Relying on Contracts
Law and Economics-Charles W. Upton
Two Principles
• Break contracts if and only if the benefits
from breach exceed the costs of the breach.
• Don’t over rely on a contract.
Relying on Contracts
The General Rule
• Rely if and only if
(Probability of Performance) x
(Gains from Relying)
>
(Probability of Breach) x
(Extra Costs Imposed by Relying)
Relying on Contracts
The Opportunity
• An Entrepreneur offers an investor a chance to go
into a business deal for $1,000. If the deal works
out (and it will if the entrepreneur works at it),
each will make $500.
• It is possible that another opportunity will come
along. If the Entrepreneur takes that, the first deal
will fail but the Entrepreneur will make $1,500
• It is also possible that the Entrepreneur will simply
take the investor’s $1,000.
Relying on Contracts
The Payoff Matrix
Perform (no
opportunity
arises)
Investor
Invest
Don’t
Invest
Entrepreneur
Perform
(opportunity
arises)
Appropriate
BE =500 BE = -1000 BE = 1000
BI = 500 BI = 500 BI = -1000
BE = 0
BE = 0
BE = 0
BI = 0
BI = 0
Relying on Contracts
BI = 0
The Payoff Matrix
Perform (no
opportunity
arises)
Investor
Invest
Don’t
Invest
Entrepreneur
Perform
(opportunity
arises)
Appropriate
BE =500 BE = -1000 BE = 1000
BI = 500 BI = 500 BI = -1000
BE = 0
BE = 0
BE = 0
BI = 0
BI = 0
Relying on Contracts
BI = 0
The Payoff Matrix
Perform (no
opportunity
arises)
Investor
Invest
Don’t
Invest
Entrepreneur
Perform
(opportunity
arises)
Appropriate
BE =500 BE = -1000 BE = 1000
BI = 500 BI = 500 BI = -1000
BE = 0
BE = 0
BE = 0
BI = 0
BI = 0
Relying on Contracts
BI = 0
The Payoff Matrix
The
entrepreneur Perform (no Entrepreneur
Perform
Appropriate
(opportunity
makes $500 opportunity
arises)
arises)
from theInvest BE =500 BE = -1000 BE = 1000
Investor
investment if
BI = 500 BI = 500 BI = -1000
he performs,
Don’t
BE = 0
BE = 0
BE = 0
Invest
but loses
BI = 0
BI = 0
$1,500 from BI = 0
the forgone
opportunity.
Relying on Contracts
The Payoff Matrix
Perform (no
opportunity
arises)
Investor
Invest
Don’t
Invest
Entrepreneur
Perform
(opportunity
arises)
Appropriate
BE =500 BE = -1000 BE = 1000
BI = 500 BI = 500 BI = -1000
BE = 0
BE = 0
BE = 0
BI = 0
BI = 0
Relying on Contracts
BI = 0
The Payoff Matrix
So what is
the right
Invest
Investor
strategy?
Don’t
Invest
Perform (no
opportunity
arises)
Entrepreneur
Perform
(opportunity
arises)
Appropriate
BE =500 BE = -1000 BE = 1000
BI = 500 BI = 500 BI = -1000
BE = 0
BE = 0
BE = 0
BI = 0
BI = 0
Relying on Contracts
BI = 0
The Payoff Matrix
Perform (no
opportunity
arises)
Entrepreneur
Perform
(opportunity
arises)
Appropriate
Without legal
Invest the
Investor
sanctions,
BE =500 BE = -1000 BE = 1000
entrepreneurBwill
BI = -1000
I = 500 BI = 500
alwaysDon’t
steal the
BE = 0
BE = 0
BE = 0
Invest
money. Ergo no
BI. = 0
BI = 0
BI = 0
investment
Relying on Contracts
We modify The Payoff Matrix
with perfect
Entrepreneur
Perform
Appropriate
expectation Perform (no
opportunity
(opportunity
arises)
arises)
damages.
