An economic theory of contract

1. Contract LawAn Economic Theory of ContractsHow to create commitment and the optimal amount of commitment Contract_B

2. An economic theory of contract Economic, or efficiency, principle of contract law: ‘economic efficiency dictates enforcing a promise if both the promisee and promisor wanted the promise enforced at the time it was made’ Contract_B

3. Cooperation and commitment Many day-to day transactions occur instantaneously - simultaneous, or instantaneous, exchange generally does not involve a promise Promises arise out of ‘deferred exchanges’ - time between the making of the promise and the ‘performance’ (future exchange) gives rise to risk that the promise will not be fulfilled From the buyer’s perspective: wants the risk of failure to fulfil to be low – otherwise would except the promise only at a discounted price From the seller’s perspective: wants to be able to make credible promises - this will make a sale more likely and avoid discounting of the transaction price Contract_B

4. Legal enforceability lowers the risk of failed promises This facilitates a much larger set of transactions – transactions that require ‘cooperation’ and ‘credible commitment’ Both the buyer and seller want the promise to be enforceable – both want the deal to go through at the time it is made Consider a country in which courts are unable to enforce contracts (contract law does exist) or unwilling to enforce contracts (the authorities are corrupt) – could we expect significant investment, or trades based on promises of any sort, to occur is such economies? Contract_B

5. Remember, with respect to efficiency ‘voluntary exchange is good’ Trading implies that assets, goods, services, etc. are being redistributed to the individual who values them most. But many such trades takes place over time. These trades require a promise. Good contract law and its enforcement greatly increase the set of Pareto improving trades that are possible. Contract_B

6. Agency games - principle-agent games Consider the following example: Player A is a potential investor with $1 to invest - if he invests with player B and player B ‘cooperates’ player A will earn $0.50 on his investment (and get back his original $1 investment) and player B will also earn $0.50 - if player A invests but player B decides to ‘appropriate’ player A's investment (not fulfil the contract) then player A will lose his $1 investment and player B will gain the $1 - if player A decides not to invest then neither player gains or loses anything Contract_B

7. The above is set out in the following table, with player A's return being the first entry in each set. Payoff Table Player B – (agent, promisor) Cooperate Appropriate Player A Invest ($0.50, $0.50) (-$1, $1) (principal, promisee) Don’t invest ($0, $0) ($0, $0) Socially optimal (efficient) outcome - invest/cooperate But what will the principal and agent actually do? Contract_B

8. Extensive form of the game – decision tree From player B's perspective Player B (agent) strategypayoff Cooperate $0.50 Invests Appropriate $1 If player A (principal) Cooperate $0 Doesn’t invest Appropriate $0 Conclusion: Player B's ‘best’ (dominant) strategy - appropriate Contract_B

9. From player A's perspective Player A (principal) strategypayoff Invest $0.50 Cooperates Don’t invest $0 If player B (agent) Appropriates Invest -$1(dominant strategy) Don’t invest $0 Player A knows that player B’s dominant strategy is to appropriate (in this type of game player A knows player B’s payoff matrix – at least generally) – Player A’s ‘best reply’ - don’t invest (no deal) Contract_B

10. The above could be: a client and a financial agent a worker and an employer an employer and a worker a customer and a store etc. The point is, without enforceability no ‘investment’ of money, time, goods, etc. will be made If there is no way to ensure that the promise will be kept (cooperation) – no Pareto improving trade is possible – no social surplus Problem: there is risk of a promise not being kept and this risk precludes the trade Contract_B

11. How the law ensures cooperation - an ‘enforceable’ promise Consider this rule: If player A invests and player B appropriates (breaches the contract), then player B gets the $1 invested by player A, but player A receives compensatory damages from player B - player B must pay player A a sum of money equal to what player A would have had player B ‘performed’ the contract Expectation damages are equal to the $1 investment plus the $0.50 that player a expected to earn on the investment Under this rule of expectation damages, player A gets the same return whether or not player B breaches Contract_B

12. The payoff table under expectation damages Payoff Table Player B – (agent, promisor) Cooperate Appropriate Player A Invest ($0.50, $0.50) ($0.50, -$0.50) (principal, promisee) Don’t invest ($0, $0) ($0, $0) Player B’s dominant strategy - cooperate Player A’s best response - invest Game solution – socially optimal outcome – invest/cooperate Contract_B

13. The deal goes through, the trade is made – both agents gain - a Pareto improvement occurs (efficient solution) Conclusion: contract law should facilitate cooperation by converting games with non-cooperative (inefficient) outcomes into games with cooperative (efficient) outcomes In the above example the threat of expectation damages being enforced by the court was sufficient to accomplish this result Contract_B

