The Economics of Contracts "Never promise more than you can perform."-Publius Syrus (42 B.C.) "A verbal contract isn’t worth the paper it is written on."-Samuel Goldwyn (1882–1974) Groucho:"That's in every contract, that's what you call a sanity clause." Chico: "You can't a fool a me, there ain't no sanity clause"-Groucho/Chico in A Night at the Opera (movie)
Fundamental Questions • What is a contract? • What promises should be enforced? • What should be the remedy for breaking enforceable promises?
A contract enforces a bargain Components of a classic bargain • Offer • Acceptance • Consideration • What the promisee gives the promisor to induce the promise. A bargain should have reciprocal inducement A promise lacks reciprocal inducement A contract typically entails delayed performance
Consideration • Money • Goods • Services • A promise
Reasons for not having a valid contract A bargain requires cooperation. A contract may not exists because cooperation is lacking • Nothing given by one party - gift • Confused promise • Deception • The remedy may be criminal or tort actions • When does withholding information constitute deception?
Remedy for breach of a bargain • A breach creates an incomplete bargain • Either or both parties can breach • Promisee is entitled to the “benefit of the bargain” • The economic measure of damages is expectation damages • Restores the victim to the where he or she would have been if the contract was completed • Not necessarily the same as what the victim expected at the beginning of the contract
Bargain theory may not enforce contracts that people want enforced, particularly if no consideration is given • Law that frustrates the desires of people is dogmatic • Law that satisfies desires is responsive
Economic Theory of Contract A theory of law based upon Pareto efficiency is responsive • Economic efficiency requires enforcement of a promise that both parties wanted when it was made • Enforces contracts that the parties want enforced • (Courts may not enforce liquidated damages clauses. This is dogmatic.) • Liquidated damages – contractually specified dollar penalties for breach • A contract typically creates a deferred exchange • Deferred exchanges create uncertainty and risk • Unforeseen circumstances may change the benefits of the bargain • Fortuitous circumstances • Unfortuitous circumstances • Unenforceable promises involve risk • Enforcing the promises reduces the risk of the contract.
The Economic Purpose of Contract Law • To enable people to convert games with inefficient solutions to games with efficient solutions • Avoid prisoner’s dilemma • To encourage the efficient disclosure of information within the contractual relationship. • Promotes efficient investment in information • To secure optimal commitment to performing. • Encourages optimal reliance • Require disclosure or allow non-disclosure • To minimize transaction costs of negotiating contracts by supplying efficient default terms and regulations • Encourage non-contractual cooperation
Agency Game without Contract Investment of $1 could produce $2. The investor is promised $1.50 Payoff is difference in wealth before and after
Agency Game with Contract and Compensatory Damages Investment of $1 could produce $2. The investor is promised $1.50 Payoff is difference in wealth before and after
Perfect expectation damages • They restore the promisee to the position he would have been in had the promise been kept. • Does not necessarily coincide with initial expectations concerning the non-contractual environment • Unexpected circumstances may change the relative benefits from the contract and change perfect expectations damages • Perfect expectation damages provide incentives for efficient performance and breach • They cause the promisor to internalize the costs of breach • Leave the victim indifferent between performance and breach • Create incentive for Pareto optimal decisions
Expectation damages create commitment • The opportunity to appropriate is foreclosed by the high cost of liability for breach • A commitment is credible when the other party observes the foreclosing of an opportunity.
Optimal Performance • What is the appropriate remedy for breaking enforceable promises? • Purpose is secure optimal commitment and provide for optimal breaches • Optimal commitment exists when the joint profits from performance are greater than the joint profits from breach • It is optimal to breach when the joint profits from a breach are greater than the joint profits with commitment.
Optimal Breach • It is optimal to breach when the party breaching is better off because of the breach and the victim is no worse off given the breach.
If liability is the only concern, the promisor will perform if cost of performance is less than liability • Promisor’s cost of performing > promisor’s liability for breaching, then breach • Promisor’s cost of performing < promisor’s liability for breaching, then perform
Efficiency requires maximizing the sum of the payoffs to the promisor and the promisee • Promisor’s cost of performing > promisee’s benefit --- then it is efficient to breach • Promisor’s cost of performing < promisee’s benefit --- then it is efficient to perform
There is an efficient incentive for breaching when liability is equal to promisee’s foregone benefit Expectation damages
Optimal Breaching If invested with no breach, a $1 investment returns $1
Alternative Example • A promises B the future delivery of widgets for $10. • B expects to earn $2 in profits if the widgets are delivered • If the widgets are not delivered B will earn zero profits • A locates an alternate offer from C of $15 for the widgets • Is it efficient for A to breach? • What decision allocates the resource to its most highly valued use?
Perfect expectation damages • They restore the promisee to the position he would have been in had the promise been kept. (This is not necessarily the same position he expected when he entered into the contract.) • Perfect expectation damages provide incentives for efficient performance and breach • They cause the promisor to internalize the costs of breach • Leave the victim indifferent between performance and breach
Opportunity Cost Damages • Damages replace the value of a lost opportunity • Leave victims indifferent between breach and performance given the best alternative contract • In perfectly competitive markets there is no difference between perfect expectation damages and opportunity cost damages • They place the victim in the position he would have been in had he taken the next best opportunity
Reliance damages • Places the victims in the position they would have been if they had never contracted with the other party • Do not take into account lost opportunities. • The promisor may invest in performance. • The promisee may invest in reliance on the promise • Reliance increases the gain from performance and the loss from breach.
