Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2009 Lecture 13

Logistics • Midterm will be returned at end of lecture • HW2 is up – due Tuesday, November 3 (11 a.m. sharp) • Second midterm (on contract law) Thursday, November 5

This past Tuesday… • More ways to get out of a contract • Efficient bearer of a risk • Impossibility • Misinformation: fraud, failure to disclose, frustration of purpose, mutual mistake • But not unilateral mistake • Uniting knowledge and control • Adhesion and unconscionability • Remedies • Expectation damages • Opportunity cost damages • Reliance damages

Different types of damages we saw Tuesday • Expectation damages • Give promisee benefit he would have had from performance • Opportunity cost damages • Give promisee benefit he would have had from next-best contract • Reliance damages • Give promisee benefit he would have had from doing nothing • Expectation Dam ³ Opp Cost Dam ³ Reliance Dam • But order can be reversed when calculated incorrectly

Other court-ordered remedies • Restitution • Return money that was already received • Disgorgement • Give up wrongfully-gained profits

Other court-ordered remedies • Restitution • Return money that was already received • Disgorgement • Give up wrongfully-gained profits • Specific Performance • Promisor is forced to honor promise • Civil law: often ordered instead of money damages • Common law: money damages more common; S.P. sometimes used when seller breaches contract to sell a unique good • Like injunctive relief

Party-designed remedies • Remedy for breach could be written directly into contract • But common law courts don’t always enforce remedy terms • Liquidated damages– party-specified damages that reasonably approximate actual harm done by breach • Penalty damages – damages greater than actual harm done • Civil law courts are generally willing to enforce penalty damages • But common law courts often do not

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Penalty Damages • Peevyhouse v Garland Coal • Peevyhouses only wanted farm strip-mined if it would be restored to original condition after • Suppose coal extracted worth $70,000 • Garland paid $25,000 for rights to mine it • Restoration work would cost $30,000 • Diminution of value was $300 • So liquidated damages would be $300 • Suppose Peevyhouses got $40,000 of disutility from land being left in poor condition

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Liquidated damages Peevyhouses Sign Don’t Garland Coal (0, 0) Restore property Don’t, pay damages (25,000, 15,000) (-14,700, 44,700) • If damages limited to liquidated damages… • Peevyhouses have no reason to believe restorative work will get done • So Peevyhouses better off refusing to sign • Even though mining and restoring Pareto-dominates

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Penalty damages Peevyhouses Sign Don’t Garland Coal (0, 0) Restore property Don’t, pay penalty (25,000, 15,000) (25,000, 5,000) • If penalty clauses in contracts enforceable… • Write contract with $40,000 penalty for leaving land unrestored • Now restoration work would get done, so Peevyhouses willing to sign • But if courts won’t enforce penalty damages, this won’t work

Penalty clauses • Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus • I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late • Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time • Either way, you get $150,000 if house is late, $200,000 if on time • Courts generally enforce bonus clauses, so no problem!

Penalty clauses • Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus • I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late • Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time • Either way, you get $150,000 if house is late, $200,000 if on time • Courts generally enforce bonus clauses, so no problem! • Similarly, Peevyhouse example • Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is not restored • Equivalently, get $65,000 for mining rights, pay $40,000 bonus if restoration is completed • But, if intent of contract is too transparent, still might not be enforced

Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

Plane worth $500,000 to youPrice $350,000Cost: either $250,000 or $1,000,000 Remedies and breach Expectation Damages Specific Performance Costs Low – Perform Costs High – Perform Costs High – Breach Costs Low – Perform Costs High – Perform CostsHigh – Renegotiate I get 100,000 -650,000 -150,000 I get 100,000 -650,000 -400,000 You get 150,000 150,000 150,000 You get 150,000 150,000 400,000 Total 250,000 -500,000 0 Total 250,000 -500,000 0 • Transaction costs low  either leads to efficient breach, but seller prefers “weaker” remedy • Transaction costs high  S.P. leads to ineff. performance

Remedies and breach • Opportunity cost damages, or reliance damages • Inefficient breach when transaction costs are high • Renegotiate contract to get efficient performance when transaction costs are low • Like nuisance law: any remedy leads to efficient breach with low TC • But only expectation damages do when TC are high • Unfortunate contingency and fortunate contingency

Efficient signing • Specific Performance • If costs stay low, I get $350,000 - $250,000 = $100,000 profit • If costs rise, I take $400,000 loss • Am I willing to sign this contract? • Even expectation damages face this problem • Expectation damages: costs stay low, same $100,000 profit • Costs rise, $150,000 loss • If probability of high costs is ½, I won’t sign contract • Expectation damages lead to efficient breach, but may not lead to efficient signing • Suggests expectation damages might be good default rule,but not good mandatory rule

Paradox of compensation • Remedy for breach sets incentive for both promisor and promisee • Promisor: perform or breach • Promisee: how much to rely • Generally impossible to set both incentives efficiently at the same time • Example: should anticipated benefit from reliance be included in expectation damages?

