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UW-Madison ECON 522 - Lecture 10

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Econ 522 – Lecture 10 (February 19 2009)On 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 the question, the bargain theory of contracts, and some of the problems with it.o Under the bargain theory, promises are legally enforceable if they were given as part of a bargain; there are three elements that must be present, offer, acceptance, and consideration- We showed an example of an agency game, where my inability to commit to a future action (in that case, returning your investment) 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…- (the example of you being unable to buy my used car, because I “know too much”about its condition and have no incentive to tell you what’s wrong with it)- …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 introduced 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 ofreliance…- …and then we ran out of time.- 1 -Today, I want to- give an example of efficient breach- give an example of reliance- then move on to default rules and mandatory rulesWe begin with an example of efficient breachSuppose 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 planeo (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 perform- The promisee’s benefit is known to be $500,000- So it’s efficient to perform whenever the cost of building the airplane is below $500,000, and efficient to breach whenever the cost is above $500,000.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 perform- In the case of expectation damages, the promisor’s liability would be the amount of benefit the promisee would have received, which is $500,000- This leads to the promisor performing whenever the cost of building the airplane is less than $500,000, which is exactly what efficiency would require- 2 -This is what we saw Tuesday – expectation damages, which set liability equal to the promisee’s benefit, lead to breach exactly when it’s efficient.It turns out that any other level of damages would lead to inefficiency- Suppose liability were just $350,000 – I can just return your money and get out ofbuilding you the plane- Then if the cost of building you the plane goes up to $400,000, I would choose to breach, even though performance is efficient – the plane is worth more than it costs to build- On the other hand, suppose the penalty for breach of contract was very large – if I breach the contract, I have to pay you $1,000,000, almost triple your money back- Then if the cost of building the plane goes up to $700,000, I would perform, even though performance is inefficient – the plane costs more than it’s worthSo what, you might ask? Remember Coase? If transaction costs are low, we can just negotiate again, right?Go back to the first example – if I breach, I just owe you your money back- We agreed on a price of $350,000- The cost of building the plane goes up to $400,000- I decide to breach- We can just renegotiate and agree on a new price of $450,000- But if I can get out of a promise just by returning your money, it might be tempting for me to do this too often, just to try to raise the price- Suppose the cost doesn’t change at all- But I know you agreed to pay $350,000, so you must value the plane more highly than that- So I go to you with a made-up story about one of my workers threatening to quit unless he gets a raise, I tell you my costs went up, and you can only have the plane if you’re willing to pay me $400,000- If it’s too easy to get out of a contract, agreements become meaningless- And if transaction costs are high – say, you’re mad because I breached the first contract, and don’t want to deal with me anymore – then you don’t get your plane,even though it would be efficient for me to build it.- 3 -Now go back to the second example – if I breach, I owe you $1,000,000- Now my costs actually go up, and it would cost me $700,000 to build the plane- I go to you and say, “look, I know I promised you a plane, but it would cost me $700,000 to build, can we just agree to undo the deal?”- And you say, “Sure, just give me the $700,000.”- And I say, “Why? You were only going to get $500,000 of benefit out of the plane.”- And you say, “Yeah, so what? If you don’t give me a plane, you owe me a lot more than that. So give me $700,000, or else.”What’s the problem with that?- In a static world, nothing- Me being forced to pay you $700,000 to get out of my promise is annoying to me,but it’s not inefficient- But now go back to when we were originally agreeing to the contract- If I know there’s a small chance my costs will go way up, and if contracts are strong enough that you could do this to me, then maybe I don’t want to take the risk of making the promise in the first place- So now even though it might be efficient for me to agree to build you a plane,


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UW-Madison ECON 522 - Lecture 10

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