1. Econ 522 Economics of Law
Dan Quint
Spring 2010
Lecture 14

2. Logistics See Fran if you’re missing midterm or HW1
HW2 due next Wednesday (2:30 p.m. sharp)
Second midterm following Wednesday

3. Monday, we considered remedies, and the incentives they create
Expectation damages; reliance damages; opportunity cost damages; specific performance
Breach: if promisor’s liability = promisee’s benefit, we “automatically” get efficient breach; if not, we don’t (or efficient breach requires renegotiation)
Signing: if liability for breach is too severe, may preclude signing contract in the first place

4. Monday, we considered remedies, and the incentives they create
Example of investment in reliance:
If damages are increased to include added value of performance due to reliance investments, promisee will rely more than the efficient amount
If damages exclude added value of performance, promisee will rely the efficient amount
Example of investment in performance:
If promisor’s liability = promisee’s anticipated benefit, promisor will invest the efficient amount in preventing breach
If liability < benefit, promisor will underinvest in performance

5. All of these effects can also be understood through language of externalities
If liability < anticipated benefit, promisor’s choice to breach imposes negative externality on promisee
So he’ll breach more than efficient amount, and invest too little in preventing breach
If liability = benefit, the externality is eliminated, and promisor will act efficiently
If liability = anticipated benefit (including added benefit from reliance), promisee’s reliance imposes negative externality on promisor
So promisee will rely more than efficient amount
If damages exclude this added benefit, externality is absent, reliance will be efficient

6. Paradox of compensation
Expectation damages include benefit from reliance investments
Expectation damages exclude benefit from reliance investments
Efficient breach
Efficient investment in performance
Over-reliance
Inefficient breach
Underinvestment in performance
Efficient reliance
Summing up most of these results, we found that
When expectation damages include the anticipated benefit from reliance, we get
efficient breach, and efficient investment in performance
seller internalizes the full cost of breach, and makes efficient decision
inefficiently high reliance
buyer reliance imposes a negative externality on seller – since he has to pay more if he breaches – so buyer does not bear full “cost” of reliance
On the other hand, when expectation damages exclude the anticipated benefit from reliance,
inefficient breach/investment in performance
breach imposes a negative externality on buyer, so seller does not bear full cost
efficient reliance
buyer bears full cost, full benefit of reliance, makes efficient decision
This is what Cooter and Ulen call the paradox of compensation
neither rule gets both parties to act efficiently
Is there a way to get efficient behavior by both parties?

7. We already saw one possible solution
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 proposed solution to this problem
Modify expectation damages to include the benefit of reliance, but only up to the efficient level of reliance, not beyond
This way, buyer has no incentive to over-rely, since he won’t get that benefit in the event of breach
And seller still bears full cost of breach, so he makes efficient decisions as well

8. Another clever (but unrealistic) solution
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

9. “Anti-insurance” 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
How do we do this?
Let’s say I’m the promisor, and you’re the promisee, and I’ve promised to build you an airplane
You and I have this friend, Bob
Bob likes money
So we go to Bob and say, hey Bob, here’s a deal for you
I’m planning to build a plane
He’s planning to buy the plane
He’s probably going to want to build a hangar
I might end up not building the plane
Here’s what we need you to do
In the event that he builds a hangar and I don’t build the plane,
I’m going to give you the value of the plane with the hangar;
And you’re going to give him the value of the plane without the hangar
And you keep the rest for yourself. OK?
And Bob says, “cool!”
This is called “anti-insurance”
Rather than buying insurance from a third party, you and I are entering into this additional contract where if things go bad, I owe Bob some additional money, beyond what I pay you
By doing this, we set both our incentives correctly
You only get the benefit of reliance if I perform, so you invest the efficient amount in reliance
I face the full cost of breach, so I invest the efficient amount in performance.

