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2012-08-10
1
Why Contract Law?
The Edgeworth Box
Why Contract Law
Apples
Bananas
The Edgeworth Box
Why Contract Law
Apples
Bananas
Harry
Sally
The Edgeworth Box
Why Contract Law
Harry
Sally
aH aS
bH
bS
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The Edgeworth Box
Why Contract Law
Harry
Sally Apples
Ban
anas
The Edgeworth Box
Why Contract Law
Harry
Sally Apples
Ban
anas
The Edgeworth Box
Why Contract Law
Harry
Sally Apples
Ban
anas A
B
C
The Edgeworth Box
Why Contract Law
Harry
Sally Apples
Ban
anas A
B
The Contract Curve
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The Contract Curve
Why Contract Law
Harry
Sally Apples
Ban
anas
The Contract Curve
Why Contract Law
Harry
Sally Apples
Ban
anas
Points in
yellow area
(the Core)
make Harry
and Sally
better off.
The Contract Curve
Why Contract Law
Harry
Sally Apples
Ban
anas
Points on
black portion
of contract
curve are
Pareto
Optimum.
The Contract Curve
Why Contract Law
Harry
Sally Apples
Ban
anas
Harry and Sally will
move to the contract
curve via voluntary
exchange.
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The Contract Curve
Why Contract Law
Harry
Sally Apples
Ban
anas
Harry and Sally will
move to the contract
curve via voluntary
exchange.
Here, they will end up
along the black
portion of the line
Life is not that Simple
• Harry is giving up Bananas; Sally is giving up Apples.
Why Contract Law
Life is not that Simple
• Harry is giving up Bananas; Sally is giving up Apples.
• But Harry knows better than Sally whether the Bananas are good or rotten; conversely, Sally has superior knowledge of the quality of her Apples.
Why Contract Law
Life is not that Simple
• Harry is giving up Bananas; Sally is giving up Apples.
• But Harry knows better than Sally whether the Bananas are good or rotten; conversely, Sally has superior knowledge of the quality of her Apples.
• A Barrier to trade: knowledge.
Why Contract Law
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A Game Theory Approach
• I am thinking of hiring you to do some work.
Why Contract Law
A Game Theory Approach
• I am thinking of hiring you to do some work.
– I get $60 of benefit
– You give up $40 of leisure
– We agree on $50.
Why Contract Law
A Game Theory Approach
• I am thinking of hiring you to do some work.
– I get $60 of benefit
– You give up $40 of leisure
– We agree on $50.
• However the agreement is not enforceable.
Why Contract Law
A Game Theory Approach
• I am thinking of hiring you to do some work.
• However the agreement is not enforceable.
• Should you show up and do the work?
Why Contract Law
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The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10)
Employee = 50 – 40 = 10
Employer = 60-50 = 10
The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10)
Employee = 0 – 40 = -40
Employer = 60-0 = 60
(-40, 60)
The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10)
Employee = 50 – 0 = 50
Employer = 0-50 = -50
(-40, 60) (50,-50)
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The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10)
Employee = 0 – 0 = 0
Employer = 0-0 = 0
(-40, 60) (50,-50) (0,0)
The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10) (-40, 60) (50,-50) (0,0)
The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10) (-40, 60) (50,-50) (0,0)
The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10) (-40, 60) (50,-50) (0,0)
A Multiple Choice Question:
Which is Better?
(a)Working for a disutility of -$40
and not getting paid?
(b)Not working and not getting paid?
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The Payoff Strategy
Why Contract Law
Employee
Employer Employer
Don’t Work Work
Pay Pay Don’t Pay Don’t Pay
(10,10) (-40, 60) (50,-50) (0,0)
Some Extensions
• If I pay you in advance, we have the same issue
Why Contract Law
Some Extensions
• If I pay you in advance, we have the same issue
• Without a legal system, we would pass up many valuable opportunities for contracts and exchange of goods and services.
Why Contract Law
First Principle of Contract Law
• Convert Non-Cooperative Games to Cooperative Games.
Why Contract Law
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When is a Contract a Contract?
Law and Economics-Charles W. Upton
Two Theories of Contract
• Traditional Legal Theory
• Economic Theory of Contract
Why Contract Law
The Legal Theory of Contracts
• Three Elements
– Offer
– Acceptance
– Consideration
•
Why Contract Law
Example 1
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you a car for $1,000. You agree, and give me $100 in Earnest Money.
