Contract

1
Contract

• Designing contracts
• A common interest in efficient contracts
• How to make a contract efficient
• Enforcing and interpreting contracts
• What contracts should be enforced?
• The case for freedom of contract
• The problems of duress
• How to fill in the blanks in interpreting
  contracts
• Preventing opportunistic breach
• By contract design
• By reputational enforcement
• By legal penalties for breach
• Permitting efficient breach

2
Designing Contracts

• Parties have a common interest
• In maximizing the size of the pie
• And can then argue over dividing it
• Since any change that produces net benefits
• Can be combined with a change of price
• That makes it beneficial to both sides
• This applies to all dimensions, including
• What happens if one party breaches
• Allocation of risk between the parties
• Fixed price vs cost vs cost plus
• Fixed price for building your house
• Gives contractor an incentive to keep down costs
• Also to reduce quality if he can get away with it
• So fixed price if quality is easily specified and
  enforced

3
What contracts should be enforced?

• Why not simply enforce all contracts as written?
• Court may wish to impose its preferences
• Court must decide if there is a contract and what
  it says
• Court must fill in the blanks
• Case for freedom of contract
• Parties want an efficient contract, and
• Using ambiguity to impose courts preferences
• Leads to writing longer contracts
• So fill in blanks with what parties would have
  agreed to.

4
Case Against Freedom of Contract

• Unequal bargaining power
• Leads to efficient contracts, with prices
  favoring the party in a strong position
• Courts are poorly suited to redistribute income
• Lost in the desert. My lifes earnings for water?
• Odd case where unlimited freedom of contract
• Increases the price I can pay, which
• Hurts me in a bilateral monopoly bargain
• Real Duress
• Your money or your life
• Case for and against enforcing the contract
• Less Real Duress

5
The sinking ship case

• 10,000,000 ship, 100,000 to save it
• Bilateral monopoly bargain
• Price that gives the right incentive to save?
• 10,000,000. Tug gets the full benefit
• And so will bear any cost to increase the
  chances of saving that is worth bearing
• Price that gives the right incentive to avoid
  needing a tug?
• 100,000
• The cost the ship imposes when it starts sinking
  somewhere where a tug can save it

6
Right rule for sinking ships?

• We have been here before
• Coasian double causation
• Of the gain of saving a sinking ship
• Jointly produced by ship owners risk and
• Tugs expenditures on being there to save
• Put the incentive where it does most good
• Mostly on the tug if his supply is elastic (high
  price)
• Mostly on the ship if his is (low price)
• Freedom of contract?
• No reason to expect the efficient result
• Bilateral bargaining with large range is costly
• Let admiralty court decide fair price?

7
In a Fully Coasean world

• We can optimize on both margins
• Tug boat pays the ship to take risks
• Ship pays the tugboat to be there if needed
• Two parties bargain to the efficient outcome
• Research project
• Look at the actual market for salvage
• To see if contracts in advance
• Solve these problems
• Bilateral monopoly bargain costs perhaps solved
  by preagreed salvage rates?

8
Contracts of Adhesion

• Fancy name for form contracts
• Suggests they are illegitimate, since
• Not bargained
• But the economic argument doesnt require
  bargaining
• Three models of control
• Democracy
• Fighting The bargaining process
• markets
• Consider the virtues of competitive dictatorship
• The arrangement we use for hotels, restaurants
• I have no vote in how they are run,
• Dont bargain over the menu, but
• Absolute control on whether I buy their services

9
Why use form contracts?

• To save costs
• With millions of customers, takes a lot of
  lawyers
• To bargain a contract for each
• To control employees
• If the Avis desk clerk can set the rate
• How do you keep him from taking bribes?
• Why not?
• Argument for efficient terms still holds
• Since you have to get the customer to sign

10
If We Accept Freedom of Contract

• The problem of interpreting contracts
• Is the same as the problem of designing them
• Find out what terms maximize the summed gain
• Write them if you are a party
• Add them if you are a court filling in blanks

11
More Reasons Not To

• Third Party Effects
• Parties maximize their summed gain
• Ignore gains or losses to others, so
• We dont enforce
• Performance contracts for assassins
• Contracts not to testify in court (except )
• Cartel agreements (in the U.S.)
• Contracts by irrational parties
• Children or
• The insane
• Or, at one time, women
• A fine line between protecting people and
• Restricting them

12
Breach

• Preventing opportunistic breach
• By contract design
• By reputational enforcement
• By penalty
• Permitting efficient breach
• Either by special casing it, or
• Pigouvian tax, aka
• Expectation damages
• Efficient incentives for choices affected by the
  risk of breach
• Whether to sign the contract
• How much to rely on the other partys performance

13
Contract design

• Opportunistic breach happens because
• At some point in the process, one side
• Is better off stopping, keeping what it has
• Than going on to completion
• One way to prevent it is to avoid that by
• Progress payments instead of
• Paying in advance--incentive to take the money
  and run
• Paying on completion--incentive for buyer to
  renegotiate at that point
• Design a schedule so it never pays either party
  to breach
• Problem We cant perfectly predict the pattern
  of costsOne solution Increase the net cost of
  breach
• By creating hostages--damage to one party
• Not matched by gain to the other
• For details, see my China to Cyberspace, webbed
  for my seminar

14
Reputation

• A lot of contract enforcement is
• Via reputational penalties
• Repeat dealings with one customer
• Or prospect of dealings with others he knows
• This requires two conditions
• Cheating once doesnt gain enough to make it
  worth losing future opportunities
• Interested hird parties can find out you cheated
  at low cost
• If they cannot, victim doesnt report you, since
  third parties wont know which one was at fault
• Ways of creating those conditions
• Post a bond for the first
• Use arbitration to lower information cost to
  third parties
• They dont have to know the facts of the dispute,
  just
• That the arbitrator you agreed to says you are
  wrong

15
Expectation Damages

• Make the other party as well off as if no breach
• Correct incentive to breach, but
• Too much incentive to rely, since
• If you breach, my reliance expenditure is wasted
• But you have to compensate me for it
• And I am the one deciding whether to make it.

16
Reliance Damages

• Make the other party as well off as if no
  contract
• Too much incentive to breach
• Since breaching party does not have to compensate
• The other party for its lost profits
• Too much incentive to rely, since
• If you breach, my reliance expenditure is wasted
• But you have to compensate me for it
• And I am the one deciding whether to make it.

17
Liquidated Damages

• Could make the other party as well off as if no
  breach
• If the amount can be
• Estimated in advance
• In which case there is
• Correct incentive to breach
• Correct incentive to rely, since
• My compensation doesnt depend on whether I
  relied
• So any wasted reliance reduces my net

18
PS Speculation and Fraud

• Is it fraud if I
• Sign a contract when I know things
• That you dont know and
• If you knew, you wouldnt sign?
• Eliminates the usual argument that
• Contracts should be enforced because they benefit
  both parties
• Looks like rent seeking, but
• Lets me gain by generating valuable information
• Speculation prevents famine
• But the speculators gain does not measure the
  social benefit
• So we might get too much or too little
  speculation
• What we want are not incentives but the right
  incentives.

19
Thursday

• Fred Foldvary (Econ Dept)
• Economics and Natural Law