CONTRACTS – Terms And Conditions
October 17, 2006
CONTRACTS – Terms And Conditions
October 17, 2006
• COLOUR CODE FOR GRAPHS
• Marginal Cost Curve for Agent (firm, individual)
under a strict liability rule
• Marginal Cost Curve for Agent (firm, individual)
under a no liability rule
• Marginal Cost Curve for Agent (firm, individual)
under a negotiated contract that follows the Theoem
of Coase
• Demand Curve for the Agent’s output
• Marginal Revenue Curve
CONTRACTS – Terms And Conditions
October 17, 2006
• COLOUR CODE FOR GRAPHS (con’t)
• Average Cost Curve for Agent (firm, individual) with
no transaction costs
• Average Cost Curve for Agent (firm, individual) with
transaction costs
• Profit of Agent (firm, individual)
• Portion of profit traded in exchange for property
rights
• Portion of profit lost due to a trade in property
rights
• Portion of profit lost due to transaction costs
CONTRACTS – Terms And Conditions
October 17, 2006
• Review of Coase Theorem
• Exceptions To Coase Theorem
• Transaction Costs - October 17, 2006
» Rules that reduce transaction costs
• Asymmetric Information – October 24, 2006
» Rules that compensate for market failure
• Empty Core - October 31, 2006
CONTRACTS – Terms And Conditions
October 17, 2006
Review The
Theorem Of Coase
CONTRACTS – Terms And Conditions
.
Agent 1 creates a harmful
nuisance that hurts
Agent 2 economically.
Agent 2 has the
exclusive use to its
property rights
CONTRACTS – Terms And Conditions
• While cooperation between the agents
determines when optimal use or the
most efficient use of an asset will occur,
what determines what that level of
efficiency will be?
• Technology
CONTRACTS – Terms And Conditions
• Agent 1
• Social surplus
increases under
the contract.
• No party can be
worse off.
P
D
S
PMC
PM
SMC
CMC
a1
CONTRACTS – Terms And Conditions
• Agent 2
P
• Social surplus is
improved to the
most efficient or
P
optimal amount
irregardless of
which agent has
the property rights.
M
a1
D
S
PMC
SMC
CMC
CONTRACTS – Terms And Conditions
Theorem of Coase
What rule applies makes no difference to
the optimal level of efficiency.
It is the cooperation of the parties that
makes the difference.
(Cooter, p. 87)
CONTRACTS – Terms And Conditions
• Agent 1
• Agent 2
P
D
CMC
S
PM
Maximum Joint
Social Surplus
a1
a1
CONTRACTS – Terms And Conditions
Theorem of Coase (continued)
Productive or allocated transfer of surplus leads
to a more efficient use of the asset
Redistributive transfer of surplus causes no
change to the efficient use of the asset
Distribution of the social surplus varies in
accordance with which agent has the property
rights.
CONTRACTS – Terms And Conditions
Theorem of Coase (continued):
The improvement in social surplus
involves the elimination of incompatible
uses through bargaining.
LEAST COST PRINCIPLE applies as the
next example shows.
CONTRACTS – Terms And Conditions
CONTRACTS – Terms And
Conditions
• Theorem of Coase (continued):
• If it is cheaper for the farmer to build a
fence around his property, than for the
rancher to hire a rustler, than the fence
will be built.
• Note the LEAST COST PRINCIPLE is a
corollary of the Theorem of Coase in
these examples.
CONTRACTS – Terms And Conditions
Set of Cost Minimizers
Set of Profit Maximizers
CONTRACTS – Terms And
Conditions
• Theorem of Coase (continued):
• Note the application of the “cheaper”
technology reconciled a “incompatible
use” with a compatible use.
• Efficiency requires limiting the use to
the party that values the property most –
higher utility or higher profits efficiency rule
• (Cooter – p. 88)
CONTRACTS – Terms And Conditions
• The elimination of
incompatible uses
through bargaining
underlies much of
the theory behind
urban geography and
urban planning
•
Former Irwin Toy factory - Toronto
CONTRACTS – Terms And Conditions
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
LATC
LATC
S
MC1
PM
PPC
a1
CONTRACTS – Terms And Conditions
Theorem of Coase (continued):
Property rights may be traded for a price.
