemons”)
One has to do with information
We mentioned earlier in the course that asymmetric, or private, information can get in the way of beneficial trade
Consider the example of one of me wanting to buy your car
Suppose I really need a car, so I figure that whatever your car is worth to you, it’s worth 50% more than that to me
So whatever the car is worth, there are clearly gains from trade.
However, you know exactly what the car is worth, and I don’t
All I know is that it’s worth somewhere between $0 and $5000, and any value within that range is equally likely
Even worse, there are no mechanics available and I know nothing about cars, so there’s no way for you to figure out its true value.
So how am I going to buy this car from you?
Well, I know that on average, the car is worth $2500 to you
And I value it at 50% more than you, so on average, I value it at $3750
So suppose I decide to offer you $3000
What happens?

28. Information Private/asymmetric information can hinder trade
Car example (George Akerloff, “The Market for Lemons”)
Well, if I offer you $3000 for my car, you’ll sell it to me when it’s worth less than $3000 to you; and when it’s worth more than $3000 to you, you’ll say no
So I can expect to only get the car when it’s worth less than $3000 to you
So the times that you sell it to me, it will be worth, on average, $1500 to you
And therefore, on average, it will be worth $2250 to me
So on average, I’d be overpaying for the car – paying $3000 for a car worth $2250
So maybe I should offer less money
But the less money I offer you, the less the car will be worth in the event that you agree to sell it to me
In this case, unless there is some way to verify the value of the car, there is no price I’d be willing to offer for the car
So even though the car is worth more to me than to you, due to asymmetric information, we are unable to transact.
(This example comes from a famous paper by George Akerloff, “The Market for Lemons.” It’s also exactly the same problem as adverse selection in insurance markets.)

29. 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.
This suggests other ways that contract law can facilitate efficient trade
Contract law could give me a way to offer a legally binding warranty
Or contract law could impose on me a legal obligation to truthfully tell you anything I know about the condition of the car
That is, once we’ve signed a contract for you to buy my car, contract law could make me liable for any mechanical problems with the car that I didn’t warn you about
In this case, requiring me to share information is efficient, since it reduces your uncertainty about the value of the car, and therefore gives us a way to trade
Which brings us to…
The second purpose of contract law is to encourage the efficient disclosure of information within the contractual relationship.

30. Next question If a contract is a promise…
what should happen when that promise gets broken?
could be: I signed a contract with no intention of living up to it
but could be: I signed a contract in good faith, intending to keep it…
…but circumstances changed, making performance of the contract less desirable, maybe even inefficient!
so what should happen to me if I fail to perform?

31. Breach

32. Breach I’m an airplane builder You and I sign a contract
You agree to pay me $350,000
I agree to build you an airplane
You value the plane at $500,000; I expect building it to cost $250,000
Lots of things could happen…
Price of materials could go up, increasing my costs to $700,000…
…making it inefficient for me to build you a plane
Costs could increase to $400,000…
…so it’s still efficient for me to build you the plane, but I no longer want to
Another buyer could arrive and offer me $600,000 for the plane
I could break my arm, making it impossible for me to build the plane
These are all reasons why I might want, or need, to back out of my promise
There are also things that could happen that might make you want to back out
You might lose an eye and be unable to fly without depth perception
You might find another seller who can build a plane more cheaply, or a nicer plane
And so on

33. Breach A contract is a promise
Breach of contract is when promisor fails to keep promise
To make a promise legally binding, there has to be some consequence when it is broken
So, what should happen when a contract is breached?
If penalty is too small, contract law has no bite
If penalty is too large, promises might get kept even when that becomes inefficient
Can we design the law to get breach of contract only when it’s efficient to breach?
Suppose I’m an artist, and I’m working on a painting
It’s still a couple of weeks away from completion, but you’ve seen my work before, and you like my theme, and you know that when I’m done, you’ll value my painting at $1,000
There are other buyers out there who might value it similarly, so you don’t want to wait until it’s done to buy it
But I’m happy to sell it to you, and we agree on a price of $600
But now, as I’m finishing the painting, my crazy cousin comes to visit
He sees my painting, and loves it, and thinks the colors would go perfectly in his beach house, and offers me $5,000 for it
Clearly, he values the painting much more highly than you do
Efficiency would require that he get it
But I’ve already committed to sell the painting to you.
And if the penalty for breach is very severe, I’ll keep that promise, and my cousin won’t get the painting