10. “Anti-insurance” 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
Now obviously, Bob is happy to do this for free; but it makes you and me worse off
So now we go to our other friend Carol, and say, Hey, Carol
Here’s a deal we’re offering
Give us $5 now, and if he builds a hangar and I don’t deliver a plane, you’ll get the difference between the value of the plane with the hangar and without the hangar
And Carol realizes this is worth more than $5, so she says, “sure.”
But now we go back to Bob, and we offer him the deal at $10 instead.
And if we make Bob and Carol compete for this deal, we should be able to get them to pay a fair amount for it up front
If they’re risk averse, of course, they’ll need to be compensated for taking on some risk
But if we have a risk-neutral friend who’s smart enough to understand the probabilities and figure out what each of us will do given our incentives, we can get them to give us the full value of the anti-insurance deal ahead of time, and divide it up among ourselves
So this way, we can give ourselves incentives for efficient reliance and efficient investment in performance at the same time.
So that’s another way to solve the paradox of compensation – even if it’s pretty unrealistic

11. Reminder: what do courts actually do?
Foreseeable reliance
Include benefits reliance that promisor could have reasonably anticipated
What courts actually do, rather than basing damages on actual or on efficient reliance, is to base damages on foreseeable reliance
That is, they base damages on what the promisor could have reasonably expected the promisee to do, not what he actually did
This was the decision in Hadley
Since the shipper could not reasonably expect the miller to rely so heavily, he was not liable for the lost profits
Most millers at the time had more than one crankshaft
So a broken shaft would not typically lead to shutdown
Under the doctrine of foreseeable reliance, if Hadley had told Baxendale that his mill was closed until repairs were made, then Baxendale would be liable for lost profits due to delay
By informing Baxendale of the reliance, Hadley would have made it foreseeable, and therefore compensable

12. Another experiment: is trust a problem?

13. A two-player game, similar to the investment/agency game
Player A starts with $10
Chooses how much of it to give to player B
That money is tripled
Player B has $10, plus 3x whatever A gave him/her
Chooses how much (if any) to give back to player A
We’ll try the game three ways:
Anonymously – A and B don’t know who each other are
Face to face – A and B know who each other are, and can discuss the game before playing, but their actions remain private
In public – A and B play out loud in front of the whole class

14. Repeated interactions

15. Repeated games
Nearly everything we’ve done so far has assumed a one-shot interaction
that is, we’ve been assuming that the parties to a contract are only interested in maximizing their gain from that one particular contract,
and are not concerned with any future interactions with the same partner.
Of course, in many cases, this is not true
Example. There’s a coffee shop near my house, and I go there several times a week.
One day, I forget my wallet, and ask if I can still buy a cup of coffee and a muffin, and pay them back the next day
They say yes, and I show up the next day with the money. Why?
(Seems pretty obvious to any reasonable people, less so to an economist.)
An economist would say:
The reason I pay them back is that I want to keep transacting with them in the future
And the value I expect to get from those future transactions is worth more to me than the $3 I could save by breaking my promise now
And the reason they trusted me is that they expected this would be the case.
From a theoretical point of view, repeated games can be very hard to analyze, because a lot of different things can happen
But one of the things that can happen is that we can cooperate in a repeated game, even if we could not cooperate in the same one-shot game.

16. Repeated games Suppose we’ll play the game over and over
Player 1 (you)
Trust me
Don’t
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(0, 200)
Let’s go back to the original agency game we did a couple weeks ago.
You choose whether to trust me with $100, which I can double by investing it; and then I decide whether to keep the $200 or return $150 to you and keep $50 for myself
But now, suppose there is the possibility of playing the game more than once.
In particular, suppose that each time we play the game, there is a 10% chance it’s the last time we play, and a 90% chance that we get to play again.
Suppose we’ll play the game over and over
After each game, 10% chance relationship ends, 90% chance we play at least once more…

17. Repeated games 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
Think about my incentives to repay your money or keep it for myself
If I keep it for myself, I get a payoff of $200; but then you’ll never trust me again, so that’s all I’ll ever get
On the other hand, if I give you back your $150, you’ll probably trust me again the next time, and the time after that, and the time after that (provided I keep returning it)
So the value I expect to get out of the relationship is
X ^2 X ^3 X 50 + … = 50 / (1 - .9) = 500 > 200
So I’m much better off returning your money, since I’ll make more money in the long-run if you keep trusting me
And because of this, it makes sense for you to trust me

