Economics of Contract Law Agency Game I Give me $100 and I’ll turn it into $200 and share the gain with you
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Transcript Economics of Contract Law Agency Game I Give me $100 and I’ll turn it into $200 and share the gain with you
Economics of
Contract Law
Agency Game I
Give me $100 and I’ll turn it into $200 and share
the gain with you
Do you trust me?
No! Player 2 has DS to breach
Player 2
Player 1
Perform
Breach
Contract
150, 50
0, 200
Don’t Contract
100, 0
100, 0
Solutions?
Reputation in a repeated game
Contract law
Agency Game II
Suppose we sign a contract in which I am
punished if I run off with the money
Court forces me to pay you $150 and charges each of us
an additional $25 fee for doing so
Player 2
Player 1
Perform
Breach
Contract
150, 50
125, 25
Don’t Contract
100, 0
100, 0
1st Purpose of Contract Law is to enable people to cooperate
Requires a way to make a promise credible (some sort of commitment)
Example 1
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.
Example 2
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.
Example 3
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 to pay
$500 in punitive damages.
Bargain Theory of Contracts I
A promise should be enforced if it was given in a
bargain, otherwise it should not.
Offer
Acceptance
Consideration
Promisor: person who gives a promise
Promisee: person who receives it
“reciprocal inducement”
Rich uncle: no consideration offered
Disputed car: no “meeting of the minds”
Grasshopper killer: enforceable bargain
How do you enforce a gift promise?
Bargain Theory of Contracts II
What should the remedy be for broken promises?
Expectations damages: amount promisee could
reasonably expect from performance
Problems with the Bargain Theory
Requires all promises to have consideration
Car shopping and a “firm offer”
Requires that all bargains be enforced
Grasshopper killer?
Economic efficiency requires enforcing a
promise that both parties want enforced.
Economic Theory of Contract
1st Purpose of Contract Law is to enable people to cooperate
Rich uncle: both want the promise enforced
Disputed car: no cooperative surplus
Grasshopper killer: enforce the promise to discourage
deceit by promisor
2nd Purpose of Contract Law is to encourage
efficient disclosure of information
Used car market
You value my car 50% more than I do
Asymmetric information exists
No mechanics
[0---------------------------5000]
$2500
(your guess as to value of car to me)
[0-------------------3000]
$1500
(your revised guess as to value of car to me)
Suppose you offer $3000
You will end up paying
$3000 for a car that’s only
worth $2250 to you
3rd Purpose of Contract Law is to secure optimal
commitment to performing.
What should be the remedy for efficient breach?
Painting sale
You value my unfinished painting at $1000
We agree on a sale price of $600 upfront
Crazy cousin makes $5000 offer
It’s efficient for me to breach contract with you:
Cost of performance > benefit you will get from the painting
Airplane sale
You value my plane at $500,000
We agree on a sale price of $350,000
Before construction begins, price of metal rises and raises my
cost to $1,000,000
3rd Purpose of Contract Law is to secure optimal
commitment to performing.
Optimal Performance
If promisor’s cost of performing > promisee’s benefit from
performing, then
breach
is efficient
If promisor’s cost of performing < promisee’s benefit from
performing, then performance is efficient
Choice of remedy is critical
If penalty for breach is too severe, the promisor will have
to perform, even though breach may be efficient
If penalty for breach is too weak, the promisor will breach
when efficiency requires performance
3rd Purpose of Contract Law is to secure optimal
commitment to performing.
Actual Performance Decision:
If promisor’s cost of performing > promisor’s liability for
breaching, then he will breach
If promisor’s cost of performing < promisor’s liability for
breaching, then he will perform
Perfect Expectations Damages
Promisor’s liability = promisee’s benefit from performance
Restores promisee to position he would have enjoyed if
promise had been kept
Painting Sale I
You value my unfinished painting at $1000
We agree on a sale price of $600 upfront
Crazy cousin makes $5000 offer
Buyer
Painter
Buy
Don’t Buy
Perform
600, 400
------
Breach
-400,
4600,5400
5600,
-400
600
------
What are Expectation Damages?
