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Econ 522 Economics of Law

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Title: Econ 522 Economics of Law


1
Econ 522Economics of Law
Dan Quint Fall 2009 Lecture 9
2
Logistics
  • Office hours between now and midterm
  • Me Tomorrow 130-330, Monday 130-330
  • Chao Thursday 100-300, Monday 1000-130
  • Midterm 1 next Tuesday, in class
  • No contract law

3
Plan
  • Last week finished property law
  • Handout two cool examples
  • This week we start contract law
  • But first a digression (true story) that
    illustrates some of the principles from both

4
So last Thursday, Im flying from Boston to
Montreal
  • Uncertainty about rights makes bargaining hard
  • Negotiating with lots of parties is hard
  • When transaction costs are high, damages are
    better than injunctions
  • But also what is a ticket?

5
Contract Law
6
Example the agency (trust) game
Player 1 (you)
Trust me
Dont
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(0, 200)
  • Subgame perfect equilibrium Ill keep all the
    money so you dont trust me
  • Inefficient outcome (100 lt 200)
  • And were both worse off

7
(One solution reputation)
8
Another solution legally binding promises
Player 1 (you)
Trust me
Dont
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

9
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.

10
The Bargain Theoryof Contracts
11
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

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
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

14
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 uncles
    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.

15
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

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

17
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

18
What does efficiency say about what promises
should 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

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
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

22
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

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)

25
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.

26
Efficient breach
  • Example Im an artist
  • You expect to value my painting at 1,000, agree
    to buy it for 600
  • My rich cousin comes to town, offers me 5,000
    for it
  • Efficient for him to get it, but Ive already
    promised it to you

27
Efficient breach
  • Example Im an artist
  • You expect to value my painting at 1,000, agree
    to buy it for 600
  • My rich cousin comes to town, offers me 5,000
    for it
  • Efficient for him to get it, but Ive already
    promised it to you
  • Breach is efficient when promisors cost of
    performing is greater than promisees benefit
    from performance

28
Efficient breach
  • Example Im an artist
  • You expect to value my painting at 1,000, agree
    to buy it for 600
  • My rich cousin comes to town, offers me 5,000
    for it
  • Efficient for him to get it, but Ive already
    promised it to you
  • Breach is efficient when promisors cost of
    performing is greater than promisees benefit
    from performance
  • Question how do we get breach only when its
    efficient?

29
Remedies and efficient breach
  • Breach is efficient when promisors cost of
    performing is greater than promisees benefit
    from performance
  • Self-interest promisor will breach when cost of
    performing is greater than liability from breach
  • So when liability from breach promisees
    benefit, promisor will choose to breach exactly
    when its efficient
  • Setting liability benefit is exactly
    expectation damages
  • (This causes promisor to internalize the
    externality he causes by breaching the contract
    so there is no externality, and he acts
    efficiently)

30
This brings us to
  • The third purpose of contract law is to secure
    optimal commitment to performing.
  • Expectation damages lead to efficient breach
    (breach of contract only when it is efficient).

31
Reliance
  • Reliance investments made by promisee, to
    increase the value of performance
  • The fourth purpose of contract law is to secure
    optimal reliance

32
Efficient reliance
  • Efficiency reliance is efficient as long
    as(probability of performance) X (increase in
    value) gt (cost)
  • We said expectation damages expected benefit
    from performance
  • Should expectation damages include increase in
    benefit due to reliance?
  • If yes promisee will rely as long as (increase
    in value) gt (cost)
  • So if yes, promisee will overrely
  • Thursday examples of efficient breach and
    reliance, and paper by Ayres and Gertner
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