econ 522 lecture 13 _contracts 5_

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					Econ 522 – Lecture 13 (March 5 2009)

      midterm will be returned on Tuesday
      one point about efficiency

Last week, we looked at a number of formation defenses and performance excuses
    incompetence
    dire constraints
    impossibility
    fraud, failure to disclose, frustration of purpose, mutual mistake
    contracts of adhesion and unconscionability

For impossibility and frustration of purpose, we came up with a simple rule for
achieving efficiency:
    When changed circumstances make performance impossible or pointless, assign
       liability to the party who can bear the risk at the least cost

We saw the rule that efficiency generally requires uniting knowledge and control
   Which explains why mutual mistake will generally void a contract, but
      unilateral mistake will not

We distinguished between productive information and redistributive information
   And saw the principle of rewarding productive information – especially if it was
       the result of active investment – to give an incentive to discover it

Next, we returned to the question of remedies. We defined several different remedies:
    expectation damages, which restore the promisee to the level of well-being he
       would have had if the contract had been performed
    opportunity cost damages, which restore the promisee to the level of well-being
       he would have had if he had pursued his next-best option instead of signing this
    reliance damages, which reimburse the promisee for any reliance investments he
    specific performance, which demands the promisor fulfill his promise rather than
       order monetary damages
    and we noted the possibility of party-imposed remedies – remedies which are
       specified in the contract itself

However, common law courts are sometimes hesitant to enforce remedies that are
specified in the contract

One type of remedy that courts will often refuse to enforce is penalty damages
    Penalty damages are damages that are greater than the actual harm that occurred
    (“Liquidated damages” refer to party-specified damages that are a reasonable
       estimate of the actual harm done by the breach; penalty damages are any damages
       that are greater than that)

Civil law courts generally enforce penalty damages

But common law courts often set aside penalty damages, and only enforce liquidated

      It’s unfortunate that penalty clauses are often not enforced, because they could be
       useful in some instances
      In particular, they could be helpful when one party to a contract places a high
       subjective value on performance
      Go back to coal mining example we saw earlier, Peevyhouse v Garland Coal

      The Peevyhouses only wanted their farm strip-mined if the land could be restored
       to its original condition
      They seemed to value the condition of their farm much more highly than “market
      Had they known the coal company would refuse to perform the restoration work,
       and instead only pay them damages, they might have refused to agree to the
       contract in the first place
      We can illustrate this with a simple dynamic game
      Suppose the coal extracted was worth $70,000 (net of costs), and Garland Coal
       agreed to pay $25,000 to mine it
      Recall that restoration work would have cost around $30,000, but damages for
       refusing to do it were assessed at $300
      Suppose that the Peevyhouses’ subjective valuation of their farm dropped by

                               Sign                     Don’t
                                                             (0, 0)
    Restore property           Don’t, pay damages

       (25,000, 15,000)     (-14,700, 44,700)

      So the Peevyhouses anticipate that once the coal has been mined, Garland will
       refuse to do the restoration work
      So now the Peevyhouses refuse the original contract

      One way to address this in a contract would have been to write into the contract a
       $40,000 penalty in the event that the restorative work was not completed
      If this was enforceable, it would ensure that the mining company followed
       through with the restorative work
      That is, it would change the game to this:

                               Sign                    Don’t
                                                             (0, 0)
    Restore property           Don’t, pay penalty

       (25,000, 15,000)      (25,000, 5,000)

      Now, the Peevyhouses are assured of getting their land restored
      So they’re happy to agree to the contract
      But, if common law courts don’t uphold penalty clauses, this won’t work

Another example: suppose you’re hiring a contractor to build a house, and you place a
very high value on its being completed by a particular date
    You are happy to pay $200,000 to get the house built, but insist on a $50,000
       penalty if it’s not ready on that date
    Now suppose there are lots of contractors who could potentially build the house
    If you offer this deal to lots of them, the ones who accept are likely the ones who
       are most confident in their ability to finish the house on time
    Since you value this highly, this may be efficient
    And this may be the easiest (or the only) way for you to elicit this information
           o If there is no penalty clause, every contractor will try to convince you he’s
               100% certain he’ll finish on time
           o But if someone accepts the $50,000 penalty clause, they’re probably pretty

