1. George Mason School of Law
Contracts I
C. Bargaining Gains
F.H. Buckley

2. Asset Purchase Agreement
This Agreement (the “Agreement’) is entered into as of the ___ day of September, 2017, between Sehler Inc. (“Sehler”), a corporation incorporated under the laws of ____, located at _____, and Beyer Inc. (“Beyer”), a corporation incorporated under the laws of ______, located at ______.

3. Who signs for the parties?
And how do you know who they are?

4. Theoretical Introduction
Last day: Benthamite utilitarianism and the economic case for contract enforcement
Is that all there is?

5. Benthamite Principles
Jeremy Bentham
Sir George Jessel

6. Today
Contract Law as a solution to the threat of defection in PD Games
Coasian bargains and trust
Modeling Bargaining gains:
a. Detrimental and Beneficial Reliance
b. Edgeworth Box Function
Defining Efficiency Criteria

7. Getting to Cooperation in PD games
Player 2
Cooperate
Defect
3, 3
-1, 4
4, -1
0, 0
Player 1

8. Defection dominates for Player 1
Cooperate
Defect 3 -1 4
Player 1  

9. Defection dominates for Player 2
Cooperate
Defect 3 4 -1  

10. The game’s “solution”
Player 2
Cooperate
Defect

11. Two kinds of PD problems
Sins of commission
Overfishing
Excessive pollution

12. Two kinds of PD problems
Sins of omission
Failure to exploit bargaining gains
Eg. Dueling, war

13. Two kinds of PD problems
Sins of omission
Failure to contribute to public goods (External benefits plus beneficiaries can’t be excluded)
National Health?
Education?
National Parks?
Films on the Internet?
Online magazine content?

14. Getting to Cooperation in PD games
So what do we do about that?
A governmental solution
Maybe it’s not so bad after all…
A Coasian solution

15. Getting to Cooperation in PD games
A government solution: Let the state enforce cooperation
Boston Commons
environmental laws
taxation and national defense

16. Getting to Cooperation in PD games
Maybe it’s not so bad after all…
De minimis non curat lex
The private provision of public goods
E.g., wikipedia, volunteer firemen

17. Getting to Cooperation in PD games
A Coasian solution
Cut a deal

18. But what if contracts aren’t enforced: The “Market for Lemons”
Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970)

19. Let’s say you want to buy a 1956 Ford…

20. Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)

21. Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller tells you it’s a beaut

22. Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart

23. Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart
What would you pay for one?

24. Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart
The trick: Seller’s willingness to sell is a signal
Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970)

25. Promises without contract law
Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)
The seller knows which kind of car he has but you can’t tell them apart
Question: Is the seller satisfied with this result?

26. So why do lemons markets exist?
Craigslist ad: 1956 Ford Fairlane –
1956 ford customline - $6000 (Riverdale)
Good condition! Brand new interior seats and door panel
Posted 14 days ago

27. Craigslist on the subject of lemons
Offers to ship a vehicle are virtually 100% fraudulent
Never use Western Union or wire transfer to pay for goods - only a scammer will ask for this, and any funds sent will be lost
Do not buy vehicles sight-unseen, regardless of low price. The vehicle does not exist, and any money you send will be lost.
Stories about divorcees or departing servicemen needing to sell quickly at a low price are generally fraudulent

28. So why do lemons markets exist?

29. So why do lemons markets exist?
Sometimes one doesn’t need a warranty.
One can verify the quality of the goods

30. So why do lemons markets exist?
Sometimes one doesn’t need a warranty.
Discounted prices

31. But that apart, a trust problem

32. Promising as a Problem of Trust
Promisor wants to persuade promisee to trust him
To do so, promisor must be able to make a credible commitment not to defect

33. Hobbes on Bare Promises Hobbes, Leviathan 14.18 (1651)
If a covenant be made wherein neither of the parties perform presently, but trust one another, in the condition of mere nature (which is a condition of war of every man against every man) upon any reasonable suspicion, it is void…
For he that performeth first hath no assurance the other will perform after, because the bonds of words are too weak to bridle men's ambition, avarice, anger, and other passions, without the fear of some coercive power; which in the condition of mere nature, where all men are equal, and judges of the justness of their own fears, cannot possibly be supposed. And therefore he which performeth first doth but betray himself to his enemy.

