Econ 522 – Lecture 11 (Oct 11 2007)Tuesday, we asked the question of what promises the law should enforce, and introduced contract law as the attempt to answer that question.- We talked about one early attempt to answer that question, the bargain theory of contracts, and some of the problems with it.- We showed an example of an agency game, where my inability to commit to a future action led to a breakdown in cooperation…- …we said that the first purpose of contract law is to enable cooperation, by turning games with noncooperative solutions into games with cooperative solutions…- …and we argued that efficiency generally requires a promise to be enforceable if both the promisor and the promisee wanted it to be enforceable when it was made- We saw an example of how asymmetric information can inhibit trade…- …and claimed that the second purpose of contract law is to encourage the efficient disclosure of information- We discussed the fact that efficiency sometimes requires breaching a contract…- …and said that the third purpose of contract law is to secure optimal commitment to performing…- …and argued that setting the promisor’s liability equal to the promisee’s benefit – expectation damages – accomplishes this goal- We discussed the idea of reliance, that is, investments made by the promisee to increase their benefit from the promise…- …and said that the fourth purpose of contract law is to secure the optimal level of reliance…- …and then we ran out of time.Today, I want to go back over the example of efficient breach, since I think I went through that a bit fast… do an example of reliance… then move on to default rules and mandatory rulesI want to quickly go back to the example of efficient breach, since I felt like we went through it too quickly. Suppose that I build airplanes, and you contract to buy one from me. You value the airplane at $500,000. We agree on a price of $350,000. It will simplify the example if we assume you paid me up front; so let’s assume this contract was money-for-a-promise: you already paid up front and I promised to deliver a plane. (This doesn’t really matter much, it just makes all the numbers positive.)The rule for efficient breach is:If [ Promisor’s Cost ] > [ Promisee’s Benefit ] Efficient to breachIf [ Promisor’s Cost ] < [ Promisee’s Benefit ] Efficient to performSince the promisee’s benefit is known to be $350,000, it is efficient to perform whenever the cost of building the airplane is below $350,000, and efficient to breach whenever the cost is above $350,000.Since the promisor only looks at his own private cost and benefit when deciding whether to breach or perform,If [ Promisor’s Cost ] > [ Liability ] Promisor will breachIf [ Promisor’s Cost ] < [ Liability ] Promisor will performIn the case of perfect expectation damages, the promisor’s liability would be the amount of benefit the promisee would have received, which is $350,000; this leads to the promisor performing whenever the cost of building the airplane is less than $350,000, which is exactly what efficiency would require. Setting the promisor’s liability at any other level would lead to some instances of either inefficient breach (if liability were too low) or inefficient performance (if liability were too high).On to reliance. You’ll recall that reliance is any investment the promisee makes that increases the value of performance. So you contract to buy my painting, and go buy a frame for it; or you contract to buy an airplane from me, and you start building a hangar.Since reliance increases the value of the promise to you, it increases my liability for breach under the concept of expectation damages as we’ve defined them. (That is, if I break the promise, I’m responsible for making you as well off as you would have been if I had kept my word; so if you’ve built a hangar, now I have to reimburse you for the value of the plane with a hangar, rather than without a hangar.) So reliance increases my losses under breach. But you don’t take that into account when deciding how much to invest in reliance, so there is no guarantee that the level of reliance will be efficient.We’ll use the same example – you contract to buy a plane from me. You value the plane at $500,000, and agree to pay $350,000 for it. Let’s assume that this time, the bargain is promise-for-a-promise – you agree to pay on delivery. And there are perf exp damages.Now you have the option of building yourself a hangar. Building a hangar costs $75,000,and increases the value of owning a plane from $500,000 to $600,000.Suppose that it’s most likely that building the plane will cost me $250,000; but that there’s some probability p that it will instead cost $1,000,000. Clearly, if it costs $1,000,000, I won’t build it; I’ll just breach the contract and accept that I have to pay you damages.Let’s look at what happens in each case.First, suppose the cost of the plane is $250,000, so I build it. Our payoffs (in thousands):If you relied (built the hangar): you get 600 – 75 – 350 = 175I get 350 – 250 = 100If you didn’t rely (build) you get 500 – 350 = 150I get the same 350 – 250 = 100Now look at the case where the cost of sheet metal went through the roof and I choose to breach. Assuming I owe perfect expectation damages as we’ve defined them – that is, enough to make you as well off as if I’d performed…If you relied (built the hangar): Your surplus would have been 600 – 350 = 250 from the plane, so I owe you 250 in damagesAnd you paid 75 to build the hangarSo you end up with payoff of 175I get –250 (since I have to pay you 250 in damages)If you didn’t rely (build) Your surplus would have been 500 – 350 = 150, so Iowe you 150 in damages, which is your payoffI get –150 after paying you damagesSo whether or not I perform, you get 175 if you relied, 150 if you didn’t. So clearly, reliance makes you better off.But then the question is, is reliance efficient? That depends on how likely I am to breach.If you rely, our combined expected payoffs are(1–p) (175 + 100) + p (175 – 250) = 275 (1–p) – 75 p = 275 – 350 pIf you didn’t rely, our combined expected payoffs are(1-p) (150 + 100) + p (150 – 150) = 250 – 250 pSo the total social gain from you building the hangar is(275 – 350 p) – (250 – 250 p) = 25 – 100 pSo it turns out that when p < ¼, reliance is
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