The Theory of Demand

1
The Theory of Demand
Sciences Po F.H. Buckley Goetz 151-153, Buckley
38-50, Buckley 136-40, Goetz 159-74
2
What were covering
? How contracts promote reliance
? Why thats a good thing
Modeling bargaining gains

• Later Classes When its not a good thing
  Paternalism and Perfectionism

3
The deeper agenda

• The overlap between fairness and efficiency
• How economics provides the analytical tools to
  explain fundamental instincts about the law

4
Contract law and the need for trust

• How can we persuade another person to rely on us
• Recall David Hume on gains from specialization
  and joint production
• Humes Treatise III.ii.V

5
Hume Your corn is ripe today, mine will be so
tomorrow
6
Recall our game-theoretic analysis of promising

• Game theoretic problems payoffs for each player
  depend on actions of both
• Two possible strategies A party cooperates when
  he performs value-increasing promises, and
  defects when he breaches

7
Modeling Promisor Choices
Player 2
Player 1
8
Payoffs in utils
Player 2
Player 1
9
Defection dominates for Player 1
Player 1
?
?
10
Defection dominates for Player 2
Player 2
?
?
11
Remedies for Breach of Contract transform the
gameParty in breach pays expectation damages of
4
Player 2
Player 1
12
Remedies for Breach of Contract transform the
gameParty in breach pays expectation damages of
4
Player 2
Player 1
13
Absent contract remedies, we are in a state of
natureHobbes, Leviathan 14.18 (1651)

• If a covenant be made wherein neither of the
  parties perform presently, but trust one another,
  in the condition of mere nature (which is a
  condition of war of every man against every man)
  upon any reasonable suspicion, it is void
• For he that performeth first hath no assurance
  the other will perform after, because the bonds
  of words are too weak to bridle men's ambition,
  avarice, anger, and other passions, without the
  fear of some coercive power which in the
  condition of mere nature, where all men are
  equal, and judges of the justness of their own
  fears, cannot possibly be supposed. And therefore
  he which performeth first doth but betray himself
  to his enemy.

14
What Happens when Promises Cant Be Relied on?
Akerlof, The Market for Lemons, 84 Q.J. Econ.
488 (1970)
15
The Market for LemonsWhat would you pay?

• Of the remaining 1956 Fords, half are worth
  nothing (lemons) and the other half are worth
  5000 (beauts)
• The seller knows which kind of car he has but you
  cant tell them apart
• The trick Sellers willingness to sell is a
  signal
• Question Is the seller satisfied with this
  result?

16
An application Marriage, divorce and natality
Rembrandt, The Jewish Bride 1666
17
No-fault divorce laws (ca. 1968)Effect on
marriages

• What did no-fault divorce do to the cost of
  matrimonial fault?
• How do you think no-fault divorce laws affected
  divorce levels?
• Bring and Buckley, 18 Int. Rev. Law Econ. 325
  (1998)
• How do you think women react to an increased
  probability of divorce?

18
Children as marriage-specific assets
Divorce rate 1965-83 Natality rate for
married couples 1965-83
19
The sellers signaling problem where no
contractual remedies are available

• International Agreements
• Problems with local court systems
• Agreements too vague to be enforceable

20
Contract law in the state of natureHow to solve
the problem of trust

• 1. Self-binding strategies
• 2. Union strategies
• 3. Social Norms and Reciprocal Altruism
• 4. Internalized Norms

21
Trust in the State of Nature1. Self-binding

• I might persuade another party to trust me if I
  make it painful for me to breach
• The use of hostages

22
Hostages The Burghers of Calais
Rodin 1885
23
Not hostages The burgers of Calais McDonald's
at Walmart, 8 South St., Calais, ME 04619
24
Modern examples of hostages to solve the problem
of trust in bargaining

• Penalty clauses
• Secured lending
• Romantic love

25
Trust in the State of Nature2. Union strategies

• The family farm
• Marriage amongst princely families
• Vertical integration
• Klein, Crawford, Alchian, 21 J.L. Econ. 297
  (1978)

26
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27
Trust in the State of Nature3. Social Norms and
Reciprocal Altruism

