Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 16

1  HW3 (contract law) due next Thursday Reminders

2 Results of Monday’s Experiment (trust)

3  Player A starts with $5  Chooses how much of it to give to player B  That money is quadrupled  Player B has $5, plus 4x whatever A gave him/her  Chooses how much (if any) to give back to player A  Tried it four ways:  Anonymous  On paper, but with names  Face to face  Openly in front of the class The game we played

4  No matter what player A does, B is best off keeping everything  So A is best off sending nothing  So subgame perfect equilibrium payoffs are ($5, $5), even though total surplus of $25 could be achieved through cooperation  So how did you guys do? What is subgame perfect equilibrium?

5 How’d you guys do? 15% got 0 backavg gain $3.02avg sent $3.6684% sent something 8% % % % % % Fraction who got 0Average back from BObservationsA sent 3% got 0 backavg gain $4.34avg sent $3.9794% sent something 6% % % % % % Fraction who got 0Average back from BObservationsA sent ANONYMOUS WITH NAMES

6  With anonymity, yes  Average A sent $3.08, got back $5.78  Trust was rewarded, but there was some risk  Of those A’s who sent something, 15% got nothing back, 19% got back less than they sent  Worse, only about 60% of the potential gains were realized  16% of A’s sent nothing, only 38% sent 5  Things got better with names  Average A sent $3.72, got back $7.79  Only 6% of A’s sent nothing, 52% sent 5  Of those who sent something…  only 3% got nothing back, and only 8% lost money  74% got back at least twice as much as they sent So, is trust a problem?

7  Face to face or in public: no problem at all  Every single A who traded face-to-face or in public sent the maximum amount, and every B sent back between $10 and $13  But trust was an issue in “anonymous” trading  Trust was rewarded, but with some risk…  …and not everyone was willing to trust, leading to some gains going unrealized So, is trust a problem?

8 Back to work

9 Paradox of compensation Inefficient breach Underinvestment in performance Efficient reliance Efficient breach Efficient investment in performance Over-reliance Expectation damages exclude benefit from reliance investments Expectation damages include benefit from reliance investments  Is there a way to get efficient behavior by both parties? Skip

10  Have expectation damages include benefit from reliance…  …but only up to the efficient level of reliance, not beyond  That is, have damages reward efficient reliance investments, but not overreliance  Promisee has no incentive to over-rely  efficient reliance  Promisor still bears full cost of breach  efficient performance  Problem: this requires court to calculate efficient level of reliance after the fact We already saw one possible solution

11  The problem:  Damages promisor pays should include gain from reliance if we want to get efficient performance  Damages promisee receives should exclude gain from reliance if we want to get efficient reliance  Solution: make damages promisor pays different from damages promisee receives!  How do we do this? Need a third party Another clever (but unrealistic) solution

12  You (promisee) and I (promisor) offer Bob this deal:  If you rely and I breach,  I pay Bob value of promise with reliance (airplane plus hangar)  Bob pays you value of promise without reliance (airplane alone)  Bob keeps the difference  You receive damages without benefit from reliance; I pay damages with benefit from reliance “Anti-insurance”

13  You (promisee) and I (promisor) offer Bob this deal:  If you rely and I breach,  I pay Bob value of promise with reliance (airplane plus hangar)  Bob pays you value of promise without reliance (airplane alone)  Bob keeps the difference  You receive damages without benefit from reliance; I pay damages with benefit from reliance  Offer the deal to two people, make them pay up front for it “Anti-insurance”

14  Foreseeable reliance  Include benefits reliance that promisor could have reasonably anticipated Reminder: what do courts actually do?

15 Repeated interactions

16 Repeated games

17 Repeated games Player 1 (you) Trust meDon’t Player 2 (me) Share profitsKeep all the money (150, 50)(0, 200) (100, 0)  Suppose we’ll play the game over and over  After each game, 10% chance relationship ends, 90% chance we play at least once more…

18  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

19  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

20  Diamond dealers in New York (Friedman) “…people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one” “Parties to a contract agree in advance to arbitration; if… one of them refuses to accept the arbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted.” Repeated games and reputation

21  The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions  The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts  Law assigns legal duties to certain long-term relationships  Bank has fiduciary duty to depositors  McDonalds franchisee has certain duties to franchisor Repeated games and reputation

22  Suppose we’ll play agency game 60 times  $50 x 60 = $3,000 > $200, so cooperation seems like no problem  But…  In game #60, reputation has no value to me  Last time we’re going to interact  So I have no reason not to keep all the money  So you have no reason to trust me  But if we weren’t going to cooperate in game #60, then in game #59… Repeated games and the endgame problem

