Econ 522
Economics of Law
Dan Quint
Spring 2013
Lecture 15
Reminders
 HW3 (contract law) due Thursday
1
Last week
 Last week – lots of reasons a contract might not be enforced







Derogation of public policy
Incompetence, but generally not drunkenness
Duress and Necessity
Impossibility
Bad information (fraud, failure to disclose, frustration of purpose,
mutual mistake), but generally not unilateral mistake
Vagueness, adhesion, unconscionability
For each: is there an economic justification?
 Today: more on remedies for breach of contract

But first…
2
Results of Wednesday’s
Experiment (trust)
3
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 four ways:




Anonymous
On paper, but with names
Face to face
In public (in front of the class)
4
So, is trust a problem?
 With anonymity, yes


Average A sent $4.20, got back $4.66
Trust was rewarded, but just barely


Of those A’s who sent money, 27% got back less than they sent
Worse, less than half of the potential gains were realized

29% of A’s sent nothing, only 25% sent 10
 With names – much less of a problem


Average A sent $6.95, got back $11.03, so 70% of gains realized
Only 8% of A’s sent nothing; of the rest…


13% got back less than they sent (10% got nothing)
49% got back at least twice what they sent
 Face-to-face and public: every A sent $10, every B $15 or $20
5
So, is trust a problem?
With Names
Anonymous
A sent
# Obs
Avg back
Avg gain
% less
% zero
0
20
0.00
+0.00
1-3
16
3.41
+1.16
19%
19%
4-6
15
5.40
+0.27
27%
27%
7-9
1
7.00
+0.00
0%
0%
10
17
10.53
+0.53
35%
24%
>0
Avg: 5.92
6.56
+0.64
27%
22%
A sent
# Obs
Avg back
Avg gain
% less
% zero
0
6
0.00
+0.00
1-3
8
2.85
+0.38
38%
25%
4-6
18
9.19
+4.19
0%
0%
7-9
6
13.85
+6.51
0%
0%
10
36
15.14
+5.14
17%
14%
12.01
+4.45
13%
10%
>0
Avg: 7.56
6
So, is trust a problem?
 Potentially, yes
 In anonymous case, A didn’t trust B that much, and B
wasn’t that trustworthy
 Knowing each others’ names helped a significant amount…
 …and interacting face-to-face solved the problem
completely
7
Remedies for breach
of contract
8
Three broad types of remedy for breach of
contract
 Party-designed remedies

Remedies specified in the contract
 Court-imposed damages

Court may decide promisee entitled to some level of damages
 Specific performance

Forces breaching party to live up to contract
9
Expectation damages
 Compensate promisee for the amount he expected to
benefit from performance




You agreed to buy an airplane for $350,000
You expected $500,000 of benefit from it
Expectation damages: if I breach, I owe you that benefit
($500,000 if you already paid, $150,000 if you didn’t)
 “Positive damages”
 Make promisee indifferent between performance and breach
10
Reliance damages
 Reimburse promisee for cost of any reliance investments
made, but not for additional surplus he expected to gain
 Restore promisee to level of well-being before he signed
the contract


You contracted to buy the plane and built a hangar
If I breach, I owe you what you spent on the hangar, nothing else
 “Negative damages” – undo the negative (harm) that
occurred
11
Opportunity cost damages
 Give promisee benefit he would have gotten from his
next-best option






Make promisee indifferent between breach of the contract that
was signed, and performance of best alternative contract
You value plane at $500,000
You contract to buy plane from me for $350,000
Someone else was selling similar plane for $400,000
By the time I breach, that plane is no longer available
I owe you $100,000 – the benefit you would have gotten from
buying the other seller’s plane
12
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Ohio State
football game for $50



Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of
whatever pre-game investments I made
13
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Ohio State
football game for $50






Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of
whatever pre-game investments I made
When you agreed to sell me ticket, other
tickets available for $70
Opportunity cost damages: $80
(I paid a scalper $150 to get in; I would
have been $80 better off if I’d ignored
your offer and paid someone else $70)
14
Ranking damages
Contract
I Sign

Best
Alternative

Do Nothing
=
=
=
Breach +
Expectation
Damages

Breach +
Opportunity Cost
Damages

Breach +
Reliance
Damages

Opportunity Cost
Damages

Reliance
Damages
Expectation
Damages
$100
$80
$15
15
Hawkins v McGee (“hairy hand case”)
 Hawkins had a scar on his hand
 McGee promised surgery to “make the hand a hundred
percent perfect”
 Surgery was a disaster, left scar bigger and covered with
hair
16
Hawkins v McGee (“hairy hand case”)
+ Opp Cost
Damages
+ Reliance
Damages
Initial Wealth
Opp Cost Damages
Reliance Damages
+ Expectation
Damages
Expectation Damages
$
Hand
Hairy Scarred
Next
best
doctor
100%
Perfect
17
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
18
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
 Specific Performance




Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
19
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
20
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)
21
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
22
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
23
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
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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
25
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
26
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!
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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
28
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
29
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
30
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
31
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
32
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
33
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
34
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?
35
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)
36
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
37
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
38
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
39
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
40
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
41
“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
42
“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
43
Reminder: what do courts actually do?
 Foreseeable reliance
 Include benefits reliance that promisor could have
reasonably anticipated
44
Repeated
interactions
(we won’t get to this)
45
Repeated games
46
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…
47
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
48
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
49
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.”
50
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
51
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…
52
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
53
One other bit
I like from Friedman
54
Friedman on premarital sex
55
Friedman on premarital sex
56
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
End of material on second midterm
 Next week, we begin tort law
57