Econ 522
Economics of Law
Dan Quint
Fall 2013
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 $10


Chooses how much of it to give to player B
That money is tripled
 Player B has $10, plus 3x whatever A gave him/her

Chooses how much (if any) to give back to player A
 Tried it three ways:



Anonymous
On paper, but with names
Face to face in front of the class
3
So, is trust a problem?
 With anonymity, yes


Average A sent $5.33, got back $7.41
Trust was rewarded, but there was some risk


Of those A’s who sent money, 29% got back less than they sent
Worse, only about half of the potential gains were realized

18% of A’s sent nothing, only 25% sent 10
 With names – less of a problem



Average A sent $6.98, got back $11.64, so 70% of gains realized
Only 8% of A’s sent nothing, almost half sent $10
Of those who sent something…


13% got back less than they sent (9% got nothing)
49% got back at least twice what they sent
 Face-to-face: every A sent $10, but B’s varied
4
So, is trust a problem?
With Names
Anonymous
A sent
# Obs
Avg back
Avg gain
% less
% zero
0
11
0.00
+0.00
1-3
4
4.00
+2.25
0%
0%
4-6
23
7.48
+2.61
30%
22%
7-9
7
7.29
+0.00
43%
29%
10
15
13.73
+3.73
27%
20%
>0
Avg: 6.53
9.08
+2.55
29%
20%
A sent
# Obs
Avg back
Avg gain
% less
% zero
0
5
0.00
+0.00
1-3
4
2.50
+0.25
0%
0%
4-6
17
8.79
+3.85
18%
12%
7-9
7
9.71
+1.71
14%
14%
10
27
17.44
+7.44
11%
7%
12.70
+5.08
13%
9%
>0
Avg: 7.62
5
Back to work
6
Monday
 Remedies for breach of contract



Specific performance – similar to injunctive relief
Court-ordered damages – different bases for calculation
Party-specified remedies – but “penalty damages” not always
enforceable in common-law courts
 Today: effects of remedy on four decisions
7
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
8
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
9
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
10
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
11
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
12
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
13
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?
14
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)
15
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
16
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
17
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
18
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
19
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
20
“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
21
“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
22
Reminder: what do courts actually do?
 Foreseeable reliance
 Include benefits reliance that promisor could have
reasonably anticipated
23
Repeated
interactions
24
Repeated games
25
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…
26
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
27
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
28
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.”
29
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
30
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…
31
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
32
One other bit
I like from Friedman
33
Friedman on premarital sex
34
Friedman on premarital sex
35
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
36
Recapping our
story to date…
(may not get to this)
37
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
38
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
39
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
40
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…
41
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
42
Tort law
43
An example
44
An example
punish the choice
• criminal law
• regulations
Choice
+
Bad Luck

Outcome
45
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”
46
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.”
47
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
48
Something to remember
distribution
but not
efficiency
efficiency
49
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”
50
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”
51