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1 George Mason School of Law Contracts I III. Bargaining Gains F.H. Buckley

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1 1 George Mason School of Law Contracts I III. Bargaining Gains F.H. Buckley fbuckley@gmu.edu

2 Today 1.Problems of PD Games 2.Solutions to PD Problems 3.Coasian bargains and trust 4.Modeling Bargaining gains: a. Detrimental and Beneficial Reliance b.Edgeworth Box Function 5.Defining Efficiency Criteria 2

3 3 CooperateDefect Cooperate3, 3-1, 4 Defect4, -10, 0 Player 2 Player 1 Getting to Cooperation in PD games

4 Two kinds of PD problems Sins of commission Overfishing Excessive pollution Tragedy of the commons 4

5 Two kinds of PD problems Sins of omission Failure to exploit bargaining gains Eg. Dueling, arms race Failure to contribute to public goods (where beneficiaries cant be excluded) E.g., free riding on defense, taxes 5

6 Getting to Cooperation in PD games So what do we do about that? Maybe its not so bad after all… Government solution A Coasian solution 6

7 Getting to Cooperation in PD games Maybe its not so bad after all… De minimis non curat lex Eleanor Ostrom on the private provision of public goods E.g., wikipedia 7

8 Getting to Cooperation in PD games Let the state enforce cooperation environmental laws taxation and national defense Boston Commons 8

9 Getting to Cooperation in PD games A Coasian solution Just how bad is the transaction cost problem? Qu. What if transaction costs were zero? Contractarianism 9

10 Enforceable Contracts: Two Problems The contract which was made and shouldnt have been made The contract that should have been made and wasnt made 10

11 Enforceable Contracts The contract which was made and shouldnt have been made 11

12 Enforceable Contracts 12 Such contracts do get made, and they disappoint Fraud Duress Mistake Unconscionability?

13 Enforceable Contracts The contract which was made and shouldnt have been made The contract that should have been made and wasnt made 13

14 Getting to Cooperation in PD games A Coasian solution What if bargaining is impossible? 14

15 15 What if one cant bargain: The Market for Lemons Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970) Trust in promises without contracts

16 16 Lets say you want to buy a 1956 Ford…

17 17 Promises without contract law Of the 1956 Fords, half are worth nothing (lemons) and the other half are worth $5,000 (beauts)

18 18 Promises without contract law Of the 1956 Fords, half are worth nothing (lemons) and the other half are worth $5,000 (beauts) The seller tells you its a beaut

19 19 Promises without contract law Of the 1956 Fords, half are worth nothing (lemons) and the other half are worth $5,000 (beauts) The seller knows which kind of car he has but you cant tell them apart

20 20 Promises without contract law Of the 1956 Fords, half are worth nothing (lemons) and the other half are worth $5,000 (beauts) The seller knows which kind of car he has but you cant tell them apart What would you pay for one?

21 21 Promises without contract law Of the 1956 Fords, half are worth nothing (lemons) and the other half are worth $5,000 (beauts) The seller knows which kind of car he has but you cant tell them apart The trick: Sellers willingness to sell is a signal Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970)

22 22 Promises without contract law Of the 1956 Fords, half are worth nothing (lemons) and the other half are worth $5,000 (beauts) The seller knows which kind of car he has but you cant tell them apart Question: Is the seller satisfied with this result?

23 So why do lemons markets exist? Craigslist ad: 1956 Ford Fairlane - Date: 2013-08-25, $18,000 Looking to sell my ALL ORIGINAL 1956 ford fairlane. Mint condition with original paint and all. Super low miles. Serious inquiries only. 301-641- xxxx. As is. 23

24 Craigslist on the subject of lemons Offers to ship a vehicle are virtually 100% fraudulent Never use Western Union or wire transfer to pay for goods - only a scammer will ask for this, and any funds sent will be lost Do not buy vehicles sight-unseen, regardless of low price. The vehicle does not exist, and any money you send will be lost. Stories about divorcees or departing servicemen needing to sell quickly at a low price are generally fraudulent If a deal sounds too good to be true, it probably is! 24

25 So why do lemons markets exist? Sometimes one doesnt need a warranty. The sale is the contract. 25

26 26 Contract Law as a solution Suppose that the defector is penalized through sanctions so that the incentive to defect disappears.

