George Mason School of Law

1. George Mason School of Law Contracts I C. Bargaining Gains F.H. Buckley fbuckley@gmu.edu

2. Last Day: Wealth and Happiness

3. Last Day: Freedom and Happiness

4. Today • The contribution of contract law • How to exploit bargaining gains • Explaining the bargaining gains

5. Today • PD Games as a Barrier to Bargaining • Promising as a problem of trust • Contract Law as a Solution • Modeling Bargaining gains: a. Detrimental and Beneficial Reliance b. EdgeworthBox Function • Defining Efficiency Criteria

6. Getting to Cooperation in PD games Player 2 Player 1

7. Two kinds of PD problems • Sins of commission • Overfishing • Excessive pollution • Tragedy of the commons

8. Two kinds of PD problems • Sins of omission • Failure to exploit bargaining gains • Eg. Dueling, arms race • Failure to contribute to public goods (where beneficiaries can’t be excluded) • E.g., free riding on defense, taxes

9. Getting to Cooperation in PD games • So what do we do about that? • Maybe it’s not so bad after all… • Government solution • A Coasian solution

10. Getting to Cooperation in PD games • Maybe it’s not so bad after all… • De minimis non curat lex • The private provision of public goods • E.g., wikipedia

11. Getting to Cooperation in PD games • Let the state enforce cooperation • Environmental laws • Taxation and national defense • Boston Commons

12. Getting to Cooperation in PD games • A Coasian solution • Bargain opportunities exploited by contract

13. Getting to Cooperation in PD games • A Coasian solution • Just how bad is the transaction cost problem?

14. Getting to Cooperation in PD games • A Coasian solution • What if bargaining is impossible? • E.g., Too many people • Not enough time • No bargaining space

15. What if one can’t bargain:The “Market for Lemons” • Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970) • The Trust problem without contracts

16. Let’s say you want to buy a 1956 Ford…

17. Promises without contract law • Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”)

18. Promises without contract law • Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”) • The seller tells you it’s a beaut

19. Promises without contract law • Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”) • The seller knows which kind of car he has but you can’t tell them apart

20. Promises without contract law • Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”) • The seller knows which kind of car he has but you can’t tell them apart • What would you pay for one?

21. Promises without contract law • Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”) • The seller knows which kind of car he has but you can’t tell them apart • The trick: Seller’s willingness to sell is a signal • Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970)

22. Promises without contract law • Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5,000 (“beauts”) • The seller knows which kind of car he has but you can’t tell them apart • Question: Is the seller satisfied with this result?

23. So why do lemons markets exist? • Craigslist ad, Aug. 16, 2014: 1956 Ford Fairlane – runs great and looks great. It has a 292 V8, with a two speed automatic. Garage kept and great for weekend driving. $9000

24. Craigslist on the subject of lemons • Offers to ship a vehicle are virtually 100% fraudulent • Never use Western Union or wire transfer to pay for goods - only a scammer will ask for this, and any funds sent will be lost • Do not buy vehicles sight-unseen, regardless of low price. The vehicle does not exist, and any money you send will be lost. • Stories about divorcees or departing servicemen needing to sell quickly at a low price are generally fraudulent • If a deal sounds too good to be true, it probably is!

25. Promising as a Problem of Trust • Promisor wants to persuade promisee to trust him • To do so, promisor must be able to make a credible commitment not to defect

26. Hobbes on Bare PromisesHobbes, Leviathan 14.18 (1651) • If a covenant be made wherein neither of the parties perform presently, but trust one another, in the condition of mere nature (which is a condition of war of every man against every man) upon any reasonable suspicion, it is void… • For he that performeth first hath no assurance the other will perform after, because the bonds of words are too weak to bridle men's ambition, avarice, anger, and other passions, without the fear of some coercive power; which in the condition of mere nature, where all men are equal, and judges of the justness of their own fears, cannot possibly be supposed. And therefore he which performeth first doth but betray himself to his enemy.

27. Contract Law as a solution • Suppose that the defector is penalized through sanctions so that the incentive to defect disappears.

28. Contract Law as a solution Player 2 Player 1

29. Contract Law as a solutionHobbes’ Leviathan (1651)

30. Contract law as a solution • So why do people fail to contract?

31. So why do people fail to contract? • Illegal contracts • Eg. Divorce waivers, security interests in consumer goods

32. So why do people fail to contract? • Illegal contracts • Transaction cost barriers • Information processing problems • Too many parties • Emergencies • Agent misbehavior

33. So why do people fail to contract? • Illegal contracts • Transaction cost barriers • Rule of Law Problems • Imperfect enforcement in corrupt countries or countries with inefficient enforcement mechanisms

34. Corruption and the rule of law Deputy Mayor of Moscow Vladimir Resin sporting a $360,000 wristwatch

35. Transparency International Global Corruption Index 2013

36. Less corruption, more wealth

37. Country corruption and NYC parking tickets for UN diplomats Source: Raymond Fishman and Edward Miguel, Corruption, Norms and Legal Enforcement: Evidence from Diplomatic Parking Tickets, 115 Journal of Political Economy 1020 (2007)

38. What do the countries in the upper right have in common?

39. Bargaining and Trust

40. Bargaining and Trust • Indifference Curves • The Budget Line • Consumer Choice • Beneficial Reliance • The Edgeworth Box Function • Pareto-Superiority and Pareto-Optimality

41. Two dimensional Commodity Space:Every point represents a combination of the two commodities Y axis Commodity y X axis 0 Commodity x

42. Two dimensional Commodity Space:Every point represents a combination of the two commodities Y axis A • Y* X axis 0 X* 42

43. The Commodities: Dollars in Two Time Periods Dollars in Time 1 A • Y* Dollars in Time 2 0 X* 43

44. Commodity space:Dollars consumed in two time periods Dollars in Time 1 More of both Dollars in Time 2 0

45. The Budget Line: Allocating $100 between two periods Dollars in Time 1 100 The budget line in red represents every trade-off of $100 in two periods Dollars in Time 2 0 100

46. Two different time preferences (Which is right?)

47. The Budget Line: Allocating $100 between two periods Dollars in Time 1 Grasshoppers 100 Ants Dollars in Time 2 0 100

48. Indifference Curves: Preferences about Consumption Dollars in Time 1 An indifference curve represents a set of trade-offs to which the subject is indifferent Dollars in Time 2 0

49. Subject is willing to give up $BC in Time 2 for $AB in Time 1 Dollars in Time 1  A B   C 0 Dollars in Time 2

50. A  C:Subject is willing to give up $BC in Time 2 for $AB in Time 1 Dollars in Time 1  A B   C 0 Dollars in Time 2 = “is indifferent to”