DE = $1000
What if D = $6000
Painter breaches and it is efficient
Painter performs though breach is efficient
Painting Sale II
You value my unfinished painting at $1000
We agree on a sale price of $600 upfront
Crazy cousin makes $5000 offer
Assume simple DE
Buyer purchases frame for $50 which raises value
of painting to $1200
Buyer
Painter
Rely
Don’t Rely
Perform
600, 550
600, 400
Breach
4400, 550
4600, 400
Whether painter performs or not, reliance makes you better off
But, is reliance efficient?
4th Purpose of Contract Law is to secure
optimal reliance.
If Expected Gain from Reliance > Cost of Reliance
then Reliance is efficient
p = probability of performance
∆V = increase in value of performance due to reliance
c = cost of reliance
If p(∆V) > C then reliance is efficient
Painter ex:
∆V = 200
c = 50
p* = 0.25
When the probability of performance is high,
more reliance tends to be efficient
4th Purpose of Contract Law is to secure
optimal reliance.
Warning: if my damages cover your benefit
whether or not it’s efficient, then you’ll always
spend on reliance (over-reliance)
Solution: Perfection Expectations Damages
damages needed to restore the promisee had the
promise been kept, and had he relied the optimal
amount
Foreseeability Doctrine
“Reasonably expected” reliance
Hadley v Baxendale (1854)
Hadley ran a mill and crankshaft broke
Baxendale was to deliver it to engineers
Delayed one week (used boat rather than rail)
Hadley sued for week’s worth of lost profits
Court ruled lost profits were not foreseeable
5th Purpose of Contract Law is to minimize
transaction costs of negotiating contracts by
supplying efficient default rules
Gaps: contract is silent about risks
Inadvertent gaps: not foreseeable
Deliberate gaps: remote risks
Cost of allocating a risk > Expected cost of allocating a loss leave gap
Cost of allocating a risk < Expected cost of allocating a loss fill gap
Default rules
Compute hypothetical bargain
Who can bear risk at lowest cost?
Adjust price of the contract
McGuire v Wabash
McGuires hire Wabash to build new house
Price of copper rises by $2000 and contract is silent
McGuires refuse to pay extra $2000
Suppose Wabash knows that copper costs could rise
by $2000 with p = 0.50
Expected cost = (0.50)(2000) = $1000
Suppose Wabash could’ve hedged risk for $400
Hypothetical bargain
Who is the low cost bearer of risk? Wabash
If risk was foreseeable, Wabash would charge extra $700
McGuires pays $700
Wabash absorbs $1300 loss
Perfect Contracts and Market Failures
Perfect Contract
All risks is efficiently allocated
All relevant information is communicated
All resources allocated to those who value it the most
Individual Irrationality
Incompetence
Dire constraints
Necessity
Duress
Transactions Costs
Spillovers
Asymmetric information
Monopoly
Exceptions to
perfect contracts
6th Purpose of Contract Law is to foster enduring
relationships, which solve the problem of cooperation
with less reliance on the courts to enforce contracts
Coffee shop and the forgotten wallet
Prisoner’s Dilemma
One-shot game: DS is to cheat
Repeated game: Cooperative outcome is Pareto Optimal
“tit-for-tat” strategy
“Rarely will buyers leave saying they bought the wrong
goods at too high
a price. Our
goal is
to make them eager to
NY Diamond
Dealer’s
Club
come back. We offer a source which provides a competitive
edge, all of which translates directly into increased profits.”
Endgame Problem
Peevyhouse v Garland Coal (1962)
Peevyhouse owned farm in Oklahoma
Garland contracted to strip-mine coal
Contract specified that Garland would take steps to restore
land to previous condition
Garland breached
Peevyhouse sued for $25,000
Restorative costs were estimated to be $29,000 at trial
Garland showed that “diminished value” of farm was only $300
Original jury awarded $5000 to Peevyhouse
OK Supreme Court reduced damages to $300
Efficient breach?
Dissent: specific performance was warranted, otherwise no
formation would have occurred