Contract Law An Economic Theory of Contracts Reliance and optimal reliance 11/2/09 Contract_C

Optimal reliance A promise is made, then time elapses During this time - promisor might incur costs associated with performing (investing in performing) - promisee might incur costs associated with the anticipation of the promise being fulfilled (invest in reliance) Reliance costs - costs incurred by the promisee in order to increase the utility, profits, etc. resulting from the fulfilment of the contract The investments in performance and reliance might take the form of time, effort, money or foregone alternatives 11/2/09 Contract_C

The third purpose of contract law is to ensure optimal reliance If there is reliance and the contract is breached, the promisee suffers the loss of: - original investment - expected profits - reliance costs We (society) want the promisee to invest in reliance since that increases the utility, profits, etc. resulting from the fulfilment of the contract Note that the promisee is going beyond the original commitment of the promisor Question? How much reliance should a promisee place on the fulfilment of the contract? The third purpose of contract law is to ensure optimal reliance 11/2/09 Contract_C

Consider the following expected gain and loss from reliance: Optimal Reliance Consider the following expected gain and loss from reliance: Expected gain to promisee from reliance is (increase in the value of performance due to reliance) x (probability of performance) Expected loss to promisee from reliance is (increase in the cost of breach due to reliance) x (probability of breach) Rule for optimal reliance - the expected gain from reliance must equal the expected loss from reliance 11/2/09 Contract_C

An example: Boy Scout Apple Day CHECK THIS EXAMPLE CAREFULLY During the Summer, the Boy Scouts contract with Farmer Jones to buy 100 bushels of apples for their fall Apple Day promotion – they pay $500 for 100 bushels which they expect to sell for $1,000 ($500 profit) 11/2/09 Contract_C

The Boy Scouts realize that the probability that Farmer Jones will not be able to supply the apples is 0.25 (25% due to hail, drought, etc.) The Boy Scouts also know that their Apple Day will generate an additional $400 in revenue if they spend $150 in promotion (signs, TV ads, soliciting corporate sponsors, etc.). Net gain from reliance is $250 ($400 - $150) Should the Boy Scouts undertake the promotion? Is it an ‘optimizing’ investment? [in addition, is it an ‘efficient’ investment?] 11/2/09 Contract_C

- increase in value of performance from reliance is $250 We know: - increase in value of performance from reliance is $250 - probability of performance is 0.75 (1 - 0.25) - increase in cost of breach from reliance is $150 - probability of breach is 0.25 Expected gain to promisee from reliance: ($250) x (0.75) = $187.50 Expected loss to promisee from breach: ($150) x (0.25) = $37.50 Yes, the Boy Scouts should undertake this investment in reliance since their expected gain from reliance is greater than their expected loss from reliance 11/2/09 Contract_C

This is the economics of efficient Reliance After the promise is made, the promisee ‘invest’ in reliance because this will generate additional benefit from performance But the promisee now stands to lose more than his original investment and expected profits if the contract fails In order to ensure an efficient amount of reliance we require that the probability of the contract failing should be considered by the promisee before investing in reliance The promisee cannot simply assume that the promisor will fulfil the contract when deciding on the appropriate amount of reliance This is the economics of efficient Reliance 11/2/09 Contract_C

Legal incentives for reliance How should the law ensure an optimal (efficient) level of reliance? By awarding damages to the promisee up to the point at which they equal the promisee’s original investment, expected profit and ‘the amount of optimal reliance’ Over-reliance would cause an excessive (inefficiently large) harm from breach – but these excessive costs cannot be recovered as damages perfect expectation damages are intended to restore the promisee to the position which they would have been in had the promise been kept - which can be expanded to include the amount of ‘optimal reliance’ 11/2/09 Contract_C

Calculating damages The Boy Scouts expect to gain $650 from Apple Day. Revenue = $1,000 plus $400 (from reliance) $1,400 LESS: Costs Apples $500 Investment in reliance $150 Total costs $ 650 Profit $ 750 What if the Boy Scouts make the above contract and farmer Jones breaches the contract? What are optimal damages? 11/2/09 Contract_C

What would perfect expectation damages be? Calculating damages What would perfect expectation damages be? Original investment (payment to Farmer) $ 500 Investment in reliance $ 150 Expected gain after ‘optimal reliance’ $ 750 Perfect expectation damages $1,400 11/2/09 Contract_C

Variation on the Boy Scout example What if Farmer Jones tells the Boy Scouts that he will accept their $500 and try to deliver the apples but his truck is broken and there is only a 70% chance that he will actually be able to deliver the apples on Apple Day. Should the Boy Scouts invest in reliance? If they do make the investment and Farmer Jones breaches, what would perfect expectation damages be? 11/2/09 Contract_C

Next section We will look at the role of transaction costs and how they result in incomplete contracts and the need for the law to supply default terms Also, what is a perfect contract and what are the implications of less than perfect contracts? 11/2/09 Contract_C