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

CONTRACTS – Exceptions To Coase’s Theorem

October 24, 2006

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


• 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


• COLOUR CODE FOR GRAPHS• Expected Marginal Cost Curve for Agent (firm,

individual)


• 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

CONTRACTS – Terms And Conditions

Exceptions to the Theorem of CoaseProperty Rules and Liability Rules


• Rules that compensate for market failures

• (a) moral hazard • (b) adverse selection• (Cooter – p. 267)

Exceptions to the Theorem of CoaseAsymmetric Information – Approximate Taxonomy

• High Transaction Low Transaction

Costs Costs

PERFECT INFORMATION

IMPERFECT INFORMATIONDAMAGES INJUNCTION

DAMAGESINJUNCTION


• The injunction is the “optimal liability" rule if the “property rule” is strict liability

• Illegal Labour Strikes• Infringement of Intellectual Property Rights

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?

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.


• 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


• However, such injunctions still work best when transaction costs are relatively low enough to reach private agreements.

• McKie v. KVP


Exceptions to the Theorem of CoaseAsymmetric Information - Signalling


When information is asymmetric, parties to contracts still communicate information.

Two models:Agent To Principal – SignallingPrincipal To Agent - Screening


Formation Of Contracts

Principal Makes

An Offer To An Agent

Agent Accepts The Offer

Performance Of The Contract

Agent Sends A

Signal to the

Principal


Signalling games include agents choosing credentials to signal their ability, without any formal contract offer from principals.

EXAMPLE: Voluntary submission of transcripts


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


Exceptions to the Theorem of CoaseAsymmetric 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



Screening games include agents choosing those contracts that provide them maximum recovery at least cost.

EXAMPLE: Insurance contracts


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.


• 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”


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.


• 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


• .

PRINCIPAL

AGENT

PRINCIPAL

AGENT

Court (as a “Principal”) imposes a rule with choices on a Principal – Agent contract


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



Court Imposes A Rule with Choiceson a Principal and an Agent

Principal Makes

An Offer To An Agent



Sub-Agency


• In Hadley v. Baxendale, a court established a rule which attempted to avoid adverse selection results in breach of contract cases


• Hadley owned a gristmill• Hadley entered into a contract with

Baxendale, a carrier, to carry a broken crankshaft to engineers to Greenwich for repair


• Repair of the crankshaft was delayed several days

• As a result, Hadley’s mill was shut down while awaiting return of the repaired shaft


• 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."


• 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


• 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.


• 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.


• 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



Court Imposes A Rule with Choiceson a Principal and an Agent

Sub-Agency


EH EL

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 agentL- low disclosure principal and agent


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


• 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.


EH


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


W2

W1

EH


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

Exceptions to the Theorem of Coase Asymmetric Information – Screening

• Sometimes the court has to “separate” the contracts that private parties negotiated as “pooling contracts”


• 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


• What if the parties agree to a termination damages clause in the contract?


• 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


• 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


Exceptions to the Theorem of Coase Expectation Damages – Single Moral Hazard

Exceptions to the Theorem of CoaseAsymmetric Information – Remedies

.

Agent 2 has the exclusive use to its property rights

Agent 1 creates a harmful

nuisance that hurts

Agent 2 economically.

Exceptions to the Theorem of CoaseAsymmetric Information - Remedies

• Agents operate two firms:

a1 = output of Agent 1a2 = output of Agent 2


• Perfect Information – Constant Marginal Costs

Strict Liabilty Rule

a1


• The profit function of Agent 1 is: 1 = pa1 – C(a1)

• The pollution function of Agent 1 is: D(a1) = (a1)^2


• Perfect Information – Increasing Marginal Costs


No Liability Rule

a1


• Agent 1 takes into account the ability of Agent 2 to sue it when it maximizes its profits:

Output = (a1)* = 5/8Pollution = (a1)^2* = 25/64


• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1

S

DP

a1

MC1

PPC

PM

LATCLATC

Strict Liability Rule




S

DP

a1

MC2

PPCPM

LATCLATC


MC2


PRINCIPAL Agent 1 Offers a Bribe or a Transfer Payment To Agent 2

AGENTAgent 2 promises to endure the pollution in exchange for the payment which makes it better off

promisepayment


Damages suffered by Agent 2

without the payment to

Agent 1 would be:

D(aP1) = 25/64However, if the ideal of “0-pollution”

operates for Agent 2 :

D(aO1) = 0Minimum Payment To Agent 2 25/64



SS = MC2

DP

a1

MC2 SATC SATC

PPC

PM

LATCLATC



Profit earned by Agent 1

without the payment to

Agent 1 would be:

1 (aSO1) = 25/16Profit earned by Agent 1 under the free

market would be:

1(aP1) = 25/12Maximum Payment from Agent 1 25/48



SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

LATCLATC



The “optimal” bribe or transfer payment lies within a “core”:

25/64 < PAYMENT TO AGENT 2 FROM AGENT 1 < 25/48


• Social surplus increases under

the contract. • No party can be

worse off.

