Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 14
Logistics
 See Fran if you’re missing midterm or HW1
 HW2 due next Wednesday (2:30 p.m. sharp)
 Second midterm following Wednesday
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Monday, we considered remedies, and the
incentives they create
 Expectation damages; reliance damages; opportunity cost
damages; specific performance
 Breach: if promisor’s liability = promisee’s benefit, we
“automatically” get efficient breach; if not, we don’t (or
efficient breach requires renegotiation)
 Signing: if liability for breach is too severe, may preclude
signing contract in the first place
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Monday, we considered remedies, and the
incentives they create
 Example of investment in reliance:


If damages are increased to include added value of performance
due to reliance investments, promisee will rely more than the
efficient amount
If damages exclude added value of performance, promisee will rely
the efficient amount
 Example of investment in performance:


If promisor’s liability = promisee’s anticipated benefit, promisor will
invest the efficient amount in preventing breach
If liability < benefit, promisor will underinvest in performance
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All of these effects can also be understood
through language of externalities
 If liability < anticipated benefit, promisor’s choice to breach
imposes negative externality on promisee


So he’ll breach more than efficient amount, and invest too little in
preventing breach
If liability = benefit, the externality is eliminated, and promisor will
act efficiently
 If liability = anticipated benefit (including added benefit from
reliance), promisee’s reliance imposes negative externality
on promisor


So promisee will rely more than efficient amount
If damages exclude this added benefit, externality is absent,
reliance will be efficient
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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


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,



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
 We’ll try the game three ways:



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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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


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


$50 x 60 = $3,000 > $200, so cooperation seems like no problem
But…
 In game #60, reputation has no value to me



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





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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Couple other
odds and ends
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Efficient bearer of risk
 Rule we saw: when performance becomes impossible,
assign liability to party who can bear risk at least cost
 How do we know who this is? Friedman offers several
bases for this decision…


Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
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Efficient bearer of risk
 Rule we saw: when performance becomes impossible,
assign liability to party who can bear risk at least cost
 How do we know who this is? Friedman offers several
bases for this decision…




Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Adverse selection: who is more aware of risk, even if he can’t do
anything about it?
“…The party with control over some part of the production process
is in a better position both to prevent losses and to predict them.
It follows that an efficient contract will usually assign the loss
associated with something going wrong to the party with control
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over that particular something.”
Hadley v Baxendale
 Suppose…


80% of millers are low-damage – suffer $100 in losses from delay
20% of millers are high-damage – suffer $200 in losses from delay
 Shipper liable for actual damages



Average miller would suffer $120 in losses
Shipper makes efficient investment for average type
But not efficient for either type
 Shipper liable for foreseeable damages


Shipper makes efficient investment for low-damage millers
High-damage millers have strong incentive to negotiate around
default rule
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One other bit I like from Friedman
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One other bit I like from Friedman
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That’s it for contract law
 Purposes for contract law:






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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