ECON 522 - DISCUSSION NOTES ON CONTRACT LAWI ContractsWhen we were studying property law we were looking at situations in which the exchange ofgoods/services takes place at the time of trade, but sometimes in trade situations the actual ex-change is delayed. Contract law covers trade in which the exchange of goods takes place after thedeal, which essentially makes contracts promises to perform in the future. Most of our analysisof contracts examines how to design the law so that individuals make contracts when there arepotential gains from trade, and also break contracts when performance becomes so costly that itis inefficient.I.1 Bargain TheoryA contract is a promise, but should every promise be a legally binding contract? The answer, forefficiency’s sake, is definitely no. But if not all promises are legally enforceable, we need to figureout which types of promises should be enforceable. The Bargain Theory is one attempt to answerthis question. Think of the bargain theory as theoretical guidelines for a court to decide when apromise (contract) should be enforceable. This does not necessarily imply that courts only enforcecontracts if they fit the bargain theory criteria, or that they enforce all contracts that do, but thetheory is a good benchmark to get us thinking about efficient enforcement.The lecture notes lay out and explain the theory, but remember that it says in order for a promiseto be a legal contract it must be part of a bargain, and a bargain has three components:(i) Offer(ii) Acceptance(iii) ConsiderationI.2 Damages Part 1All right, so contracts are promises, but only certain promises should be enforceable as contracts.Now we need to decide what enforcement mechanisms will be efficient.One key concept that pops up throughout our contract law studies (and pretty much everythingelse too) is that an individual’s actions can produce externalities. With contracts, if the promisordecides to breach (break) a contract, then there is the negative externality of lost benefit to thepromisee. The point is that when deciding to breach, the promisor only takes into account hisown costs, not the costs to the promisee, so he may breach even if total social welfare wouldbe higher without breach. The solution is to force the promisor to internalize the externality, byrequiring him to pay the promisee whatever expected value is lost due to the breach. This penaltyis called expectation damages.Expectation damages are great because they guarantee efficient breach. However, there are otherdimensions of a contract that we also want to be performed efficiently, and we1I.3 RelianceRecall that reliance is investments made by the promisee to improve the value of the contract (e.g.the hangar for the plane, or furniture for my new house). The main point in our analysis of relianceis that it may be efficient to have some reliance, but it’s very difficult to design an enforcementmechanism that provides incentive to rely the optimal (efficient) amount. Once again the problemis externalities, which we’ll discuss below.So we’ve decided expectation damages are good because they give us efficient breach, but now wehave the problem of figuring out if expectation damages should include reliance. Remember thatexpectation damages are equal to the expected benefit of a contract to the promisee. If the promiseehas relied at all, then clearly the expected benefit of the contract increases to the promisee (recallthe airplane and hangar example: if I don’t get my plane, then the hangar isn’t worth anything tome, but my plane is worth a lot more to me if I have a hangar to put it in). However, if we includereliance in expectation damages, then people will over-rely.The reasoning is as follows: if I know that any dollar that I invest in reliance is going to give memy expected return with probability one (with certainty), then I will invest as if the probability ofbreach is zero. However, if the probability of breach is not zero (there’s some probability thatthe contract must be broken by the promisor), then the promisor is forced to pay me for myinvestment, at no cost to me. Thus every dollar that I decide to invest in reliance imposes anegative externality on the promisor. Since I don’t have to pay at all for that negative externality,I will over-rely.Solution: Don’t include reliance in expectation damages. If reliance is not included in expecta-tion damages, then every dollar that I invest in reliance only gives a return if the contract is notbreached. Thus I pay the total cost of any investment in reliance; I internalize the externality, sothat I rely the efficient amount. But. . .One problem may be that I can’t accurately predict the probability of breach, so my reliance stillmay not be optimal. But even in a world of perfect information, excluding reliance from expecta-tion damages affects how much the promisee invests in performance, which we’ll discuss next.I.4 Investment in PerformanceInvestment in performance is what the promisee does to reduce the probability of breach. For exam-ple, if I decide to pay a contractor to build me a new house the contractor can buy fire extinguishersto reduce the chance that the house burns down mid-project, or it can buy the materials ahead oftime to secure prices and reduce the probability of breach due to cost increases. But these actionscost something, they aren’t free. Thus, when the promisee is deciding whether or not to invest inperformance, he will compare how much benefit he gets from the investment (the increased prob-ability of successfully completing the contract and getting paid) to the cost (what the investmentcosts, and what the expected cost of breach will be based on the probability of breach).What we saw in lecture was that if expectation damages include reliance, then a promisor willinvest the efficient amount in performance, but if reliance is not included in expectation damagesthen there will be under-investment in performance.The reasoning is just as before. If I’m the promisor, then if I don’t have to pay back reliancein expectation damages, I won’t take into account the fact that the promisee loses the money2invested in reliance if I breach. Thus every dollar that I don’t invest in performance imposes anegative externality on the promisee (or, every dollar that I do invest imposes a positive externalty).To force me to internalize this externality, we have to include reliance in expectation damages, asthe
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