1. Econ 522 Economics of Law Dan Quint Spring 2011 Lecture 14

2. 1  Contracts as promises  First purpose: facilitate cooperation  Second purpose: encourage efficient disclosure of information  Breach of contract  Third purpose: secure efficient commitment to performance  Reliance  Fourth purpose: secure efficient reliance  Default rules  Fifth purpose: reduce transaction costs via efficient default rules  C&U: apply rule parties would have wanted  (Typically means allocating each risk to efficient bearer of that risk)  Ayres and Gertner: penalty defaults Before Spring Break…

3. 2  Regulations/immutable rules  Ways to get out of a contract  Formation defenses  Incompetence  Dire constraints (duress and necessity)  Adhesion, unconscionability  Fraud, frustration of purpose, mutual mistake  Generally: situations where assumptions of Coase Theorem fail  Performance excuses  Impossibility; allocating a loss to the efficient bearer of that risk  Remedies for breach of contract  Court-ordered damages of various types  Party-specified damages (but: penalty damages not always enforced)  Specific Performance Before Spring Break…

4. 3 Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

5. 4 Remedies and breach Expectation Damages 0-500,000250,000Total 150,000 You get -150,000-650,000100,000I get Costs High – Breach Costs High – Perform Costs Low – Perform Specific Performance 0-500,000250,000Total 400,000150,000 You get -400,000-650,000100,000I get Costs High – Renegotiate Costs High – Perform Costs Low – Perform  Transaction costs low  either leads to efficient breach, but seller prefers “weaker” remedy  Transaction costs high  S.P. leads to ineff. performance Plane worth $500,000 to you Price $350,000 Cost: either $250,000 or $1,000,000

6. 5  Opportunity cost damages, or reliance damages  Inefficient breach when transaction costs are high  Renegotiate contract to get efficient performance when transaction costs are low  Like nuisance law: any remedy leads to efficient breach with low TC  But only expectation damages do when TC are high  Unfortunate contingency and fortunate contingency Remedies and breach

7. 6  Specific Performance  If costs stay low, I get $350,000 - $250,000 = $100,000 profit  If costs rise, I take $400,000 loss  Am I willing to sign this contract?  Even expectation damages face this problem  Expectation damages: costs stay low, same $100,000 profit  Costs rise, $150,000 loss  If probability of high costs is ½, I won’t sign contract  Expectation damages lead to efficient breach, but may not lead to efficient signing  Suggests expectation damages might be good default rule, but not good mandatory rule Efficient signing

8. 7 Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

9. 8  If reliance investments increase damages you receive, we get overreliance  To get efficient reliance, we need to exclude gains from reliance in calculation of expectation damages  But then promisor’s liability < promisee’s benefit, leading to inefficient breach  With low transaction costs, fix this through renegotiation  But what about unobservable actions the promisor needs to take, to make breach less likely?  Investment in performance Did example of reliance a few days ago

10. 9 Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

11. 10  Some investment I can make to reduce likelihood that breach becomes necessary  Suppose probability of breach is initially ½… but for every $27,726 I invest, I cut the probability in half  Invest nothing  probability of breach is 1/2  Invest $27,726  probability is 1/4  Invest $55,452  probability is 1/8  Any investment z  probability is.5 * (.5) z / 27,726  Wrote it this way so p =.5 e – z / 40,000 Investment in performance (continuing with airplane example)

12. 11  Suppose you’ve built a $90,000 hangar  Increases value of performance by $180,000…  …so value of performance is $150,000 + $180,000 = $330,000  Probability of breach =.5 e – z/40,000  Let D = damages I owe if I breach  Same questions as before:  What is efficient level of investment in performance?  How much will I choose to invest in performance? Investment in performance (continuing with airplane example)

13. 12  Suppose you’ve built a $90,000 hangar  Increases value of performance by $180,000…  …so value of performance is $150,000 + $180,000 = $330,000  Probability of breach =.5 e – z/40,000  Let D = damages I owe if I breach  Same questions as before:  What is efficient level of investment in performance? Enough to reduce probability of breach to 40,000/430,000  How much will I choose to invest in performance? Enough to reduce probability of breach to 40,000/(100,000 + D) Investment in performance (continuing with airplane example)

14. 13  What is the efficient level of investment in performance?  Enough so that p(z) = 40,000/430,000  What will promisor do under various rules for damages?  Enough so that p(z) = 40,000/(100,000 + D)  So if D = 330,000, efficient investment in performance  D = 330,000 is promisee’s benefit, including reliance  So expectation damages, with benefit of reliance, leads to efficient investment in performance  If D < 330,000, too little investment in performance  If D > 330,000, too much  Makes sense – think about externalities What do these results mean?

