Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2009 Lecture 14

Logistics • See Chao if you’re missing midterm or HW1 • HW2 due next Tuesday (11 a.m. sharp) • Second midterm next Thursday (Nov 5)

Last Thursday: paradox of compensation Expectation damages include benefit from reliance investments Expectation damages exclude benefit from reliance investments • Efficient breach • Efficient investment in performance • Over-reliance • Inefficient breach • Underinvestment in performance • Efficient reliance

We already saw one possible solution • Have expectation damages include benefit from reliance… • …but only up to the efficient level of reliance, not beyond • That is, have damages reward efficient reliance investments, but not overreliance • Promisee has no incentive to over-rely  efficient reliance • Promisor still bears full cost of breach  efficient performance • (Requires court to calculate efficient level of reliance after the fact)

Another clever (but unrealistic) solution • The problem: • Damages promisor pays need to include gain from reliance if we want to get efficient performance • Damages promisee receives need to exclude gain from reliance if we want to get efficient reliance • So… • Make damages promisor pays different from damages promisee receives!

“Anti-insurance” • You (promisee) and I (promisor) offer Bob this deal: • If you rely and I breach, • I pay Bob value of promise with reliance (airplane plus hangar) • Bob pays you value of promise without reliance (airplane alone) • Bob keeps the difference • You receive damages without benefit from reliance; I pay damages with benefit from reliance

“Anti-insurance” • You (promisee) and I (promisor) offer Bob this deal: • If you rely and I breach, • I pay Bob value of promise with reliance (airplane plus hangar) • Bob pays you value of promise without reliance (airplane alone) • Bob keeps the difference • You receive damages without benefit from reliance;I pay damages with benefit from reliance • Offer the deal to two people, make them pay up front for it

Reminder: what do courts actually do? • Foreseeable reliance • Include benefits reliance that promisor could have reasonably anticipated

Timing of breach

Timing of breach • You agree to sell me 10 tons of corn in June for $5/bushel • Breach in June • Damages might be difference between $5/bushel and spot price • Breach in January (“renounce/repudiate”) • Damages might be difference between $5 and price of June corn at time you breach

Repeatedinteractions

Repeated games

Repeated games Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (0, 200) • Suppose we’ll play the game over and over • After each game, 10% chance relationship ends, 90% chance we play at least once more…

Repeated games • Suppose you’ve chosen to trust me • Keep all the money: I get $200 today, nothing ever again • Share profits: I get $50 today, $50 tomorrow, $50 day after… • Value of relationship = • Since this is more than $200, we can get cooperation

Repeated games and reputation • Diamond dealers in New York (Friedman) “…people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one” “Parties to a contract agree in advance to arbitration;if… one of them refuses to accept the arbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted.”

Repeated games and reputation • The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions • The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts • Law assigns legal duties to certain long-term relationships • Bank has fiduciary duty to depositors • McDonalds franchisee has certain duties to franchisor

Repeated games and the endgame problem • Suppose we’ll play agency game 60 times • $50 x 60 = $3,000 > $200, so cooperation seems like no problem • But… • In game #60, reputation has no value to me • Last time we’re going to interact • So I have no reason not to keep all the money • So you have no reason to trust me • But if we weren’t going to cooperate in game #60, then in game #59…

Repeated games and the endgame problem • Endgame problem: once there’s a definite end to our relationship, no reason to trust each other • Example: collapse of communism in late 1980s • Communism believed to be much less efficient than capitalism • But fall of communism led to decrease in growth • Under communism, lots of production relied on gray market • Transactions weren’t protected by law, so they relied on long-term relationships • Fall of communism upset these relationships

Couple otherodds and ends

Efficient bearer of risk • Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost • How do we know who this is? Friedman offers several bases for this decision… • Spreading losses across many transactions • Moral hazard: who is in better position to influence outcome?

Efficient bearer of risk • Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost • How do we know who this is? Friedman offers several bases for this decision… • Spreading losses across many transactions • Moral hazard: who is in better position to influence outcome? • Adverse selection: who is more aware of risk, even if he can’t do anything about it? • “…The party with control over some part of the production process is in a better position both to prevent losses and to predict them. It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”

Hadley v Baxendale • Suppose… • 80% of millers are low-damage – suffer $100 in losses from delay • 20% of millers are high-damage – suffer $150 in losses from delay • Shipper liable for actual damages • Average miller would suffer $110 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

One other bit I like from Friedman

That’s it for contract law • Purposes for contract law: • Encourage cooperation • Encourage efficient disclosure of information • Secure optimal commitment to performance • Secure efficient reliance • Provide efficient default rules and regulations • Foster enduring relationships • Thursday, we begin tort law • Don’t forget, HW2 due in a week End of material on second midterm

Econ 522 Economics of Law