Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 12

Econ 522Economics of Law

Dan Quint

Spring 2014

Lecture 12

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Contract Legally binding promise Allows for transactions that doesn’t occur “all at once”

Which promises should we enforce? Bargain Theory: enforce promises made as part of a bargain

Requires three elements: offer, acceptance, consideration Efficiency: promises that both parties wanted to be enforceable

Breach of contract Breach is efficient when cost to perform > promisee’s benefit Breach will happen when cost to perform > promisor’s liability To get efficient breach, set promisor’s liability = promisee’s benefit from

performance – this is expectation damages

Last week

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Reliance

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Reliance

You expect an airplane to arrive in spring – you might… Sign up for flying lessons Build yourself a hangar Buy a helmet and goggles

Reliance – investments which depend on performance Reliance increases the value of performance to promisee Reliance increases the social cost of breach

Another aim of contract law is to secure optimal level of reliance

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When is reliance efficient?

When social benefit of reliance > social cost of reliance

Social benefit: increased benefit to promisee (Value of airplane + hangar) – (Value of airplane without hangar) Value is only realized if the promise is performed

Social cost: direct cost borne by promisee Cost occurs whether or not promise is performed

Reliance is efficient whenever

Increase in value of

performance

Cost ofinvestment>Probability of

performanceX

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How should reliance figure into damages?

Expectation damages = expected benefit from performance

If your reliance investment increases your anticipated benefit…

should it increase the damages I owe you if I breach?

Can we design damages to get efficient reliance, in addition to efficient breach?

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You’re buying an airplane from me Price is $350,000, to be paid on delivery Airplane alone gives you benefit of $500,000 Building a hangar costs $75,000 Airplane with hangar gives you benefit of $600,000

Without hangar, expectation damages = $150,000

If you build a hangar and I fail to deliver plane, do I owe… $150,000? (Value of original promise) $250,000? (Value of performance after your investment) $225,000? (Value of original promise, plus reimburse you for investment

you made) Some other amount?

Reliance and damages:example

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000

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The only way to guarantee efficient breach is if damages included the added benefit from reliance Once you’ve made investment, you anticipate benefit of $250,000

from performance If damages are anything less than that, I’ll breach too often (If damages exclude the added benefit, then I’m back to imposing

an externality when I choose to breach the contract)

So what happens to the incentive for reliance investments if damages will increase to include this added benefit?

To get efficient breach…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000

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If you don’t build hangar, your payoff will be… $150,000 if I deliver the plane ($500,000 – $350,000) $150,000 if I breach and pay expectation damages

If you build hangar, your payoff will be… $175,000 if I deliver the plane ($600,000 – $350,000 – $75,000) $175,000 if I breach and pay (higher) expectation damages

So if expectation damages include the increased value of performance due to reliance investments… You’ll invest whenever (increase in benefit) > (cost) In this case, you’ll invest (because $100,000 > $75,000)

If exp damages includebenefit from reliance…


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If expectation damages include increased value of performance, you’ll invest for sure

Is this efficient? Reliance is efficient if

(increase in benefit) X (probability of performance) > (cost)

$100,000 X (probability of performance) > $75,000 Only efficient if probability of performance > ¾ If probability of performance < ¾, reliance is inefficient, but happens

anyway

Overreliance!

If exp damages includebenefit from reliance…


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Overreliance

If reliance investments increase the damages you’ll receive in the event of breach, you’ll over-rely You’ll rely if

Efficient to rely if

So if damages increase when you make reliance investments, we’re sure to get overreliance!

(Your investment imposes an externality on me)

Increasein benefit

Cost ofinvestment>Prob. of

perform.X Increasein damages

Prob. of breachX+

Increasein benefit

Cost ofinvestment>Prob. of

perform.X

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Better example:Continuous reliance

xy 600

Investment in hangar

Additionalvalue ofplane

$100

$10,

000

$40,

000

$160

,000

$640

,000

Tarp and rope - $6,000 benefit

Plywood frame, canvas roof - $60,000

Metal poles, rigid roof - $120,000

Functional heating - $240,000

Designer hangar with Starbucks - $480,000

Price of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x

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Let p be probability of breach

Three questions What is the efficient level of reliance?

What will promisee do if expectation damages include anticipated benefit from reliance?

What will promisee do if expectation damages exclude anticipated benefit from reliance?