18. Repeated games 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
The same thing can also happen with a repeated version of the prisoner’s dilemma.
Recall that in the one-shot prisoner’s dilemma, the only equilibrium was for both of us to rat on each other and go to jail for several years
However, if we expect to play the prisoner’s dilemma over and over, it turns out to be an equilibrium to both keep quiet
Actually, what turns out to be an equilibrium is for both of us to do the following:
Keep quiet the first time we play
As long as neither of us has ever ratted on the other, keep quiet
Once either of us has ever ratted, I rat every time we play forever
This is called a “grim trigger” strategy – we play a good (cooperative) strategy, but if either of us every rats, this triggers a “punishment phase” where we are unable to cooperate
The threat of moving to this punishment phase keeps us both quiet, even though either of us would gain in the short-term by ratting each other out.
So in the prisoner’s dilemma, or the agency game, if the game will be played over and over, it’s possible to get cooperation.
Similarly, in situations where contracts cannot be enforced, repeated interactions with the same parties can lead to voluntary cooperation.
Even when you won’t always be transacting with the same person, transacting within a small community, where people are aware of your reputation, leads to a similar incentive.

19. Repeated games and reputation
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.”
The Friedman book mentions an article by Lisa Bernstein on diamond dealers in New York. Quoting from Friedman:
Buying and selling diamonds is a business in which people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one.
The New York diamond industry was at one time dominated by orthodox Jews, forbidden by their religious beliefs from suing each other – making it a trust-intensive industry conducted almost entirely by people who could not use the legal system to enforce their agreements. While the industry had become more diverse by the time Bernstein studied it, dealers continue to rely almost entirely on private mechanisms to enforce contracts – in part for religious reasons, in part to maintain privacy, in part, perhaps, because those mechanisms functioned better than the courts.
At the center of the system is the New York Diamond Dealers’ Club, which arranges private arbitration of disputes among diamond merchants. Parties to a contract agree in advance to arbitration; if, when a dispute arises, 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. Similar arrangements exist elsewhere in the world and exchange information with each other. Presumably the amount diamond merchants are willing to risk on a single deal depends in part on how long the other party has been involved in the industry and thus how much he would lose if he had to leave it.

20. Repeated games and reputation
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
Recall that in the first couple lectures on contract law, we introduced a number of pronouncements from Cooter and Ulen, including:
The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solution
Considering the effect of repeated games, Cooter and Ulen add a sixth one to the list:
The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on the courts to enforce contracts.
We saw with the agency game that one way to allow for cooperation was to introduce enforceable contracts
Repeated interactions, or enduring relationships, give another way to get cooperation in what seems like a game with a noncooperative solution
The textbook gives a couple of examples of how courts sometimes try to foster enduring relationships:
By assigning legal duties to relationships that arise out of contracts
example: a bank has a fiduciary duty to its depositors which goes well beyond the terms they agree to on the account
a franchisee who runs a local McDonalds has certain duties to the franchisor
These duties are meant to encourage an enduring business relationship.
Similarly, courts sometimes treat long-term business relationships differently
encouraging the parties to “repair the relationship” rather than simply ruling on the merits of the dispute.

21. Repeated games and the endgame problem
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…
So we’ve seen that repeated interactions and reputation can solve the agency problem and lead to cooperation
But there’s also a potential problem with this
In the examples so far, we’ve assumed that we don’t know how long we’ll keep interacting, but that it might go on indefinitely
However, if there is a particular date when we know our relationship will be over for sure, this can lead to a problem.
Suppose we are going to play the agency game once a month for five years – that is, we’re going to play 60 times
Clearly, getting $50 60 times is much better than getting $200 once, so it seems there should be no problem with getting me to return your money early on in the interaction.
However, think about the problem from the other end.
The last time we play, there’s no longer any future gain if I return your money, since we already know it’s our last time playing.
Given that, you expect me to steal the money you give me in game #60, so you don’t lend me the money.
But now think about game #59
We both know that we won’t cooperate in game #60 – that’s true regardless of what happens in game #59.
So what happens in game #59 doesn’t affect future play
So once again I have no reason to return your money, so I keep it; and you expect this, so you don’t trust me.
But now if we don’t expect to cooperate in game #59 or #60, there’s no reason for you to trust me in game #58.
And so on.
So in a finitely repeated game, cooperation can unravel from the back, and we can fail to cooperate form the very beginning!
This is referred to in Cooter and Ulen as the “endgame problem”
Once we know there is a finite end date to our interaction, cooperation can unravel

