George Mason School of Law

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

2. Next Day • Montesquieu • John Stuart Mill, On Liberty • Scott 480-501

3. Up to now • Let’s assume that societal wealth has something to do with national happiness

5. Up to now • And does contract enforceability have something to do with societal wealth?

6. Where does contract law come in? • What is the relationship between enforceable promises and wealth?

7. Bargains as a Prisoner Dilemma game Player 2 Player 1

8. Defection dominates for both Players Player 2

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

10. Why Enforce Contracts:An Economic Analysis of Bargaining Gains

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

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

13. Two dimensional Commodity Space:Every point represents a combination of the two commodities Y axis A • Y* X axis 0 X* 13

14. The Commodities: Dollars in Two Time Periods Dollars in Time 1 A • Y* Dollars in Time 2 0 X* 14

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

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

17. 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

18. 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

19. Indifference Curves: Preferences about Consumption Dollars in Time 1 Convexity (curve bends inward) assumes decreasing marginal utility Dollars in Time 2 0

20. Decreasing marginal utility: We’ll always want more, but will enjoy each new scoop less and less

21. 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”

22. 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

23. Indifference Curves: Preferences about Consumption Dollars in Time 1 One is better off the further one gets from the origin Dollars in Time 2 0

24. More is better:I2 > I1 Dollars in Time 1 More is better I2 I1 0 Dollars in Time 2

25. Ordinal Utility:We can’t say how much better I2 is than I1 Dollars in Time 1 I3 I2 I1 0 Dollars in Time 2

26. Ordinal Utility:We can’t say how much better I2 is than I1 Ordinal numbers: First, second, third

27. Ordinal Utility:We can’t say how much better I2 is than I1 Ordinal numbers: First, second, third Cardinal numbers: 1,2, 3

28. Consumption Decision:Uncle Ebenezer gives David $100 Time 1 I 2 I 1 100 I 2 I 1 I3 0 100 Time 2

29. Consumption Decision:David has $100 and is best off at AMaximization subject to the constraint of the Budget Line Time 1 I 2 I 1 100 A 50  I 2 I 1 I3 0 50 100 Time 2

30. Consumption Decision:David has $100 and is best off at AMaximization subject to the constraint of the Budget Line Time 1 I 2 I 1 100 A 50  I B  2 I 1 B is not optimal I3 0 50 100 Time 2 30

31. Consumption Decision:David has $100 and is best off at AMaximization subject to the constraint of the Budget Line Time 1 I 2 I 1 100 C is not feasible  C A 50  I B  2 I 1 B is not optimal I3 0 50 100 Time 2 31

32. Ebenezer gives David another $100:The Shift to a New Budget Line 200 I 200 I 100 100 A 50, 50 50 0 100

33. A new Consumption Decision Time 1 B 100, 100 100 I 200 A 50, 50 50 I 100 I DR Time 2 0 50 100

34. What happens when the donor promises to give in the future? • Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period • What Should David Do?

35. What happens when the donor promises to give in the future? • Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period • David’s election: to rely or not to rely on the promise in the first period

36. The good scenario:David relies and Ebenezer performs 200 Reliance by David means spending $100 in period 1 B 100, 100 100 I 200 A 50, 50 50 I 100 200 0 50 100

37. A bad scenario: Detrimental Reliance:David relies and Ebenezer breaches Time 1 David spends 100 in period 1 and now has nothing left to spend in period 2 C 100,0 D B 100, 100 A 50, 50 50 I 100 I DR 0 50 100

38. A bad scenario: Detrimental Reliance:David relies and Ebenezer breaches Time 1 What do we need to give David to make him as well off as he would be had the promise been performed? C 100,0 D B 100, 100 A 50, 50 50 I 100 I DR 0 50 100

39. A bad scenario: Detrimental Reliance:David relies and Ebenezer breaches Time 1 The Expectation Interest is CB, or $100 C 100,0 D B 100, 100 A 50, 50 50 I 100 I DR 0 50 100

40. A bad scenario: Detrimental Reliance:David relies and Ebenezer breaches Time 1 What do we need to give David to make him as well off as he would have been had the promise not been made, or had he not relied? C 100,0 D B 100, 100 A 50, 50 50 I 100 I DR 0 50 100

41. A bad scenario: Detrimental Reliance:David relies and Ebenezer breaches Time 1 The Reliance Interest is CD, or about $25 C 100,0 D B 100, 100 A 50, 50 50 I 100 I DR 0 50 100

42. Fool me once…: Non-reliance:David assumes Ebenezer will breach Time 1 I 1 100 50 B I Now David spends only 50 in period 1 1 0 50 100 Time 2

43. Fool me once…: Non-reliance:Ebenezer breaches: No harm, no foul Time 1 I 1 100 50 B I Now David spends only 50 in period 1 1 0 50 100 Time 2

44. Loss of Beneficial Reliance:David doesn’t rely and Ebenezer performs Where David is on performance 100 I 200 E Ino-reliance 150, 50 50 David spends only 50 in period 1 0 100 150 Goetz and Scott, 89 Yale L.J. 1261 (1980)

45. Loss of Beneficial Reliance:David doesn’t rely and Ebenezer performs Where David would have been had he relied B 100, 100 100 I 200 E Ino-reliance 150, 50 50 David spends only 50 in period 1 0 100 150 Goetz and Scott, 89 Yale L.J. 1261 (1980)

46. Loss of Beneficial Reliance:David doesn’t rely and Ebenezer performs B 100, 100 100 I 200 E Ino-reliance 150, 50 50 0 100 150 Goetz and Scott, 89 Yale L.J. 1261 (1980)

47. Enforceable Contracts provide the gains associated with beneficial reliance

48. Now: How parties gain from contracting “If one person does not lose, the other does not gain.” St. Augustine

49. Modeling a Bargain:Mums and Roses Mums 0 Roses

50. Two bargainers Mums Mums Mary Roses Bess Roses