Econ 522
Economics of Law
Dan Quint
Fall 2011
Lecture 10
Reminders
 First midterm Wednesday, in class
 HW2 solutions at end of lecture
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Contract Law
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Why do we need contracts?
 Some transactions don’t occur all at once


I’m flying to Boston for Thanksgiving…
…or I hire someone to paint my house…
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Why do we need contracts?
 Some transactions don’t occur all at once



I’m flying to Boston for Thanksgiving…
…or I hire someone to paint my house…
…or you can get $10 for a purple poker chip, but don’t have any
cash on you right now to buy it from someone with a lower number
 A contract is a promise…
 …which enables trade when transactions aren’t concluded
immediately
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Example: the agency (trust) game
Player 1 (you)
Don’t
Trust me
Player 2 (me)
(100, 0)
Share profits
(150, 50)
Keep all the money
(0, 200)
 Subgame perfect equilibrium: I’ll keep all the money; so you
don’t trust me


Inefficient outcome (100 < 200)
And we’re both worse off
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(One solution: reputation)
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Another solution: legally binding promises
Player 1 (you)
Don’t
Trust me
Player 2 (me)
(100, 0)
Share profits
(150, 50)
Keep all the money
(125, 25)
 Now we get cooperation (and efficiency)
 Purpose of contract law: to allow trade in situations where
this requires credible promises
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So… what types of promises should be
enforced by the law?
 “The rich uncle of a struggling college student learns at the graduation party that
his nephew graduated with honors. Swept away by good feeling, the uncle
promises the nephew a trip around the world. Later the uncle reneges on his
promise. The student sues his uncle, asking the court to compel the uncle to
pay for a trip around the world.”
 “One neighbor offers to sell a used car to another for $1000. The buyer gives
the money to the seller, and the seller gives the car keys to the buyer. To her
great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the
back yard, not the shiny Cadillac in the driveway. The seller is equally surprised
to learn that the buyer expected the Cadillac. The buyer asks the court to order
the seller to turn over the Cadillac.”
 “A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,”
mails $25 and receives in the mail two wooden blocks with the instructions,
“Place grasshopper on Block A and smash with Block B.” The buyer asks the
court to require the seller to return the $25 and pay $500 in punitive damages.”
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The Bargain Theory
of Contracts
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The bargain theory of contracts
 Developed in the late 1800s/early 1900s
 A promise should be enforced if it was given as part of
a bargain, otherwise it should not
 Bargains were taken to have three elements



Offer
Acceptance
Consideration
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What is consideration?
 Promisor: person who gives a promise
 Promisee: person who receives it
 In a bargain, both sides must give up something

reciprocal inducement
 Consideration is what the promisee gives to the
promisor, in exchange for the promise
 Under the bargain theory, a contract becomes enforceable
once consideration is given
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What is consideration?
 Promisor: person who gives a promise
 Promisee: person who receives it
 In a bargain, both sides must give up something

reciprocal inducement
 Consideration is what the promisee gives to the
promisor, in exchange for the promise
 Under the bargain theory, a contract becomes enforceable
once consideration is given
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The bargain theory does not distinguish
between fair and unfair bargains
 Hamer v Sidway (NY Appeals Ct, 1891)
 Uncle offered nephew $5,000 to give up drinking and
smoking until his 21st birthday, then refused to pay
“The promisee [previously] used tobacco, occasionally drank liquor,
and he had a legal right to do so. That right he abandoned for a period
of years upon the strength of the promise… We need not speculate
on the effort which may have been required to give up the use of
these stimulants. It is sufficient that he restricted his lawful freedom of
action within certain prescribed limits upon the faith of his uncle’s
agreement, and now, having fully performed the conditions imposed,
it is of no moment whether such performance actually proved a
benefit to the promisor, and the court will not inquire into it.”
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Under the bargain theory, what is the
remedy?
 Expectation damages

the amount of benefit the promisee could reasonably expect from
performance of the promise

meant to make the promisee as well of as he would have been, had
the promise been fulfilled
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Problems with the bargain theory
 Not that accurate a description of what modern courts
actually do
 Not always efficient

Does not enforce certain promises that both promisor and promisee
might have wanted to be enforceable
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Problems with the bargain theory
 Not that accurate a description of what modern courts
actually do
 Not always efficient

Does not enforce certain promises that both promisor and promisee
might have wanted to be enforceable

Does enforce certain promises that maybe should not be enforced
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What does efficiency say about
what promises should be enforced?
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What promises should be enforced?
 In general, efficiency requires enforcing a promise if both
the promisor and the promisee wanted it to be
enforceable when it was made

different from wanting it to actually be enforced
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What promises should be enforced?
 In general, efficiency requires enforcing a promise if both
the promisor and the promisee wanted it to be
enforceable when it was made

different from wanting it to actually be enforced
 The first purpose of contract law is to enable people to
cooperate by converting games with noncooperative
solutions into games with cooperative solutions

or, enable people to convert games with inefficient equilibria into
games with efficient equilibria
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What promises should be enforced?
 In general, efficiency requires enforcing a promise if both
the promisor and the promisee wanted it to be
enforceable when it was made

different from wanting it to actually be enforced
 The first purpose of contract law is to enable people to
cooperate by converting games with noncooperative
solutions into games with cooperative solutions

or, enable people to convert games with inefficient equilibria into
games with efficient equilibria
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So now we know…
 What promises should be enforceable?

