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CONTRACTS October 3, 2006

CONTRACTS October 3, 2006. Contracts. BILATERAL AGENCY CONTRACTS. BILATERAL AGENCY CONTRACTS. Bilateral Agency. Property Rights Primarily “imposed rules” with some scope for contracting within the imposed framework

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CONTRACTS October 3, 2006

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  1. CONTRACTS October 3, 2006

  2. Contracts BILATERAL AGENCY CONTRACTS

  3. BILATERAL AGENCYCONTRACTS Bilateral Agency . Property Rights Primarily “imposed rules” with some scope for contracting within the imposed framework Horizontal –joint or group rights Vertical – many landlord and tenant cases - subordinate possession Contracts Primarily “voluntary rules” with some scope for contracting hierarchies Horizontal – equal partners Vertical – creating subordinate agents – most common form of contract

  4. PRINCIPAL – AGENCY CONTRACTS “SUPER” Principal Its “problem” is to maximize social surplus Principal promise payment AGENT

  5. PRINCIPAL – AGENCY CONTRACTS • This “Principal-Agency ” exchange model is the principal model featured in Cooter's treatment of contract law

  6. PRINCIPAL – AGENCY CONTRACTS Formation Of Contracts Principal Makes An Offer To An Agent Agent Accepts The Offer Performance Of The Contract

  7. CAPACITY FORMATION OF CONTRACTS

  8. FORMATION OF CONTRACTS • Competent Parties: • Both parties must have the capacity to understand the terms of the contract they are entering into, and the consequences of the promises they make.

  9. FORMATION OF CONTRACTS • For example, animals, minor children, and mentally disabled individuals do not have the capacity to form every contract • Any contracts with them will be considered void or voidable.

  10. FORMATION OF CONTRACTS • Corporations are considered persons under the law, and thus competent to engage in contracts.

  11. SUBJECT-MATTER FORMATION OF CONTRACTS

  12. FORMATION OF CONTRACTS • Proper Subject Matter: • The contract must have a lawful purpose. • A contract to commit murder in exchange for money will not be enforced by the courts.

  13. FORMALITIES FORMATION OF CONTRACTS

  14. FORMATION OF CONTRACTS • Need for a written contract? • A spoken contract is often called an "oral contract", not a "verbal contract". • A verbal contract is simply a contract that uses words. Most oral contracts and written contracts are verbal contracts.

  15. FORMATION OF CONTRACTS • Need for a written contract? • An informal exchange of promises may be binding and legally as valid as a oral or a written contract.

  16. FORMATION OF CONTRACTS • Statutory Regulation of Contracts • The Statute of Frauds requires that contracts pertaining to land be in writing. • The Statute of Frauds attempts to prevent false allegations of the existence of contracts that were never made.

  17. OFFER FORMATION OF CONTRACTS

  18. FORMATION OF CONTRACTS • Offer • Acceptance • Exchange

  19. FORMATION OF CONTRACTS • Offer • Principal writes the document, but the document does not become a contract until the agent signs it

  20. FORMATION OF CONTRACTS • Offer • In presenting the written document to the agent as the first step for its review the parties are following a form of the Prisoner’s dilemna that is sequential and not simultaneous

  21. FORMATION OF CONTRACTS • Offer • The classical “bargaining theory of contract law assigns the legal word “offer” to the document • Note – What judges say and due involves language. What one observes them do and why is the domain of economic analysis

  22. FORMATION OF CONTRACTS • Offer • Another way of characterizing “the first step”, taken by the principal is to describe the principal as the “first mover” • (Cooter and Ulen, Law and Economics, 4th edn, Addison-Wesley, Longman, 2004, at p. 196)

  23. FORMATION OF CONTRACTS • Offer • Principal writes the document, with a view to selecting several potential agents

  24. FORMATION OF CONTRACTS • Offer • In an “economic” sense, this step follows the Stackelberg process of a Principal that maximizes the profit or utility of the “agent” as part of its profit or utility maximizing step

  25. FORMATION OF CONTRACTS • Offer • Cooter assumes that the Principal-Agency game is played as a Stackleberg game • Before making the “first move”, the Principal considers the “second move” that would be made by the Agent

  26. FORMATION OF CONTRACTS • A boss designing a contract for a worker (which, usually but not always, must satisfy a “participation constraint” that the worker be willing to accept it instead of quitting the job)

  27. FORMATION OF CONTRACTS • Offer • The Agent’s “incentive compatibility constraint” is binding A((1-a)CA(a)– 1) = 0 A > 0

  28. FORMATION OF CONTRACTS • Offer • The offer generates an agency cost • This agency cost depends upon the amount of effort provided by the agent • This cost enters the “contract problem” through the incentive constraint.

