Econ 522 Economics of LawLogisticsLast week…Slide 3So…Why does the penalty for breach matter?Slide 7When is breach efficient?Efficient BreachWhen do we expect breach to happen?Slide 11So how do we get efficient breach?Efficient breachExample of efficient breachSlide 15Slide 16But so what? Can’t we just “Coase” back to efficiency?Another way to think about expectation damages: eliminating an externalitySlide 18RelianceWhen is reliance efficient?Efficient relianceReliance and Damages: exampleReliance and damages: exampleSlide 25What do we learn?So what do we do?Slide 28Foreseeable reliance: Hadley v BaxendaleUp nextEcon 522Economics of LawDan QuintSpring 2010Lecture 102Midterm on WednesdayOffice hours tomorrowMe (Soc Sci 7428) 9:30-11:30 a.m.Fran (Soc Sci 6443) 12:30-2:30 p.m.Logistics3Why do we need contracts?To get cooperation/trade when transactions aren’t instantaneousWhat promises should be enforced?Bargain Theory of ContractsEfficiencyFirst purpose of contract law: enable cooperationSecond purpose of contract law: encourage efficient disclosure of informationLast week…4Breach5A contract is just a promiseThe idea here is that we want some promises to be legally bindingThis means there has to be some legal consequence for breaking such a promiseBreach of contract is when the promisor fails to live up to his promiseJust like property rights are meaningless unless there is a remedy when they are violated……contract law is meaningless unless there is a penalty for breachSo, what happens when a contract is breached?So…6Why does the penalty for breach matter?If penalty is too weak, contract law has no bite, and we’re back to our original problemBut sometimes, circumstances change, and breach of contract becomes desirableExample: I promise to sell you a painting7Why does the penalty for breach matter?If penalty is too weak, contract law has no bite, and we’re back to our original problemBut sometimes, circumstances change, and breach of contract becomes desirableExample: I promise to sell you a paintingExample: I promise to build you a planeIf penalty for breach is too severe, I’ll have to honor these promises even when this is inefficientCan we design the law so that we only get breach of contract when it’s efficient?8When is breach efficient?Breach is efficient ifsocial benefit of breach > social cost of breachSocial cost of breach is that promisee doesn’t get the benefit from the promiseSocial benefit of breach is that promisor doesn’t have to incur the cost of delivering (performing)So breach is efficient ifpromisor’s cost to perform> promisee’s benefit from performance9Efficient BreachPromisor’sCostPromisee’sBenefitEfficient to BreachPromisor’sCostPromisee’sBenefitEfficient to PerformEfficiency:10When do we expect breach to happen?Promisor weighs private cost of performance vs breachWhatever the penalty for breach, if it’s cheaper to perform, promisor will perform; if it’s cheaper to breach, he’ll breachThat is, we expect breach to occur wheneverpromisor’s cost to perform> penalty for breach11Efficient BreachPromisor’sCostPromisee’sBenefitEfficient to BreachPromisor’sCostPromisee’sBenefitEfficient to PerformPromisor’sCostPromisor’s LiabilityPromisor will BreachPromisor’sCostPromisor’sLiabilityPromisor will PerformWhat will actually happen (incentives of promisor):Efficiency:12So how do we get efficient breach?Promisor’sCostPromisee’sBenefitEfficient to BreachPromisor’sCostPromisor’s LiabilityPromisor will BreachWhat will actually happen (incentives of promisor):Efficiency:Promisor’sLiabilityfor BreachPromisee’sBenefit fromPerformanceSo if we design the law such thatthe promisor will breach exactly when breach is efficient13Efficient breachWhen liability from breach = promisee’s benefit from performance, we get breach exactly when it’s efficientSo for efficiency, when a promisor breaches a contract, we want him to owe a penalty exactly equal to the benefit the promisee expected to receiveThis is called expectation damagesExpectation damages: if I promise you something that has value of $100 to you, and then I break my promise, I owe you $100This way,if it costs me more than $100 to keep my promise, I’ll break it, which is efficientif it costs me less than $100 to keep my promise, I’ll keep it, which is efficient14I build airplanesYou value one of my planes at $500,000You agree to buy one for $350,000, and pay up frontAfter you pay, price of materials goes upExample of efficient breachValue to you = $500,000Price = $350,00015Promisee’s benefit = $500,000If it costs me less than $500,000 to build plane, efficient to build itIf it costs me more than $500,000, efficient to breachExample of efficient breachValue to you = $500,000Price = $350,000Promisor’sCostPromisee’sBenefitEfficient to Breach16Liability is just to return your moneyIf my costs rise to $400,000, performance is still efficient, but I’ll choose to breachLiability is $1,000,000If costs rise to $700,000, performance is inefficient, but I’d rather perform than breachLiability = promisee’s benefit ($500,000)I’ll perform when performance is efficient, breach when breach is efficientExample of efficient breachValue to you = $500,000Price = $350,000Promisor’sCostPromisor’sLiabilityPromisor will Breach17Liability is $350,000, my costs rise to $400,000I’ll breach original contract, but we can renegotiate to higher priceBut I might try to do that even if my costs don’t go up…Liability is $1,000,000, my costs rise to $700,000Rather than performing, I can offer you money to let me cancel contractBut my threat point is very low – you can demand a lot of moneyIf I realize that might happen, maybe I’m afraid to sign original contractExpectation damages avoid these problemsBut so what? Can’t we just“Coase” back to efficiency?Value to you = $500,000Price = $350,00018If I breach contract, I impose externality on youYou’re $500,000 worse offIf I have to pay you $500,000, then I internalize the externalityNow my action no longer affects your well-being(You get a payoff of $500,000 if I build the plane, and a benefit of $500,000 if I don’t.)So I
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