Econ 522 Economics of LawLogisticsContract law: the story so farSlide 4Slide 4RelianceWhen is reliance efficient?How should reliance figure into damages?Reliance and damages: exampleTo get efficient breach…If exp damages include benefit from reliance…Slide 12Better example: continuous investmentThree questionsSlide 15OverrelianceReliance and breachSo what do we do?Slide 19Foreseeable reliance: Hadley v BaxendaleSlide 20Default rulesSlide 23What should default rules be?Slide 25Slide 26Slide 27Slide 28Slide 29Slide 30Default rules: a different viewPenalty defaults: Hadley v BaxendalePenalty defaults: other examplesSlide 34When to use penalty defaults?Slide 35Default rules versus regulationsOne example of a regulation/immutable rule: derogation of public policySlide 39Derogation of public policyExpectation damages: default rule or immutable rule?Slide 42We can also think about Peevyhouse in terms of penalty defaultsEcon 522Economics of LawDan QuintSpring 2011Lecture 112Midterm WednesdayRemaining office hours this weekMe: tomorrow, 9:30-11:30 and 2-4Fran: Wednesday, 10:50-12:50Logistics3Contract = legally binding promiseAllow for cooperation/trade when transactions aren’t instantaneousFirst purpose of contract law: enable cooperationWhat promises should be enforced?Bargain theory: those given as part of a bargainThree elements: offer, acceptance, considerationEfficiency: any promise both promisor and promisee wanted to be enforceableInformationAsymmetric/private info can prevent trade; contract law can helpSecond purpose: encourage efficient disclosure of informationContract law: the story so far4May become efficient/necessary to break a promiseWhen should a contract be breached?Breach of contract is efficient when cost to perform > benefit of performance to promiseeBreach is in promisor’s interest whencost to perform > promisor’s liability from breachExpectation damages: liability from breach = benefit to promiseeLeads to breach exactly when it’s efficientThink of this as “designing the law to internalize an externality”Third purpose of contract law: obtain optimal commitment to performanceContract law: the story so far5Reliance6RelianceYou expect an airplane to arrive in spring – you might…Sign up for flying lessonsBuild yourself a hangarBuy a helmet and gogglesReliance – investments which depend on performanceReliance increases the value of performance to promiseeReliance increases the social cost of breachThe fourth purpose of contract law is to secure optimal reliance7When is reliance efficient?When social benefit of reliance > social cost of relianceSocial benefit is increased benefit to promisee(Value of airplane + hangar) – (Value of airplane without hangar)Value is only realized if the promise is performedSocial cost is cost borne by promiseeCost occurs whether or not promise is performedReliance is efficient ifIncrease in value of performanceCost ofinvestment>Probability of performanceX8How should reliance figure into damages?We know expectation damages lead to efficient breachExpectation damages = expected benefit from performanceIf reliance increases anticipated benefit, does it increase expectation damages in event of breach?Can we design damages to also get efficient reliance?9You’re buying an airplane from mePrice is $350,000, to be paid on deliveryAirplane alone gives you benefit of $500,000Building a hangar costs $75,000Airplane with hangar gives you benefit of $600,000Without hangar, expectation damages = $150,000If you build a hangar and I fail to deliver plane, do I owe…$150,000? (Value of original promise)$250,000? (Value of performance after your investment)$225,000? (Value of original promise, plus reimburse you for investment you made)Some other amount?Reliance and damages:examplePrice of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,00010The only way to guarantee efficient breach is if damages included the added benefit from relianceOnce you’ve made investment, you anticipate benefit of $250,000 from performanceIf damages are anything less than that, I’ll breach too often(If damages exclude the added benefit, then I’m back to imposing an externality when I choose to breach the contract)So what happens to the incentive for reliance investments if damages will increase to include this added benefit?To get efficient breach…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,00011If you don’t build hangar, your payoff will be…$150,000 if I deliver the plane ($500,000 – $350,000)$150,000 if I breach and pay expectation damagesIf you build hangar, your payoff will be…$175,000 if I deliver the plane ($600,000 – $350,000 – $75,000)$175,000 if I breach and pay (higher) expectation damagesSo if expectation damages include the increased value of performance due to reliance investments…You’ll invest whenever (increase in benefit) > (cost)In this case, you’ll invest (because $100,000 > $75,000)If exp damages includebenefit from reliance…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,00012If expectation damages include increased value of performance, you’ll invest for sureIs this efficient?Reliance is efficient if(increase in benefit) X (probability of performance) > (cost)$100,000 X (probability of performance) > $75,000Only efficient if probability of performance > ¾If probability of performance < ¾, reliance is inefficient, but happens anywayOverreliance!If exp damages includebenefit from reliance…Price of plane = $350,000 Value of plane = $500,000Cost of hangar = $75,000Value of plane + hangar = $600,00013Better example:continuous investmentxy 600Investment in hangarAdditionalvalue ofplane$100$10,000$40,000$160,000$640,000Tarp and rope - $6,000 benefitPlywood frame, canvas roof - $60,000Metal poles, rigid roof - $120,000Functional heating - $240,000Designer hangar with Starbucks - $480,000Price of plane = $350,000Cost: either $250,000 or $1,000,000Value of plane + $x hangar =$500,000 + 600x14Let p be probability of breachThree questionsWhat is the efficient level of reliance?What will promisee do if expectation
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