Econ 522
Economics of Law
Dan Quint
Fall 2011
Lecture 14
Monday, we ran out of time talking about
penalty damages
 Common law courts often refuse to enforce “penalty
damages” written into a contract

That is, damages which appear substantially larger than the harm
actually done by breach
 Started to look at how penalty damages could have led to
the desired outcome in Peevyhouse v Garland Coal
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To remind you of the
case…
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

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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 courts will only enforce liquidated damages…


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Peevyhouses shouldn’t believe restorative work will get done
So Peevyhouses better off refusing to sign
Even though mining and restoring Pareto-dominates
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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 damages 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
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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!
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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
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Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
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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
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Remedies and breach
 Opportunity cost damages, or reliance damages
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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
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Efficient signing
 Specific Performance

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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

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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
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Reliance – did example a few days 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
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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

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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
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Investment in performance
(continuing with airplane example)
 Suppose you’ve built a $90,000 hangar

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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?
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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)
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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
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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
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Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
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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?
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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

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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
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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
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“Anti-insurance”
 You (promisee) and I (promisor) offer Bob this deal:
 If you rely and I breach,

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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
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“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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Another experiment:
is trust a problem?
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A two-player game, similar to the
investment/agency game
 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
 So for example…

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if player A decides to send $3…
then A has $7 left, and B has $19…
and then B can send back to A any amount from 0 to $19
if A sends $9, B has $37, A has $1 plus whatever B sends back
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A two-player game, similar to the
investment/agency game
 We’ll try the game four different ways:

Anonymously – A and B don’t know who each other are

Privately – A and B don’t interact, but will learn who each other are
after the game

Face to face – A and B know who each other are, and can discuss
the game before playing, but their actions remain private

Publicly – A and B play out loud in front of the class
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Repeated
interactions
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Repeated games
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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…
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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
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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
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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.”
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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

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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

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$50 x 60 = $3,000 > $200, so cooperation seems like no problem
But…
 In game #60, reputation has no value to me
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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
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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
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One other bit
I like from Friedman
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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:

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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
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