Econ 522
Economics of Law
Dan Quint
Spring 2011
Lecture 10
Reminders
 Second homework due tomorrow, 5 p.m.
 First midterm next Wednesday (March 2)
 Extra OH next week
1
Applications/examples of property law…
 What things can be privately owned?

Intellectual Property – patents, copyrights, trademarks, trade secrets
 What can/can’t an owner do with his/her property?

Restraints on alienation, unbundling, inalienability, regulation
 How are property rights established?


First Possession versus Tied Ownership
How are they lost: adverse possession, eminent domain
 What remedies are given?



Injunctions vs damages; temporary vs permanent damages
Private necessity (emergency) as exception to property protection
Eminent domain as damages protection; regulatory takings
2
Contract Law
3
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…
4
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
5
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
6
(One solution: reputation)
7
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
8
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.”
9
The Bargain Theory
of Contracts
10
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
11
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
12
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
13
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.”
14
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
15
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
16
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
17
What does efficiency say about
what promises should be enforced?
18
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
19
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
20
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
21
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
22
Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
23
Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
24
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.
25
Breach
26
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?
27
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
28
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?
29
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
30
Efficient Breach
Efficiency:
Promisor’s
Cost
Promisor’s
Cost
>
Promisee’s
Benefit

Efficient to Breach
<
Promisee’s
Benefit

Efficient to Perform
31
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
32
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
33
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
34
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
35
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
36
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
37
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
38
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
39
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
40
Reliance
(plan to end here)
41
Reliance
 Reliance – investments made by promisee, to increase the
value of performance
 The fourth purpose of contract law is to secure optimal
reliance
42
When is reliance efficient?
 When social benefit of reliance > social cost of reliance
 Social benefit is increased benefit to promisee when
promise is performed
 Social cost is cost borne by promisee, whether or not
promise is performed
 So reliance is efficient as long as
(probability of performance) X (increase in value) > (cost)
43
Efficient reliance
 Efficiency: reliance is efficient as long as
(probability of performance) X (increase in value) > (cost)
 We said expectation damages = expected benefit from
performance



Should expectation damages include increase in benefit due to
reliance?
If yes: promisee will rely as long as (increase in value) > (cost)
So if yes, promisee will overrely



(Another way to think about this: there’s some chance I’ll have to breach
If your reliance increases my liability, then it increases the expected
damages I’ll owe, which makes me worse off
If your reliance imposes a negative externality, you’ll do it more than the
44
efficient amount)
Reliance and Damages: example
 Reliance increases your benefit from my promise



Airplane gives you benefit of $500,000
Costs $75,000 to build a hangar
Airplane with hangar gives you benefit of $600,000
 Suppose price is $350,000, to be paid on delivery



Expectation damages restore you to well-being you expected to
have from performance
Without a hangar, if I breach, I owe you $150,000
If you build a hangar and I breach, do I owe you $250,000?
45
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
 Cost of building plane: maybe $250,000, maybe $700,000
You don’t
You build hangar
Costs
stay low
Costs
rise
You get
I get
You get
I get
600 - 75 - 350 =
350 - 250 =
500 - 350 =
350 - 250 =
175
100
150
100
-250
150
-150
- 75 + 250 =
175
 Clearly, you’ll choose to build the hangar
 But, is that efficient?
46
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
 Let p be probability my costs go up
 Combined expected payoffs if you rely:
(1 – p) (175 + 100) + p (175 – 250)
= 275 (1 – p) – 75 p = 275 – 350 p
 Combined expected payoffs if you don’t rely:
(1 – p) (150 + 100) + p (150 – 150)
= 250 (1 – p) = 250 – 250 p
 Which is bigger?
275 – 350 p > 250 – 250 p
 25 > 100 p  p < ¼
 So if p < ¼, reliance is efficient; if p > ¼, it’s not
 But you’re going to rely either way!
47
What do we learn?
 When probability of breach is low, more reliance tends to
be efficient
 When probability of breach is high, less reliance tends to
be efficient
 If expectation damages include increased benefit from
reliance, we sometimes get overreliance
 (OTOH, if expectation damages exclude increased benefit
from reliance, liability < benefit, so inefficient breach)
48
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
49
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
50
Foreseeable reliance: Hadley v Baxendale
 1850s England




Hadley owned gristmill, mill shaft broke
Baxendale’s firm hired to transport 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 pay
51
Up next
 Default rules


What principles should we use to address contingencies not
considered in a contract?
Paper by Ayres and Gertner on syllabus
52