34. Contract Law as a solution Leviathan

35. Contract Law as a solution
Suppose that the defector is penalized through sanctions so that the incentive to defect disappears.

36. PD games before Contract Law
Player 2
Cooperate
Defect
3, 3
-1, 4
4, -1
0, 0
Player 1

37. PD Games after damages for breach
Player 2
Cooperate
Defect
3, 3
2, -3
-3, 2
0, 0
Player 1

38. What is collectively rational is now individually rational
Player 2
Cooperate
Defect
3, 3
2, -4
-4, 2
0, 0
Player 1

39. So why do people fail to contract?

40. So why do people fail to contract?
Illegal contracts
Eg. Divorce waivers, security interests in consumer goods

41. So why do people fail to contract?
Illegal contracts
Transaction cost barriers
Information processing problems
Too many parties
Emergencies
Agent misbehavior

42. So why do people fail to contract?
Illegal contracts
Transaction cost barriers
Rule of Law Problems
Imperfect enforcement in corrupt countries
Or countries with inefficient enforcement mechanisms

43. Transparency International Corruption Perceptions Index

44. Corruption and the rule of law
Deputy Mayor of Moscow
Vladimir Resin
sporting a $360,000
wristwatch

45. Country corruption and NYC parking tickets for UN diplomats
Source: Raymond Fishman and Edward Miguel, Corruption, Norms and Legal Enforcement: Evidence from Diplomatic Parking Tickets, 115 Journal of Political Economy 1020 (2007)

46. Modeling Bargaining Gains
Indifference Curves
The Budget Line
Consumer Choice
Beneficial Reliance
The Edgeworth Box Function
Pareto-Superiority and Pareto-Optimality

47. Two dimensional Commodity Space: Every point represents a combination of the two commodities
Y axis
Commodity y
X axis
Commodity x

48. Two dimensional Commodity Space: Every point represents a combination of the two commodities
Y axis A Y* •
X axis X* 48 48

49. The Commodities: Dollars in Two Time Periods
Dollars in Time 1 A Y* •
Dollars in Time 2 X* 49 49

50. Commodity space: Dollars consumed in two time periods
Dollars in Time 1
More of both
Dollars in Time 2

51. The Budget Line: Allocating $100 between two periods
Dollars in Time 1
100
The budget line in red
represents every trade-off
of $100 in two periods
Dollars in Time 2
100

52. Two different time preferences
(Which is right?)

53. The Budget Line: Allocating $100 between two periods
Dollars in Time 1
Grasshoppers
100
Ants
Dollars in Time 2
100

54. Indifference Curves: Preferences about Consumption
Dollars in Time 1
An indifference curve represents a set of trade-offs to which the subject is indifferent
Dollars in Time 2

55. Subject is willing to give up $BC in Time 2 for $AB in Time 1
Dollars in Time 1 A  B   C
Dollars in Time 2

56. A  C: Subject is willing to give up $BC in Time 2 for $AB in Time 1
Dollars in Time 1 A  B   C
Dollars in Time 2
 = “is indifferent to”

57. Indifference Curves: Preferences about Consumption
Dollars in Time 1
Convexity (curve bends inward)
assumes decreasing marginal utility
Dollars in Time 2

58. Decreasing marginal utility:
We’ll always want more,
but will enjoy each new scoop
less and less

60. Indifference Curves: Preferences about Consumption
Dollars in Time 1
One is better off the further
one gets from the origin
Dollars in Time 2

61. More is better: I2 > I1 More is better I2 I1 Dollars in Time 1
Dollars in Time 2

62. Ordinal Utility: We can’t say how much better I2 is than I1
Dollars in Time 1 I3 I2 I1
Dollars in Time 2

63. Ordinal Utility: We can’t say how much better I2 is than I1
Ordinal numbers: First, second, third

64. Ordinal Utility: We can’t say how much better I2 is than I1
Ordinal numbers: First, second, third
Cardinal numbers: 1,2, 3

65. Consumption Decision: Uncle Ebenezer gives David $100
Time 1 I 2 I 1
100 I 2 I 1 I3
100
Time 2

66. Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line
Time 1 I 2 I 1
100 A 50  I 2 I 1 I3 50
100
Time 2

67. Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line
Time 1 I 2 I 1
100 A 50  B I  2 I 1
B is not optimal I3 50
100
Time 2 67 67

68. Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line
Time 1 I 2 I 1
100
C is not feasible  C A 50  B I  2 I 1
B is not optimal I3 50
100
Time 2 68 68

69. Ebenezer gives David another $100: The Shift to a New Budget Line
200 I
200 I
100
100 A
50, 50 50
100

70. A new Consumption Decision
Time 1 B
100
100, 100 I
200 A
50, 50 50 I
100 I DR
Time 2 50
100

71. A new Consumption Decision
We didn’t have to end up at 100,100.
I just like round numbers …
Time 1 B
100
100, 100 I
200 A
50, 50 50 I
100 I DR
Time 2 50
100

72. What happens when the donor promises to give in the future?
Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period
What Should David Do?

73. What happens when the donor promises to give in the future?
Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period
David’s election: to rely or not to rely on the promise in the first period

74. But now Uncle Ebenezer comes along: David’s election
t0 Ebenezer makes promise
t1 David relies doesn’t rely
t2 Ebenezer performs doesn’t perform performs doesn’t perform

75. Four possibilities David Ebenezer Doesn’t Rely Relies Performs
Doesn’t Perform
Ebenezer

76. The good scenario: David relies and Ebenezer performs
Doesn’t Rely
Performs
Doesn’t Perform
Ebenezer

77. The good scenario: David relies and Ebenezer performs
Reliance by David means he spends $100 of his own money in period 1 in the expectation he’ll get another $100 in period 2
200 B
100
100, 100 I
200 A
50, 50 50 I
100
200 50
100

78. The good scenario: David relies and Ebenezer performs
200
Because Ebenezer performs, David has another $100 to spend in period 2 B
100
100, 100 I
200 A
50, 50 50 I
100
200 50
100

79. A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
Doesn’t Rely
Performs
Doesn’t Perform
Ebenezer

80. A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
David spends 100 in period 1 and because Ebenezer breaches David has nothing left to spend in period 2
Time 1
C 100,0 D B
100, 100 A
50, 50 50 I
100 I DR 50
100

81. A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
What do we need to give David to make him as well off as he would have been had the promise been performed?
Time 1
C 100,0 D B
100, 100 A
50, 50 50 I
100 I DR 50
100

82. A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
Time 1
The Expectation Interest is CB, or $100
C 100,0 D B
100, 100 A
50, 50 50 I
100 I DR 50
100 82

83. A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
What do we need to give David to make him as well off as he would have been had he not relied?
Time 1
C 100,0 D B
100, 100 A
50, 50 50 I
100 I DR 50
100

84. A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches
Time 1
The Reliance Interest is CD,
or about $25
C 100,0 D B
100, 100 A
50, 50 50 I
100 I DR 50
100 84

85. Fool me once…: Non-reliance: What does David do if he assumes Ebenezer will breach?
Time 1 I 1
100 50 B I 1 50
100
Time 2

86. Fool me once…: Non-reliance: David assumes Ebenezer will breach
Time 1
Now David spends only $50 in period 1, and has $50 left over for period 2 I 1
100 50 B I 1 50
100
Time 2

87. David doesn’t rely and Ebenezer doesn’t perform
Relies
Doesn’t Rely
Performs
Doesn’t Perform
Ebenezer

88. No harm, no foul? David Ebenezer Doesn’t Rely Relies Performs
Doesn’t Perform
Ebenezer

89. But now suppose Ebenezer performs
Time 1 I 1
100 50 B I 1 50
100
Time 2

90. David doesn’t rely, Ebenezer performs
Relies
Doesn’t Rely
Performs
Doesn’t Perform
Ebenezer

91. Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs
Where David is
on Ebenezer’s
performance
100 I
200 E 50
150, 50
Ino-reliance
David spends
only 50 in
period 1
100
150
Goetz and Scott, 89 Yale L.J (1980)

92. Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs
Where David would
have been had he relied B
100, 100
100 I
200 E 50
150, 50
Ino-reliance
David spends
only 50 in
period 1
100
150
Goetz and Scott, 89 Yale L.J (1980)

93. Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs
100, 100
100 I
200 E 50
150, 50
Ino-reliance
100
150
Goetz and Scott, 89 Yale L.J (1980)