Each Agent does not have an incentive to
defect
CONTRACTS – Terms And Conditions
Nash Equilibria
• Prisoners dilemna works
against a collusive duopoly
• Prisoners dilemna could be
“solved” in a collusive
externality agency
P.O.E
P.O.E
N.E
and
N. E
CONTRACTS – Terms And Conditions
Nash Equilibria
a2
• Cournot Duopoly
• Negative Externality
Axes
Iso-Profit Curve For Agent 2
E
Iso-Profit Curve
For Agent 1
CONTRACTS – Terms And Conditions
October 17, 2006
Coase Theorem
Short Run
CONTRACTS – Terms And Conditions
Short Run
• Why the Theorem of Coase might be
true in the short run, but not the long
run
• (See Cooter, p. 90, for a fuller explanation)
CONTRACTS – Terms And Conditions
Short Run
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
LATC
MC1
SATC
PM
PPC
a1
S = MC1
LATC
S
SATC
CONTRACTS – Terms And Conditions
Strict Liability Rule
.
Agent 1 creates a harmful
nuisance that hurts
Agent 2 economically.
Agent 2 has the
exclusive use to its
property rights
CONTRACTS – Terms And Conditions
Short Run
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
LATC
MC1
SATC
PM
PPC
Strict Liability Rule
a1
S = MC1
LATC
S
SATC
CONTRACTS – Terms And Conditions
Strict Liability Rule - Short Run
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
P
D
LATC
MC2
SATC
PM
PPC
Strict Liability Rule
a1
S = MC2
LATC
S
SATC
CONTRACTS – Terms And Conditions
Short Run - Strict Liability Rule
PRINCIPAL
Agent 1 Offers a Bribe
or a Transfer Payment
To Agent 2
promise
payment
AGENT
Agent 2 promises to
endure the pollution in
exchange for the
payment which makes
it better off
CONTRACTS – Terms And Conditions
Short Run - Strict Liability Rule
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
LATC
MC1
SATC
PM
PPC
Strict Liability Rule
a1
S = MC1
LATC
S
SATC
CONTRACTS – Terms And Conditions
Short Run - Strict Liability Rule
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
P
D
LATC
MC2
SATC
PM
PPC
Strict Liability Rule
a1
S = MC2
LATC
S
SATC
CONTRACTS – Terms And Conditions
Short Run - No Liability Rule
.
Agent 1 creates a harmful
nuisance that hurts
Agent 2 economically.
Agent 2 loses the
exclusive use to its
property rights to
protect it against
pollution
CONTRACTS – Terms And Conditions
Short Run
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
LATC
MC1
SATC
PM
PPC
No Liability Rule
a1
S = MC1
LATC
S
SATC
CONTRACTS – Terms And Conditions
Short Run
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
P
D
LATC
MC2
SATC
PM
PPC
No Liability Rule
a1
S = MC2
LATC
S
SATC
CONTRACTS – Terms And Conditions
No Liability Rule
PRINCIPAL
Agent 2 Offers a Bribe
or a Transfer Payment
To Agent 1
promise
payment
AGENT
Agent 1 promises to
cutback production or
incur the expense of
pollution abatement
CONTRACTS – Terms And Conditions
Short Run - No Liability Rule
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
LATC
MC1
SATC
PM
PPC
No Liability Rule
a1
S = MC1
LATC
S
SATC
CONTRACTS – Terms And Conditions
Short Run - No Liability Rule
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
P
D
LATC
MC2
SATC
PM
PPC
No Liability Rule
a1
S = MC2
LATC
S
SATC
CONTRACTS – Terms And Conditions
Exceptions to the Theorem of Coase
Transaction Costs - Fees
CONTRACTS – Terms And Conditions
Transaction Costs
• Rules that reduce transaction costs
• Default rules are developed by courts to
reduce transaction costs.
• For example, if A1 knows how much it
will have to pay A2 for breach of
contract, it will not incur the cost of
consulting a lawyer or losing in court
(paying the legal fees of the winner)
• (Cooter – p. 267)
CONTRACTS – Terms And Conditions
Transaction Costs – Legal Fees
What are
transaction
costs?
