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 102Office hours between now and midterm:Me: Monday 1:30-3:30Chao: today 1:00-3:00, Monday 10:00-1:30Midterm #1 Tuesday, in classNo contract lawLogistics3Why do we need contracts?What promises should be enforced?Bargain Theory of ContractsEfficiencyFirst purpose of contract law: enable cooperationSecond purpose of contract law: encourage efficient disclosure of informationThird purpose of contract law: secure optimal commitment to performance (efficient breach)Fourth purpose of contract law: secure optimal relianceTuesday…4Efficient Breach5Efficient BreachPromisor’sCostPromisee’sBenefitEfficient to BreachPromisor’sCostPromisee’sBenefitEfficient to PerformPromisor’sCostPromisor’s LiabilityPromisor will BreachPromisor’sCostPromisor’sLiabilityPromisor will PerformSelf-Interest (incentives of promisor):Efficiency:6I 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 = $350,0007Promisee’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 Breach8Liability 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 Breach9Liability 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 = $350,00010If 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-beingSo I choose efficiently when deciding whether to perform or breachAnother way to think about expectation damages: eliminating an externality11Reliance12Reliance: investments you make to increase your benefit from performanceIncreases my liability if I breachIf expectation damages include added benefit due to reliance, leads to more than efficient level of relianceThere’s some chance I’ll need to breach the contractYour reliance investments increase my liability from breach, so they impose a negative externalityActivities which impose negative externality happen too muchOverrelianceNext: Reliance13Reliance increases your benefit from my promiseAirplane gives you benefit of $500,000Costs $75,000 to build a hangarAirplane with hangar gives you benefit of $600,000Suppose price is $350,000, to be paid on deliveryExpectation damages restore you to well-being you expected to have from performanceWithout a hangar, if I breach, I owe you $150,000If you build a hangar and I breach, do I owe you $250,000?Reliance and Damages: example14Cost of building plane: maybe $250,000, maybe $700,000Clearly, you’ll choose to build the hangarBut, 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 hangar15Let p be probability my costs go upCombined expected payoffs if you rely:(1 – p) (175 + 100) + p (175 – 250)= 275 (1 – p) – 75 p = 275 – 350 pCombined expected payoffs if you don’t rely:(1 – p) (150 + 100) + p (150 – 150)= 250 (1 – p) = 250 – 250 pWhich 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 notBut 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 = $600,00016When probability of breach is low, more reliance tends to be efficientWhen probability of breach is high, less reliance tends to be efficientIf 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?17Cooter and Ulen: include only efficient reliancePerfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amountSo promisee rewarded for efficient reliance, not for overrelianceSo what do we do?18Cooter and Ulen: include only efficient reliancePerfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amountSo promisee rewarded for efficient reliance,
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