Investor
Invest
Don’t
Invest
BE =500 BE = -1000 BE = 1000
-500
BI = 500 BI = 500
BI = -1000
500
BE = 0
BE = 0
BE = 0
BI = 0
BI = 0
Relying on Contracts
BI = 0
Now crimeThe Payoff Matrix
does not
Entrepreneur
Perform
Appropriate
pay. But it Perform (no
opportunity
(opportunity
arises)
arises)
does pay to
Invest
Investor
walk away BE =500 BE = -1000 BE = 1000
-500
if the
BI = 500 BI = 500
opportunity
BI = -1000
500
arises.
Don’t
Invest
BE = 0
BI = 0
BE = 0
BI = 0
Relying on Contracts
BE = 0
BI = 0
When we add in the
from the
The Payoff$1,500
Matrix
opportunity,
the
net
gain
Now it
Entrepreneur
to
the
entrepreneur is now
does not
Perform (no
Perform
Appropriate
$1,000
opportunity
(opportunity
pay to
arises)
arises)
Invest
Investor But
steal.
BE =500 BE = -1000 BE = 1000
-5001000
it does pay B = 500 B = 500
I
I
to walk
BI = -1000
away if the
500
Don’t
BE = 0
BE = 0
BE = 0
opportunity
Invest
arises.
B =0
B =0
B =0
I
I
Relying on Contracts
I
Moral
• Perfect expectation damages seem to give
the entrepreneur the right incentives.
Perform, unless there is a better opportunity.
Relying on Contracts
Moral
• Perfect expectation damages seem to give
the entrepreneur the right incentives.
Perform, unless there is a better opportunity.
• But there is more to the story: the tale of the
investor.
Relying on Contracts
Moral
The investor is indifferent
• Perfect expectation damages seem to give
between the entrepreneur
the entrepreneur the right incentives.
performing and not
Perform, unless there is a better opportunity.
performing. He will invest
• But thereeven
is more
to theisstory:
the tale of the
if there
a 100%
investor. chance of the other
opportunity coming along.
Relying on Contracts
Moral
The investor is indifferent
• Perfect expectation damages seem to give
between the entrepreneur
the entrepreneur the right incentives.
performing and not
Perform, unless there is a better opportunity.
performing. He will invest
Thisthe
seems
• But thereeven
is more
to
the
story:
if there is a 100% tale of the
wasteful
investor. chance of the other
opportunity coming along.
Relying on Contracts
The Payoff Matrix
Another aspect.
Entrepreneur
Lets focus on the
Perform (no
Perform
Appropriate
(opportunity
payoff matrixopportunity
arises)
arises)
Invest
Investorwithout
BE =500 BE = -1000 BE = 1000
expectation
BI = 500 BI = 500 BI = -1000
damages.
Don’t
Invest
BE = 0
BI = 0
BE = 0
BI = 0
Relying on Contracts
BE = 0
BI = 0
The Payoff Matrix
Entrepreneur
Perform
Breach
Investor
Invest
Don’t
Invest
BE =500 BE = 1000
BI = 500 BI = -1000
BE = 0
BE = 0
BI = 0
BI = 0
Relying on Contracts
Might He invest Too Much?
• Suppose the investor can put another $1,000
in the project and if successful, earn another
$100. Should he do so?
Relying on Contracts
The Payoff Matrix
Entrepreneur
Perform
Breach
Investor
Invest
$1000
BE =500 BE = 1000
Invest
$2000
BI = 500 BI = -1000
BE =500 BE = 1000
Don’t
Invest
BI = 600 BI = -2000
BE = 0
BE = 0
B =0
BI = 0
I on Contracts
Relying
How to Analyze
• Compute the expected gains from the
two possible investments.
• The investor should invest if the
expected gains are positive.
