Econ 522
Economics of Law
Dan Quint
Fall 2015
Lecture 14
Last week
 Reasons a contract might not be enforced
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Derogation of public policy, incompetence, duress and necessity,
impossibility, bad information (fraud, failure to disclose, frustration of
purpose, mutual mistake), vagueness, unconscionability
But generally not drunkenness, adhesion, or unilateral mistake
For each: is there an economic justification?
 Different remedies
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Different types of damages; specific performance
 We noted that “penalty damages” are not always enforced
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Could be useful if subjective valuation is very different from liquidated
damages – ruling in Peevyhouse seemed inefficient?
(Peevyhouses would not have signed contract at all if they had
known Garland could avoid restoration work and just pay $300)
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One last point on penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus
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I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
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One last point on penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus
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I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
Similarly, Peevyhouse example
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Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is
not restored
Equivalently, get $65,000 for mining rights, pay $40,000 bonus if
restoration is completed
But, if intent of contract is too transparent, still might not be enforced
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Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
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Plane worth $500,000 to you
Price $350,000
Cost: either $250,000 or $1,000,000
Remedies and breach
Expectation Damages
Specific Performance
Costs
Low –
Perform
Costs
High –
Perform
Costs
High –
Breach
I get
100,000
-650,000
-150,000
You get
150,000
150,000
150,000
Total
250,000
-500,000
0
Costs
Low –
Perform
Costs
High –
Perform
Costs
High –
Renegotiate
I get
100,000 -650,000
-400,000
–650,000
+ ½ (500,000)
You get
150,000
150,000
400,000
150,000
+ ½ (500,000)
Total
250,000 -500,000
0
 Transaction costs low  either leads to efficient breach, but seller
prefers “weaker” remedy
 Transaction costs high  S.P. leads to ineff. performance
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Remedies and breach
 Opportunity cost damages, or reliance damages
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Inefficient breach when transaction costs are high
Renegotiate contract to get efficient performance when transaction
costs are low
Like nuisance law: any remedy leads to efficient breach with low TC
But only expectation damages do when TC are high
 Unfortunate contingency and fortunate contingency
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Efficient signing
 Specific Performance
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If costs stay low, I get $350,000 – $250,000 = $100,000 profit
If costs rise, I take $400,000 loss
Am I willing to sign this contract?
 Even expectation damages face this problem
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Expectation damages: costs stay low, same $100,000 profit
Costs rise, $150,000 loss
If probability of high costs is ½, I won’t sign contract
 Expectation damages lead to efficient breach, but may
not lead to efficient signing
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Reliance – did example a while ago
 If reliance investments increase the damages you receive,
we expect to get overreliance

To get efficient reliance, need to exclude gains from reliance in
calculation of expectation damages
 But then promisor’s liability < promisee’s benefit, leading to
inefficient breach
 With low transaction costs, fix this through renegotiation
 But what about unobservable actions the promisor needs
to take, to make breach less likely?

Investment in performance
Skip
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Investment in performance
 Investments promisor can make to reduce likelihood that he/she
will have to breach
 We said expectation damages lead to efficient investment in
performance. Why?
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Social cost = private cost = actual cost of investment
Social benefit = (reduction in prob of breach) x (social cost of breach)
= (reduction in prob of breach) x (promisee’s benefit from performance)
Private benefit = (reduction in prob of breach) x (private cost of breach)
= (reduction in prob of breach) x (promisor’s liability)
So if liability = anticipated benefit, SC = PC, SB = PB  efficient behavior
If liability < anticipated benefit, PB < SB  less than efficient investment
If liability > anticipated benefit, PB > SB  more than efficient investment
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Investment in performance
(continuing with airplane example)
 Suppose probability of breach if I invest nothing is ½…
but for every $27,726 I invest, I cut the probability in half
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Invest nothing  probability of breach is 1/2
Invest $27,726  probability is 1/4
Invest $55,452  probability is 1/8
Any investment z  probability is .5 * (.5) z / 27,726
 Wrote it this way so p = .5 e – z / 40,000
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Investment in performance
(continuing with airplane example)
 Suppose you’ve built a $90,000 hangar
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Increases value of performance by $180,000…
…so value of performance is $150,000 + $180,000 = $330,000
Probability of breach = .5 e – z/40,000
Let D = damages I owe if I breach
 Same questions as before:
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What is efficient level of investment in performance?
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How much will I choose to invest in performance?
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Investment in performance
(continuing with airplane example)
 Suppose you’ve built a $90,000 hangar
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Increases value of performance by $180,000…
…so value of performance is $150,000 + $180,000 = $330,000
Probability of breach = .5 e – z/40,000
Let D = damages I owe if I breach
 Same questions as before:

