Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 9
Logistics
 Office hours between now and midterm:


Me: Tomorrow 1:30-3:30, Monday 1:30-3:30
Chao: Thursday 1:00-3:00, Monday 10:00-1:30
 Midterm #1 next Tuesday, in class

No contract law
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Plan
 Last week – finished property law

Handout – two cool examples
 This week – we start contract law
 But first – a digression (true story) that illustrates some of
the principles from both
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So last Thursday, I’m flying from Boston to
Montreal…
 Uncertainty about rights makes bargaining hard
 Negotiating with lots of parties is hard
 When transaction costs are high, “damages” are better
than “injunctions”
 But also… what is a ticket?
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Contract Law
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Example: the agency (trust) game
Player 1 (you)
Don’t
Trust me
Player 2 (me)
(100, 0)
Share profits
(150, 50)
Keep all the money
(0, 200)
 Subgame perfect equilibrium: I’ll keep all the money; so you
don’t trust me


Inefficient outcome (100 < 200)
And we’re both worse off
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(One solution: reputation)
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Another solution: legally binding promises
Player 1 (you)
Don’t
Trust me
Player 2 (me)
(100, 0)
Share profits
(150, 50)
Keep all the money
(125, 25)
 Now we get cooperation (and efficiency)
 Purpose of contract law: to allow trade in situations where
this requires credible promises
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So… what types of promises should be
enforced by the law?
 “The rich uncle of a struggling college student learns at the graduation party that
his nephew graduated with honors. Swept away by good feeling, the uncle
promises the nephew a trip around the world. Later the uncle reneges on his
promise. The student sues his uncle, asking the court to compel the uncle to
pay for a trip around the world.”
 “One neighbor offers to sell a used car to another for $1000. The buyer gives
the money to the seller, and the seller gives the car keys to the buyer. To her
great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the
back yard, not the shiny Cadillac in the driveway. The seller is equally surprised
to learn that the buyer expected the Cadillac. The buyer asks the court to order
the seller to turn over the Cadillac.”
 “A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,”
mails $25 and receives in the mail two wooden blocks with the instructions,
“Place grasshopper on Block A and smash with Block B.” The buyer asks the
court to require the seller to return the $25 and pay $500 in punitive damages.”
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The Bargain Theory
of Contracts
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The bargain theory of contracts
 Developed in the late 1800s/early 1900s
 A promise should be enforced if it was given as part of
a bargain, otherwise it should not
 Bargains were taken to have three elements



Offer
Acceptance
Consideration
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What is consideration?
 Promisor: person who gives a promise
 Promisee: person who receives it
 In a bargain, both sides must give up something

reciprocal inducement
 Consideration is what the promisee gives to the
promisor, in exchange for the promise
 Under the bargain theory, a contract becomes enforceable
once consideration is given
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What is consideration?
 Promisor: person who gives a promise
 Promisee: person who receives it
 In a bargain, both sides must give up something

reciprocal inducement
 Consideration is what the promisee gives to the
promisor, in exchange for the promise
 Under the bargain theory, a contract becomes enforceable
once consideration is given
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The bargain theory does not distinguish
between fair and unfair bargains
 Hamer v Sidway (NY Appeals Ct, 1891)
 Uncle offered nephew $5,000 to give up drinking and
smoking until his 21st birthday, then refused to pay
“The promisee [previously] used tobacco, occasionally drank liquor,
and he had a legal right to do so. That right he abandoned for a period
of years upon the strength of the promise… We need not speculate
on the effort which may have been required to give up the use of
these stimulants. It is sufficient that he restricted his lawful freedom of
action within certain prescribed limits upon the faith of his uncle’s
agreement, and now, having fully performed the conditions imposed,
it is of no moment whether such performance actually proved a
benefit to the promisor, and the court will not inquire into it.”
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Under the bargain theory, what is the
remedy?
 Expectation damages

the amount of benefit the promisee could reasonably expect from
performance of the promise

meant to make the promisee as well of as he would have been, had
the promise been fulfilled
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Problems with the bargain theory
 Not that accurate a description of what modern courts
actually do
 Not always efficient