Of course, it’s also easy to come up with examples where penalty clauses seem excessive
and nasty
    Imagine if Blockbuster charged late fees of $1,000 per day
    You go to rent a video, they tell you it’s yours for a week, but it’s $1,000 if it’s a
       day late
    You might rent the video anyway, thinking it’s within your power to return it on
    But in the event that something happens (your daughter gets sick, or you get
       called out of town on business), you’re going to be pretty upset to be charged
    Similarly, a rental car company that attached a $50,000 fine to any damage to
       their $10,000 car would look pretty mean-spirited

Still, in some instances, penalty damages seem beneficial
     Especially if one party would not agree to a mutually beneficial contract without
     So it seems like the fact that they’re not enforced is a problem
     However, it turns out, most things you could accomplish with penalties, you could
         restate in a different way with a performance bonus

      Go back to the house-building example
           o I’m happy to pay $200,000 to get the house built by a certain date
           o But I insist on a $50,000 penalty if it’s not ready on time
      We could alternatively write the contract this way:
           o I pay $150,000 for the building of the house
           o And I pay an additional $50,000 performance bonus if the house is
               completed by a certain date
      Courts generally have no problem enforcing contracts with bonuses in them, so
       this would likely be enforced as written
      But it ahs the same effect as the contract with the penalty
      (Under either contract, the builder gets $200,000 for finishing the house on time,
       and $150,000 for finishing it late.)

Similarly, go back to the Peevyhouse example
    Instead of a $40,000 penalty that might not be upheld, the Peevyhouse contract
       also could have been rewritten as a bonus
    We imagined that Garland paid $25,000 to mine the coal
    Suppose the contract were written in this way:
            o Garland pays the Peevyhouses $65,000 to mine the coal
            o The Peevyhouses pay Garland a $40,000 bonus if the resoration work is
    This would create exactly the same incentives as a $40,000 penalty clause
    (In this case, though, the intent of the contract might have been so transparent that
       it still might not have been enforced)

So that’s penalty damages.

Next, I want to consider the effect of different remedies for breach, in terms of the
incentives they lead to for…
     the promisor’s decision to perform or breach
     the promisor’s investment in performing, and
     the promisee’s investment in reliance

      Put aside the question of reliance for the moment, and suppose that performance
       of the promise will have a fixed benefit for the promisee
      The fact that the two parties agreed to the contract in the first place implies they
       believed this benefit was likely to greater than the cost to the promisor of
      But as we’ve already discussed, circumstances may change after the promise is
       made, in a way that makes the promisor less keen to keep his promise
           o The price of building the airplane may go up
           o My rich cousin may appear and value my painting more highly than you

      There are two ways for me to get out of my promise
          o I can renegotiate with you, getting you to “let me off the hook,”
              presumably in exchange for some money
          o Or I can breach our contract and live with the consequences, most likely
              the damages that a court imposes

      Think back to nuisance law, and consider some entitlement – say, the right to
       breath clean air
      When it was protected by injunction, the parties could still bargain for it – the
       polluter could offer the neighbor enough money to be willing to live with the
      When an entitlement was protected by damages, the polluter could instead simply
       pollute and pay whatever damages were ordered
      We found that when transaction costs were low, either remedy would lead to
      But since the two remedies changed the noncooperative outcome (the threat point)
       for each side, they led to different allocations of surplus
      On the other hand, when transaction costs were high, the two remedies could
       lead to different results.
      With contract law, the result is exactly the same
      When transaction costs are low, all remedies lead to efficiency, but they will lead
       to different outcomes for each party
      When transaction costs are high, some remedies will be more efficient than others

For example, let’s compare a contract enforced by specific performance – the promisor
is not allowed to breach unless the promisee agrees – versus a promise enforced by
expectation damages

      Let’s stick with the example of the airplane I agreed to build for you
      The plane will give you a value of $500,000
      We agree on a price of $350,000
      I expect the plane to cost me $250,000 to build, but there is some chance it will
       instead cost me $1,000,000

First, let’s consider what happens if our contract is protected by expectation damages.