22. Repeated games and the endgame problem
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
This is referred to in Cooter and Ulen as the “endgame problem”
Once we know there is a finite end date to our interaction, cooperation can unravel
They discuss an example where this happened: the collapse of communism across much of eastern Europe in 1989.
Communism was believed to be much less efficient than capitalism
But when central planning was replaced by markets, this actually led to a decrease in growth rather than the anticipated increase. Why?
Under communism, a lot of production relied on the black market, or the semi-legal gray market.
Since these transactions weren’t protected by law, they relied on long-term relationships to accomplish cooperation.
However, the fall of communism, and the uncertainty that came with it, upset these relationships, causing lots of important cooperation to break down.
So while repeated interaction gives us a way to cooperate without relying on courts to enforce contracts, having a definite end date to the interaction can spoil it.
Keep in mind, though, that to sustain cooperation, the game doesn’t have to actually go on forever; it just has to be possible at each stage that it might continue.
The probability the game will be played again is like a discount factor – you discount the future gains by the probability they will occur
As long as this probability is not too low, the possibility of future gains may still be enough to sustain cooperation.

23. Couple other odds and ends

24. Efficient bearer of risk
Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost
How do we know who this is? Friedman offers several bases for this decision…
Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Recall the rule we saw before: efficient default rules assign liability to the party who can bear the risk at least cost
Friedman offers several ways to figure out who this is
First: spreading losses
“Suppose I am having a house built by a large firm that builds many houses each year.
There is some risk that the house might burn down while it is being built.
We could allocate that risk either to me, by specifying that I will have to pay for the additional construction costs in such a case, or to the builder.
Since the builder is building many houses in different places, he can spread the risk; I cannot.
From that standpoint at least, our contract should specify a fixed price, whether or not something goes wrong.
If the contract does not specify who bears the risk, risk spreading provides an argument for assigning it to the builder.”
Second: who is in a better position to influence the outcome?
“In the case of a firm that builds houses the two arguments go in the same direction.
The builder is not only in a better position than I am to spread the risk, he is also in a better position than I am to keep the house from burning down while he is building it.”

25. Efficient bearer of risk
Rule we saw: when performance becomes impossible, assign liability to party who can bear risk at least cost
How do we know who this is? Friedman offers several bases for this decision…
Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Adverse selection: who is more aware of risk, even if he can’t do anything about it?
“…The party with control over some part of the production process is in a better position both to prevent losses and to predict them.
It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”
I promise to sell you 10,000 widgets; a drunk driver crashes into my factory, destroying half of them. I deliver them late, costing you money. Do I owe you damages?
“A third factor in allocating risk is adverse selection.
…I did not know that that particular drunk driver was going to crash through that particular wall.
But I probably do know a good deal more than you do about the chance that something – accident, strike, or bad planning – will prevent me from delivering the widgets to you on schedule.
If our contract makes me liable for the resulting loss, you don’t have to worry about that risk in deciding whom to buy your widgets from. You know what price I am charging, and you know that I am insuring you against the risk of nondelivery.
If the contract specified that you had to bear the risk, you would need to know the reliability of alternative sellers as well as their price in order to decide which one is offering the best deal.
“As this example suggests, moral hazard and adverse selection tend to cut in the same direction.
As a general rule the party with control over some part of the production process is in a better position both to prevent losses and to predict them.
It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”