Three questionsPrice of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x

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Let p be probability of breach

Three questions What is the efficient level of reliance?

x = $90,000 (1 – p)2

What will promisee do if expectation damages include anticipated benefit from reliance?

x = $90,000

What will promisee do if expectation damages exclude anticipated benefit from reliance?

x = $90,000 (1 – p)2

Three questionsPrice of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x

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Reliance and breach

Just showed: if damages include added benefit from reliance, promisee will invest more than efficient amount

But if damages exclude added benefit… Then promisor’s liability < promisee’s benefit from performance Which means: promisor will breach more often than efficient And promisor will underinvest in performance

“Paradox of compensation” Single “price” (damages owed) sets multiple incentives… …impossible to set them all efficiently!

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Cooter and Ulen: include only efficient reliance Perfect expectation damages: restore promisee to level of well-

being he would have gotten from performance if he had relied the efficient amount

So promisee rewarded for efficient reliance, not for overreliance

So what do we do?

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Cooter and Ulen: include only efficient reliance Perfect expectation damages: restore promisee to level of well-

being he would have gotten from performance if he had relied the efficient amount

So promisee rewarded for efficient reliance, not for overreliance

Actual courts: include only foreseeable reliance That is, if promisor could reasonably expect promisee to rely that

much

So what do we do?

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1850s England Hadley ran flour mill, crankshaft broke Baxendale’s firm hired to transport

broken shaft for repair Baxendale shipped by boat instead of

train, making it a week late Hadley sued for the week’s lost profits

“The shipper assumed that Hadley, like most millers, kept a spare shaft. …Hadley did not inform him of the special urgency in getting the shaft repaired.” Court listed several circumstances where broken shaft would not force mill

to shut down Ruled lost profits not foreseeable Baxendale didn’t have to pay

Foreseeable reliance: Hadley v Baxendale

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“Before you can award damages for wages paid and lost sales while the mill was idle, you must first find that at that time they entered into the contract to ship the crankshaft, the shipping company contem-plated that the mill owner would suffer those idleness damagesas a result of late delivery.”

To award damages for lost sales, Hadley should have to prove that Baxendale could have predicted those losses


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Why didn’t Hadley and Baxendalejust specify in the original contractwhat happens in case of delay?

What rules should apply in circumstances that aren’t addressed in a contract?


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DefaultRules

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Gaps: risks or circumstances that aren’t specifically addressed in a contract

Default rules: rules applied by courts to fill gaps

Default rules

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Gaps: risks or circumstances that aren’t specifically addressed in a contract

Default rules: rules applied by courts to fill gaps

Writing something into a contract vs leaving a gap Allocating a risk (ex ante), before it becomes a loss Versus allocating a loss (ex post)

Only have to deal with it if the loss occurs

Default rules

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Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue

This will be whatever rule is efficient

What should default rules be?

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Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue

This will be whatever rule is efficient

Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules Do this by imputing the terms the parties would have chosen if they

had addressed this contingency

What should default rules be?

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Don’t want ambiguity in the law

So default rule can’t vary with every case

Majoritarian default rule: the terms that most parties would have agreed to In cases where this rule is not efficient, parties can still override it in the

contract

Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate

Default rules

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Example: probability ½, the cost of construction will increase by $2,000 Construction company can hedge this risk for $400 Family can’t do anything about it

Price goes up – who pays for it?

Default rules

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Price goes up – who pays for it? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction

company Should prices be adjusted to compensate?

Default rules

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Price goes up – who pays for it? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction

company Should prices be adjusted to compensate?

Default rules

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So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases

Most contracts can leave this gap, save on transaction costs

In cases where this rule is inefficient, parties can contract around it

Default rules

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Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules”

Sometimes better to make default rule something the parties would not have wanted To give incentive to address an issue rather than leave a gap Or to give one party incentive to disclose information “Penalty default”

Default rules: a different view

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Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk

If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent

So Hadley might hide this information, which is inefficient Ayres and Gertner: Ruling in Hadley was a good one, not because

it was efficient, but because it was inefficient… …but in a way that created incentive for disclosing information

Penalty defaults: Hadley v Baxendale

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Suppose… 80% of millers are low-damage – suffer $100 in losses from delay 20% of millers are high-damage – suffer $200 in losses from delay

Shipper liable for actual damages Average miller would suffer $120 in losses Shipper makes efficient investment for average type But not efficient for either type

Shipper liable for foreseeable damages Shipper makes efficient investment for low-damage millers High-damage millers have strong incentive to negotiate around default

rule

Penalty defaults: example

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Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to

bring it up if it’s efficient to change this

Penalty defaults: other examples

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Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to

bring it up if it’s efficient to change this

Courts will impute missing price of a good, but not quantity Forces parties to explicitly contract on quantity, rather than leave it

for court to decide

Penalty defaults: other examples

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Look at why the parties left a gap in contract Because of transaction costs use efficient rule For strategic reasons penalty default may be more efficient

Similar logic in a Supreme Court dissent by Justice Scalia Congress passed a RICO law without statute of limitations Majority decided on 4 years – what they thought legislature would have

chosen Scalia proposed no statute of limitations; “unmoved by the fear that

this… might prove repugnant to the genius of our law…” “Indeed, it might even prompt Congress to enact a limitations period that

it believes appropriate, a judgment far more within its competence than ours.”