• Robert Trivers Cooperative behavior amongst
  animals

28
Is there a genetic basis for trust?

• Trivers on evolutionary biology
• Trivers, 46 Quart. Rev. Biol. 35 (1971)
• Low trust societies (Italy)
• Banfield, The Moral Basis of a Backward Society
  (1958)

29
Robert Trivers
30
Reciprocal altruism The Iterated Prisoners
Dilemma
31
The Iterated Prisoners Dilemma How do
strategies change

• Axelrod, The Evolution of Cooperation (1984)
• Tit-for-tat (TFT) Cooperate first round, then do
  what your opponent did on the previous round
• All-defect (All-D)

32
The Iterated Prisoners Dilemma How do
strategies change

• In what sense does TFT dominate?
• Its advantages forgiving, but not a sucker
  easily communicated stable
• An evolutionary stable strategy (ESS)
• All-D also ESS

33
TFT in action The Christmas truce of 1914
Youre a good sort, Fritzie, for a Hun
Ver ist der turkey? Und der Belgians?
34
TFT in actionPosner and Goldsmith on
Ambassadors in International Law
Carpaccio, The Legend of St. Ursula The Arrival
of the English Ambassadors
35
Example of TFT communities

• Old-boy networks
• Americans like to form clubs. Tocqueville
• Racial communities New York City Diamond
  Merchants

36
Diamond district, West 47th Street, NYC
L. Bernstein, 21 J. Legal Stud. 115 (1992)
37
Institutions and contract law as substitute
trust-building devices
38
TFT An Application?

• America is at war with Canada and Al-Quaeda.
  American POWs in Canada are housed in a five
  star hotel where they are feted with wonderful
  meals and fine wines. American POWs held by
  Al-Quaeda are beheaded, every one of them.

39
TFT An Application?

• America is at war with Canada and Al-Quaeda.
  American POWs in Canada are housed in a five
  star hotel where they are feted with wonderful
  meals and fine wines. American POWs held by
  Al-Quaeda are beheaded, every one of them.
• The Geneva Convention prescribes that POWs shall
  be provided with exercise facilities. Is America
  in breach of this if it offers Canadian but not
  Al-Quaeda POWs exercise facilities?

40
Trust in the State of Nature4. Internalized
Norms

• Ruth Benedict on shame cultures
• The Chrysanthemum and the Sword (1989)
• What happens when this is internalized?
• Robert Frank, Passion within Reason (1988)

41
Guilt on Breach of Trust

• The Lemons Problem Guilt solves the problem of
  trust only if it can be recognized by others
• How to identify false signalers?

42
Deception Detection Devices

• Speech is the gift God gave us to hide our
  thoughts. Talleyrand
• Which explains why we have faces
• Deception detection Guilt and facial signals
• Paul Ekman, Darwin and Facial Expressions (1973)
  What the Face Reveals (1997)

43
Whom would you vote for?
Alexander Todorov et al., Inferences of
competence from faces predict election outcomes.
Science (in press)
44
Zygomatic smiles
45
Microexpressions

• We are able to detect visual cues that can be
  seen for only a fraction of a moment
• Two stable equlibria

46
Can these strategies substitute for Contract Law?

• Manifestly, they havent. Especially in the
  wealthiest societies.
• Why is that?

47
The advantages of contract law

• Privatized and decentralized
• Democratic and open to outsiders
• Sir Henry Maine The movement of the progressive
  societies has hitherto been a movement from
  Status to Contract.

48
Modeling bargaining gains

• The nihilism of the 1970s Whats wrong with this
  contract?
• If one person does not lose, the other does not
  gain. Augustine

49
Measuring quantity of one commodity on the x-axis























































































X axis




0
















50
Modeling quantity of second commodity on the
y-axis

Y axis


























































































0
















51
Two dimensional Commodity SpaceEvery point
represents a combination of the two commodities

Y axis






















































































X axis




0
















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Two dimensional Commodity SpaceEvery point
represents a combination of the two commodities