                       Costs Low              Costs High              Costs High (Breach,
                       (Perform)              (Perform)               pay exp damages)
I Get                  100,000                -650,000                -150,000
You Get                150,000                150,000                 150,000
Total                  250,000                -500,000                0

Now let’s see what happens if our contract is protected by specific performance, that is,
you have the right to demand the airplane, and I can only breach with your permission.

                       Costs Low              Costs High              Costs High
                       (Perform)              (Perform)               (renegotiate)
I Get                  100,000                -650,000
You Get                150,000                150,000
Total                  250,000                -500,000                0

      Since performance is very costly, my threat point is very low, so renegotiation
       may force me to accept fairly bad terms
      Notice that by renegotiating the contract, we create a total surplus of $500,000
       (beyond our outside options if you forced me to build the plane)
      Suppose that our negotiations lead us to divide this additional surplus evenly
      This would lead you to get $250,000 beyond your outside option, which was
       $150,000, so your payoff would be $400,000
      I would get $250,000 beyond my outside option, which was -650,000, which
       would be -400,000
      (So this means, in return for getting out of the contract, I pay you $400,000)

      As long as transaction costs are low, either remedy will lead to the same outcome
           o When it is efficient to breach, expectation damages lead me to breach
              without permission
           o Under specific performance, when it is efficient to breach, renegotiation
              will lead us to some sort of agreement to let me off the hook.

      But when the transaction costs of renegotiating our contract are too high…
          o Expectation damages still allow me to breach
          o Specific performance would lead to inefficient performance
          o I would have to build you the plane, even though it costs me more than
             your benefit

      Other types of damages – opportunity cost damages, or reliance damages – would
       lead to inefficient breach
      That is, I would choose to breach even when my cost of performing is lower than
       your benefit
      However, when transaction costs are low, this could also be fixed through

      For example, consider opportunity cost damages
      Suppose that the next-best contract would have sold you a similar plane for
       $400,000, but that now at this late date, no other planes are available
      We agreed on a price of $350,000, but now costs go up somewhat, to $460,000.

                      Perform                Breach and pay Opp     Renegotiate and
                                             Cost Damages           Perform
I Get                 -110,000               -100,000               P – 460,000
You Get               150,000                100,000                500,000 – P
Total                 40,000                 0                      40,000

      Renegotiating the contract (instead of me breaching) generates additional surplus
       of $40,000
      If we split this evenly, we would each get a payoff $20,000 higher than our
       outside option, which would require the renegotiated price to be $380,000

      Again, however, if transaction costs were high, we would be unable to renegotiate
       the contract, and I would choose to breach and pay you $100,000 in opportunity
       cost damages.

(Cooter and Ulen point out that, just like efficiency demands enforcing contracts
whenever the parties wanted them to be enforceable, efficiency demands enforcing
renegotiated contracts whenever the parties wanted them to be enforceable at the time of

So just like with nuisance law, we find the following:
     if it is cheap/easy to renegotiate terms, any of the remedies will lead to efficient
        breach, although they will lead to different allocations of surplus
     if it is expensive/hard to renegotiate terms, only expectation damages are
        guaranteed to lead to efficient breach – specific performance may lead to
        inefficient performance, and lower damages may lead to inefficient breach

      An increase in the cost of performance is referred to as an unfortunate
      On the other hand, I may want to break my promise because I discover another
       buyer who values my product more than you do
      This is referred to as a fortunate contingency
      Earlier, we saw the example where you contracted to buy my painting, but my
       rich cousin appeared and valued it much more highly than you did
      We can do the same exercise as before with the different remedies, and see the
       same thing
           o With low transaction costs, any remedy will lead to efficient breach, but
               with different allocations of surplus
           o An example of this is done in the textbook (p. 267)
           o Once again, specific performance is the most advantageous to the buyer,
               and higher damages are better for the buyer than lower damages.


