Contract design

1
Contract design

• Opportunistic breach happens because
• At some point in the process, one side
• Is better off stopping, keeping what it has
• Than going on to completion
• One way to prevent it is to avoid that by
• Progress payments instead of
• Paying in advance--incentive to take the money
  and run
• Paying on completion--incentive for buyer to
  renegotiate at that point
• Design a schedule so it never pays either party
  to breach
• Problem We cant perfectly predict the pattern
  of costs
• One solution Increase the net cost of breach
• By creating hostages--damage to one party
• Not matched by gain to the other
• For details, see my China to Cyberspace

2
Reputation

• A lot of contract enforcement is
• Via reputational penalties
• Repeat dealings with one customer
• Or prospect of dealings with others he knows
• This requires two conditions
• Cheating once doesnt gain enough to make it
  worth losing future opportunities
• Interested third parties can find out you cheated
  at low cost
• If they cannot, victim doesnt report you, since
  third parties wont know which one was at fault
• Ways of creating those conditions
• Post a bond for the first
• Use arbitration to lower information cost to
  third parties
• They dont have to know the facts of the dispute,
  just
• That the arbitrator you agreed to says you are
  wrong

3
Liability rules for Breach

• Expectation damages
• Make the other party as well off as if no breach
• Correct incentive to breach, but
• Too much incentive to rely, since
• If you breach, my reliance expenditure is wasted
• But you have to compensate me for it
• And I am the one deciding whether to make it.
• Reliance damages
• Make the other party as well off as if no
  contract
• Too much incentive to breach
• Since breaching party does not have to compensate
• The other party for its lost profits
• Too much incentive to rely, since
• If you breach, my reliance expenditure is wasted
• But you have to compensate me for it
• And I am the one deciding whether to make it.

4
Property Rules for Breach

• Liquidated Damages
• Could make the other party as well off as if no
  breach
• If the amount can be estimated in advance
• In which case there is
• Correct incentive to breach
• Correct incentive to rely, since
• My compensation doesnt depend on whether I
  relied
• So any wasted reliance reduces my net
• Specific performance
• Can still get efficient breach via bargaining
• Coaseian solution
• No liability. Ditto for only efficient breach.

5
PS Speculation and Fraud

• Is it fraud if I
• Sign a contract when I know things
• That you dont know and
• If you knew, you wouldnt sign?
• Eliminates the usual argument that
• Contracts should be enforced because they benefit
  both parties
• Looks like rent seeking, but
• Lets me gain by generating valuable information
• Speculation prevents famine
• But the speculators gain does not measure the
  social benefit
• So we might get too much or too little
  speculation
• What we want are not incentives but the right
  incentives.

6
Family Law

• Why is marriage?
• Why has marriage become less common, less stable?
• Why have out of wedlock births greatly increased?
• 19th century seduction law
• Should we legalize
• the baby market?
• Prostitution?
• Polygamy?
• The future of marriage and reproduction

7
Why is marriage?

• Family as a unit to exploit division of labor
  makes sense, but
• Why traditionally as a lifetime contract?
• Why do long term contracts exist in general?
• Firm specific sunk costs create a bilateral
  monopoly
• With opportunities for bargaining cost etc.
• So specify the terms in advance
• Marriage as an example
• Relationship specific sunk costs in
• Specializing in being Xs spouse, and
• Shared children
• Permanent contract as one solution.
• Still room for bargaining within marriage
• Partly controlled by traditional roles
• Penalties for breach another, but
• Hard to know who is breaching, since
• Quality of performance hard to observe.
• Al-Tanukhi story.

8
What has changed?

• Divorce more common because such sunk costs
  reduced by
• Lower infant mortality and
• Division of labor taking much household
  production out of the house.
• But divorce on demand raises a new problem of
  opportunistic breach, because
• Women perform early, men late, aka
• Women depreciate faster than men on the marriage
  market
• So if on demand without penalty, men can engage
  in opportunistic breach
• And women respond by adjusting the timing of
  performance
• Later child-bearing
• Less specialization in household production
• Both of which have happened
• Analogous to my house building story in the
  previous chapter.

9
Out of Wedlock Births

• Have increased enormously over past 40 years
• Not only in the U.S.
• And not only among the poor
• Why?
• Welfare? Perhaps.
• But that does not explain the increase among the
  not poor
• Perhaps several simultaneous causes?
• Gender ratio
• More war, less death in childbirth
• Shifts the market against women? But not by very
  much in the U.S.
• Except--in populations where many men are in
  prison
• And, temporarily, in the sixties?
• Men marry women a few years younger, so
• Consider men born in 1945 and women born in 1947
• Rising income?
• Why put up with a husband
• If you can afford to do without one?

