Econ 522 – Lecture 13 (Oct 21 2008)
Some Logistics

Homework 2 due Thursday, 1 p.m. sharp
o (if you’re coming late to lecture, email the homework to me ahead of time)

Midterm a week from today
o In class (sorry if it’s crowded)
o Best guide for what types of questions I ask are homework questions (two
on HW2 are from last year’s exams), also numerical examples like we’ve
done in lecture

I was asked to encourage everyone who’s eligible to register to vote. The
following is from an email from Provost Patrick Farrell:
With the Tuesday, Nov. 4 presidential election drawing near, we would like to ask your
help in promoting civic engagement by encouraging UW-Madison students to register
and vote…
Most students who are U.S. citizens, will be 18 years of age on or before Election Day,
and have been a resident of Wisconsin for at least 10 days prior to registering are
eligible to vote.
Students may register to vote in person with the Madison city clerk from now until Nov. 4
or at their polling place on Election Day. Students who have moved since they originally
registered need to re-register.
If students plan to register in person at the clerk's office or at the polls, proof of residence
is required to register and is important to bring to the polls. For students in University
Housing, a UW-Madison ID is acceptable.
Also, despite persistent rumors, registering to vote has no impact on a student's
insurance, financial aid or student status. These rumors are totally false.
So, to sum up… do your homework, study for the midterm, and vote.
Last Thursday, we looked at the different types of remedies a court could impose for
breach of contract. In particular, we considered:
 Expectation damages, designed to replace the value of performance
 Opportunity cost damages, designed to replace the value of the next-best
alternative forgone by the promisee
 Reliance damages, designed to only replace the value lost by the promisee due to
reliance
 Specific performance – requiring the promisor to honor the promise rather than
imposing damages
Today, we’ll look more carefully at the different incentives created by each, and in
particular how they influence the following three decisions:
 the promisor’s decision to perform or breach
 the promisor’s investment in performing, and
 the promisee’s investment in reliance
Put aside the question of reliance for the moment, and suppose that performance of the
promise will have a fixed benefit for the promisee. The fact that the two parties agreed to
the contract in the first place implies they believed this benefit was likely to greater than
the cost to the promisor of performing. However, as we’ve already discussed,
circumstances may change after the promise is made, in a way that makes the promisor
less keen to keep his promise. (The price of building the airplane may go up, or my rich
cousin may appear and value my painting more highly than you do.)
There are two ways for me to get out of my promise: I can renegotiate with you, getting
you to “let me off the hook,” presumably in exchange for some money. Or I can breach
our contract and live with the consequences, most likely the damages that a court
imposes.
Think back to nuisance law. Recall that when an entitlement (say, the right to breathe
clean air) was protected by injunction, the parties could still bargain for it – the polluter
could offer the neighbor enough money to be willing to live with the pollution. When an
entitlement was protected by damages, the polluter could instead simply pollute and pay
whatever damages were ordered. We found that when transaction costs were low,
either remedy would lead to efficiency; but since the two remedies changed the
noncooperative outcome (the threat point) for each side, they led to different allocations
of surplus. On the other hand, when transaction costs were high, the two remedies
could lead to different results.
Here, the story is exactly the same. Consider a promise that is enforced by specific
performance – the promisor is not allowed to breach unless the promisee agrees – versus
a promise enforced by, say, expectation damages. When transaction costs are low,
either one will lead to efficient breach; but the allocation of surplus to the two parties will
be different. And when transaction costs are high, they may lead to different outcomes.
Let’s continue beating to death the example of the airplane I agreed to build for you. The
plane will give you a value of $500,000, and we agree on a price of $350,000; I expect
the plane to cost me $250,000 to build, but there is some chance it will instead cost me
$1,000,000.
First, let’s consider what happens if our contract is protected by expectation damages.
I Get
You Get
Total
Costs Low
(Perform)
100,000
150,000
250,000
Costs High
(Perform)
-650,000
150,000
-500,000
Costs High (Breach,
pay exp damages)
-150,000
150,000
0
Now let’s see what happens if our contract is protected by specific performance, that is,
you have the right to demand the airplane, and I can only breach with your permission.
