Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Fall 2013 Lecture 15

2. Logistics • First midterm will hopefully be graded by Wednesday • HW3 (contract law) due next Thursday (November 7) • Second midterm Wednesday before Thanksgiving (November 20) • Definitely no lecture Wednesday of Thanksgiving week • Possibly no lecture Monday of Thanksgiving week

3. Last week • Last week – lots of reasons a contract might not be enforced • Derogation of public policy • Incompetence, but generally not drunkenness • Duress and Necessity • Impossibility • Bad information (fraud, failure to disclose, frustration of purpose, mutual mistake), but generally not unilateral mistake • Vagueness, adhesion, unconscionability • For each: is there an economic justification? • Today: more on remedies for breach of contract • But first…

4. Another experiment:is trust a problem?

5. We motivated contracts with an agency (trust) game Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (0, 200) • Without binding contracts, might be no reason for me to return your money, so no reason for you to trust me

6. To see if trust is a problem, we’ll use a similar game as an experiment • Player A starts with $10 • Chooses how much of it to give to player B • That money is tripled • Player B has $10, plus 3x whatever A gave him/her • Chooses how much (if any) to give back to player A • So for example… • if player A decides to send $3… • then A has $7 left, and B has $19… • and then B can send back to A any amount from 0 to $19

7. To see if trust is a problem, we’ll use a similar game as an experiment Player 1 Send 0 Send 10 x Player 2 Return 0 Return 10+3x y ((10 – x) + y, (10 + 3x) – y) • Player 1 gets whatever he kept, plus whatever 2 sends him • Player 2 gets 10, plus three times what 1 sends him, minus whatever he sends to player 1

8. We’ll try this game four different ways • Anonymously – A and B don’t know who each other are • we’ll use student ID numbers to identify players, and play on paper • Privately – A and B don’t interact, but will learn who each other are after the game • still on paper, but with names, so B sees A’s name • after class, Nathan will email A with B’s name • Face to face – A and B can discuss the game before playing, but their actions remain private • Publicly – A and B play out loud in front of the class

9. Remedies for breachof contract

10. Three broad types of remedy for breach of contract • Party-designed remedies • Remedies specified in the contract • Court-imposed damages • Court may decide promisee entitled to some level of damages • Specific performance • Forces breaching party to live up to contract

11. Expectation damages • Compensate promisee for the amount he expected to benefit from performance • You agreed to buy an airplane for $350,000 • You expected $500,000 of benefit from it • Expectation damages: if I breach, I owe you that benefit • ($500,000 if you already paid, $150,000 if you didn’t) • “Positive damages” • Make promisee indifferent between performance and breach

12. Reliance damages • Reimburse promisee for cost of any reliance investments made, but not for additional surplus he expected to gain • Restore promisee to level of well-being before he signed the contract • You contracted to buy the plane and built a hangar • If I breach, I owe you what you spent on the hangar, nothing else • “Negative damages” – undo the negative (harm) that occurred

13. Opportunity cost damages • Give promisee benefit he would have gotten from his next-best option • Make promisee indifferent between breach of the contract that was signed, and performance of best alternative contract • You value plane at $500,000 • You contract to buy plane from me for $350,000 • Someone else was selling similar plane for $400,000 • By the time I breach, that plane is no longer available • I owe you $100,000 – the benefit you would have gotten from buying the other seller’s plane

14. Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Ohio State football game for $50 • Expectation damages: you owe me value of game minus $50 • If I pay scalper $150, then expectation damages = $100 • Reliance damages: maybe 0, or cost of whatever pre-game investments I made

15. Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Ohio State football game for $50 • Expectation damages: you owe me value of game minus $50 • If I pay scalper $150, then expectation damages = $100 • Reliance damages: maybe 0, or cost of whatever pre-game investments I made • When you agreed to sell me ticket, othertickets available for $70 • Opportunity cost damages: $80 • (I paid a scalper $150 to get in; I would have been $80 better off if I’d ignored your offer and paid someone else $70)

16. Ranking damages ContractI Sign BestAlternative Do Nothing ³ ³ = = = Breach +ExpectationDamages Breach +Opportunity Cost Damages Breach +RelianceDamages ³ ³ ExpectationDamages Opportunity CostDamages RelianceDamages ³ ³ $100 $80 $15

17. Hawkins v McGee (“hairy hand case”) • Hawkins had a scar on his hand • McGee promised surgery to “make the hand a hundred percent perfect” • Surgery was a disaster, left scar bigger and covered with hair

18. Hawkins v McGee (“hairy hand case”) $ + Expectation Damages + Opp Cost Damages Expectation Damages Reliance Damages Opp Cost Damages + Reliance Damages Initial Wealth Hand Hairy Scarred Nextbestdoctor 100%Perfect

