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

Last day 1.The historical ancestors of law and economics: Benthamite utilitarianism and the nineteenth century bench 2

The historical antecedents The nineteenth century 3 John Stuart Mill Sir George Jessel

Last day 1.The historical ancestors of law and economics: Benthamite utilitarianism and the nineteenth century bench 2.Wealth creation and its moral defense 3.The contribution of contract law, per Sir George Jessell 4.The Sanctity of Contract and the Rule of Law 4

The historical antecedents The nineteenth century 5 Weighing locations by GDP and projecting to the earth’s surface

Today 1.Contract Law as a solution to the threat of defection in PD Games 2.Coasian bargains and trust 3.Modeling Bargaining gains: a. Detrimental and Beneficial Reliance b.Edgeworth Box Function 4.Defining Efficiency Criteria 6

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

Two kinds of PD problems  Sins of commission Overfishing Excessive pollution Tragedy of the commons 8

Two kinds of PD problems  Sins of omission Failure to exploit bargaining gains  Eg. Dueling, arms race Failure to contribute to public goods (External benefits plus beneficiaries can’t be excluded)  E.g., free riding on defense 9

Getting to Cooperation in PD games  So what do we do about that? Maybe it’s not so bad after all… A governmental solution A Coasian solution 10

Getting to Cooperation in PD games  Maybe it’s not so bad after all… De minimis non curat lex The private provision of public goods  E.g., wikipedia, volunteer firemen 11

Getting to Cooperation in PD games  Let the state enforce cooperation Boston Commons environmental laws taxation and national defense 12

Getting to Cooperation in PD games  A Coasian solution Just how bad is the transaction cost problem? 13

Enforceable Contracts  The contract which was made and shouldn’t have been made 14

Enforceable Contracts 15  Such contracts do get made, and they disappoint Fraud Duress Mistake Unconscionability? Paternalism Common Law Illegality

Enforceable Contracts  The contract that should have been made and wasn’t made 16

Getting to Cooperation in PD games  A Coasian solution What if bargaining is impossible? 17

18 What if one can’t bargain: The “Market for Lemons”  Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970)

19 Let’s say you want to buy a 1956 Ford…

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

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 tells you it’s a beaut

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 can’t tell them apart

23 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 can’t tell them apart  What would you pay for one?

24 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 can’t tell them apart  The trick: Seller’s willingness to sell is a signal Akerlof, The Market for Lemons, 84 Q.J. Econ. 488 (1970)

25 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 can’t tell them apart  Question: Is the seller satisfied with this result?

So why do lemons markets exist?  Craigslist ad: 1956 Ford Fairlane – ford customline - $6000 (Riverdale) Good condition! Brand new interior seats and door panel Posted 14 days ago

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! 27

So why do lemons markets exist? 28

So why do lemons markets exist?  Sometimes one doesn’t need a warranty. One can verify the quality of the goods  Discounted prices 29

But that apart, a trust problem 30

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 31

32 Hobbes on Bare Promises Hobbes, Leviathan (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 Contract Law as a solution Leviathan

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

35 CooperateDefect Cooperate3, 3-1, 4 Defect4, -10, 0 Player 2 Player 1 PD games before Contract Law

36 CooperateDefect Cooperate3, 32, -2 Defect-2, 20, 0 Player 2 Player 1 PD Games after damages for breach

37 CooperateDefect Cooperate3, 32, -2 Defect-2, 20, 0 Player 2 Player 1 What is collectively rational is now individually rational

So why do people fail to contract? 38

So why do people fail to contract?  Illegal contracts  Eg. Divorce waivers, security interests in consumer goods 39

So why do people fail to contract?  Illegal contracts  Transaction cost barriers  Information processing problems  Too many parties  Emergencies  Agent misbehavior 40

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 41

42

Transparency International Corruption Perceptions Index 43

Less corruption, more wealth 44

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

Country corruption and NYC parking tickets for UN diplomats 46 Source: Raymond Fishman and Edward Miguel, Corruption, Norms and Legal Enforcement: Evidence from Diplomatic Parking Tickets, 115 Journal of Political Economy 1020 (2007)

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

48 0 Two dimensional Commodity Space: Every point represents a combination of the two commodities X axis Y axis Commodity x Commodity y

49 0 Two dimensional Commodity Space: Every point represents a combination of the two commodities X axis Y axis A X* Y* 49

50 0 The Commodities: Dollars in Two Time Periods Dollars in Time 2 Dollars in Time 1 A X* Y* 50

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

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

53 Two different time preferences (Which is right?)

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

55 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

56 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 

57 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”

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

59 Decreasing marginal utility: We’ll always want more, but will enjoy each new scoop less and less

60

61 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

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

63 Dollars in Time 1 0 Dollars in Time 2 Ordinal Utility: We can’t say how much better I 2 is than I 1 I1I1 I2I2 I3I3

64 Ordinal Utility: We can’t say how much better I 2 is than I 1 Ordinal numbers: First, second, third

65 Ordinal Utility: We can’t say how much better I 2 is than I 1 Ordinal numbers: First, second, third Cardinal numbers: 1,2, 3

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

67 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 A I 2 I Time 2 

68 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 A I 2 I Time 2 B   B is not optimal 68

69 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 A I 2 I Time 2 C B    C is not feasible B is not optimal 69

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

A new Consumption Decision B 100, I 200 A 50, I 100 I DR Time 1 Time 2 71

A new Consumption Decision B 100, I 200 A 50, I 100 I DR Time 1 Time 2 72 We didn’t have to end up at 100,100. I just like round numbers …

73 What happens when the donor promises to give in the future?  Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period  What Should David Do?