• Agent 1

S

DP

a1

PM

PMC

SMC

CMC


• Social surplus is improved to the most efficient or optimal amount irregardless of which agent has the property rights.

• Agent 2

S

DP

a1

PM

PMC

SMC

CMC


• Agent 2

S

DP

a2

PM

• Agent 1

S

a1

CMC

Maximum Joint Social Surplus


• While there may be no “incentive” to break this contract, other “interventions” may happen:

• The contract could be frustrated• A new owner might ignore the contract and increase

pollution• The downstream victim might decide to sue

irregardless of the victims compensation• A storm or hurricane


• What happens:• There is a reduction in optimal social surplus• A1 may sue A2 for its loss of the reduced surplus• A2 may sue A1 for its loss of the reduced surplus

• Could this happen?:• There must be full disclosure by each party• Usually, there is not• In this case, since the strict liability rule applies, the

“burden” is on A1 to make sure the contract succeeds


• Agent 2

S

DP

a2

PM

• Agent 1

S

a1

CMC

Maximum Joint Social Surplus

Exceptions to the Theorem of Coase

Asymmetric Information - Remedies

• The Contract Model – Implied Insurance• A1 is the superior risk bearer if it is in the best

position to prevent or meet the risk» Get the relevant information at least cost» Insure against the risk at least cost

• The level of effort, a1, includes a “precautionary input” to reduce the risk of breach of contract


• Perfect Information – Increasing Marginal• Costs• $C1


Contract Liability Rule

a1



• The Contract Model – Expected Costs• A1 is the superior risk bearer• As the level of effort, a1, increases, the likelihood of a

“breach of contract”, p(a1), decreases

• As p(a1) decreases, the level of “expected damages”,

Dp(a1), decreases, where D = the loss A1 bears because the contract failed

• D has two components» The difference in profit A2 would have received if the

contract was performed and what A2 actually gets

» The difference in profit A1 would have received if the contract was performed and what A1 actually gets


• Imperfect Information•Decreasing Marginal Costs Due to Precaution

•Increasing Marginal Costs Due To Production

Strict Liabilty Rule –MC1

Contracted Liability Rule – MC1

Expected Liability – MC1

a1

$C1



• The Contract Model – Expected Costs

• What exactly is p(a)?• Certain underlying assumptions might be made about p(a)• p(a) is distributed in accordance with an underlying

probability distribution where the area under the probability curve is equal to 1

• For example» Uniform distribution» Normal distribution



• Uniform Distribution

a1

Area Under the Probability Curve = 1.0



• Normal Distribution

a1a1

Area Under the Probability Curve = 1.0


Asymmetric Information – Optimal Remedy

• a1 = level of precaution invested by the agent-promisor (Agent 1) against breach of contract against (Agent 2)

• a2 = level of reliance invested by the agent-promisee (Agent 2) in Agent 1 (polluter)



• p(a1) = Probability of No Breach • Probability of Performance• A Completed Contract

• p’(a1) > 0• More effort results in more precaution against

breach

• p’’(a1) < 0• Diminishing “returns” to precaution as more

effort invested



• Agent 1 can take costly precaution that increases the probability that he or she performs the contract as promised

• (Cooter, 4th, p. 298)


Asymmetric Information – Optimal Remedy$C1

a1

R2[P(a1)]

R2[1- P(a1)]

Agent 1’s Marginal Cost Curve (under the Coasean Contract)



• R2[P(a1)] = Total revenue of Agent 2 under the contract if the contract is fully performed

• R2[1 - P(a1)] = Total revenue of Agent 2 under the contract if the contract is breached



Profit of Agent 2 if contract is performed

P(a2) = R2[P(a1)] - a2

Profit of Agent 2 if contract is not performed

NP(a2) = R2[1-P(a1)] - a2



• Solving the “legal problem” involves maximizing the joint social surplus of the parties

