Econ 522
Economics of Law
Dan Quint
Fall 2010
Lecture 11
Logistics
 Midterm will (hopefully) be returned Wednesday
 HW2 also returned Wednesday
 HW3 will be up later this week – due Fri Nov 5
1
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


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
2
Contract law: the story so far
 When should promises be broken?
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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
We can think of this as “designing the law to internalize an
externality”
Third purpose of contract law: obtain optimal commitment to
performance
3
Reliance
4
Reliance
 You expect an airplane to arrive
in spring – you might…
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
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Build yourself a hangar
Sign up for flying lessons
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
5
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

Cost occurs whether or not promise is performed
 Reliance is efficient if
Increase in
value of
performance
X
Probability of
performance
>
Cost of
investment
6
Reliance and damages
 Reliance is efficient if
(increase in value) X (probability of performance) > (cost)
 Can we design damages to get efficient reliance?
 We know expectation damages lead to efficient breach
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Expectation damages = expected benefit from performance
If reliance increases anticipated benefit, does it increase expectation
damages in event of breach?
7
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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
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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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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)
9
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!
10
Overreliance
 If reliance investments increase the damages you’ll receive
in the event of breach, you’ll over-rely

You’ll rely if
Increase
in benefit


+
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 overreliance guaranteed if damages increase when you make
reliance investments
Your investment causes an externality
11
Reliance and breach
 Just showed: to get efficient reliance, ignore reliance
investments when calculating expectation damages
 But if we do that…
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Then promisor’s liability from breach < promisee’s benefit from
performance
Which means: inefficient breach
 “Paradox of compensation”
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Single “price” (damages owed) sets multiple incentives…
…impossible to set them all efficiently!
12
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
13
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
14
Foreseeable reliance: Hadley v Baxendale
 1850s England
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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.”

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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 pay
15
Another experiment:
is trust a problem?
16
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
 We’ll try the game three ways:
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Anonymously – A and B don’t know who each other are
Face to face – A and B know who each other are, and can discuss
the game before playing, but their actions remain private
In public – A and B play out loud in front of the whole class
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Default Rules
18
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


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

Do this by imputing the terms the parties would have chosen if they
had addressed this contingency
22
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

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
23
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?
24
Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


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?
25
Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


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?
26
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
27
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”
28
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”


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

Forces parties to explicitly contract on quantity, rather than leave it
for court to decide
31
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.”
Regulations
(don’t expect to get to this)
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Default rules versus regulations
 Default rules can be contracted around
 Some rules cannot – immutable rules, or mandatory
rules, or regulations
 Fifth purpose of contract law is to minimize transaction
costs of negotiating contracts by supplying efficient default
rules and regulations.
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Coase: if individuals are rational and there are no transaction costs,
private negotiations lead to efficiency
So additional regulations can only make things worse
But when people are not rational, or when there are transaction
costs/market failures, regulations may help
34
One example of a regulation/immutable rule:
derogation of public policy
 Derogate, verb. detract from; curtail application of (a law)
 Contracts which derogate public policy – that is,
contradict a law or regulation – are not enforceable
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Contracts which could only be performed by breaking a law

Contracts whose effect is to circumvent a law
A
(other factory)
“if I ever work for C for
less than $15/hr, I’ll work
for you for $1/hr”
B
(union)
C
(ownership)
35
One example of a regulation/immutable rule:
derogation of public policy
 Derogate, verb. detract from; curtail application of (a law)
 Contracts which derogate public policy – that is,
contradict a law or regulation – are not enforceable

Contracts which could only be performed by breaking a law

Contracts whose effect is to circumvent a law
A
(other factory)
“if I ever work for C for
less than $15/hr, I’ll work
for you for $1/hr”
B
(union)
C
(ownership)
36
Derogation of public policy
 In general: contracts which can only be performed by
breaking the law are not enforceable
 But…
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“A married man may be liable for inducing a woman to rely on his
promise of marriage, even though the law prohibits him from
marrying without first obtaining a divorce.”
“A company that fails to supply a good as promised may be liable
even though selling a good with the promised design violates a
government safety regulation.”
“A company that fails to supply a good as promised may be liable
even though producing the good is impossible without violating an
environmental regulation.”
 “A promisor should be liable for breach if he knew that the
promise was illegal”
37
Expectation damages: default rule or
immutable rule?
 Peevyhouse v Garland Coal and Mining Co
(OK Supreme Court, 1962)
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Garland contracted to strip-mine coal on Peevyhouse’s farm
Contract specified Garland would restore property to original
condition; Garland did not
Restoration would have cost $29,000…
…but “diminution in value” of farm only $300
Original jury awarded $5,000 in damages, both parties appealed
Oklahoma Supreme Court reduced damages to $300
38
Expectation damages: default rule or
immutable rule?
 Seems like classic case of efficient breach
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Performing last part of contract would cost $29,000
Benefit to Peevyhouses would be $300
Efficient to breach and pay expectation damages, which is what
happened
 But…


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Most coal mining contracts: standard per-acre diminution payment
Peevyhouses refused to sign contract unless it specifically
promised the restorative work
Dissent: Peevyhouses entitled to “specific performance”
39
We can also think about Peevyhouse in
terms of penalty defaults
 Which works better in this case:


Default rule allowing Garland to breach and pay diminution fee?
Default rule forcing Garland to perform restorative work?
 Ayres and Gertner: default rule should “penalize” the
better-informed party
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Garland routinely signed contracts like these
Peevyhouses were doing this for the first time
Default rule allows Garland to pay diminution fee: they have no
reason to bring it up, Peevyhouses don’t know
Default rule forces Garland to do cleanup: if that’s inefficient, they
could bring it up during negotiations
In this case, specific performance would work as a penalty default
40