One further point that we mentioned earlier but didn’t talk much about: efficient signing.

      We saw that with expectation damages, when my costs remain low and I perform,
       I get a profit of $100,000 (the price you pay, $350, minus the costs I incur, $250)
      And when my costs jump up and I breach, I owe $150,000

      If the probability my costs rise is small enough, that’s no big deal
      I take the risk of owing you expectation damages, because my profits in the cases
       where I don’t breach are large enough that it’s worth the risk.

      But if the probability my costs rise is high, then my expected profit from this
       contract is negative
      For example, suppose the probability of a dramatic rise in costs is ½
      Then my expected payoffs from agreeing to build you the airplane are
       ½ (100,000) + ½ (-150,000) = -25,000

      So now there’s no way I’d agree to the contract in the first place
      This is the point we mentioned before:
      Expectation damages lead to efficient breach, but they may lead to inefficient
      (If I’m the only airplane manufacturer available, it’s still efficient for us to sign
       this contract – it generates positive expected surplus – but under expectation
       damages, I would not sign this contract.)

      This suggests that, even if expectation damages make a sensible default rule, it’s
       efficient for parties to be able to specify a different damages rule in the contract
      That is, even if expectation damages are often efficient, they are not always
       efficient, so there’s no reason for them to be mandatory

<<< END SKIP >>>

                                           - 10 -
So that’s breach

What’s left is investment in reliance, which we’ve already talked a bit about; and
investment in performance, which we haven’t.

      The book makes a big deal out of “the paradox of compensation”
      This is an idea we’ve already mentioned: the remedy for breach sets an incentive
       for both the promisor and the promisee, and it’s generally impossible to set both
       of these incentives efficiently at the same time
      (The particular conflict they look at here is the way that reliance figures into
       expectation damages.)

      Let’s go back to the airplane example once again, and again assume that, once
       you contract to buy my plane, you consider building yourself a hangar
      But this time, rather than just a decision to build or not build, there is a whole
       range of different-quality hangars you could elect to build.

Suppose that, for any investment of x dollars, you can build a hangar that will enhance
the value of having a plane by 600 sqrt(x), but is worthless without a plane.

Investment    Value of
     x        600 sqrt(x)
    100          6,000       Large tarp held up by some rope connected to a telephone
                             pole – still keeps some rain off the airplane
 10,000             60,000   Basic plywood frame, canvas roof
 40,000            120,000   Metal poles, rigid roof
 160,000           240,000   Functional heating
 640,000           480,000   Designer hangar with working Starbucks

Recall that whatever investment is made in reliance pays off when the promise is kept,
but is lost when the promise is broken.

                                           - 11 -
We will ask three questions:

1. What is the efficient level of reliance?

2. What would the buyer do if expectation damages included the anticipated benefit
from reliance?

3. What would the buyer do if expectation damages do not include the anticipated
benefit from reliance?

First, What is the efficient level of reliance?

       The total social gain from the contract when costs stay low is
        500,000 + 600 sqrt(x) – 250,000 – x

       The total social gain is from the contract when costs go up and the seller breaches
        is –x (the reliance investment is lost, everything else is just transfers)

       Suppose the probability of breach is p; then the expected social benefit is
              (1-p) (500,000 + 600 sqrt(x) – 250,000 – x) + p(–x)

       We can simplify this to
              250,000*(1 – p) + 600 (1– p) sqrt(x) – x

       If we take the derivative and set it equal to 0, we get
                600 (1 – p) / 2sqrt(x) – 1 = 0

       If we solve this for x, we find the efficient level of reliance is 90,000 (1-p)^2

                                              - 12 -
Next, what will the buyer do if that expectations damages include the benefits
anticipated based on reliance investments?

