Contract design

Contract design • Opportunistic breach happens because – At some point in the process, one side – Is better off stopping, keeping what it has – Than going on to completion • One way to prevent it is to avoid that by – Progress payments instead of • Paying in advance--incentive to take the money and run • Paying on completion--incentive for buyer to “renegotiate” at that point – Design a schedule so it never pays either party to breach • Problem: We can’t perfectly predict the pattern of costs – – – – One solution: Increase the net cost of breach By creating hostages--damage to one party Not matched by gain to the other For details, see my “China to Cyberspace” Reputation • A lot of contract enforcement is – Via reputational penalties – Repeat dealings with one customer – Or prospect of dealings with others he knows • This requires two conditions – Cheating once doesn’t gain enough to make it worth losing future opportunities – Interested third parties can find out you cheated at low cost – If they cannot, victim doesn’t report you, since third parties won’t know which one was at fault • Ways of creating those conditions – – – – Post a bond for the first Use arbitration to lower information cost to third parties They don’t have to know the facts of the dispute, just That the arbitrator you agreed to says you are wrong Liability rules for Breach • Expectation damages – Make the other party as well off as if no breach – Correct incentive to breach, but … – Too much incentive to rely, since • If you breach, my reliance expenditure is wasted • But you have to compensate me for it • And I am the one deciding whether to make it. • Reliance damages – Make the other party as well off as if no contract – Too much incentive to breach • Since breaching party does not have to compensate • The other party for its lost profits – Too much incentive to rely, since • If you breach, my reliance expenditure is wasted • But you have to compensate me for it • And I am the one deciding whether to make it. Property Rules for Breach • Liquidated Damages – Could make the other party as well off as if no breach • If the amount can be estimated in advance • In which case there is – Correct incentive to breach – Correct incentive to rely, since • My compensation doesn’t depend on whether I relied • So any wasted reliance reduces my net • Specific performance – Can still get efficient breach via bargaining – Coaseian solution • No liability. Ditto for only efficient breach. PS: Speculation and Fraud • Is it fraud if I – Sign a contract when I know things – That you don’t know and – If you knew, you wouldn’t sign? • Eliminates the usual argument that – Contracts should be enforced because they benefit both parties – Looks like rent seeking, but • Lets me gain by generating valuable information – – – – Speculation prevents famine But the speculator’s gain does not measure the social benefit So we might get too much or too little speculation What we want are not “incentives” but “the right incentives.” Family Law • Why is marriage? • Why has marriage become less common, less stable? • Why have out of wedlock births greatly increased? • 19th century seduction law • Should we legalize – the baby market? – Prostitution?: New Zealand has – Polygamy? • The future of marriage and reproduction Why is marriage? • Family as a unit to exploit division of labor makes sense, but … • Why traditionally as a lifetime contract? • Why do long term contracts exist in general? – Firm specific sunk costs create a bilateral monopoly – With opportunities for bargaining cost etc. – So specify the terms in advance • Marriage as an example – Relationship specific sunk costs in • Specializing in being X’s spouse, and … • Shared children – Permanent contract as one solution. • Still room for bargaining within marriage • Partly controlled by traditional roles – Penalties for breach another, but … • Hard to know who is breaching, since … • Quality of performance hard to observe. • Al-Tanukhi story. What has changed? • Divorce more common because such sunk costs reduced by … – Lower infant mortality and … – Division of labor taking much household production out of the house. • But divorce on demand raises a new problem of opportunistic breach, because … – Women perform early, men late, aka – Women depreciate faster than men on the marriage market – So if on demand without penalty, men can engage in opportunistic breach – And women respond by adjusting the timing of performance • • • • Later child-bearing Less specialization in household production Both of which have happened Analogous to my house building story in the previous chapter. Out of Wedlock Births • Have increased enormously over past 40 years – Not only in the U.S. – And not only among the poor – Why? • Welfare? Perhaps. – But that does not explain the increase among the not poor – Perhaps several simultaneous causes? • Gender ratio – – – – More war, less death in childbirth Shifts the market against women? But not by very much in the U.S. Except--in populations where many men are in prison And, temporarily, in the sixties? • Men marry women a few years younger, so … • Consider men born in 1945 and women born in 1947 • Rising income? – Why put up with a husband – If you can afford to do without one? Akerlof Yellin argument • Consider a world without birth control or abortion – Men and women both want sex • Arguably men, at least young men, want it more • If the cost is the same to both • But it isn't--because sex and pregnancy are joint products – So most women are unwilling to have sex without some guarantee of support for any resulting children – So most men, to get sex, have to offer such a guarantee • Introduce reliable birth control, readily available abortion – Now sex and pregnancy are no longer joint products – So women who don't currently want children but do want sex are willing to have it without a guarantee of support – And their competition makes it harder for women who do want children to get men to guarantee to support them as a condition of having sex – So some of them choose to have children without husbands • Women who don't want children are better off – Women