34. When is breach of contract efficient?
Efficiency:
>
Social benefit of breach
Social cost of breach
Efficient to Breach 
<
Social benefit of breach
Social cost of breach
Efficient to Perform 
Social benefit of breach: promisor saves cost of performing
Social cost of breach: promisee loses benefit from promise
Like anything, breach is efficient when its social benefit is greater than its social cost

35. When is breach of contract efficient?
Efficiency:
>
Promisor’s cost to perform
Promisee’s benefit from performance
Efficient to Breach 
<
Promisor’s cost to perform
Promisee’s benefit from performance
Efficient to Perform 
Social benefit of breach: promisor saves cost of performing
Social cost of breach: promisee loses benefit from promise

36. How do we expect promisors to behave?
Efficiency:
>
Promisor’s cost to perform
Promisee’s benefit from performance
Efficient to Breach 
<
Promisor’s cost to perform
Promisee’s benefit from performance
Efficient to Perform 
What will actually happen (incentives of promisor):
Like any decisionmaker, we expect the promisor to consider his private cost and private benefit when deciding what to do
>
Promisor’s cost to perform
Promisor’s liability from breach
Promisor will Breach 
<
Promisor’s cost to perform
Promisor’s liability from breach
Promisor will Perform 

37. Can we design the law to get only efficient breach of contract?
Efficiency:
>
Promisor’s cost to perform
Promisee’s benefit from performance
Efficient to Breach 
<
Promisor’s cost to perform
Promisee’s benefit from performance
Efficient to Perform 
What will actually happen (incentives of promisor):
Promisor’s cost to perform
Promisor’s liability from breach 
Promisor will Breach
>
<
Promisor’s cost to perform
Promisor’s liability from breach
Promisor will Perform 

38. Can we design the law to get only efficient breach of contract?
>
Promisor’s cost to perform
Promisee’s benefit from performance
Efficient to Breach 
Promisor’s cost to perform
Promisor’s liability from breach 
Promisor will Breach
>
If we set liability from breach = promisee’s benefit from performance, promisor will breach exactly when it’s efficient
When a promisor breaches a contract, he should owe a penalty exactly equal to the benefit the promisee expected to receive
This is 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

39. Back to airplane example
Plane worth $500,000 to you, agree to price of $350,000, my cost of building the plane changes
Expectation damages: I owe you $150,000 if I fail to deliver the plane
Whenever cost is less than $500,000…
I’m better off keeping my promise
And it’s efficient for me to build you the plane
Whenever cost is above $500,000
I’m better off breaking my promise and paying damages
And it’s efficient for me to break my promise

40. Another way to think about expectation damages: eliminating an externality
If I breach contract, I impose externality on you
You expected payoff of $150,000 if I performed…
…so if I breach, you’re $150,000 worse off
If I have to pay you $150,000 if I breach, then I internalize the externality
Now my action no longer affects your payoff
(You get the same surplus of $150,000, whether or not I build the plane.)
No more externality  I choose efficiently when deciding whether to perform or breach

41. What would happen under other remedies?
Plane worth $500,000 to you, agree to price of $350,000, my cost of building the plane changes
No penalty
If costs rise to $400,00, I’ll choose to breach…
…but performance would be efficient
Penalty for breach is $1,000,000
If costs rise to $700,000, I’ll choose to perform…
…but breach would be efficient

