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UW-Madison ECON 522 - Econ 522 Lecture 12 Notes

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Econ 522 – Lecture 12 (Oct 16 2007)Last week, we asserted five economic purposes to contract law:- enable cooperation by turning games with noncooperative solutions into games with cooperative solutions- encourage efficient disclosure of information- secure optimal performance (efficient breach)- secure optimal reliance (although what’s actually done is rewarding “foreseeable” reliance)- lower transaction costs by supplying efficient default rules for when gaps are left in contract terms, and efficient regulations (immutable rules)(We’ll get to a sixth today.)We discussed Ayres and Gertner, who give a different view of default rules: that default rules should not always be efficient, but should be designed in such a way as to give an incentive to disclose relevant information. (This is what was done implicitly in the Hadley v Baxendale decision – the shipper was not liable for the miller’s lost profits, since the miller did not tell him how urgently he needed the crankshaft delivered.)We wrapped up with examples of some regulations, or immutable rules. In particular, welooked at some situations in which a contract would not be held to be binding, even if both parties apparently wanted it to be binding at the time it was signed. Two were examples where the rationality of the parties was in question – when one of them was a minor, or insane. Two were examples where one of the players faced “dire constraints,” specifically, duress or necessity.It’s not that hard to argue against holding you responsible for promises made under duress or necessity based on notions of fairness and morality. The Friedman book (Law’sOrder) tries to understand these in straight economic terms, and I think it’s worth a digression.DuressHe begins with an example of duress. A mugger approaches you in an alley and threatensto kill you unless you give him $100. You don’t have $100 on you, but he says he’ll accept a check. When you get home, can you stop payment on the check? Or do you have to honor the agreement you made?Clearly, he wants the agreement to be enforceable; he’d rather have $100 than kill you. And if you believe he’ll kill you if you don’t give him the money, then you clearly want itto be enforceable as well. So making the contract enforceable seems to be a Pareto-improvement. So what’s the problem?The problem, of course, is that even if such a contract is a Pareto-improvement once you’re in the situation, making such contracts enforceable encourages more muggings, since it increases the gains. So refusing to enforce contracts signed under duress seems totrade off a short-term “loss” – the efficiency lost by ruling out some mutually beneficial trades – against creating less incentive for the bad behavior that put you in that situation in the first place.(The fact that there is a tradeoff implies that it may not be optimal to rule out enforceability under every instance of duress. For example, peace treaties can be thoughtof as contracts signed under duress – the losing side is facing the threat of continuing to battle a superior force. Most people agree that peace treaties being enforceable is a good thing. Peace treaties are clearly a good thing “ex post” – they make war less costly, by ending it more quickly. Perhaps by making war less costly, they encourage more wars – but it seems unlikely that this has much effect. It’s probably efficient for peace treaties tobe enforceable, but for promises made to a mugger to be unenforceable.)NecessityHowever, the logic that tells us that contracts with muggers shouldn’t be enforced doesn’twork for contracts signed under necessity.You’re out sailing on your $10 million boat and get caught in a storm. The boat starts taking on water and slowly begins to sink. A tugboat comes by and offers to tow you back to shore, if you pay him $9 million. If not, he won’t leave you to die – he’ll give you and your crew a ride back to shore, but your boat will be lost.With duress, we argued that making the contract enforceable would encourage muggers to commit more crimes, which is bad. But here, making the contract enforceable would encourage tugboats to make themselves available to rescue more boats – so how is that a bad thing?In fact, Friedman points out that if we consider the tugboat captain’s decision beforehand – how much to invest in being in the right place at the right time – the higher the price, the better. The total gain (to all parties) from the tugboat being there is the value of your boat, minus the cost of rescuing it – say, $10,000,000 - $10,000 = $9,990,000. Allowing the tugboat to recover the entire value of the boat would make his private gain from rescuing you exactly match the social gain – which would cause the tugboat captain to invest the socially optimal amount in being able to rescue you!But on the other hand, consider your decision about whether to take your boat out on a day when a storm is a possibility. Suppose there’s a 1-in-100 chance of being caught in a storm; and if you are caught in a storm, there’s a one-in-two chance a tugboat will be there to rescue you.If he can charge you the full value of your boat, then when weighing the costs and benefits of going sailing that day, you consider a 1-in-100 chance of losing the full value of the boat. That is, in your analysis of whether it’s worth going sailing, you’ll include the 1/200 possibility the boat sinks, and the 1/200 possibility you pay its full value to an opportunistic tugboat captain – a total expected cost of $100,000. So you’ll only go sailing on days where your benefit is greater than $100,000.But when you go sailing and start to sink, half the time, your loss is the tugboat captain’s gain. The social cost of you sailing includes a 1-in-200 chance the boat is lost, plus a 1-in-200 chance it has to be towed to shore; for an expected cost of$10,000,000 / 200 + $10,000 / 200 = $50,050. So efficiency says you should go out sailing whenever the benefit to you is greater than $50,050.So if the tugboat captain is able to charge you the full value of the boat, you will “undersail” – that is, in cases where your private gain from sailing is between $50,050 and $100,000, efficiency would suggest you should sail, but since the private cost outweighs the benefit, you choose not to.On the other hand, suppose the tugboat could only charge you the cost of


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