Why Contract Law
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Example 1
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you a car for $1,000. You agree, and
give me $100 in Earnest Money.
Why Contract Law
Example 2
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you a car for $1,000. You agree, to pay me tomorrow.
Why Contract Law
Example 2
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you a car for $1,000. You agree, to pay me tomorrow.
Why Contract Law
Consideration lies in the
expectation of payment
tomorrow.
Example 3
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you the sure way to get an “A” in this course for $100. You accept and pay me.
• Later I give you the sure way: “Study. Very Hard.”
Why Contract Law
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Example 3
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you the sure way to get an “A” in this course for $100.
You accept and pay me.
• Later I give you the sure way: “Study. Very Hard.”
Why Contract Law
, A contract but
surely not one
we want
enforced.
Example 4
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you my good car for $12,000. You agree and give me $1,000 for a down payment.
Why Contract Law
To me: the good car is the 1996 Buick
To you: the good car is my 2002 Pontiac
Example 4
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer to sell you my good car for $12,000. You
agree and give me $1,000 for a down payment.
Why Contract Law
No contract: we
were talking about
different things.
Example 5
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer KSU a $1,000,000 donation. They accept. I give $50,000, then change my mind.
Why Contract Law
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Example 5
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer KSU a $1,000,000 donation. They accept. I give $50,000, then change my mind.
Why Contract Law
No consideration. I got
nothing.
Example 6
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer KSU a $1,000,000 donation to rename this building Upton hall. I give $50,000, the building is renamed. I then change my mind.
Why Contract Law
Example 6
• Three Elements
–Offer
–Acceptance
–Consideration
• I offer KSU a $1,000,000 donation to rename this building Upton hall. I give $50,000, the building is renamed. I then change my mind.
Why Contract Law
I –or at least
my ego – got
something.
An Economic Theory of Contract
• A Contract is a Contract when Both Parties want it Enforced.
• Think of my offer to pay $50 for an afternoon’s work.
– I want the contract enforced. I want the work done.
– You want it enforced. You want to be paid.
Why Contract Law
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Example 1
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you a car for $1,000. You agree, and give me $100 in Earnest Money.
Why Contract Law
Example 1
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you a car for $1,000. You agree, and give me $100 in Earnest Money.
Why Contract Law
For me: Benefit of $1000 > Benefit of Car
For you: Benefit of Car > $1000
Example 2
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you a car for $1,000. You agree, to pay me tomorrow.
Why Contract Law
Example 2
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you a car for $1,000. You agree, to pay me tomorrow.
Why Contract Law
For me: Benefit of $1000 > Benefit of Car
For you: Benefit of Car > $1000
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Example 3
Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you the sure way to get an “A” in this course for $100. You accept and pay me.
• Later I give you the sure way: “Study. Very Hard.”
Why Contract Law
Example 3
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you the sure way to get an “A” in this course for $100. You accept and pay me.
• Later I give you the sure way: “Study. Very Hard.”
Why Contract Law
, I had no intention
of having this
contract enforced
Example 4
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you my good car for $12,000. You agree and give me $1,000 for a down payment.
Why Contract Law
To me: the good car is
the 1996 Buick
To you: the good car is
my 2002 Pontiac
Example 4
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer to sell you my good car for $12,000. You agree and give me $1,000 for a down payment.
Why Contract Law
To me: the good car is
the 1996 Buick
To you: the good car is
my 2002 Pontiac
No contract: we
were talking about
different things.
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Example 5
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer KSU a $1,000,000 donation. They accept. I give $50,000, then change my mind.
Why Contract Law
Example 5
• Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer KSU a $1,000,000 donation. They accept. I give $50,000, then change my mind.
Why Contract Law
Now why would I want this
agreement enforced?
Example 5
Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer KSU a $1,000,000 donation to rename this building Upton hall. I give $50,000, the building is renamed. I then change my mind.
Why Contract Law
Example 5
Do both parties want the agreement enforced? Do both stand to gain by having the agreement honored?
• I offer KSU a $1,000,000 donation to rename this building Upton hall. I give $50,000, the building is renamed. I then change my mind.
Why Contract Law
This one, I
wanted
enforced.
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What about an Unfair Contract
• Suppose you and I reach a contract that you later decide is unfair. What is your remedy?
