Econ 522
Economics of Law
Dan Quint
Fall 2012
Lecture 12
Economic Issues
in the
November Election
Thursday, October 25th
3pm-5pm
6210 Social Science
Please join the Department of Economics and the Economics Student Association as we host Douglas HoltzEakin and Jeffrey Liebman, discussing economic policy issues in the upcoming election.
Holtz-Eakin, is former Director of the Congressional Budget Office and was a top economic adviser for McCain
2008. Liebman, is the former Deputy Director of the Office of Management and Budget and is an economic
adviser for Obama 2012.
They will address economic issues such as the labor market, tax and budget policy, and the international
economy: issues that are at the heart of the November election.
1
Logistics
 MT1 – to be returned today
 HW3 (contract law) – online, due Thursday November 8
2
Results of Monday’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”
4
What did we find
 With anonymity, trust was a problem

Average A sent $5.15, got back $5.50


So about half of potential gains were realized
On average, trust paid off, but just barely: of those who sent money,



44% got back less than they sent
including 22% who got back zero
on the other hand, 27% got back at least twice what they sent
 Names made a huge difference!


Average A sent $7.91, got back $12.39, so 80% of gains realized
Of those who sent something…


11% got back less than they sent (7% got nothing)
54% got back at least twice what they sent
 Face to face: every A sent $10, every B sent $20 (boring!)
5
What did we find
With Names
Anonymous
A sent
# Obs
Avg back
Avg gain
% less
% zero
10
14
10.79
+0.79
43%
21%
6-9
6
8.17
+0.67
50%
0%
3-5
21
4.57
+0.43
38%
19%
1-2
4
0.25
–1.25
75%
75%
0
9
0.00
+0.00
100%
>0
Avg: 6.18
6.60
+0.42
44%
22%
A sent
# Obs
Avg back
Avg gain
% less
% zero
10
34
16.03
+6.03
9%
6%
6-9
9
11.00
+4.56
11%
11%
3-5
11
5.45
+0.91
9%
9%
1-2
2
1.00
–0.50
50%
0%
0
1
0.00
+0.00
12.60
+4.55
>0
Avg: 8.05
100%
11%
7%
6
Reliance
7
Monday
 Breach of contract

To get efficient breach, make promisor’s liability for breach =
promisee’s benefit from performance (expectation damages)
 Reliance





Any investment whose value depends on performance
Or, any investment which increases value of performance
If reliance increases damages owed, promisees will rely more than
the efficient amount (overreliance)
I promised you a continuous example of this
Stick with example we’ve already used:



I’m building you an airplane
Price is $350,000, you value plane at $500,000
You need to decide how much to invest in building a hangar
8
Continuous reliance
investments
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500,000 + 600x
Additional
value of
plane
y  600 x
Designer hangar with Starbucks - $480,000
Functional heating - $240,000
Metal poles, rigid roof - $120,000
Plywood frame, canvas roof - $60,000
Tarp and rope - $6,000 benefit
Investment in hangar
9
Three questions
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500,000 + 600x
 Let p be probability of breach
 Three questions

What is the efficient level of reliance?

What will promisee do if expectation damages include anticipated
benefit from reliance?

What will promisee do if expectation damages exclude anticipated
benefit from reliance?
10
Three questions
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500,000 + 600x
 Let p be probability of breach
 Three questions

What is the efficient level of reliance?
x = $90,000 (1 – p)2

What will promisee do if expectation damages include anticipated
benefit from reliance?
x = $90,000

What will promisee do if expectation damages exclude anticipated
benefit from reliance?
x = $90,000 (1 – p)2
11
Reliance and breach
 Just showed: if damages include added benefit from
reliance, promisee will invest more than efficient amount
 But if damages exclude added benefit…



Then promisor’s liability < promisee’s benefit from performance
Which means: promisor will breach more often than efficient
And promisor will underinvest in performance
 “Paradox of compensation”


Single “price” (damages owed) sets multiple incentives…
…impossible to set them all efficiently!
12
So what do we do?
 Cooter and Ulen: include only efficient reliance


Perfect expectation damages: restore promisee to level of wellbeing he would have gotten from performance if he had relied the
efficient amount
So promisee rewarded for efficient reliance, not for overreliance
13
So what do we do?
 Cooter and Ulen: include only efficient reliance


Perfect expectation damages: restore promisee to level of wellbeing he would have gotten from performance if he had relied the
efficient amount
So promisee rewarded for efficient reliance, not for overreliance
 Actual courts: include only foreseeable reliance

That is, if promisor could reasonably expect promisee to rely that
much
14
Foreseeable reliance: Hadley v Baxendale
 1850s England




Hadley ran flour mill, crankshaft broke
Baxendale’s firm hired to transport
broken shaft for repair
Baxendale shipped by boat instead of
train, making it a week late
Hadley sued for the week’s lost profits
 “The shipper assumed that Hadley, like most millers, kept a
spare shaft. …Hadley did not inform him of the special
urgency in getting the shaft repaired.”