42. Of course, with low TC, we could always negotiate around an inefficient rule (Coase)
Plane worth $500,000 to you, agree to price of $350,000, my cost of building the plane changes
No penalty
If costs rise to $400,00, I would want to breach…
…but we could renegotiate a different price
Penalty for breach is $1,000,000
If costs rise to $700,000, I would have to perform…
…but we could negotiate a “buy-out” price
Only expectation damages guarantee efficient breach/ performance even without renegotiation
But if we knew this was a possibility – that I could breach our contract without penalty, and get you to negotiate a new, higher price…
…then even if my costs didn’t really go up, I might be tempted to lie, and claim that they had, to force you to pay more
And on the other hand, if the penalty for breach is too severe…
…you might charge me a lot of money to get out of performing when my costs go up a lot…
…which means I might be more hesitant to agree to the initial contract

43. Another reason the remedy for breach matters: investment in performance
Many things promisors can do to reduce likelihood they will have to breach a contract
If promisor agreed to build a house, he can…
Buy materials ahead of time and store them in a warehouse
Spend more time lobbying (or bribing!) local government to ensure he can get required permits
Pay his assistant well, so he’s less likely to quit
Some of these things may be hard to observe/verify, so impossible to build them into the contract itself

44. Another reason the remedy for breach matters: investment in performance
Expectation damages (and only expectation damages) will lead to efficient level of these investments
If promisor internalizes the cost of breach…
…then he receives the full benefit of these investments,
along with paying their full cost,
so to minimize private cost, he chooses efficient level
If penalty for breach is less than expectation damages…
Breach still imposes negative externality, so investments in performance impose positive externality on promisee…
…so promisor will invest less than efficient amount
Similarly, if penalty for breach was more than expectation damages,
the promisor would choose more than the efficient level of investment

45. So now we’ve seen three things contract law can accomplish…
1. Facilitate non-simultaneous trade when trust is required
Turn games with inefficient equilibrium into games with efficient equilibrium
2. Encourage efficient disclosure of information
3. Secure efficient level of breach, and efficient level of investment in performance
Via expectation damages
Next, we’ll see a fourth…

46. Reliance (won’t get to this)

47. Reliance You expect an airplane to arrive in spring – you might…
Sign up for flying lessons
Build yourself a hangar
Buy a helmet and goggles
Reliance – investments which depend on performance
Reliance increases the value of performance to promisee
Reliance increases the social cost of breach
Another aim of contract law is to secure optimal level of reliance
I’m an airplane builder
You come to me in the fall and order an airplane, which I will build over the winter and deliver in the spring
Now that you’re expecting an airplane in the spring, there are a bunch of things you might do
You might sign up for flying lessons
You might build yourself a hangar – a covered parking space for the plane – so that your plane doesn’t get rained on after I deliver it
You might buy an awesome leather helmet and aviator goggles, so you can look like this guy
Similarly, the farmer who has mailed in a check for $25 for a sure means to kill grasshoppers might plant more crops, since he’s no longer worried about the risk of grasshopper damage
Similarly, the nephew whose uncle promised him a trip around the world might go out and buy a backpack, or a linen suit to wear in the tropics
These are all examples of reliance – investments whose value depend on performance of the promise
(An airplane hangar is very valuable if you end up with an airplane, and worthless otherwise)
Or to put it another way, reliance is any investment which increases the value of performance to the promisee
(An airplane is more valuable if you already have a hangar)
Is reliance a good thing?
well, in some cases, it may be cheaper to make these investments ahead of time
if you wait to build a hangar until I deliver your airplane, the plane might get damaged in a hailstorm before the hangar is complete
if the nephew waits to buy a linen suit until his uncle sends him plane tickets, he might miss a big spring sale
On the other hand, we know that the promisor may not always perform (and that this may be OK)
So reliance investments are not a sure thing – if I fail to keep my promise, your investment in reliance is lost
Or, since reliance increases the value of performance, it also increases the social cost of breach – you’ve built a hangar for nothing, or you resell the helmet and goggles at a loss
And this brings us to:
The fourth purpose of contract law is to secure optimal reliance.

