Econ 522 – Lecture 13 (March 5 2009)
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midterm will be returned on Tuesday
one point about efficiency
Last week, we looked at a number of formation defenses and performance excuses
 incompetence
 dire constraints
 impossibility
 fraud, failure to disclose, frustration of purpose, mutual mistake
 contracts of adhesion and unconscionability
For impossibility and frustration of purpose, we came up with a simple rule for
achieving efficiency:
 When changed circumstances make performance impossible or pointless, assign
liability to the party who can bear the risk at the least cost
We saw the rule that efficiency generally requires uniting knowledge and control
 Which explains why mutual mistake will generally void a contract, but
unilateral mistake will not
We distinguished between productive information and redistributive information
 And saw the principle of rewarding productive information – especially if it was
the result of active investment – to give an incentive to discover it
Next, we returned to the question of remedies. We defined several different remedies:
 expectation damages, which restore the promisee to the level of well-being he
would have had if the contract had been performed
 opportunity cost damages, which restore the promisee to the level of well-being
he would have had if he had pursued his next-best option instead of signing this
contract
 reliance damages, which reimburse the promisee for any reliance investments he
made
 specific performance, which demands the promisor fulfill his promise rather than
order monetary damages
 and we noted the possibility of party-imposed remedies – remedies which are
specified in the contract itself
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However, common law courts are sometimes hesitant to enforce remedies that are
specified in the contract
One type of remedy that courts will often refuse to enforce is penalty damages
 Penalty damages are damages that are greater than the actual harm that occurred
 (“Liquidated damages” refer to party-specified damages that are a reasonable
estimate of the actual harm done by the breach; penalty damages are any damages
that are greater than that)
Civil law courts generally enforce penalty damages
But common law courts often set aside penalty damages, and only enforce liquidated
damages
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It’s unfortunate that penalty clauses are often not enforced, because they could be
useful in some instances
In particular, they could be helpful when one party to a contract places a high
subjective value on performance
Go back to coal mining example we saw earlier, Peevyhouse v Garland Coal
The Peevyhouses only wanted their farm strip-mined if the land could be restored
to its original condition
They seemed to value the condition of their farm much more highly than “market
value”
Had they known the coal company would refuse to perform the restoration work,
and instead only pay them damages, they might have refused to agree to the
contract in the first place
We can illustrate this with a simple dynamic game
Suppose the coal extracted was worth $70,000 (net of costs), and Garland Coal
agreed to pay $25,000 to mine it
Recall that restoration work would have cost around $30,000, but damages for
refusing to do it were assessed at $300
Suppose that the Peevyhouses’ subjective valuation of their farm dropped by
$40,000
PEEVYHOUSES
Don’t
Sign
GARLAND COAL
Restore property
(25,000, 15,000)
Don’t, pay damages
(-14,700, 44,700)
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(0, 0)
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So the Peevyhouses anticipate that once the coal has been mined, Garland will
refuse to do the restoration work
So now the Peevyhouses refuse the original contract
One way to address this in a contract would have been to write into the contract a
$40,000 penalty in the event that the restorative work was not completed
If this was enforceable, it would ensure that the mining company followed
through with the restorative work
That is, it would change the game to this:
PEEVYHOUSES
Don’t
Sign
GARLAND COAL
Restore property
(25,000, 15,000)
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Don’t, pay penalty
(0, 0)
(25,000, 5,000)
Now, the Peevyhouses are assured of getting their land restored
So they’re happy to agree to the contract
But, if common law courts don’t uphold penalty clauses, this won’t work
Another example: suppose you’re hiring a contractor to build a house, and you place a
very high value on its being completed by a particular date
 You are happy to pay $200,000 to get the house built, but insist on a $50,000
penalty if it’s not ready on that date
 Now suppose there are lots of contractors who could potentially build the house
 If you offer this deal to lots of them, the ones who accept are likely the ones who
are most confident in their ability to finish the house on time
 Since you value this highly, this may be efficient
 And this may be the easiest (or the only) way for you to elicit this information
o If there is no penalty clause, every contractor will try to convince you he’s
100% certain he’ll finish on time
o But if someone accepts the $50,000 penalty clause, they’re probably pretty
sure
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Of course, it’s also easy to come up with examples where penalty clauses seem excessive
and nasty
 Imagine if Blockbuster charged late fees of $1,000 per day
 You go to rent a video, they tell you it’s yours for a week, but it’s $1,000 if it’s a
day late
 You might rent the video anyway, thinking it’s within your power to return it on
time
 But in the event that something happens (your daughter gets sick, or you get
called out of town on business), you’re going to be pretty upset to be charged
$1,000
 Similarly, a rental car company that attached a $50,000 fine to any damage to
their $10,000 car would look pretty mean-spirited
Still, in some instances, penalty damages seem beneficial
 Especially if one party would not agree to a mutually beneficial contract without
them
 So it seems like the fact that they’re not enforced is a problem
 However, it turns out, most things you could accomplish with penalties, you could
restate in a different way with a performance bonus
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Go back to the house-building example
o I’m happy to pay $200,000 to get the house built by a certain date
o But I insist on a $50,000 penalty if it’s not ready on time
We could alternatively write the contract this way:
o I pay $150,000 for the building of the house
o And I pay an additional $50,000 performance bonus if the house is
completed by a certain date
Courts generally have no problem enforcing contracts with bonuses in them, so
this would likely be enforced as written
But it ahs the same effect as the contract with the penalty
(Under either contract, the builder gets $200,000 for finishing the house on time,
and $150,000 for finishing it late.)
