Econ 522
Economics of Law
Dan Quint
Spring 2013
Lecture 16
Reminders
 HW3 (contract law) due Thursday
 No section this week – have a good Spring Break!
1
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
 Effects of remedy on…




Breach, or renegotiation
Signing
Investment in performance
Reliance
2
We ran out of time interpreting the results on
investment in performance
 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
3
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
4
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
5
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
6
“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
7
“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
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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
10
Repeated games
11
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…
12
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
13
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
14
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.”
15
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
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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…
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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





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
18
One other bit
I like from Friedman
19
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:






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
 And now, a brief preview of where we’re headed next
22
Recapping our
story to date…
23
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
24
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
25
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
26
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…
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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
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Tort law
29
An example
30
An example
punish the choice
• criminal law
• regulations
Choice
+
Bad Luck

Outcome
31
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”
32
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.”
33
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
34
Something to remember
distribution
but not
efficiency
efficiency
35
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”
36
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”
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