48. When is reliance efficient?
When social benefit of reliance > social cost of reliance
Social benefit: increased benefit to promisee
(Value of airplane + hangar) – (Value of airplane without hangar)
Value is only realized if the promise is performed
Social cost: direct cost borne by promisee
Cost occurs whether or not promise is performed
Reliance is efficient whenever
(True of both discrete choices – whether or not to build a hangar – and also on the margin, for continuous choices)
Increase in value of performance
Probability of performance
Cost of investment X
>

49. How should reliance figure into damages?
Expectation damages = expected benefit from performance
If your reliance investment increases your anticipated benefit…
should it increase the damages I owe you if I breach?
Can we design damages to get efficient reliance, in addition to efficient breach?

50. Reliance and damages: example
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
Reliance and damages: example
You’re buying an airplane from me
Price is $350,000, to be paid on delivery
Airplane alone gives you benefit of $500,000
Building a hangar costs $75,000
Airplane with hangar gives you benefit of $600,000
Without hangar, expectation damages = $150,000
If you build a hangar and I fail to deliver plane, do I owe…
$150,000? (Value of original promise)
$250,000? (Value of performance after your investment)
$225,000? (Value of original promise, plus reimburse you for investment you made)
Some other amount?

51. To get efficient breach…
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
To get efficient breach…
The only way to guarantee efficient breach is if damages included the added benefit from reliance
Once you’ve made investment, you anticipate benefit of $250,000 from performance
If damages are anything less than that, I’ll breach too often
(If damages exclude the added benefit, then I’m back to imposing an externality when I choose to breach the contract)
So what happens to the incentive for reliance investments if damages will increase to include this added benefit?

52. If exp damages include benefit from reliance…
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
If exp damages include benefit from reliance…
If you don’t build hangar, your payoff will be…
$150,000 if I deliver the plane ($500,000 – $350,000)
$150,000 if I breach and pay expectation damages
If you build hangar, your payoff will be…
$175,000 if I deliver the plane ($600,000 – $350,000 – $75,000)
$175,000 if I breach and pay (higher) expectation damages
So if expectation damages include the increased value of performance due to reliance investments…
You’ll invest whenever (increase in benefit) > (cost)
In this case, you’ll invest (because $100,000 > $75,000)

53. If exp damages include benefit from reliance…
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
If exp damages include benefit from reliance…
If expectation damages include increased value of performance, you’ll invest for sure
Is this efficient?
Reliance is efficient if
(increase in benefit) X (probability of performance) > (cost)
$100,000 X (probability of performance) > $75,000
Only efficient if probability of performance > ¾
If probability of performance < ¾, reliance is inefficient, but happens anyway
Overreliance!

54. Better example: continuous investment
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500, Öx
Better example: continuous investment
Additional value of plane
Designer hangar with Starbucks - $480,000
Functional heating - $240,000
Metal poles, rigid roof - $120,000
Plywood frame, canvas roof - $60,000
Tarp and rope - $6,000 benefit
Investment in hangar
$100
$10,000
$40,000
$160,000
$640,000

55. Three questions Let p be probability of breach Three questions
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500, Öx
Three questions
Let p be probability of breach
Three questions
What is the efficient level of reliance?
What will promisee do if expectation damages include anticipated benefit from reliance?
What will promisee do if expectation damages exclude anticipated benefit from reliance?

