Econ 522 Economics of LawPlanWhy do we need contracts?Slide 4Example: the agency (trust) game(One solution: reputation)Another solution: legally binding promisesSo… what types of promises should be enforced by the law?Slide 8The bargain theory of contractsWhat is consideration?Slide 12The bargain theory does not distinguish between fair and unfair bargainsUnder the bargain theory, what is the remedy?Problems with the bargain theorySlide 16Slide 16What promises should be enforced?Slide 19Slide 20So now we know…InformationSlide 23Slide 24Econ 522Economics of LawDan QuintSpring 2010Lecture 92Monday – finished property lawHandout – two cool examplesFirst midterm (next Wed) covers through end of property lawNext: contract lawPlan3Some transactions don’t occur all at onceI’m flying to Washington DC over Spring Break……or I hire someone to paint my house…Why do we need contracts?4Some transactions don’t occur all at onceI’m flying to Washington DC over Spring Break……or I hire someone to paint my house……or you can get $10 for a purple poker chip, but don’t have any cash on you right now to buy it from someone with a lower numberA contract is a promise……which enables trade when transactions aren’t concluded immediatelyWhy do we need contracts?5Subgame perfect equilibrium: I’ll keep all the money; so you don’t trust meInefficient outcome (100 < 200)And we’re both worse offExample: the agency (trust) gamePlayer 1 (you)Trust me Don’tPlayer 2 (me)Share profits Keep all the money(150, 50) (0, 200)(100, 0)6(One solution: reputation)7Now we get cooperation (and efficiency)Purpose of contract law: to allow trade in situations where this requires credible promisesAnother solution: legally binding promisesPlayer 1 (you)Trust me Don’tPlayer 2 (me)Share profits Keep all the money(150, 50) (125, 25)(100, 0)8“The rich uncle of a struggling college student learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world.”“One neighbor offers to sell a used car to another for $1000. The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back yard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac.”“A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,” mails $25 and receives in the mail two wooden blocks with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and pay $500 in punitive damages.”So… what types of promises should be enforced by the law?9The Bargain Theoryof Contracts10Developed in the late 1800s/early 1900sA promise should be enforced if it was given as part of a bargain, otherwise it should notBargains were taken to have three elementsOfferAcceptanceConsiderationThe bargain theory of contracts11Promisor: person who gives a promisePromisee: person who receives itIn a bargain, both sides must give up somethingreciprocal inducementConsideration is what the promisee gives to the promisor, in exchange for the promiseUnder the bargain theory, a contract becomes enforceable once consideration is givenWhat is consideration?12Promisor: person who gives a promisePromisee: person who receives itIn a bargain, both sides must give up somethingreciprocal inducementConsideration is what the promisee gives to the promisor, in exchange for the promiseUnder the bargain theory, a contract becomes enforceable once consideration is givenWhat is consideration?13Hamer v Sidway (NY Appeals Ct, 1891)Uncle offered nephew $5,000 to give up drinking and smoking until his 21st birthday, then refused to pay“The promisee [previously] used tobacco, occasionally drank liquor, and he had a legal right to do so. That right he abandoned for a period of years upon the strength of the promise… We need not speculate on the effort which may have been required to give up the use of these stimulants. It is sufficient that he restricted his lawful freedom of action within certain prescribed limits upon the faith of his uncle’s agreement, and now, having fully performed the conditions imposed, it is of no moment whether such performance actually proved a benefit to the promisor, and the court will not inquire into it.”The bargain theory does not distinguish between fair and unfair bargains14Expectation damagesthe amount of benefit the promisee could reasonably expect from performance of the promisemeant to make the promisee as well of as he would have been, had the promise been fulfilledUnder the bargain theory, what is the remedy?15Problems with the bargain theoryNot that accurate a description of what modern courts actually doNot always efficientDoes not enforce certain promises that both promisor and promisee might have wanted to be enforceable16Problems with the bargain theoryNot that accurate a description of what modern courts actually doNot always efficientDoes not enforce certain promises that both promisor and promisee might have wanted to be enforceableDoes enforce certain promises that maybe should not be enforced17What does efficiency say about what promises should be enforced?18What promises should be enforced?In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was madedifferent from wanting it to actually be enforced19What promises should be enforced?In general, efficiency requires enforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was madedifferent from wanting it to actually be enforcedThe first purpose of contract law is to enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutionsor, enable people to convert games with inefficient equilibria into games with efficient equilibria20What promises should
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