Court listed several circumstances where broken shaft would not
force mill to shut down
Ruled lost profits not foreseeable  Baxendale didn’t have to pay15
Foreseeable reliance: Hadley v Baxendale
 “Before you can award damages
for wages paid and lost sales while
the mill was idle, you must first find
that at that time they entered into
the contract to ship the crankshaft,
the shipping company contemplated
that the mill owner would suffer
those idleness damages as a result
of late delivery.”
 To award damages for lost sales, Hadley should have to
prove that Baxendale could have predicted those losses
16
Foreseeable reliance: Hadley v Baxendale
 Why didn’t Hadley and Baxendale
just specify in the original contract
what happens in case of delay?
 What rules should apply in circumstances that aren’t
addressed in a contract?
17
Default
Rules
18
Default rules
 Gaps: risks or circumstances that aren’t specifically
addressed in a contract
 Default rules: rules applied by courts to fill gaps
19
Default rules
 Gaps: risks or circumstances that aren’t specifically
addressed in a contract
 Default rules: rules applied by courts to fill gaps
 Writing something into a contract vs leaving a gap


Allocating a risk (ex ante), before it becomes a loss
Versus allocating a loss (ex post)

Only have to deal with it if the loss occurs
20
What should default rules be?
 Cooter and Ulen: use the rule parties would have wanted,
if they had chosen to negotiate over this issue
 This will be whatever rule is efficient
21
What should default rules be?
 Cooter and Ulen: use the rule parties would have wanted,
if they had chosen to negotiate over this issue
 This will be whatever rule is efficient
 Fifth purpose of contract law is to minimize transaction
costs of negotiating contracts by supplying efficient
default rules

Do this by imputing the terms the parties would have chosen if they
had addressed this contingency
22
Default rules
 Don’t want ambiguity in the law
 So default rule can’t vary with every case
 Majoritarian default rule: the terms that most parties would
have agreed to

In cases where this rule is not efficient, parties can still override it in
the contract
 Court: figure out efficient allocation of risks, then
(possibly) adjust prices to compensate
23
Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?
24
Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?



Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
25
Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?



Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
26
Default rules
 So, Cooter and Ulen say: set the default rule that’s efficient
in the majority of cases

Most contracts can leave this gap, save on transaction costs

In cases where this rule is inefficient, parties can contract around it
27
Default rules: a different view
 Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete
Contracts: An Economic Theory of Default Rules”
 Sometimes better to make default rule something the
parties would not have wanted



To give incentive to address an issue rather than leave a gap
Or to give one party incentive to disclose information
“Penalty default”
28
Penalty defaults: Hadley v Baxendale
 Baxendale (shipper) is only one who can influence when
crankshaft is delivered; so he’s efficient bearer of risk
 If default rule held Baxendale liable, Hadley has no need to
tell him the shipment is urgent
 So Hadley might hide this information, which is inefficient


Ayres and Gertner: Ruling in Hadley was a good one, not because
it was efficient, but because it was inefficient…
…but in a way that created incentive for disclosing information
29
Penalty defaults: example
 Suppose…


80% of millers are low-damage – suffer $100 in losses from delay
20% of millers are high-damage – suffer $200 in losses from delay
 Shipper liable for actual damages



Average miller would suffer $120 in losses
Shipper makes efficient investment for average type
But not efficient for either type
 Shipper liable for foreseeable damages


Shipper makes efficient investment for low-damage millers
High-damage millers have strong incentive to negotiate around
default rule
30
Penalty defaults: other examples
 Real estate brokers and “earnest money”


Broker knows more about real estate law
Default rule that seller keeps earnest money encourages broker to
bring it up if it’s efficient to change this
31
Penalty defaults: other examples
 Real estate brokers and “earnest money”


Broker knows more about real estate law
Default rule that seller keeps earnest money encourages broker to
bring it up if it’s efficient to change this
 Courts will impute missing price of a good, but not quantity

Forces parties to explicitly contract on quantity, rather than leave it
for court to decide
32
When to use penalty defaults?
 Look at why the parties left a gap in contract


Because of transaction costs  use efficient rule
For strategic reasons  penalty default may be more efficient
 Similar logic in a Supreme Court dissent by Justice Scalia




Congress passed a RICO law without statute of limitations
Majority decided on 4 years – what they thought legislature would
have chosen
Scalia proposed no statute of limitations; “unmoved by the fear that
this… might prove repugnant to the genius of our law…”
“Indeed, it might even prompt Congress to enact a limitations period
that it believes appropriate, a judgment far more within its
competence than ours.”
33
When should a contract
not be enforced?
34
When should voluntary trade not be
allowed?
 Going back to property law…