Perfect expectation damages ≥ Opportunity cost damages ≥ Reliance damages
The Case of the Hairy HandHawkins v. McGee (N.H., 1929), The plaintiff, George Hawkins, suffered a childhood accident that left a permanent scar on his hand. When Hawkins was 18 years old, his family physician, McGee, persuaded him to submit to an operation that the doctor asserted would restore the hand to perfection. In the operation, skin from the plaintiff’s chest was grafted onto his hand. The result was hideous. The formerly small scar was enlarged, covered with hair, and irreversibly worse. Hawkins prevailed against McGee in a suit alleging that the doctor had broken his contractual promise to make the hand perfect.
Damages for Mr. Hawkins? • Reliance damages • Opportunity cost damages • Expectation damages
The Court Decision “ We, therefore, conclude that the true measure of the plaintiff's damage in the present case is the difference between the value to him of a perfect hand or a good hand, such as the jury found the defendant promised him, and the value of his hand in its present condition, including any incidental consequences fairly within the contemplation of the parties when they made their contract.” Expectation Damages
Tattooed Man and Artist Argue Over Misspelling Aug 1999 Seaside Heights--A tattoo artist who draws better than he spells is in trouble with a customer who got more than he bargained for. The customer, Joseph Beahm of Woodbridge, wanted a tattoo on his right shoulder showing a knife stabbing into a man's back, with the words "Why Not, Everyone Else Does" accompanying it. But the tattoo artist, James Kastel of Body Art World, misspelled "else," making the tattoo read: "Why Not, Everyone Elese Does.“ Mr. Beahm wants the tattoo parlor to pay $2,100 for laser surgery to remove the misspelled word. The parlor offered Mr. Beahm his $100 back or alterations that would cover it up, but Mr. Beahm said no. Mr. Kastel said Mr. Beahm should have caught the mistake earlier. He was shown a rendering of the tattoo--including the mistake--before it was applied Aug. 7, Mr. Kastel said. Mr. Beahm says he wants to sue for $20,000 in damages. He is trying to hire a lawyer, he said yesterday. "Everywhere I go, people are making fun of me," Mr. Beahm said. http://www.cnn.com/US/9908/26/fringe/tattoo.update/
Damage Exercise Question 7.1 p. 255
B London Grain Speculator D New Orleans Grain Dealer
Calculate • Expectation damages • Opportunity cost damages • Reliance damages
Did B Over rely? • Reliance Costs • Rented dock • Sold grain in forward market • Should the New Orleans grain dealer be responsible for London’s speculative losses? • Should it matter whether he knew that B was a speculator?
Cooter & Ulen suggested answer Think about the ease of finding substitute performance in each situation. Clearly, the law ought to encourage B to purchase the substitute widget after A repudiates at the lowest alternative price. (This is called “mitigating damages.”) Note: This places the responsibility on B to remedy the uncertainty that A has created. A could just as well mitigate damages.
Alternate Question 7.5 If A wanted to accept the risk, he could have purchased product for delivery for June 1 on June 1
Airline Overbooking • How should damages be calculated? • A ticket refund • A ticket on an alternative flight • Are the expectation damages foreseeable?
Damages for Airline Overbooking • There is no compensation if alternative transportation gets the passenger to the destination within one hour of the original scheduled arrival. • The equivalent of the passenger's one way fare up to a maximum of $400 for substitute domestic flights that arrive between one and two hours after the original scheduled arrival time or for substitute international flights that arrive between one and four hours after the original scheduled arrival time. • If the substitute transportation is scheduled to get you to your destination more than two hours later (four hours internationally), or if the airline does not make any substitute travel arrangements for you, the compensation doubles to a maximum of $800.
Optimal Reliance A promise is made, then time elapses During this time - promisor might incur costs associated with performing (investing in performing) - promisee might incur costs associated with the anticipation of the promise being fulfilled (invest in reliance) Reliance costs - costs incurred by the promisee in order to increase the utility, profits, etc. resulting from the fulfilment of the contract The investments in performance and reliance might take the form of time, effort, money or foregone alternatives
Reliance • Reliance increases the benefits of the bargain • Reliance increases expectation damages • Should all reliance costs be reimbursed? • Can there be overreliance? Question? How much reliance should a promisee place on the fulfilment of the contract? What is optimal reliance?
For the want of a nail~Anonymous proverb For want of a nail the shoe was lost. For want of a shoe the horse was lost. For want of a horse the rider was lost. For want of a rider the battle was lost. For want of a battle the kingdom was lost. And all for the want of a horseshoe nail Should the blacksmith be liable for the loss of the kingdom?
Modern version Because the stationary wasn’t delivered The envelope was not mailed Therefore the payment for raw materials was not received Therefore the raw materials were not delivered Therefore the factory shut down Should the delivery boy be liable? If not, why not?