27 27 CooperateDefect Cooperate3, 32, 0 Defect0, 20, 0 Player 2 Player 1 Contract Law as a solution

28 So why do people fail to contract? 28

29 So why do people fail to contract? Illegal contracts Eg. Divorce waivers, security interests in consumer goods 29

30 So why do people fail to contract? Illegal contracts Transaction cost barriers Information processing problems Too many parties Emergencies Agent misbehavior 30

31 So why do people fail to contract? Illegal contracts Transaction cost barriers Rule of Law Problems Imperfect enforcement in corrupt countries or countries with inefficient enforcement mechanisms 31

32 32 Hobbes on Bare Promises Hobbes, Leviathan 14.18 (1651) If a covenant be made wherein neither of the parties perform presently, but trust one another, in the condition of mere nature (which is a condition of war of every man against every man) upon any reasonable suspicion, it is void… For he that performeth first hath no assurance the other will perform after, because the bonds of words are too weak to bridle men's ambition, avarice, anger, and other passions, without the fear of some coercive power; which in the condition of mere nature, where all men are equal, and judges of the justness of their own fears, cannot possibly be supposed. And therefore he which performeth first doth but betray himself to his enemy.

33 33 Contract Law as a solution Leviathan

34 Promising as a Problem of Trust Promisor wants to persuade promisee to trust him To do so, promisor must be able to make a credible commitment not to defect 34

35 Promising as a Problem of Trust Promisor wants to persuade promisee to trust him Corruption weakens trust 35

36 36 Corruption and the rule of law Deputy Mayor of Moscow Vladimir Resin sporting a $360,000 wristwatch

37 Less corruption, more wealth 37

38 38

39 Country corruption and NYC parking tickets for UN diplomats 39 Source: Raymond Fishman and Edward Miguel, Corruption, Norms and Legal Enforcement: Evidence from Diplomatic Parking Tickets, 115 Journal of Political Economy 1020 (2007)

40 40 Modeling Bargaining Gains Indifference Curves The Budget Line Consumer Choice Beneficial Reliance The Edgeworth Box Function Pareto-Superiority and Pareto- Optimality

41 41 0 Two dimensional Commodity Space: Every point represents a combination of the two commodities X axis Y axis Commodity x Commodity y

42 42 0 Two dimensional Commodity Space: Every point represents a combination of the two commodities X axis Y axis A X* Y* 42

43 43 0 The Commodities: Dollars in Two Time Periods Dollars in Time 2 Dollars in Time 1 A X* Y* 43

44 44 Dollars in Time 1 0 Dollars in Time 2 Commodity space: Dollars consumed in two time periods More of both

45 45 The Budget Line: Allocating $100 between two periods Dollars in Time 1 100 0 Dollars in Time 2 The budget line in red represents every trade-off of $100 in two periods

46 46 Two different time preferences (Which is right?)

47 47 The Budget Line: Allocating $100 between two periods Dollars in Time 1 100 0 Dollars in Time 2 Grasshoppers Ants

48 48 Indifference Curves: Preferences about Consumption Dollars in Time 1 0 Dollars in T ime 2 An indifference curve represents a set of trade-offs to which the subject is indifferent

49 49 Subject is willing to give up $BC in Time 2 for $AB in Time 1 Dollars in Time 1 0 Dollars in T ime 2 B C A

50 50 A C: Subject is willing to give up $BC in Time 2 for $AB in Time 1 Dollars in Time 1 0 Dollars in T ime 2 B C A = is indifferent to

51 51 Indifference Curves: Preferences about Consumption Dollars in Time 1 0 Dollars in T ime 2 Convexity (curve bends inward) assumes decreasing marginal utility

52 52 Decreasing marginal utility: Well always want more, but will enjoy each new scoop less and less

53 53

54 54 Indifference Curves: Preferences about Consumption Dollars in Time 1 0 Dollars in T ime 2 One is better off the further one gets from the origin

55 55 Dollars in Time 1 0 Dollars in Time 2 More is better: I 2 > I 1 I1I1 I2I2 More is better

56 56 Dollars in Time 1 0 Dollars in Time 2 Ordinal Utility: We cant say how much better I 2 is than I 1 I1I1 I2I2 I3I3

57 57 Ordinal Utility: We cant say how much better I 2 is than I 1 Ordinal numbers: First, second, third

58 58 Ordinal Utility: We cant say how much better I 2 is than I 1 Ordinal numbers: First, second, third Cardinal numbers: 1,2, 3

59 59 Consumption Decision: Uncle Ebenezer gives David $100 I3I3 Time 1 I 2 I 1 100 I 2 I 1 0 Time 2