Coase Theorem: to get efficient outcomes, we should let people
trade whenever they want to
But also saw some exceptions – some trades that aren’t, and
shouldn’t, be allowed
Selling enriched uranium to a terrorist
 Similarly with contract law…


First day: to get efficient outcomes, enforce any contract both
parties wanted enforced
But next, we’ll see exceptions – contracts which shouldn’t be
enforced, due to externalities or market failures/transaction costs
35
Example of an unenforceable contract: a
contract which breaks the law
 Obvious: contract to buy a
kilo of cocaine is unenforceable
36
Example of an unenforceable contract: a
contract which breaks the law
 Obvious: contract to buy a
kilo of cocaine is unenforceable
 Less obvious: otherwise-legal contract whose real purpose
is to circumvent a law




Legal doctrine: derogation of public policy
Derogate, verb. detract from; curtail application of (a law)
Applies to contracts which could only be performed by breaking
law…
…but also to “innocent” contracts whose purpose is to get around a
law or regulation
37
Derogation of public policy – example
 Labor unions required by law to negotiate “in good faith”
 Recent NBA labor troubles



Old CBA: 57% of “basketball-related income” went to player salaries
Owners were offering less than 50%, players demanding 53%...
Imagine the following contract:



“For the next 50 years, if the NBAPA
accepts a CBA paying less than 55%
of BRI in player salaries, then we also
agree that all non-retired players will
work for you as coal miners every
offseason at federal minimum wage.”
Purpose is purely to “bind hands” in
negotiations with ownership
Contract would not be enforced
38
Derogation of public policy
 In general: a contract is not enforceable if it cannot be
performed without breaking the law
 Exception: if promisor knew (and promisee didn’t)




I’m married, my girlfriend in California doesn’t know; I promise her
I’ll marry her, she quits her job and moves to Madison
My company agrees to supply a product that we can’t produce
without violating a safety or environmental regulation
Keeping either promise would require breaking the law…
…but I’d still be liable for damages for breach
 Like in Ayres and Gertner: default rule penalizes betterinformed party for withholding information
39
Default rules versus regulations
 Talked earlier about default rules


Default rules apply if no other rule is specified…
…but can be contracted around
 Rules like “derogation of public policy” cannot be
contracted around


Parties to a contract can’t say, “even though this type of contract
would normally not be valid, this one is”
Rules which always apply: immutable rules, or mandatory rules,
or regulations
 Fifth purpose of contract law is to minimize transaction
costs of negotiating contracts by supplying efficient default
rules and regulations.
40
Ways to get out
of a contract
41
Formation Defenses and Performance
Excuses
 Formation defense


Claim that a valid contract does not exist
(Example: no consideration)
 Performance excuse


Yes, a valid contract was created
But circumstances have changed and I should be allowed to not
perform without penalty
 Most doctrines for invalidating a contract can be explained
as either…


Individuals agreeing to the contract were not rational, or
Transaction cost or market failure
42
One formation defense: incompetence
 Courts will not enforce
contracts with people
who can’t be presumed
to be rational


Children
Legally insane
 Incompetence


One party was “not
competent to enter into
the agreement”
No “meeting of the minds”
43
So…
 If courts won’t enforce a contract signed by someone who
wasn’t competent…
 What if you signed a contract while drunk?



You need to have been really, really, really drunk to get out of a
contract
(“Intoxicated to the extent of being unable to comprehend the
nature and consequences of the instrument he executed”)
Lucy v. Zehmer, Virginia Sup Ct 1954
44
Lucy v. Zehmer
 Zehmer and his wife owned a farm (“the Ferguson farm”),
Lucy had been trying to buy it for some time
 While out drinking, Lucy offers $50,000, Zehmer responds,
“You don’t have $50,000”
 “We hereby agree to sell to
W.O. Lucy the Ferguson Farm
complete for $50,00000, title
satisfactory to buyer.”
45
Lucy v. Zehmer
 Zehmer and his wife owned a farm (“the Ferguson farm”),
Lucy had been trying to buy it for some time
 While out drinking, Lucy offers $50,000, Zehmer responds,
“You don’t have $50,000”
 “We hereby agree to sell to
W.O. Lucy the Ferguson Farm
complete for $50,00000, title
satisfactory to buyer.”
46
Lucy v. Zehmer
 So, you can be pretty drunk and still be bound by the
contract you signed


Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
47
Lucy v. Zehmer
 So, you can be pretty drunk and still be bound by the
contract you signed


Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
 Borat lawsuits

Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk
Journalist for Make Benefit Guileless Americans In Film”
 Moral of the story: don’t get drunk with people who might
ask you to sign a contract
48
First Midterm
 Overall: pretty good
 Average and median both 81, std dev 11
 Not assigning letter grades till end of semester, but…



A-H
to give a rough idea of how you’re doing,
based on distribution of scores on first midterm,
77-87 roughly a B, 65-72 roughly a C
I-O
P-Z
49