LAW AND ECONOMICS

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CONTRACTS October 3, 2006
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BILATERAL AGENCY CONTRACTS
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BILATERAL AGENCYCONTRACTS
Bilateral Agency
.
Property Rights Primarily imposed rules with
some scope for contracting within the imposed
framework Horizontal joint or
group rights Vertical many
landlord and tenant cases -
subordinate possession
Contracts Primarily voluntary rules with some
scope for contracting hierarchies Horizontal
equal partners Vertical creating subordinate
agents most common form of contract
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PRINCIPAL AGENCY CONTRACTS
SUPER Principal Its problem is to maximize
social surplus
Principal
promise
payment
AGENT
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• PRINCIPAL AGENCY
• CONTRACTS

• This Principal-Agency exchange model is the
  principal model featured in Cooter's treatment of
  contract law

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PRINCIPAL AGENCY CONTRACTS
Formation Of Contracts
Principal Makes An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
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FORMATION OF CONTRACTS
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FORMATION OF CONTRACTS

• Competent Parties
• Both parties must have the capacity to understand
  the terms of the contract they are entering into,
  and the consequences of the promises they make.

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FORMATION OF CONTRACTS

• For example, animals, minor children, and
  mentally disabled individuals do not have the
  capacity to form every contract
• Any contracts with them will be considered void
  or voidable.

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FORMATION OF CONTRACTS

• Corporations are considered persons under the
  law, and thus competent to engage in contracts.

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FORMATION OF CONTRACTS
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FORMATION OF CONTRACTS

• Proper Subject Matter
• The contract must have a lawful purpose.
• A contract to commit murder in exchange for money
  will not be enforced by the courts.

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FORMATION OF CONTRACTS
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FORMATION OF CONTRACTS

• Need for a written contract?
• A spoken contract is often called an "oral
  contract", not a "verbal contract".
• A verbal contract is simply a contract that uses
  words. Most oral contracts and written contracts
  are verbal contracts.

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FORMATION OF CONTRACTS

• Need for a written contract?
• An informal exchange of promises may be binding
  and legally as valid as a oral or a written
  contract.

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FORMATION OF CONTRACTS

• Statutory Regulation of Contracts
• The Statute of Frauds requires that contracts
  pertaining to land be in writing.
• The Statute of Frauds attempts to prevent false
  allegations of the existence of contracts that
  were never made.

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FORMATION OF CONTRACTS
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FORMATION OF CONTRACTS

• Offer
• Acceptance
• Exchange

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FORMATION OF CONTRACTS

• Offer
• Principal writes the document, but the document
  does not become a contract until the agent signs
  it

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FORMATION OF CONTRACTS

• Offer
• In presenting the written document to the agent
  as the first step for its review the parties are
  following a form of the Prisoners dilemna that
  is sequential and not simultaneous
  

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FORMATION OF CONTRACTS

• Offer
• The classical bargaining theory of contract law
  assigns the legal word offer to the document
• Note What judges say and due involves
  language. What one observes them do and why is
  the domain of economic analysis

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FORMATION OF CONTRACTS

• Offer
• Another way of characterizing the first step,
  taken by the principal is to describe the
  principal as the first mover
• (Cooter and Ulen, Law and Economics, 4th edn,
  Addison-Wesley, Longman, 2004, at p. 196)

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FORMATION OF CONTRACTS

• Offer
• Principal writes the document, with a view to
  selecting several potential agents
  

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FORMATION OF CONTRACTS

• Offer
• In an economic sense, this step follows the
  Stackelberg process of a Principal that maximizes
  the profit or utility of the agent as part of
  its profit or utility maximizing step
  

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FORMATION OF CONTRACTS

• Offer
• Cooter assumes that the Principal-Agency game is
  played as a Stackleberg game
• Before making the first move, the Principal
  considers the second move that would be made by
  the Agent

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FORMATION OF CONTRACTS

• A boss designing a contract for a worker (which,
  usually but not always, must satisfy a
  participation constraint that the worker be
  willing to accept it instead of quitting the job)

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FORMATION OF CONTRACTS

• Offer
• The Agents incentive compatibility constraint
  is binding
• ?A((1-a)CA(a) 1) 0
• ?A gt 0

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FORMATION OF CONTRACTS

• Offer
• The offer generates an agency cost
• This agency cost depends upon the amount of
  effort provided by the agent
• This cost enters the contract problem through
  the incentive constraint.

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FORMATION OF CONTRACTS

• Offer
• This agency cost is usually described as a
  disutility of effort or a benefit from shirking
  or foregone pleasurable activities.
• This agency cost is the marginal cost of effort
  and may vary with effort.

