Economics of Contract Law: Promises, Breach, and Optimal Reliance

1. Econ 522Economics of Law Dan Quint Spring 2011 Lecture 11

2. Logistics • Midterm Wednesday • Remaining office hours this week • Me: tomorrow, 9:30-11:30 and 2-4 • Fran: Wednesday, 10:50-12:50

3. Contract law: the story so far • Contract = legally binding promise • Allow for cooperation/trade when transactions aren’t instantaneous • First purpose of contract law: enable cooperation • What promises should be enforced? • Bargain theory: those given as part of a bargain • Three elements: offer, acceptance, consideration • Efficiency: any promise both promisor and promisee wanted to be enforceable • Information • Asymmetric/private info can prevent trade; contract law can help • Second purpose: encourage efficient disclosure of information

4. Contract law: the story so far • May become efficient/necessary to break a promise • When should a contract be breached? • Breach of contract is efficient when cost to perform > benefit of performance to promisee • Breach is in promisor’s interest when cost to perform > promisor’s liability from breach • Expectation damages: liability from breach = benefit to promisee • Leads to breach exactly when it’s efficient • Think of this as “designing the law to internalize an externality” • Third purpose of contract law: obtain optimal commitment to performance

5. Reliance

6. Reliance • You expect an airplane to arrive in spring – you might… • Sign up for flying lessons • Build yourself a hangar • Buy a helmet and goggles • Reliance – investments which depend on performance • Reliance increases the value of performance to promisee • Reliance increases the social cost of breach • The fourth purpose of contract law is to secure optimal reliance

7. When is reliance efficient? • When social benefit of reliance > social cost of reliance • Social benefit is increased benefit to promisee • (Value of airplane + hangar) – (Value of airplane without hangar) • Value is only realized if the promise is performed • Social cost is cost borne by promisee • Cost occurs whether or not promise is performed • Reliance is efficient if Increase in value of performance Probability of performance Cost ofinvestment X >

8. How should reliance figure into damages? • We know expectation damages lead to efficient breach • Expectation damages = expected benefit from performance • If reliance increases anticipated benefit, does it increase expectation damages in event of breach? • Can we design damages to also get efficient reliance?

9. Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 Reliance and damages:example • You’re buying an airplane from me • Price is $350,000, to be paid on delivery • Airplane alone gives you benefit of $500,000 • Building a hangar costs $75,000 • Airplane with hangar gives you benefit of $600,000 • Without hangar, expectation damages = $150,000 • If you build a hangar and I fail to deliver plane, do I owe… • $150,000? (Value of original promise) • $250,000? (Value of performance after your investment) • $225,000? (Value of original promise, plus reimburse you for investment you made) • Some other amount?

10. Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 To get efficient breach… • The only way to guarantee efficient breach is if damages included the added benefit from reliance • Once you’ve made investment, you anticipate benefit of $250,000 from performance • If damages are anything less than that, I’ll breach too often • (If damages exclude the added benefit, then I’m back to imposing an externality when I choose to breach the contract) • So what happens to the incentive for reliance investments if damages will increase to include this added benefit?

11. Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 If exp damages includebenefit from reliance… • If you don’t build hangar, your payoff will be… • $150,000 if I deliver the plane ($500,000 – $350,000) • $150,000 if I breach and pay expectation damages • If you build hangar, your payoff will be… • $175,000 if I deliver the plane ($600,000 – $350,000 – $75,000) • $175,000 if I breach and pay (higher) expectation damages • So if expectation damages include the increased value of performance due to reliance investments… • You’ll invest whenever (increase in benefit) > (cost) • In this case, you’ll invest (because $100,000 > $75,000)

12. Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000 If exp damages includebenefit from reliance… • If expectation damages include increased value of performance, you’ll invest for sure • Is this efficient? • Reliance is efficient if (increase in benefit) X (probability of performance) > (cost) $100,000 X (probability of performance) > $75,000 • Only efficient if probability of performance > ¾ • If probability of performance < ¾, reliance is inefficient, but happens anyway • Overreliance!

13. Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600Öx Better example:continuous investment 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

14. Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600Öx Three questions • Let p be probability of breach • 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?

15. Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600Öx Three questions • Let p be probability of breach • 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

16. Overreliance • If reliance investments increase the damages you’ll receive in the event of breach, you’ll over-rely • You’ll rely if • Efficient to rely if • So if damages increase when you make reliance investments, we’re sure to get overreliance! • (Your investment imposes an externality on me) Increasein benefit Prob. of perform. Increasein damages Prob. of breach Cost ofinvestment X + X > Increasein benefit Prob. of perform. Cost ofinvestment X >

17. Reliance and breach • Just showed: if damages include added benefit from reliance, promisee will invest more than efficient amount • But if damages exclude added benefit… • Then promisor’s liability < promisee’s benefit from performance • Which means: promisor will breach more often than efficient • “Paradox of compensation” • Single “price” (damages owed) sets multiple incentives… • …impossible to set them all efficiently!

