Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre http://www.econ.jku.at/schneider

1. Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre http://www.econ.jku.at/schneider Recht und Ökonomie (Law and Economics) LVA-Nr.: 239.203 WS 2012/13 (6) Contract Law (Vertragsrecht) Law and Economics

2. 1. Contract • Contract: agreement that regulates an exchange that is mutually beneficial. • Contracts to give or to make. • Replicable goods or ‘specific’ goods. • General problems: • breach of contract; • information may be asymmetric (one party knows more); • correct incentives to fulfil the contract. Law and Economics

3. 2. Incompleteness of Contracts • Complete contingent contract (hypothetical) • Incompleteness: Costs of specification: • ex ante, e. g. lawyers fees. • ex post, conflict resolution. • Minimise cost by comparing: • ex ante cost (usually certain) to • ex post cost, usually with presumed probability • assumption: many contracts concluded. Law and Economics

4. 3. Breach or Re-Negotiation • Suppose seller (S) and buyer (B) contract for 100 washing machines per month for € 35.000. • ‘Daily’ cost of equipment (sunk cost) € 15.000. • sunk costs = incurred costs that cannot be recovered. • Opportunity cost € 25.000 (value of best alternative use of the equipment). • Buyer could re-negotiate contract for a new price of less than € 35.000 (but more than € 25.000). • Post-contractual opportunistic negotiations. Law and Economics

5. 4. Incompleteness and Contract Law • Reliance on contract law (C. L.) to resolve unexpected (unlikely) occurrences. • Only major or contract specific terms have to be contained in the contract. • Plus some clause: “ … contract is to be governed by the laws of…” • Contract law thus: • serves as ‘default option’; • reduces transaction costs through provision of (efficient) enforcement mechanisms. Law and Economics

6. 5. Inefficient Contract Laws • Breach of contract reduces profits (welfare). • Possible solution: penalty  • e.g.: “ … delay of delivery (finishing construction, …) leads to a penalty of € … per day (week, …)”; • recovers profits foregone by buyer. • Seller can choose to deliver on time or with delay to maximise his profits  optimal solution for both. • Poor enforcement mechanisms (may) lead to reduced economic activities, reducing welfare. • Uncertain debt recovery (or payment) will lead to request for securities, increases cost. Law and Economics

7. 6. Efficient Contract Laws • Reduce transaction costs. • Economise on information costs. • Imperfect versus asymmetric information. • Lead to only efficient contract breaches. • Penalty. • Imply efficient reliance. • Avoid opportunistic re-negotiation. • Involve risk minimisation: • precautions to avoid risk; • cost-minimising risk bearing. Law and Economics

8. 7. Asymmetric Information • Problem: one party in a transaction has more or better information compared to other party  can take advantage of other party’s lack of knowledge market failure (?) • Causes general problems: • Adverse selection. • Moral hazard. • Principal-Agent-Problem Law and Economics

9. 7. Asymmetric Information (cont.) • Example: consider used car market. • With 100 cars: 50 ‚plums‘ and 50 ‚lemons‘. • Sellers know the quality of car, buyers do not ( asymmetric information). • ‚Plums‘ would be offered for € 6.000, ‚lemons‘ for € 3.000. • Willingness-to-pay (WTP): € 7.200 and € 3.600, respectively. • WTP with no information on quality: € 5.400. • Result: only ‚lemons‘ would be offered no contract. Law and Economics

10. 8. Adverse Selection Example 1: Bicycle Insurance. • Assume regional differences in theft rates. • Insurance company offers insurance based on average theft rate. • Only people in areas with high theft rates will take out insurance  adverse selection (A. S.). • Result: company will go out of business due to adverse selection (and not due to unbiased selection). Law and Economics

11. 8. Adverse Selection (cont.) Example 2: Health Insurance. • Insurance company bases rates on average occurrence of health problems. • Individuals know their health status (better), insurance companies do not (or know it lessthan individuals). • Result: Only high risk people will take out insurance. • Solutions to avoid A. S.: • mandatory insurance (e. g. Europe); • ‘health plan’ by firms (e. g. US, also Europe). Law and Economics

12. 9. Moral Hazard Example: Bicycle Insurance. • Assume probability of theft (also) depends on action, that is care taken by owners (e.g. type of locks). • If no insurance is available: maximum care  • Marginal Costs (MC) of taking care = Marginal Benefit (MB) of taking care. • With insurance: level of care is reduced (change of behaviour)  moral hazard (M. H.). • Holds also for health insurance, fire insurance, ... • Solutions: • deductibles: no full coverage; • try to observe level of care: • rates differ for smokers, houses with sprinkler systems, … Law and Economics

13. 9.1. Adverse Selection and Moral Hazard • Adverse Selection is due to ‘hidden information’: • one side of the market cannot observe quality. • Moral Hazard is due to ‘hidden action’: • one side of the market cannot observe care. • Lack of information causes inefficiency. • Government action may alleviate the problem only in case of hidden information. • Compulsory insurance. Law and Economics

14. 10. Signalling • Car example: seller knows more ( signal to buyer): • warranty on used cars; • reputation of seller. • Quality of workers: employee knows more ( signal to employer): • years of school attended; • diploma (‘sheepskin effect’); • additional qualifications; • voluntary work; • … • Objective: reduce the asymmetry in information (at low cost!). Law and Economics

15. 11. Incentives and Asymmetric Information • Which contract ensures that someone does what I want her/him to do for me? • Also known as ‘Principal–Agent–Problem’: a principal hires one (or more) agent(s), to pursue principal's interests. • Problem: performance of agent(s) not perfectly observable  information asymmetry  incentive scheme / contract? • Examples: employer and employee; owner and manager of company. Law and Economics

16. 11. Incentives and Asymmetric Information (cont.) • Consider four types of contracts: • Rent; • wage labour; • take-it-or-leave-it; • Sharecropping. Law and Economics

17. 11.1. Rent • Agent (hirer) pays fixed amount to principal (landowner). • Agent gets all the surplus beyond rent. • Maximum output produced  efficient. • Utility maximizing for agent. • But: agent also bears all the risk. • If agent is more risk averse than the owner the result will be inefficient. • Agent would be willing to give up some income for a reduction in risk. Law and Economics

18. 11.2. Wage Labour • Principal (employer) pays to agent (worker) a constant amount per unit of effort. • Utility maximizing agent chooses his effort such that marginal product of effort equals marginal cost of effort  efficient. • With asymmetric information: effort cannot be observed by principal (only hours can be observed). • Unless: piece work. Law and Economics

19. 11.3. Take-it-or-leave-it • Agent (worker) is paid the full amount if he/she chooses the optimum effort level – and zero otherwise. • Outcome: agent chooses this optimal level  efficient. • With asymmetric information: • agent bears all the risk (if payment is based on output); or • effort cannot be observed (payment based on input). Law and Economics

20. 11.4. Sharecropping • Principal (landowner) and agent each get some fixed proportion of total output. • Since agent gets only a fraction of output he/she will equalize this fraction of marginal product (MP) to the marginal cost (MC). • Leads to an inefficient level of effort (output). • Introducing risk aversion of actors leads to optimum output since both (principal and agent) bear risk. Law and Economics

21. 12. Conclusions • Results of ‘simple’ economic models may change if one adds: • asymmetry of information; • risk (uncertainty) considerations (risk neutral, risk averse, or risk loving); • behavioural insights (how are decisions actually made?). • If one wants to arrive at recommendations for the concrete design of contracts (more) advanced economic analysis may be required. Law and Economics