Y axis























A








Y
























































X axis




0

X















53
Commodity space Dollars consumed in two time
periods


Dollars in Time 1






More of both















































































Dollars in Time 2





0














54
The Budget Line Allocating 100 between two
periods


Dollars in Time 1



















100






The budget line in red represents every
trade-off of 100 in two periods






























































Dollars in Time 2
0
100















55
Indifference Curves Preferences about
Consumption

Dollars in Time 1






An indifference curve represents a set of
trade-offs to which the subject is indifferent














































































Dollars in Time 2
0










56
Indifference curves resemble a topographical
mapGoetz p. 150
? 249-60
? well
? McNabb
? Zepp
? 249-59
57
Indifference curves resemble a topographical
mapTwo houses
? 249-60
? well
? McNabb
? Zepp
? 249-59
58
Indifference curves resemble a topographical
mapTwo boundary posts
? 249-60
? well
? McNabb
? Zepp
? 249-59
59
Antenna to be placed at the highest point in the
triangle where is that?
? 249-60
? well
? McNabb
? Zepp
? 249-59
60
Antenna to be placed at the highest point in the
triangle where is that?Lets assume here
? 249-60
? well
? McNabb
? Zepp
?
? 249-59
61
Indifference Curves Preferences about
Consumption

Dollars in Time 1






One is better off the further one gets from the
origin














































































Dollars in Time 2
0










62
More is betterI2 gt I1





Dollars in Time 1



More is better

























I2







































I1



















0









Dollars in Time 2






63
Ordinal Utility We cant say how much better I2
is than I1





Dollars in Time 1



























I3

I2







































I1















0













Dollars in Time 2






64
A ? C Subject is willing to give up BC in Time
2 for AB in Time 1

Dollars in Time 1




























Convexity (curve bends inward) assumes
decreasing marginal utility









?
A





















?
B
?







C















0




Dollars in Time 2










65
Consumption DecisionDavid has 100 and is best
off at AMaximization subject to the constraint
of the Budget Line




Time 1








I


2





I

1
100



























A


50
















I

2







I

1






I3





0
50
100









Time 2


66
Ebenezer gives David another 100 The Shift to
a New Budget Line





200








I

200













I

100


















100






























A





50, 50
50

















































0





100







67
A new Consumption Decision










Time 1


























B

100, 100


100













I

200
















A





50, 50
50






































I

100
I






DR



Time 2


0



50


100




68
What happens when the donor promises to give in
the future?

• Uncle Ebenezer doesnt have the 100 to give
  today but promises to give it to David in the
  next period
• Davids election to rely or not to rely on the
  promise in the first period

69
The good scenario David relies and Ebenezer
performs

200













Reliance by David means spending 100 in period 1






















B

100, 100


100













I

200
















A





50, 50
50






































I

100










200


0



50


100




70
A bad scenario Detrimental Reliance David
relies and Ebenezer breaches



Time 1

David spends 100 in period 1 and now has nothing
left to spend in period 2



























C 100,0
B

D




100, 100































A



50, 50








50




























I

100


I






DR




0




50


100




71
A bad scenario Detrimental Reliance David
relies and Ebenezer breaches



Time 1

Davids reliance loss CD



























C 100,0
B

D




100, 100































A



50, 50








50




























I

100


I






DR




0




50


100




72
Fool me once Non-reliance David assumes
Ebenezer will breach




Time 1














I

1
100





























50



B



















I

Now David spends only 50 in period 1
1











0
50
100









Time 2


73
Loss of Beneficial Reliance David doesnt rely
and Ebenezer performs










Where David would have been had he relied

























B

100, 100


100














I
200




















E
Ino-reliance
150, 50
50



















David spends only 50 in period 1
































0





100


150


Goetz and Scott, 89 Yale L.J. 1261 (1980)

74
Loss of Beneficial Reliance David doesnt rely
and Ebenezer performs










So St. Augustine was wrong

























B

100, 100


100














I
200




















E
Ino-reliance
150, 50
50



















































0





100


150


Goetz and Scott, 89 Yale L.J. 1261 (1980)