For efficiency: enforce those which both promisor and promisee
wanted to be enforceable when they were made
 One purpose of contract law

Enable cooperation by changing a game to have a cooperative
solution
 Contract law can serve a number of other purposes as well
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Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
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Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
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Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
 Contract law could help



You could offer me a legally binding warranty
Or, contract law could impose on you an obligation to tell me what
you know about the condition of the car
Forcing you to share information is efficient, since it makes us more
likely to trade
 The second purpose of contract law is to encourage the
efficient disclosure of information within the contractual
relationship.
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Breach
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So…
 A contract is just a promise


The idea here is that we want some promises to be legally binding
This means there has to be some legal consequence for breaking
such a promise
 Breach of contract is when the promisor fails to live up to
his promise


Just like property rights are meaningless unless there is a remedy
when they are violated…
…contract law is meaningless unless there is a penalty for breach
 So, what happens when a contract is breached?
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Why does the penalty for breach matter?
 If penalty is too weak, contract law has no bite, and we’re
back to our original problem
 But sometimes, circumstances change, and breach of
contract becomes desirable

Example: I promise to sell you a painting
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Why does the penalty for breach matter?
 If penalty is too weak, contract law has no bite, and we’re
back to our original problem
 But sometimes, circumstances change, and breach of
contract becomes desirable



Example: I promise to sell you a painting
Example: I promise to build you a plane
If penalty for breach is too severe, I’ll have to honor these promises
even when this is inefficient
 Can we design the law so that we only get breach of
contract when it’s efficient?
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When is breach efficient?
 Breach is efficient if
social benefit of breach > social cost of breach
 Social cost of breach is that promisee doesn’t get the
benefit from the promise
 Social benefit of breach is that promisor doesn’t have to
incur the cost of delivering (performing)
 So breach is efficient if
promisor’s cost to perform
> promisee’s benefit from performance
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Efficient Breach
Efficiency:
Promisor’s
Cost
Promisor’s
Cost
>
Promisee’s
Benefit

Efficient to Breach
<
Promisee’s
Benefit

Efficient to Perform
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When do we expect breach to happen?
 Promisor weighs private cost of performance vs breach
 Whatever the penalty for breach, if it’s cheaper to perform,
promisor will perform; if it’s cheaper to breach, he’ll breach
 That is, we expect breach to occur whenever
promisor’s cost to perform
> penalty for breach
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Efficient Breach
Efficiency:
Promisor’s
Cost
Promisor’s
Cost
>
Promisee’s
Benefit

Efficient to Breach
<
Promisee’s
Benefit

Efficient to Perform
What will actually happen (incentives of promisor):
Promisor’s
Cost
Promisor’s
Cost
>
Promisor’s
Liability

Promisor will Breach
<
Promisor’s
Liability

Promisor will Perform
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So how do we get efficient breach?
Efficiency:
Promisor’s
Cost
>
Promisee’s
Benefit

Efficient to Breach
What will actually happen (incentives of promisor):
Promisor’s
Cost
>
Promisor’s
Liability

Promisor will Breach
So if we design the law such that
Promisor’s
Liability
for Breach
=
Promisee’s
Benefit from
Performance
the promisor will breach exactly when breach is efficient
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Efficient breach
 When liability from breach = promisee’s benefit from
performance, we get breach exactly when it’s efficient




So for efficiency, when a promisor breaches a contract, we want him
to owe a penalty exactly equal to the benefit the promisee
expected to receive
This is called expectation damages
Expectation damages: if I promise you something that has value of
$100 to you, and then I break my promise, I owe you $100
This way,


if it costs me more than $100 to keep my promise, I’ll break it, which is
efficient
if it costs me less than $100 to keep my promise, I’ll keep it, which is
efficient
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Example of efficient breach
Value to you = $500,000
Price = $350,000
 I build airplanes
 You value one of my planes at $500,000
 You agree to buy one for $350,000, and pay up front
 After you pay, price of materials goes up
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Example of efficient breach
Promisor’s
Cost
>
Promisee’s
Benefit

Value to you = $500,000
Price = $350,000
Efficient to Breach
 Promisee’s benefit = $500,000

If it costs me less than $500,000 to build plane, efficient to build it

If it costs me more than $500,000, efficient to breach
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Value to you = $500,000
Example of efficient breach
Promisor’s
Cost
>
Promisor’s
Liability

Price = $350,000
Promisor will Breach
 Liability is just to return your money


What if my costs rise to $400,000?
Performance is still efficient, but I’ll choose to breach
 Liability is $1,000,000


What if my costs rise to $700,000?
Performance is now inefficient, but I’d rather perform than breach
 Liability = promisee’s benefit ($500,000)

I’ll perform when performance is efficient, breach when breach is
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efficient
But so what? Can’t we just
“Coase” back to efficiency?
Value to you = $500,000
Price = $350,000
 Liability is $350,000, my costs rise to $400,000


I’ll breach original contract, but we can renegotiate to higher price
But I might try to do that even if my costs don’t go up…
 Liability is $1,000,000, my costs rise to $700,000



Rather than performing, I can offer you money to let me cancel
contract
But my threat point is very low – you can demand a lot of money
If I realize that might happen, maybe I’m afraid to sign original
contract
 Expectation damages avoid these problems
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Another way to think about expectation
damages: eliminating an externality
 If I breach contract, I impose externality on you

You’re $500,000 worse off
 If I have to pay you $500,000, then I internalize the
externality



Now my action no longer affects your well-being
(You get a payoff of $500,000 if I build the plane, and a benefit of
$500,000 if I don’t.)
So I choose efficiently when deciding whether to perform or breach
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