23  Endgame problem: once there’s a definite end to our relationship, no reason to trust each other  Example: collapse of communism in late 1980s  Communism believed to be much less efficient than capitalism  But fall of communism led to decrease in growth  Under communism, lots of production relied on gray market  Transactions weren’t protected by law, so they relied on long-term relationships  Fall of communism upset these relationships Repeated games and the endgame problem

24 One other bit I like from Friedman

25 Friedman on premarital sex

26 Friedman on premarital sex

27  Purposes for contract law:  Encourage cooperation  Encourage efficient disclosure of information  Secure optimal commitment to performance  Secure efficient reliance  Provide efficient default rules and regulations  Foster enduring relationships  Next up: tort law That’s it for contract law

28 But first, let’s recap our story so far…

29  Efficiency  Maximizing total surplus realized by everyone in society  Scarce resources are owned by whoever values them most  Actions are taken if social benefit exceeds social cost  Design a legal system that leads to efficient outcomes  Once we set up the rules, we don’t expect people to act based on what’s efficient  We expect people to do whatever’s in their own best interest  So the goal is set up the rules such that people acting in their own best interest will naturally lead to efficiency Our story so far

30  Coase gives us one way to do that  If property rights are clearly defined and tradable, and there are no transaction costs, people have incentive to trade until each resource is efficiently owned  So initial allocation of rights doesn’t matter for efficiency  But if there are transaction costs, we may not get efficiency this way  Led us to two normative views of the legal system:  1. Minimize transaction costs (“lubricate” private exchange)  2. Allocate rights as efficiently as possible  Tradeoff between injunctive relief and damages Our story so far

31  Property law works well for simultaneous trade  Contracts allow for non-simultaneous trade  Contract law can…  Enable cooperation  Encourage efficient disclosure of information  Secure optimal commitment to performance  Secure efficient reliance  Supply efficient default rules and regulations  Foster enduring relationships Our story so far

32  So far, we’ve been talking about voluntary exchange  Coase is predicated on exchange being voluntary for both parties  Contracts are an extension of voluntary trade  Up next: “involuntary trade”  You’re bicycling to class, I’m texting while driving and I hit you  You didn’t want to deal with me, I didn’t want to deal with you… Our story so far

33  To put it another way…  Property law covers situations where transaction costs are low enough to get agreement ahead of time  Exceptions to property law – private necessity, eminent domain – when this isn’t the case  Contract law covers situations when transaction costs are low enough for us to agree to a contract, high enough that we may not want to renegotiate the contract later  Tort law covers situations where transaction costs are too high to agree to anything in advance Our story so far

34 Tort law

35 An example

36 An example ChoiceBad LuckOutcome +  punish the choice criminal law regulations

37 An example ChoiceBad LuckOutcome +  punish the choice criminal law regulations punish the combination of choice and outcome “negligence” punish the outcome “strict liability”

38  Tort, noun. from French word meaning injury  Contract law: situations where someone harms you by breaking a promise they had made  Tort law: situations where someone harms you without having made any promises  “If someone shoots you, you call a cop. If he runs his car into yours, you call a lawyer.” Tort law

39  I hit you with my car, do $1,000 worth of damage  You’re $1,000 worse off  (No damage to me or my car)  Should I have to pay you damages? As always, we’ll be focused on achieving efficiency –1,000 Combined payoffs –50,000–1,0000My payoff 49,0000–1,000Your payoff I owe $50,000I owe $1,000I owe nothing

40 Something to remember distribution but not efficiency efficiency

41  Question: how to structure the law to get people to behave in a way that leads to efficient outcomes?  Deliberate harms: make punishment severe (criminal law)  Accidental harms: trickier  Goal isn’t “no accidents”; goal is “efficient number of accidents” Tort law

42  Question: how to structure the law to get people to behave in a way that leads to efficient outcomes?  Deliberate harms: make punishment severe (criminal law)  Accidental harms: trickier  Goal isn’t “no accidents”; goal is “efficient number of accidents”  Unlike nuisance law, injunctive relief is not an option  Unlike contract law, no agreement ahead of time  Cooter and Ulen: essence of tort law is “the attempt to make injurers internalize the externalities they cause, in situations where transaction costs are too high to do this through property or contract rights” Tort law

43  Plaintiff – person who brings a lawsuit  Defendant – person who is being sued  In a nuisance case, the defendant caused a nuisance, plaintiff was bothered by it, might be asking for injunction or damages  In a contract case, defendant breached a contract or violated its terms  In a tort case, defendant caused some harm to plaintiff, plaintiff is asking for damages  Plaintiff is the victim (person who was harmed)  Defendant is the injurer (person who caused the harm) Cast of characters

44  “Classic” legal theory of torts  Simple economic model to study incentives Next week