• Fees paid
to lawyers
to draft a
contract
CONTRACTS – Terms And Conditions
Transaction Costs – Legal Fees
• When bargaining costs are low, the
efficient use of assets or resources
results from private negotiation
irregardless of what the legal rules are
• When bargaining costs are high, the
efficient use of assets or resources
results from which legal rules is chosen
• (Cooter – p. 89)
CONTRACTS – Terms And Conditions
Transaction Costs – Legal Fees
• Which legal rule should be chosen in
this case?
• Choose the legal rule that favours the
party that “most values” the asset or
resource.
• This is an application of the NORMATIVE
HOBBES THEOREM
• (Cooter – p. 98)
CONTRACTS – Terms And Conditions
Strict Liability Rule – Short Run
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
SATC
+ TC
MC1
SATC
PM
PPC
Transaction
Costs
a1
S = MC1
LATC
S
SATC
CONTRACTS – Terms And Conditions
Strict Liability Rule – Long Run
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
P
D
LATC
S
PM
PPC
Strict Liability Rule
a1
CONTRACTS – Terms And Conditions
No Liability Rule – Long Run
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
P
D
LATC
MC2
S
MC2
PM
PM
PPC
No Liability Rule
a1
CONTRACTS – Terms And Conditions
Transaction Costs – Legal Fees
a2
• Cournot Duopoly
• Negative Externality
Axes
Iso-Profit Curve For Agent 2
E
Iso-Profit Curve
For Agent 1
CONTRACTS – Terms And Conditions
Transaction Costs – Legal Fees
• Prisoners dilemna • Prisoners dilemna works
against negative
works against a
externalities under the
collusive duopoly
exceptions to the
P.O.E
Theorem of Coase
N.E
P.O.E
N.E
CONTRACTS – Terms And Conditions
Exceptions to the Theorem of Coase
Transaction Costs - Enforcement
CONTRACTS – Terms And Conditions
Transaction Costs - Enforcement
What are transaction
costs?
• Enforcement
Fees
» Fees paid to
lawyers to go
to court to
enforce a
broken
contract and
obtain
remedies for
their clients
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
Formation
Of Contracts
Agent Sends
A
Signal
to the
Principal
Principal
Makes
An Offer To
An Agent
Agent Accepts
The Offer
Performance Of
The Contract
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
• When A1 sues A2 in court, A2 will either argue
•
(a)there never was a contract in
the first place
•
(b) there was a contract, but A1
failed to perform its part of the
contract
• What usually happens is some external
change in A2 circumstances makes A2's
position under the contract Pareto inferior, so
that A2 wants out
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
LEGAL DEFENCE
ECONOMIC ANALYSIS
INCOMPETENCE
Mental illness
Agent is not a utility or
profit maximizer
INCAPACITY
Under 18
Undischarged
Bankrupt
The competent A1 can protect the interests
of incompetent A2 at least cost, so an
“efficient” rule of contract assigns liability
to A1 (Cooter – p. 268)
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
LEGAL DEFENCE
ECONOMIC ANALYSIS
COERCION
The Agent’s income
compatibility constraint is
restricted or challenged in
some way
DURESS
Constraint:
A1 threatens A2 if
A2 does not sign
the contract
A promise extracted by A1 from A2 by a
threat reduces social surplus, so the
“efficient” rule of contract declares such a
promise unenforceable (Cooter p. 271)
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
LEGAL DEFENCE
ECONOMIC ANALYSIS
NECESSITY
The Agent’s income
compatibility constraint is
restricted or challenged in
some way
Constraint:
A1 extracts a
“gouging” price
due to A2's need
Cooter agrees, in part, with Adam Smith's
argument about why prices have to be
higher (within reason) (Cooter - pp. 273-274)
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
• Opportunistic types took
advantage of the need
and would sell a bottle for
$200.00 or more!
