Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2009 Lecture 10

Logistics • Office hours between now and midterm: • Me: Monday 1:30-3:30 • Chao: today 1:00-3:00, Monday 10:00-1:30 • Midterm #1 Tuesday, in class • No contract law

Tuesday… • Why do we need contracts? • What promises should be enforced? • Bargain Theory of Contracts • Efficiency • First purpose of contract law: enable cooperation • Second purpose of contract law: encourage efficient disclosure of information • Third purpose of contract law: secure optimal commitment to performance (efficient breach) • Fourth purpose of contract law: secure optimal reliance

Efficient Breach

Efficient Breach Efficiency: > Promisor’sCost Promisee’sBenefit Efficient to Breach  < Promisor’sCost Promisee’sBenefit Efficient to Perform  Self-Interest (incentives of promisor): > Promisor’sCost Promisor’s Liability Promisor will Breach  < Promisor’sCost Promisor’sLiability Promisor will Perform 

Value to you = $500,000 Price = $350,000 Example of efficient breach • I build airplanes • You value one of my planes at $500,000 • You agree to buy one for $350,000, and pay up front • After you pay, price of materials goes up

Value to you = $500,000 Price = $350,000 Example of efficient breach > Promisor’sCost Promisee’sBenefit Efficient to Breach  • Promisee’s benefit = $500,000 • If it costs me less than $500,000 to build plane, efficient to build it • If it costs me more than $500,000, efficient to breach

Value to you = $500,000 Price = $350,000 Example of efficient breach > Promisor’sCost Promisor’sLiability Promisor will Breach  • Liability is just to return your money • If my costs rise to $400,000, performance is still efficient, but I’ll choose to breach • Liability is $1,000,000 • If costs rise to $700,000, performance is inefficient, but I’d rather perform than breach • Liability = promisee’s benefit ($500,000) • I’ll perform when performance is efficient, breach when breach is efficient

Value to you = $500,000 Price = $350,000 But so what? Can’t we just“Coase” back to efficiency? • Liability is $350,000, my costs rise to $400,000 • I’ll breach original contract, but we can renegotiate to higher price • But I might try to do that even if my costs don’t go up… • Liability is $1,000,000, my costs rise to $700,000 • Rather than performing, I can offer you money to let me cancel contract • But my threat point is very low – you can demand a lot of money • If I realize that might happen, maybe I’m afraid to sign original contract • Expectation damages avoid these problems

Another way to think about expectation damages: eliminating an externality • If I breach contract, I impose externality on you • You’re $500,000 worse off • If I have to pay you $500,000, then I internalize the externality • Now my action no longer affects your well-being • So I choose efficiently when deciding whether to perform or breach

Reliance

Next: Reliance • Reliance: investments you make to increase your benefit from performance • Increases my liability if I breach • If expectation damages include added benefit due to reliance, leads to more than efficient level of reliance • There’s some chance I’ll need to breach the contract • Your reliance investments increase my liability from breach, so they impose a negative externality • Activities which impose negative externality happen too much • Overreliance

Reliance and Damages: example • Reliance increases your benefit from my promise • Airplane gives you benefit of $500,000 • Costs $75,000 to build a hangar • Airplane with hangar gives you benefit of $600,000 • Suppose price is $350,000, to be paid on delivery • Expectation damages restore you to well-being you expected to have from performance • Without a hangar, if I breach, I owe you $150,000 • If you build a hangar and I breach, do I owe you $250,000?

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 Reliance and damages:example • Cost of building plane: maybe $250,000, maybe $700,000 • Clearly, you’ll choose to build the hangar • But, is that efficient? You build hangar You don’t You get I get You get I get Costsstay low 600 - 75 - 350 = 175 350 - 250 =100 500 - 350 =150 350 - 250 =100 Costsrise - 75 + 250 =175 -250 150 -150

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 Reliance and damages:example • Let p be probability my costs go up • Combined expected payoffs if you rely: (1 – p) (175 + 100) + p (175 – 250) = 275 (1 – p) – 75 p = 275 – 350 p • Combined expected payoffs if you don’t rely: (1 – p) (150 + 100) + p (150 – 150) = 250 (1 – p) = 250 – 250 p • Which is bigger? 275 – 350 p > 250 – 250 p « 25 > 100 p « p < ¼ • So if p < ¼, reliance is efficient; if p > ¼, it’s not • But you’re going to rely either way!