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FORMATION OF CONTRACTS

• Offer
• If the Agent would co-operate, the first move
  occurs by the Principal
• If the Agent would not cooperate, then no
  first move
• No Offer
• No Contract
• (Cooter, Figure 6.1, 4th p. 197)

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FORMATION OF CONTRACTS

• Offer (Advertising)
• How, where, when and what?
• Carlill v. Carbolic Smoke Ball Company 1893 1
  QB 256 Court of Appeal, 1892 Dec. 6,7, LINDLEY,
  BOWEN and A. L. SMITH, L.JJ.

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FORMATION OF CONTRACTS
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FORMATION OF CONTRACTS

• Acceptance
• If there is only one Agent, he or she has the
  choice of accepting or rejecting the offer
  

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FORMATION OF CONTRACTS

• Acceptance
• If the Agent or group of Agents reject the
  offer, the contract game is over

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FORMATION OF CONTRACTS

• Acceptance
• The classical bargaining theory of contract law
  assigns the legal word acceptance to the
  document if the Agent or one of the Agents
  accepts the offer

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FORMATION OF CONTRACTS

• Acceptance
• Another way of characterizing the second step,
  taken by the agent is to describe the agent as
  the second mover

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FORMATION OF CONTRACTS

• Acceptance
• The participation constraint of the Agent is
  binding
• mA (TA (1-a)C(a) - a) 0
• mA gt 0

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FORMATION OF CONTRACTS

• Acceptance
• Acceptance of the offer generates a second
  agency cost.
• The second agency cost is the opportunity cost of
  the agent participating in the contract.
• It is also referred to as a reservation utility
  (0) and enters into the contract problem
  through the participation constraint.

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FORMATION OF CONTRACTS
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FORMATION OF CONTRACTS Performance
Formation Of Contracts
Agent Sends A Signal to the Principal
Principal Makes An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
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FORMATION OF CONTRACTS Performance
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PRINCIPAL
Payment For Performance
Promise To Perform
AGENT(Chosen)
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FORMATION OF CONTRACTSPerformance

• Parties enter into a principal-agency contract
• 0 input of Principal
• a input of Agent
• y C(0,a) output of the contract

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FORMATION OF CONTRACTS

• Performance
• The parties perform the contract in accordance
  with an agreed upon exchange
• The principal makes an exchange of a payment
  to an agent
• The agent performs or executes a promise for
  the principal

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FORMATION OF CONTRACTS

• Performance
• If the principal is operating in a perfectly
  competitive market outside of its relationship
  with the agent, its longrun profit function 0

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FORMATION OF CONTRACTS
U(F)
There is a third constraint in the Principal
Agency Problem The Budget Constraint of the
Principal
E
FOutput
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FORMATION OF CONTRACTS

• Performance
• This agency has the following profit function
• p(0,a) aC(0,a) - a
• or
• p(a) aC(a) - a

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FORMATION OF CONTRACTS
LEGAL ANALYSIS PROMISED
ECONOMIC ANALYSIS
Principal PAYMENT
Agent PARTICIPATION CONSTRAINT
Agent PROMISED PERFORMANCE
INCENTIVE COMPATIBILITY CONSTRAINT
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FORMATION OF CONTRACTS
U(F)
A perfectly competitive risk neutral Principal
contracts a complete contract with the risk
averse agent Contract Equilibrium Point The
parties are paid in output shares
E
FOutput
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FORMATION OF CONTRACTS

• Performance
• One of the primary conclusions of the
  Principal-Agency contract model is that, because
• (1) the agent receives only a partial share of
  the profits generated from the agents effort,
• (2) the agents effort is not perfectly observed
  by the principal, and
• (3) the agent bears the entire cost of that
  effort,
• the optimal incentive contract between the
  principal and agent cannot achieve a Pareto
  optimal outcome.

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FORMATION OF CONTRACTS

• Performance
• Even with risk neutrality on the part of both
  parties, moral hazard and inefficiency remain as
  long as there is a cost of effort born only by
  the agent and the agent receives only a share of
  the benefits generated by that effort

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FORMATION OF CONTRACTS

• Performance
• The principal is unable to costlessly observe (or
  verify) the agents actions
• The sub-optimal contract results in moral hazard
  and inefficiency.
• The principals value and the total value of the
  agents effort are not maximized.

