ECON 522 - DISCUSSION NOTES ON CONTRACT LAWI ContractsWhen we were studying property law we were looking at situations in which the exchange of goods/servicestakes place at the time of trade, but sometimes in trade situations the actual exchange is delayed. Contractlaw covers trade in which the exchange of goods takes place after the deal, which essentially makes contractspromises to perform in the future. Most of our analysis of contracts examines how to design the law sothat individuals make contracts when there are potential gains from trade, and also break contracts whenperformance becomes so costly that it is inefficient.I.1 Bargain TheoryA contract is a promise, but should every promise be a legally binding contract? The answer, for efficiency’ssake, is definitely no. But if not all promises are legally enforceable, we need to figure out which typesof promises should be enforceable. The Bargain Theory is one attempt to answer this question. Thinkof the bargain theory as theoretical guidelines for a court to decide when a promise (contract) should beenforceable. This does not necessarily imply that courts only enforce contracts if they fit the bargain theorycriteria, or that they enforce all contracts that do, but the theory is a good benchmark to get us thinking aboutefficient enforcement.The lecture notes lay out and explain the theory, but remember that it says in order for a promise to be alegal contract it must be part of a bargain, and a bargain has three components:(i) Offer(ii) Acceptance(iii) ConsiderationI.2 Damages Part 1All right, so contracts are promises, but only certain promises should be enforceable as contracts. Now weneed to decide what enforcement mechanisms will be efficient.One key concept that pops up throughout our contract law studies (and pretty much everything else too)is that an individual’s actions can produce externalities. With contracts, if the promisor decides to breach(break) a contract, then there is the negative externality of lost benefit to the promisee. The point is thatwhen deciding to breach, the promisor only takes into account his own costs, not the costs to the promisee,so he may breach even if total social welfare would be higher without breach. The solution is to force thepromisor to internalize the externality, by requiring him to pay the promisee whatever expected value is lostdue to the breach. This penalty is called expectation damages.Expectation damages are great because they guarantee efficient breach. However, there are other dimensionsof a contract that we also want to be performed efficiently. . .I.3 RelianceRecall that reliance is investments made by the promisee to improve the value of the contract (e.g. thehangar for the plane, or furniture for my new house). The main point in our analysis of reliance is thatit may be efficient to have some reliance, but it’s very difficult to design an enforcement mechanism that1provides incentive to rely the optimal (efficient) amount. Once again the problem is externalities, whichwe’ll discuss below.So we’ve decided expectation damages are good because they give us efficient breach, but now we havethe problem of figuring out if expectation damages should include reliance. Remember that expectationdamages are equal to the expected benefit of a contract to the promisee. If the promisee has relied at all,then clearly the expected benefit of the contract increases for the promisee (recall the airplane and hangarexample: if I don’t get my plane, then the hangar isn’t worth anything to me, but my plane is worth a lotmore to me if I have a hangar to put it in). However, if we include reliance in expectation damages, thenpeople will over-rely.The reasoning is as follows: if I know that any dollar that I invest in reliance is going to give me myexpected return with probability one (with certainty), then I will invest as if the probability of breach is zero.However, if the probability of breach is not zero (there’s some probability that the contract will be brokenby the promisor), then the promisor is forced to pay me for my investment, at no cost to me. Thus everydollar that I decide to invest in reliance imposes a negative externality on the promisor. Since I don’t haveto pay at all for that negative externality, I will over-rely.Solution: Don’t include reliance in expectation damages. If reliance is not included in expectation damages,then every dollar that I invest in reliance only gives a return if the contract is not breached. Thus I paythe total cost of any investment in reliance; I internalize the externality, so that I rely the efficient amount.But. . .One problem may be that I can’t accurately predict the probability of breach, so my reliance still may not beoptimal. But even in a world of perfect information, excluding reliance from expectation damages affectshow much the promisee invests in performance, which we’ll discuss next.I.4 Investment in PerformanceInvestment in performance is what the promisee does to reduce the probability of breach. For example, if Idecide to pay a contractor to build me a new house the contractor can buy fire extinguishers to reduce thechance that the house burns down mid-project, or it can buy the materials ahead of time to secure prices andreduce the probability of breach due to cost increases. But these actions cost something, they aren’t free.Thus, when the promisee is deciding whether or not to invest in performance, he will compare how muchbenefit he gets from the investment (the increased probability of successfully completing the contract andgetting paid) to the cost (what the investment costs, and what the expected cost of breach will be based onthe probability of breach).What we saw in lecture was that if expectation damages include reliance, then a promisor will invest theefficient amount in performance, but if reliance is not included in expectation damages then there will beunder-investment in performance.The reasoning is just as before. If I’m the promisor, and if I don’t have to pay back reliance in expectationdamages, then I won’t take into account the fact that the promisee loses the money invested in reliance if Ibreach. Thus every dollar that I don’t invest in performance imposes a negative externality on the promisee(or, every dollar that I do invest imposes a positive externalty). To force me to internalize this externality,we have to include reliance in expectation damages, as the following
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