What do we learn? • When probability of breach is low, more reliance tends to be efficient • When probability of breach is high, less reliance tends to be efficient • If expectation damages include increased benefit from reliance, we sometimes get overreliance • (OTOH, if expectation damages exclude increased benefit from reliance, liability < benefit, so inefficient breach)

So what do we do? • Cooter and Ulen: include only efficient reliance • Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount • So promisee rewarded for efficient reliance, not for overreliance

So what do we do? • Cooter and Ulen: include only efficient reliance • Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount • So promisee rewarded for efficient reliance, not for overreliance • Actual courts: include only foreseeable reliance • That is, if promisor could reasonably expect promisee to rely that much

Foreseeable reliance: Hadley v Baxendale • 1850s England • Hadley owned gristmill, mill shaft broke • Baxendale’s firm hired to transport shaft for repair • Baxendale shipped by boat instead of train, making it a week late • Hadley sued for the week’s lost profits • “The shipper assumed that Hadley, like most millers, kept a spare shaft. …Hadley did not inform him of the special urgency in getting the shaft repaired.” • Court listed several circumstances where broken shaft would not force mill to shut down • Ruled lost profits not foreseeable  Baxendale didn’t have to pay

Default Rules

Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps

Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps • Writing something into a contract vs leaving a gap • Allocating a loss (ex post) • Versus allocating a risk (ex ante), before it becomes a loss

What should default rules be? • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue • This will be whatever rule is efficient

What should default rules be? • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue • This will be whatever rule is efficient • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules • Do this by imputing the terms the parties would have chosen if they had addressed this contingency

Default rules • Don’t want ambiguity in the law • So default rule can’t vary with every case • Majoritarian default rule: the terms that most parties would have agreed to • In cases where this rule is not efficient, parties can still override it in the contract • Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate

Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it?

Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it? • Construction company is efficient bearer of this risk • So efficient contract would allocate this risk to construction company • Should prices be adjusted to compensate?

Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it? • Construction company is efficient bearer of this risk • So efficient contract would allocate this risk to constructioncompany • Should prices be adjusted to compensate?

Default rules • So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases • Most contracts can leave this gap, save on transaction costs • In cases where this rule is inefficient, parties can contract around it

Default rules: a different view • Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules” • Sometimes better to make default rule something the parties would not have wanted • To give incentive to address an issue rather than leave a gap • Or to give one party incentive to disclose information • “Penalty default”

Penalty defaults: Hadley v Baxendale • Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk • If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent • So Hadley might hide this information, which is inefficient • Ayres and Gertner: Ruling in Hadley was a good one, not because it was efficient, but because it was inefficient… • …but in a way that created incentive for disclosing information

Penalty defaults: other examples • Real estate brokers and “earnest money” • Broker knows more about real estate law • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this

Penalty defaults: other examples • Real estate brokers and “earnest money” • Broker knows more about real estate law • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this • Courts will impute missing price of a good, but not quantity • Forces parties to explicitly contract on quantity, rather than leave it for court to decide

When to use penalty defaults? • Look at why the parties left a gap in contract • Because of transaction costs  use efficient rule • For strategic reasons  penalty default may be more efficient • Similar logic in a Supreme Court dissent by Justice Scalia • Congress passed a RICO law without statute of limitations • Majority decided on 4 years – what they thought legislature would have chosen • Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…” • “Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.”

Default rules versus regulations • Default rules can be contracted around • Some rules cannot – immutable rules, or mandatory rules, or regulations • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations. • Coase: if individuals are rational and there are no transaction costs, private negotiations lead to efficiency • So additional regulations would just get in the way • So regulations only make sense when people are not rational, or when there are transaction costs/market failures

Econ 522 Economics of Law