60 60 Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line I3I3 Time 1 I 2 I 1 100 50 A I 2 I 1 0 100 Time 2

61 61 Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line I3I3 Time 1 I 2 I 1 100 50 A I 2 I 1 0 100 Time 2 B B is not optimal 61

62 62 Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line I3I3 Time 1 I 2 I 1 100 50 A I 2 I 1 0 100 Time 2 C B C is not feasible B is not optimal 62

63 Ebenezer gives David another $100: The Shift to a New Budget Line 200 I 100 A 50, 50 50 I 100 0 63

64 A new Consumption Decision B 100, 100 100 I 200 A 50, 50 50 I 100 I DR 0 50 100 Time 1 Time 2 64

65 A new Consumption Decision B 100, 100 100 I 200 A 50, 50 50 I 100 I DR 0 50 100 Time 1 Time 2 65 We didnt have to end up at 100,100. I just like round numbers …

66 66 What happens when the donor promises to give in the future? Uncle Ebenezer doesnt have the $100 to give today but promises to give it to David in the next period What Should David Do?

67 67 What happens when the donor promises to give in the future? Uncle Ebenezer doesnt have the $100 to give today but promises to give it to David in the next period Davids election: to rely or not to rely on the promise in the first period

68 But now Uncle Ebenezer comes along: Davids election t 0 Ebenezermakes promise t 1 David relies doesnt rely t 2 Ebenezerperforms doesnt performperforms doesnt perform 68

69 69 ReliesDoesnt Rely Performs Doesnt Perform David Ebenezer Four possibilities

70 70 ReliesDoesnt Rely Performs Doesnt Perform David Ebenezer The good scenario: David relies and Ebenezer performs

71 B 100, 100 100 I 200 A 50, 50 50 I 100 0 50 100 200 Reliance by David means he spends $100 of his own money in period 1 in the expectation hell get another $100 in period 2 71

72 The good scenario: David relies and Ebenezer performs B 100, 100 100 I 200 A 50, 50 50 I 100 0 50 100 200 Because Ebenezer performs, David has another $100 to spend in period 2 72

73 73 ReliesDoesnt Rely Performs Doesnt Perform David Ebenezer A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches

74 B 100, 100 I 100 I DR 0 50 100 A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, 50 50 Time 1 David spends 100 in period 1 and because Ebenezer breaches David has nothing left to spend in period 2 74

75 B 100, 100 I 100 I DR 0 50 100 A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, 50 50 Time 1 What do we need to give David to make him as well off as he would have been had the promise been performed? 75

76 B 100, 100 I 100 I DR 0 50 100 A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, 50 50 Time 1 The Expectation Interest is CB, or $100 76

77 B 100, 100 I 100 I DR 0 50 100 A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, 50 50 Time 1 What do we need to give David to make him as well off as he would have been had he not relied? 77

78 B 100, 100 I 100 I DR 0 50 100 A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, 50 50 Time 1 The Reliance Interest is CD, or about $25 78

79 79 Fool me once…: Non-reliance: What does David do if he assumes Ebenezer will breach? Time 1 I 1 100 50 B I 1 0 100 Time 2

80 80 Fool me once…: Non-reliance: David assumes Ebenezer will breach Time 1 I 1 100 50 B I 1 0 100 Time 2 Now David spends only $50 in period 1, and has $50 left over for period 2

81 81 ReliesDoesnt Rely Performs Doesnt Perform David Ebenezer David doesnt rely and Ebenezer doesnt perform

82 82 But now suppose Ebenezer performs Time 1 I 1 100 50 B I 1 0 100 Time 2

83 83 ReliesDoesnt Rely Performs Doesnt Perform David Ebenezer David doesnt rely, Ebenezer performs

84 100 I 200 50 E 150, 50 0 100 150 Loss of Beneficial Reliance: David doesnt rely and Ebenezer performs I no- reliance Goetz and Scott, 89 Yale L.J. 1261 (1980) David spends only 50 in period 1 84 Where David is on Ebenezers performance

85 B 100, 100 100 I 200 50 E 150, 50 0 100 150 Loss of Beneficial Reliance: David doesnt rely and Ebenezer performs I no- reliance Goetz and Scott, 89 Yale L.J. 1261 (1980) David spends only 50 in period 1 Where David would have been had he relied 85

86 B 100, 100 100 I 200 50 E 150, 50 0 100 150 Loss of Beneficial Reliance: David doesnt rely and Ebenezer performs I no- reliance Goetz and Scott, 89 Yale L.J. 1261 (1980) 86