I Get
You Get
Total
Costs Low
(Perform)
100,000
150,000
250,000
Costs High
(Perform)
-650,000
150,000
-500,000
Costs High
(renegotiate)
0
Since performance is very costly, my outside option is very bad, so renegotiation may
force me to accept fairly bad terms. Notice that by renegotiating the contract, we create a
total surplus of $500,000 (beyond our outside options if you forced me to build the
plane). Suppose that our negotiations lead us to divide this additional surplus evenly.
This would lead you to get $250,000 beyond your outside option, which was $150,000,
so your payoff would be $400,000; I would get $250,000 beyond my outside option,
which was -650,000, which would be -400,000.
So as long as transaction costs are low, either remedy will lead to the same outcome.
When it is efficient to breach, expectation damages lead me to breach without
permission; and renegotiation will lead us to some sort of agreement to let me off the
hook.
Of course, when the transaction costs of renegotiating our contract are too high, specific
performance would lead to inefficient performance – I would have to build you the plane,
even though it costs me more than your benefit – while expectation damages would still
allow me to breach.
Other types of damages – opportunity cost damages, or reliance damages – would lead to
inefficient breach, that is, I would choose to breach even when my cost of performing is
lower than your benefit. However, when transaction costs are low, this could also be
fixed through renegotiation.
To see an example of this, consider the same situation, but now suppose that the next-best
contract would have sold you a similar plane for $400,000, but that now at this late date,
no other planes are available. We agreed on a price of $350,000, but now costs go up
somewhat, to $460,000.
Perform
I Get
You Get
Total
-110,000
150,000
40,000
Breach and pay Opp
Cost Damages
-100,000
100,000
0
Renegotiate and
Perform
P – 460,000
500,000 – P
40,000
Renegotiating generates additional surplus of $40,000; if we split this evenly, we would
each get a payoff $20,000 higher than our outside option, which would require the
renegotiated price to be $380,000.
Again, however, if transaction costs were high, we would be unable to renegotiate the
contract, and I would choose to breach and pay you $100,000 in opportunity cost
damages.
(Cooter and Ulen point out that, just like efficiency demands enforcing contracts
whenever the parties wanted them to be enforceable, efficiency demands enforcing
renegotiated contracts whenever the parties wanted them to be enforceable at the time of
renegotiation.)
So just like with nuisance law, we find the following:
 if it is cheap/easy to renegotiate terms, any of the remedies will lead to efficient
breach, although they will lead to different allocations of surplus
 if it is expensive/hard to renegotiate terms, only expectation damages are
guaranteed to lead to efficient breach – specific performance may lead to
inefficient performance, and lower damages may lead to inefficient breach
An increase in the cost of performance is referred to as an unfortunate contingency. On
the other hand, I may be less keen to keep my promise because I discover another buyer
who values my product more than you do. This is referred to as a fortunate
contingency. Earlier, we saw the example where you contracted to buy my painting, but
my rich cousin appeared and valued it much more highly than you did. We can do the
same exercise as before with the different remedies, and see the same thing – with low
transaction costs, any remedy will lead to efficient breach, but with different allocations
of surplus. This is done in the book (p. 267). Once again, specific performance is the
most advantageous to the buyer, and higher damages are better for the buyer than lower
damages.
One further point that we mentioned earlier but didn’t talk much about: efficient signing.
We saw that with expectation damages, when my costs remain low and I perform, I get a
profit of $100,000 (the price you pay, $350, minus the costs I incur, $250). And when
my costs jump up and I breach, I owe $150,000.
If the probability my costs rise is small enough, that’s no big deal – I take the risk of
owing you expectation damages, because my profits in the cases where I don’t breach are
large enough that it’s worth the risk.
But if the probability my costs rise is high, then my expected profit from this contract is
negative. For example, suppose the probability of a dramatic rise in costs is ½. Then my
expected payoffs from agreeing to build you the airplane are
½ (100,000) + ½ (-150,000) = -25,000
So now there’s no way I’d agree to the contract in the first place.
