Econ 522Economics of Law

Dan QuintFall 2009Lecture 9

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Office hours between now and midterm: Me: Tomorrow 1:30-3:30, Monday 1:30-3:30 Chao: Thursday 1:00-3:00, Monday 10:00-1:30

Midterm #1 next Tuesday, in class No contract law

Logistics

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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

Plan

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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?

So last Thursday, I’m flying from Boston to Montreal…

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Contract Law

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Subgame perfect equilibrium: I’ll keep all the money; so you don’t trust me Inefficient outcome (100 < 200) And we’re both worse off

Example: the agency (trust) game

Player 1 (you)Trust me Don’t

Player 2 (me)

Share profits Keep all the money

(150, 50) (0, 200)

(100, 0)

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(One solution: reputation)

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Now we get cooperation (and efficiency) Purpose of contract law: to allow trade in situations where

this requires credible promises

Another solution: legally binding promises

Player 1 (you)Trust me Don’t

Player 2 (me)

Share profits Keep all the money

(150, 50) (125, 25)

(100, 0)

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“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.”

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

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The Bargain Theoryof Contracts

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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

The bargain theory of contracts

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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

What is consideration?

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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

What is consideration?

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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 uncle’s 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.”

The bargain theory does not distinguish between fair and unfair bargains

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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

Under the bargain theory, what is the remedy?

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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

Problems with the bargain theory

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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: I’m 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 I’ve already promised it to you

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Efficient breach

Example: I’m 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 I’ve already promised it to you

Breach is efficient when promisor’s cost of performing is greater than promisee’s benefit from performance

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Efficient breach

Example: I’m 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 I’ve already promised it to you

Breach is efficient when promisor’s cost of performing is greater than promisee’s benefit from performance

Question: how do we get breach only when it’s efficient?

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Remedies and efficient breach

Breach is efficient when promisor’s cost of performing is greater than promisee’s benefit from performance

Self-interest: promisor will breach when cost of performing is greater than liability from breach

So when liability from breach = promisee’s benefit, promisor will choose to breach exactly when it’s 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) > (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

Thursday: examples of efficient breach and reliance, and paper by Ayres and Gertner