Econ 522Economics of Law

Dan Quint

Fall 2009

Lecture 14

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See Chao if you’re missing midterm or HW1

HW2 due next Tuesday (11 a.m. sharp)

Second midterm next Thursday (Nov 5)

Logistics

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Last Thursday: paradox of compensation

• Inefficient breach

• Underinvestment in performance

• Efficient reliance

• Efficient breach

• Efficient investment in performance

• Over-reliance

Expectation damages exclude benefit from reliance investments

Expectation damages include benefit from reliance investments

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Have expectation damages include benefit from reliance…

…but only up to the efficient level of reliance, not beyond

That is, have damages reward efficient reliance investments, but not overreliance Promisee has no incentive to over-rely efficient reliance Promisor still bears full cost of breach efficient performance

(Requires court to calculate efficient level of reliance after the fact)

We already saw one possible solution

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The problem: Damages promisor pays need to include gain from reliance if we

want to get efficient performance Damages promisee receives need to exclude gain from reliance if

we want to get efficient reliance

So… Make damages promisor pays different from damages promisee

receives!

Another clever (but unrealistic) solution

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You (promisee) and I (promisor) offer Bob this deal:

If you rely and I breach, I pay Bob value of promise with reliance (airplane plus hangar) Bob pays you value of promise without reliance (airplane alone) Bob keeps the difference

You receive damages without benefit from reliance; I pay damages with benefit from reliance

“Anti-insurance”

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You (promisee) and I (promisor) offer Bob this deal:

If you rely and I breach, I pay Bob value of promise with reliance (airplane plus hangar) Bob pays you value of promise without reliance (airplane alone) Bob keeps the difference

You receive damages without benefit from reliance;I pay damages with benefit from reliance

Offer the deal to two people, make them pay up front for it

“Anti-insurance”

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Foreseeable reliance

Include benefits reliance that promisor could have reasonably anticipated

Reminder: what do courts actually do?

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Timing of breach

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You agree to sell me 10 tons of corn in June for $5/bushel

Breach in June Damages might be difference between $5/bushel and spot price

Breach in January (“renounce/repudiate”) Damages might be difference between $5 and price of June corn at

time you breach

Timing of breach

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Repeatedinteractions

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Repeated games

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Repeated games

Player 1 (you)

Trust me Don’t

Player 2 (me)

Share profits Keep all the money

(150, 50) (0, 200)

(100, 0)

Suppose we’ll play the game over and over After each game, 10% chance relationship ends, 90% chance we

play at least once more…

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Suppose you’ve chosen to trust me

Keep all the money: I get $200 today, nothing ever again

Share profits: I get $50 today, $50 tomorrow, $50 day after…

Value of relationship =

Since this is more than $200, we can get cooperation

Repeated games

50 29.509.50 39.50 ... 5009.1

50

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Suppose you’ve chosen to trust me

Keep all the money: I get $200 today, nothing ever again

Share profits: I get $50 today, $50 tomorrow, $50 day after…

Value of relationship =

Since this is more than $200, we can get cooperation

Repeated games

50 29.509.50 39.50 ... 5009.1

50

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Diamond dealers in New York (Friedman)

“…people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one”

“Parties to a contract agree in advance to arbitration;if… one of them refuses to accept the arbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted.”

Repeated games and reputation

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The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions

The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts

Law assigns legal duties to certain long-term relationships Bank has fiduciary duty to depositors McDonalds franchisee has certain duties to franchisor

Repeated games and reputation

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Suppose we’ll play agency game 60 times $50 x 60 = $3,000 > $200, so cooperation seems like no problem But…

In game #60, reputation has no value to me Last time we’re going to interact So I have no reason not to keep all the money So you have no reason to trust me

But if we weren’t going to cooperate in game #60, then in game #59…

Repeated games and the endgame problem

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Endgame problem: once there’s a definite end to our relationship, no reason to trust each other

Example: collapse of communism in late 1980s Communism believed to be much less efficient than capitalism But fall of communism led to decrease in growth Under communism, lots of production relied on gray market Transactions weren’t protected by law, so they relied on long-term

relationships Fall of communism upset these relationships

Repeated games and the endgame problem

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Couple otherodds and ends

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Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost

How do we know who this is? Friedman offers several bases for this decision… Spreading losses across many transactions Moral hazard: who is in better position to influence outcome?

Efficient bearer of risk

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Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost

How do we know who this is? Friedman offers several bases for this decision… Spreading losses across many transactions Moral hazard: who is in better position to influence outcome? Adverse selection: who is more aware of risk, even if he can’t do anything

about it? “…The party with control over some part of the production process is in a

better position both to prevent losses and to predict them.

It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”

Efficient bearer of risk

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Suppose… 80% of millers are low-damage – suffer $100 in losses from delay 20% of millers are high-damage – suffer $150 in losses from delay

Shipper liable for actual damages Average miller would suffer $110 in losses Shipper makes efficient investment for average type But not efficient for either type

Shipper liable for foreseeable damages Shipper makes efficient investment for low-damage millers High-damage millers have strong incentive to negotiate around default

rule

Hadley v Baxendale

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One other bit I like from Friedman

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One other bit I like from Friedman

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Purposes for contract law: Encourage cooperation Encourage efficient disclosure of information Secure optimal commitment to performance Secure efficient reliance Provide efficient default rules and regulations Foster enduring relationships

Thursday, we begin tort law Don’t forget, HW2 due in a week

That’s it for contract law

End of material on second midterm