Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 10.

Econ 522Economics of Law

Dan Quint

Spring 2010

Lecture 10

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Midterm on Wednesday

Office hours tomorrow Me (Soc Sci 7428) 9:30-11:30 a.m. Fran (Soc Sci 6443) 12:30-2:30 p.m.

Logistics

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Why do we need contracts? To get cooperation/trade when transactions aren’t instantaneous

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

Last week…

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Breach

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A contract is just a promise The idea here is that we want some promises to be legally binding This means there has to be some legal consequence for breaking

such a promise

Breach of contract is when the promisor fails to live up to his promise Just like property rights are meaningless unless there is a remedy

when they are violated… …contract law is meaningless unless there is a penalty for breach

So, what happens when a contract is breached?

So…

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Why does the penalty for breach matter?

If penalty is too weak, contract law has no bite, and we’re back to our original problem

But sometimes, circumstances change, and breach of contract becomes desirable Example: I promise to sell you a painting

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Why does the penalty for breach matter?

If penalty is too weak, contract law has no bite, and we’re back to our original problem

But sometimes, circumstances change, and breach of contract becomes desirable Example: I promise to sell you a painting Example: I promise to build you a plane If penalty for breach is too severe, I’ll have to honor these promises even

when this is inefficient

Can we design the law so that we only get breach of contract when it’s efficient?

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When is breach efficient?

Breach is efficient if

social benefit of breach > social cost of breach

Social cost of breach is that promisee doesn’t get the benefit from the promise

Social benefit of breach is that promisor doesn’t have to incur the cost of delivering (performing)

So breach is efficient if

promisor’s cost to perform

> promisee’s benefit from performance

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Efficient Breach

Promisor’sCost

Promisee’sBenefit Efficient to Breach

Promisor’sCost

Promisee’sBenefit Efficient to Perform

Efficiency:

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When do we expect breach to happen?

Promisor weighs private cost of performance vs breach

Whatever the penalty for breach, if it’s cheaper to perform, promisor will perform; if it’s cheaper to breach, he’ll breach

That is, we expect breach to occur whenever

promisor’s cost to perform

> penalty for breach

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Efficient Breach

Promisor’sCost

Promisee’sBenefit Efficient to Breach

Promisor’sCost

Promisee’sBenefit Efficient to Perform

Promisor’sCost

Promisor’s Liability Promisor will Breach

Promisor’sCost

Promisor’sLiability Promisor will Perform

What will actually happen (incentives of promisor):

Efficiency:

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So how do we get efficient breach?

Promisor’sCost

Promisee’sBenefit Efficient to Breach

Promisor’sCost

Promisor’s Liability Promisor will Breach

What will actually happen (incentives of promisor):

Efficiency:

Promisor’sLiability

for Breach

Promisee’sBenefit fromPerformance

So if we design the law such that

the promisor will breach exactly when breach is efficient

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Efficient breach

When liability from breach = promisee’s benefit from performance, we get breach exactly when it’s efficient So for efficiency, when a promisor breaches a contract, we want him

to owe a penalty exactly equal to the benefit the promisee expected to receive

This is called expectation damages Expectation damages: if I promise you something that has value of

$100 to you, and then I break my promise, I owe you $100 This way,

if it costs me more than $100 to keep my promise, I’ll break it, which is efficient

if it costs me less than $100 to keep my promise, I’ll keep it, which is efficient

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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

Example of efficient breachValue to you = $500,000

Price = $350,000

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Promisee’s 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

Example of efficient breachValue to you = $500,000

Price = $350,000

Promisor’sCost

Promisee’sBenefit Efficient to Breach

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Liability is just to return your money If my costs rise to $400,000, performance is still efficient, but I’ll choose to

breach

Liability is $1,000,000 If costs rise to $700,000, performance is inefficient, but I’d rather perform than

breach

Liability = promisee’s benefit ($500,000) I’ll perform when performance is efficient, breach when breach is efficient

Example of efficient breachValue to you = $500,000

Price = $350,000

Promisor’sCost

Promisor’sLiability Promisor will Breach

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Liability is $350,000, my costs rise to $400,000 I’ll breach original contract, but we can renegotiate to higher price But I might try to do that even if my costs don’t 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 I’m afraid to sign original contract

Expectation damages avoid these problems

But so what? Can’t we just“Coase” back to efficiency?

Value to you = $500,000

Price = $350,000

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If I breach contract, I impose externality on you You’re $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 (You get a payoff of $500,000 if I build the plane, and a benefit of

$500,000 if I don’t.) So I choose efficiently when deciding whether to perform or breach

Another way to think about expectation damages: eliminating an externality

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Reliance

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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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When is reliance efficient?

When social benefit of reliance > social cost of reliance

Social benefit is increased benefit to promisee when promise is performed

Social cost is cost borne by promisee, whether or not promise is performed

So reliance is efficient as long as(probability of performance) X (increase in value) > (cost)

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Efficient reliance

Efficiency: reliance is efficient as long as(probability of performance) X (increase in value) > (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) > (cost) So if yes, promisee will overrely

(Another way to think about this: there’s some chance I’ll have to breach If your reliance increases my liability, then it increases the expected damages

I’ll owe, which makes me worse off If your reliance imposes a negative externality, you’ll do it more than the

efficient amount)

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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?

Reliance and Damages: example

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Cost of building plane: maybe $250,000, maybe $700,000

Clearly, you’ll choose to build the hangar But, is that efficient?

Reliance and damages:example

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000

-150150-250- 75 + 250 =

175Costsrise

350 - 250 =

100500 - 350 =

150350 - 250 =

100600 - 75 - 350 =

175Costsstay low

I getYou getI getYou get

You don’tYou build hangar

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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 don’t rely:

(1 – p) (150 + 100) + p (150 – 150)

= 250 (1 – p) = 250 – 250 p Which is bigger?

275 – 350 p > 250 – 250 p

25 > 100 p p < ¼ So if p < ¼, reliance is efficient; if p > ¼, it’s not But you’re going to rely either way!

Reliance and damages:example

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000

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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 < benefit, so inefficient breach)

What do we learn?

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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

So what do we do?

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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

So what do we do?

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1850s England Hadley owned gristmill, mill shaft broke Baxendale’s firm hired to transport shaft for repair Baxendale shipped by boat instead of train, making it a week late Hadley sued for the week’s 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 didn’t have to pay

Foreseeable reliance: Hadley v Baxendale

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Default rules What principles should we use to address contingencies not

considered in a contract? Paper by Ayres and Gertner on syllabus

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