Economics of Contract Law

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Economics of Contract Law
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Agency Game I

• Give me 100 and Ill turn it into 200 and share
  the gain with you
• Do you trust me?
• No! Player 2 has DS to breach
• Solutions?
• Reputation in a repeated game
• Contract law

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Agency Game II

• Suppose we sign a contract in which I am punished
  if I run off with the money
• Court forces me to pay you 150 and charges each
  of us an additional 25 fee for doing so

1st Purpose of Contract Law is to enable people
to cooperate
Requires a way to make a promise credible (some
sort of commitment)
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Example 1
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.
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Example 2
One neighbor offers to sell a used car to another
for 1000. 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.
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Example 3
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 to pay
500 in punitive damages.
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Bargain Theory of Contracts I

• A promise should be enforced if it was given in a
  bargain, otherwise it should not.
• Offer
• Acceptance
• Consideration
• Rich uncle no consideration offered
• Disputed car no meeting of the minds
• Grasshopper killer enforceable bargain

Promisor person who gives a promise
Promisee person who receives it
reciprocal inducement
How do you enforce a gift promise?
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Bargain Theory of Contracts II

• What should the remedy be for broken promises?
• Expectations damages amount promisee could
  reasonably expect from performance
• Problems with the Bargain Theory
• Requires all promises to have consideration
• Car shopping and a firm offer
• Requires that all bargains be enforced
• Grasshopper killer?

Economic efficiency requires enforcing a promise
that both parties want enforced.
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Economic Theory of Contract
1st Purpose of Contract Law is to enable people
to cooperate

• Rich uncle both want the promise enforced
• Disputed car no cooperative surplus
• Grasshopper killer enforce the promise to
  discourage deceit by promisor

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2nd Purpose of Contract Law is to encourage
efficient disclosure of information

• Used car market
• You value my car 50 more than I do
• Asymmetric information exists
• No mechanics

0---------------------------5000
2500 (your guess as to value of car to me)
Suppose you offer 3000
0-------------------3000
You will end up paying 3000 for a car thats
only worth 2250 to you
1500 (your revised guess as to value of car to
me)
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3rd Purpose of Contract Law is to secure optimal
commitment to performing.

• What should be the remedy for efficient breach?
• Painting sale
• You value my unfinished painting at 1000
• We agree on a sale price of 600 upfront
• Crazy cousin makes 5000 offer
• Its efficient for me to breach contract with
  you
• Cost of performance gt benefit you will get from
  the painting
• Airplane sale
• You value my plane at 500,000
• We agree on a sale price of 350,000
• Before construction begins, price of metal rises
  and raises my cost to 1,000,000

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3rd Purpose of Contract Law is to secure optimal
commitment to performing.

• Optimal Performance
• If promisors cost of performing gt promisees
  benefit from performing, then breach is
  efficient
• If promisors cost of performing lt promisees
  benefit from performing, then performance is
  efficient
• Choice of remedy is critical
• If penalty for breach is too severe, the promisor
  will have to perform, even though breach may be
  efficient
• If penalty for breach is too weak, the promisor
  will breach when efficiency requires performance

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3rd Purpose of Contract Law is to secure optimal
commitment to performing.

• Actual Performance Decision
• If promisors cost of performing gt promisors
  liability for breaching, then he will breach
• If promisors cost of performing lt promisors
  liability for breaching, then he will perform
• Perfect Expectations Damages
• Promisors liability promisees benefit from
  performance
• Restores promisee to position he would have
  enjoyed if promise had been kept

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Painting Sale I

• You value my unfinished painting at 1000
• We agree on a sale price of 600 upfront
• Crazy cousin makes 5000 offer
• What are Expectation Damages?
• DE 1000
• What if D 6000

4600, 400
-400, 5400
Painter breaches and it is efficient
Painter performs though breach is efficient
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Painting Sale II

