Midterm Will Be Returned at End of Lecture

Econ 522 – Lecture 14 (March 10 2009)

·  midterm will be returned at end of lecture

·  section at lecture time Thursday this week; no section meetings Friday

·  HW2 (contract law) due March 31

(written on board before we start)

Expectation damages include anticipated benefit from reliance / Expectation damages exclude anticipated benefit from reliance
·  efficient breach and investment in performance
·  overreliance / ·  inefficient breach and investment in performance
·  efficient reliance

Last Thursday, we worked through examples of breach, reliance, and investment in performance. We found that

·  When expectation damages include the anticipated benefit from reliance, we get

o  efficient breach, and efficient investment in performance

§  why? seller internalizes the full cost of breach, and makes efficient decision

o  inefficiently high reliance

§  why? buyer reliance imposes a negative externality on seller – since he has to pay more if he breaches – so buyer does not bear full “cost” of reliance

·  On the other hand, when expectation damages exclude the anticipated benefit from reliance,

o  inefficient breach/investment in performance

§  breach imposes a negative externality on buyer, so seller does not bear full cost

o  efficient reliance

§  buyer bears full cost, full benefit of reliance, makes efficient decision

·  This is what Cooter and Ulen call the paradox of compensation

o  neither rule gets both parties to act efficiently

We already saw one proposed solution to this problem

·  Modify expectation damages to include the benefit of reliance, but only up to the efficient level of reliance, not beyond

·  This way, buyer has no incentive to over-rely, since he won’t get that benefit in the event of breach

·  And seller still bears full cost of breach, so he makes efficient decisions as well

The textbook discusses another clever, if unrealistic solution:

anti-insurance

What’s causing the problem?

·  Well, you only make efficient reliance investment if the damages you receive don’t reward you for reliance

·  And I only make efficient investment in performance if the damages I pay do include the benefit of reliance

·  One way to fix this: make the damages you receive different from the damages I pay!

How do we do this?

·  You and I have this friend, Bob

·  Bob likes money

·  So we go to Bob and say, hey Bob, here’s a deal for you

·  I’m planning to build a plane

·  He’s planning to buy the plane

·  He’s probably going to want to build a hangar

·  I might end up not building the plane

·  Here’s what we need you to do

In the event that he builds a hangar and I don’t build the plane,

·  I’m going to give you the value of the plane with the hangar;

·  And you’re going to give him the value of the plane without the hangar

·  And you keep the rest for yourself. OK?

And Bob says, “cool!”

This is called “anti-insurance”

·  Rather than buying insurance from a third party, you and I are basically entering into this additional contract where if things go bad, I owe Bob some additional money, beyond what I pay you

·  By doing this, we set both our incentives correctly

o  You only get the benefit of reliance if I perform, so you invest the efficient amount in reliance

o  I face the full cost of breach, so I invest the efficient amount in performance.

·  Now obviously, Bob is happy to do this for free

·  But now we go to our other friend Carol, and say, Hey, Carol

·  Here’s a deal we’re offering

·  Give us $5 now, and if he builds a hangar and I don’t deliver a plane, you’ll get the difference between the value of the plane with the hangar and without the hangar

·  And Carol realizes this is worth more than $5, so she says, “sure.”

·  But now we go back to Bob, and we offer him the deal at $10 instead.

·  And if we make Bob and Carol compete for this deal, we should be able to get them to pay a fair amount for it up front

·  If they’re risk averse, of course, they’ll need to be compensated for taking on some risk

·  But if we have a risk-neutral friend who’s smart enough to understand the probabilities and figure out what each of us will do given our incentives, we can get them to give us the full value of the anti-insurance deal ahead of time, and divide it up among ourselves

·  So this way, we can give ourselves incentives for efficient reliance and efficient investment in performance at the same time.

So that’s one way to solve the paradox of compensation – even if it’s pretty unrealistic

We already mentioned the idea of limiting damages to include the benefits of efficient reliance but not overreliance

What courts actually do, rather than basing damages on actual or on efficient reliance, is to base damages on foreseeable reliance

That is, they base damages on what the promisor could have reasonably expected the promisee to do, not what he actually did

·  This was the decision in Hadley

·  Since the shipper could not reasonably expect the miller to rely so heavily, he was not liable for the lost profits

o  Most millers at the time had more than one crankshaft

o  So a broken shaft would not typically lead to shutdown

·  Under the doctrine of foreseeable reliance, if Hadley had told Baxendale that his mill was closed until repairs were made, then Baxendale would be liable for lost profits due to delay

o  By informing Baxendale of the reliance, Hadley would have made it foreseeable, and therefore compensable

Next topic: timing

Everything we’ve done so far has assumed that the timing of the contract is fairly rigid

·  first, we sign a contract

·  next, you decide how much to rely, and I decide how much to invest in performance

·  Then, things happen, I decide whether to perform or breach, and if I breach, I pay damages.

But often, the different stages may overlap a bit more

·  If I’m building a house for you, I’m unlikely to build it in a day

·  You may be able to see how some of the progress is going before making all of your reliance investments

Similarly, the question of when someone decides to breach a contract may affect the damage done by breach, which may therefore affect damages.