75
Modeling a Bargain Mums and Roses

Mums

















































































0
Roses













76
Two bargainers





Mums




Mums



























































































































































Mary














Roses



Beth





Roses



77
Rotating Beths diagram I


Mums







Mums






























































































































Roses































Beth








Mary





Roses






78
Rotating Beths diagram II





Mums





































































































Mary





Roses






79


Rotating Beths diagram III





Mums












80


Rotating Beths diagram IV





Roses



























































































Beth





















Mums













81
Rotating Beths diagram V
0
0
Roses
82
Edgeworth Box Function Bargaining from
endowment point A
Beth
0
A
?
Mary
0
83
Edgeworth Box Function Bargaining from
endowment point A
Beth
0
A
?
Mary
0
84
Recall the well of McNabb and Zepp Would they
want to move the well?
? well
? Zepp
? McNabb
85
Would McNabb and Zepp wish to move the well to
another location?
? well
? Zepp
? McNabb
Are the two green lines longer than the red line?
86
Would McNabb and Zepp wish to move the well to
another location?
? well
? Zepp
? McNabb
Any point on the line joining the two house
minimizes the distance the water must travel
87
Edgeworth Box Function Bargaining from
endowment point A
Beth
0
A
?
Mary
0
88
Edgeworth Box Function Bargaining from
endowment point A
Beth
0
Rosesbeth
Mumsmary
Mumsbeth
A
?
Rosesmary
Mary
0
89
Paretian standardsVilfredo Pareto (1848-1923)

• Pareto-superiority A transformation from A to B
  is Pareto-superior if at least one person is
  better off and no one is worse off
• Pareto-optimality No further Pareto-superior
  transformations are possible

90
Are these attractive moral standards?

• Exclude envy the envious person is worse off if
  another is better off
• Exclude spite the spiteful person is better off
  if another is worse off

91
B and C as Pareto-superior to A D and E as
Pareto-inferior
Beth
E
?
A
?
C
?
?
B
?
D
Mary
Coleman, 8 Hofstra L.Rev. 905 (1980)
92
Are all bargaining gains exploited at F?The
bargaining lens shrinks through bargaining
Beth
E
?
A
?
C
F
?
?
?
B
?
D
Mary
93
Are all bargaining gains exploited at G?The
bargaining lens disappears when the indifference
curves are tangent
Beth
E
?
A
?
C
F
?
?
?
G
?
B
?
D
Mary
94
The Contract Curve All possible Pareto-optimal
contracts represented at the points of tangency
Beth
E
?
A
?
C
?
F
?
?
G
?
B
D
?
Mary
95
Efficient BreachAssume that the endowment point
is ROand that the parties bargain to RC
Beth
RO
?RC
Mary
96
But now Beths preferences shift so that she
would now be considerably worse off at Rc than
she is at Ro
Beth
RO
?RC
Mary
97
Damages are compensatory they put the injured
party in the same position she would be in had
the breach not occurred (i.e., had the contract
been performed)
Beth
RO
For Mary, this is Rc
?RC
Mary
98
This implies that damages of Ro-Rf will
compensate Mary for the breach
Beth
Mary is as well off at Rf as she is at Rc
RF
RO
Goetzs quasi-performance indifference curve
?RC
Mary
99
A note about remedies in contract law

• Damages give the innocent party his expectation
  interest, or the benefit of what he would have
  received had the contract been performed.
• Specific performance is the exceptional remedy at
  common law but the presumptive one in civil law
• The reliance interest gives the innocent party
  only such damages as she incurred by actually
  relying on the party in breach. This is NOT the
  remedy in contract.

100
Damages of Ro-Rf will give Mary her expectation
interest
Beth
Mary is as well off at Rf as she is at Rc
RF
RO
Goetzs quasi-performance indifference curve
?RC
Mary
101
Would Pareto smile?

• At Rf, the party is breach is better off than she
  would be on performance and the injured party is
  no worse off than she would be on performance
• Does it bother you that the gains from breach
  accrue solely to the party in breach

102
Do you agree with Oliver Wendell Holmes?

• The law of damages does not stigmatize breach or
  treat it as a moral flaw. Instead it gives the
  party the option of performance or damages for
  breach. That is simply a financial issue.
  Morality has nothing to do with it.

103
Would Pareto smile at the law of damages?

• At Rf, the party is breach is better off than she
  would be on performance and the injured party is
  no worse off than she would be on performance
• Does it bother you that the gains from breach
  accrue solely to the party in breach
• Is the rule of efficiency nevertheless one in
  which Beth should have an incentive to breach?

104
Would Pareto smile at the law of damages?

• At Rf, the party is breach is better off than she
  would be on performance and the injured party is
  no worse off than she would be on performance
• Does it bother you that the gains from breach
  accrue solely to the party in breach
• Is the rule of efficiency nevertheless one in
  which Beth should have an incentive to breach?
• Would a right to specific performance on breach
  be inefficient?

105
Beth would be willing to pay Mary up to Ro-Rsp to
avoid an order of specific performance
Beth
RSP
RF
What happens to the incentive to breach, however?
RO
?RC
Mary
106
Government Grants Matthews v. Massell

• Revenue Sharing was a Nixon plan to promote
  federalism by transferring funds from the federal
  government to the states to be spent for the
  purposes listed in 103(a).
• Spending funds for other purposes was penalized
  under 123(a).
• What did Mayor Massell say he would do with the
  Revenue Sharing Funds?
• How would you represent all this in a diagram?

107
Government Grants Matthews v. Massell
Dollars spent on non-priority purposes
Here we assume that the preferences of the
entire city Can be represented with a single
Indifference Curve
Dollars spent on priority purposes
108
Government Grants Matthews v. MassellThe Budget
Line before the federal grant
Everything spent on non-priority purposes
Everything spent on priority purposes
109
Government Grants Matthews v. Massell
non- priority purposes
Put them together and you have the consumption
decision before the grant
yNG
xNG
priority purposes
110
How would you represent revenue sharing as
envisaged by President Nixon?
non- priority purposes
yNG
priority purposes
xNG
111
How would you represent revenue sharing as
envisaged by President Nixon?
non- priority purposes
The budget line shifts outward but not in a
parallel way
yNG
priority purposes
xNG
112
How would you represent revenue sharing as
envisaged by President Nixon?
non- priority purposes
This implies a different consumption decision
y
xG
priority purposes
xNG
113
How would you represent revenue sharing as
envisaged by President Nixon?
non- priority purposes
Note that, as I drew this, there was no
difference between YNG and YG. But this was
arbitrary. If YG gt YNG, would this be consistent
with the statute?
y
xG
priority purposes
xNG
114
How do you think the mayor envisaged revenue
sharing?
non- priority purposes
The budget line shifts outward in a parallel way
yNG
priority purposes
xNG
115
How do you think the mayor envisaged revenue
sharing?
non- priority purposes
The budget line shifts outward in a parallel way
yNG
priority purposes
xNG
116
How do you think the mayor envisaged revenue
sharing?
non- priority purposes
As I have drawn it (and as the mayor saw
it) this means a lot more consumption of
non-priority purposes.
yNG
priority purposes
xNG
117
Some final questions

• Suppose the mayor had kept his mouth shut. What
  would the court have done?

118
Some final questions

• Do you see a parallel between this case and
  welfare schemes? How would you represent
• A grant of money to the poor
• A reduction in income tax
• Subsidized housing
• A free bread program

119
Do you see the parallel to Tilton v. Richardson

• Under the US Constitution, Congress shall make no
  law to establish a religion or to prevent the
  free exercise of religion
• Tocqueville In America, the state is relatively
  small and its place is taken by private
  associations, such as churches.
• President Bushs faith-based initiative would
  have more welfare programs undertaken by churches
  or synagogues.

120
How do you think the court would handle a grant
to a church without strings attached?
religious purposes
But isnt the waiver of property taxes on
churches like this?
non-religious purposes
121
So what about a grant exclusively for
non-religious purposes?
religious purposes
y
xG
non-religious purposes
xNG
122
Suppose the indifference curves look like this??
religious purposes
And just how do you suppose the churchs
indifference curve looks?
yG
yNG
non-religious purposes
xNG
123

• What do you think of the argument that, to avoid
  religious entanglement all grants of any kind
  to Catholic colleges should be banned?