The Economics of Contracts Chapter 10 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

1

The Economics of ContractsChapter 10


2

Introduction

3

A Tale of Two Tank Farms


BP ARCO Corporation’s refinery in Carson, California, near Los Angeles. The refinery is the only such facility in its

area, and BP ARCO owns all of the tanks.

Industrial waterfront in Bayonne, New Jersey, with

tanks as far as the eye can see. Some are owned by Bayonne’s

many refiners and petrochemical producers, and

some are the property of specialists like PD Oil and

Chemical Storage, Inc.

4

What’s Next?


Any mutually agreed-upon exchange creates economic value. The benefits of any transaction, however, can be increased if its terms are better tailored to the parties’ particular situations. Our

basic transaction and market models were purposely simple—a standardized good changed hands at the same time payment was made. Now we look in more detail at the arrangement and

enforcement of more complex agreements to see the benefits and difficulties they can create.

5

SPECIFIC INVESTMENTS AND OPPORTUNISM



6

What a Contract Does or Doesn’t Allow – The Missing $6 Million

In 2004 food supplier Gate Gourmet had halted all deliveries to Delta. The companies, of course, had a

contract, but several months earlier Delta had refused to pay Gate Gourmet $6 million, claiming it was an overcharge under the contract’s terms. Unable to resolve the dispute and concerned about Delta’s

worsening financial condition in a declining market for air travel, Gate Gourmet ceased food deliveries.

7

What a Contract Does or Doesn’t Allow – The Missing $6 Million


Why might such a dispute have arisen?

1. Delta was financially stressed and may have chosen to claim that a payment it properly owed Gate Gourmet was in fact an overcharge.

2. Gate Gourmet might have known that its billing was questionable but nevertheless took the chance that Delta would pay routinely or quickly settle over part of it rather than risk interruption.

3. The contract may have been silent about the $6 million, which (let us assume) arose in a situation that neither party had expected when they negotiated their contract. Now that the situation had materialized, they would either negotiate a settlement or go to court if they could not reach one.

8

What a Contract Does or Doesn’t Allow - Opportunism


An outsider cannot definitively determine why Delta refused to pay or Gate Gourmet stopped delivering.

They may have reasonably differed over exactly what the contract required. The contract language may

have been unclear or might not have addressed some particular situation they found themselves in. It is

also possible that Delta or Gate Gourmet was trying to profit from actions it knew the contract mightnot allow, hoping the other party would drop the dispute or pay up. Such actions are examples of

opportunistic behavior or opportunism, competing not just according to preestablished rules but also by

breaking or bending those rules.

9

What a Contract Does or Doesn’t Allow - Opportunism


Up to now in our study of economics we have only seen sellers who competed for the business of

buyers on the basis of price, product design, or other aspects of their transactions. Opportunism adds the possibility that a party can gain by disregarding or

breaking the rules. Opportunismthen entails transaction costs the parties will wish to

minimize, and they will attempt to do that by their choices of contract provisions.

10

Specific Assets and Opportunism - The Importance of Specific Assets


The food preparation facilities Gate Gourmet uses to serve Delta are examples of specific assets, those that create more

economic value when making meals for Delta than in any alternative use.

Many aspects of specificity can raise the cost of redeployment and the risks of opportunism:

1. Task specificity: Specialized equipment is often necessary for low-cost production.

2. Locational specificity: Once built, facilities like electrical generators are immovable.

3. Dedicated specificity: Gate Gourmet’s capital probably included equipment that it only bought in the expectation that Delta would remain a customer for a long time.

4. Human specificity: Workers can also have degrees of specificity.

11

Specific Assets and Opportunism – Why Limit Your Options?


Having a choice of many trading partners at all times is

not always as desirable as may first appear. More value might be created if a buyer agrees to limits on

his ability to deal with different producers or if a seller agrees not to deal with customers other than

this particular buyer.For example, the buyer might promise to take delivery of a specified amount of some good in every

week of the next year, with delivery and payment dates specified in advance. Such an agreement can

give the seller the benefit of a steady operation.