Why Contract Law
What about an Unfair Contract
• Suppose you and I reach a contract that you later decide is unfair. What is your remedy?
• None. If the courts intervened, a contract would not be a contract.
Why Contract Law
What about an Unfair Contract
• Suppose you and I reach a contract that you later decide is unfair. What is your remedy?
• None. If the courts intervened, a contract would not be a contract.
Why Contract Law
Exceptions
• Contracts with minor and incompetents are unenforceable.
• Some outrageous bargains cannot be enforced (the $100 A).
• Contracts made under duress.
Why Contract Law
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Breaking Contracts
Law and Economics-Charles W. Upton
When to Breach
• After agreeing to work for me for the afternoon for $50, you get an opportunity to earn $100 from Sally.
• What should you do?
Why Contract Law
The Analysis
• Benefit of your work for me is (at most) $60.
• The Benefit of your working for Sally is at least $100.
• Ergo, economic efficiency requires that you breach your contract with me.
Why Contract Law
A Counteroffer
• Suppose Harry, who gets $55 worth of benefit from your work, offers you $52 to work for him.
Why Contract Law
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A Counteroffer
• Suppose Harry, who gets $55 worth of benefit from your work, offers you $52 to work for him.
• Economic efficiency requires that you work for me.
Why Contract Law
A Counteroffer
• Suppose Harry, who gets $55 worth of benefit from your work, offers you $52 to work for him..
• Economic efficiency requires that you work for me.
• But $52 > $50 and your incentives are not to show up.
Why Contract Law
Why Contract Law
Is your cost of
performing >
Your cost of non-
performing?
No
Honor the
contract
Break the
contract
Yes
Why Contract Law
Is your cost of
performing >
Your cost of non-
performing?
No
Honor the
contract
Break the
contract
Yes
$100>$50 Sally
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Why Contract Law
Is your cost of
performing >
Your cost of non-
performing?
No
Honor the
contract
Break the
contract
Yes
$100>$50 Sally
The Right
Decision
Why Contract Law
Is your cost of
performing >
Your cost of non-
performing?
No
Honor the
contract
Break the
contract
Yes
$52>$50 Harry
Why Contract Law
Is your cost of
performing >
Your cost of non-
performing?
No
Honor the
contract
Break the
contract
Yes
$52>$50 Harry
The Wrong
Decision
Why Contract Law
Is your cost of
performing >
Your cost of non-
performing?
No
Honor the
contract
Break the
contract
Yes
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Why Contract Law
Is your cost of
performing >
Your cost of non-
performing?
No
Honor the
contract
Break the
contract
Yes Suppose you
have to pay me
damages, equal
to my loss ($10)
Why Contract Law
Performance cost:
lost wages in other
job >
Lost wages on my job
plus the damages to
me?
No
Honor the
contract
Break the
contract
Yes
Why Contract Law
Performance cost:
lost wages in other
job >
Lost wages on my job
plus the damages to
me?
No
Honor the
contract
Break the
contract
Yes
$100>$50 +
$10
Sally
The Right
Decision
Why Contract Law
Performance cost:
lost wages in other
job >
Lost wages on my job
plus the damages to
me?
No
Honor the
contract
Break the
contract
Yes
$52>$50 +
$10
Harry
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Why Contract Law
Performance cost:
lost wages in other
job >
Lost wages on my job
plus the damages to
me?
No
Honor the
contract
Break the
contract
Yes
$52>$50 +
$10
Harry
The Right
Decision
The Second Principle of Contract Law
• Give optimal incentives to perform.
• This does not mean an absolute incentive to perform. We want people to break contracts iffi it is socially optimal.
Why Contract Law
What are my damages?
• I expected to get $60 of value from your work, for a net gain of $10. If you don’t show up, I might still get the work done but for more money, and at some time cost.
Why Contract Law
What are my damages?
• I expected to get $60 of value from your work, for a net gain of $10. If you don’t show up, I might still get the work done but for more money, and at some time cost.
• The real loss is possibly the extra effort of getting the work done.
Why Contract Law
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The Second Principle of Contract Law
(Clarified)
• Both parties must have incentives.
Why Contract Law
The General Principle
• The innocent party can take steps to cut the social cost of breaching, and should do so.