15. 14 Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

16. 15 Paradox of compensation Inefficient breach Underinvestment in performance Efficient reliance Efficient breach Efficient investment in performance Over-reliance Expectation damages exclude benefit from reliance investments Expectation damages include benefit from reliance investments  Is there a way to get efficient behavior by both parties?

17. 16  Have expectation damages include benefit from reliance…  …but only up to the efficient level of reliance, not beyond  That is, have damages reward efficient reliance investments, but not overreliance  Promisee has no incentive to over-rely  efficient reliance  Promisor still bears full cost of breach  efficient performance  Problem: this requires court to calculate efficient level of reliance after the fact We already saw one possible solution

18. 17  The problem:  Damages promisor pays should include gain from reliance if we want to get efficient performance  Damages promisee receives should exclude gain from reliance if we want to get efficient reliance  Solution: make damages promisor pays different from damages promisee receives!  How do we do this? Need a third party Another clever (but unrealistic) solution

19. 18  You (promisee) and I (promisor) offer Bob this deal:  If you rely and I breach,  I pay Bob value of promise with reliance (airplane plus hangar)  Bob pays you value of promise without reliance (airplane alone)  Bob keeps the difference  You receive damages without benefit from reliance; I pay damages with benefit from reliance “Anti-insurance”

20. 19  You (promisee) and I (promisor) offer Bob this deal:  If you rely and I breach,  I pay Bob value of promise with reliance (airplane plus hangar)  Bob pays you value of promise without reliance (airplane alone)  Bob keeps the difference  You receive damages without benefit from reliance; I pay damages with benefit from reliance  Offer the deal to two people, make them pay up front for it “Anti-insurance”

21. 20  Foreseeable reliance  Include benefits reliance that promisor could have reasonably anticipated Reminder: what do courts actually do?

22. 21 Another experiment: is trust a problem?

23. 22  Player A starts with $10  Chooses how much of it to give to player B  That money is tripled  Player B has $10, plus 3x whatever A gave him/her  Chooses how much (if any) to give back to player A  So for example…  if player A decides to send $3…  then A has $7 left, and B has $19…  and then B can send back to A any amount from 0 to $19  if A sends $9, B has $37, A has $1 plus whatever B sends back A two-player game, similar to the investment/agency game

24. 23  We’ll try the game four different ways:  Anonymously – A and B don’t know who each other are  Privately – A and B don’t interact, but will learn who each other are after the game  Face to face – A and B know who each other are, and can discuss the game before playing, but their actions remain private  Publicly – A and B play out loud in front of the class A two-player game, similar to the investment/agency game

25. 24 Repeated interactions

26. 25 Repeated games

27. 26 Repeated games Player 1 (you) Trust meDon’t Player 2 (me) Share profitsKeep all the money (150, 50)(0, 200) (100, 0)  Suppose we’ll play the game over and over  After each game, 10% chance relationship ends, 90% chance we play at least once more…

28. 27  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

29. 28  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

30. 29  Diamond dealers in New York (Friedman) “…people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one” “Parties to a contract agree in advance to arbitration; if… one of them refuses to accept the arbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted.” Repeated games and reputation

31. 30  The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions  The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts  Law assigns legal duties to certain long-term relationships  Bank has fiduciary duty to depositors  McDonalds franchisee has certain duties to franchisor Repeated games and reputation

32. 31  Suppose we’ll play agency game 60 times  $50 x 60 = $3,000 > $200, so cooperation seems like no problem  But…  In game #60, reputation has no value to me  Last time we’re going to interact  So I have no reason not to keep all the money  So you have no reason to trust me  But if we weren’t going to cooperate in game #60, then in game #59… Repeated games and the endgame problem

33. 32  Endgame problem: once there’s a definite end to our relationship, no reason to trust each other  Example: collapse of communism in late 1980s  Communism believed to be much less efficient than capitalism  But fall of communism led to decrease in growth  Under communism, lots of production relied on gray market  Transactions weren’t protected by law, so they relied on long-term relationships  Fall of communism upset these relationships Repeated games and the endgame problem

34. 33 One other bit I like from Friedman

35. 34 Friedman on premarital sex  Under traditional common law, a jilted bride could sue for breach of promise to marry

36. 35 Friedman on premarital sex  Under traditional common law, a jilted bride could sue for breach of promise to marry  Between 1935 and 1945, lawsuits for breach of promise to marry stopped being recognized in many states  Diamond engagement rings became common in 1930s, peaked in 1950s, since declined

37. 36  Purposes for contract law:  Encourage cooperation  Encourage efficient disclosure of information  Secure optimal commitment to performance  Secure efficient reliance  Provide efficient default rules and regulations  Foster enduring relationships  Wednesday, we begin tort law That’s it for contract law End of material on second midterm

38. 37  Overall very good  Mean 87, std dev 8  Most points lost on question 1  Not assigning letter grades till after final  Second exam typically harder than first First Midterm A-GQ-ZH-P