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UW-Madison ECON 522 - Logistics

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Econ 522 Economics of LawLogisticsTuesday…Slide 3Efficient BreachExample of efficient breachSlide 7Slide 8But so what? Can’t we just “Coase” back to efficiency?Another way to think about expectation damages: eliminating an externalitySlide 10Next: RelianceReliance and Damages: exampleReliance and damages: exampleSlide 15What do we learn?So what do we do?Slide 18Foreseeable reliance: Hadley v BaxendaleSlide 19Default rulesSlide 22What should default rules be?Slide 24Slide 25Slide 26Slide 27Slide 28Slide 29Default rules: a different viewPenalty defaults: Hadley v BaxendalePenalty defaults: other examplesSlide 33When to use penalty defaults?Default rules versus regulationsEcon 522Economics of LawDan QuintFall 2009Lecture 102Office hours between now and midterm:Me: Monday 1:30-3:30Chao: today 1:00-3:00, Monday 10:00-1:30Midterm #1 Tuesday, in classNo contract lawLogistics3Why do we need contracts?What promises should be enforced?Bargain Theory of ContractsEfficiencyFirst purpose of contract law: enable cooperationSecond purpose of contract law: encourage efficient disclosure of informationThird purpose of contract law: secure optimal commitment to performance (efficient breach)Fourth purpose of contract law: secure optimal relianceTuesday…4Efficient Breach5Efficient BreachPromisor’sCostPromisee’sBenefitEfficient to BreachPromisor’sCostPromisee’sBenefitEfficient to PerformPromisor’sCostPromisor’s LiabilityPromisor will BreachPromisor’sCostPromisor’sLiabilityPromisor will PerformSelf-Interest (incentives of promisor):Efficiency:6I build airplanesYou value one of my planes at $500,000You agree to buy one for $350,000, and pay up frontAfter you pay, price of materials goes upExample of efficient breachValue to you = $500,000Price = $350,0007Promisee’s benefit = $500,000If it costs me less than $500,000 to build plane, efficient to build itIf it costs me more than $500,000, efficient to breachExample of efficient breachValue to you = $500,000Price = $350,000Promisor’sCostPromisee’sBenefitEfficient to Breach8Liability is just to return your moneyIf my costs rise to $400,000, performance is still efficient, but I’ll choose to breachLiability is $1,000,000If costs rise to $700,000, performance is inefficient, but I’d rather perform than breachLiability = 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’sLiabilityPromisor will Breach9Liability is $350,000, my costs rise to $400,000I’ll breach original contract, but we can renegotiate to higher priceBut I might try to do that even if my costs don’t go up…Liability is $1,000,000, my costs rise to $700,000Rather than performing, I can offer you money to let me cancel contractBut my threat point is very low – you can demand a lot of moneyIf I realize that might happen, maybe I’m afraid to sign original contractExpectation damages avoid these problemsBut so what? Can’t we just“Coase” back to efficiency?Value to you = $500,000Price = $350,00010If I breach contract, I impose externality on youYou’re $500,000 worse offIf I have to pay you $500,000, then I internalize the externalityNow my action no longer affects your well-beingSo I choose efficiently when deciding whether to perform or breachAnother way to think about expectation damages: eliminating an externality11Reliance12Reliance: investments you make to increase your benefit from performanceIncreases my liability if I breachIf expectation damages include added benefit due to reliance, leads to more than efficient level of relianceThere’s some chance I’ll need to breach the contractYour reliance investments increase my liability from breach, so they impose a negative externalityActivities which impose negative externality happen too muchOverrelianceNext: Reliance13Reliance increases your benefit from my promiseAirplane gives you benefit of $500,000Costs $75,000 to build a hangarAirplane with hangar gives you benefit of $600,000Suppose price is $350,000, to be paid on deliveryExpectation damages restore you to well-being you expected to have from performanceWithout a hangar, if I breach, I owe you $150,000If you build a hangar and I breach, do I owe you $250,000?Reliance and Damages: example14Cost of building plane: maybe $250,000, maybe $700,000Clearly, you’ll choose to build the hangarBut, is that efficient?Reliance and damages:examplePrice of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,000-150150-250- 75 + 250 =175Costsrise350 - 250 =100500 - 350 =150350 - 250 =100600 - 75 - 350 = 175Costsstay lowI getYou getI getYou getYou don’tYou build hangar15Let p be probability my costs go upCombined expected payoffs if you rely:(1 – p) (175 + 100) + p (175 – 250)= 275 (1 – p) – 75 p = 275 – 350 pCombined expected payoffs if you don’t rely:(1 – p) (150 + 100) + p (150 – 150)= 250 (1 – p) = 250 – 250 pWhich is bigger?275 – 350 p > 250 – 250 p 25 > 100 p  p < ¼ So if p < ¼, reliance is efficient; if p > ¼, it’s notBut you’re going to rely either way!Reliance and damages:examplePrice of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,00016When probability of breach is low, more reliance tends to be efficientWhen probability of breach is high, less reliance tends to be efficientIf expectation damages include increased benefit from reliance, we sometimes get overreliance(OTOH, if expectation damages exclude increased benefit from reliance, liability < benefit, so inefficient breach)What do we learn?17Cooter and Ulen: include only efficient reliancePerfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amountSo promisee rewarded for efficient reliance, not for overrelianceSo what do we do?18Cooter and Ulen: include only efficient reliancePerfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amountSo promisee rewarded for efficient reliance,


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UW-Madison ECON 522 - Logistics

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