Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 10
Logistics
 Midterm on Wednesday
 Office hours tomorrow


Me (Soc Sci 7428) 9:30-11:30 a.m.
Fran (Soc Sci 6443) 12:30-2:30 p.m.
1
Last week…
 Why do we need contracts?

To get cooperation/trade when transactions aren’t instantaneous
 What promises should be enforced?


Bargain Theory of Contracts
Efficiency
 First purpose of contract law: enable cooperation
 Second purpose of contract law: encourage efficient
disclosure of information
2
Breach
3
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?
4
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
5
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?
6
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
7
Efficient Breach
Efficiency:
Promisor’s
Cost
Promisor’s
Cost
>
Promisee’s
Benefit

Efficient to Breach
<
Promisee’s
Benefit

Efficient to Perform
8
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
9
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
10
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
11
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
12
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
13
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
14
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

If my costs rise to $400,000, performance is still efficient, but I’ll
choose to breach
 Liability is $1,000,000

If costs rise to $700,000, performance is 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
efficient
15
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
16
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
17
Reliance
18
Reliance
 Reliance – investments made by promisee, to increase the
value of performance
 The fourth purpose of contract law is to secure optimal
reliance
19
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)
20
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
21
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?
22
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?
23
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!
24
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)
25
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
26
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
27
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
28
Up next
 Default rules


What principles should we use to address contingencies not
considered in a contract?
Paper by Ayres and Gertner on syllabus
29