94. To Review…
David
Relies
Doesn’t Rely
Performs
Doesn’t Perform
Ebenezer

95. Scenario I: David doesn’t rely and Ebenezer doesn’t perform
Relies
Doesn’t Rely
Performs
Doesn’t Perform
David spends $50 now, $50 later
(No Harm,
No Foul)
Ebenezer

96. Scenario II: David Relies and Ebenezer Performs
Doesn’t Rely
Performs
David spends $100 now, $100 later
Doesn’t Perform
Ebenezer

97. Scenario III: David relies and Ebenezer breaches
Doesn’t Rely
Performs
Doesn’t Perform
David spends $100 now, 0 later (Detrimental Reliance)
Ebenezer

98. Scenario IV: David doesn’t rely and Ebenezer performs
Relies
Doesn’t Rely
Performs
David spends $50 now, $150 later
Doesn’t Perform
Ebenezer

99. Modeling the Bargaining Game
David
Relies
Doesn’t Rely
Performs
Beneficial Reliance
Doesn’t Perform
Ebenezer

100. Loss of Beneficial Reliance
The problem of trust
David
Relies
Doesn’t Rely
Performs
Beneficial Reliance
Loss of Beneficial Reliance
Doesn’t Perform
Ebenezer

101. Enforceable Contracts provide the gains associated with beneficial reliance

102. David is better off because he relied and Ebenezer is better off because he had a charitable motive

103. How are two people made better off when they exchange goods?

104. How are two people made better off when they exchange goods?
After the bargain, same horse, same cow

105. Aristotle on Corrective Justice Does this assume zero-sum bargaining?
These names, both loss and gain, have come from voluntary exchange; for to have more than one's own is called gaining, and to have less than one's original share is called losing, e.g. in buying and selling and in all other matters in which the law has left people free to make their own terms; but when they get neither more nor less but just what belongs to themselves, they say that they have their own and that they neither lose nor gain.
Therefore the just is intermediate between a sort of gain and a sort of loss, viz. those which are involuntary; it consists in having an equal amount before and after the transaction.

106. Modeling a Bargain: Two Commodities: Mums and Roses
Roses

107. Modeling a Bargain: Two Bargainers: Mary and Bess
Mums
Good Queen Mary
“Bloody” Bess
Roses

108. Two bargainers
Mums
Mums
Mary
Roses
Bess
Roses

109. Rotating Bess’s diagram I
Mums
Mums
Roses
Bess
Mary
Roses

110. Rotating Bess’s diagram II
Roses
Mums
Bess
Mums
Mary
Roses

111. Rotating Bess’s diagram III
Mums
Mary
Roses
Bess
Roses
Mums

112. Rotating Bess’s diagram IV
Roses
Mums
Mary
Roses
Bess
Mums

113. Rotating Bess’s diagram V
Mums
Roses
Bess
Mary
Roses

114. Edgeworth Box Function: Bargaining from endowment point A
Bess A 
Mary

115. Edgeworth Box Function: Bargaining from endowment point A
Bess
Rosesbess
Mumsmary A
Mumsbess 
Rosesmary
Mary

116. Edgeworth Box Function: Bargaining from endowment point A
Bess A 
Mary

117. The Edgeworth Box Function permits us to define Efficiency Standards
Pareto-superiority
Pareto-optimality

118. Efficiency (Paretian) standards Vilfredo Pareto (1848-1923)
Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off
Pareto-optimality: No further Pareto-superior transformations are possible

119. Pareto-Superiority B and C as Pareto-superior to A D and E as Pareto-inferior
Bess E  A  C  B   D
Mary
Coleman, 8 Hofstra L.Rev. 905 (1980)

120. Are all bargaining gains exploited at F
Are all bargaining gains exploited at F? The bargaining “lens” shrinks through bargaining
Bess E  A  F C   B   D
Mary

121. The bargaining “lens” shrinks through bargaining
Bess E  A  F C    G B   D
Mary
121
121

122. Pareto Optimality At G no further Pareto-superior transformations are possible
Bess E  A  F C    G B   D
Mary
122
122

123. The Contract Curve G is a point of tangency of the two sets of indifference curves
Bess E  A  F C    G B   D
Mary
123
123

124. The Contract Curve All possible Pareto-optimal contracts at the points of tangency
Bess  E A  F  C   G B  D 
Mary

125. Efficiency (Paretian) standards Vilfredo Pareto (1848-1923)
Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off
Pareto-optimality: No further Pareto-superior transformations are possible