      Then the buyer knows he’ll get the added benefit, whether or not the seller

      So in deciding how nice a hangar to build, the buyer would maximize
              500,000 + 600 sqrt(x) – 350,000 – x

      Solving this gives the first-order condition
              600/2sqrt(x) – 1 = 0  x = 300^2 = 90,000

      So the buyer, when insulated from the risk of breach, invests $90,000 in a pretty
       nice hangar, which gives anticipated benefit of 600 sqrt(90,000) = 180,000

      Note that the reliance investment, 90,000, is more than the efficient level,
       90,000(1-p)^2, as long as p > 0 (there is any chance of breach)

      This makes sense: in this scenario, reliance imposes a negative externality on the
       seller (since he incurs a greater cost when he breaches), so it is overprovided

      Or, the buyer gets all the benefit from reliance, but not all of the cost, so he
       invests too much

On the other hand, suppose expectation damages do not include the benefits of reliance

      Then the buyer maximizes
              (1-p) (payoff without breach) + p (payoff with breach)
              = (1-p) (500,000 + 600 sqrt(x) – 350,000 – x) + p (150,000 – x)
              = 150,000 + (1-p) 600 sqrt(x) – x

      This leads to the efficient level of reliance

      So if damages include the gains from reliance, this leads to overreliance
      But if the level of damages excludes the gains from reliance, this leads to efficient

      But we also know that if the level of damages exclude the gains from reliance,
       and the buyer relies anyway, that this will lead to inefficient breach
      That is, since the seller’s liability from breach is lower than the buyer’s gain from
       performance, there will be some instances where the seller breaches even though
       efficiency requires performance

                                            - 13 -
   We said before that with no transaction costs, this problem can be solved
      o When breach would be inefficient, the parties can contract around it
      o Since it’s generally very clear whether a party has breached a contract or
           not, this shouldn’t be a particular problem.

   However, there are situations in which a promisor can take actions to make
    performance less costly
   Or, to put it another way, to lessen the probability that breach is necessary
         o A contractor could buy raw materials ahead of time, to avoid the risk of
             changing prices
         o A manufacturer could start a project earlier and frontload the labor to
             avoid the risk of a strike
         o If a project were to require a building permit or zoning easement, he could
             lobby the local government (or bribe someone) to decrease the chances of
             hitting a snag.
   This sort of investment in performance, however, may be unobservable, or
   So even when this sort of investment is efficient, it may be very hard to build it
    into the contract
   (It’s very hard to enforce a contract specifying “how hard I have to try” to
    convince the zoning board to approve your project.)
   So investment in performance may only occur when it is in the promisor’s best

   We’ll stick with the airplane example

   Suppose there is some investment I can take that reduces the chance that my costs
    go up
        o I can buy some of my supplies ahead of time
        o This will reduce the risk of having to breach
        o But I can’t completely insulate myself from risk

   Suppose that for each $27,726 I invest, I can reduce the probability I will need to
    breach by ½
        o That is, if I invest $27,726, the probability of breach goes from ½ to ¼
        o If I invest another $27,726, it goes down to 1/8
        o And so on

   For any investment z, then, we can write the probability that breach is still
    required as ½ * ½ ^(z / 27,726)

                                        - 14 -
   The reason I chose the number 27,726 is that we can rewrite this probability as
           ½ e^{- z/40,000)
    which makes it much easier to work with.

   So, how much will a self-interested promisor invest in performance?

   Let’s let D be the amount of damages that the promisor is liable for if he breaches
        o D could be nothing
        o or the investment in reliance
        o or the opportunity cost
        o or the gain the buyer expected to achieve, with or without reliance.

