Econ 522 Economics of LawLast weekSlide 2RelianceWhen is reliance efficient?How should reliance figure into damages?Reliance and damages: exampleTo get efficient breach…If exp damages include benefit from reliance…Slide 10OverrelianceBetter example: Continuous relianceThree questionsSlide 14Reliance and breachSo what do we do?Slide 17Foreseeable reliance: Hadley v BaxendaleSlide 19Slide 20Slide 20Default rulesSlide 23What should default rules be?Slide 25Slide 26Slide 27Slide 28Slide 29Slide 30Default rules: a different viewPenalty defaults: Hadley v BaxendalePenalty defaults: examplePenalty defaults: other examplesSlide 35When to use penalty defaults?Slide 36When should voluntary trade not be allowed?Example of an unenforceable contract: a contract which breaks the lawSlide 40Derogation of public policy – exampleDerogation of public policyDefault rules versus regulationsSlide 43Formation Defenses and Performance ExcusesOne formation defense: incompetenceSo…Lucy v. ZehmerSlide 49Slide 50Slide 51Econ 522Economics of LawDan QuintSpring 2014Lecture 122ContractLegally binding promiseAllows for transactions that doesn’t occur “all at once”Which promises should we enforce?Bargain Theory: enforce promises made as part of a bargainRequires three elements: offer, acceptance, considerationEfficiency: promises that both parties wanted to be enforceableBreach of contractBreach is efficient when cost to perform > promisee’s benefitBreach will happen when cost to perform > promisor’s liabilityTo get efficient breach, set promisor’s liability = promisee’s benefit from performance – this is expectation damagesLast week3Reliance4RelianceYou expect an airplane to arrive in spring – you might…Sign up for flying lessonsBuild yourself a hangarBuy a helmet and gogglesReliance – investments which depend on performanceReliance increases the value of performance to promiseeReliance increases the social cost of breachAnother aim of contract law is to secure optimal level of reliance5When is reliance efficient?When social benefit of reliance > social cost of relianceSocial benefit: increased benefit to promisee(Value of airplane + hangar) – (Value of airplane without hangar)Value is only realized if the promise is performedSocial cost: direct cost borne by promiseeCost occurs whether or not promise is performedReliance is efficient wheneverIncrease in value of performanceCost ofinvestment>Probability of performanceX6How should reliance figure into damages?Expectation damages = expected benefit from performanceIf your reliance investment increases your anticipated benefit…should it increase the damages I owe you if I breach?Can we design damages to get efficient reliance, in addition to efficient breach?7You’re buying an airplane from mePrice is $350,000, to be paid on deliveryAirplane alone gives you benefit of $500,000Building a hangar costs $75,000Airplane with hangar gives you benefit of $600,000Without hangar, expectation damages = $150,000If you build a hangar and I fail to deliver plane, do I owe…$150,000? (Value of original promise)$250,000? (Value of performance after your investment)$225,000? (Value of original promise, plus reimburse you for investment you made)Some other amount?Reliance and damages:examplePrice of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,0008The only way to guarantee efficient breach is if damages included the added benefit from relianceOnce you’ve made investment, you anticipate benefit of $250,000 from performanceIf damages are anything less than that, I’ll breach too often(If damages exclude the added benefit, then I’m back to imposing an externality when I choose to breach the contract)So what happens to the incentive for reliance investments if damages will increase to include this added benefit?To get efficient breach…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,0009If you don’t build hangar, your payoff will be…$150,000 if I deliver the plane ($500,000 – $350,000)$150,000 if I breach and pay expectation damagesIf you build hangar, your payoff will be…$175,000 if I deliver the plane ($600,000 – $350,000 – $75,000)$175,000 if I breach and pay (higher) expectation damagesSo if expectation damages include the increased value of performance due to reliance investments…You’ll invest whenever (increase in benefit) > (cost)In this case, you’ll invest (because $100,000 > $75,000)If exp damages includebenefit from reliance…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,00010If expectation damages include increased value of performance, you’ll invest for sureIs this efficient?Reliance is efficient if(increase in benefit) X (probability of performance) > (cost)$100,000 X (probability of performance) > $75,000Only efficient if probability of performance > ¾If probability of performance < ¾, reliance is inefficient, but happens anywayOverreliance!If exp damages includebenefit from reliance…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,00011OverrelianceIf reliance investments increase the damages you’ll receive in the event of breach, you’ll over-relyYou’ll rely if Efficient to rely ifSo if damages increase when you make reliance investments, we’re sure to get overreliance!(Your investment imposes an externality on me)Increasein benefitCost ofinvestment>Prob. of perform.XIncreasein damagesProb. of breachX+Increasein benefitCost ofinvestment>Prob. of perform.X12Better example:Continuous reliancexy 600Investment in hangarAdditionalvalue ofplane$100$10,000$40,000$160,000$640,000Tarp and rope - $6,000 benefitPlywood frame, canvas roof - $60,000Metal poles, rigid roof - $120,000Functional heating - $240,000Designer hangar with Starbucks - $480,000Price of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x13Let p be probability of breachThree questionsWhat is the efficient level of reliance?What will promisee do if expectation damages include anticipated benefit from reliance?What will promisee do if expectation damages
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