56. Three questions Let p be probability of breach Three questions
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500, Öx
Three questions
Let p be probability of breach
Three questions
What is the efficient level of reliance?
x = $90,000 (1 – p)2
What will promisee do if expectation damages include anticipated benefit from reliance?
x = $90,000
What will promisee do if expectation damages exclude anticipated benefit from reliance?
Total social gain when costs stay low: 500, sqrt(x) – 250,000 – x
Total social gain when costs go up: – x
If probability costs rise is p, expected total social gain is
(1-p) (250, sqrt(x) – x) + p (-x)
250,000 (1-p) (1-p) sqrt(x) – x
Choose x to maximize this: derivative is
600 (1-p) /(2sqrt(x)) – 1 = 0
x = 90,000 (1 – p)2
x = 90,000 (1 – p)2 is the efficient level of reliance
When expectation damages include anticipated benefit,
private gain to promisee when costs stay low: 500, sqrt(x) – 350,000 – x = 150, sqrt(x) – x
Private gain to promisee when costs go up: 150, sqrt(x) – x
Expected private gain to promisee is 150, sqrt(x) – x
Choose x to maximize this: derivative is 600/(2Öx) – 1 = 0
x = 90,000
So promisee would invest x = $90,000 in reliance
When expectation damages exclude anticipated benefit,
Private gain to promisee when costs stay low: 500, sqrt(x) – 350,000 – x = 150, sqrt(x) – x
Private gain to promisee when costs go up: 150,000 – x
Expected private gain to promisee is 150,000 + (1 – p) 600 sqrt(x) – x
Choose x to maximize this: derivative is 600 (1 – p)/(2sqrt(x)) – 1 = 0
So promisee would invest x = $90,000 (1-p)2 in reliance

57. X + X > X > Overreliance
If reliance investments increase the damages you’ll receive in the event of breach, you’ll over-rely
You’ll rely if
Efficient to rely if
So if damages increase when you make reliance investments, we’re sure to get overreliance!
(Your investment imposes an externality on me)
Increase in benefit X
Prob. of perform. +
Increase in damages X
Prob. of breach
>
Cost of investment
Increase in benefit X
Prob. of perform.
>
Cost of investment

58. Reliance and breach
Just showed: if damages include added benefit from reliance, promisee will invest more than efficient amount
But if damages exclude added benefit…
Then promisor’s liability < promisee’s benefit from performance
Which means: promisor will breach more often than efficient
And promisor will underinvest in performance
“Paradox of compensation”
Single “price” (damages owed) sets multiple incentives…
…impossible to set them all efficiently!
(When we get to tort law – that is, rules covering liability for accidents – we’ll see this same problem
One price – how much I owe you if I hit you with my car – will create incentives for me (how fast to drive), and for you (how carefully to look when crossing the street)
And it’s hard to set both incentives efficiently
In tort law, we’ll see, there is a trick we can use)

59. So what do we do? Cooter and Ulen: include only efficient reliance
Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount
So promisee rewarded for efficient reliance, not for overreliance
So how do we fix this? Cooter and Ulen adjust their definition of expectation damages in the following way:
Perfect expectation damages restore the promisee to the level of well-being he would have had, had the promise been kept, and had he relied the optimal amount
(This is why they attach the word “perfect” to expectation damages)
Thus, the promisee is rewarded for efficient reliance
this increases his payoff from performance of the promise, and also increases his payoff from breach, since it increases the amount of damages he receives
But the promisee is not rewarded for excessive reliance – overreliance
damages are limited to the benefit he would have received given the optimal level of reliance.
It’s a nice idea, but it seems like it would be very hard in general for a court to determine after the fact what the optimal level of reliance was
(It might also be hard for the promisee to know this, since he may not know the probability of breach.)