Incentives for reliance(continuing with airplane example) 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

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?

What is efficient level of reliance? • Total social gain when costs stay low: 500,000 + 600 Öx – 250,000 – x • Total social gain when costs go up: – x • If probability costs rise is p, expected total social gain is (1-p) (250,000 + 600 Öx – x) + p (-x) 250,000 (1-p) + 600 (1-p) Öx – x • Choose x to maximize this: derivative is 600 (1-p) /(2Öx) – 1 = 0 x = 90,000 (1 – p)2 • So x = 90,000 (1 – p)2 is the efficient level of reliance

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

What will promisee do if damages include benefit from reliance? • Private gain to promisee when costs stay low: 500,000 + 600 Öx – 350,000 – x = 150,000 + 600 Öx – x • Private gain to promisee when costs go up: 150,000 + 600 Öx – x • Expected private gain to promisee is 150,000 + 600 Öx – x • Choose x to maximize this: derivative is 600/(2Öx) – 1 = 0 x = 90,000 • So promisee would invest x = $90,000 in reliance

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?

What will promisee do if damages exclude benefit from reliance? • Private gain to promisee when costs stay low: 500,000 + 600 Öx – 350,000 – x = 150,000 + 600 Öx – x • Private gain to promisee when costs go up: 150,000 – x • Expected private gain to promisee is 150,000 + (1 – p) 600 Öx – x • Choose x to maximize this: derivative is 600 (1 – p)/(2Öx) – 1 = 0 x = 90,000 (1 – p)2 • So promisee would invest x = $90,000 (1-p)2in reliance

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

So… • To get efficient reliance, we need to exclude gains from reliance in calculation of expectation damages • But then promisor’s liability < promisee’s benefit, leading to inefficient breach • With low transaction costs, we can fix this through renegotiation • But what about unobservable actions the promisor needs to take, to make breach less likely? • Investment in performance

Investment in performance(continuing with airplane example) • Some investment I can make to reduce likelihood that breach becomes necessary • Suppose probability is 1/2, but for every $27,726 I invest, I cut the probability in half again • Invest nothing  probability of breach is 1/2 • Invest $27,726  probability is 1/4 • Invest $55,452  probability is 1/8 • Any investment z  probability is .5 * (.5) z / 27,726 • Wrote it this way so p = .5 e– z / 40,000

Same questions as before • What is the efficient level of investment in performance? • What will promisor do under various rules for calculating damages?

What is the efficient level of investment in performance? • Suppose promisee has decided to spend $90,000 on hangar • Gives $180,000 benefit • So benefit of performance is now 150,000 + 180,000 = 330,000 • Cost of hangar is a sunk cost – we can ignore it • Social surplus is… • 330,000 + 100,000 if costs stay low • 0 if costs rise • So expected social surplus is (1 – p(z)) (430,000) – z

What is the efficient level of investment in performance? • Expected social surplus is (1 – p(z)) (430,000) – z 430,000 – 430,000 * 0.5 * e–z/40,000 – z • Take derivative to maximize this: – 430,000 * 0.5 * (–1/40,000) e– z/40,000 – 1 = 0 • Could solve for z, but simpler to solve for p(z) 0.5 * e– z/40,000 = 40,000 / 430,000 = p(z) • Efficient level of investment in performance is enough to reduce probability of breach to 40,000/430,000

Same questions as before • What is the efficient level of investment in performance? • Enough so that p(z) = 40,000/430,000 • What will promisor do under various rules for calculating damages?

How much will promisor choose to invest in performance? • Let’s let D denote liability from breach • Private gain to promisor is 100,000 when costs stay low, -D when costs go up, minus whatever he invests in performance • Expected private gain is (1 – p(z)) 100,000 + p(z) (-D) – z 100,000 – p(z) (100,000 + D) – z 100,000 – (100,000 + D) * 0.5 * e–z/40,000 – z • Take derivative to maximize this: – (100,000 + D) * 0.5 * (–1/40,000) e– z/40,000 – 1 = 0 • Again, solve for p(z) 0.5 * e– z/40,000 = 40,000 / (100,000 + D) = p(z) • For any level of liability D, promisor invests enough to reduce probability of breach to 40,000/(100,000+D)

Same questions as before • What is the efficient level of investment in performance? • Enough so that p(z) = 40,000/430,000 • What will promisor do under various rules for calculating damages? • Enough so that p(z) = 40,000/(100,000 + D) • So if D = 330,000, efficient investment in performance • D = 330,000 is promisee’s benefit, including reliance • So expectation damages, with benefit of reliance, give efficient investment in performance • If D < 330,000, too little investment in performance • If D > 330,000, too much

Midterm • Overall pretty good • Mean 75, median 76, std dev 12 • Not actually assigning letter grades till after final • But to have an approximate idea of where you stand… > 80 roughly AB or A 70-80 roughly B 60-70 roughly BC below 60 roughly C or worse last names A-Llast names M-Z

Econ 522 Economics of Law