14. Game theorist would say: Making a contract enforceable results in ‘commitment’ of the promisor It forecloses the opportunity to appropriate The commitment is ‘credible’ if the promisee knows that the promisor’s dominant strategy is to cooperate Enforceable contracts allow the promisor to make a ‘credible commitment’ which induces the promisee to enter into the contract - a cooperative (efficient) solution Contract_B

15. Credible Commitment? Julius Caesar burning the bridges behind the Roman Legions Marriage was for much of western history a subject of contract law – men and women (or their families) entered into marriage ‘contracts’, dowries, exchanging rings, etc. are all part of the history of formal contract – divorce was viewed a the breaking of a ‘contract’ How did prospective spouses show credible commitment? They agreed to the marriage contract. What about modern times (last 50 years or so)? How do prospective spouses show commitment? Young men spend way too much time shopping at malls and young women spend way too much time watching football (please excuse the sexism) What is the role of an engagement ring in marriage? Contract_B

16. What is the appropriate remedy for breach of contract? – What remedy will ensure optimal commitment (performance)? Performance – fulfilling the contract The remedy is the price paid by the promisor for breaching the contract (the price of non-performance) The higher the price of breaching, the stronger is the promisor’s commitment to perform The law could make this price extremely low (zero) or extremely high (death), or anything in between Contract_B

17. However, efficiency might require that a promises be broken (contract breached – not performed) We need a remedy rule that will be flexible enough to allow contracts that ‘become’ inefficient contracts to be broken Become? Recall that contracts are made over time and over time the world changes – a contract that made economic sense at time t might not make economic sense at time t+1 Within the economic theory of contracts, the second major role for contract law is to ensure an ‘optimum’ commitment to fulfil the contract – optimal performance Optimum is defined in terms of efficiency Contract_B

18. Perfect expectations damages At times the promisor’s only motivation to perform is the remedy for non-performance (We will see that in many commercial settings this is an extremely short-sighted attitude) When is this likely to be true: travelling carnivals, tourist shops, some real estate transactions (one time transactions - any situation in which reputation does not matter) Contract_B

19. If liability for damages is the promisor’s only concern, then the following private maximizing rule holds for the promisor: This is how the promisor views the situation if promisor’s cost of performing > promisor’s liability for breaching, then the promisor will breach if promisor’s cost of performing < promisor’s liability for breaching, then the promisor will perform Contract_B

20. What is the efficient (socially optimal) rule for determining when a promisor should be allowed to breach? Efficiency requires that the sum of the payoffs to the promisor and promisee should be maximized, which leads to the following socially efficient rule: This is how society views the situation if promisor’s cost of performing > promisee’s benefit from performing, then it is efficient to breach if promisor’s cost of performing < promisee’s benefit from performing, then it is efficient to perform Contract_B

21. Wait a minute! Didn’t the promisor and promisee make a deal. If the promisor’s cost of performing is greater than the promisee’s benefit from performing, then why did the promisor make the promise in the first place? Because, the deal made economic sense at the time that it was made but then the world changed and it no longer makes economic sense What is happening here is that the promisor’s cost of performing must have gone up after the promise was made but before it was fulfilled. Contract_B

22. The cost of performing might increase or decrease subsequent to the promise being made From society’s perspective (in terms of efficiency) the state of the world might change such that we would no longer want the promisor to perform – if the cost of the resources required to fulfil the promise exceed the benefit that the promisee will gain – the promise is no longer a Pareto Improving trade. Contract_B

23. Let’s re-write the efficiency rule to be more precise (introducing time explicitly): Again, this is how society views the situation if promisor’s cost of performing at the time of performing > promisee’s benefit from performing, then it is efficient to breach if promisor’s cost of performing at the time of performing < promisee’s benefit from performing, then it is efficient to perform Now what if the remedy for breach is always perfect expectation damages - which are equal to what the promisee expected to get when the contract was made? Contract_B

24. We can re-write the efficiency rule as (introducing expectation damages): Again, from society’s perspective if promisor’s cost of performing at the time of performing > expectation damages, then it is efficient to breach if promisor’s cost of performing at the time of performing < expectation damages, then it is efficient to perform But this is exactly how the promisor views the situation: - then the promisor will perform when performance is the most efficient outcome - the promisor will breach when breaching is the most efficient outcome Contract_B

25. Conclusion: Expectation damages which are equal to the foregone benefits of the promisee are efficient damages They result in an ‘efficient commitment’ or ‘optimal commitment’ to perform But what about litigation costs or third party costs – make the promisor liable for all litigation and third party costs? Contract_B

