Econ 522
Economics of Law
Dan Quint
Spring 2014
Lecture 16
Reminders
 HW3 (contract law) due next Thursday
1
Results of Monday’s
Experiment (trust)
2
The game we played
 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
 Tried it four ways:




Anonymous
On paper, but with names
Face to face
Openly in front of the class
3
What is subgame perfect equilibrium?
 No matter what player A does, B is best off keeping
everything
 So A is best off sending nothing
 So subgame perfect equilibrium payoffs are ($5, $5), even
though total surplus of $25 could be achieved through
cooperation
 So how did you guys do?
4
How’d you guys do?
WITH NAMES
ANONYMOUS
A sent
Observations
Average back from B
Fraction who got 0
0
10
1.00
80%
1
4
3.00
25%
2
10
1.70
40%
3
10
6.30
0%
4
5
9.40
20%
5
24
8.96
8%
84% sent something
avg sent $3.66
avg gain $3.02
15% got 0 back
A sent
Observations
Average back from B
Fraction who got 0
0
4
0.00
100%
1
3
4.70
0%
2
9
3.00
0%
3
9
6.80
0%
4
6
6.00
0%
5
34
10.80
6%
94% sent something
avg sent $3.97
avg gain $4.34
3% got 0 back
5
So, is trust a problem?
 With anonymity, yes


Average A sent $3.08, got back $5.78
Trust was rewarded, but there was some risk


Of those A’s who sent something, 15% got nothing back, 19% got back
less than they sent
Worse, only about 60% of the potential gains were realized

16% of A’s sent nothing, only 38% sent 5
 Things got better with names



Average A sent $3.72, got back $7.79
Only 6% of A’s sent nothing, 52% sent 5
Of those who sent something…


only 3% got nothing back, and only 8% lost money
74% got back at least twice as much as they sent
6
So, is trust a problem?
 Face to face or in public: no problem at all

Every single A who traded face-to-face or in public sent the
maximum amount, and every B sent back between $10 and $13
 But trust was an issue in “anonymous” trading


Trust was rewarded, but with some risk…
…and not everyone was willing to trust, leading to some gains
going unrealized
7
Back to work
8
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
9
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
10
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
11
“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
12
“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
13
Reminder: what do courts actually do?
 Foreseeable reliance
 Include benefits reliance that promisor could have
reasonably anticipated
14
Repeated
interactions
15
Repeated games
16
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…
17
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
18
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
19
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.”
20
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
21
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…
22
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
23
One other bit
I like from Friedman
24
Friedman on premarital sex
25
Friedman on premarital sex
26
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
 Next up: tort law
27
But first, let’s recap
our story so far…
28
Our story so far
 Efficiency



Maximizing total surplus realized by everyone in society
Scarce resources are owned by whoever values them most
Actions are taken if social benefit exceeds social cost
 Design a legal system that leads to efficient outcomes



Once we set up the rules, we don’t expect people to act based on
what’s efficient
We expect people to do whatever’s in their own best interest
So the goal is set up the rules such that people acting in their
own best interest will naturally lead to efficiency
29
Our story so far
 Coase gives us one way to do that



If property rights are clearly defined and tradable, and there are
no transaction costs, people have incentive to trade until each
resource is efficiently owned
So initial allocation of rights doesn’t matter for efficiency
But if there are transaction costs, we may not get efficiency this way
 Led us to two normative views of the legal system:


1. Minimize transaction costs (“lubricate” private exchange)
2. Allocate rights as efficiently as possible
 Tradeoff between injunctive relief and damages
30
Our story so far
 Property law works well for simultaneous trade
 Contracts allow for non-simultaneous trade
 Contract law can…






Enable cooperation
Encourage efficient disclosure of information
Secure optimal commitment to performance
Secure efficient reliance
Supply efficient default rules and regulations
Foster enduring relationships
31
Our story so far
 So far, we’ve been talking about voluntary exchange


Coase is predicated on exchange being voluntary for both parties
Contracts are an extension of voluntary trade
 Up next: “involuntary trade”


You’re bicycling to class, I’m texting while driving and I hit you
You didn’t want to deal with me, I didn’t want to deal with you…
32
Our story so far
 To put it another way…
 Property law covers situations where transaction costs are
low enough to get agreement ahead of time

Exceptions to property law – private necessity, eminent domain –
when this isn’t the case
 Contract law covers situations when transaction costs are
low enough for us to agree to a contract, high enough that
we may not want to renegotiate the contract later
 Tort law covers situations where transaction costs are too
high to agree to anything in advance
33
Tort law
34
An example
35
An example
punish the choice
• criminal law
• regulations
Choice
+
Bad Luck

Outcome
36
An example
punish the choice
punish the outcome
• criminal law
• “strict liability”
• regulations
Choice
+
Bad Luck

Outcome
punish the combination of choice and outcome
• “negligence”
37
Tort law
 Tort, noun. from French word meaning injury
 Contract law: situations where someone harms you by
breaking a promise they had made
 Tort law: situations where someone harms you without
having made any promises
 “If someone shoots you, you call a cop. If he runs his car
into yours, you call a lawyer.”
38
As always, we’ll be focused on achieving
efficiency
 I hit you with my car, do $1,000 worth of damage



You’re $1,000 worse off
(No damage to me or my car)
Should I have to pay you damages?
I owe nothing
I owe $1,000
I owe $50,000
–1,000
0
49,000
My payoff
0
–1,000
–50,000
Combined
payoffs
–1,000
–1,000
–1,000
Your payoff
39
Something to remember
distribution
but not
efficiency
efficiency
40
Tort law
 Question: how to structure the law to get people to behave
in a way that leads to efficient outcomes?

Deliberate harms: make punishment severe (criminal law)

Accidental harms: trickier

Goal isn’t “no accidents”; goal is “efficient number of accidents”
41
Tort law
 Question: how to structure the law to get people to behave
in a way that leads to efficient outcomes?

Deliberate harms: make punishment severe (criminal law)

Accidental harms: trickier

Goal isn’t “no accidents”; goal is “efficient number of accidents”

Unlike nuisance law, injunctive relief is not an option

Unlike contract law, no agreement ahead of time

Cooter and Ulen: essence of tort law is “the attempt to make
injurers internalize the externalities they cause, in situations
where transaction costs are too high to do this through
property or contract rights”
42
Cast of characters
 Plaintiff – person who brings a lawsuit
 Defendant – person who is being sued

In a nuisance case, the defendant caused a nuisance, plaintiff was
bothered by it, might be asking for injunction or damages

In a contract case, defendant breached a contract or violated its
terms

In a tort case, defendant caused some harm to plaintiff, plaintiff is
asking for damages

Plaintiff is the victim (person who was harmed)

Defendant is the injurer (person who caused the harm)
43
Next week
 “Classic” legal theory of torts
 Simple economic model to study incentives
44