12

Vertical Integration – The Refineries Revisited


An oil refinery is an ideal example of a highly specific asset.

A refinery is a custom-constructed complex of very costly equipment, much of which is useless for any purpose other than processing crude oil. For this

example, one more aspect of specificity is important: refining oil requires a continuous flow of feedstocks

and coordination of many distinct operations. A quick or unexpected shutdown of the refinery can damage costly equipment, and even a startup that

follows a nonemergency shutdown can cost millions.

13

Vertical Integration – Why Vertical Integration?


Now we can explain why a stand-alone tank farm is feasible in Bayonne while the refinery in Carson owns all of its tanks. An

extensive systemof railroads and pipes on the New Jersey waterfront gives over 50 nearby refiners and petrochemical producers the option to

store with PD. That company can survive as a standalone specialist in storage because it need not do business in the

future with a customer who tries to act opportunistically—there are many others in the area who might use its tanks.

If BP ARCO’s only alternative to self-storage is an independent operator next door (who has no other potential customers), there will be incentives for opportunistic behavior and BP ARCO is better off vertically integrating into the storage

business.

14

What Happened to Coase?


Coasian reasoning puts the example of the refiner and the storage operator into perspective. The risks of

opportunistic behavior illustrated by that example will vanish if their agreement is complete and not subject to uncertain or ambiguous interpretations. Any real

contract between a refiner and tank owner would permit deviations from the

contract price only in precisely defined situations. Behind every contract stands a body of commercial law that has developed over centuries and that tells

the parties how acourt is likely to rule if a dispute arises.


15

DAMAGES FOR BREACH OF CONTRACT

16

Liquidated Damages and Penalties


Two parties who enter into an efficient contract can create more economic value than they can without a

contract. Contracts often require the parties to invest in specific resources. Breach by one of them leaves

these investments worth less than if both had kept to the agreement. The legal remedy for a breach is

often liquidated damages. Assume that Jones breaches a contract with Smith that would have

created substantial economic value had they both performed as agreed upon. If a court determines that there was a breach, their contract may specify that

Jones pay Smith a particular form of them called expectation damages.

17

Liquidated Damages and Penalties


If Jones and Smith limit themselves to one well each, they can each earn $15 net of the costs of sinking the

wells and other expenses. If they each have two wells, each makes $10. Under expectation damages, Jones’s breach entitles Smith to a $10 payment from him. As long as Jones extracts between $15 and $25

worth of oil when he breaches, the expectation damages will deter him from doing so.

18

Can Breach Be Desirable?


We often speak of “sanctity of contracts” or assert that “a deal is a deal,” but in certain situations breaching an agreement can be economically efficient, because

it creates more value for the two parties than they can get if they both abide by the contract.

Assume that Jones is the producer of a certain good and Smith is the purchaser. Suppose a purchaser approaches Jones and offers

to pay $35 for the goods promised to Smith. Here a breach of contract is efficient. Because it increases value.

19

Specific Performance


In some contract disputes a court will require the breaching party to take a particular action rather than

pay damages. Assume that you are assembling a group of lots on which you intend to build a shopping mall. You want to keep their owners unaware of your intentions,

because the value of each acre will jump after you acquire all of the lots. Assume that the last of the owners has contracted to sell you her land for $1 million, but just

before conveying the title she learns about the mall and refuses to deal with you. In this case a court will probably

order specific performance, in which the owner must accept the originally agreed-on price for her property and

turn it over to you.Specific performance makes economic sense when lost economic value is hard to calculate.


20

PRINCIPALS AND AGENTS

21

Observability and Opportunism


Remittances by foreigners working in the United States to their home countries are a little-noticed form of foreign

aid. Often the senders want the members of their households to spend the funds in particular ways, while

the recipients prefer to spend them otherwise. Many senders want their relatives to purchase materials to build

homes that the senders plan on occupying when they return from the United States.