who want children are worse off – Men are better off--including married men! (why?) – Children are … Glittering Bonds • The puzzle: Why the custom of engagement rings • The problem – How can a woman have sex before marriage without – Risking being seduced and abandoned? – Which badly hurts her value on the marriage market • The legal solution – The tort action for breach of promise – Which was gradually abandoned by U.S. courts • The private solution – The man gives the woman a valuable ring when they get engaged – Sex after engagement is permitted – If the man jilts her, the ring forfeits. A performance bond • The custom declined as – Increasing acceptance of non-marital sex – And better contraception – Reduced the risk Byways of seduction law • 19th c. English and American law – – – – Adult daughter is seduced and pregnant Father sues, as Master collecting damages for injury to a servant Even if all she does is act as hostess at tea once a week • The legal explanation – Daughter cannot sue, because fornication is illegal – And she participated – So use the fiction of master-servant instead • My explanation – “Seduction” might be a way of evading paternal control over whom she married – If she controlled the legal action, makes tactic work better – If father controls it, makes it work worse Law, sex and markets • The baby market – Why is it illegal for adoptive parents to pay the mother? • She can transfer parental rights • Why can’t she sell them? – Why the strong feeling against it? • Anyone not share it? • Can anyone explain it? • Prostitution – To prevent competition with marriage? – Because it “commodifies” sex? – So legal as act, illegal as speech??? • More generalized puzzle about attitudes towards money – – – – To varying degrees taboo In social interactions. Friends might owe me a dinner, but can’t pay with cash We give gift cards when cash would be easier for both sides Are babies a good thing? • Over-population argument, econ version – Children produce negative externalities – So people have too many of them – So we need to limit population increase • What are the negative externalities? – Use scarce land, resources? • As long as those are private property • Consuming them is a cost, but not an external cost • Babies aren't born with a deed to someone else's land clutched in their fists – Pollute, commit crime, go on welfare, … . Go to school? • But there are also positive externalities – Make new discoveries from which others benefit – Pay taxes--perhaps to pay for welfare. Or schools • To make the argument, you need to somehow estimate all of these well enough to sign the sum – This is a general problem with externalities as a policy argument – People only consider those externalities with the sign they want – Externalities from education; are some of them negative? Economics of Polygamy • Terminology – Polygyny: One husband, two or more wives – Polyandry: One wife, two or more husbands – Polygamy: Either of the above • Currently polygamy is illegal, although – Low profile polygamy occurs, and … – One could describe the usual pattern as serial polygamy • Suppose you legalize polygyny? – What is the effect on women? – What is the effect on men? – What is the net effect? Efficient or inefficient? • What about legalizing polyandry? Marriage seen as a market • Supply, demand and price – Supply of wives=demand for husbands=nbr of women who want to get married – Demand for wives=supply of husbands = … – Both depend on the "price" of a husband or wife • • • • • Think of the price as implicit in the terms of marriage Terms favorable to women = high price for a wife Terms favorable to men = high price for a husband The same transaction, so high price for wifelow price for husband Could do the analysis either way--doesn't matter • Market price is where qty supplied = qty demanded – So price of a wife is increased by anything • That increases demand for wives • Or reduces supply – Legalizing polygyny … ? Polyandry? Legalizing polygyny • At the old price, qty of wives demanded = qty supplied • What if the price didn't change? – Men who marry one wife do it on the same terms as before – Men who marry two must, in order to get a wife, offer good enough terms to be equivalent to monogamy on the old terms – But now some men can "buy" two wives, increasing demand • Demand shifts out, supply doesn't change, so – Price of a wife goes up, meaning – Men with one wife must offer her better terms than before – Men with two must offer enough better to be equivalent to that • Net effect – Women are better off, monogamous men are worse off – Polygynous men might be either--two wives, but at a higher price – There is a net gain, since • Men's loss from higher price balances women's gain from higher price • Additional gain to polygynous men of having two wives – Legalizing polyandry has the same result in the other direction • This assumes that women own themselves Some further points – So the gain from a higher price goes to them – In some societies it might go to their fathers – In the form of higher bride price or lower dowry • The result would be obvious for cars – – – – – – – – – Making it legal for some men to own more than one car Increases the demand for cars Which benefits sellers at the cost of buyers And produces a net benefit Different husbands of different value to different wives And vice versa, so a difficult sorting/search problem And the problems of enforcing the terms of the contract And how to take account of costs/benefits to the children All of which I have been assuming away for simplicity • The marriage market has a variety of complications Time in Economics • When I talk about legalizing polygyny – The argument is put in terms of a sequence in time – Which raises some obvious questions • What happens to the already married couples? • Does the wife raise her price by threatening to leave? – But the real comparison is between two alternative presents • The world with polygyny illegal and • An otherwise identical world with it legal • This is true of many economic arguments – We are comparing two alternative arrangements – But put the comparison in terms of changing from one to the other