Contract Designing contracts –A common interest in efficient contracts –How to make a contract efficient Enforcing and interpreting contracts –What contracts should be enforced? The case for freedom of contract The problems of duress –How to fill in the blanks in interpreting contracts –Preventing opportunistic breach By contract design By reputational enforcement By legal penalties for breach –Permitting efficient breach

Designing Contracts Parties have a common interest –In maximizing the size of the pie –And can then argue over dividing it Since any change that produces net benefits –Can be combined with a change of price –That makes it beneficial to both sides This applies to all dimensions, including –What happens if one party breaches –Allocation of risk between the parties –Fixed price vs cost vs cost plus … Fixed price for building your house Gives contractor an incentive to keep down costs Also to reduce quality if he can get away with it So fixed price if quality is easily specified and enforced –…

What contracts should be enforced? Why not simply enforce all contracts as written? –Court may wish to impose its preferences –Court must decide if there is a contract and what it says –Court must fill in the blanks Case for freedom of contract –Parties want an efficient contract, and –Using ambiguity to impose courts preferences –Leads to writing longer contracts –So fill in blanks with what parties would have agreed to.

Case Against Freedom of Contract Unequal bargaining power –Leads to efficient contracts, with prices favoring the party in a strong position –Courts are poorly suited to redistribute income –Lost in the desert. My lifes earnings for water? Odd case where unlimited freedom of contract Increases the price I can pay, which Hurts me in a bilateral monopoly bargain Real Duress –Your money or your life –Case for and against enforcing the contract Less Real Duress

The sinking ship case $10,000,000 ship, $100,000 to save it Bilateral monopoly bargain Price that gives the right incentive to save? –$10,000,000. Tug gets the full benefit –And so will bear any cost to increase the chances of saving that is worth bearing Price that gives the right incentive to avoid needing a tug? –$100,000 –The cost the ship imposes when it starts sinking somewhere where a tug can save it

Right rule for sinking ships? We have been here before –Coasian double causation –Of the gain of saving a sinking ship –Jointly produced by ship owners risk and –Tugs expenditures on being there to save Put the incentive where it does most good –Mostly on the tug if his supply is elastic (high price) –Mostly on the ship if his is (low price) Freedom of contract? –No reason to expect the efficient result –Bilateral bargaining with large range is costly –Let admiralty court decide fair price?

In a Fully Coasean world We can optimize on both margins –Tug boat pays the ship to take risks –Ship pays the tugboat to be there if needed –Two parties bargain to the efficient outcome Research project –Look at the actual market for salvage –To see if contracts in advance –Solve these problems –Bilateral monopoly bargain costs perhaps solved by preagreed salvage rates?

Contracts of Adhesion Fancy name for form contracts –Suggests they are illegitimate, since –Not bargained –But the economic argument doesnt require bargaining Three models of control –Democracy –Fighting: The bargaining process –markets Consider the virtues of competitive dictatorship –The arrangement we use for hotels, restaurants –I have no vote in how they are run, –Dont bargain over the menu, but –Absolute control on whether I buy their services

Why use form contracts? To save costs –With millions of customers, takes a lot of lawyers –To bargain a contract for each To control employees –If the Avis desk clerk can set the rate –How do you keep him from taking bribes? Why not? –Argument for efficient terms still holds –Since you have to get the customer to sign

If We Accept Freedom of Contract The problem of interpreting contracts Is the same as the problem of designing them Find out what terms maximize the summed gain Write them if you are a party Add them if you are a court filling in blanks

More Reasons Not To Third Party Effects –Parties maximize their summed gain –Ignore gains or losses to others, so … –We dont enforce Performance contracts for assassins Contracts not to testify in court (except …) Cartel agreements (in the U.S.) Contracts by irrational parties –Children or … –The insane –Or, at one time, women A fine line between protecting people and Restricting them

Breach Preventing opportunistic breach –By contract design –By reputational enforcement –By penalty Permitting efficient breach –Either by special casing it, or –Pigouvian tax, aka –Expectation damages Efficient incentives for choices affected by the risk of breach –Whether to sign the contract –How much to rely on the other partys performance

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 cant perfectly predict the pattern of costsOne 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, webbed for my seminar

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 doesnt gain enough to make it worth losing future opportunities –Interested hird parties can find out you cheated at low cost –If they cannot, victim doesnt report you, since third parties wont 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 dont have to know the facts of the dispute, just –That the arbitrator you agreed to says you are wrong

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.

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 doesnt depend on whether I relied –So any wasted reliance reduces my net

PS: Speculation and Fraud Is it fraud if I –Sign a contract when I know things –That you dont know and –If you knew, you wouldnt 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 speculators 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.

Thursday Fred Foldvary (Econ Dept) Economics and Natural Law