Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2010 Lecture 10

2. Logistics • Midterm on Wednesday • Office hours tomorrow • Me (Soc Sci 7428) 9:30-11:30 a.m. • Fran (Soc Sci 6443) 12:30-2:30 p.m.

3. Last week… • Why do we need contracts? • To get cooperation/trade when transactions aren’t instantaneous • What promises should be enforced? • Bargain Theory of Contracts • Efficiency • First purpose of contract law: enable cooperation • Second purpose of contract law: encourage efficient disclosure of information

4. Breach

5. So… • A contract is just a promise • The idea here is that we want some promises to be legally binding • This means there has to be some legal consequence for breaking such a promise • Breach of contract is when the promisor fails to live up to his promise • Just like property rights are meaningless unless there is a remedy when they are violated… • …contract law is meaningless unless there is a penalty for breach • So, what happens when a contract is breached?

6. Why does the penalty for breach matter? • If penalty is too weak, contract law has no bite, and we’re back to our original problem • But sometimes, circumstances change, and breach of contract becomes desirable • Example: I promise to sell you a painting

7. Why does the penalty for breach matter? • If penalty is too weak, contract law has no bite, and we’re back to our original problem • But sometimes, circumstances change, and breach of contract becomes desirable • Example: I promise to sell you a painting • Example: I promise to build you a plane • If penalty for breach is too severe, I’ll have to honor these promises even when this is inefficient • Can we design the law so that we only get breach of contract when it’s efficient?

8. When is breach efficient? • Breach is efficient if social benefit of breach > social cost of breach • Social cost of breach is that promisee doesn’t get the benefit from the promise • Social benefit of breach is that promisor doesn’t have to incur the cost of delivering (performing) • So breach is efficient if promisor’s cost to perform > promisee’s benefit from performance

9. Efficient Breach Efficiency: > Promisor’sCost Promisee’sBenefit Efficient to Breach  < Promisor’sCost Promisee’sBenefit Efficient to Perform 

10. When do we expect breach to happen? • Promisor weighs private cost of performance vs breach • Whatever the penalty for breach, if it’s cheaper to perform, promisor will perform; if it’s cheaper to breach, he’ll breach • That is, we expect breach to occur whenever promisor’s cost to perform > penalty for breach

11. Efficient Breach Efficiency: > Promisor’sCost Promisee’sBenefit Efficient to Breach  < Promisor’sCost Promisee’sBenefit Efficient to Perform  What will actually happen (incentives of promisor): > Promisor’sCost Promisor’s Liability Promisor will Breach  < Promisor’sCost Promisor’sLiability Promisor will Perform 

12. So how do we get efficient breach? Efficiency: > Promisor’sCost Promisee’sBenefit Efficient to Breach  What will actually happen (incentives of promisor): > Promisor’sCost Promisor’s Liability Promisor will Breach  So if we design the law such that = Promisor’sLiabilityfor Breach Promisee’sBenefit fromPerformance the promisor will breach exactly when breach is efficient

13. Efficient breach • When liability from breach = promisee’s benefit from performance, we get breach exactly when it’s efficient • So for efficiency, when a promisor breaches a contract, we want him to owe a penalty exactly equal to the benefit the promisee expected to receive • This is called expectation damages • Expectation damages: if I promise you something that has value of $100 to you, and then I break my promise, I owe you $100 • This way, • if it costs me more than $100 to keep my promise, I’ll break it, which is efficient • if it costs me less than $100 to keep my promise, I’ll keep it, which is efficient

14. Value to you = $500,000 Price = $350,000 Example of efficient breach • I build airplanes • You value one of my planes at $500,000 • You agree to buy one for $350,000, and pay up front • After you pay, price of materials goes up

15. Value to you = $500,000 Price = $350,000 Example of efficient breach > Promisor’sCost Promisee’sBenefit Efficient to Breach  • Promisee’s benefit = $500,000 • If it costs me less than $500,000 to build plane, efficient to build it • If it costs me more than $500,000, efficient to breach

