Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 13
Logistics
 Midterm will be returned at end of lecture
 HW2 is up – due Tuesday, November 3 (11 a.m. sharp)
 Second midterm (on contract law) Thursday, November 5
1
This past Tuesday…
 More ways to get out of a contract
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Efficient bearer of a risk
Impossibility
Misinformation: fraud, failure to disclose, frustration of purpose,
mutual mistake
But not unilateral mistake
Uniting knowledge and control
Adhesion and unconscionability
 Remedies
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Expectation damages
Opportunity cost damages
Reliance damages
2
Different types of damages we saw Tuesday
 Expectation damages

Give promisee benefit he would have had from performance
 Opportunity cost damages

Give promisee benefit he would have had from next-best contract
 Reliance damages

Give promisee benefit he would have had from doing nothing
 Expectation Dam  Opp Cost Dam  Reliance Dam

But order can be reversed when calculated incorrectly
3
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
4
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
 Specific Performance
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Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
5
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
 Specific Performance




Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
6
Party-designed remedies
 Remedy for breach could be written directly into contract
 But common law courts don’t always enforce remedy terms
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Liquidated damages – party-specified damages that reasonably
approximate actual harm done by breach
Penalty damages – damages greater than actual harm done
Civil law courts are generally willing to enforce penalty damages
But common law courts often do not
7
Penalty Damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
 Peevyhouse v Garland Coal
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Peevyhouses only wanted farm strip-mined if it would be restored to
original condition after
Suppose coal extracted worth $70,000
Garland paid $25,000 for rights to mine it
Restoration work would cost $30,000
Diminution of value was $300
So liquidated damages would be $300
Suppose Peevyhouses got $40,000 of disutility from land being left
in poor condition
8
Liquidated damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay damages
(-14,700, 44,700)
 If damages limited to liquidated damages…
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Peevyhouses have no reason to believe restorative work will get done
So Peevyhouses better off refusing to sign
Even though mining and restoring Pareto-dominates
9
Penalty damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay penalty
(25,000, 5,000)
 If penalty clauses in contracts enforceable…
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Write contract with $40,000 penalty for leaving land unrestored
Now restoration work would get done, so Peevyhouses willing to sign
But if courts won’t enforce penalty damages, this won’t work
10
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus
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I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
11
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus
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I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
Similarly, Peevyhouse example

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Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is
not restored
Equivalently, get $65,000 for mining rights, pay $40,000 bonus if
restoration is completed
But, if intent of contract is too transparent, still might not be enforced
12
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
13
Plane worth $500,000 to you
Price $350,000
Cost: either $250,000 or $1,000,000
Remedies and breach
Expectation Damages
Specific Performance
Costs
Low –
Perform
Costs
High –
Perform
Costs
High –
Breach
I get
100,000
-650,000
-150,000
You get
150,000
150,000
150,000
Total
250,000
-500,000
0
Costs
Low –
Perform
Costs
High –
Perform
Costs
High –
Renegotiate
I get
100,000 -650,000
-400,000
You get
150,000
150,000
400,000
Total
250,000 -500,000
0
 Transaction costs low  either leads to efficient breach, but
seller prefers “weaker” remedy
 Transaction costs high  S.P. leads to ineff. performance
14
Remedies and breach
 Opportunity cost damages, or reliance damages
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Inefficient breach when transaction costs are high
Renegotiate contract to get efficient performance when transaction
costs are low
Like nuisance law: any remedy leads to efficient breach with low TC
But only expectation damages do when TC are high
 Unfortunate contingency and fortunate contingency
15
Efficient signing
 Specific Performance
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If costs stay low, I get $350,000 - $250,000 = $100,000 profit
If costs rise, I take $400,000 loss
Am I willing to sign this contract?
 Even expectation damages face this problem
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Expectation damages: costs stay low, same $100,000 profit
Costs rise, $150,000 loss
If probability of high costs is ½, I won’t sign contract
 Expectation damages lead to efficient breach, but may
not lead to efficient signing

Suggests expectation damages might be good default rule,
but not good mandatory rule
16
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
17
Paradox of compensation
 Remedy for breach sets incentive for both promisor and
promisee
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Promisor: perform or breach
Promisee: how much to rely
 Generally impossible to set both incentives efficiently at the
same time
 Example: should anticipated benefit from reliance be
included in expectation damages?
18
Incentives for reliance
(continuing with airplane example)
Additional
value of
plane
y  600 x
Designer hangar with Starbucks - $480,000
Functional heating - $240,000
Metal poles, rigid roof - $120,000
Plywood frame, canvas roof - $60,000
Tarp and rope - $6,000 benefit
Investment in hangar
19
Three questions
 What is the efficient level of reliance?
 What will promisee do if expectation damages include
anticipated benefit from reliance?
 What will promisee do if expectation damages exclude
anticipated benefit from reliance?
20
What is efficient level of reliance?
 Total social gain when costs stay low:
500,000 + 600 x – 250,000 – x
 Total social gain when costs go up:
–x
 If probability costs rise is p, expected total social gain is
(1-p) (250,000 + 600 x – x) + p (-x)
250,000 (1-p) + 600 (1-p) x – x
 Choose x to maximize this: derivative is
600 (1-p) /(2x) – 1 = 0
x = 90,000 (1 – p)2
 So x = 90,000 (1 – p)2 is the efficient level of reliance
21
Three questions
 What is the efficient level of reliance?