   But suppose that D is low enough that the seller will still choose to breach when
    costs go up
        o Since we’ve been talking about costs rising to 1,000,000, this just requires
            D < 650,000, the loss I would take from performing

   When costs remain low, the seller expects $100,000 in profits

   So when deciding how much to invest in performance, the seller maximizes

    (1 – Pr(breach)) 100,000 + Pr(breach) (-D) – investment in performance

    = 100,000 – Pr(breach)(D + 100,000) – z

    = 100,000 – ½ e^(-z/40,000) (D+100,000) – z

   Taking the derivative gives

    ½ 1/40,000 e^(-z/40,000) (D+100,000) – 1 = 0

    ½ e^(-z/40,000) = 40,000/(D+100,000)

   So whatever D is, the seller invests enough to reduce the probability of breach to

   If the seller can breach for free, he’ll invest enough to reduce the probability of
    breach from ½ to 40,000/100,000 = 2/5
         o He still prefers profits (100,000) over nothing
         o But he only invests a little, since he can still get out of the contract for free
         o (The investment here is about $9,000.)

                                         - 15 -
Suppose D was expectation damages, without reliance
    If he would owe expectation damages (without reliance) of $150,000, then he
      invests enough to reduce the chance of breach from ½ to
      40,000/(150,000+100,000) = 4/25 = 16%
    (The investment this time is about $45,000.)

Suppose D was expectations damages, with reliance
    We said that if expectation damages include reliance, the buyer spends $90,000
      on a hangar giving $180,000 in benefits
    So the promisee’s benefit from performance is now 500,000 – 350,000 + 180,000
      = 330,000
    With damages at that level, the seller invests enough to reduce the probability of
      breach to 40,000/(330,000 + 100,000) = 40/430 = 9%
    (The investment to do this is about $67,000.)

But what would be efficient?
    Suppose that the buyer has already decided to build himself that nice $90,000
    So the benefit of performance is 330,000
    The cost of the hangar is sunk, so we can forget about it for now
    The total social surplus is

       (1 – Pr(breach)) (330,000 + 100,000) + Pr(breach) (0) – z

       = 430,000 – 430,000 ½ e^(-z/40000) – z

      To maximize this, we take the derivative:

       430,000 ½ 1/40,000 e^(-z/40000) – 1 = 0

       Pr(breach) = 40,000/430,000

      So given that level of reliance, the efficient level of investment in performance is
       enough to reduce the chance of breach to 40,000/430,000

      Which we just saw is exactly what the seller would do when he’s liable for
       expectation damages which include the benefit from reliance!

                                           - 16 -
So we’ve found…

      The efficient level of investment leads to a 40,000/430,000 chance of breach

      Damages which are set equal to D lead to a self-interested promisor to allow a
       probability of breach of 40,000/(D + 100,000)

      So when damages are set to 330,000 – damages include the benefit from reliance
       – the investment in performance is efficient

      When damages are lower than that, the seller will underinvest in performance,
       leaving the risk of breach inefficiently high

      When damages are higher than this, the seller will overinvest in performance

And what’s the overall lesson?

      Making the seller liable for reliance – that is, increasing expectation damages to
       include benefit due to reliance – leads the seller to invest efficiently in
       performance; just like it led to efficient breach
      But it leads the buyer to overinvest in reliance

      On the other hand, making the seller not liable for reliance – leaving
       expectation damages where they were without reliance – leads to
       underinvestment in performance
      But it leads to the efficient level of reliance

      So like we saw last week with the sailboat example from Friedman:
      The level of damages leads to multiple different incentives
      And it’s impossible to come up with a level of damages that makes everyone
       behave efficiently

We already saw one attempt to get around this problem:
   limit damages to the efficient level of reliance, not the actual level of reliance
   that way, the promisee has no incentive to overinvest in reliance, so he invests the
       efficient amount
   but the promisor still internalizes the full cost of breach
   so he invests the efficient amount in performance

The textbook also discusses another clever, if unrealistic, solution to the problem, which
is where we’ll begin on Tuesday.

                                           - 17 -

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