18. 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

19. 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

20. 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

21. Default Rules

22. Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps

23. Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps • Writing something into a contract vs leaving a gap • Allocating a loss (ex post) • Versus allocating a risk (ex ante), before it becomes a loss

24. What should default rules be? • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue • This will be whatever rule is efficient

25. What should default rules be? • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue • This will be whatever rule is efficient • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules • Do this by imputing the terms the parties would have chosen if they had addressed this contingency

26. Default rules • Don’t want ambiguity in the law • So default rule can’t vary with every case • Majoritarian default rule: the terms that most parties would have agreed to • In cases where this rule is not efficient, parties can still override it in the contract • Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate

27. Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it?

28. Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it? • Construction company is efficient bearer of this risk • So efficient contract would allocate this risk to construction company • Should prices be adjusted to compensate?

29. Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it? • Construction company is efficient bearer of this risk • So efficient contract would allocate this risk to construction company • Should prices be adjusted to compensate?

30. Default rules • So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases • Most contracts can leave this gap, save on transaction costs • In cases where this rule is inefficient, parties can contract around it

31. Default rules: a different view • Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules” • Sometimes better to make default rule something the parties would not have wanted • To give incentive to address an issue rather than leave a gap • Or to give one party incentive to disclose information • “Penalty default”

32. Penalty defaults: Hadley v Baxendale • Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk • If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent • So Hadley might hide this information, which is inefficient • Ayres and Gertner: Ruling in Hadley was a good one, not because it was efficient, but because it was inefficient… • …but in a way that created incentive for disclosing information

33. Penalty defaults: other examples • Real estate brokers and “earnest money” • Broker knows more about real estate law • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this

34. Penalty defaults: other examples • Real estate brokers and “earnest money” • Broker knows more about real estate law • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this • Courts will impute missing price of a good, but not quantity • Forces parties to explicitly contract on quantity, rather than leave it for court to decide

35. When to use penalty defaults? • Look at why the parties left a gap in contract • Because of transaction costs  use efficient rule • For strategic reasons  penalty default may be more efficient • Similar logic in a Supreme Court dissent by Justice Scalia • Congress passed a RICO law without statute of limitations • Majority decided on 4 years – what they thought legislature would have chosen • Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…” • “Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.”

36. Regulations(don’t expect to get to this)

37. Default rules versus regulations • Default rules can be contracted around • Some rules cannot – immutable rules, or mandatory rules, or regulations • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations. • Coase: if individuals are rational and there are no transaction costs, private negotiations lead to efficiency • So additional regulations can only make things worse • But when people are not rational, or when there are transaction costs/market failures, regulations may help

38. One example of a regulation/immutable rule: derogation of public policy • Derogate, verb. detract from; curtail application of (a law) • Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable • Contracts which could only be performed by breaking a law • Contracts whose effect is to circumvent a law “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr” A(other factory) B(union) C(ownership)

39. One example of a regulation/immutable rule: derogation of public policy • Derogate, verb. detract from; curtail application of (a law) • Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable • Contracts which could only be performed by breaking a law • Contracts whose effect is to circumvent a law “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr” A(other factory) B(union) C(ownership)

40. Derogation of public policy • In general: contracts which can only be performed by breaking the law are not enforceable • But… • “A married man may be liable for inducing a woman to rely on his promise of marriage, even though the law prohibits him from marrying without first obtaining a divorce.” • “A company that fails to supply a good as promised may be liable even though selling a good with the promised design violates a government safety regulation.” • “A company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation.” • “A promisor should be liable for breach if he knew that the promise was illegal”

41. Expectation damages: default rule or immutable rule? • Peevyhouse v Garland Coal and Mining Co(OK Supreme Court, 1962) • Garland contracted to strip-mine coal on Peevyhouse’s farm • Contract specified Garland would restore property to original condition; Garland did not • Restoration would have cost $29,000… • …but “diminution in value” of farm only $300 • Original jury awarded $5,000 in damages, both parties appealed • Oklahoma Supreme Court reduced damages to $300

42. Expectation damages: default rule or immutable rule? • Seems like classic case of efficient breach • Performing last part of contract would cost $29,000 • Benefit to Peevyhouses would be $300 • Efficient to breach and pay expectation damages, which is what happened • But… • Most coal mining contracts: standard per-acre diminution payment • Peevyhouses refused to sign contract unless it specifically promised the restorative work • Dissent: Peevyhouses entitled to “specific performance”

43. We can also think about Peevyhouse in terms of penalty defaults • Which works better in this case: • Default rule allowing Garland to breach and pay diminution fee? • Default rule forcing Garland to perform restorative work? • Ayres and Gertner: default rule should “penalize” the better-informed party • Garland routinely signed contracts like these • Peevyhouses were doing this for the first time • Default rule allows Garland to pay diminution fee: they have no reason to bring it up, Peevyhouses don’t know • Default rule forces Garland to do cleanup: if that’s inefficient, they could bring it up during negotiations • In this case, specific performance would work as a penalty default