When to use penalty defaults?

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When should a contractnot be enforced?

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Going back to property law… Coase Theorem: to get efficient outcomes, we should let people trade

whenever they want to But also saw some exceptions – some trades that aren’t, and

shouldn’t, be allowed Selling enriched uranium to a terrorist

Similarly with contract law… First day: to get efficient outcomes, enforce any contract both parties

wanted enforced But next, we’ll see exceptions – contracts which shouldn’t be

enforced, due to externalities or market failures/transaction costs

When should voluntary trade not be allowed?

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Obvious: contract to buy a kilo of cocaine is unenforceable

Example of an unenforceable contract: a contract which breaks the law

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Obvious: contract to buy a kilo of cocaine is unenforceable

Less obvious: otherwise-legal contract whose real purpose is to circumvent a law Legal doctrine: derogation of public policy Derogate, verb. detract from; curtail application of (a law) Applies to contracts which could only be performed by breaking

law… …but also to “innocent” contracts whose purpose is to get around a

law or regulation

Example of an unenforceable contract: a contract which breaks the law

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Labor unions required by law to negotiate “in good faith”

Recent NBA labor troubles Old CBA: 57% of “basketball-related income” went to player salaries Owners were offering less than 50%, players demanding 53%... Imagine the following contract:

“For the next 50 years, if the NBAPAaccepts a CBA paying less than 55%of BRI in player salaries, then we alsoagree that all non-retired players will work for you as coal miners everyoffseason at federal minimum wage.”

Purpose is purely to “bind hands” innegotiations with ownership

Contract would not be enforced

Derogation of public policy – example

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In general: a contract is not enforceable if it cannot be performed without breaking the law

Exception: if promisor knew (and promisee didn’t) I’m married, my girlfriend in California doesn’t know; I promise her I’ll

marry her, she quits her job and moves to Madison My company agrees to supply a product that we can’t produce without

violating a safety or environmental regulation Keeping either promise would require breaking the law… …but I’d still be liable for damages for breach

Like in Ayres and Gertner: default rule penalizes better-informed party for withholding information

Derogation of public policy

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Talked earlier about default rules Default rules apply if no other rule is specified… …but can be contracted around

Rules like “derogation of public policy” cannot be contracted around Parties to a contract can’t say, “even though this type of contract would

normally not be valid, this one is” Rules which always apply: immutable rules, or mandatory rules, or

regulations

Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations.

Default rules versus regulations

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Ways to get outof a contract

(probably won’t get to this)

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Formation defense Claim that a valid contract does not exist (Example: no consideration)

Performance excuse Yes, a valid contract was created But circumstances have changed and I should be allowed to not

perform without penalty

Most doctrines for invalidating a contract can be explained as either… Individuals agreeing to the contract were not rational, or Transaction cost or market failure

Formation Defenses and Performance Excuses

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Courts will not enforce contracts with peoplewho can’t be presumed to be rational Children Legally insane

Incompetence One party was “not

competent to enter intothe agreement”

No “meeting of the minds”

One formation defense: incompetence

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If courts won’t enforce a contract signed by someone who wasn’t competent…

What if you signed a contract while drunk? You need to have been really, really, really drunk to get out of a

contract (“Intoxicated to the extent of being unable to comprehend the

nature and consequences of the instrument he executed”) Lucy v. Zehmer, Virginia Sup Ct 1954

So…

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Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time

While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”

“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”

Lucy v. Zehmer

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Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time

While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”

“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”

Lucy v. Zehmer

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So, you can be pretty drunk and still be bound by the contract you signed Might think “meeting of the minds” would be impossible But imagine what would happen if the rule went the other way

Lucy v. Zehmer

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So, you can be pretty drunk and still be bound by the contract you signed Might think “meeting of the minds” would be impossible But imagine what would happen if the rule went the other way

Borat lawsuits Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk

Journalist for Make Benefit Guileless Americans In Film”

Moral of the story: don’t get drunk with people who might ask you to sign a contract

Lucy v. Zehmer

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Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 12