What is efficient level of investment in performance?
Enough to reduce probability of breach to 40,000/430,000
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How much will I choose to invest in performance?
Enough to reduce probability of breach to 40,000/(100,000 + D)
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What do these results mean?
 What is the efficient level of investment in performance?
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Enough so that p(z) = 40,000/430,000
 What will promisor do under various rules for damages?
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Enough so that p(z) = 40,000/(100,000 + D)
 So if D = 330,000, efficient investment in performance
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D = 330,000 is promisee’s benefit, including reliance
So expectation damages, with benefit of reliance, leads to
efficient investment in performance
If D < 330,000, too little investment in performance
If D > 330,000, too much
Makes sense – think about externalities
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Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
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Paradox of compensation
Expectation damages
include benefit from
reliance investments
Expectation damages
exclude benefit from
reliance investments
• Efficient breach
• Inefficient breach
• Efficient investment in
performance
• Underinvestment in
performance
• Over-reliance
• Efficient reliance
 Is there a way to get efficient behavior by both parties?
Skip
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We already saw one possible solution
 Have expectation damages include benefit from reliance…
 …but only up to the efficient level of reliance, not beyond
 That is, have damages reward efficient reliance
investments, but not overreliance
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Promisee has no incentive to over-rely  efficient reliance
Promisor still bears full cost of breach  efficient performance
 Problem: this requires court to calculate efficient level of
reliance after the fact
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Another clever (but unrealistic) solution
 The problem:
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Damages promisor pays should include gain from reliance if we
want to get efficient performance
Damages promisee receives should exclude gain from reliance if
we want to get efficient reliance
 Solution: make damages promisor pays different from
damages promisee receives!
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How do we do this? Need a third party
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“Anti-insurance”
 You (promisee) and I (promisor) offer Bob this deal:
 If you rely and I breach,
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I pay Bob value of promise with reliance (airplane plus hangar)
Bob pays you value of promise without reliance (airplane alone)
Bob keeps the difference
 You receive damages without benefit from reliance;
I pay damages with benefit from reliance
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“Anti-insurance”
 You (promisee) and I (promisor) offer Bob this deal:
 If you rely and I breach,
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I pay Bob value of promise with reliance (airplane plus hangar)
Bob pays you value of promise without reliance (airplane alone)
Bob keeps the difference
 You receive damages without benefit from reliance;
I pay damages with benefit from reliance
 Offer the deal to two people, make them pay up front for it
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Reminder: what do courts actually do?
 Foreseeable reliance
 Include benefits reliance that promisor could have
reasonably anticipated
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Repeated
interactions
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Repeated games
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Repeated games
Player 1 (you)
Don’t
Trust me
Player 2 (me)
(100, 0)
Share profits
(150, 50)
Keep all the money
(0, 200)
 Suppose we’ll play the game over and over
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After each game, 10% chance relationship ends, 90% chance we
play at least once more…
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Repeated games
 Suppose you’ve chosen to trust me
 Keep all the money: I get $200 today, nothing ever again
 Share profits: I get $50 today, $50 tomorrow, $50 day after…
 Value of relationship =
50
 500
50  50 .9  50 .9  50 .9  ... 
1  .9
2
3
 Since this is more than $200, we can get cooperation
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Repeated games
 Suppose you’ve chosen to trust me
 Keep all the money: I get $200 today, nothing ever again
 Share profits: I get $50 today, $50 tomorrow, $50 day after…
 Value of relationship =
50
 500
50  50 .9  50 .9  50 .9  ... 
1  .9
2
3
 Since this is more than $200, we can get cooperation
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Repeated games and reputation
 Diamond dealers in New York (Friedman)
“…people routinely exchange large sums of money for
envelopes containing lots of little stones without first
inspecting, weighing, and testing each one”
“Parties to a contract agree in advance to arbitration;
if… one of them refuses to accept the arbitrator’s verdict,
he is no longer a diamond merchant – because everyone
in the industry now knows he cannot be trusted.”
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Repeated games and reputation
 The first purpose of contract law is to enable cooperation,
by converting games with noncooperative solutions into
games with cooperative solutions
 The sixth purpose of contract law is to foster enduring
relationships, which solve the problem of cooperation with
less reliance on courts to enforce contracts
 Law assigns legal duties to certain long-term relationships
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Bank has fiduciary duty to depositors
McDonalds franchisee has certain duties to franchisor
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Repeated games and the endgame problem
 Suppose we’ll play agency game 60 times
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$50 x 60 = $3,000 > $200, so cooperation seems like no problem
But…
 In game #60, reputation has no value to me
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Last time we’re going to interact
So I have no reason not to keep all the money
So you have no reason to trust me
 But if we weren’t going to cooperate in game #60, then in
game #59…
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Repeated games and the endgame problem
 Endgame problem: once there’s a definite end to our
relationship, no reason to trust each other
 Example: collapse of communism in late 1980s
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Communism believed to be much less efficient than capitalism
But fall of communism led to decrease in growth
Under communism, lots of production relied on gray market
Transactions weren’t protected by law, so they relied on long-term
relationships
Fall of communism upset these relationships
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One other bit
I like from Friedman
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Friedman on premarital sex
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Friedman on premarital sex
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That’s it for contract law
 Purposes for contract law:
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Encourage cooperation
Encourage efficient disclosure of information
Secure optimal commitment to performance
Secure efficient reliance
Provide efficient default rules and regulations
Foster enduring relationships
 Wednesday, we’ll begin Tort Law
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