26. Hadley v Baxendale Suppose… Shipper liable for actual damages
80% of millers are low-damage – suffer $100 in losses from delay
20% of millers are high-damage – suffer $200 in losses from delay
Shipper liable for actual damages
Average miller would suffer $120 in losses
Shipper makes efficient investment for average type
But not efficient for either type
Shipper liable for foreseeable damages
Shipper makes efficient investment for low-damage millers
High-damage millers have strong incentive to negotiate around default rule
This is why the decision in Hadley v Baxendale is not obvious – since Baxendale controlled the shipping process, he was in better position to influence the outcome, so we would think Baxendale might be efficient risk bearer
The book Game Theory and the Law (by Baird, Gertner, and Picker) has a nice analysis of the problem
“Let us assume that there are two types of millers. One type of miller is low-damage. In the event that the carrier fails to deliver the crankshaft on time, the low-damage miller suffers damages of $100. The other type of miller is high-damage and suffers $200 in damages when the carrier fails to deliver the crankshaft on time. The carrier knows that 20% of millers are high-damage and 80% are low-damage, but the carrier has no way of telling one type from the other.”
If miller was making the decision, high-damage millers would spend more to ensure prompt delivery
Consider rule where shipper is liable for actual damages. If there’s no way for shipper to figure out what type of miller he’s dealing with, the shipper knows that when there’s a delay, on average, he’ll owe $120.
So the shipper will choose efficient investment level for average case – that is, $120 in expected damages. So he spends inefficiently little for high-damage millers, inefficiently much for low-damage millers.
If the shipper is liable only for foreseeable damages, this would be $100; so he would spend efficient investment level for low-damage case.
This means the high-damage millers do badly – there’s an inefficiently high risk of delay, and they don’t get fully compensated if it happens.
But now high-damage millers have strong incentive to negotiate around the rule – basically, to buy insurance from shipper against delay. This would lead shipper to know who he’s dealing with, leading to efficient contracts for both types.

27. One other bit I like from Friedman
“Premarital sex is not, popular opinion to the contrary, a new discovery.
In most societies we know of, however, men prefer to marry women who have never slept with anyone else.
This creates a problem. Unmarried women are reluctant to have sex for fear that it will lower their ability to find a suitable husband, and as a result unmarried men have difficulty finding women to sleep with.
One traditional solution to this problem is for unmarried couples to sleep together on the understanding that if the woman gets pregnant the man will marry her.
This practice was sufficiently common in a number of societies… that between a quarter and half of all brides went to the alter pregnant.
One problem with his practice is that it creates an opportunity for opportunistic breach by the man, the strategy of seduce and abandon familiar in folk songs, romantic literature, and real life.
That problem can be reduced by converting the understanding into an enforceable contract.
Under traditional common law a jilted bride could sue for breach of promise to marry.
The damages she could collect reflected the reduction in her future marital prospects.
They were in fact, although not in form, damages for loss of virginity.

28. One other bit I like from Friedman
Starting in the 1930s U.S. courts became increasingly reluctant to recognize the action for breach of promise to marry, with the result that between 1935 and 1945 it was abolished in states containing about half the population.
This created a problem for women who wanted to engage in premarital sex but did not want to end up as single mothers in a society in which that status was both economically difficult and heavily stigmatized.
The solution they found was described in “Rings and Promises,” an ingenious article by Margaret Brinig.
The practice of a man giving his intended a valuable diamond engagement ring is not, De Beers’ ads to the contrary, an ancient custom.
Data for diamond imports in the early part of the century are not very good, but Brining’s conclusion from such information as she was able to find was that the practice became common only in the 1930s, peaked in the 1950s, and has since declined.
Her explanation was that the engagement ring served as a performance bond for the promise to marry.
Instead of suing, the jilted bride could simply keep the ring, confiscating the posted bond.
The practice eventually declined not because of further legal changes – at present no states recognize the action for breach of promise to marry – but as a result of social changes.
As premarital sex became more common, contraception more reliable, and virginity of less importance on the marriage market, the risk of opportunistic breach, and thus the need for a bonding mechanism, declined.”

29. That’s it for contract law
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 week, we begin tort law
The first purpose for contract law is to encourage cooperation, by changing games with noncooperative equilibria into games with cooperative equilibria
Encouraging cooperation means that contracts should generally be enforceable when both parties wanted them to be enforceable
The second purpose is to encourage efficient disclosure of information
This is sometimes accomplished through penalty defaults – rules that penalize a better-informed party that withheld information
The third purpose is to secure optimal commitment to performance – that is, efficient investment in performance, and breach only when it’s efficient
This is generally accomplished through expectation damages
The fourth purpose is to secure efficient reliance investments
This requires not including the anticipated benefits from overreliance in damages – but we saw multiple ways to try to accomplish this, and the paradox of compensation
The fifth is to provide efficient default rules and regulations
Efficient default rules generally require allocating a risk to the low-cost bearer
And we saw a number of examples of regulations – situations where contracts would not be enforced
The sixth purpose is to foster enduring relationships – as we saw today, repeated interactions and reputations can lead to cooperation without relying on the court system, but endgames pose a problem
End of material on second midterm