This is the point we mentioned before – expectation damages lead to efficient breach,
but they may lead to inefficient signing. (If I’m the only airplane manufacturer
available, it’s still efficient for us to sign this contract – it generates positive expected
surplus – but under expectation damages, I would not sign this contract.)
(This does suggest that, even if expectation damages make a sensible default rule, it’s
efficient for parties to be able to specify a different damages rule in the contract – that is,
even if expectation damages are often efficient, they are not always efficient, so there’s
no reason for them to be mandatory…)
So that’s breach. What’s left is investment in reliance, which we’ve already talked a bit
about; and investment in performance, which we haven’t.
The book makes a big deal out of “the paradox of compensation,” which is basically
what we already talked about earlier: the remedy for breach sets an incentive for both the
promisor and the promisee, and it’s generally impossible to set both of these incentives
efficiently at the same time. (The particular conflict they look at here is the way that
reliance figures into expectation damages.)
Let’s go back to the airplane example once again, and again assume that, once you
contract to buy my plane, you consider building yourself a hangar. But this time, rather
than just a decision to build or not build, there is a whole range of different-quality
hangars you could elect to build.
Suppose that, for any investment of x dollars, you can build a hangar that will enhance
the value of having a plane by 600 sqrt(x), but is worthless without a plane.
Investment
x
100
Value of
Hangar
600 sqrt(x)
6,000
10,000
40,000
160,000
640,000
60,000
120,000
240,000
480,000
Large tarp held up by some rope connected to a telephone
pole – still keeps some rain off the airplane
Basic plywood frame, canvas roof
Metal poles, rigid roof
Functional heating
Designer hangar with working Starbucks
Recall that whatever investment is made in reliance pays off when the promise is kept,
but is lost when the promise is broken.
Suppose that expectations damages include the benefits anticipated based on reliance
investments. Then the buyer would maximize
500,000 + 600 sqrt(x) – 350,000 – x
since he gets the same benefit whether or not the seller breaches; solving this gives the
first-order condition
600/2sqrt(x) – 1 = 0  x = 300^2 = 90,000
so the buyer, when insulated from the risk of breach, invests $90,000 in a reasonably nice
hangar, giving anticipated benefit of 600 sqrt(90,000) = 180,000.
What is the efficient level of reliance? The total social gain from the contract is
500,000 + 600 sqrt(x) – 250,000 – x
without breach, and –x with breach (the reliance investment is lost, and other than that,
all that happens is transfers). Suppose the probability of breach is p; then the expected
social benefit is
(1-p) (500,000 + 600 sqrt(x) – 250,000 – x) + (1 – p)(–x)
which leads to an efficient level of reliance equal to 90,000 (1-p)^2.
So for any p > 0, damages which include benefits from reliance lead to overreliance, that
is, investment in reliance that is higher than what would be efficient.
On the other hand, suppose expectation damages did not include the benefits of reliance.
Then the buyer maximizes
(1-p) (payoff without breach) + p (payoff with breach) =
(1-p) (500,000 + 600 sqrt(x) – 350,000 – x) + p (150,000 – x) =
150,000 + (1-p) 600 sqrt(x) – x
which leads to the same (efficient) level of reliance.
So if the level of damages includes the gains from reliance, this leads to overreliance; if
the level of damages excludes the gains from reliance, this leads to efficient reliance.
(Recall that Cooter and Ulen hoped for damages which included the gains only from
“efficient” reliance, which is a nice idea but incredibly hard to measure after the fact…)
But we also know that if the level of damages exclude the gains from reliance, and the
buyer relies anyway, that this will lead to inefficient breach. That is, since the seller’s
liability from breach is lower than the buyer’s gain from performance, there will be some
instances where the seller breaches even though efficiency requires performance.
We said before that with no transaction costs, this problem can be solved: when breach
would be inefficient, the parties can contract around it. Since it’s generally very clear
whether a party has breached a contract or not, this shouldn’t be a particular problem.