Why Contract Law
Some Examples
• I promise to sell you a car for $1000 and breach.
• A year later, you sue for $2,500 for taxi fares because you did not have a car.
•
Why Contract Law
The Bad Car
• I promise to sell you a car for $1000 and breach.
• A year later, you sue for $2,500 for taxi fares because you did not have a car.
• In fact, you could have bought another car for $1,100.
• Your damages are really $100.
Why Contract Law
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The Bad Car
• I promise to sell you my good car for $12,000.
• It turns out that we have different interpretations of what is my “good” car.
• I don’t honor the deal.
• You sue.
•
Why Contract Law
The Bad Car
• I promise to sell you my good car for $12,000.
• It turns out that we have different interpretations of what is my “good” car.
• I don’t honor the deal.
• You sue.
• Sorry, you should have made the effort to make sure what was meant by the “good car”.
Why Contract Law
The Third Principle of Contract Law
• Induce Optimal Reliance.
Why Contract Law
Healthy Cookies
• I make and sell Healthy Cookies. I promise they will never spoil.
• In the store, you see the box is torn, and contains something like rat droppings.
•
Why Contract Law
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Healthy Cookies
• I make and sell Healthy Cookies. I promise they will never spoil.
• In the store, you see the box is torn, and contains something like rat droppings.
• Commonsense says you should not rely on my promise.
Why Contract Law
Healthy Cookies
• I make and sell Healthy Cookies. I promise they will never spoil.
• The box looks in perfect condition.
•
Why Contract Law
Healthy Cookies
• I make and sell Healthy Cookies. I promise they will never spoil.
• The box looks in perfect condition.
• You should be able to rely on my promise.
Why Contract Law
How to get an “A”
• Remember my offer of the secret of getting an “A” in the course.
• You party the night before the exam and see me just before the final.
•
Why Contract Law
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How to get an “A”
• Remember my offer of the secret of getting an “A” in the course.
• You party the night before the exam and see me just before the final.
• I look forward to seeing you in the course next year.
• You have over-relied
Why Contract Law
The World’s Best Foot Long Hot Dog
• A restaurant sells what it calls “the worlds best foot long hot dog”. You bite.
• While the wiener is ok, you have had better.
• And, it is 11” long.
Why Contract Law
The World’s Best Foot Long Hot Dog
• A restaurant sells what it calls “the worlds best foot long hot dog”. You bite.
• While the wiener is ok, you have had better.
• And, it is 11” long.
• You are old enough not to
believe all advertising, so you
are out of luck on the “world’s
best” claim.
Why Contract Law
The World’s Best Foot Long Hot Dog
• A restaurant sells what it calls “the worlds best foot long hot dog”. You bite.
• While the wiener is ok, you have had better.
• And, it is 11” long.
• You are old enough not to
believe all advertising, so you
are out of luck on the “world’s
best” claim.
• But you have a case on the
missing inch.
Why Contract Law
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Relying on Contracts
Two Principles
• Break contracts if and only if the benefits from breach exceed the costs of the breach.
• Don’t over rely on a contract.
Why Contract Law
The General Rule
Why Contract Law
• Rely if and only if
(Probability of Performance) x
(Gains from Relying)
>
(Probability of Breach) x
(Extra Costs Imposed by Relying)
The Opportunity
• An Entrepreneur offers an investor a chance to go into a business deal for $1,000. If the deal works out (and it will if the entrepreneur works at it), each will make $500.
• It is possible that another opportunity will come along. If the Entrepreneur takes that, the first deal will fail but the Entrepreneur will make $1,500
• It is also possible that the Entrepreneur will simply take the investor’s $1,000.
Why Contract Law
2012-08-10
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The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
The
entrepreneur
makes $500
from the
investment if
he performs,
but loses
$1,500 from
the forgone
opportunity.
2012-08-10
28
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
So what is
the right
strategy?
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
Without legal
sanctions, the
entrepreneur will
always steal the
money. Ergo no
investment.
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000 -500
BI = -1000 500
Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
We modify
with perfect
expectation
damages.
2012-08-10
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The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000 -500
BI = -1000 500
Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
Now crime
does not
pay. But it
does pay to
walk away
if the
opportunity
arises.
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
-5001000
BI = -1000 500
Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
Now it
does not
pay to steal.
But it does
pay to walk
away if the
opportunity
arises.
