Econ 522 Economics of Law

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Econ 522Economics of Law
Dan Quint Fall 2009 Lecture 9
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Logistics

• Office hours between now and midterm
• Me Tomorrow 130-330, Monday 130-330
• Chao Thursday 100-300, Monday 1000-130
• Midterm 1 next Tuesday, in class
• No contract law

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Plan

• Last week finished property law
• Handout two cool examples
• This week we start contract law
• But first a digression (true story) that
  illustrates some of the principles from both

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So last Thursday, Im flying from Boston to
Montreal

• Uncertainty about rights makes bargaining hard
• Negotiating with lots of parties is hard
• When transaction costs are high, damages are
  better than injunctions
• But also what is a ticket?

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Contract Law
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Example the agency (trust) game
Player 1 (you)
Trust me
Dont
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(0, 200)

• Subgame perfect equilibrium Ill keep all the
  money so you dont trust me
• Inefficient outcome (100 lt 200)
• And were both worse off

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(One solution reputation)
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Another solution legally binding promises
Player 1 (you)
Trust me
Dont
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(125, 25)

• Now we get cooperation (and efficiency)
• Purpose of contract law to allow trade in
  situations where this requires credible promises

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So what types of promises should be enforced by
the law?

• 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.
• 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.
• 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 pay 500
  in punitive damages.

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The Bargain Theoryof Contracts
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The bargain theory of contracts

• Developed in the late 1800s/early 1900s
• A promise should be enforced if it was given as
  part of a bargain, otherwise it should not
• Bargains were taken to have three elements
• Offer
• Acceptance
• Consideration

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What is consideration?

• Promisor person who gives a promise
• Promisee person who receives it
• In a bargain, both sides must give up something
• reciprocal inducement
• Consideration is what the promisee gives to the
  promisor, in exchange for the promise
• Under the bargain theory, a contract becomes
  enforceable once consideration is given

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What is consideration?

• Promisor person who gives a promise
• Promisee person who receives it
• In a bargain, both sides must give up something
• reciprocal inducement
• Consideration is what the promisee gives to the
  promisor, in exchange for the promise
• Under the bargain theory, a contract becomes
  enforceable once consideration is given

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The bargain theory does not distinguish between
fair and unfair bargains

• Hamer v Sidway (NY Appeals Ct, 1891)
• Uncle offered nephew 5,000 to give up drinking
  and smoking until his 21st birthday, then refused
  to pay
• The promisee previously used tobacco,
  occasionally drank liquor, and he had a legal
  right to do so. That right he abandoned for a
  period of years upon the strength of the promise
  We need not speculate on the effort which may
  have been required to give up the use of these
  stimulants. It is sufficient that he restricted
  his lawful freedom of action within certain
  prescribed limits upon the faith of his uncles
  agreement, and now, having fully performed the
  conditions imposed, it is of no moment whether
  such performance actually proved a benefit to the
  promisor, and the court will not inquire into it.

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Under the bargain theory, what is the remedy?

• Expectation damages
• the amount of benefit the promisee could
  reasonably expect from performance of the promise
• meant to make the promisee as well of as he would
  have been, had the promise been fulfilled

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Problems with the bargain theory

• Not that accurate a description of what modern
  courts actually do
• Not always efficient
• Does not enforce certain promises that both
  promisor and promisee might have wanted to be
  enforceable

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Problems with the bargain theory

• Not that accurate a description of what modern
  courts actually do
• Not always efficient
• Does not enforce certain promises that both
  promisor and promisee might have wanted to be
  enforceable
• Does enforce certain promises that maybe should
  not be enforced

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What does efficiency say about what promises
should be enforced?
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What promises should be enforced?

• In general, efficiency requires enforcing a
  promise if both the promisor and the promisee
  wanted it to be enforceable when it was made
• different from wanting it to actually be enforced

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What promises should be enforced?

• In general, efficiency requires enforcing a
  promise if both the promisor and the promisee
  wanted it to be enforceable when it was made
• different from wanting it to actually be enforced
• The first purpose of contract law is to enable
  people to cooperate by converting games with
  noncooperative solutions into games with
  cooperative solutions
• or, enable people to convert games with
  inefficient equilibria into games with efficient
  equilibria

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What promises should be enforced?

• In general, efficiency requires enforcing a
  promise if both the promisor and the promisee
  wanted it to be enforceable when it was made
• different from wanting it to actually be enforced
• The first purpose of contract law is to enable
  people to cooperate by converting games with
  noncooperative solutions into games with
  cooperative solutions
• or, enable people to convert games with
  inefficient equilibria into games with efficient
  equilibria

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So now we know

• What promises should be enforceable?
• For efficiency enforce those which both promisor
  and promisee wanted to be enforceable when they
  were made
• One purpose of contract law
• Enable cooperation by changing a game to have a
  cooperative solution
• Contract law can serve a number of other purposes
  as well

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Information

• Private/asymmetric information can hinder trade
• Car example (George Akerloff, The Market for
  Lemons)

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Information

• Private/asymmetric information can hinder trade
• Car example (George Akerloff, The Market for
  Lemons)

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Information

• Private/asymmetric information can hinder trade
• Car example (George Akerloff, The Market for
  Lemons)
• Contract law could help
• You could offer me a legally binding warranty
• Or, contract law could impose on you an
  obligation to tell me what you know about the
  condition of the car
• Forcing you to share information is efficient,
  since it makes us more likely to trade
• The second purpose of contract law is to
  encourage the efficient disclosure of information
  within the contractual relationship.

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Efficient breach

• Example Im an artist
• You expect to value my painting at 1,000, agree
  to buy it for 600
• My rich cousin comes to town, offers me 5,000
  for it
• Efficient for him to get it, but Ive already
  promised it to you

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Efficient breach

• Example Im an artist
• You expect to value my painting at 1,000, agree
  to buy it for 600
• My rich cousin comes to town, offers me 5,000
  for it
• Efficient for him to get it, but Ive already
  promised it to you
• Breach is efficient when promisors cost of
  performing is greater than promisees benefit
  from performance

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Efficient breach

• Example Im an artist
• You expect to value my painting at 1,000, agree
  to buy it for 600
• My rich cousin comes to town, offers me 5,000
  for it
• Efficient for him to get it, but Ive already
  promised it to you
• Breach is efficient when promisors cost of
  performing is greater than promisees benefit
  from performance
• Question how do we get breach only when its
  efficient?

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Remedies and efficient breach

• Breach is efficient when promisors cost of
  performing is greater than promisees benefit
  from performance
• Self-interest promisor will breach when cost of
  performing is greater than liability from breach
• So when liability from breach promisees
  benefit, promisor will choose to breach exactly
  when its efficient
• Setting liability benefit is exactly
  expectation damages
• (This causes promisor to internalize the
  externality he causes by breaching the contract
  so there is no externality, and he acts
  efficiently)

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This brings us to

• The third purpose of contract law is to secure
  optimal commitment to performing.
• Expectation damages lead to efficient breach
  (breach of contract only when it is efficient).

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Reliance

• Reliance investments made by promisee, to
  increase the value of performance
• The fourth purpose of contract law is to secure
  optimal reliance

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Efficient reliance

• Efficiency reliance is efficient as long
  as(probability of performance) X (increase in
  value) gt (cost)
• We said expectation damages expected benefit
  from performance
• Should expectation damages include increase in
  benefit due to reliance?
• If yes promisee will rely as long as (increase
  in value) gt (cost)
• So if yes, promisee will overrely
• Thursday examples of efficient breach and
  reliance, and paper by Ayres and Gertner