However, there are situations in which a promisor can take actions to make performance
less costly, or, to put it another way, to lessen the probability that breach is efficient. A
contractor could buy raw materials ahead of time, to avoid the risk of changing prices; a
manufacturer could start a project earlier and frontload the labor to avoid the risk of a
strike. If a project were to require a building permit or zoning easement, he could lobby
the local government (or bribe someone) to decrease the chances of hitting a snag.
This sort of investment in performance, however, may be unobservable, or unverifiable;
and therefore, even when this sort of investment is efficient, it may be very hard to build
it into the contract. (It’s very hard to enforce a contract specifying “how hard I have to
try” to convince the zoning board to approve your project.) Thus, investment in
performance may only occur when it is in the promisor’s best interest.
Go back to the airplane example, and suppose there is some investment I can take that
reduces the chance that my costs go up. (I can buy some of my supplies ahead of time,
but I can’t completely insulate myself from risk.) Suppose that for each $27,726 I invest,
I can reduce the probability I will need to breach by ½. That is, if I invest $27,726, the
probability of breach goes from ½ to ¼. If I invest another $27,726, it goes down to 1/8.
And so on.
For any investment z, then, we can write the probability that breach is still required as
½ * ½ ^(z / 27,726)
The reason I chose the number 27,726 is that we can rewrite this probability as
½ e^{- z/40,000)
Which makes it much easier to work with.
So, how much would a self-interested promisor invest in performance? Go back to the
airplane example, and let D be the amount of damages that the promisor is liable for if he
breaches. (D could be nothing; or the investment in reliance; or the opportunity cost; or
the gain the buyer expected to achieve, with or without reliance.) Suppose only that D is
low enough that breach is still preferable when costs go up. (Since we’ve been talking
about costs rising to 1,000,000, this just requires D < 650,000, the loss I would take from
performing.)
When costs remain low, the seller expects $100,000 in profits. So when deciding how
much to invest in performance, the seller maximizes
(1 – Pr(breach)) 100,000 + Pr(breach) (-D) – investment in performance
= 100,000 – Pr(breach)(D + 100,000) – z
= 100,000 – ½ e^(-z/40,000) (D+100,000) – z
Taking the derivative gives ½ 1/40,000 e^(-z/40,000) (D+100,000) – 1 = 0
or ½ e^(-z/40,000) = 40,000/(D+100,000)
so the seller invests enough to reduce the probability of breach to 40,000/(D+100,000)
So if the seller can breach for free, he’ll invest enough to reduce the probability of breach
from ½ to 40,000/100,000 = 2/5. He still prefers profits (100,000) over nothing, but he
only invests a little, since he can still get out of the contract for free. (The investment
here is about $9,000.)
Suppose D were expectation damages, without reliance. If he would owe expectation
damages (without reliance) of $150,000, then he invests enough to reduce the chance of
breach from ½ to 40,000/(150,000+100,000) = 4/25. (The investment this time is about
$45,000.)
Suppose D were expectations damages, with reliance. We said that if expectation
damages include reliance, the buyer spends $90,000 on a hangar giving $180,000 in
benefits, so his benefit from performance is now 500,000 – 350,000 + 180,000 =
330,000. With damages at that level, the seller invests enough to reduce the probability
of breach to 40,000/(330,000 + 100,000) = 40/430. (The investment to do this is about
$67,000.)
But what would be efficient? Suppose that the buyer has already decided to build himself
that nice $90,000 hangar. So the benefit of performance is 330,000. The cost of the
hangar is sunk, so we can forget about it for now.
The total social surplus is
(1 – Pr(breach)) (330,000 + 100,000) + Pr(breach) (0) – z
= 430,000 – 430,000 ½ e^(-z/40000) – z
To maximize this, we take the derivative:
430,000 ½ 1/40,000 e^(-z/40000) – 1 = 0
Pr(breach) = 40,000/430,000
So given that level of reliance, the efficient level of investment in performance is enough
to reduce the chance of breach to 40,000/430,000.
Which we just saw is exactly what the seller would do when he’s liable for expectation
damages which include the benefit from reliance!
To sum up, the efficient level of investment leads to a 40,000/430,000 chance of breach.
