Econ 522
Economics of Law
Dan Quint
Spring 2011
Lecture 14
Before Spring Break…
 Contracts as promises
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First purpose: facilitate cooperation
Second purpose: encourage efficient disclosure of information
 Breach of contract
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Third purpose: secure efficient commitment to performance
 Reliance
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Fourth purpose: secure efficient reliance
 Default rules
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Fifth purpose: reduce transaction costs via efficient default rules
C&U: apply rule parties would have wanted
(Typically means allocating each risk to efficient bearer of that risk)
1
Ayres and Gertner: penalty defaults
Before Spring Break…
 Regulations/immutable rules
 Ways to get out of a contract
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Formation defenses
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Incompetence
Dire constraints (duress and necessity)
Adhesion, unconscionability
Fraud, frustration of purpose, mutual mistake
Generally: situations where assumptions of Coase Theorem fail
Performance excuses
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Impossibility; allocating a loss to the efficient bearer of that risk
 Remedies for breach of contract
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Court-ordered damages of various types
Party-specified damages (but: penalty damages not always enforced)
Specific Performance
2
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
3
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
You get
150,000
150,000
400,000
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
4
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
5
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

Suggests expectation damages might be good default rule,
but not good mandatory rule
6
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
7
Did example of reliance a few days ago
 If reliance investments increase damages you receive, we
get overreliance
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To get efficient reliance, we 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?
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Investment in performance
8
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
9
Investment in performance
(continuing with airplane example)
 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
10
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:
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What is efficient level of investment in performance?
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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
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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:
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What is efficient level of investment in performance?
Enough to reduce probability of breach to 40,000/430,000
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How much will I choose to invest in performance?
Enough to reduce probability of breach to 40,000/(100,000 + D)
12
What do these results mean?
 What is the efficient level of investment in performance?
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Enough so that p(z) = 40,000/430,000
 What will promisor do under various rules for damages?
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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
13
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
14
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?
15
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
16
Another clever (but unrealistic) solution
 The problem:
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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!
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How do we do this? Need a third party
17
“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
18
“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
 Offer the deal to two people, make them pay up front for it
19
Reminder: what do courts actually do?
 Foreseeable reliance
 Include benefits reliance that promisor could have
reasonably anticipated
20
Another experiment:
is trust a problem?
21
A two-player game, similar to the
investment/agency game
 Player A starts with $10
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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
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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
22
A two-player game, similar to the
investment/agency game
 We’ll try the game four different ways:
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Anonymously – A and B don’t know who each other are
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Privately – A and B don’t interact, but will learn who each other are
after the game
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Face to face – A and B know who each other are, and can discuss
the game before playing, but their actions remain private
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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
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After each game, 10% chance relationship ends, 90% chance we
play at least once more…
26
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
27
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
28
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.”
29
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
30
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…
31
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
32
One other bit
I like from Friedman
33
Friedman on premarital sex
 Under traditional common law, a jilted bride could sue for
breach of promise to marry
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Friedman on premarital sex
 Under traditional common law, a jilted bride could sue for
breach of promise to marry
 Between 1935 and 1945, lawsuits for breach of promise to
marry stopped being recognized in many states
 Diamond engagement rings became common in 1930s,
peaked in 1950s, since declined
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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
 Wednesday, we begin tort law
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First Midterm
 Overall very good
 Mean 87, std dev 8
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Most points lost on question 1
 Not assigning letter grades till after final
 Second exam typically harder than first
A-G
H-P
Q-Z
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