  29. FORMATION OF CONTRACTS • Offer • This agency cost is usually described as a disutility of effort or a benefit from shirking or foregone pleasurable activities. • This agency cost is the marginal cost of effort and may vary with effort.

  30. FORMATION OF CONTRACTS • Offer • If the Agent “would co-operate”, the “first move” occurs by the Principal • If the Agent “would not cooperate”, then no “first move” • No Offer • No Contract • (Cooter, Figure 6.1, 4th p. 197)

  31. FORMATION OF CONTRACTS • Offer (Advertising) • How, where, when and what? • Carlill v. Carbolic Smoke Ball Company [1893] 1 QB 256; Court of Appeal, 1892 Dec. 6,7, LINDLEY, BOWEN and A. L. SMITH, L.JJ.

  32. ACCEPTANCE FORMATION OF CONTRACTS

  33. FORMATION OF CONTRACTS • Acceptance • If there is only one Agent, he or she has the choice of accepting or rejecting the offer

  34. FORMATION OF CONTRACTS • Acceptance • If the Agent or group of Agents reject the offer, the contract game is over

  35. FORMATION OF CONTRACTS • Acceptance • The classical “bargaining theory of contract law assigns the legal word “acceptance” to the document if the Agent or one of the Agents accepts the offer

  36. FORMATION OF CONTRACTS • Acceptance • Another way of characterizing “the second step”, taken by the agent is to describe the agent as the “second mover”

  37. FORMATION OF CONTRACTS • Acceptance • The “participation constraint” of the Agent is binding mA (TA+ (1-a)C(a)- a) = 0 • mA > 0

  38. FORMATION OF CONTRACTS • Acceptance • Acceptance of the offer generates a “second” agency cost. • The second agency cost is the opportunity cost of the agent participating in the contract. • It is also referred to as a reservation utility (0) and enters into the “contract problem” through the participation constraint.

  39. Performance FORMATION OF CONTRACTS

  40. FORMATION OF CONTRACTS Performance 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

  41. FORMATION OF CONTRACTS Performance . PRINCIPAL Payment For Performance Promise To Perform AGENT(Chosen)

  42. FORMATION OF CONTRACTSPerformance • Parties enter into a “principal-agency” contract: 0 = input of Principal a = input of Agent y = C(0,a) = output of the contract

  43. FORMATION OF CONTRACTS • Performance • The parties perform the contract in accordance with an agreed upon exchange • The “principal” makes an exchange of a “payment” to an “agent” • The “agent” performs or executes a “promise” for the “principal”

  44. FORMATION OF CONTRACTS • Performance • If the principal is operating in a perfectly competitive market outside of its relationship with the agent, its longrun profit function = 0

  45. FORMATION OF CONTRACTS U(F) There is a “third” constraint” in the Principal – Agency Problem The “Budget Constraint” of the Principal E F=Output

  46. FORMATION OF CONTRACTS • Performance • This agency has the following profit function: p(0,a) = aC(0,a) - a or p(a) = aC(a) - a

  47. FORMATION OF CONTRACTS LEGAL ANALYSIS PROMISED ECONOMIC ANALYSIS Principal PAYMENT Agent PARTICIPATION CONSTRAINT Agent PROMISED PERFORMANCE INCENTIVE COMPATIBILITY CONSTRAINT

  48. FORMATION OF CONTRACTS U(F) A “perfectly competitive” risk neutral Principal contracts a “complete” contract with the “risk averse” agent Contract Equilibrium Point The parties are paid in “output” shares E F=Output

  49. FORMATION OF CONTRACTS • Performance • One of the primary conclusions of the Principal-Agency contract model is that, because • (1) the agent receives only a partial share of the profits generated from the agent’s effort, • (2) the agent’s effort is not perfectly observed by the principal, and • (3) the agent bears the entire cost of that effort, the optimal incentive contract between the principal and agent cannot achieve a Pareto optimal outcome.

  50. FORMATION OF CONTRACTS • Performance • Even with risk neutrality on the part of both parties, moral hazard and inefficiency remain as long as there is a cost of effort born only by the agent and the agent receives only a share of the benefits generated by that effort

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