1. Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 11

2. 1  Contract = legally binding promise  Allow for cooperation/trade when transactions aren’t instantaneous  First purpose of contract law: enable cooperation  What promises should be enforced?  Bargain theory: those given as part of a bargain  Three elements: offer, acceptance, consideration  Efficiency: any promise both promisor and promisee wanted to be enforceable  Information  Asymmetric/private info can prevent trade; contract law can help  Second purpose: encourage efficient disclosure of information Contract law: the story so far

3. 2  May become efficient/necessary to break a promise  When should a contract be breached?  Breach of contract is efficient when cost to perform > benefit of performance to promisee  Breach is in promisor’s interest when cost to perform > promisor’s liability from breach  Expectation damages: liability from breach = benefit to promisee  Leads to breach exactly when it’s efficient  Think of this as “designing the law to internalize an externality”  Third purpose of contract law: obtain optimal commitment to performance Contract law: the story so far

4. 3 Reliance

5. 4  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  The fourth purpose of contract law is to secure optimal reliance

6. 5 When is reliance efficient?  When social benefit of reliance > social cost of reliance  Social benefit is increased benefit to promisee  (Value of airplane + hangar) – (Value of airplane without hangar)  Value is only realized if the promise is performed  Social cost is cost borne by promisee  Cost occurs whether or not promise is performed  Reliance is efficient if Increase in value of performance Cost of investment > Probability of performance X

7. 6 How should reliance figure into damages?  Expectation damages = expected benefit from performance  If reliance investments increase the anticipated benefit…  should they increase the damages I owe you in the event of breach?  Can we design damages to get efficient reliance, in addition to efficient breach?

8. 7  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? 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

9. 8  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? 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

10. 9  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) 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

11. 10  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! 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

12. 11 Better example: continuous investment Investment in hangar Additional value of plane $100$10,000$40,000$160,000$640,000 Tarp and rope - $6,000 benefit Plywood frame, canvas roof - $60,000 Metal poles, rigid roof - $120,000 Functional heating - $240,000 Designer hangar with Starbucks - $480,000 Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600  x

13. 12  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? Three questions Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600  x

14. 13  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? x = $90,000 (1 – p) 2 Three questions Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600  x

15. 14 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 Cost of investment > Prob. of perform. X Increase in damages Prob. of breach X+ Increase in benefit Cost of investment > Prob. of perform. X

16. 15 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  “Paradox of compensation”  Single “price” (damages owed) sets multiple incentives…  …impossible to set them all efficiently!

17. 16  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 what do we do?

18. 17  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 So what do we do?

19. 18  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 Foreseeable reliance: Hadley v Baxendale

20. 19  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 Foreseeable reliance: Hadley v Baxendale

21. 20 Default Rules

22. 21  Gaps: risks or circumstances that aren’t specifically addressed in a contract  Default rules: rules applied by courts to fill gaps Default rules

23. 22  Gaps: risks or circumstances that aren’t specifically addressed in a contract  Default rules: rules applied by courts to fill gaps  Writing something into a contract vs leaving a gap  Allocating a loss (ex post)  Versus allocating a risk (ex ante), before it becomes a loss Default rules

24. 23  Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue  This will be whatever rule is efficient What should default rules be?

25. 24  Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue  This will be whatever rule is efficient  Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules  Do this by imputing the terms the parties would have chosen if they had addressed this contingency What should default rules be?

26. 25  Don’t want ambiguity in the law  So default rule can’t vary with every case  Majoritarian default rule: the terms that most parties would have agreed to  In cases where this rule is not efficient, parties can still override it in the contract  Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate Default rules

27. 26  Example: probability ½, the cost of construction will increase by $2,000  Construction company can hedge this risk for $400  Family can’t do anything about it  Price goes up – who pays for it? Default rules

28. 27  Example: probability ½, the cost of construction will increase by $2,000  Construction company can hedge this risk for $400  Family can’t do anything about it  Price goes up – who pays for it?  Construction company is efficient bearer of this risk  So efficient contract would allocate this risk to construction company  Should prices be adjusted to compensate? Default rules

29. 28  Example: probability ½, the cost of construction will increase by $2,000  Construction company can hedge this risk for $400  Family can’t do anything about it  Price goes up – who pays for it?  Construction company is efficient bearer of this risk  So efficient contract would allocate this risk to construction company  Should prices be adjusted to compensate? Default rules

30. 29  So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases  Most contracts can leave this gap, save on transaction costs  In cases where this rule is inefficient, parties can contract around it Default rules

31. 30  Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules”  Sometimes better to make default rule something the parties would not have wanted  To give incentive to address an issue rather than leave a gap  Or to give one party incentive to disclose information  “Penalty default” Default rules: a different view

32. 31  Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk  If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent  So Hadley might hide this information, which is inefficient  Ayres and Gertner: Ruling in Hadley was a good one, not because it was efficient, but because it was inefficient…  …but in a way that created incentive for disclosing information Penalty defaults: Hadley v Baxendale

33. 32  Real estate brokers and “earnest money”  Broker knows more about real estate law  Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this Penalty defaults: other examples

34. 33  Real estate brokers and “earnest money”  Broker knows more about real estate law  Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this  Courts will impute missing price of a good, but not quantity  Forces parties to explicitly contract on quantity, rather than leave it for court to decide Penalty defaults: other examples

35. 34  Look at why the parties left a gap in contract  Because of transaction costs  use efficient rule  For strategic reasons  penalty default may be more efficient  Similar logic in a Supreme Court dissent by Justice Scalia  Congress passed a RICO law without statute of limitations  Majority decided on 4 years – what they thought legislature would have chosen  Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…”  “Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.” When to use penalty defaults?