When we add in the
$1,500 from the
opportunity, the net gain
to the entrepreneur is now
$1,000
Moral
• Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity.
Why Contract Law
Moral
• Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity.
• But there is more to the story: the tale of the investor.
Why Contract Law
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Moral
• Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity.
• But there is more to the story: the tale of the investor.
Why Contract Law
The investor is indifferent
between the entrepreneur
performing and not
performing. He will invest
even if there is a 100%
chance of the other
opportunity coming along.
Moral
• Perfect expectation damages seem to give the entrepreneur the right incentives. Perform, unless there is a better opportunity.
• But there is more to the story: the tale of the investor.
Why Contract Law
The investor is indifferent
between the entrepreneur
performing and not
performing. He will invest
even if there is a 100%
chance of the other
opportunity coming along.
This seems
wasteful
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform (no
opportunity
arises)
Perform
(opportunity
arises)
Appropriate
Investor Invest BE =500
BI = 500
BE = -1000
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
BE = 0
BI = 0
Another aspect.
Lets focus on the
payoff matrix
without
expectation
damages.
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest BE =500
BI = 500
BE = 1000
BI = -1000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
2012-08-10
31
Might He invest Too Much?
• Suppose the investor can put another $1,000 in the project and if successful, earn another $100. Should he do so?
Why Contract Law
The Payoff Matrix
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest
$1000 BE =500
BI = 500
BE = 1000
BI = -1000 Invest
$2000 BE =500
BI = 600
BE = 1000
BI = -2000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
How to Analyze
• Compute the expected gains from the two
possible investments.
• The investor should invest if the expected
gains are positive.
• Those gains depend on the probability p of
no new opportunity arising
Why Contract Law
If it works out
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest
$1000 BE =500
BI = 500
BE = 1000
BI = -1000 Invest
$2000 BE =500
BI = 600
BE = 1000
BI = -2000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
Gains from a
$1000
investment =
$1000
Gains from a
$2000
investment =
$1100
2012-08-10
32
If it doesn’t works out
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest
$1000 BE =500
BI = 500
BE = 1000
BI = -1000 Invest
$2000 BE =500
BI = 600
BE = 1000
BI = -2000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
Losses from a
$1000
investment =
$0
Losses from a
$2000
investment = $-
1000
The $1000 Investment
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest
$1000 BE =500
BI = 500
BE = 1000
BI = -1000 Invest
$2000 BE =500
BI = 600
BE = 1000
BI = -2000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
Losses from a
$1000
investment =
$0
Gains from a
$1000
investment =
$1000
The $1000 Investment
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest
$1000 BE =500
BI = 500
BE = 1000
BI = -1000 Invest
$2000 BE =500
BI = 600
BE = 1000
BI = -2000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
Losses from a
$1000
investment =
$0
Gains from a
$1000
investment =
$1000
Expected gain =
p($1000) + (1-p)($0)=
p($1000)
The $2,000 Investment
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest
$1000 BE =500
BI = 500
BE = 1000
BI = -1000 Invest
$2000 BE =500
BI = 600
BE = 1000
BI = -2000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
Losses from a
$2000
investment = $-
1000
Gains from a
$2000
investment =
$1100
2012-08-10
33
The $2,000 Investment
Why Contract Law
Entrepreneur
Perform Breach
Investor Invest
$1000 BE =500
BI = 500
BE = 1000
BI = -1000 Invest
$2000 BE =500
BI = 600
BE = 1000
BI = -2000 Don’t
Invest BE = 0
BI = 0
BE = 0
BI = 0
Losses from a
$2000
investment = $-
1000
Gains from a
$2000
investment =
$1100
Expected gain =
p($1100) + (1-p)(-$1000)=
p($2100)-$1000
You do the Math
• Expected gains from a $1000 investment
1000p
• Expected gains from a $2000 investment
2100p - 1000
Why Contract Law
You do the Math
• Expected gains from a $1000 investment
1000p
• Expected gains from a $2000 investment
2100p – 1000
• Do the $2000 only if
2100p – 1000 > 1000p
P>0.91
Why Contract Law
Might He invest Too Much?
• Suppose the investor can put another $1,000 in the project and if successful, earn another $100. Should he do so?
• If he gets perfect expectation damages, there is no risk in his doing so.
