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Economics of Contract LawⅡ
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山东大学
Painting Sale I
 You value my unfinished painting at $1000
 We agree on a sale price of $600 upfront
 Crazy cousin makes $5000 offer
Buyer
Painter
Buy
Don’t Buy
Perform
600, 400
------
Breach
-400,
4600,5400
5600,
-400
600
------
 What are Expectation Damages?
 DE = $1000
 What if D = $6000
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Painter breaches and it is efficient
Painter performs though breach is efficient
山东大学
Painting Sale II





You value my unfinished painting at $1000
We agree on a sale price of $600 upfront
Crazy cousin makes $5000 offer
Assume simple DE
Buyer purchases frame for $50 which raises value
of painting to $1200
Buyer
Painter
Rely
Don’t Rely
Perform
600, 550
600, 400
Breach
4400, 550
4600, 400
Whether painter performs or not, reliance makes you better off
But, is reliance efficient?
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4th Purpose of Contract Law is to secure
optimal reliance.
If Expected Gain from Reliance > Cost of Reliance
then Reliance is efficient
p = probability of performance
∆V = increase in value of performance due to reliance
c = cost of reliance
If p(∆V) > C then reliance is efficient
Painter ex:
∆V = 200
c = 50
When the probability of performance is high,
more reliance tends to be efficient
 p* = 0.25
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4th Purpose of Contract Law is to secure
optimal reliance.
 Warning: if my damages cover your benefit
whether or not it’s efficient, then you’ll always
spend on reliance (over-reliance)
 Solution: Perfection Expectations Damages
 damages needed to restore the promisee had the
promise been kept, and had he relied the optimal
amount
 Foreseeability Doctrine
 “Reasonably expected” reliance
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Hadley v Baxendale (1854)
 Hadley ran a mill and crankshaft broke
 Baxendale was to deliver it to engineers
 Delayed one week (used boat rather than rail)
 Hadley sued for week’s worth of lost profits
 Court ruled lost profits were not foreseeable
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5th Purpose of Contract Law is to minimize
transaction costs of negotiating contracts by
supplying efficient default rules
 Gaps: contract is silent about risks
 Inadvertent gaps: not foreseeable
 Deliberate gaps: remote risks
Cost of allocating a risk > Expected cost of allocating a loss  leave gap
Cost of allocating a risk < Expected cost of allocating a loss  fill gap
 Default rules
 Compute hypothetical bargain
• Who can bear risk at lowest cost?
• Adjust price of the contract
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Perfect Contracts and Market Failures
 Perfect Contract
 All risks is efficiently allocated
 All relevant information is communicated
 All resources allocated to those who value it the most
 Individual Irrationality
 Incompetence
 Dire constraints
• Necessity
• Duress
 Transactions Costs
Exceptions to
perfect contracts
 Spillovers
 Asymmetric information
 Monopoly
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6th Purpose of Contract Law is to foster enduring
relationships, which solve the problem of cooperation
with less reliance on the courts to enforce contracts
 Coffee shop and the forgotten wallet
 Prisoner’s Dilemma
 One-shot game: DS is to cheat
 Repeated game: Cooperative outcome is Pareto Optimal
“tit-for-tat” strategy
“Rarely will buyers leave saying they bought the wrong
goods at too high
a price. Our
goal is
to make them eager to
NY Diamond
Dealer’s
Club
come back. We offer a source which provides a competitive
edge, all of which translates directly into increased profits.”
 Endgame Problem
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Peevyhouse v Garland Coal (1962)
 Peevyhouse owned farm in Oklahoma
 Garland contracted to strip-mine coal
 Contract specified that Garland would take steps to restore
land to previous condition
 Garland breached
 Peevyhouse sued for $25,000
 Restorative costs were estimated to be $29,000 at trial
 Garland showed that “diminished value” of farm was only $300
 Original jury awarded $5000 to Peevyhouse
 OK Supreme Court reduced damages to $300
 Efficient breach?
 Dissent: specific performance was warranted, otherwise no
formation would have occurred
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