Economics of
Contract Law
Agency Game I
 Give me $100 and I’ll turn it into $200 and share
the gain with you
 Do you trust me?
 No! Player 2 has DS to breach
Player 2
Player 1
Perform
Breach
Contract
150, 50
0, 200
Don’t Contract
100, 0
100, 0
 Solutions?
 Reputation in a repeated game
 Contract law
Agency Game II
 Suppose we sign a contract in which I am
punished if I run off with the money
 Court forces me to pay you $150 and charges each of us
an additional $25 fee for doing so
Player 2
Player 1
Perform
Breach
Contract
150, 50
125, 25
Don’t Contract
100, 0
100, 0
1st Purpose of Contract Law is to enable people to cooperate
Requires a way to make a promise credible (some sort of commitment)
Example 1
The rich uncle of a struggling college student
learns at the graduation party that his nephew
graduated with honors. Swept away by good
feeling, the uncle promises the nephew a trip
around the world. Later the uncle reneges on
his promise. The student sues his uncle, asking
the court to compel the uncle to pay for a trip
around the world.
Example 2
One neighbor offers to sell a used car to another
for $1000. The buyer gives the money to the
seller, and the seller gives the car keys to the
buyer. To her great surprise, the buyer discovers
that the keys fit the rusting Chevrolet in the
back yard, not the shiny Cadillac in the driveway.
The seller is equally surprised to learn that the
buyer expected the Cadillac. The buyer asks the
court to order the seller to turn over the
Cadillac.
Example 3
A farmer, in response to a magazine ad for “a
sure means to kill grasshoppers,” mails $25 and
receives in the mail two wooden blocks with the
instructions, “Place grasshopper on Block A and
smash with Block B.” The buyer asks the court
to require the seller to return the $25 and to pay
$500 in punitive damages.
Bargain Theory of Contracts I
 A promise should be enforced if it was given in a
bargain, otherwise it should not.
 Offer
 Acceptance
 Consideration
Promisor: person who gives a promise
Promisee: person who receives it
“reciprocal inducement”
 Rich uncle: no consideration offered
 Disputed car: no “meeting of the minds”
 Grasshopper killer: enforceable bargain
How do you enforce a gift promise?
Bargain Theory of Contracts II
 What should the remedy be for broken promises?
 Expectations damages: amount promisee could
reasonably expect from performance
 Problems with the Bargain Theory
 Requires all promises to have consideration
 Car shopping and a “firm offer”
 Requires that all bargains be enforced
 Grasshopper killer?
Economic efficiency requires enforcing a
promise that both parties want enforced.
Economic Theory of Contract
1st Purpose of Contract Law is to enable people to cooperate
 Rich uncle: both want the promise enforced
 Disputed car: no cooperative surplus
 Grasshopper killer: enforce the promise to discourage
deceit by promisor
2nd Purpose of Contract Law is to encourage
efficient disclosure of information
 Used car market
 You value my car 50% more than I do
 Asymmetric information exists
 No mechanics
[0---------------------------5000]
$2500
(your guess as to value of car to me)
[0-------------------3000]
$1500
(your revised guess as to value of car to me)
Suppose you offer $3000
You will end up paying
$3000 for a car that’s only
worth $2250 to you
3rd Purpose of Contract Law is to secure optimal
commitment to performing.
 What should be the remedy for efficient breach?
 Painting sale




You value my unfinished painting at $1000
We agree on a sale price of $600 upfront
Crazy cousin makes $5000 offer
It’s efficient for me to breach contract with you:
 Cost of performance > benefit you will get from the painting
 Airplane sale
 You value my plane at $500,000
 We agree on a sale price of $350,000
 Before construction begins, price of metal rises and raises my
cost to $1,000,000
3rd Purpose of Contract Law is to secure optimal
commitment to performing.
 Optimal Performance
 If promisor’s cost of performing > promisee’s benefit from
performing, then
breach
is efficient
 If promisor’s cost of performing < promisee’s benefit from
performing, then performance is efficient
 Choice of remedy is critical
 If penalty for breach is too severe, the promisor will have
to perform, even though breach may be efficient
 If penalty for breach is too weak, the promisor will breach
when efficiency requires performance
3rd Purpose of Contract Law is to secure optimal
commitment to performing.
 Actual Performance Decision:
 If promisor’s cost of performing > promisor’s liability for
breaching, then he will breach
 If promisor’s cost of performing < promisor’s liability for
breaching, then he will perform
 Perfect Expectations Damages
 Promisor’s liability = promisee’s benefit from performance
 Restores promisee to position he would have enjoyed if
promise had been kept
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
Painter breaches and it is efficient
Painter performs though breach is efficient
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?
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
 p* = 0.25
When the probability of performance is high,
more reliance tends to be efficient
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
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
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
McGuire v Wabash
 McGuires hire Wabash to build new house
 Price of copper rises by $2000 and contract is silent
 McGuires refuse to pay extra $2000
 Suppose Wabash knows that copper costs could rise
by $2000 with p = 0.50
 Expected cost = (0.50)(2000) = $1000
 Suppose Wabash could’ve hedged risk for $400
 Hypothetical bargain
 Who is the low cost bearer of risk? Wabash
 If risk was foreseeable, Wabash would charge extra $700
 McGuires pays $700
 Wabash absorbs $1300 loss
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
 Spillovers
 Asymmetric information
 Monopoly
Exceptions to
perfect contracts
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
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