Econ 522
Economics of Law
Dan Quint
Fall 2011
Lecture 11
Contract law: the story so far
 Contract = legally binding promise
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Allow for cooperation/trade when transactions aren’t instantaneous
First purpose of contract law: enable cooperation
 What promises should be enforced?
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Bargain theory: those given as part of a bargain

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Three elements: offer, acceptance, consideration
Efficiency: any promise both promisor and promisee wanted to be
enforceable
 Information
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Asymmetric/private info can prevent trade; contract law can help
Second purpose: encourage efficient disclosure of information
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Contract law: the story so far
 May become efficient/necessary to break a promise
 When should a contract be breached?
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Breach of contract is efficient when
cost to perform > benefit of performance to promisee
Breach is in promisor’s interest when
cost to perform > promisor’s liability from breach
Expectation damages: liability from breach = benefit to promisee
Leads to breach exactly when it’s efficient
Think of this as “designing the law to internalize an externality”
Third purpose of contract law: obtain optimal commitment to
performance
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Reliance
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Reliance
 You expect an airplane to arrive
in spring – you might…
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Sign up for flying lessons
Build yourself a hangar
Buy a helmet and goggles
 Reliance – investments which depend on performance
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Reliance increases the value of performance to promisee
Reliance increases the social cost of breach
 The fourth purpose of contract law is to secure optimal
reliance
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When is reliance efficient?
 When social benefit of reliance > social cost of reliance
 Social benefit is increased benefit to promisee
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(Value of airplane + hangar) – (Value of airplane without hangar)
Value is only realized if the promise is performed
 Social cost is cost borne by promisee
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Cost occurs whether or not promise is performed
 Reliance is efficient if
Increase in
value of
performance
X
Probability of
performance
>
Cost of
investment
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How should reliance figure into damages?
 Expectation damages = expected benefit from performance
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If reliance investments increase the anticipated benefit…
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should they increase the damages I owe you in the event of breach?
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Can we design damages to get efficient reliance, in addition to
efficient breach?
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Reliance and damages:
example
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 You’re buying an airplane from me
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Price is $350,000, to be paid on delivery
Airplane alone gives you benefit of $500,000
Building a hangar costs $75,000
Airplane with hangar gives you benefit of $600,000
 Without hangar, expectation damages = $150,000
 If you build a hangar and I fail to deliver plane, do I owe…
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$150,000? (Value of original promise)
$250,000? (Value of performance after your investment)
$225,000? (Value of original promise, plus reimburse you for
investment you made)
Some other amount?
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To get efficient breach…
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 The only way to guarantee efficient breach is if damages
included the added benefit from reliance
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Once you’ve made investment, you anticipate benefit of $250,000
from performance
If damages are anything less than that, I’ll breach too often
(If damages exclude the added benefit, then I’m back to imposing
an externality when I choose to breach the contract)
 So what happens to the incentive for reliance investments
if damages will increase to include this added benefit?
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If exp damages include
benefit from reliance…
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 If you don’t build hangar, your payoff will be…
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$150,000 if I deliver the plane ($500,000 – $350,000)
$150,000 if I breach and pay expectation damages
 If you build hangar, your payoff will be…
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$175,000 if I deliver the plane ($600,000 – $350,000 – $75,000)
$175,000 if I breach and pay (higher) expectation damages
 So if expectation damages include the increased value of
performance due to reliance investments…
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You’ll invest whenever (increase in benefit) > (cost)
In this case, you’ll invest (because $100,000 > $75,000)
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If exp damages include
benefit from reliance…
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 If expectation damages include increased value of
performance, you’ll invest for sure
 Is this efficient?
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Reliance is efficient if
(increase in benefit) X (probability of performance) > (cost)
$100,000 X (probability of performance) > $75,000
Only efficient if probability of performance > ¾
If probability of performance < ¾, reliance is inefficient, but happens
anyway
 Overreliance!
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Better example:
continuous investment
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
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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
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What is the efficient level of reliance?
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What will promisee do if expectation damages include anticipated
benefit from reliance?
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What will promisee do if expectation damages exclude anticipated
benefit from reliance?
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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
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What is the efficient level of reliance?
x = $90,000 (1 – p)2
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What will promisee do if expectation damages include anticipated
benefit from reliance?
x = $90,000
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What will promisee do if expectation damages exclude anticipated
benefit from reliance?
x = $90,000 (1 – p)2
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Overreliance
 If reliance investments increase the damages you’ll receive
in the event of breach, you’ll over-rely
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You’ll rely if
Increase
in benefit
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+
Increase
in damages
X
Prob. of
breach
>
Cost of
investment
>
Cost of
investment
Efficient to rely if
Increase
in benefit

X
Prob. of
perform.
X
Prob. of
perform.
So if damages increase when you make reliance investments, we’re
sure to get overreliance!
(Your investment imposes an externality on me)
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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…
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Then promisor’s liability < promisee’s benefit from performance
Which means: promisor will breach more often than efficient
 “Paradox of compensation”
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Single “price” (damages owed) sets multiple incentives…
…impossible to set them all efficiently!
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So what do we do?
 Cooter and Ulen: include only efficient reliance
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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
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So what do we do?
 Cooter and Ulen: include only efficient reliance
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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
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That is, if promisor could reasonably expect promisee to rely that
much
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Foreseeable reliance: Hadley v Baxendale
 1850s England
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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.”
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Court listed several circumstances where broken shaft would not
force mill to shut down
Ruled lost profits not foreseeable  Baxendale didn’t have to pay18
Foreseeable reliance: Hadley v Baxendale
 1850s England
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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.”
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Court listed several circumstances where broken shaft would not
force mill to shut down
Ruled lost profits not foreseeable  Baxendale didn’t have to pay19
Default Rules
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Default rules
 Gaps: risks or circumstances that aren’t specifically
addressed in a contract
 Default rules: rules applied by courts to fill gaps
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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
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Allocating a loss (ex post)
Versus allocating a risk (ex ante), before it becomes a loss
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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
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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
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Do this by imputing the terms the parties would have chosen if they
had addressed this contingency
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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
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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
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000
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Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000
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Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?
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Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000
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Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?
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Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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Default rules
 So, Cooter and Ulen say: set the default rule that’s efficient
in the majority of cases
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Most contracts can leave this gap, save on transaction costs
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In cases where this rule is inefficient, parties can contract around it
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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
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To give incentive to address an issue rather than leave a gap
Or to give one party incentive to disclose information
“Penalty default”
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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
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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
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Penalty defaults: other examples
 Real estate brokers and “earnest money”
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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
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Penalty defaults: other examples
 Real estate brokers and “earnest money”
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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
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Forces parties to explicitly contract on quantity, rather than leave it
for court to decide
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When to use penalty defaults?
 Look at why the parties left a gap in contract
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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
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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
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competence than ours.”