Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 10
Logistics
 Office hours between now and midterm:


Me: Monday 1:30-3:30
Chao: today 1:00-3:00, Monday 10:00-1:30
 Midterm #1 Tuesday, in class

No contract law
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Tuesday…
 Why do we need contracts?
 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
 Third purpose of contract law: secure optimal commitment
to performance (efficient breach)
 Fourth purpose of contract law: secure optimal reliance
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Efficient Breach
3
Efficient Breach
Efficiency:
Promisor’s
Cost
Promisor’s
Cost
>
Promisee’s
Benefit

Efficient to Breach
<
Promisee’s
Benefit

Efficient to Perform
Self-Interest (incentives of promisor):
Promisor’s
Cost
Promisor’s
Cost
>
Promisor’s
Liability

Promisor will Breach
<
Promisor’s
Liability

Promisor will Perform
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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
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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
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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
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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
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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
So I choose efficiently when deciding whether to perform or breach
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Reliance
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Next: Reliance
 Reliance: investments you make to increase your benefit
from performance
 Increases my liability if I breach
 If expectation damages include added benefit due to
reliance, leads to more than efficient level of reliance




There’s some chance I’ll need to breach the contract
Your reliance investments increase my liability from breach, so they
impose a negative externality
Activities which impose negative externality happen too much
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Overreliance
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?
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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?
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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!
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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)
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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
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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
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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
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Default Rules
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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
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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
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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
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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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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?



Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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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?



Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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Default rules
 So, Cooter and Ulen say: set the default rule that’s efficient
in the majority of cases

Most contracts can leave this gap, save on transaction costs

In cases where this rule is inefficient, parties can contract around it
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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



To give incentive to address an issue rather than leave a gap
Or to give one party incentive to disclose information
“Penalty default”
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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


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”


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
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When to use penalty defaults?
 Look at why the parties left a gap in contract


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




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.”
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.



Coase: if individuals are rational and there are no transaction costs,
private negotiations lead to efficiency
So additional regulations would just get in the way
So regulations only make sense when people are not rational, or
when there are transaction costs/market failures
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