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Similarly, go back to the Peevyhouse example
 Instead of a $40,000 penalty that might not be upheld, the Peevyhouse contract
also could have been rewritten as a bonus
 We imagined that Garland paid $25,000 to mine the coal
 Suppose the contract were written in this way:
o Garland pays the Peevyhouses $65,000 to mine the coal
o The Peevyhouses pay Garland a $40,000 bonus if the resoration work is
completed
 This would create exactly the same incentives as a $40,000 penalty clause
 (In this case, though, the intent of the contract might have been so transparent that
it still might not have been enforced)
So that’s penalty damages.
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Next, I want to consider the effect of different remedies for breach, in terms of the
incentives they lead to for…
 the promisor’s decision to perform or breach
 the promisor’s investment in performing, and
 the promisee’s investment in reliance
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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
But 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
o The price of building the airplane may go up
o My rich cousin may appear and value my painting more highly than you
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There are two ways for me to get out of my promise
o I can renegotiate with you, getting you to “let me off the hook,”
presumably in exchange for some money
o Or I can breach our contract and live with the consequences, most likely
the damages that a court imposes
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Think back to nuisance law, and consider some entitlement – say, the right to
breath clean air
When it 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.
With contract law, the result is exactly the same
When transaction costs are low, all remedies lead to efficiency, but they will lead
to different outcomes for each party
When transaction costs are high, some remedies will be more efficient than others
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For example, let’s compare a contract enforced by specific performance – the promisor
is not allowed to breach unless the promisee agrees – versus a promise enforced by
expectation damages
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Let’s stick with the example of the airplane I agreed to build for you
The plane will give you a value of $500,000
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
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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 threat point is very low, 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 this means, in return for getting out of the contract, I pay you $400,000)
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As long as transaction costs are low, either remedy will lead to the same outcome
o When it is efficient to breach, expectation damages lead me to breach
without permission
o Under specific performance, when it is efficient to breach, renegotiation
will lead us to some sort of agreement to let me off the hook.
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But when the transaction costs of renegotiating our contract are too high…
o Expectation damages still allow me to breach
o Specific performance would lead to inefficient performance
o I would have to build you the plane, even though it costs me more than
your benefit
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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.
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For example, consider opportunity cost damages
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
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-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 the contract (instead of me breaching) 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.)
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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
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An increase in the cost of performance is referred to as an unfortunate
contingency
On the other hand, I may want to break 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
o With low transaction costs, any remedy will lead to efficient breach, but
with different allocations of surplus
o An example of this is done in the textbook (p. 267)
o Once again, specific performance is the most advantageous to the buyer,
and higher damages are better for the buyer than lower damages.
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<<< SKIPPED THIS PART IN LECTURE >>>
One further point that we mentioned earlier but didn’t talk much about: efficient signing.
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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
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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.
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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
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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 suggests 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
<<< END SKIP >>>
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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.
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The book makes a big deal out of “the paradox of compensation”
This is an idea we’ve already mentioned: 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.
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We will ask three questions:
1. What is the efficient level of reliance?
2. What would the buyer do if expectation damages included the anticipated benefit
from reliance?
3. What would the buyer do if expectation damages do not include the anticipated
benefit from reliance?
First, What is the efficient level of reliance?
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The total social gain from the contract when costs stay low is
500,000 + 600 sqrt(x) – 250,000 – x
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The total social gain is from the contract when costs go up and the seller breaches
is –x (the reliance investment is lost, everything else is just transfers)
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Suppose the probability of breach is p; then the expected social benefit is
(1-p) (500,000 + 600 sqrt(x) – 250,000 – x) + p(–x)
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We can simplify this to
250,000*(1 – p) + 600 (1– p) sqrt(x) – x
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If we take the derivative and set it equal to 0, we get
600 (1 – p) / 2sqrt(x) – 1 = 0
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If we solve this for x, we find the efficient level of reliance is 90,000 (1-p)^2
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Next, what will the buyer do if that expectations damages include the benefits
anticipated based on reliance investments?