74 What happens when the donor promises to give in the future?  Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period  David’s election: to rely or not to rely on the promise in the first period

But now Uncle Ebenezer comes along: David’s election t 0 Ebenezermakes promise t 1 David relies doesn’t rely t 2 Ebenezerperforms doesn’t performperforms doesn’t perform 75

76 ReliesDoesn’t Rely Performs Doesn’t Perform David Ebenezer Four possibilities

77 ReliesDoesn’t Rely Performs Doesn’t Perform David Ebenezer The good scenario: David relies and Ebenezer performs

B 100, I 200 A 50, I Reliance by David means he spends $100 of his own money in period 1 in the expectation he’ll get another $100 in period 2 78

The good scenario: David relies and Ebenezer performs B 100, I 200 A 50, I Because Ebenezer performs, David has another $100 to spend in period 2 79

80 ReliesDoesn’t Rely Performs Doesn’t Perform David Ebenezer A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches

B 100, 100 I 100 I DR A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, Time 1 David spends 100 in period 1 and because Ebenezer breaches David has nothing left to spend in period 2 81

B 100, 100 I 100 I DR A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 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? 82

B 100, 100 I 100 I DR A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, Time 1 The Expectation Interest is CB, or $100 83

B 100, 100 I 100 I DR A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 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? 84

B 100, 100 I 100 I DR A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches C 100,0 D A 50, Time 1 The Reliance Interest is CD, or about $25 85

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

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

88 ReliesDoesn’t Rely Performs Doesn’t Perform David Ebenezer David doesn’t rely and Ebenezer doesn’t perform

89 ReliesDoesn’t Rely Performs Doesn’t Perform David Ebenezer No harm, no foul?

90 But now suppose Ebenezer performs Time 1 I B I Time 2

91 ReliesDoesn’t Rely Performs Doesn’t Perform David Ebenezer David doesn’t rely, Ebenezer performs

100 I E 150, Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs I no- reliance Goetz and Scott, 89 Yale L.J (1980) David spends only 50 in period 1 92 Where David is on Ebenezer’s performance

B 100, I E 150, Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs I no- reliance Goetz and Scott, 89 Yale L.J (1980) David spends only 50 in period 1 Where David would have been had he relied 93

B 100, I E 150, Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs I no- reliance Goetz and Scott, 89 Yale L.J (1980) 94

95 ReliesDoesn’t Rely Performs Doesn’t Perform David Ebenezer To Review…

96 ReliesDoesn’t Rely Performs Doesn’t Perform David spends $50 now, $50 later (No Harm, No Foul) David Ebenezer Scenario I: David doesn’t rely and Ebenezer doesn’t perform

97 ReliesDoesn’t Rely Performs David spends $100 now, $100 later Doesn’t Perform David Ebenezer Scenario II: David Relies and Ebenezer Performs

98 ReliesDoesn’t Rely Performs Doesn’t Perform David spends $100 now, 0 later (Detrimental Reliance) David Ebenezer Scenario III: David relies and Ebenezer breaches

99 ReliesDoesn’t Rely Performs David spends $50 now, $150 later Doesn’t Perform David Ebenezer Scenario IV: David doesn’t rely and Ebenezer performs

100 ReliesDoesn’t Rely Performs Beneficial Reliance Doesn’t Perform David Ebenezer Modeling the Bargaining Game

101 ReliesDoesn’t Rely Performs Beneficial Reliance Loss of Beneficial Reliance Doesn’t Perform David Ebenezer The problem of trust

102 Enforceable Contracts provide the gains associated with beneficial reliance

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

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

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

106 Aristotle on Corrective Justice Does this assume zero-sum bargaining? These names, both loss and gain, have come from voluntary exchange; for to have more than one's own is called gaining, and to have less than one's original share is called losing, e.g. in buying and selling and in all other matters in which the law has left people free to make their own terms; but when they get neither more nor less but just what belongs to themselves, they say that they have their own and that they neither lose nor gain. Therefore the just is intermediate between a sort of gain and a sort of loss, viz. those which are involuntary; it consists in having an equal amount before and after the transaction.

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

108 Modeling a Bargain: Two Bargainers: Mary and Bess 0 Mums Roses Good Queen Mary “Bloody” Bess

109 Mums Mary Roses Two bargainers Mums Bess Roses

110 Mums Mary Roses Rotating Bess’s diagram I Roses Mums Bess

111 Mums Mary Roses Rotating Bess’s diagram II Roses Mums Bess

112 Rotating Bess’s diagram III Mums

113 Rotating Bess’s diagram IV Mums Bess Roses

114 Rotating Bess’s diagram V 0 0 Roses

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

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

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

The Edgeworth Box Function permits us to define Efficiency Standards  Pareto-superiority  Pareto-optimality 118

119 Efficiency (Paretian) standards Vilfredo Pareto ( )  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

120 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)

121 Are all bargaining gains exploited at F? The bargaining “lens” shrinks through bargaining Mary Bess A   B C D E  F   

122 The bargaining “lens” shrinks through bargaining Mary Bess A   B C D E  F     G 122

123 Pareto Optimality At G no further Pareto-superior transformations are possible Mary Bess A   B C D E  F     G 123

124 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 124

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

126 Efficiency (Paretian) standards Vilfredo Pareto ( ) 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