19. Other court-ordered remedies • Restitution • Return money that was already received • Disgorgement • Give up wrongfully-gained profits

20. Other court-ordered remedies • Restitution • Return money that was already received • Disgorgement • Give up wrongfully-gained profits • Specific Performance • Promisor is forced to honor promise • Civil law: often ordered instead of money damages • Common law: money damages more common; S.P. sometimes used when seller breaches contract to sell a unique good • Like injunctive relief

21. Expectation damages vs. specific performance • Peevyhouse v Garland Coal and Mining Co(OK Supreme Court, 1962) • Garland contracted to strip-minecoal on Peevyhouse’s farm • Contract specified Garlandwould restore property to originalcondition; Garland did not • Restoration would cost $29,000 • But “diminution in value” of farmwas only $300 • Original jury awarded $5,000 indamages, both parties appealed • OK Supreme Court reduceddamages to $300

22. Expectation damages vs. specific performance • At first, sounds like a perfect example of efficient breach • Performing last part of contract would cost $29,000 • Benefit to Peevyhouses would be $300 • Efficient to breach and pay expectation damages, which is what happened • But… • Most coal mining contracts: standard per-acre diminution payment • Peevyhouses refused to sign contract unless it specifically promised the restorative work • Dissent: Peevyhouses entitled to specific performance • (Peevyhouses seemed to value condition of property much more highly than change in market value)

23. Think about Peevyhouse in terms of penalty defaults • Contract promised restoration work, didn’t specify remedy if it wasn’t performed • Which default rule works better: • Default rule allowing Garland to breach and pay diminution fee? • Default rule forcing Garland to perform restoration work? • Ayres and Gertner: default rule should penalize the better-informed party • Garland routinely signed contracts like these • Peevyhouses were doing this for the first time • Default rule allows Garland to pay diminution fee: they have no reason to bring it up, Peevyhouses don’t know • Default rule forces Garland to do cleanup: if that’s inefficient, they could bring it up during negotiations • In this case, specific performance would serve as a penalty default

24. Party-designed remedies • Remedy for breach could be written directly into contract • But common law courts don’t always enforce remedy terms • Liquidated damages– party-specified damages that reasonably approximate actual harm done by breach • Penalty damages – damages greater than actual harm done • Civil law courts are generally willing to enforce penalty damages • But common law courts often do not

25. Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Penalty Damages • Peevyhouse v Garland Coal • Peevyhouses only wanted farm strip-mined if it would be restored to original condition after • Suppose coal extracted worth $70,000 • Garland paid $25,000 for rights to mine it • Restoration work would cost $30,000 • Diminution of value was $300 • So liquidated damages would be $300 • Suppose Peevyhouses got $40,000 of disutility from land being left in poor condition

26. Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Liquidated damages Peevyhouses Sign Don’t Garland Coal (0, 0) Restore property Don’t, pay damages (25,000, 15,000) (-14,700, 44,700) • If damages limited to liquidated damages… • Peevyhouses shouldn’t believe restorative work will get done • So Peevyhouses better off refusing to sign • Even though mining and restoring Pareto-dominates

27. Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Penalty damages Peevyhouses Sign Don’t Garland Coal (0, 0) Restore property Don’t, pay penalty (25,000, 15,000) (25,000, 5,000) • If penalty clauses in contracts were enforceable… • Write contract with $40,000 penalty for leaving land unrestored • Now restoration work would get done, so Peevyhouses willing to sign • But if courts won’t enforce penalty damages, this won’t work

28. Penalty clauses • Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus • I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late • Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time • Either way, you get $150,000 if house is late, $200,000 if on time • Courts generally enforce bonus clauses, so no problem!

29. Penalty clauses • Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus • I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late • Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time • Either way, you get $150,000 if house is late, $200,000 if on time • Courts generally enforce bonus clauses, so no problem! • Similarly, Peevyhouse example • Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is not restored • Equivalently, get $65,000 for mining rights, pay $40,000 bonus if restoration is completed • But, if intent of contract is too transparent, still might not be enforced

30. Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

31. Plane worth $500,000 to youPrice $350,000Cost: either $250,000 or $1,000,000 Remedies and breach Expectation Damages Specific Performance Costs Low – Perform Costs High – Perform Costs High – Breach Costs Low – Perform Costs High – Perform CostsHigh – Renegotiate I get 100,000 -650,000 -150,000 I get 100,000 -650,000 -400,000 –650,000 + ½ (500,000) You get 150,000 150,000 150,000 You get 150,000 150,000 400,000 150,000 + ½ (500,000) Total 250,000 -500,000 0 Total 250,000 -500,000 0 • Transaction costs low  either leads to efficient breach, but seller prefers “weaker” remedy • Transaction costs high  S.P. leads to ineff. performance

