Law and Economics-Charles W. Upton Breaking Contracts

When to Breach After agreeing to work for me for the afternoon for $50, you get an opportunity to earn $100 from Sally. What should you do?

Breaking Contracts The Analysis Benefit of your work for me is (at most) $60. The Benefit of your working for Sally is at least $100. Ergo, economic efficiency requires that you breach your contract with me.

Breaking Contracts A Counteroffer Suppose Harry, who gets $55 worth of benefit from your work, offers you $52 to work for him.

Breaking Contracts A Counteroffer Suppose Harry, who gets $55 worth of benefit from your work, offers you $52 to work for him. Economic efficiency requires that you work for me.

Breaking Contracts A Counteroffer Suppose Harry, who gets $55 worth of benefit from your work, offers you $52 to work for him.. Economic efficiency requires that you work for me. But $52 > $50 and your incentives are not to show up.

Breaking Contracts Is your cost of performing > Your cost of non- performing? No Honor the contract Break the contract Yes

Breaking Contracts Is your cost of performing > Your cost of non- performing? No Honor the contract Break the contract Yes $100>$50 Sally

Breaking Contracts Is your cost of performing > Your cost of non- performing? No Honor the contract Break the contract Yes $100>$50 Sally The Right Decision

Breaking Contracts Is your cost of performing > Your cost of non- performing? No Honor the contract Break the contract Yes $52>$50 Harry

Breaking Contracts Is your cost of performing > Your cost of non- performing? No Honor the contract Break the contract Yes $52>$50 Harry The Wrong Decision

Breaking Contracts Is your cost of performing > Your cost of non- performing? No Honor the contract Break the contract Yes

Breaking Contracts Is your cost of performing > Your cost of non- performing? No Honor the contract Break the contract Yes Suppose you have to pay me damages, equal to my loss ($10)

Breaking Contracts Performance cost: lost wages in other job > Lost wages on my job plus the damages to me? No Honor the contract Break the contract Yes

Breaking Contracts Performance cost: lost wages in other job > Lost wages on my job plus the damages to me? No Honor the contract Break the contract Yes $100>$50 + $10 Sally The Right Decision

Breaking Contracts Performance cost: lost wages in other job > Lost wages on my job plus the damages to me? No Honor the contract Break the contract Yes $52>$50 + $10 Harry

Breaking Contracts Performance cost: lost wages in other job > Lost wages on my job plus the damages to me? No Honor the contract Break the contract Yes $52>$50 + $10 Harry The Right Decision

Breaking Contracts The Second Principle of Contract Law Give optimal incentives to perform. This does not mean an absolute incentive to perform. We want people to break contracts iffi it is socially optimal.

Breaking Contracts What are my damages? I expected to get $60 of value from your work, for a net gain of $10. If you don’t show up, I might still get the work done but for more money, and at some time cost.

Breaking Contracts What are my damages? I expected to get $60 of value from your work, for a net gain of $10. If you don’t show up, I might still get the work done but for more money, and at some time cost. The real loss is possibly the extra effort of getting the work done.

Breaking Contracts The Second Principle of Contract Law (Clarified) Both parties must have incentives.

Breaking Contracts The General Principle The innocent party can take steps to cut the social cost of breaching, and should do so.

Breaking Contracts Some Examples I promise to sell you a car for $1000 and breach. A year later, you sue for $2,500 for taxi fares because you did not have a car.

Breaking Contracts The Bad Car I promise to sell you a car for $1000 and breach. A year later, you sue for $2,500 for taxi fares because you did not have a car. In fact, you could have bought another car for $1,100. Your damages are really $100.

Breaking Contracts The Bad Car I promise to sell you my good car for $12,000. It turns out that we have different interpretations of what is my “good” car. I don’t honor the deal. You sue.

Breaking Contracts The Bad Car I promise to sell you my good car for $12,000. It turns out that we have different interpretations of what is my “good” car. I don’t honor the deal. You sue. Sorry, you should have made the effort to make sure what was meant by the “good car”.

Breaking Contracts The Third Principle of Contract Law Induce Optimal Reliance.

Breaking Contracts Healthy Cookies I make and sell Healthy Cookies. I promise they will never spoil. In the store, you see the box is torn, and contains something like rat droppings.

Breaking Contracts Healthy Cookies I make and sell Healthy Cookies. I promise they will never spoil. In the store, you see the box is torn, and contains something like rat droppings. Commonsense says you should not rely on my promise.

Breaking Contracts Healthy Cookies I make and sell Healthy Cookies. I promise they will never spoil. The box looks in perfect condition.

Breaking Contracts Healthy Cookies I make and sell Healthy Cookies. I promise they will never spoil. The box looks in perfect condition. You should be able to rely on my promise.

Breaking Contracts How to get an “A” Remember my offer of the secret of getting an “A” in the course. You party the night before the exam and see me just before the final.

Breaking Contracts How to get an “A” Remember my offer of the secret of getting an “A” in the course. You party the night before the exam and see me just before the final. I look forward to seeing you in the course next year. You have over- relied

Breaking Contracts The World’s Best Foot Long Hot Dog A restaurant sells what it calls “the worlds best foot long hot dog”. You bite. While the wiener is ok, you have had better. And, it is 11” long.

Breaking Contracts The World’s Best Foot Long Hot Dog A restaurant sells what it calls “the worlds best foot long hot dog”. You bite. While the wiener is ok, you have had better. And, it is 11” long. You are old enough not to believe all advertising, so you are out of luck on the “world’s best” claim.

Breaking Contracts The World’s Best Foot Long Hot Dog A restaurant sells what it calls “the worlds best foot long hot dog”. You bite. While the wiener is ok, you have had better. And, it is 11” long. You are old enough not to believe all advertising, so you are out of luck on the “world’s best” claim. But you have a case on the missing inch.

Breaking Contracts End ©2004 Charles W. Upton