1. Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 14

2. 1  See Chao if you’re missing midterm or HW1  HW2 due next Tuesday (11 a.m. sharp)  Second midterm next Thursday (Nov 5) Logistics

3. 2 Last Thursday: 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

4. 3  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  (Requires court to calculate efficient level of reliance after the fact) We already saw one possible solution

5. 4  The problem:  Damages promisor pays need to include gain from reliance if we want to get efficient performance  Damages promisee receives need to exclude gain from reliance if we want to get efficient reliance  So…  Make damages promisor pays different from damages promisee receives! Another clever (but unrealistic) solution

6. 5  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”

7. 6  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”

8. 7  Foreseeable reliance  Include benefits reliance that promisor could have reasonably anticipated Reminder: what do courts actually do?

9. 8 Timing of breach

10. 9  You agree to sell me 10 tons of corn in June for $5/bushel  Breach in June  Damages might be difference between $5/bushel and spot price  Breach in January (“renounce/repudiate”)  Damages might be difference between $5 and price of June corn at time you breach Timing of breach

11. 10 Repeated interactions

12. 11 Repeated games

13. 12 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…

14. 13  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

15. 14  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

16. 15  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

17. 16  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

18. 17  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

19. 18  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

20. 19 Couple other odds and ends

21. 20  Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost  How do we know who this is? Friedman offers several bases for this decision…  Spreading losses across many transactions  Moral hazard: who is in better position to influence outcome? Efficient bearer of risk

22. 21  Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost  How do we know who this is? Friedman offers several bases for this decision…  Spreading losses across many transactions  Moral hazard: who is in better position to influence outcome?  Adverse selection: who is more aware of risk, even if he can’t do anything about it?  “…The party with control over some part of the production process is in a better position both to prevent losses and to predict them. It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.” Efficient bearer of risk

23. 22  Suppose…  80% of millers are low-damage – suffer $100 in losses from delay  20% of millers are high-damage – suffer $150 in losses from delay  Shipper liable for actual damages  Average miller would suffer $110 in losses  Shipper makes efficient investment for average type  But not efficient for either type  Shipper liable for foreseeable damages  Shipper makes efficient investment for low-damage millers  High-damage millers have strong incentive to negotiate around default rule Hadley v Baxendale

24. 23 One other bit I like from Friedman

25. 24 One other bit I like from Friedman

26. 25  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  Thursday, we begin tort law  Don’t forget, HW2 due in a week That’s it for contract law End of material on second midterm