10
Akerlof Yellin argument

• Consider a world without birth control or
  abortion
• Men and women both want sex
• Arguably men, at least young men, want it more
• If the cost is the same to both
• But it isn't--because sex and pregnancy are joint
  products
• So most women are unwilling to have sex without
  some guarantee of support for resulting children
• So most men, to get sex, have to offer such a
  guarantee
• Introduce reliable birth control, readily
  available abortion
• Now sex and pregnancy are no longer joint
  products
• So women who don't currently want children but do
  want sex are willing to have it without a
  guarantee of support
• And their competition makes it harder for women
  who do want children to get men to guarantee to
  support them as a condition of having sex
• So some of them choose to have children without
  husbands
• Women who don't want children are better off
• Women who want children are worse off
• Men are better off--including married men! (why?)
• Children are

11
Glittering Bonds

• The puzzle Why the custom of engagement rings
• The problem
• How can a woman have sex before marriage without
• Risking being seduced and abandoned?
• Which badly hurts her value on the marriage
  market
• The legal solution
• The tort action for breach of promise
• Which was gradually abandoned by U.S. courts
• The private solution
• The man gives the woman a valuable ring when they
  get engaged
• Sex after engagement is permitted
• If the man jilts her, the ring forfeits. A
  performance bond
• The custom declined as
• Increasing acceptance of non-marital sex
• And better contraception
• Reduced the risk

12
Byways of seduction law

• 19th c. English and American law
• Adult daughter is seduced and pregnant
• Father sues, as
• Master collecting damages for injury to a servant
• Even if all she does is act as hostess at tea
  once a week
• The legal explanation
• Daughter cannot sue, because fornication is
  illegal
• And she participated
• So use the fiction of master-servant instead
• My explanation
• Seduction might be a way of evading paternal
  control over whom she married
• If she controlled the legal action, makes tactic
  work better
• If father controls it, makes it work worse

13
Law, sex and markets

• The baby market
• Why is it illegal for adoptive parents to pay the
  mother?
• She can transfer parental rights
• Why cant she sell them?
• Why the strong feeling against it?
• Anyone not share it?
• Can anyone explain it?
• Prostitution
• To prevent competition with marriage?
• Because it commodifies sex?
• So legal as act, illegal as speech???
• More generalized puzzle about attitudes towards
  money
• To varying degrees taboo
• In social interactions.
• Friends might owe me a dinner, but cant pay with
  cash
• We give gift cards when cash would be easier for
  both sides

14
Are babies a good thing?

• Over-population argument, econ version
• Children produce negative externalities
• So people have too many of them
• So we need to limit population increase
• What are the negative externalities?
• Use scarce land, resources?
• As long as those are private property
• Consuming them is a cost, but not an external
  cost
• Babies aren't born with a deed to someone else's
  land clutched in their fists
• Pollute, commit crime, go on welfare, . Go to
  school?
• But there are also positive externalities
• Make new discoveries from which others benefit
• Pay taxes--perhaps to pay for welfare. Or schools
• To make the argument, you need to somehow
  estimate all of these well enough to sign the sum
• This is a general problem with externalities as a
  policy argument
• People only consider those externalities with the
  sign they want
• Externalities from education?

15
Economics of Polygamy

• Terminology
• Polygyny One husband, two or more wives
• Polyandry One wife, two or more husbands
• Polygamy Either of the above
• Currently polygamy is illegal, although
• Low profile polygamy occurs, and
• One could describe the usual pattern as serial
  polygamy
• Suppose you legalize polygyny?
• What is the effect on women?
• What is the effect on men?
• What is the net effect? Efficient or inefficient?
• What about legalizing polyandry?

16
Marriage seen as a market

• Supply, demand and price
• Supply of wivesdemand for husbandsnbr of women
  who want to get married
• Demand for wivessupply of husbands
• Both depend on the "price" of a husband or wife
• Think of the price as implicit in the terms of
  marriage
• Terms favorable to women high price for a wife
• Terms favorable to men high price for a husband
• One transaction, so high price for wife?low price
  for husband
• Could do the analysis either way--doesn't matter
• Market price is where qty supplied qty demanded
• So price of a wife is increased by anything
• That increases demand for wives
• Or reduces supply
• Legalizing polygyny ? Polyandry?

17
Legalizing polygyny

• At the old price, qty of wives demanded qty
  supplied
• What if the price didn't change?
• Men who marry one wife do it on the same terms as
  before
• Men who marry two must offer good enough terms to
  be equivalent to monogamy on the old terms
• But now some men can "buy" two wives, increasing
  demand
• Demand shifts out, supply doesn't change, so
• Price of a wife goes up, meaning
• Men with one wife must offer her better terms
  than before
• Men with two must offer enough better to be
  equivalent to that
• Net effect
• Women are better off, monogamous men are worse
  off
• Polygynous men might be either--two wives, but at
  a higher price
• There is a net gain, since
• Men's loss from higher price balances women's
  gain from higher price
• Additional gain to polygynous men of having two
  wives
• Legalizing polyandry has the same result in the
  other direction

18
Some further points

• This assumes that women own themselves
• So the gain from a higher price goes to them
• In some societies it might go to their fathers
• In the form of higher bride price or lower dowry
• The result would be obvious for cars
• Making it legal for some men to own more than one
  car
• Increases the demand for cars
• Which benefits sellers at the cost of buyers
• But produces a net benefit
• The marriage market has a variety of
  complications
• Different husbands of different value to
  different wives
• And vice versa, so a difficult sorting/search
  problem
• And the problems of enforcing the terms of the
  contract
• And how to take account of costs/benefits to the
  children
• All of which I have been assuming away for
  simplicity

19
Time in Economics

• When I talk about legalizing polygyny
• The argument is put in terms of a sequence in
  time
• Which raises some obvious questions
• What happens to the already married couples?
• Does the wife raise her price by threatening to
  leave?
• But the real comparison is between two
  alternative presents
• The world with polygyny illegal and
• An otherwise identical world with it legal
• This is true of many economic arguments
• We are comparing two alternative arrangements
• But put the comparison in terms of changing from
  one to the other