32. Remedies and breach • Opportunity cost damages, or reliance damages • Inefficient breach when transaction costs are high • Renegotiate contract to get efficient performance when transaction costs are low • Like nuisance law: any remedy leads to efficient breach with low TC • But only expectation damages do when TC are high • Unfortunate contingency and fortunate contingency

33. Efficient signing • Specific Performance • If costs stay low, I get $350,000 – $250,000 = $100,000 profit • If costs rise, I take $400,000 loss • Am I willing to sign this contract? • Even expectation damages face this problem • Expectation damages: costs stay low, same $100,000 profit • Costs rise, $150,000 loss • If probability of high costs is ½, I won’t sign contract • Expectation damages lead to efficient breach, but may not lead to efficient signing

34. Reliance – did example a while ago • If reliance investments increase the damages you receive, we expect to get overreliance • To get efficient reliance, need to exclude gains from reliance in calculation of expectation damages • But then promisor’s liability < promisee’s benefit, leading to inefficient breach • With low transaction costs, fix this through renegotiation • But what about unobservable actions the promisor needs to take, to make breach less likely? • Investment in performance Skip

35. Investment in performance • Some investment I can make to reduce likelihood that breach becomes necessary • Suppose probability of breach is initially ½… but for every $27,726 I invest, I cut the probability in half • Invest nothing  probability of breach is 1/2 • Invest $27,726  probability is 1/4 • Invest $55,452  probability is 1/8 • Any investment z  probability is .5 * (.5) z / 27,726 • Wrote it this way so p = .5 e – z / 40,000

36. Investment in performance(continuing with airplane example) • Suppose you’ve built a $90,000 hangar • Increases value of performance by $180,000… • …so value of performance is $150,000 + $180,000 = $330,000 • Probability of breach = .5 e – z/40,000 • Let D = damages I owe if I breach • Same questions as before: • What is efficient level of investment in performance? • How much will I choose to invest in performance?

37. Investment in performance(continuing with airplane example) • Suppose you’ve built a $90,000 hangar • Increases value of performance by $180,000… • …so value of performance is $150,000 + $180,000 = $330,000 • Probability of breach = .5 e – z/40,000 • Let D = damages I owe if I breach • Same questions as before: • What is efficient level of investment in performance? Enough to reduce probability of breach to 40,000/430,000 • How much will I choose to invest in performance? Enough to reduce probability of breach to 40,000/(100,000 + D)

38. What do these results mean? • What is the efficient level of investment in performance? • Enough so that p(z) = 40,000/430,000 • What will promisor do under various rules for damages? • Enough so that p(z) = 40,000/(100,000 + D) • So if D = 330,000, efficient investment in performance • D = 330,000 is promisee’s benefit, including reliance • So expectation damages, with benefit of reliance, leads to efficient investment in performance • If D < 330,000, too little investment in performance • If D > 330,000, too much • Makes sense – think about externalities

39. Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

40. Paradox of compensation Expectation damages include benefit from reliance investments Expectation damages exclude benefit from reliance investments • Efficient breach • Efficient investment in performance • Over-reliance • Inefficient breach • Underinvestment in performance • Efficient reliance • Is there a way to get efficient behavior by both parties? Skip

41. We already saw one possible solution • Have expectation damages include benefit from reliance… • …but only up to the efficient level of reliance, not beyond • That is, have damages reward efficient reliance investments, but not overreliance • Promisee has no incentive to over-rely  efficient reliance • Promisor still bears full cost of breach  efficient performance • Problem: this requires court to calculate efficient level of reliance after the fact

42. Another clever (but unrealistic) solution • The problem: • Damages promisor pays should include gain from reliance if we want to get efficient performance • Damages promisee receives should exclude gain from reliance if we want to get efficient reliance • Solution: make damages promisor pays different from damages promisee receives! • How do we do this? Need a third party

43. “Anti-insurance” • You (promisee) and I (promisor) offer Bob this deal: • If you rely and I breach, • I pay Bob value of promise with reliance (airplane plus hangar) • Bob pays you value of promise without reliance (airplane alone) • Bob keeps the difference • You receive damages without benefit from reliance; I pay damages with benefit from reliance

44. “Anti-insurance” • You (promisee) and I (promisor) offer Bob this deal: • If you rely and I breach, • I pay Bob value of promise with reliance (airplane plus hangar) • Bob pays you value of promise without reliance (airplane alone) • Bob keeps the difference • You receive damages without benefit from reliance;I pay damages with benefit from reliance • Offer the deal to two people, make them pay up front for it

45. Reminder: what do courts actually do? • Foreseeable reliance • Include benefits reliance that promisor could have reasonably anticipated