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CONTRACTS – Exceptions To Coase’s Theorem October 24, 2006

CONTRACTS – Exceptions To Coase’s Theorem October 24, 2006. Exceptions to the Theorem of Coase Asymmetric Information. Coase Theorem Exceptions To Coase Theorem Transaction Costs - October 17, 2006 Asymmetric Information - October 24, 2006 Empty Core - October 31, 2006.

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CONTRACTS – Exceptions To Coase’s Theorem October 24, 2006

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  1. CONTRACTS – Exceptions To Coase’s Theorem October 24, 2006

  2. Exceptions to the Theorem of CoaseAsymmetric Information • Coase Theorem • Exceptions To Coase Theorem • Transaction Costs - October 17, 2006 • Asymmetric Information - October 24, 2006 • Empty Core - October 31, 2006

  3. Exceptions to the Theorem of CoaseAsymmetric Information • COLOUR CODE FOR GRAPHS • Marginal Cost Curve for Agent (firm, individual) under a strict liability rule • Marginal Cost Curve for Agent (firm, individual) under a no liability rule • Marginal Cost Curve for Agent (firm, individual) under a negotiated contract that follows the Theoem of Coase • Demand Curve for the Agent’s output • Marginal Revenue Curve

  4. Exceptions to the Theorem of CoaseAsymmetric Information • COLOUR CODE FOR GRAPHS • Expected Marginal Cost Curve for Agent (firm, individual)

  5. Exceptions to the Theorem of CoaseAsymmetric Information • COLOUR CODE FOR GRAPHS (con’t) • Average Cost Curve for Agent (firm, individual) with no transaction costs • Average Cost Curve for Agent (firm, individual) with transaction costs • Profit of Agent (firm, individual) • Portion of profit traded in exchange for property rights • Portion of profit lost due to a trade in property rights • Portion of profit lost due to transaction costs

  6. Exceptions to the Theorem of Coase Property Rules and Liability Rules CONTRACTS – Terms And Conditions

  7. Exceptions to the Theorem of CoaseAsymmetric Information • Rules that compensate for market failures • (a) moral hazard • (b) adverse selection • (Cooter – p. 267)

  8. Exceptions to the Theorem of CoaseAsymmetric Information – Approximate Taxonomy • High Transaction Low Transaction Costs Costs INJUNCTION DAMAGES PERFECT INFORMATION DAMAGES INJUNCTION IMPERFECT INFORMATION

  9. Exceptions to the Theorem of CoaseAsymmetric Information • The injunction is the “optimal liability" rule if the “property rule” is strict liability • Illegal Labour Strikes • Infringement of Intellectual Property Rights

  10. Exceptions to the Theorem of CoaseAsymmetric Information - Injunction • When the relevant economic information is not symmetrically known, then the injunction might serve to more "clearly" assign a property right, instead of damages – Why? • Injunctions are clearer and simpler because the determination of damages in the courts can be both imprecise and uncertain when information is asymmetric. • How long will the illegal strike last? • How many copies of Cold Play were downloaded?

  11. Exceptions to the Theorem of CoaseAsymmetric Information – Injunction • The measurement of damages inflicted upon the recipient of pollution may not be reliably verifiable • Here the state (or court) might choose to impose an injunction against the polluter so that the polluter will take its own initiative to internalize the pollution.

  12. Exceptions to the Theorem of CoaseAsymmetric Information - Injunction • It may be less costly for the polluters to internalize the pollution than to incur the transaction costs to ascertain the true level of harm in damages. • studies • experts • hiring lawyers • going to court

  13. Exceptions to the Theorem of CoaseAsymmetric Information - Injunction • However, such injunctions still work best when transaction costs are relatively low enough to reach private agreements. • McKie v. KVP

  14. Exceptions to the Theorem of Coase Asymmetric Information - Signalling CONTRACTS – Terms And Conditions

  15. Exceptions to the Theorem of CoaseAsymmetric Information When information is asymmetric, parties to contracts still communicate information. Two models: Agent To Principal – Signalling Principal To Agent - Screening

  16. Exceptions to the Theorem of Coase Asymmetric Information - Signalling 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

  17. Exceptions to the Theorem of CoaseAsymmetric Information - Signalling Signalling games include agents choosing credentials to signal their ability, without any formal contract offer from principals. EXAMPLE: Voluntary submission of transcripts

  18. Exceptions to the Theorem of CoaseAsymmetric Information - Signalling A signaling game is an adverse selection game where the informed party (agent) is the first mover. Another Example: A seller offers a warranty on a product sold – What is the signal? Longer the warranty – the lower the cost the seller expects to pay if the product needs to be replaced

  19. Exceptions to the Theorem of Coase Asymmetric Information - Screening CONTRACTS – Terms And Conditions

  20. Exceptions to the Theorem of Coase Asymmetric Information - Screening Formation Of Contracts Principal makes more than one kind of offer to the Agent. Each Agent type self-selects their optimal choice of offer Performance Of The Contract

  21. Exceptions to the Theorem of CoaseAsymmetric Information - Screening Screening games include agents choosing those contracts that provide them maximum recovery at least cost. EXAMPLE: Insurance contracts

  22. Exceptions to the Theorem of CoaseAsymmetric Information - Screening If a principal does not know which agent type is present, he or she “writes” more than one type of contract to “sort” the agent types EXAMPLE: Suppose an agent does not want to “disclose” their entire wealth. This “low disclosure” agent can choose cheaper insurance with more limited coverage.