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FORMATION OF CONTRACTS

• Performance Solution to the contract
  problem
• p(a) aC(a) - a
• ?A((1-a)CA(a) 1) 0 ?A gt 0
• mA (TA (1-a)C(a) - a) 0 mA gt 0

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FORMATION OF CONTRACTS

• L(a) aC a ?A((1-a)CA 1)
• mA (TA (1-a)C - a)
• dL/da 0 implies
• aCAA ?A(1-a)CAA mA((1-a)CA - 1) 0
• dL/da 0 implies 1 ?ACA/C mA

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FORMATION OF CONTRACTS
Solving aCAA ?A(1-a)CAA mA((1-a)CA - 1)
0 1 ?ACA/C mA proves p(a) aC(a) - a
and (1-a)C(a) a are are optimal if a 0
because the principal applies no effort
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PERFORMANCE OF CONTRACTSExample

• Principal Buyer - Contract
• A seller owns a house she values at 300,000.00
• A buyer has 500,000.00 but values the house at
  400,000.00

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PERFORMANCE OF CONTRACTS Example
U(F)
A Principal (buyer) contracts a complete
contract with the risk averse Agent
(seller) Contract Equilibrium Point The
parties are paid in output shares
E
FOutput
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PERFORMANCE OF CONTRACTS Example

• If the parties fail to agree on a price, P,
  social surplus between the parties is sub-optimal
  at 800,000.00
• SS SSA SSB
• 300,000.00 500,000.00
  800,000.00

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PERFORMANCE OF CONTRACTS Example

• Principal Buyer - Contract
• P(Vs, VB) P(300,000, 400,000)
• maximizes
• SSB (500,000 - P) 400,000
• subject to
• SSs P

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PERFORMANCE OF CONTRACTS Example

• Principal Buyer Contract
• Sequential Solution
• If the parties successfully agree on a price, P,
  social surplus between the parties is optimize at
  900,000.00
• SS SSA SSB
• P (500,000.00 P) 400,000.00
• 900,000.00

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PERFORMANCE OF CONTRACTS Example
U(F)
350,000.00 Nash Equilibrium
FOutput
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FORMATION OF CONTRACTS
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FORMATION OF CONTRACTSAdverse Selection
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PRINCIPAL
ASYMMETRIC INFORMATION
AGENT 1
AGENT 2
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FORMATION OF CONTRACTSAdverse Selection
In the adverse selection game the agents have
some information the principal does not
know. (See http//graphicsdept.com/melfarr7/)
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FORMATION OF CONTRACTSAdverse Selection

• The question arises?
• What if the principal cannot discern the type of
  agent or
  
  
  the law says
  that they cannot use this information?

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FORMATION OF CONTRACTSAdverse Selection
Example

• Privacy laws prevent employers from accessing
  student university marks without the student's
  written consent.
• So if all students agree to keep their marks
  private no prospective employer can get anyone's
  marks.
• So everybody's job search is on a level playing
  field.

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FORMATION OF CONTRACTSAdverse Selection Example

• An application is submitted by student A. No
  transcript is provided. Employer assumes A was
  probably an average student (68 or GPA 2.5?)
• Student A got 84 and G.P.A. 3.7. What do you
  predict A will do?
• Eventually all the above average students give
  permission to release their marks.
• (Posner, 6th ed., c. 1, p. 20)

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FORMATION OF CONTRACTSAdverse Selection Example

• Now what happens?
• The employer assumes the students who did not
  submit their transcripts are below average.
• Their marks are somewhere between 68 and 0.
• The student closest 68 will release his marks and
  so on until only the student that got the lowest
  mark is left.

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FORMATION OF CONTRACTSAdverse Selection Example

• Strategic behaviour prevented students from
  pursuing differentiated behaviour.
• Instead they strategically pursued a form of
  common behaviour

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FORMATION OF CONTRACTSAdverse Selection Example

• Economists and game theorists describe as a
  pooling equilibrium
• (Posner, 6th ed., c. 1, p. 21)
• Cooter explains adverse selection
• (4th ed., 2004, c. 2., X, p. 54)

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FORMATION OF CONTRACTS Adverse Selection
Alternatively, the law might forbid the
principal from acting on information that the
principal does have on the agents Example
laws against discrimination
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BILATERAL AGENCY - EXPLICIT Vertical Contract
(Principal Agency)
U(F)
A perfectly competitive risk neutral Principal
contracts a complete contract with the
agents In this case two different agents
two different contracts H high risk agent L-
low risk agent
EH EL
FOutput
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FORMATION OF CONTRACTSAdverse Selection
The objective of the Principal is that the two
(2) types of agents reveal themselves through the
choice of written contracts the Principal writes
and the agents accept
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FORMATION OF CONTRACTSAdverse Selection
Can agents with different risk preferences or
other characteristics be determined or sorted out
through their choice of contract?
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FORMATION OF CONTRACTSAdverse Selection
U(F)
EH
F
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FORMATION OF CONTRACTSAdverse Selection