Why Contract Law
2012-08-10
34
The Solution
• Tell the investor that he cannot just blindly invest the extra $1,000. He will not get damages if he over-relied (that is, he will not get his last $1,000 unless there was less than a 9% chance of the new project coming along).
Why Contract Law
Other Over Reliance
• You eat the obviously damaged box of Healthy Cookies.
• You get ill
•
Why Contract Law
Other Over Reliance
• You eat the obviously damaged box of Healthy Cookies.
• You get ill
• Tough. You over-relied.
Why Contract Law
Other Over Reliance
• You take the box of Healthy Cookies to the manager who tells you not to worry.
• You eat them.
• You get sick.
•
Why Contract Law
2012-08-10
35
Other Over Reliance
• You take the box of Healthy Cookies to the manager who tells you not to worry.
• You eat them.
• You get sick.
• Tough. You over-relied.
Why Contract Law
Other Over Reliance
• You rely on my promise of the easy way to get an “A” in this course and don’t study.
• You fail.
•
Why Contract Law
Other Over Reliance
• You rely on my promise of the easy way to get an “A” in this course and don’t study.
• You fail.
• Tough. You over-relied.
Why Contract Law
Gaps in Contracts
2012-08-10
36
Contingency
• All Contracts are Inherently Incomplete
– The possibilities cannot be enunciated.
– And even if they could some are so rare that it is not worth the cost to anticipate them.
• What to do?
Why Contract Law
An Example
• Several years ago, a contractor cut an electrical cable on the KSU campus. The campus was closed for the day.
• I had an exam scheduled.
Why Contract Law
The Incomplete Contract
• My syllabus is essentially a contract of the form “I propose to do this in the course and I expect you to…”
• No clause covering the possibility of this accident.
Why Contract Law
The Incomplete Contract
• My syllabus is essentially a contract of the form “I propose to do this in the course and I expect you to…”
• No clause covering the possibility of this accident.
Why Contract Law
2012-08-10
37
The Incomplete Contract
• My syllabus is essentially a contract of the form “I propose to do this in the course and I expect you to…”
• No clause covering the possibility of this accident.
• Should I have a clause?
Why Contract Law
The Incomplete Contract
Why Contract Law
Costs of covering
this contingency
Probability
of this
happening X
<
Cost of
dealing
with it after
the fact
The Incomplete Contract
Why Contract Law
Costs of covering
this contingency
Probability
of this
happening X
<
Cost of
dealing with it
after the fact And this does not even
cover possibilities I cannot
think about.
The Fourth Objective
• Minimize Transaction Costs of Negotiating Contracts by providing efficient default terms.
Why Contract Law
2012-08-10
38
Reactions
• Allocate responsibility to efficient risk bearer, the person who can handle the situation at least cost.
Why Contract Law
An Electrical Shut-Down
• In the event of another electrical shutdown, who is the efficient risk bearer?
– The central administration?
– The professor?
– The students?
Why Contract Law
An Electrical Shut-Down
• In the event of another electrical shutdown, who is the efficient risk bearer?
– The central administration?
– The professor
– The students?
Why Contract Law
The Tribe
• You buy tickets to an Indians game on an April Evening which turns out to be quite cold. Who is the efficient risk bearer?
– The Indians
– You
• You buy tickets to an Indians game on an April Evening which is rained out. Who is the efficient risk bearer?
– The Indians
– You
Why Contract Law
2012-08-10
39
The Tribe
• You buy tickets to an Indians game on an April Evening which turns out to be quite cold. Who is the efficient risk bearer?
– The Indians
– You
• You buy tickets to an Indians game on an April Evening which is rained out. Who is the efficient risk bearer?
– The Indians
– You
Why Contract Law
Building A House
• I am building a house. Due to Chilean politics, the cost of copper piping goes through the roof. Who is the efficient risk bearer?
• The contractor
• Me
Why Contract Law
Building A House
• I am building a house. Due to Chilean politics, the cost of copper piping goes through the roof. Who is the efficient risk bearer?
• The contractor
• Me
Why Contract Law
Building A House
• I am building a house. Due to Chilean politics, the cost of copper piping goes through the roof. Who is the efficient risk bearer?
• The contractor
• Me
Why Contract Law
All bets are off if I
schedule a house party
two days after the
scheduled completion
date.
2012-08-10
40
End
Why Contract Law