  23. Exceptions to the Theorem of CoaseAsymmetric Information - Screening • A major part of contract theory is default rules. • Contracts are usually incomplete and therefore a court or legislature must fill gaps. • This involves “sub-agencies”

  24. Exceptions to the Theorem of CoaseAsymmetric Information - Screening If a court anticipates that more than one “contract” type could appear in court on a breach of contract issue, it can “write” different rules to match each contract type. EXAMPLE: Suppose an agent does not want to “disclose” their entire wealth to a security agent. This “low disclosure” agent has, in effect chosen a “lower” recovery rule for damages.

  25. A principal in a private bilateral contract relationship writes a contract that may serve to “sort” or “separate” agents into more efficient contracts A court in a private bilateral agency relationship writes a rule that may serve to “sort” or “separate” contracts into more efficient outcomes Exceptions to the Theorem of CoaseAsymmetric Information - Screening

  26. . Exceptions to the Theorem of CoaseAsymmetric Information - Screening Court (as a “Principal”) imposes a rule with choices on a Principal – Agent contract PRINCIPAL PRINCIPAL AGENT AGENT

  27. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 CONTRACTS – Terms And Conditions

  28. Expectation DamagesHadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 Court Imposes A Rule with Choices on a Principal and an Agent Agent Accepts The Offer Agent Accepts The Offer Principal Makes An Offer To An Agent Performance Of The Contract Sub-Agency

  29. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • In Hadley v. Baxendale, a court established a rule which attempted to avoid adverse selection results in breach of contract cases

  30. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • Hadley owned a gristmill • Hadley entered into a contract with Baxendale, a carrier, to carry a broken crankshaft to engineers to Greenwich for repair

  31. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • Repair of the crankshaft was delayed several days • As a result, Hadley’s mill was shut down while awaiting return of the repaired shaft

  32. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • Hadley claimed profits lost during the shutdown period • Trial court rules in Hadley’s favour • This was reversed in the Court of Appeal • This court established or reaffirmed the primary rule of contract law: • “ ... that the amount which would have been received if the contract had been kept, is the measure of damages if the contract is broken."

  33. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • The Court of Appeal held Hadley’s lost profits were not recoverable • Hadley had not made full disclosure to Baxendale about his reliance on the damaged crankshaft in order to emphasize the urgency of the problem

  34. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • Only what is “disclosed” to Baxendale can be included in the recovery of damages: • Now, if the special circumstances under which the contract was actually made were communicated by the plaintiffs to the defendants, and thus known to both parties, the damages resulting from the breach of such a contract, which they would reasonably contemplate, would be the amount of injury, which would ordinarily follow from a breach of contract under these circumstances so known and communicated.

  35. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • However, Baxendale was still liable for “some damages” due to his inattention to the delivery of the crankshaft: • But, on the other had, if these special circumstances were wholly unknown to the party breaking the contract, he, at the most, could only be supposed to have had in his contemplation the amount of injury which would arise generally, and in the great multitude of cases not affected by any special circumstances, from such breach of contract.

  36. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • So the Court of Appeal established two rules for recovery (or two (2) branches of the rule) • Recovery of damages is lower when Hadley chooses not to disclose the nature of his reliance in the crankshaft • Recovery of damages is higher had Hadley chosen to disclose the nature of his reliance in the crankshaft

  37. Expectation DamagesHadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 Court Imposes A Rule with Choices on a Principal and an Agent Agent Accepts The Offer Sub-Agency

  38. Expectation DamagesHadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 A Court imposes a “complete” rule with the agents and principals In this case two “different” agents – “two” different contracts “two” different rules H – high disclosure principal and agent L- low disclosure principal and agent EH EL

  39. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 The objective of the rule is that the two (2) types of principals reveal themselves through the choice of disclosure the principals reveal and the agents receive

  40. Expectation DamagesHadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 • The Hadley default rule serves to distinguish two contractual types who differ in a single respect. • The low value type places a lower value disclosure and will, therefore, receive low damages in the event of default. • The high value type places a higher value on contract performance and will, therefore, receive high damages in the event of default.

  41. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 EH

  42. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 The high disclosure rule (analogous to the high risk budget constraint) acts as an “imposed” incentive compatibility constraint on the low disclosure agents who either may not sue or who may not enter contracts In other words, high-disclosure agents impose a negative “non-disclosure” externality on low-disclosure agents under the Expectation Damages Rule

  43. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 W2 EH W1

  44. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 A separating equilibrium “sorts” the contracts so that: (i) the low-disclosure agents gravitate towards a rule with lower recovery of damages (ii) the high-disclosure agents gravitate towards an expectation damages rule that would take economic loss (loss of profits) into account

  45. Exceptions to the Theorem of CoaseAsymmetric Information – Screening • Sometimes the court has to “separate” the contracts that private parties negotiated as “pooling contracts”

  46. Exceptions to the Theorem of CoaseAsymmetric Information – Screening • Macaulay v. Schroeder Publishing Co. Ltd. (1974). • A standard form contract • “Pooled” bad writers with good writers by subsidizing the “bad” writers with profits made by the “good” writers • House of Lords – Highest English court – strikes down contract with an “efficiency” argument against “pooling” contracts

  47. Exceptions to the Theorem of CoaseAsymmetric Information – Screening • What if the parties agree to a termination damages clause in the contract?

  48. Exceptions to the Theorem of CoaseAsymmetric Information – Screening • The “liquidated damage rule” prevents enforcement of contractual damage measures that require the Agent, if it breaches the contract, to transfer to the Principal a sum that exceeds the net gain the Principal expected to make from performance

  49. Exceptions to the Theorem of CoaseAsymmetric Information – Screening • This rule permits the Agent to transfer less than the Principal’s expectation that would be allowed under the Expectation Damages Rule. • This is an example of a “limited liability” condition inserted into the contract

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