• In a perfectly competitive market, the
  principal will want to offer the more profitable
  high risk contract to BOTH agents

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FORMATION OF CONTRACTSAdverse Selection

• This will adversely select against the low
  risk agent who will opt for no contract or a
  sub-optimal contract
• The exchange point of the adversely selected
  group lies in the area indicated by the red arrow

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FORMATION OF CONTRACTSAdverse Selection
U(F)
EH
F
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FORMATION OF CONTRACTSAdverse Selection

• In this equilibrium, adverse selection occurs
  against the low risk agents.
• So some low risk agents leave the market

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FORMATION OF CONTRACTSAdverse Selection
U(F)
EH
EL
F
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FORMATION OF CONTRACTSAdverse Selection
The high risk budget constraint acts as an
incentive compatibility constraint on the low
risk agents who either drop out of the market
entirely or agree to a suboptimal exchange
In other words,
high-risk agents impose a negative risk
externality on low-risk agents
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FORMATION OF CONTRACTSAdverse Selection
W2
EH
W1
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CONTRACTS - OFFERS
Formation Of Contracts
Principal Makes An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
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BILATERAL AGENCY - EXPLICIT
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CONTRACTS - OFFERSSeparating Equilibria
The separating equilibrium in this market
entails a welfare loss a reduction in social
surplus.
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CONTRACTS - OFFERSSeparating Equilibria
Under the Rothschild-Stiglitz hypothesis, the
principals and agents act non-strategically.
Neither principals nor agents anticipate the
others possible reactions when deciding their
strategy.
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CONTRACTS - OFFERSSeparating Equilibria
U(F)
Area where Principal lose money
E3 E4
F
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CONTRACTS - OFFERSSeparating Equilibria
In the separating equilibrium the two types of
risk averse agents sort the exchanges out among
themselves so that
(i) the low-risk group gets incomplete
bargain EL (ii) the high-risk
group gets complete bargain EH
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CONTRACTS - OFFERSSeparating Equilibria
U(F)
Area where principals lose money
EH EL
F
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CONTRACTS - OFFERSSeparating Equilibria
The separating equilibrium sorts the contracts
so that (i) the low-risk
agents gravitate towards the less than
optimal equilibrium EL
(ii) the high-risk agents gravitate towards
the optimal equilibrium EH
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BILATERAL AGENCY - EXPLICIT
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CONTRACTS - OFFERSPooling Equilibria
In 1976, C. Wilson removed the Rothschild-Stiglitz
hypothesis. He altered the perfect competitive
characterization of principals' supply to one of
oligopoly. This permits principals to act
strategically.
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CONTRACTS - OFFERSPooling Equilibria
More specifically, oligopoly on the supply side
also requires principals behave
non-competitively. The principals make some
profit instead of negative profits at the pooling
equilibrium point.
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CONTRACTS - OFFERSPooling Equilibria
So under Wilsons revision, the pooling
equilibrium preferred by the low-risk agents
becomes stable provided there are suitably few
high-risk agents in the market
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CONTRACTS - OFFERSPooling Equilibria
U(F)
Pooling constraint
E3 E4
F
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CONTRACTS - OFFERSPooling Equilibria
When the percentage of high-risk agents is small
enough, low-risk agents prefer to cross-subsidize
exchanges for high-risk agents in the pooling
equilibrium rather than accept a lower level of
coverage in the separating equilibrium.
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BILATERAL AGENCY - EXPLICIT
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CONTRACTS - OFFERS Screening
A screening game is an adverse selection game
where the uninformed party (principal) is the
first mover. Example A principal offers a
selection of contracts that sort out the
agents
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CONTRACTS - OFFERS Screening
Screening is an action taken by the uninformed
principal to determine information possessed by
informed agents
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CONTRACTS - OFFERS Screening
Examples (1) Buyer test driving different used
cars (2) Insurance company setting premiums based
on age, marital status
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BILATERAL AGENCY - EXPLICIT
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CONTRACTS - NEGOTIATION Signalling
Formation Of Contracts
Agent Sends A Signal to the Principal
Principal Makes An Offer To An Agent
Agent Accepts The Offer
Performance Of The Contract
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CONTRACTS - NEGOTIATION Signalling
A signaling game is an adverse selection game
where the informed party (agent) is the first
mover. Example An agent advertises (1)
posts a resume (2) offers a warranty
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CONTRACTS - NEGOTIATION Signalling
Action taken by an informed person to send
information to a less-informed person
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CONTRACTS - NEGOTIATION Signalling
Also for signals to be effective the cost of
sending the signal should vary with type
otherwise everybody would send the same signal
and the signal would be of no use.