16. Value to you = $500,000 Price = $350,000 Example of efficient breach > Promisor’sCost Promisor’sLiability Promisor will Breach  • Liability is just to return your money • If my costs rise to $400,000, performance is still efficient, but I’ll choose to breach • Liability is $1,000,000 • If costs rise to $700,000, performance is inefficient, but I’d rather perform than breach • Liability = promisee’s benefit ($500,000) • I’ll perform when performance is efficient, breach when breach is efficient

17. Value to you = $500,000 Price = $350,000 But so what? Can’t we just“Coase” back to efficiency? • Liability is $350,000, my costs rise to $400,000 • I’ll breach original contract, but we can renegotiate to higher price • But I might try to do that even if my costs don’t go up… • Liability is $1,000,000, my costs rise to $700,000 • Rather than performing, I can offer you money to let me cancel contract • But my threat point is very low – you can demand a lot of money • If I realize that might happen, maybe I’m afraid to sign original contract • Expectation damages avoid these problems

18. Another way to think about expectation damages: eliminating an externality • If I breach contract, I impose externality on you • You’re $500,000 worse off • If I have to pay you $500,000, then I internalize the externality • Now my action no longer affects your well-being • (You get a payoff of $500,000 if I build the plane, and a benefit of $500,000 if I don’t.) • So I choose efficiently when deciding whether to perform or breach

19. Reliance

20. Reliance • Reliance – investments made by promisee, to increase the value of performance • The fourth purpose of contract law is to secure optimal reliance

21. When is reliance efficient? • When social benefit of reliance > social cost of reliance • Social benefit is increased benefit to promisee when promise is performed • Social cost is cost borne by promisee, whether or not promise is performed • So reliance is efficient as long as(probability of performance) X (increase in value) > (cost)

22. Efficient reliance • Efficiency: reliance is efficient as long as(probability of performance) X (increase in value) > (cost) • We said expectation damages = expected benefit from performance • Should expectation damages include increase in benefit due to reliance? • If yes: promisee will rely as long as (increase in value) > (cost) • So if yes, promisee will overrely • (Another way to think about this: there’s some chance I’ll have to breach • If your reliance increases my liability, then it increases the expected damages I’ll owe, which makes me worse off • If your reliance imposes a negative externality, you’ll do it more than the efficient amount)

23. Reliance and Damages: example • Reliance increases your benefit from my promise • Airplane gives you benefit of $500,000 • Costs $75,000 to build a hangar • Airplane with hangar gives you benefit of $600,000 • Suppose price is $350,000, to be paid on delivery • Expectation damages restore you to well-being you expected to have from performance • Without a hangar, if I breach, I owe you $150,000 • If you build a hangar and I breach, do I owe you $250,000?

24. Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 Reliance and damages:example • Cost of building plane: maybe $250,000, maybe $700,000 • Clearly, you’ll choose to build the hangar • But, is that efficient? You build hangar You don’t You get I get You get I get Costsstay low 600 - 75 - 350 = 175 350 - 250 =100 500 - 350 =150 350 - 250 =100 Costsrise - 75 + 250 =175 -250 150 -150

25. Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 Reliance and damages:example • Let p be probability my costs go up • Combined expected payoffs if you rely: (1 – p) (175 + 100) + p (175 – 250) = 275 (1 – p) – 75 p = 275 – 350 p • Combined expected payoffs if you don’t rely: (1 – p) (150 + 100) + p (150 – 150) = 250 (1 – p) = 250 – 250 p • Which is bigger? 275 – 350 p > 250 – 250 p « 25 > 100 p « p < ¼ • So if p < ¼, reliance is efficient; if p > ¼, it’s not • But you’re going to rely either way!

26. What do we learn? • When probability of breach is low, more reliance tends to be efficient • When probability of breach is high, less reliance tends to be efficient • If expectation damages include increased benefit from reliance, we sometimes get overreliance • (OTOH, if expectation damages exclude increased benefit from reliance, liability < benefit, so inefficient breach)

27. 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

28. 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

29. Foreseeable reliance: Hadley v Baxendale • 1850s England • Hadley owned gristmill, mill shaft broke • Baxendale’s firm hired to transport 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

30. Up next • Default rules • What principles should we use to address contingencies not considered in a contract? • Paper by Ayres and Gertner on syllabus