• What did Smith
recommend – let the
market rule. Okay to
make a dollar (or pound)
off someone’s suffering –
as long as the conduct is
not fraudulent
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
LEGAL DEFENCE
ECONOMIC ANALYSIS
IMPOSSIBILITY
The Agent’s income
compatibility constraint is
restricted or challenged in
some way
Constraint:
The contract
cannot be
performed
The “efficient” rule of contract assigns
liability to the party who, at least cost, can
bear the risk that performance becomes
impossible (Cooter - p. 275)
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
• Who is this party?
• Cooter calls this party the “efficient”
risk bearer
• Posner calls this party the “superior”
risk bearer
• Posner extends the “least cost
principle” to a theory that most contrcts
create implied insurance – some party is
bearing the risk of loss
• (Posner, s. 4.5)
CONTRACTS – Terms And Conditions
Transaction Costs – Enforcement
LEGAL DEFENCE
ECONOMIC ANALYSIS
ILLEGALITY
The Agent’s income
compatibility constraint is
restricted or challenged in
some way
Transaction costs due to unenforceability
apply
CONTRACTS – Terms And Conditions
Exceptions to the Theorem of Coase
Asymmetric Information
CONTRACTS – Terms And Conditions
Asymmetry Of Information
•
In the Cournot duopoly example,
what happens if both duopolists have
identical costs, but only one of the agents
knows this?
CONTRACTS – Terms And Conditions
Asymmetry Of Information
•
The uninformed agent would have to
guess on the rival’s costs.
•
What if the uninformed agent
“guesses wrong” and overestimates the
rival’s costs?
CONTRACTS – Terms And Conditions
Asymmetry of Information - Nash Equilibria
a2
• Cournot Duopoly – Perfect
Axes
Information
• Cournot Duopoly –
Asymmetric Information
Iso-Profit Curve For Agent 2
E
Iso-Profit Curve
For Agent 1
a1
CONTRACTS – Terms And Conditions
Asymmetry Of Information
•
The uninformed agent will “mistakenly” increase
its production levels in the “wrong expectation” that its
rival is cutting back.
•
The “rival” will in fact cut back to save money.
•
The “Nash equilibrium” moves to the right
reflecting more production and lower social surplus.
CONTRACTS – Terms And Conditions
Asymmetry of Information - Nash Equilibria
a2
• Cournot Duopoly – Perfect
Axes
Information
• Cournot Duopoly –
Asymmetric Information
Iso-Profit Curve For Agent 2
E
Iso-Profit Curve
For Agent 1
a1
CONTRACTS – Terms And Conditions
Asymmetry Of Information
•
What if the uninformed agent “guesses
wrong” and underestimates the rival’s costs?
•
In effect, the uninformed agent “believes”
its costs are higher, so it cuts back
•
The “informed agent” will expand its
production
•
Nash equilibrium moves to the left
CONTRACTS – Terms And Conditions
Asymmetry of Information - Nash Equilibria
a2
• Cournot Duopoly – Perfect
Axes
Information
• Cournot Duopoly –
Asymmetric Information
Iso-Profit Curve For Agent 2
E
Iso-Profit Curve
For Agent 1
a1
CONTRACTS – Terms And Conditions
Asymmetry of Information – Search Costs and Disclosure
Laidlaw v. Organ
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Kronman applies the
Least Cost Principle
to derive the most
“efficient” disclosure
rule for contracts.
• Kronman, A., "Mistake,
Disclosure, Information and
the Law of Contracts", (1978)
7 Journal of Legal Studies 1
CONTRACTS – Terms And Conditions
Asymmetry Of Information – Search Costs
•
Productive or allocative information
is information that, if disclosed, leads to a
more efficient use of the asset
•
Redistributive information is
information that, if disclosed, causes no
change to the efficient use of the asset
(Cooter, pp. 281 – 282)
CONTRACTS – Terms And Conditions
Asymmetry Of Information - Search Costs
LEGAL DEFENCE
ECONOMIC ANALYSIS
MISTAKE
Market failure due to
moral hazard
Assumptions upon
which the contract was
made
MISREPRESENTATION
Inducing one of the
parties to enter the
contract
Transaction costs due to search costs apply
CONTRACTS – Terms And Conditions
Asymmetry Of Information - Search Costs
• Innocent Misrepresentation
• Negligent Misrepresentation
• Fraudulent Misrepresentation
CONTRACTS – Terms And Conditions
Asymmetry Of Information - Search Costs
• Mutual Mistake
• With mutual mistake both parties have
the same fundamental
misunderstanding about the nature of
the contract.
