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UW-Madison ECON 522 - Econ 522 – Lecture 13

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Econ 522 – Lecture 13 (Oct 18 2007)Homework 1b due Tuesday!Over the last three lectures, we’ve developed a theory of contract law. We said that contract law must address two fundamental questions:- what promises are enforceable?- what is the remedy when they are broken?And we said that contract law can ideally accomplish six things:- enable cooperation- encourage disclosure of information- secure optimal performance- secure optimal reliance- lower transaction costs through efficient default rules and regulations- foster enduring relationshipsWe also saw that it may be impossible for a single remedy rule to set all the different incentives efficiently. The Peevyhouse case (and the $10,000,000 sailboat example) showed there is sometimes a conflict between obtaining efficient signing and efficient breach; and the differences between Cooter and Ulen’s take on default rules and Ayres and Gertner’s showed there is sometimes a tradeoff between setting efficient default rules(to minimize transaction costs) and encouraging information disclosure.Today we look closer at specific types of remedies for breach of contract, and at the different incentives they create.First of all, note that there are three general types of remedies for breach of contract:- party-designed remedies- court-imposed damages- specific performanceThe contract itself may specify what the remedy should be for violation of particular terms – for example, a construction contract might stipulate a particular daily fee if completion of the building is delayed.Second, the court may impose the payment of some sort of damages.And third, the court may require specific performance – basically, force the breaching party to live up to the contract. (This is what the dissenting opinion in Peevyhouse did – rather than calculating monetary damages, he said that the coal company should be required to do the restorative work as promised.)Remedies that are stipulated in the contract are fairly clear-cut (although we’ll come to anexample of some that are often not enforced). Specific performance is also fairly clean, although we’ll discuss it a bit more later today. The difficult one is when the court has to step in and calculate the appropriate level of monetary damages.There are a number of different standards which can be used for this. We’ve already seenone: expectation damages.Expectation damages are meant to compensate the promisee for the amount he expected to benefit from performance of the promise. In the airplane example we did a while back,you contracted to buy an airplane from me for $350,000, and you expected to derive $500,000 of benefits from it; so under expectation damages, I would owe you that benefit. ($500,000 if you had already paid me, or $500,000 - $350,000 = $150,000 if youhad not.)The civil law refers to these as positive damages, as they compensate you for the positive benefit you anticipated from the contract.When they are calculated correctly, expectation damages make the promisee indifferent about whether the promisor performs or breaches. Thus, under perfect expectation damages, the promisor internalizes all the costs of breach, and therefore makes the efficient decision about breach.A second type of damages are reliance damages. These compensate the promisee for any investments he made in reliance on the promise, but not for the additional surplus he expected to gain. Reliance damages, therefore, restore the promisee to the level of well-being he would have had if he had not received the promise in the first place.In the airplane example, if I chose not to deliver the plane but you had built yourself a hangar, reliance damages would require me to reimburse you the cost of the hangar, but not the surplus you expected to earn from owning the plane. In the rich uncle example – the rich uncle promises his nephew a trip around the world, then changes his mind – reliance damages would pay for whatever supplies the nephew had purchased in preparation for the trip (minus whatever price he could resell them for), putting him back in the position he was in before the promise.The civil law tradition refers to these as negative damages, as they undo the negative (the harm) that actually occurred in response to the promise. Of course, if no investmentswere made in reliance on the promise, reliance damages would be 0 – sort of a “no harm, no foul” rule.A third type of damages are opportunity cost damages. These recognize that, if you contract to buy a plane from me, you may therefore pass up another chance to buy a planefrom someone else; and if I breach our contract, that other option may no longer be available. Opportunity cost damages are set to restore the promisee to the level of well-being he would have had if he had not contracted with this promisor, and instead had gone with his “next-best option”.Opportunity cost damages can be seen as an extension of reliance damages, where now turning down another opportunity is seen as a form of reliance, that is, as an investment you make in reliance on the promise that was made.Thus, opportunity cost damages leave the promisee indifferent between breach of the contract that was signed and fulfillment of the best alternative contract.In the airplane example, you contracted to buy a plane worth $500,000 for $350,000. Suppose someone else had an equally attractive airplane for sale at $400,000. Opportunity cost damages would be $100,000, since this is the surplus you would have realized by foregoing the contract with me and instead buying that plane.The textbook works through a couple of not-particularly-compelling examples of calculating the three types of damages. We’ll adapt one of them.I haven’t yet been to a Badgers home game, and I decide I want to go to the Northern Illinois game. One of you has a roommate with an extra ticket, and so you agree to sell it to me for $50. At the last minute, your roommate decides to go to the game, and you breach your promise.Expectation damages are supposed to make me as well-off as if you had indeed sold me the ticket for $50. It may be hard to measure exactly how well-off the football game would have made me. But once you tell me my ticket is gone, I could show up at the stadium before the game and buy a ticket from a scalper. Say this costs $150. This gives us an easy way to compute expectation damages: if you had lived up to your promise, I’d be $100 better off,


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UW-Madison ECON 522 - Econ 522 – Lecture 13

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