• You value my unfinished painting at 1000
• We agree on a sale price of 600 upfront
• Crazy cousin makes 5000 offer
• Assume simple DE
• Buyer purchases frame for 50 which raises value
  of painting to 1200

Whether painter performs or not, reliance makes
you better off
But, is reliance efficient?
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4th Purpose of Contract Law is to secure optimal
reliance.
If Expected Gain from Reliance gt Cost of Reliance
then Reliance is efficient
p probability of performance ?V increase in
value of performance due to reliance c cost of
reliance
If p(?V) gt C then reliance is efficient
Painter ex ?V 200 c 50
When the probability of performance is high, more
reliance tends to be efficient
? p 0.25
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4th Purpose of Contract Law is to secure optimal
reliance.

• Warning if my damages cover your benefit whether
  or not its efficient, then youll always spend
  on reliance (over-reliance)
• Solution Perfection Expectations Damages
• damages needed to restore the promisee had the
  promise been kept, and had he relied the optimal
  amount
• Foreseeability Doctrine
• Reasonably expected reliance

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Hadley v Baxendale (1854)

• Hadley ran a mill and crankshaft broke
• Baxendale was to deliver it to engineers
• Delayed one week (used boat rather than rail)
• Hadley sued for weeks worth of lost profits
• Court ruled lost profits were not foreseeable

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5th Purpose of Contract Law is to minimize
transaction costs of negotiating contracts by
supplying efficient default rules

• Gaps contract is silent about risks
• Inadvertent gaps not foreseeable
• Deliberate gaps remote risks
• Default rules
• Compute hypothetical bargain
• Who can bear risk at lowest cost?
• Adjust price of the contract

Cost of allocating a risk gt Expected cost of
allocating a loss ? leave gap
Cost of allocating a risk lt Expected cost of
allocating a loss ? fill gap
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McGuire v Wabash

• McGuires hire Wabash to build new house
• Price of copper rises by 2000 and contract is
  silent
• McGuires refuse to pay extra 2000
• Suppose Wabash knows that copper costs could rise
  by 2000 with p 0.50
• Expected cost (0.50)(2000) 1000
• Suppose Wabash couldve hedged risk for 400
• Hypothetical bargain
• Who is the low cost bearer of risk?
• If risk was foreseeable, Wabash would charge
  extra 700
• McGuires pays 700
• Wabash absorbs 1300 loss

Wabash
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Perfect Contracts and Market Failures

• Perfect Contract
• All risks is efficiently allocated
• All relevant information is communicated
• All resources allocated to those who value it the
  most
• Individual Irrationality
• Incompetence
• Dire constraints
• Necessity
• Duress
• Transactions Costs
• Spillovers
• Asymmetric information
• Monopoly

Exceptions to perfect contracts
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6th Purpose of Contract Law is to foster enduring
relationships, which solve the problem of
cooperation with less reliance on the courts to
enforce contracts

• Coffee shop and the forgotten wallet
• Prisoners Dilemma
• One-shot game DS is to cheat
• Repeated game Cooperative outcome is Pareto
  Optimal
• Endgame Problem

tit-for-tat strategy
Rarely will buyers leave saying they bought the
wrong goods at too high a price. Our goal is to
make them eager to come back. We offer a source
which provides a competitive edge, all of which
translates directly into increased profits.
NY Diamond Dealers Club
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Peevyhouse v Garland Coal (1962)

• Peevyhouse owned farm in Oklahoma
• Garland contracted to strip-mine coal
• Contract specified that Garland would take steps
  to restore land to previous condition
• Garland breached
• Peevyhouse sued for 25,000
• Restorative costs were estimated to be 29,000 at
  trial
• Garland showed that diminished value of farm
  was only 300
• Original jury awarded 5000 to Peevyhouse
• OK Supreme Court reduced damages to 300
• Efficient breach?
• Dissent specific performance was warranted,
  otherwise no formation would have occurred