FE486A: Law and Economics
Homework 3
Due April 8th
Please indicate the students that you worked on this homework assignment with, if any. Note
that this differs from the text’s discussion of optimal reliance since actual reliance here is a choice
variable, thus you cannot merely look up an answer and plug something in formula.
You (promisee) have bargained with, and paid $500 to, a garage owner (promisor) to rebuild your blown
car engine before the end of this month. In anticipation of performance, you then plan a vacation trip
driving your car to Florida starting the first of next month.
Your cost of a hotel in Florida is $100 per day (constant marginal cost). The hotel requires you to pay
the full amount in advance as a nonrefundable deposit. Your marginal benefit (MB) per day (D) at the
hotel, measured in dollars, is decreasing in the number of days being MB = $300 - $25*D, i.e. you
eventually get bored (diminishing marginal utility) and the marginal benefit when day at the hotel = 12
is zero. Assume all such costs and benefits are continuous (not discrete), i.e. fully divisible (hours,
seconds) and answers below can also be decimals or fractions in terms of days.
If the garage owner’s mechanic quits she cannot fulfill the obligation of getting your car fixed on time
which has a probability of ¼. She knows of such risk, but you do not. If the mechanic quits, your car is
not ready on time, you cannot drive to Florida, and you lose any deposit.
1.)
What is the actual level of reliance given the assumption of perfect expectation damages to
make you whole? i.e. given breach of contract, or nonperformance, by the garage owner (not
fixing your car before the end of the month), such entitles you to the remedy of 100% of any of
your lost deposit for the Florida hotel, how many days do you contract at the hotel? Show
calculations. Discuss why this is the correct answer.
8 days. The actual level of reliance given the assumption of expectation damages is the number of
days you contract at the Florida hotel. If your car is ready and you go to Florida, your
private Marginal Benefit (MB) of a hotel stay of D Days is $300 - $25*D while Marginal
Cost (MC) is $100, and this state of the world has a ¾ probability of being realized. If you
cannot get to Florida to enjoy the hotel due to breach or nonperformance (car not ready
before the end of the month), then Marginal Benefit of the hotel is zero, but your Marginal
Cost of the hotel is also zero since you are reimbursed by the garage owner for your deposit.
The choice of number of days to book to optimally maximize your personal gains from trade
or personal Total Benefit minus Total Costs (area between your Marginal Benefit and
Marginal Cost), is where you book until personal MB = MC (all prior days MB > MC for a
gain) or where $300 - $25*D = $100, personally maximizing net total benefit at D = 8.
2.)
What is the optimal level of reliance, i.e. efficient level of days contracted with the hotel?
Show calculations. Discuss why this is the correct answer.
6 days. The optimal level of reliance is the efficient level of days contracted with the hotel.
This is where expected Marginal Benefit = expected Marginal Cost for society in toto. Given
performance or breach, social MC is the same, $100 per night booked (borne by you if the garage
owner performs, or the garage owner upon breach given expectation damages). The expected
Marginal Benefit per night is the probability you will be in Florida to enjoy the hotel room (given
your car is ready on time) times actual Marginal Benefit if you are there or ¾*($300 - $25*D) plus
probability you are not there (you car is not ready, you do not go to Florida) times Marginal Benefit
per night if you are not there or ¼*($0*D). The actual expected Marginal Benefit per day booked
is ¾ what it would be with 100% certainty such since there is a ¼ chance you will not be able to go
to Florida. Maximizing expected Total Societal Gains minus Societal Costs is D where expected
Societal MB = MC, or where ¾ * ($300 - $25*D) = $100, thus the socially optimal level of reliance
is D = 6.
3.)
Given common law rules to efficiently allocate risk, who should directly bear the burden or
liability of lost deposits given the garage owner did not know of the reliance, i.e. it was
unforseen? Discuss why this is the correct answer.
You. If the garage owner was not cognizant of the investment in reliance, i.e. it was unforeseen,
then the burden of liability should be on you. Why? - You are the most efficient person to allocate
risk since you have the best information. The garage owner does not know of potential gains and
losses by reliance. You by possessing such information can best take actions to mitigate the
potential loss due to reliance, and bearing the burden gives you the incentive. E.g. you could
spend some minimal amount of time finding a hotel which has a refundable deposit, and if it costs
more per night than the hotel with a nonrefundable deposit, the difference could be considered a
form of insurance. Liability also gives you an incentive not to over-rely and you would reserve
fewer days (6) more efficiently balancing expected costs and benefits.
4.)
Given common law rules to efficiently allocate risk, who should directly bear the burden or
liability of lost deposits given the garage owner was informed of the reliance? Discuss why
this is the correct answer.
The garage owner. If the garage owner was perfectly informed of the investment in reliance, then
the burden of liability should be on the garage owner. The garage owner foreseeing the potential
liability if your car was not ready on time would 1.) take steps to more efficiently invest in
precaution to avoid breach, e.g. pay one of the other mechanics overtime to get you car finished on
time, and 2.) likely charge you more for services to compensate herself for the potential liability.
If transaction costs were zero, the contract between you and the garage owner would be perfect
covering all potential states of the world including over the amount of your reliance and you would
be charged more (less) if you relied more (less) thus indirectly giving you incentive for optimal
reliance.
This Common Law rule may mitigate inefficient overreliance by promisee. These Hadley Rules in
3.) and 4.) promote sharing of information. They also promote price discrimination as low
reliance types would want to reveal information to get a better price, and high reliance types would
want to reveal information to avoid direct liability.
5.)
What is the best reason you can offer as to why the parties originally did not explicitly contract
terms over the state of the world being delay and your car not being ready on time?
The best explanation of why the original contract was not “perfect” covering all possible states of
the world is simply that transaction costs to negotiate the original bargain were positive. There is
a trade-off between up-front transaction costs and perceived inefficiencies due to asymmetric
information. The Coase Theorem says that when transaction costs or zero, agents will have perfect
contracts covering all states of the world and exhausting the gains from trade, or when transaction
costs are positive there may be some economization over such up-front transaction costs resulting in
savings on such by leaving gaps in contracts.
6.)
Suppose that government passes a law to prevent lawsuits over reliance dammages forcing all
garage owners to disclose in writing to customers their good faith estimate of expected time of
delivery of services and contractual terms contingent on nondelivery which customers must
acknowledge and sign. Would this result in efficiency gains? Why, or why not?
Several answers are possible, but generally these disclosure rules would not result in efficiency
gains. If it was efficient to disclose terms and contingencies, private parties would likely have
done so without a government rule mandating such. If transaction costs are positive for such
disclosure of terms and contracting, then mandating such may cause an added burden on society
being such costs. However it may be alternatively argued that there may also be a gain in terms of
efficiency caused by the sharing of information and otherwise given expectation damages, high
reliance types have an incentive not to reveal information since they will be charged more. The
possible gain would be the reduction in overreliance cause by contracting over such terms. If such
mandatory disclosure and contracting over reliance were efficient, then the additional transaction
costs incurred would have to be less than gains by more efficient reliance. If transaction costs are
minimal, than it can also be argued that mandatory disclosure and contracting over reliance may be
beneficial in avoiding inefficiency due to asymmetric information - this is an Akerlof’s Lemons
type problem not covered in the text.