Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2012 Lecture 11

Contract law: the story so far • Contract = legally binding promise • Allow for cooperation/trade when transactions aren’t instantaneous • First purpose of contract law: enable cooperation • What promises should be enforced? • Bargain theory: those given as part of a bargain • Requires consideration – promisee giving up something in exchange for the promise • Efficiency: any promise both promisor and promisee wanted to be enforceable • Think of Coase – allow all voluntary transactions to get to efficiency

Contract law: the story so far • May become efficient/necessary to break a promise • When should a contract be breached? Breach is efficient when cost to perform > benefit of performance to promisee • When will breach happen? Breach is in promisor’s interest when cost to perform > promisor’s liability from breach • Expectation damages: liability from breach = benefit expected by promisee • Leads to breach exactly when it’s efficient • Also leads to efficient level of investment in performance • “Designing the law to internalize an externality” • What else can contract law accomplish?

Reliance

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 • The fourth purpose of contract law is to secure optimal reliance

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 Probability of performance Cost ofinvestment X >

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?

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 Reliance and damages:example • 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?

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

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 If exp damages includebenefit from reliance… • 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)

Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 If exp damages includebenefit from reliance… • 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!

Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600Öx Better example:continuous investment Additionalvalue ofplane Designer hangar with Starbucks - $480,000 Functional heating - $240,000 Metal poles, rigid roof - $120,000 Plywood frame, canvas roof - $60,000 Tarp and rope - $6,000 benefit Investment in hangar $100 $10,000 $40,000 $160,000 $640,000

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

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

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 Prob. of perform. Increasein damages Prob. of breach Cost ofinvestment X + X > Increasein benefit Prob. of perform. Cost ofinvestment X >

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!

So what do we do? • 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? • 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

Foreseeable reliance: Hadley v Baxendale • 1850s England • Hadley ran flour mill, crankshaft broke • Baxendale’s firm hired to transportbroken 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 • “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 contemplated that the mill owner would suffer those idleness damages as a result of late delivery.” • To award damages for lost sales, Hadley should have to prove that Baxendale could have predicted those losses

Foreseeable reliance: Hadley v Baxendale • 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?

Default Rules

Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps

Default rules • 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

What should default rules be? • 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? • 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

Default rules • 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 • 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 • 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? • 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 • 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: a different view • 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”

Penalty defaults: Hadley v Baxendale • 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: example • 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: other examples • 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 • 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

When to use penalty defaults? • 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 should a contractnot be enforced?

When should a contract not be enforced? • We said earlier: in general, efficiency requires enforcing contract whenever both sides wanted it to be enforced • Coase: if people are rational and there are no transaction costs, private negotiations should lead to efficiency… • …so any additional regulations/limitations on trade can only make things worse • But: if a contract imposes externalities, or there are transaction costs or market failures, maybe not • Next: settings where a contract may not be enforced

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

Derogation of public policy – example • 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 • 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

Default rules versus regulations • 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. • Next week: other reasons a contract might not be enforced

Econ 522 Economics of Law