87 87 ReliesDoesnt Rely Performs Doesnt Perform David Ebenezer To Review…

88 88 ReliesDoesnt Rely Performs Doesnt Perform David spends $50 now, $50 later (No Harm, No Foul) David Ebenezer Scenario I: David doesnt rely and Ebenezer doesnt perform

89 89 ReliesDoesnt Rely Performs David spends $100 now, $100 later Doesnt Perform David Ebenezer Scenario II: David Relies and Ebenezer Performs

90 90 ReliesDoesnt Rely Performs Doesnt Perform David spends $100 now, 0 later (Detrimental Reliance) David Ebenezer Scenario III: David relies and Ebenezer breaches

91 91 ReliesDoesnt Rely Performs David spends $50 now, $150 later Doesnt Perform David Ebenezer Scenario IV: David doesnt rely and Ebenezer performs

92 92 ReliesDoesnt Rely Performs Beneficial Reliance Doesnt Perform David Ebenezer Modeling the Bargaining Game

93 93 ReliesDoesnt Rely Performs Beneficial Reliance Loss of Beneficial Reliance Doesnt Perform David Ebenezer The problem of trust

94 94 Enforceable Contracts provide the gains associated with beneficial reliance

95 95 David is better off because he relied and Ebenezer is better off because he had a charitable motive

96 96 How are two people made better off when they exchange goods?

97 97 How are two people made better off when they exchange goods? After the bargain, same horse, same cow

98 98 Modeling a Bargain: Two Commodities: Mums and Roses 0 Mums Roses

99 99 Modeling a Bargain: Two Bargainers: Mary and Bess 0 Mums Roses Good Queen Mary Bloody Bess

100 100 Mums Mary Roses Two bargainers Mums Bess Roses

101 101 Mums Mary Roses Rotating Besss diagram I Roses Mums Bess

102 102 Mums Mary Roses Rotating Besss diagram II Roses Mums Bess

103 103 Rotating Besss diagram III Mums

104 104 Rotating Besss diagram IV Mums Bess Roses

105 105 Rotating Besss diagram V 0 0 Roses

106 106 Mary Edgeworth Box Function: Bargaining from endowment point A 0 Bess A 0

107 107 Edgeworth Box Function: Bargaining from endowment point A Mary Bess A 0 0 Roses bess Mums mary Mums bess Roses mary

108 108 Edgeworth Box Function: Bargaining from endowment point A Mary Bess A 0 0

109 The Edgeworth Box Function permits us to define Efficiency Standards Pareto-superiority Pareto-optimality 109

110 110 Efficiency (Paretian) standards Vilfredo Pareto (1848-1923) Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off Pareto-optimality: No further Pareto- superior transformations are possible

111 111 Pareto-Superiority B and C as Pareto-superior to A D and E as Pareto-inferior Mary Bess A B C D E Coleman, 8 Hofstra L.Rev. 905 (1980)

112 112 Are all bargaining gains exploited at F? The bargaining lens shrinks through bargaining Mary Bess A B C D E F

113 113 The bargaining lens shrinks through bargaining Mary Bess A B C D E F G 113

114 114 Pareto Optimality At G no further Pareto-superior transformations are possible Mary Bess A B C D E F G 114

115 115 The Contract Curve G is a point of tangency of the two sets of indifference curves Mary Bess A B C D E F G 115

116 116 Mary The Contract Curve All possible Pareto-optimal contracts at the points of tangency Bess A B C D E F G

117 117 Efficiency (Paretian) standards Vilfredo Pareto (1848-1923) Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off Pareto-optimality: No further Pareto- superior transformations are possible

118 Are Paretian standards morally attractive? 118 Greed is good! Michael Douglas as Gordon Gecko in Wall Street (1987)

119 Are Paretian standards morally attractive? 119 OMG!!!! Closing books Ash tray suspenders 222 Broadway

120 120 Are Paretian standards morally attractive? Paretian man is not an altruist He takes no interest in the other person

121 121 Varieties of altruism: Charity Madonna buys a pump for the poor

122 122 Varities of altruism: Envy Gericault, Portrait

123 Tonga: Where people dont promise 123 The Queen of Tonga with the Queen Mother at the Coronation, 1953

124 Could promising exist without promissory institutions? 124 There is apparently no word for promise in Tonganese

125 Could promising exist without promissory institutions? 125 I intend to do x, but if I change my mind, well, then was then, now is now.

126 Could promising exist without promissory institutions? 126 In such a place, is promising intelligible?


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