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Die Johannes Kepler Universitt Linz Powered By Docstoc
					Prof. Dr. Friedrich Schneider
Institut für Volkswirtschaftslehre
http://www.econ.jku.at/schneider




    Recht und Ökonomie (Law and Economics)
                                               LVA-Nr.: 239.203
                                                       SS 2011


                                (7) Contract Law (Vertragsrecht)

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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




1. Contract
 Agreement that regulates an exchange that is mutually
     beneficial

      — contracts to give or to make

      — replicable goods or „specific‟ goods

 General problems

      — breach of contract

      — information may be asymmetric

      — correct incentives to fulfil the contract


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




2. Incompleteness of Contracts
 Complete contingent contract (hypothetical)

 Incompleteness: Costs of specification

      — ex ante, e. g. lawyers fees

      — ex post, conflict resolution

 Minimise cost by comparing

      — ex ante cost (usually certain) to

      — ex post cost, usually with presumed probability

             • assumption: many contracts concluded


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




3. Breach or Re-Negotiation
  Suppose S & B contract for 100 washing machines per
      month for € 35,000

  „Daily‟ cost of equipment (sunk cost) € 15,000

  Opportunity cost € 25,000 (value of sales in best alternative
      use of equipment)

  B could re-negotiate contract for a new price of less than €
      35,000 (but more than € 25,000)

  post-contractual opportunistic negotiations



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Recht und Ökonomie SS 2011         Contract Law (Vertragsrecht)            Prof. Dr. Friedrich Schneider




4. Incompleteness and Contract Law
 Reliance               on   C.    L.       to       resolve     unexpected     (unlikely)
     occurrences

 Only major or contract specific terms have to be contained in
     the contract

 Plus some clause: “ … contract is to be governed by the laws
     of…”

 Contract law thus

      — serves as „default option‟

      — reduces transaction costs through provision of (efficient)
           enforcement mechanisms
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Recht und Ökonomie SS 2011     Contract Law (Vertragsrecht)                  Prof. Dr. Friedrich Schneider




5. Inefficient Contract Laws
 Breach of contract reduces profits (welfare)
 Possible solution: penalty
      — e.g.: “ … delay of delivery (finishing construction, …) leads
           to a penalty of € … per day (week, …)”
      — recovers profits foregone by buyer
 Seller can choose to deliver on time or with delay to maximise
     his profits >> optimal solution for both
 Poor           enforcement      mechanisms                  (may)   lead   to        reduced
     economic activities, reducing welfare
 Uncertain debt recovery (or payment) will lead to request for
     securities, increases cost
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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




6. Efficient Contract Laws
  Reduce transaction costs
  Economise on information costs
       — imperfect vs asymmetric information
  Lead to only efficient contract breaches
       — cf. penalty
  Imply efficient reliance
       — avoid opportunistic re-negotiation
  Involve risk minimisation
       — precautions to avoid risk
       — cost-minimising risk bearing


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




7. Asymmetric Information
 Consider used car market for, say, 100 cars

 50 ‚plums„ and 50 ‚lemons„

 Sellers know the quality of car, buyers do not

 ‚Plums„ would be offered for € 6,000, ‚lemons„ for € 3,000

 Willingness to pay: € 7,200 and € 3,600, resp.

 WtP with no information on quality: € 5,400

 Only ‚lemons„ would be offered >> no contract


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




8. Adverse Selection
  Example 1: Bicycle Insurance

  Assume regional differences in theft rates

  Insurance company offers insurance based on average theft
      rate

  Only people in areas with high theft rates will take out
      insurance – A. S.

  Company will go out of business due to adverse selection
      (and not unbiased selection)


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




8. Adverse Selection
 Example 2: Health Insurance
 Insurance company bases rates on average occurrence of
     health problems
 Individuals know their health status (better), insurance
     companies do not (or know it less)
 Only high risk people will take out insurance
 Solutions:
      — mandatory insurance (e. g. Europe)
      — „health plan‟ by firms (e. g. US, also Europe)



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Recht und Ökonomie SS 2011    Contract Law (Vertragsrecht)      Prof. Dr. Friedrich Schneider




9. Moral Hazard (M.H.)
     Example: Bicycle Insurance
     Assume probability of theft (also) depends on action – care – taken
      by owners (type of locks)
     If no insurance is available: maximum care
       — MC of taking care = MB of taking care
     With insurance: level of care is reduced – M. H.
       — holds also for health insurance, fire insurance, ...
     Solutions:
       — deductibles: no full coverage
       — try to observe level of care
              • rates differ for smokers, houses with sprinkler systems, …

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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




9. Adverse Selection and Moral Hazard (A.S. & M.H.)
  Adverse Selection is due to „hidden information‟

       — one side of the market cannot observe quality

  Moral Hazard is due to „hidden action‟

       — one side of the market cannot observe care

  Lack of information causes inefficiency

  Government action may alleviate the problem only in case of
     hidden information

       — compulsory insurance



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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




9. Signalling
 Car example: warranty on used cars

 Quality of workers:

       — years of school attended

       — diploma („sheepskin effect‟)

       — additional qualifications

       — voluntary work

       —…

 Objective: reduce asymmetry in information (at low cost!)


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




10. Incentives and Asymmetric Information
 Which contract ensures that someone does what I want
      her/him to do for me?

 aka „Principal – Agent – Problem‟

 Consider four types of contracts:

       —rent

       —wage labour

       —take-it-or-leave-it

       —sharecropping
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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




11. Rent
    Agent pays fixed amount to principal

    Agent gets all the surplus beyond rent

    Maximum output produced >> efficient

          — utility maximizing for agent

    but: agent also bears all the risk

    if she is more risk averse than the owner the result will be
        inefficient

    Agent would be willing to give up some income for a
        reduction in risk


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




12. Wage Labour
 Principal pays to agent (worker) a constant amount per
      unit of effort

 Utility maximizing agent chooses his effort such that
      marginal product of effort equals marginal cost of effort
      >> efficient

 with asymmetric information: effort cannot be observed
      by principal (only hours)

 unless: piece work


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




13. Take-it-or-leave-it
   Agent (worker) is paid the full amount if s/he chooses the
       optimum effort level – and zero otherwise

   Outcome: agent chooses this optimal level
               thus >> efficient

   With asymmetric information:

         — agent bears all the risk (if payment is based on output)

         — effort cannot be observed (payment based on input)




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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




14. Sharecropping
    Principal (landowner) and agent each get some fixed
        proportion of total output

    Since agent gets only a fraction of output s/he will
        equalize this fraction of marginal product to the
        marginal cost

    Leads to an inefficient level of effort (output)

    Introducing risk aversion of actors leads to optimum
        output since both P. & A. bear risk


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Recht und Ökonomie SS 2011   Contract Law (Vertragsrecht)   Prof. Dr. Friedrich Schneider




15. Conclusions
   Results of „simple‟ economic models may change if one
       adds

         — asymmetry of information

         — risk (uncertainty) considerations (risk neutral, risk
             averse, or risk loving)

         — behavioural insights (How are decisions actually made?)

   If one wants to arrive at recommendations for the concrete
       design of contracts (more) advanced economic analysis
       may be required


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posted:11/16/2011
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