60. So what do we do? Cooter and Ulen: include only efficient reliance
Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount
So promisee rewarded for efficient reliance, not for overreliance
Actual courts: include only foreseeable reliance
That is, if promisor could reasonably expect promisee to rely that much
What is actually done in practice?
The usual rule is that liability is limited to the level of reliance that is foreseeable.
Reliance is foreseeable if the promisor could reasonably expect the promisee to rely that much under the circumstances
Reliance is unforeseeable if it would not be reasonably expected
American and British law tend to define overreliance as unforeseeable, and therefore noncompensable.
An example of unforeseeable reliance
telegraph company fails to transmit a stockbroker’s message, resulting in millions of dollars in losses
the telegraph company could not reasonably expect the stockbroker to rely that heavily on one message
so the telegraph company would not be liable for the full extent of the losses
Another example: the rich uncle’s nephew, when he was promised a trip around the world, goes out and buys “a white silk suit for the tropics and matching diamond belt buckle”.
After the uncle refuses to pay for the trip, the nephew sells the suit and belt buckle at a loss, and sues his uncle for the difference
The court might find the silk suit foreseeable reliance, but the diamond belt buckle unforeseeable, and only award him the loss on the suit.
(The book points out that “in American law, gift promises are usually enforceable to the extent of reasonable reliance.”)

61. Foreseeable reliance: Hadley v Baxendale
1850s England
Hadley ran flour mill, crankshaft broke
Baxendale’s firm hired to transport broken shaft for repair
Baxendale shipped by boat instead of train, making it a week late
Hadley sued for the week’s lost profits
“The shipper assumed that Hadley, like most millers, kept a spare shaft. …Hadley did not inform him of the special urgency in getting the shaft repaired.”
Court listed several circumstances where broken shaft would not force mill to shut down
Ruled lost profits not foreseeable  Baxendale didn’t have to pay
Reliance is part of the issue in the famous case of Hadley v Baxendale, a precedent-setting English case decided in the 1850s
I give a link to the actual court decision on the syllabus
Hadley owned a gristmill – turned wheat into flour, using a mill powered by a steam engine
the crankshaft of the mill broke, and he didn’t have a spare, so the mill shut down until the crankshaft could be repaired
The shaft had to be sent back to the manufacturer for repair; Hadley hired a shipping firm where Baxendale worked to ship it
Baxendale decided to ship it by boat instead of by train, and as a result, it took a week longer than it was supposed to
Hadley sued for the profits he lost during that extra week in which the mill was shut down
Quoting from the textbook:
The shipper assumed that Hadley, like most millers, kept a spare shaft. The shipper contended that Hadley did not inform him of the special urgency in getting the shaft repaired. The shipper prevailed in court on the damages issue, and the case subsequently stands for the principle that recovery for breach of contract is limited to foreseeable damages.
The ruling was that the lost profits were not foreseeable
the court specifically listed several circumstances in which a broken crankshaft would not force a mill to shut down – and therefore why it was reasonable that Baxendale would not have imagined the harm from delay would be so high
Baxendale was only held liable for damages he could reasonably have foreseen

62. Foreseeable reliance: Hadley v Baxendale
“Before you can award damages for wages paid and lost sales while the mill was idle, you must first find that at that time they entered into the contract to ship the crankshaft, the shipping company contemplated that the mill owner would suffer those idleness damages as a result of late delivery.”
To award damages for lost sales, Hadley should have to prove that Baxendale could have predicted those losses
(During the appeal, the shipping company argued that the jury should be given roughly the following instructions, and the appeals court agreed:
before you can award damages for wages paid and lost sales while the mill was idle, you must first find that at the time they entered into the contract to ship the crankshaft, the shipping company contemplated that the mill owner would suffer those idleness damages as a result of late delivery. 
That is, to award damages for lost sales, Hadley should have to prove that Baxendale could have predicted those losses
However, this isn’t only a question of reliance
Part of the issue is that Hadley knew about the urgency of getting the crankshaft fixed quickly, but did not tell Baxendale
Last week, we said that one purpose of contract law is to encourage the efficient disclosure of information
We’ll come back to this question of information shortly.

63. Foreseeable reliance: Hadley v Baxendale
Why didn’t Hadley and Baxendale just specify in the original contract what happens in case of delay?
What rules should apply in circumstances that aren’t addressed in a contract?
Wednesday: “default rules”, including paper by Ayres and Gertner, “Filling Gaps in Incomplete Contracts…” \