x = $90,000 (1 – p)2
 What will promisee do if expectation damages include
anticipated benefit from reliance?
 What will promisee do if expectation damages exclude
anticipated benefit from reliance?
22
What will promisee do if damages include
benefit from reliance?
 Private gain to promisee when costs stay low:
500,000 + 600 x – 350,000 – x
= 150,000 + 600 x – x
 Private gain to promisee when costs go up:
150,000 + 600 x – x
 Expected private gain to promisee is
150,000 + 600 x – x
 Choose x to maximize this: derivative is
600/(2x) – 1 = 0
x = 90,000
 So promisee would invest x = $90,000 in reliance
23
Three questions
 What is the efficient level of reliance?

x = $90,000 (1 – p)2
 What will promisee do if expectation damages include
anticipated benefit from reliance?

x = $90,000
 What will promisee do if expectation damages exclude
anticipated benefit from reliance?
24
What will promisee do if damages exclude
benefit from reliance?
 Private gain to promisee when costs stay low:
500,000 + 600 x – 350,000 – x
= 150,000 + 600 x – x
 Private gain to promisee when costs go up:
150,000 – x
 Expected private gain to promisee is
150,000 + (1 – p) 600 x – x
 Choose x to maximize this: derivative is
600 (1 – p)/(2x) – 1 = 0
x = 90,000 (1 – p)2
 So promisee would invest x = $90,000 (1-p)2 in reliance
25
Three questions
 What is the efficient level of reliance?

x = $90,000 (1 – p)2
 What will promisee do if expectation damages include
anticipated benefit from reliance?

x = $90,000
 What will promisee do if expectation damages exclude
anticipated benefit from reliance?

x = $90,000 (1 – p)2
26
So…
 To get efficient reliance, we need to exclude gains from
reliance in calculation of expectation damages
 But then promisor’s liability < promisee’s benefit, leading to
inefficient breach
 With low transaction costs, we can fix this through
renegotiation
 But what about unobservable actions the promisor needs
to take, to make breach less likely?

Investment in performance
27
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
28
Investment in performance
(continuing with airplane example)
 Some investment I can make to reduce likelihood that
breach becomes necessary
 Suppose probability is 1/2, but for every $27,726 I invest, I
cut the probability in half again
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Invest nothing  probability of breach is 1/2
Invest $27,726  probability is 1/4
Invest $55,452  probability is 1/8
Any investment z  probability is .5 * (.5) z / 27,726
 Wrote it this way so p = .5 e– z / 40,000
29
Same questions as before
 What is the efficient level of investment in performance?
 What will promisor do under various rules for calculating
damages?
30
What is the efficient level of investment in
performance?
 Suppose promisee has decided to spend $90,000 on hangar
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Gives $180,000 benefit
So benefit of performance is now 150,000 + 180,000 = 330,000
Cost of hangar is a sunk cost – we can ignore it
 Social surplus is…
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
330,000 + 100,000 if costs stay low
0 if costs rise
 So expected social surplus is (1 – p(z)) (430,000) – z
31
What is the efficient level of investment in
performance?
 Expected social surplus is
(1 – p(z)) (430,000) – z
430,000 – 430,000 * 0.5 * e–z/40,000 – z
 Take derivative to maximize this:
– 430,000 * 0.5 * (–1/40,000) e– z/40,000 – 1 = 0
 Could solve for z, but simpler to solve for p(z)
0.5 * e– z/40,000 = 40,000 / 430,000 = p(z)
 Efficient level of investment in performance is enough
to reduce probability of breach to 40,000/430,000
32
Same questions as before
 What is the efficient level of investment in performance?

Enough so that p(z) = 40,000/430,000
 What will promisor do under various rules for calculating
damages?
33
How much will promisor choose to invest in
performance?
 Let’s let D denote liability from breach

Private gain to promisor is 100,000 when costs stay low, -D when
costs go up, minus whatever he invests in performance
Expected private gain is

(1 – p(z)) 100,000 + p(z) (-D) – z
100,000 – p(z) (100,000 + D) – z
100,000 – (100,000 + D) * 0.5 * e–z/40,000 – z
Take derivative to maximize this:

– (100,000 + D) * 0.5 * (–1/40,000) e– z/40,000 – 1 = 0
Again, solve for p(z)

0.5 * e– z/40,000 = 40,000 / (100,000 + D) = p(z)
 For any level of liability D, promisor invests enough to
reduce probability of breach to 40,000/(100,000+D) 34
Same questions as before
 What is the efficient level of investment in performance?

Enough so that p(z) = 40,000/430,000
 What will promisor do under various rules for calculating
damages?

Enough so that p(z) = 40,000/(100,000 + D)
 So if D = 330,000, efficient investment in performance
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D = 330,000 is promisee’s benefit, including reliance
So expectation damages, with benefit of reliance, give efficient
investment in performance
If D < 330,000, too little investment in performance
If D > 330,000, too much
35
Midterm
 Overall pretty good
 Mean 75, median 76, std dev 12
 Not actually assigning letter grades till after final
 But to have an approximate idea of where you stand…
> 80
roughly AB or A
70-80
roughly B
60-70
roughly BC
below 60
roughly C or worse
last names A-L
last names M-Z
36