• Both Cooter and Posner refer to the concept of “optimal social surplus” by the term “efficiency”

[] Cooter, R., Law and Economics - Mathematical Appendix, (4th ed.) pp. 298-299



• Y = C(a1,a2)

= p(a1)RP(a2) + [1 - p(a1)]RNP(a2) Contract

a1, a2 - effort inputs - precaution - hours of work - joint

investment



• The parties will choose that level of effort which maximizes their respective incentive compatibility constraints:

• Max [p(a1)RP(a2) + [1 - p(a1)]RNP(a2)] - a1 - a2

[] Cooter, R., Law and Economics - Mathematical Appendix, (4th ed.) pp. 298-299



• 1 = marginal expenditure

• p'(a1)[RP(a2) - RNP(a2)] = marginal expected revenues of Agent 2

[] Cooter, R., Law and Economics - Mathematical Appendix, pp. 298-299



• 1 = marginal reliance expenditure

• p(a1)RP'(a2) + [1 - p(a1)]RNP'(a2) =net marginal expected increase in revenues

Cooter, R., Law and Economics - Mathematical Appendix, p. 299



• Incentive Compatibility Constraint of AGENT 2

C2(e1,e2) - 1 = 0

• [p(a1)RP'(a2) + [1 - p(a1)]RNP'(a2)] = 1 net marginal expected increase in

revenues = marginal reliance expenditure



• Solving the system of incentive compatibility constraints

[p(a1)RP'(a2) + [1 - p(a1)]RNP'(a2)] = 1 p'(a1)[RP(a2) - RNP(a2)] = 1

yields a1= a*1 and a2= a*2



Axes

$C1

a1

P

NP Marginal Cost Curve of Agent 1

a10 a1* a11



• e1= e*1 and e2= e*2 generate “socially optimal” reliance and precaution

• However, since 0 < p(e*2) < 1then the “actual solution” to the principal’s problem will lie within the “core” y0 < e*1 < y1



• “Liability rule” or “liability marginal cost curve” for Agent 1 is added in orange to the joint social surplus of the parties

• Max [p(e2)RP(e1) + [1 - p(e2)]RNP(e1)] - e1 - e2 - [1-p(e2)]De



• Property rule is added in orange as a “second” incentive compatibility constraint to the Agent 1

• p'(a1)[RP(a2) - RNP(a2)] = 1• Marginal expected revenue = marginal expenditure

1 = p’(a1)De

• Marginal cost of precaution = marginal reduction in expected liability

Cooter, (4th) pp. 300 - 301


Asymmetric Information – Optimal Remedy$C1

a1

P

NP Marginal Cost Curve of Agent 1

Expected Marginal Cost Curve of Agent 1 under Expectation Damages

a10 a1* a11



• De = RP(e1) - RNP(e1)]

• Expectation Damages – De - puts the principal-promisee in the same position as if the contract had been performed

• (Cooter, 4th, p. 299)


Modification, Renegotiation and Re-Contracting


• How does one distinguish opportunistic behaviour (breach of contract) from socially optimal modification of contract (recontracting)?


• The Contract Model – Implied Insurance• Courts presume against

renegotiation or re-contracting in contracts in the absence of very clear clauses allowing changes in the contract.

» Unlimited modification undermines the “efficiency” of the implied insurance in the contract


• Aivazian, Trebilcock and Penney (1984) argue is safe to enforce modifications when

• It is not clear who the superior risk bearer is – insurance would not be an issue then.

• The risk is to small to worry about


• A,T & P recognize that the “Cooter emphasis” on “efficient breach” might encourage too much flexibility and lead to opportunistic behaviour

• A, T & P an “ex ante” approach with a long-term incentive structure that would both anticipate changes and reduce the transaction costs of modification


• Unambiguous laws• Allowing modification• Disallowing modification

have no impact on the optimal location of the contract point in these strategic changes (ATP – p. 190)


• Laws disallowing modification in strategic situations are more efficient in high transaction cost jurisdictions since parties minimize both agency and transaction costs following the “ex ante” approach to contract design – “Get it right the first time” (ATP – p. 190)

• Plea bargains• Separation agreements


• Laws disallowing modification in economic changes are still more efficient unless

• The “superior risk bearer” is too difficult to identify• The type of risk is remote (wars – ATP – p. 207)

in which cases contract modification should happen. (ATP – pp. 196-197)

Documents

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