Damages which are set equal to D lead to a self-interested promisor to allow a probability
of breach of 40,000/(D + 100,000). So when damages are set to 330,000 – damages
include the benefit from reliance – the investment in performance is efficient. When
damages are lower, the seller will underinvest in performance, leaving the risk of breach
inefficiently high. (When damages are higher than this, the seller will overinvest in
performance.)
So what have we found? Making the seller liable for reliance – that is, increasing
expectation damages to include benefit due to reliance – leads the seller to invest
efficiently in performance; but it leads the buyer to overinvest in reliance.
On the other hand, making the seller not liable for reliance – leaving expectation damages
where they were without reliance – leads to efficient reliance, but leads to
underinvestment in performance. (We saw before that even if expectation damages do
not include reliance, the buyer still chooses to rely some, just less; so D < benefit, and the
seller underinvests in performance.)
So like we saw last week with the sailboat example from Friedman, the level of damages
leads to multiple different incentives; and it’s impossible to come up with a level of
damages that makes everyone behave efficiently.
anti-insurance
The textbook discusses one rather clever solution to this problem. It’s not all that
realistic, but it is clever, and it’s worth mentioning.
We saw that, in order for you to invest the efficient amount in reliance, you need to
receive damages that do not include the benefit from reliance.
And we saw that, in order for me to invest the efficient amount in performance, I need to
owe damages that do include the benefit from reliance.
How can we can accomplish both these things? Well, we can set the level of damages
that I pay to be different from the level of damages that you receive!
You and I have this friend, Bob. Bob likes money. So we go to Bob and say, hey Bob,
here’s a deal for you. I’m planning to build a plane. He’s planning to buy the plane.
He’s probably going to want to build a hangar. I might end up not building the plane.
Here’s what we need you to do.
In the event that he builds a hangar and I don’t build the plane, I’m going to give you the
value of the plane with the hangar; and you’re going to give him the value of the plane
without the hangar; and you’re going to keep the rest for yourself. OK?
And Bob says, “cool!”
This is called “anti-insurance”. Rather than buying insurance from a third party, you and
I are basically entering into this additional contract where if things go bad, I owe Bob
some additional money, beyond what I pay you.
By doing this, we set both our incentives correctly, so we get efficient reliance and
efficient investment in performance.
Now obviously, Bob is happy to do this for free. But now we go to our other friend
Carol, and say, Hey, Carol. Here’s a deal we’re offering. Give us $5 now, and if he
builds a hangar and I don’t deliver a plane, you’ll get the difference between the value of
the plane with the hangar and without the hangar.
And Carol realizes this is worth more than $5, so she says, “sure.”
But now we go back to Bob, and we offer him the deal at $10 instead.
And if we make Bob and Carol compete for this deal, we should be able to get them to
pay a fair amount for it up front. If they’re risk averse, of course, they’ll need to be
compensated for taking on some risk; but if we have a risk-neutral friend who’s smart
enough to understand the probabilities and figure out what each of us will do given our
incentives, we can get them to give us the full value of the anti-insurance deal ahead of
time, and divide it up among ourselves.
So this way, we can give ourselves incentives for efficient reliance and efficient
investment in performance at the same time.
There are other ways to get around the problem. We already introduced the notion of
basing damages, not on the benefit expected under the actual level of reliance, but on the
benefit expected under the hypothetical “efficient” level of reliance. If we write this into
the contract (and are able to calculate it correctly), then we can use expectation damages
with reliance to set the seller’s incentives correctly, while still not causing the buyer to
over-rely.
This could either be done explicitly in the contract – we agree that I have to pay
expectation damages up to the value you would receive from a $60,000 hangar but not
more than that – or it could be imposed by the court after the fact.
As we mentioned before, what courts actually do, rather than basing damages on actual or
on efficient reliance, is to base damages on foreseeable reliance. That is, they base
damages on what the promisor could reasonably expect the promisee to do, not what he
actually did. This was the decision in Hadley: since the shipper could not reasonably
expect the miller to rely so heavily, he was not liable for the lost profits. (Most millers at
the time had more than one crankshaft., so a broken shaft would not typically lead to
shutdown.)
