1. Econ 522 Economics of Law
Dan Quint
Fall 2015
Lecture 10

2. Reminders Homework 2 due Thursday at midnight Midterm 1 next Monday
covers everything so far, but not today’s lecture

3. Contract Law

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 (if all rights are well-defined and tradeable)
“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?
In particular, we haven’t worried at all about the timing of transactions

7. Lots of transactions don’t take place all at once
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
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
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 payoffs, so the game looks like…
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 a “bad” equilibrium where we don’t cooperate, it has a “good” equilibrium where we do
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 a 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. So that’s one early 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
The bargain theory, while fairly straightforward, turns out not to be a totally accurate description of how courts actually decide cases
It also 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 the promise is not enforceable unless it arises as part of a bargain
But such a promise may still represent a Pareto-improvement, and therefore, it might be efficient for the legal system to enforce such promises.
An example of this
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. So that’s one early 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, 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 miss out on a profitable exchange of some sort.
This brings us to Cooter and Ulen’s first (of many) proclamations about 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 did an example a couple weeks ago of asymmetric information, and how that can disrupt trade
We used the example of me wanting to buy your car, but you having more information than me about the condition of the car, and therefore how much it’s worth
And in the example we solved, we found we could only trade when the car was basically worthless – otherwise, I’m too afraid of you being opportunistic and only selling me the car if it’s in bad shape

28. 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.
But this offers another way contract law can facilitate efficient trade – by helping us to overcome adverse selection problems
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.

29. 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?

30. Breach

31. 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

32. 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

33. 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

34. 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

35. 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 

36. 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 

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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
Wednesday, we’ll see a fourth…