A sender faces a principal/agent problem. The sender is the principal, who wishes to see the house

built according to his specifications. The sender would greatly value the services of someone who could monitor the relatives more closely or better

yet, make sure that they were buying the right materials.

22

Payment Arrangements – Inducing Effort


Assume that you have been injured while using a product you recently

purchased. Perhaps a bottle unexpectedly exploded or a gadget released a toxic chemical when you inadvertently dropped it. You contact an attorney who believes you are likely to win if you sue the manufacturer. You are the principal and the attorney is your

agent.You cannot personally observe her during the hours she claims to be working on your behalf. Even if you could watch you could not

evaluate thequality of the motions she files or her negotiations with the

defendant’s attorneys. Knowing that you cannot evaluate the diligence of her efforts or the quality of her work, she might act

opportunistically.

23

Payment Arrangements - Payment, Performance and Information


In a case like this, your lawyer would probably work on a the basis of a contingent fee arrangement, taking a portion of any

settlement as pay for the work done. A contingency arrangement partially aligns your interests and your

attorney’s in maximizing the amount recovered.To see the importance of incentives let’s look at a payment

scheme that fails. Assume that (for unknown reasons) you and the attorney agree to a fixed dollar payment at the outset and no

more in the future regardless of how the case develops. An arrangement like this (known in medicine as capitation, where it

is frequently seen) fails on two counts. First, the attorney will happily accept a worthless case, work very little on it, and

pocket the fee. Second, many potentially valuable cases will require extra effort by the attorney. Even if an extra hour of

work on his part will yield you a large sum, he will choose not to work because he receives zero in return for his effort.

24

Payment Arrangements - Payment, Performance and Information


The principal/agent model also helps explain why the defendant’s lawyer will most likely bill by the hour, plus expenses. The difference between the

plaintiff’s and defendant’s payment methods reflects differences in the cost of monitoring.

25

The Generality of Principal/Agent Relationships


Principal/agent problems exist in almost any business

situation. The principal/ agent relationship between a corporation’s shareholders and its board of

directors is particularly important for the analysis of managerial decisions.

The model of principal and agent can also provide insight into situations that do not take place in

markets.Lower-level employees act as agents performing

tasks for higher-level employees who cannot monitor them perfectly, and employees as a group

are agents of the firm’s owners.


26

INCOMPLETE CONTRACTS

27

Incompleteness: The WTC’s Insurance Policy


Consider the case of the World Trade Center totally destroyed by two separate planes, one hitting each tower within a space

of minutes. The WTC’s developer, Silverstein Properties, Inc., of course carried insurance, issued by a consortium of companies

led by Swiss Reinsurance Co. Like all insurance contracts, it listed events that would trigger a payout and the maximum

amounts payable if they happened.

No one disputed that the policy covered an air crash, or that it would pay a maximum of $3.5 billion “per occurrence.” But was

this one occurrenceor two?

28

Why Keep a Contract Incomplete?


The cost of negotiating sets limits on the completeness of an actual agreement. The basic rule

will be one of marginal choice: resolve an unclear condition only if expected marginal benefit to the

parties exceeds expected marginal cost.

29

Incompleteness and Opportunism


A contract can be so complete that it can encourage the parties to act opportunistically. Reaching

agreement on what the contract will not specify can reduce those incentives

and increase the economic value it creates.The risk of opportunism falls if the contract price

changes with the fuel’s market price. If it rises with market price your gain from breaching our

agreement is less, and vice versa for me if market price falls. Contract prices for widely traded items often carry provisions called adjustment clauses or

escalators that change their prices as marketprices change.

30

Termination and Reopening


Assume that the market price of our fuel is almost always between $7 and $11 and that the few times it has crossed those boundaries have been short-lived

situations. But this will not necessarily always be so. Our contract can anticipate this possibility by

including a reopener provision that requires us to renegotiate certain portions of it after a drastic

change in market price.

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The Economics of Contracts Chapter 10 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly