Econ 522 Economics of Law

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Econ 522Economics of Law
Dan Quint Fall 2009 Lecture 10
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Logistics

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

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Tuesday

• Why do we need contracts?
• What promises should be enforced?
• Bargain Theory of Contracts
• Efficiency
• First purpose of contract law enable cooperation
• Second purpose of contract law encourage
  efficient disclosure of information
• Third purpose of contract law secure optimal
  commitment to performance (efficient breach)
• Fourth purpose of contract law secure optimal
  reliance

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Efficient Breach
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Efficient Breach
Efficiency
gt
PromisorsCost
PromiseesBenefit
Efficient to Breach
?
lt
PromisorsCost
PromiseesBenefit
Efficient to Perform
?
Self-Interest (incentives of promisor)
gt
PromisorsCost
Promisors Liability
Promisor will Breach
?
lt
PromisorsCost
PromisorsLiability
Promisor will Perform
?
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Example of efficient breach
Value to you 500,000 Price 350,000

• I build airplanes
• You value one of my planes at 500,000
• You agree to buy one for 350,000, and pay up
  front
• After you pay, price of materials goes up

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Example of efficient breach
Value to you 500,000 Price 350,000
gt
PromisorsCost
PromiseesBenefit
Efficient to Breach
?

• Promisees benefit 500,000
• If it costs me less than 500,000 to build plane,
  efficient to build it
• If it costs me more than 500,000, efficient to
  breach

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Example of efficient breach
Value to you 500,000 Price 350,000
gt
PromisorsCost
PromisorsLiability
Promisor will Breach
?

• Liability is just to return your money
• If my costs rise to 400,000, performance is
  still efficient, but Ill choose to breach
• Liability is 1,000,000
• If costs rise to 700,000, performance is
  inefficient, but Id rather perform than breach
• Liability promisees benefit (500,000)
• Ill perform when performance is efficient,
  breach when breach is efficient

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But so what? Cant we justCoase back to
efficiency?
Value to you 500,000 Price 350,000

• Liability is 350,000, my costs rise to 400,000
• Ill breach original contract, but we can
  renegotiate to higher price
• But I might try to do that even if my costs dont
  go up
• Liability is 1,000,000, my costs rise to
  700,000
• Rather than performing, I can offer you money to
  let me cancel contract
• But my threat point is very low you can demand
  a lot of money
• If I realize that might happen, maybe Im afraid
  to sign original contract
• Expectation damages avoid these problems

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Another way to think about expectation damages
eliminating an externality

• If I breach contract, I impose externality on you
• Youre 500,000 worse off
• If I have to pay you 500,000, then I internalize
  the externality
• Now my action no longer affects your well-being
• So I choose efficiently when deciding whether to
  perform or breach

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Reliance
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Next Reliance

• Reliance investments you make to increase your
  benefit from performance
• Increases my liability if I breach
• If expectation damages include added benefit due
  to reliance, leads to more than efficient level
  of reliance
• Theres some chance Ill need to breach the
  contract
• Your reliance investments increase my liability
  from breach, so they impose a negative
  externality
• Activities which impose negative externality
  happen too much
• Overreliance

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Reliance and Damages example

• Reliance increases your benefit from my promise
• Airplane gives you benefit of 500,000
• Costs 75,000 to build a hangar
• Airplane with hangar gives you benefit of
  600,000
• Suppose price is 350,000, to be paid on delivery
• Expectation damages restore you to well-being you
  expected to have from performance
• Without a hangar, if I breach, I owe you 150,000
• If you build a hangar and I breach, do I owe you
  250,000?

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Reliance and damagesexample
Price of plane 350,000 Value of plane
500,000Cost of hangar 75,000Value of plane
hangar 600,000

• Cost of building plane maybe 250,000, maybe
  700,000
• Clearly, youll choose to build the hangar
• But, is that efficient?

You dont
You build hangar
I get
You get
I get
You get
350 - 250 100
500 - 350 150
350 - 250 100
600 - 75 - 350 175
Costsstay low
-150
150
-250
- 75 250 175
Costsrise
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Reliance and damagesexample
Price of plane 350,000 Value of plane
500,000Cost of hangar 75,000Value of plane
hangar 600,000

• Let p be probability my costs go up
• Combined expected payoffs if you rely
• (1 p) (175 100) p (175 250)
• 275 (1 p) 75 p 275 350 p
• Combined expected payoffs if you dont rely
• (1 p) (150 100) p (150 150)
• 250 (1 p) 250 250 p
• Which is bigger?
• 275 350 p gt 250 250 p
• 25 gt 100 p p lt ¼
• So if p lt ¼, reliance is efficient if p gt ¼,
  its not
• But youre going to rely either way!

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What do we learn?

• When probability of breach is low, more reliance
  tends to be efficient
• When probability of breach is high, less reliance
  tends to be efficient
• If expectation damages include increased benefit
  from reliance, we sometimes get overreliance
• (OTOH, if expectation damages exclude increased
  benefit from reliance, liability lt benefit, so
  inefficient breach)

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So what do we do?

• 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

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So what do we do?

• 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

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Foreseeable reliance Hadley v Baxendale

• 1850s England
• Hadley owned gristmill, mill shaft broke
• Baxendales firm hired to transport shaft for
  repair
• Baxendale shipped by boat instead of train,
  making it a week late
• Hadley sued for the weeks 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
  didnt have to pay

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Default Rules
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Default rules

• Gaps risks or circumstances that arent
  specifically addressed in a contract
• Default rules rules applied by courts to fill
  gaps

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Default rules

• Gaps risks or circumstances that arent
  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

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What should default rules be?

• 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

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What should default rules be?

• 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

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Default rules

• Dont want ambiguity in the law
• So default rule cant 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

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Default rules

• Example probability ½, the cost of construction
  will increase by 2,000
• Construction company can hedge this risk for 400
• Family cant do anything about it
• Price goes up who pays for it?

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Default rules

• Example probability ½, the cost of construction
  will increase by 2,000
• Construction company can hedge this risk for 400
• Family cant 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?

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Default rules

• Example probability ½, the cost of construction
  will increase by 2,000
• Construction company can hedge this risk for 400
• Family cant 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
  constructioncompany
• Should prices be adjusted to compensate?

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Default rules

• So, Cooter and Ulen say set the default rule
  thats 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

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Default rules a different view

• 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

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Penalty defaults Hadley v Baxendale

• Baxendale (shipper) is only one who can influence
  when crankshaft is delivered so hes 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

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Penalty defaults other examples

• 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 its
  efficient to change this

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Penalty defaults other examples

• 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 its
  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

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When to use penalty defaults?

• 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.

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Default rules versus regulations

• Default rules can be contracted around
• Some rules cannot immutable rules, or mandatory
  rules, or regulations
• Fifth purpose of contract law is to minimize
  transaction costs of negotiating contracts by
  supplying efficient default rules and
  regulations.
• Coase if individuals are rational and there are
  no transaction costs, private negotiations lead
  to efficiency
• So additional regulations would just get in the
  way
• So regulations only make sense when people are
  not rational, or when there are transaction
  costs/market failures