Does not enforce certain promises that both promisor and promisee
might have wanted to be enforceable
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Problems with the bargain theory
 Not that accurate a description of what modern courts
actually do
 Not always efficient

Does not enforce certain promises that both promisor and promisee
might have wanted to be enforceable

Does enforce certain promises that maybe should not be enforced
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What does efficiency say about
what promises should be enforced?
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What promises should be enforced?
 In general, efficiency requires enforcing a promise if both
the promisor and the promisee wanted it to be
enforceable when it was made

different from wanting it to actually be enforced
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What promises should be enforced?
 In general, efficiency requires enforcing a promise if both
the promisor and the promisee wanted it to be
enforceable when it was made

different from wanting it to actually be enforced
 The first purpose of contract law is to enable people to
cooperate by converting games with noncooperative
solutions into games with cooperative solutions

or, enable people to convert games with inefficient equilibria into
games with efficient equilibria
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What promises should be enforced?
 In general, efficiency requires enforcing a promise if both
the promisor and the promisee wanted it to be
enforceable when it was made

different from wanting it to actually be enforced
 The first purpose of contract law is to enable people to
cooperate by converting games with noncooperative
solutions into games with cooperative solutions

or, enable people to convert games with inefficient equilibria into
games with efficient equilibria
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So now we know…
 What promises should be enforceable?

For efficiency: enforce those which both promisor and promisee
wanted to be enforceable when they were made
 One purpose of contract law

Enable cooperation by changing a game to have a cooperative
solution
 Contract law can serve a number of other purposes as well
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Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
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Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
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Information
 Private/asymmetric information can hinder trade

Car example (George Akerloff, “The Market for Lemons”)
 Contract law could help



You could offer me a legally binding warranty
Or, contract law could impose on you an obligation to tell me what
you know about the condition of the car
Forcing you to share information is efficient, since it makes us more
likely to trade
 The second purpose of contract law is to encourage the
efficient disclosure of information within the contractual
relationship.
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Efficient breach
 Example: I’m an artist



You expect to value my painting at $1,000, agree to buy it for $600
My rich cousin comes to town, offers me $5,000 for it
Efficient for him to get it, but I’ve already promised it to you
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Efficient breach
 Example: I’m an artist



You expect to value my painting at $1,000, agree to buy it for $600
My rich cousin comes to town, offers me $5,000 for it
Efficient for him to get it, but I’ve already promised it to you
 Breach is efficient when promisor’s cost of performing is
greater than promisee’s benefit from performance
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Efficient breach
 Example: I’m an artist



You expect to value my painting at $1,000, agree to buy it for $600
My rich cousin comes to town, offers me $5,000 for it
Efficient for him to get it, but I’ve already promised it to you
 Breach is efficient when promisor’s cost of performing is
greater than promisee’s benefit from performance
 Question: how do we get breach only when it’s efficient?
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Remedies and efficient breach
 Breach is efficient when promisor’s cost of performing is
greater than promisee’s benefit from performance
 Self-interest: promisor will breach when cost of performing
is greater than liability from breach
 So when liability from breach = promisee’s benefit,
promisor will choose to breach exactly when it’s efficient


Setting liability = benefit is exactly expectation damages
(This causes promisor to internalize the externality he causes by
breaching the contract – so there is no externality, and he acts
efficiently)
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This brings us to…
 The third purpose of contract law is to secure optimal
commitment to performing.
 Expectation damages lead to efficient breach (breach of
contract only when it is efficient).
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Reliance
 Reliance – investments made by promisee, to increase the
value of performance
 The fourth purpose of contract law is to secure optimal
reliance
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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
 Thursday: examples of efficient breach and reliance, and
paper by Ayres and Gertner
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