·  Suppose you’re a farmer, and I’m a grain wholesaler

·  You agree to deliver me 10 tons of corn on a given date at a given price

·  This is a futures transaction – a promise to transact a good on a future date

·  In some cases, there may be a going market rate for corn delivered on that date

·  And this price can rise or fall as the date approaches.

·  So we agree that you’ll sell me 10 tons of corn next June, at a price of (I don’t know the price of corn), say, $500 per ton

·  Over the course of the winter, circumstances may change

o  maybe it’s a dry winter, so irrigation will be more expensive in the spring

o  maybe other crop prices go up and you decide to plant wheat in more of your field.

·  If you decide to breach, you could wait until the last minute to tell me

o  in which case, damages might reflect the cost to me of buying corn on the spot market, that is, the day I was expecting delivery.

·  Alternatively, you could tell me in January that you plan to breach our contract

o  This would allow me to contract in advance with someone else to sell me corn in June

o  which might be cheaper than if I waited till the last minute

·  Breaching a contract in advance on is sometimes called renouncing or repudiating a contract

o  you announce early your intention to breach

o  When this happens, if there is a market for a substitute good – in this case, June corn – then damages would reflect the price of June corn futures at the time you renounced the contract, say, in January.

§  I could actually buy the futures in January

§  or I could wait and take my chances

§  but what happens after that tends not to affect the damages you owe me.

·  To use another example from two weeks ago…

·  Suppose one of you agreed a week in advance to sell me a ticket to the Michigan basketball game for $50

·  At the time we agreed to the deal, there were lots of tickets available for $75

·  If you breached early in the week, I could have bought a replacement ticket for $75; so expectation damages would be limited to $25, the damage breaching early did to me relative to performing

o  If I chose not to buy another ticket in advance, and waited and overpaid on the day of the game, that was a risk I chose to take, but not your responsibility.

·  But if you waited till the end of the week to breach, a replacement ticket might be more expensive, so damages would be higher

·  In cases where there is a liquid market for substitutes, there’s little difference between you renouncing our agreement and paying damages, or you going out and buying another ticket on Craigslist to sell to me at our agreed price

·  If transaction costs are low, the two are equivalent

·  So when there is a market for a substitute good and transaction costs are low, you are indifferent between breaching and paying damages, and buying and delivering a substitute product.

(SKIP THIS: In well-behaved markets, futures prices are generally assumed to reflect the market’s expectation about what the future spot price of the good will be. That is, if everyone knows there will be a liquid market for tickets at $150 at the end of the week, there’s no reason for them to be selling for $75 early in the week; under certain conditions, futures prices should just be the expected value of the future spot price. So in terms of the expected payoffs, and the incentives to breach, there shouldn’t be a difference whether courts impose damages equal to the futures price at the time a contract is renounced, or equal to the spot price realized at the date of promised delivery.)

·  When goods are traded that do not have close substitutes, however, the value is sometimes hard to calculate

·  So courts sometimes impose only reliance damages simply because it’s easier

·  Renouncing a contract earlier obviously stops the promisee from making further investments in reliance

·  However, when damages are set lower then the benefits of performing, we’ve seen before that this will lead to inefficient breach

·  (There are some further complications.

·  The law on anticipatory breach, and breach following partial performance, are a little bit murky

·  In some of these cases, renegotiation of the contract may be preferable to outright breach

·  Again we come to the suggestion that efficiency demands enforcing renegotiated contracts as long as both parties wanted it enforceable at the time of renegotiation.)

Last new topic for contract law: Repeated Games

Nearly everything we’ve done so far has assumed a one-shot interaction

·  that is, we’ve been assuming that the parties to a contract are only interested in maximizing their gain from that one particular contract,

·  and are not concerned with any future interactions with the same partner.

Of course, in many cases, this is not true

·  Example. There’s a coffee shop near my house, and I go there several times a week.

·  One day, I forget my wallet, and ask if I can still buy a cup of coffee and a muffin, and pay them back the next day

·  They say yes, and I show up the next day with the money. Why?

(Seems pretty obvious to any reasonable people, less so to an economist.)

An economist would say:

·  The reason I pay them back is that I want to keep transacting with them in the future

·  And the value I expect to get from those future transactions is worth more to me than the $3 I could save by breaking my promise now

·  And the reason they trusted me is that they expected this would be the case.

·  From a theoretical point of view, repeated games can be very hard to analyze, because a lot of different things can happen

·  But one of the things that can happen is that we can cooperate in a repeated game, even if we could not cooperate in the same one-shot game.

Let’s go back to the original agency game we did a couple weeks ago.

·  You choose whether to trust me with $100, which I can double by investing it; and then I decide whether to keep the $200 or return $150 to you and keep $50 for myself

·  But now, suppose there is the possibility of playing the game more than once.

·  In particular, suppose that each time we play the game, there is a 10% chance it’s the last time we play, and a 90% chance that we get to play again.

Think about my incentives to repay your money or keep it for myself

·  If I keep it for myself, I get a payoff of $200; but then you’ll never trust me again, so that’s all I’ll ever get

·  On the other hand, if I give you back your $150, you’ll probably trust me again the next time, and the time after that, and the time after that (provided I keep returning it)