• In cases of mutual mistake, both
parties may be excused from the
contract
• (Kronman, p. 5)
CONTRACTS – Terms And Conditions
Asymmetry Of Information - Search Costs
• Unilateral Mistake
• Unilateral mistake goes to a mistaken
assumption by one of the parties upon
which the contract was made
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Laidlaw, a wholesaler of tobacco,
cannot move its supply due to the
British bolockade of New Orleans
• This depresses the price
• Organ knows that the blockade is
about to end
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Organ negotiates a contract with
Laidlaw’s agent at a price favourable to a
quick resale profit without making any
illegal misrepresentation to the agent
• After the news becomes public, Laidlaw
refuses to deliver the tobacco to Organ
unless he agrees to pay a higher price
• Organ sues Laidlaw for delivery and wins
• Laidlaw appeals to the U.S. Supreme
Court
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Chief Justice
Marshall grants
Laidlaw’s appeal,
but only in so far
as Laidlaw gets a
right to a new trial
in New Orleans
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Marshall emphasizes his opinion
that Laidlaw is not likely to win at
trial
• The contract was complete
• Any “after the fact” economic
disadvantage to Laidlaw is not
relevant unless there had been a
misrepresentation, breach of trust
or express proviso in the contract
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• What is the most efficient contract rule?
• The agent who acquires relevant
productive information at least cost or at
a cost lower than that possible for the
agent not in possession of the
information – should disclose.
• If that agent does not disclose, it should
be liable.
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• The agent who acquires relevant
productive information at greater cost or
at the same cost as possible for the
agent not in possession of the
information – need not disclose
• The agent should not be liable if it does
not disclose
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• The agent who acquires relevant
redistributive information irregardless of
cost – need not disclose.
• If that agent does not disclose, it should
not be liable.
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Based on the foregoing analysis, Kronman
and Cooter believe the outcome in Laidlaw
was inefficient.
• (Cooter, p. 283)
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
What happens if an express disclosure
clause appears in a contract involving
purely redistributive information?
• In 1987, Aivazian and McCabe
concluded that the disclosure rule is
best left as a matter of contract, not a
matter of rigid common law or statute
law.
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Provided that the way relevant
contractual information arises is
common knowledge to the agents, they
will contract on this.
• If the relevant sources of information are
themselves asymmetric, then resort
must be made to a transactions cost
approach.
• Aivazian, V. and McCabe, P., "The Duty of Disclosure in Contractual
Relations", Law and Economics Workshop, December, 1987
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• What is the most efficient contract rule if
information is mixed?
• (For example both productive and
redistributive information?)
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Does all economic relevant information
fall under the categories of productive
information or redistributive information
or both?
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• What if a home seller deliberately
witholds information that the house he
or she is selling is infested with
termites?
• The efficiency rule would require
disclosure, but the common law rule
would not require disclosure. Why?
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• Common law is predicated
on the principle of “caveat
emptor”
• Why?
• Justice Joseph Story – On
Supreme Court with Marshall at
the time Laidlaw v. Organ was
decided. Would later defend the
decision on the basis of “caveat
emptor” – buyer beware
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• The analysis of Justice
Story’s views on
caveat emptor and
disclosure were
incorporated into
Canadian and English
law in Smith v. Hughes
by Lord Chief Justice
Cockburn
• A painting of the Lord Chief
Justice presiding at the perjury
trial of Arthur Orton
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• The Canadian courts give greater latitude
to the possessor of productive information
than those who follow Kronman’s “efficient
disclosure rule” provided the possessor
does not misrepresent the facts upon which
a contract is formed.
CONTRACTS – Terms And Conditions
Asymmetry of Information - Disclosure
• http://www.jus.unitn.it/cardozo/review/Contr
act/Musy-1995/musy1.htm
• http://www.niehs.nih.gov/kids/lyrics/battleof.
htm