Econ 522 – Lecture 11 (Feb 24 2009)- HW 1 will be returned on Thursdayo (if you didn’t get, I have extra copies of my solutions)- HW 2 is online, not due for a while- Midterm is next Tuesdayo Chao and I are switching our office hours next week to Monday:o Me: Monday 1:30-3:30, Social Sciences 7428o Chao: Monday 10-12, Social Sciences 7231Last Thursday, we examined efficient breach and efficient reliance. We found:- It’s efficient to breach a contract whenever the cost of performance exceeds the value of performance- Expectation damages lead to breach only when it’s efficient- Reliance is efficient if its expected benefit (its benefit times the probability of performance) exceeds its cost- Including the benefit from reliance in expectation damages may lead to overreliance- Adjusting expectation damages to include only efficient reliance creates the correct incentive, but is difficult from a practical point of view- The law tends to only reward foreseeable reliance, which is reliance that could reasonably be expected given the situationWe also introduced the notion of default rules – rules that apply in contingencies that weren’t explicitly addressed in a contract. We saw two very different views of what default rules should be.- Cooter and Ulen supported efficient default rules – that is, the rules that most parties would have chosen if they had addressed a particular risko most parties can save transaction costs by not bothering to address those risks- Ayres and Gertner introduced the idea of penalty defaults – default rules that are not efficient, but which penalize one party, in order to encourage them to disclose information while negotiating the contract- We saw an example of this: Hadley v Baxendaleo The efficient rule would likely be for the shipper to bear the risk of lost profits due to delay – since he has more control over how quickly the delivery happenso But the ruling penalized Hadley for hiding the urgency of the shipment – giving an incentive to reveal informationDefault rules can be overridden by specific terms of a contract, and are only used in contingencies the contract didn’t address.At the end of the last lecture , we introduced the idea of immutable rules, or regulations, which are rules that always apply, that is, that can’t be overridden.- 1 -Going back to Coase- if individuals are rational and there are no transaction costs, private negotiations (in this case, contracting) will lead to efficiency- so any additional regulation (any rules they’re not allowed to contract around) would be inefficient- on the other hand, regulation could be efficient in situations where individuals are not rational, or where there are transaction costs, externalities, or market failures.One example of an immutable rule: a contract is not enforceable if its completion would require violating the law.- The legal doctrine is derogation of public policy- Contracts which derogate public policy are not enforceable- Obvious examples of this would be a sales contract for a kilo of cocaine, or a contract to kill someone- However, there are also less obvious situations where a contract derogates public policy, and would therefore be unenforceable- In the U.S., labor unions have a statutory obligation to bargain with management “in good faith”- A contract between a labor union and a third party, which would violate this obligation, would therefore derogate public policy, and not be enforced- An example of this is a contract that “ties the union’s hands” in negotiations- Suppose that the union (B) and ownership (C) at a factory are bargaining over wages- The union wants its workers to earn $15 an hour, ownership is offering $10 an hour, and negotiations are ongoing.- Now the union goes to a competing factory owner (A) and signs the following contract:- “If I ever agree to work for C for less than $15 an hour, I promise to have all my members work for you for $1 an hour.”- The intent of the contract is not for it to actually happen, just to change the union’s bargaining position with C, by “burning its bridges,” that is, making it much more costly to back down from its demands.- Since this would violate the union’s obligation to bargain in good faith, this contract would not be enforced.Other examples of contracts which would derogate public policy.- 2 -- A victim of a crime offering a policeman a reward for solving the crimeo The police’s job is to solve crimeso Allowing rewards might distort the focus toward crimes with rewards, away from more important crimes without rewards- A contract among competitors to act as a cartel, similar to a monopolyo A contract that fixed prices, say, would derogate laws designed to foster competition, and would therefore be unenforceable.- In general, contracts which can only be performed by breaking the law are not enforceable- However, there are still some instances where, even though performing would require laws to be broken, a contract is still enforced, that is, a remedy is still supplied for breach- Three examples from the textbook: o “A married man may be liable for inducing a woman to rely on his promise of marriage, even though the law prohibits him from marrying without first obtaining a divorce.”o “A company that fails to supply a good as promised may be liable even though selling a good with the promised design violates a government safety regulation.”o “A company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation.”- In all these examples, the liability rests with the party that knew, or should have known, that it was committing to something illegal- This is similar to the reasoning in Ayres and Gertner- Putting the liability on the informed party gives them an incentive to be honest (orin these cases, to not enter into this type of contract)- Cooter and Ulen argue that the promisor should be liable for breach if he knew (orshould have known) that the promise was illegal but the promisee did not- On the other hand, the promisor should not be liable if he did not know the promise was illegal and the promisee did.- 3 -Derogation of public policy is one example of an immutable rule, or a regulation – a rule that the parties to a contract cannot overrule- Most of what we’ve done up to now has been focused on default rules – rules which hold when the parties chose not to overrule them-
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