Of course, under the doctrine of foreseeable reliance, if Hadley had told Baxendale that
his mill was closed until repairs were made, then Baxendale would be liable for lost
profits due to delay; by informing Baxendale of the reliance, Hadley would have made it
foreseeable, and therefore compensable.
Next: timing.
Everything we’ve done so far has assumed that the timing of the contract is fairly rigid:
first, we sign a contract. Next, you decide how much to rely, and I decide how much to
invest in performance. Then, I decide whether to perform or breach, and if I breach, I
pay damages.
But often, the different stages may overlap a bit more. If I’m building a house for you,
I’m unlikely to build it in a day; you may be able to see how some of the progress is
going before making all of your reliance investments.
Similarly, the question of when someone decides to breach a contract may affect the
damage done by breach, which may therefore affect damages.
Suppose you’re a farmer, and I’m a grain wholesaler, and you agree to deliver me 10 tons
of corn on a given date at a given price. This is a futures transaction – a promise to
transact a good on a future date. In some cases, there may be a going market rate for corn
delivered on that date. And this price can rise or fall as the date approaches.
So we agree that you’ll sell me 10 tons of corn next June, at a price of (I don’t know the
price of corn), say, $500 per ton. Over the course of the winter, circumstances may
change – maybe it’s a dry winter, so irrigation will be more expensive in the spring;
maybe other crop prices go up and you decide to plant wheat in more of your field.
If you decide to breach, you could wait until the last minute to tell me – in which case,
damages might reflect the cost to me of buying corn on the spot market, that is, the day I
was expecting delivery.
Alternatively, you could tell me in January that you plan to breach our contract. This
would allow me to contract in advance with someone else to sell me corn in June, which
might be cheaper than if I waited till the last minute.
Breaching a contract in advance on is sometimes called “renouncing” or “repudiating” a
contract – you announce early your intention to breach. When this happens, if there is a
market for a substitute good – in this case, June corn – then damages would reflect the
price of June corn futures at the time you renounced the contract, say, in January.
I could actually buy the futures in January, or I could wait and take my chances; but what
happens after that tends not to affect the damages you owe me.
To use another example from last week, suppose one of you agreed last week to sell me a
ticket to the Wisconsin- Illinois game for $50. At the time we agreed to the deal, there
were lots of tickets available for $75. If you breached early in the week, I could have
bought a replacement ticket for $75; so expectation damages would be limited to $25, the
damage breaching early did to me relative to performing.
If I chose not to buy another ticket in advance, and waited and overpaid on the morning
of the game, that was a risk I chose to take, but not your responsibility.
(Of course, in cases where there is a liquid market for substitutes, there’s little difference
between you renouncing our agreement and paying damages, or you going out and
buying another ticket on Craigslist to sell to me at our agreed price. If transaction costs
are low, the two are equivalent. So when there is a market for a substitute good and
transaction costs are low, you are indifferent between breaching and paying damages, and
buying and delivering a substitute product.)
(SKIP THIS: In well-behaved markets, futures prices are generally assumed to reflect
the market’s expectation about what the future spot price of the good will be. That is, if
everyone knows there will be a liquid market for tickets at $150 at the end of the week,
there’s no reason for them to be selling for $75 early in the week; under certain
conditions, futures prices should just be the expected value of the future spot price. So in
terms of the expected payoffs, and the incentives to breach, there shouldn’t be a
difference whether courts impose damages equal to the futures price at the time a contract
is renounced, or equal to the spot price realized at the date of promised delivery.)
When goods are traded that do not have close substitutes, however, the value is
sometimes hard to calculate, so courts sometimes impose only reliance damages simply
because it’s easier. Renouncing a contract earlier obviously stops the promisee from
making further investments in reliance. However, when damages are set lower then the
benefits of performing, we’ve seen before that this will lead to inefficient breach.
(There are some further complications – the law on anticipatory breach, and breach
following partial performance, are a little bit murky. In some of these cases,
renegotiation of the contract may be preferable to outright breach; again we come to the
suggestion that efficiency demands enforcing renegotiated contracts as long as both
parties wanted it enforceable at the time of renegotiation.)