Econ 522 Economics of LawLogisticsLast Thursday: paradox of compensationWe already saw one possible solutionAnother clever (but unrealistic) solution“Anti-insurance”Slide 7Reminder: what do courts actually do?Timing of breachSlide 10Slide 10Repeated gamesSlide 13Slide 14Slide 15Repeated games and reputationSlide 17Repeated games and the endgame problemSlide 19Slide 19Efficient bearer of riskSlide 22Hadley v BaxendaleOne other bit I like from FriedmanSlide 25That’s it for contract lawEcon 522Economics of LawDan QuintFall 2009Lecture 142See Chao if you’re missing midterm or HW1HW2 due next Tuesday (11 a.m. sharp)Second midterm next Thursday (Nov 5)Logistics3Last Thursday: paradox of compensation• Inefficient breach• Underinvestment in performance• Efficient reliance• Efficient breach• Efficient investment in performance• Over-relianceExpectation damages exclude benefit from reliance investmentsExpectation damages include benefit from reliance investments4Have expectation damages include benefit from reliance……but only up to the efficient level of reliance, not beyondThat is, have damages reward efficient reliance investments, but not overreliancePromisee has no incentive to over-rely efficient reliancePromisor still bears full cost of breach efficient performance(Requires court to calculate efficient level of reliance after the fact)We already saw one possible solution5The problem:Damages promisor pays need to include gain from reliance if we want to get efficient performanceDamages promisee receives need to exclude gain from reliance if we want to get efficient relianceSo…Make damages promisor pays different from damages promisee receives!Another clever (but unrealistic) solution6You (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 differenceYou receive damages without benefit from reliance; I pay damages with benefit from reliance“Anti-insurance”7You (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 differenceYou receive damages without benefit from reliance;I pay damages with benefit from relianceOffer the deal to two people, make them pay up front for it“Anti-insurance”8Foreseeable relianceInclude benefits reliance that promisor could have reasonably anticipatedReminder: what do courts actually do?9Timing of breach10You agree to sell me 10 tons of corn in June for $5/bushelBreach in JuneDamages might be difference between $5/bushel and spot priceBreach in January (“renounce/repudiate”)Damages might be difference between $5 and price of June corn at time you breachTiming of breach11Repeatedinteractions12Repeated games13Repeated gamesPlayer 1 (you)Trust me Don’tPlayer 2 (me)Share profits Keep all the money(150, 50) (0, 200)(100, 0)Suppose we’ll play the game over and overAfter each game, 10% chance relationship ends, 90% chance we play at least once more…14Suppose you’ve chosen to trust meKeep all the money: I get $200 today, nothing ever againShare profits: I get $50 today, $50 tomorrow, $50 day after…Value of relationship =Since this is more than $200, we can get cooperationRepeated games5029.50 9.50 39.50 ...5009.15015Suppose you’ve chosen to trust meKeep all the money: I get $200 today, nothing ever againShare profits: I get $50 today, $50 tomorrow, $50 day after…Value of relationship =Since this is more than $200, we can get cooperationRepeated games5029.50 9.50 39.50 ...5009.15016Diamond 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 reputation17The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutionsThe sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contractsLaw assigns legal duties to certain long-term relationshipsBank has fiduciary duty to depositorsMcDonalds franchisee has certain duties to franchisorRepeated games and reputation18Suppose we’ll play agency game 60 times$50 x 60 = $3,000 > $200, so cooperation seems like no problemBut…In game #60, reputation has no value to meLast time we’re going to interactSo I have no reason not to keep all the moneySo you have no reason to trust meBut if we weren’t going to cooperate in game #60, then in game #59…Repeated games and the endgame problem19Endgame problem: once there’s a definite end to our relationship, no reason to trust each otherExample: collapse of communism in late 1980sCommunism believed to be much less efficient than capitalismBut fall of communism led to decrease in growthUnder communism, lots of production relied on gray marketTransactions weren’t protected by law, so they relied on long-term relationshipsFall of communism upset these relationshipsRepeated games and the endgame problem20Couple otherodds and ends21Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least costHow do we know who this is? Friedman offers several bases for this decision…Spreading losses across many transactionsMoral hazard: who is in better position to influence outcome?Efficient bearer of risk22Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least costHow do we know who this is? Friedman offers several bases for this decision…Spreading losses across many transactionsMoral hazard: who is in better position to influence outcome?Adverse selection: who is more aware of risk, even if he
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