26. Optimal performance: an example Recall our original example - when the contract was made the payoff table looked like this: Payoff Table – no performance costs Player B – (agent, promisor) Cooperate Appropriate Player A Invest ($0.50, $0.50) ($0.50, -$0.50) (principal, promisee) Don’t invest ($0, $0) ($0, $0) Socially optimal (efficient) outcome - invest/cooperate Contract_B

27. Now what if player B faces a performance cost of $1.50. (Perhaps the price of oil increased and player B’s costs went up) The payoff table would change as follows: Payoff Table – with $1.50 in performance costs Player B – (agent, promisor) Cooperate Appropriate Player A Invest ($0.50, -$1.00) ($0.50, -$0.50) (principal, promisee) Don’t invest ($0, $0) ($0, $0) If cooperation occurs then player A receives $0.50 in profits (plus his original $1.00), while player B will receive her $0.50 in profits but will now face an additional $1.50 in performance costs, yielding a net return of -$1.00 for player B. What is the socially optimal (efficient) outcome? Contract_B

28. Consider the above example in the presence of a contract with perfect expectation damages: At the time the At the time the contract contract was made must be performed Perform Breach Perform Breach B’s B’s Payoff $0.50 -$0.50 Payoff -$1.00 -$0.50 A’s A’s Payoff $0.50 $0.50 Payoff $0.50 $0.50 Player B will breach if the performance costs exceed the expectation damages and player A does not care because he is guaranteed an amount equal to whatever it was that he was promised Contract_B

29. Note, that had the parties known of the performance costs, they would never have entered into the contract Also note that player B must bear the entire amount of the unexpected performance costs This can be viewed as the costs associated with the inherent uncertainty of future states of the world (later on in the chapter we will see the conditions under which both players might be expected to pay some of the unaccounted for performance costs) What if the performance costs which arose after that contract was made were equal to $0.25. How would the above payoff matrix change and why? What would player B do and why? Contract_B

30. Conclusion: the existence of a contract with perfect expectation damages facilitates the efficient breach of contract when unaccounted for performance costs arise ex post We can state that perfect expectation damages creates an ‘efficient level of commitment’ All parties realize that the promisor will perform when it is efficient to do so and will not perform when performance would be inefficient – BUT this does not present a risk to the promisee Contract_B

31. Although in principle perfect expectation damages are efficient, they can be difficult to determine as a practical matter It might be difficult for the court to determine what the promisee originally expected to gain from the contract and the extent to which the promisor fell short of fulfilling the original promise. If the parties included a remedy for breach in the original contract, the optimum remedy, from their joint perspective, would be a perfect expectation damages remedy. Contract_B

32. EXAMPLE - Society might benefit from someone breaching a contract – see note package A-I Steel Mill has a contract with Auto Company to provide it with $1,000,000 of steel each month. One month Aircraft Manufacturer contacts the Steel Mill and offers to buy the same steel, previously contracted for sale to Auto Company, but for $1,250,000. Contract_B

33. Steel Mill decides to break its contract with Auto Company and sell the steel to Aircraft Manufacturer. Auto Company claims that Steel Mill’s failure to deliver the steel as promised has cost it $150,000 in profits (added costs of shipping from a warehouse in another part of the country). Should the Steel Mill be allowed to break such a contract for the stated reason given? Is it efficient to do so? YES - the steel will produced something of greater value in the aircraft industry than in the automotive industry Contract_B

34. How should the Auto Company be compensated? Under expectation damages it should be awarded its lost profits - $150,000 Note that Steel Mill gets to keep $100,000 in increased revenue even after compensating Auto Company ($250,000 - $150,000) This $100,000 is a measure of the net increase in value to society of transferring the steel from auto production to aircraft production Contract_B

35. What should happen to the Aircraft Manufacture? Nothing. What would happen if there was an outright ban on breaking contracts? Then, as the state of the universe evolved in unexpected ways economic agents would be frozen in ‘inefficient’ contract arrangements which did not foresee the changes which have occurred – the universe is very dynamic – it is impossible to foresee all events The law must allow for the Pareto efficient reallocation of steel inputs, even if this requires a contract to be breached What if the failure to deliver the steel to Auto Company caused it to lose $300,000 in profits? Then Steel Mill would not break its contract because it would not have sufficient extra profits to compensate Auto Company. Again this is the ‘efficient’ result. Contract_B

36. What about other parties affected by the breach of contract? Presumably other economic agents who were not parties to the contract were affected? Steel does not get delivered – plant shuts down – workers are laid off. What recourse do the workers have? What recourse do other affected firms have? Contract_B

37. Next section We will consider reliance If a promises is made in a contract, to what extent should the promisee be allowed to rely on the promise? Can the promisee extend the commitment of the promisor? Contract_B