Econ 522
Economics of Law
Dan Quint
Spring 2014
Lecture 15
Logistics
 HW3 (contract law) due next Thursday (April 3)
 Second midterm in a few weeks


Wednesday April 16
No lecture that Monday, and no office hours that Tuesday
1
Before Spring Break
 Contracts as promises

Which ones should be enforced?
 Incentives for breach of contract
 Incentives for reliance investments
 Reasons a contract might not be enforced



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

Different types of damages; specific performance
 Before we get back to work…
2
Another experiment:
is trust a problem?
3
We motivated contracts with an agency
(trust) game
Player 1 (you)
Don’t
Trust me
Player 2 (me)
(100, 0)
Share profits
(150, 50)
Keep all the money
(0, 200)
 Without binding contracts, might be no reason for me to
return your money, so no reason for you to trust me
4
To see if trust is a problem, we’ll use a
similar game as an experiment
 Player A starts with $5


Chooses how much of it to give to player B
That money is quadrupled
 Player B has $5, plus 4x whatever A gave him/her

Chooses how much (if any) to give back to player A
 So for example…



if player A decides to send $3…
then B has $5 + $12 = $17, and can send A any amount up to 17
and keep the rest…
…and A ends up with $2 plus whatever B sends
5
To see if trust is a problem, we’ll use a
similar game as an experiment
Player 1
Send 0
x
Send 5
Player 2
Return 0
y
Return 5 + 4x
((5 – x) + y, (5 + 4x) – y)
 Player 1 gets whatever he kept, plus whatever 2 sends him
 Player 2 gets 5, plus four times what 1 sends him, minus
whatever he sends to player 1
6
We’ll try this game four different ways
 Anonymously – A and B don’t know who each other are

we’ll use student ID numbers to identify players, and play on paper
 Privately – A and B don’t interact, but will learn who each
other are after the game


still on paper, but with names, so B sees A’s name
after class, Nathan will email A with B’s name
 Face to face – A and B can discuss the game before
playing, but their actions remain private
 Publicly – A and B play out loud in front of the class
7
Remedies for breach
of contract
8
Before the break, we discussed different
remedies for breach of contract
 Court-imposed damages



Expectation damages
Opportunity cost damages
Reliance damages
 Specific performance

Forces breaching party to live up to contract
 Party-specified remedies

Remedy could be written directly into contract
9
Expectation damages vs. specific performance
 Peevyhouse v Garland Coal and Mining Co
(OK Supreme Court, 1962)






Garland contracted to strip-mine
coal on Peevyhouse’s farm
Contract specified Garland
would restore property to original
condition; Garland did not
Restoration would cost $29,000
But “diminution in value” of farm
was only $300
Original jury awarded $5,000 in
damages, both parties appealed
OK Supreme Court reduced
damages to $300
10
Expectation damages vs. specific performance
 At first, sounds like a perfect example of efficient breach



Performing last part of contract would cost $29,000
Benefit to Peevyhouses would be $300
Efficient to breach and pay expectation damages, which is what
happened
 But…




Most coal mining contracts: standard per-acre diminution payment
Peevyhouses refused to sign contract unless it specifically
promised the restorative work
Dissent: Peevyhouses entitled to specific performance
(Peevyhouses seemed to value condition of property much more
highly than change in market value)
11
Think about Peevyhouse in terms of penalty
defaults
 Contract promised restoration work, didn’t specify remedy if
it wasn’t performed
 Which default rule works better:


Default rule allowing Garland to breach and pay diminution fee?
Default rule forcing Garland to perform restoration work?
 Ayres and Gertner: default rule should penalize the betterinformed party





Garland routinely signed contracts like these
Peevyhouses were doing this for the first time
Default rule allows Garland to pay diminution fee: they have no
reason to bring it up, Peevyhouses don’t know
Default rule forces Garland to do cleanup: if that’s inefficient, they
could bring it up during negotiations
12
In this case, specific performance would serve as a penalty default
Party-designed remedies
 Remedy for breach could be written directly into contract
 But common law courts don’t always enforce remedy terms




Liquidated damages – party-specified damages that reasonably
approximate actual harm done by breach
Penalty damages – damages greater than actual harm done
Civil law courts are generally willing to enforce penalty damages
But common law courts often do not
13
Penalty Damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
 Peevyhouse v Garland Coal







Peevyhouses only wanted farm strip-mined if it would be restored to
original condition after
Suppose coal extracted worth $70,000
Garland paid $25,000 for rights to mine it
Restoration work would cost $30,000
Diminution of value was $300
So liquidated damages would be $300
Suppose Peevyhouses got $40,000 of disutility from land being left
in poor condition
14
Liquidated damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay damages
(-14,700, 44,700)
 If damages limited to liquidated damages…



Peevyhouses shouldn’t believe restorative work will get done
So Peevyhouses better off refusing to sign
Even though mining and restoring Pareto-dominates
15
Penalty damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay penalty
(25,000, 5,000)
 If penalty clauses in contracts were enforceable…



Write contract with $40,000 penalty for leaving land unrestored
Now restoration work would get done, so Peevyhouses willing to sign
But if courts won’t enforce penalty damages, this won’t work
16
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus




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!
17
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus





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



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
18
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
19
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
20
Remedies and breach
 Opportunity cost damages, or reliance damages




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
21
Efficient signing
 Specific Performance



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



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
22
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
23
Investment in performance
 Some investment I can make to reduce likelihood that
breach becomes necessary
 Suppose probability of breach is initially ½…
but for every $27,726 I invest, I cut the probability in half




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
24
Investment in performance
(continuing with airplane example)
 Suppose you’ve built a $90,000 hangar




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?

How much will I choose to invest in performance?
25
Investment in performance
(continuing with airplane example)
 Suppose you’ve built a $90,000 hangar




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

How much will I choose to invest in performance?
Enough to reduce probability of breach to 40,000/(100,000 + D)
26
What do these results mean?
 What is the efficient level of investment in performance?

Enough so that p(z) = 40,000/430,000
 What will promisor do under various rules for damages?

Enough so that p(z) = 40,000/(100,000 + D)
 So if D = 330,000, efficient investment in performance





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
27
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
28
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
29
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


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
30
Another clever (but unrealistic) solution
 The problem:


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!

How do we do this? Need a third party
31
“Anti-insurance”
 You (promisee) and I (promisor) offer Bob this deal:
 If you rely and I breach,



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
32
“Anti-insurance”
 You (promisee) and I (promisor) offer Bob this deal:
 If you rely and I breach,



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
33
Reminder: what do courts actually do?
 Foreseeable reliance
 Include benefits reliance that promisor could have
reasonably anticipated
34
Repeated
interactions
35
Repeated games
36
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

After each game, 10% chance relationship ends, 90% chance we
play at least once more…
37
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
38
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
39
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.”
40
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


Bank has fiduciary duty to depositors
McDonalds franchisee has certain duties to franchisor
41
Repeated games and the endgame problem
 Suppose we’ll play agency game 60 times


$50 x 60 = $3,000 > $200, so cooperation seems like no problem
But…
 In game #60, reputation has no value to me



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…
42
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





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
43
One other bit
I like from Friedman
44
Friedman on premarital sex
45
Friedman on premarital sex
46
That’s it for contract law
 Purposes for contract law:






Encourage cooperation
Encourage efficient disclosure of information
Secure optimal commitment to performance
Secure efficient reliance
Provide efficient default rules and regulations
Foster enduring relationships
47