• Those gains depend on the probability p
of no new opportunity arising
Relying on Contracts
If it works out
Gains from a
$1000
Entrepreneur
Perform
Breach
investment =
Invest
Investor
BE =500 BE = 1000
$1000
$1000
Gains from a
$2000
investment =
$1100
Invest
$2000
BI = 500 BI = -1000
BE =500 BE = 1000
Don’t
Invest
BI = 600 BI = -2000
BE = 0
BE = 0
B =0
BI = 0
I on Contracts
Relying
If it doesn’t works out
Losses from a
$1000
Entrepreneur
Perform
Breach
investment =
Invest
Investor
BE =500 BE = 1000
$1000
$0
Invest
$2000
BI = 500 BI = -1000
BE =500 BE = 1000
Losses from a
$2000
BI = 600 BI = -2000
Don’t
BE = 0
BE = 0
investment = $-Invest
1000
BI = on0ContractsBI = 0
Relying
The $1000 Investment
Losses from a
$1000
Entrepreneur
Perform
Breach
investment =
Invest
Investor
BE =500 BE = 1000
$1000
$0
Gains from a
$1000
investment =
$1000
Invest
$2000
BI = 500 BI = -1000
BE =500 BE = 1000
Don’t
Invest
BI = 600 BI = -2000
BE = 0
BE = 0
B =0
BI = 0
I on Contracts
Relying
The $1000 Investment
Losses from a
$1000
Entrepreneur
Perform
Breach
investment =
Invest
Investor
BE =500 BE = 1000
$1000
$0
Gains from a
$1000
investment =
$1000
Invest
$2000
BI = 500 BI = -1000
BE =500 BE = 1000
Don’t
Invest
BI = Expected
600 BI = -2000
gain =
BE = 0
BE = 0
p($1000) + (1-p)($0)=
BI = on0Contracts
BI = 0
p($1000)
Relying
The $2,000 Investment
Losses from a
$2000
Entrepreneur
Perform
Breach
investment = $Invest
Investor
1000 $1000 BE =500 BE = 1000
Gains from a
$2000
investment =
$1100
Invest
$2000
BI = 500 BI = -1000
BE =500 BE = 1000
Don’t
Invest
BI = 600 BI = -2000
BE = 0
BE = 0
B =0
BI = 0
I on Contracts
Relying
The $2,000 Investment
Losses from a
Expected gain =
$2000
Entrepreneur
p($1100)
+
(1-p)(-$1000)=
Perform
Breach
investment = $Invest
Investor
p($2100)-$1000
BE = 1000
1000 $1000 BE =500
Gains from a
$2000
investment =
$1100
Invest
$2000
BI = 500 BI = -1000
BE =500 BE = 1000
Don’t
Invest
BI = 600 BI = -2000
BE = 0
BE = 0
B =0
BI = 0
I on Contracts
Relying
You do the Math
• Expected gains from a $1000 investment
1000p
• Expected gains from a $2000 investment
2100p - 1000
Relying on Contracts
You do the Math
• Expected gains from a $1000 investment
1000p
• Expected gains from a $2000 investment
2100p – 1000
• Do the $2000 only if
2100p – 1000 > 1000p
P>0.91
Relying on Contracts
Might He invest Too Much?
• Suppose the investor can put another $1,000
in the project and if successful, earn another
$100. Should he do so?
• If he gets perfect expectation damages,
there is no risk in his doing so.
Relying on Contracts
The Solution
• Tell the investor that he cannot just blindly
invest the extra $1,000. He will not get
damages if he over-relied (that is, he will
not get his last $1,000 unless there was less
than a 9% chance of the new project coming
along).
Relying on Contracts
Other Over Reliance
• You eat the
obviously damaged
box of Healthy
Cookies.
• You get ill
Relying on Contracts
Other Over Reliance
• You eat the
obviously damaged
box of Healthy
Cookies.
• You get ill
• Tough. You overrelied.
Relying on Contracts
Other Over Reliance
• You take the box of
Healthy Cookies to
the manager who
tells you not to
worry.
• You eat them.
• You get sick.
Relying on Contracts
Other Over Reliance
• You take the box of
Healthy Cookies to
the manager who
tells you not to
worry.
• You eat them.
• You get sick.
• Tough. You overrelied.
Relying on Contracts
Other Over Reliance
• You rely on my
promise of the easy
way to get an “A”
in this course and
don’t study.
• You fail.
Relying on Contracts
Other Over Reliance
• You rely on my
promise of the easy
way to get an “A”
in this course and
don’t study.
• You fail.
• Tough. You overrelied.
Relying on Contracts
End
©2004 Charles
W. Upton
Relying on Contracts