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Then the buyer knows he’ll get the added benefit, whether or not the seller
performs
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So in deciding how nice a hangar to build, the buyer would maximize
500,000 + 600 sqrt(x) – 350,000 – x
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Solving this gives the first-order condition
600/2sqrt(x) – 1 = 0  x = 300^2 = 90,000
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So the buyer, when insulated from the risk of breach, invests $90,000 in a pretty
nice hangar, which gives anticipated benefit of 600 sqrt(90,000) = 180,000
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Note that the reliance investment, 90,000, is more than the efficient level,
90,000(1-p)^2, as long as p > 0 (there is any chance of breach)
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This makes sense: in this scenario, reliance imposes a negative externality on the
seller (since he incurs a greater cost when he breaches), so it is overprovided
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Or, the buyer gets all the benefit from reliance, but not all of the cost, so he
invests too much
On the other hand, suppose expectation damages do not include the benefits of reliance
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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
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This leads to the efficient level of reliance
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So if damages include the gains from reliance, this leads to overreliance
But if the level of damages excludes the gains from reliance, this leads to efficient
reliance
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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
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We said before that with no transaction costs, this problem can be solved
o When breach would be inefficient, the parties can contract around it
o Since it’s generally very clear whether a party has breached a contract or
not, this shouldn’t be a particular problem.
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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 necessary
o A contractor could buy raw materials ahead of time, to avoid the risk of
changing prices
o A manufacturer could start a project earlier and frontload the labor to
avoid the risk of a strike
o 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
So 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.)
So investment in performance may only occur when it is in the promisor’s best
interest
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We’ll stick with the airplane example
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Suppose there is some investment I can take that reduces the chance that my costs
go up
o I can buy some of my supplies ahead of time
o This will reduce the risk of having to breach
o But I can’t completely insulate myself from risk
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Suppose that for each $27,726 I invest, I can reduce the probability I will need to
breach by ½
o That is, if I invest $27,726, the probability of breach goes from ½ to ¼
o If I invest another $27,726, it goes down to 1/8
o And so on
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For any investment z, then, we can write the probability that breach is still
required as ½ * ½ ^(z / 27,726)
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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.
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So, how much will a self-interested promisor invest in performance?
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Let’s let D be the amount of damages that the promisor is liable for if he breaches
o D could be nothing
o or the investment in reliance
o or the opportunity cost
o or the gain the buyer expected to achieve, with or without reliance.
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But suppose that D is low enough that the seller will still choose to breach when
costs go up
o 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
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When costs remain low, the seller expects $100,000 in profits
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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
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Taking the derivative gives
½ 1/40,000 e^(-z/40,000) (D+100,000) – 1 = 0
½ e^(-z/40,000) = 40,000/(D+100,000)
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So whatever D is, the seller invests enough to reduce the probability of breach to
40,000/(D+100,000)
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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
o He still prefers profits (100,000) over nothing
o But he only invests a little, since he can still get out of the contract for free
o (The investment here is about $9,000.)
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Suppose D was 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 = 16%
 (The investment this time is about $45,000.)
Suppose D was 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 the promisee’s 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 = 9%
 (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
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To maximize this, we take the derivative:
430,000 ½ 1/40,000 e^(-z/40000) – 1 = 0
Pr(breach) = 40,000/430,000
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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
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Which we just saw is exactly what the seller would do when he’s liable for
expectation damages which include the benefit from reliance!
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So we’ve found…
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The efficient level of investment leads to a 40,000/430,000 chance of breach
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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)
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So when damages are set to 330,000 – damages include the benefit from reliance
– the investment in performance is efficient
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When damages are lower than that, the seller will underinvest in performance,
leaving the risk of breach inefficiently high
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When damages are higher than this, the seller will overinvest in performance
And what’s the overall lesson?
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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; just like it led to efficient breach
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
underinvestment in performance
But it leads to the efficient level of reliance
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
We already saw one attempt to get around this problem:
 limit damages to the efficient level of reliance, not the actual level of reliance
 that way, the promisee has no incentive to overinvest in reliance, so he invests the
efficient amount
 but the promisor still internalizes the full cost of breach
 so he invests the efficient amount in performance
The textbook also discusses another clever, if unrealistic, solution to the problem, which
is where we’ll begin on Tuesday.
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