Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2010 Lecture 9

2. Plan • Monday – finished property law • Handout – two cool examples • First midterm (next Wed) covers through end of property law • Next: contract law

3. Why do we need contracts? • Some transactions don’t occur all at once • I’m flying to Washington DC over Spring Break… • …or I hire someone to paint my house…

4. Why do we need contracts? • Some transactions don’t occur all at once • I’m flying to Washington DC over Spring Break… • …or I hire someone to paint my house… • …or you can get $10 for a purple poker chip, but don’t have any cash on you right now to buy it from someone with a lower number • A contract is a promise… • …which enables trade when transactions aren’t concluded immediately

5. Example: the agency (trust) game Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (0, 200) • Subgame perfect equilibrium: I’ll keep all the money; so you don’t trust me • Inefficient outcome (100 < 200) • And we’re both worse off

6. (One solution: reputation)

7. Another solution: legally binding promises Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (125, 25) • Now we get cooperation (and efficiency) • Purpose of contract law: to allow trade in situations where this requires credible promises

8. So… what types of promises should be enforced by the law? • “The rich uncle of a struggling college student learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world.” • “One neighbor offers to sell a used car to another for $1000. The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back yard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac.” • “A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,” mails $25 and receives in the mail two wooden blocks with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and pay $500 in punitive damages.”

9. The Bargain Theoryof Contracts

10. The bargain theory of contracts • Developed in the late 1800s/early 1900s • A promise should be enforced if it was given as part of a bargain, otherwise it should not • Bargains were taken to have three elements • Offer • Acceptance • Consideration

11. What is consideration? • Promisor: person who gives a promise • Promisee: person who receives it • In a bargain, both sides must give up something • reciprocal inducement • Consideration is what the promisee gives to the promisor, in exchange for the promise • Under the bargain theory, a contract becomes enforceable once consideration is given

12. What is consideration? • Promisor: person who gives a promise • Promisee: person who receives it • In a bargain, both sides must give up something • reciprocal inducement • Consideration is what the promisee gives to the promisor, in exchange for the promise • Under the bargain theory, a contract becomes enforceable once consideration is given

13. The bargain theory does not distinguish between fair and unfair bargains • Hamer v Sidway (NY Appeals Ct, 1891) • Uncle offered nephew $5,000 to give up drinking and smoking until his 21st birthday, then refused to pay “The promisee [previously] used tobacco, occasionally drank liquor, and he had a legal right to do so. That right he abandoned for a period of years upon the strength of the promise… We need not speculate on the effort which may have been required to give up the use of these stimulants. It is sufficient that he restricted his lawful freedom of action within certain prescribed limits upon the faith of his uncle’s agreement, and now, having fully performed the conditions imposed, it is of no moment whether such performance actually proved a benefit to the promisor, and the court will not inquire into it.”

14. Under the bargain theory, what is the remedy? • Expectation damages • the amount of benefit the promisee could reasonably expect from performance of the promise • meant to make the promisee as well of as he would have been, had the promise been fulfilled

15. Problems with the bargain theory • Not that accurate a description of what modern courts actually do • Not always efficient • Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable

16. Problems with the bargain theory • Not that accurate a description of what modern courts actually do • Not always efficient • Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable • Does enforce certain promises that maybe should not be enforced

17. What does efficiency say about what promises should be enforced?

18. What promises should be enforced? • In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was made • different from wanting it to actually be enforced

19. What promises should be enforced? • In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was made • different from wanting it to actually be enforced • The first purpose of contract law is to enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions • or, enable people to convert games with inefficient equilibria into games with efficient equilibria

20. What promises should be enforced? • In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was made • different from wanting it to actually be enforced • The first purpose of contract law is to enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions • or, enable people to convert games with inefficient equilibria into games with efficient equilibria

21. So now we know… • What promises should be enforceable? • For efficiency: enforce those which both promisor and promisee wanted to be enforceable when they were made • One purpose of contract law • Enable cooperation by changing a game to have a cooperative solution • Contract law can serve a number of other purposes as well

22. Information • Private/asymmetric information can hinder trade • Car example (George Akerloff, “The Market for Lemons”)

23. Information • Private/asymmetric information can hinder trade • Car example (George Akerloff, “The Market for Lemons”)

24. Information • Private/asymmetric information can hinder trade • Car example (George Akerloff, “The Market for Lemons”) • Contract law could help • You could offer me a legally binding warranty • Or, contract law could impose on you an obligation to tell me what you know about the condition of the car • Forcing you to share information is efficient, since it makes us more likely to trade • The second purpose of contract law is to encourage the efficient disclosure of information within the contractual relationship.