Econ 522Economics of Law

Dan Quint

Spring 2014

Lecture 16

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HW3 (contract law) due next Thursday

Reminders

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Results of Monday’s Experiment (trust)

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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

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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?

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How’d you guys do?

15% got 0 backavg gain $3.02avg sent $3.6684% sent something

8%8.96245

20%9.4054

0%6.30103

40%1.70102

25%3.0041

80%1.00100

Fraction who got 0Average back from BObservationsA sent

3% got 0 backavg gain $4.34avg sent $3.9794% sent something

6%10.80345

0%6.0064

0%6.8093

0%3.0092

0%4.7031

100%0.0040

Fraction who got 0Average back from BObservationsA sent

AN

ON

YM

OU

SW

ITH

NA

ME

S

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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?

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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?

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Back to work

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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

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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

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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

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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”

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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”

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Foreseeable reliance

Include benefits reliance that promisor could have reasonably anticipated

Reminder: what do courts actually do?

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Repeatedinteractions

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Repeated games

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Repeated games

Player 1 (you)

Trust me Don’t

Player 2 (me)

Share profits Keep 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…

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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

50 29.509.50 39.50 ... 5009.1

50

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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

50 29.509.50 39.50 ... 5009.1

50

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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

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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

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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

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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

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One other bitI like from Friedman

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Friedman on premarital sex

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Friedman on premarital sex

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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

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But first, let’s recapour story so far…

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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

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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

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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

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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

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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

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Tort law

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An example

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An example

Choice Bad Luck Outcome+

punish the choice

• criminal law

• regulations

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An example

Choice Bad Luck Outcome+

punish the choice

• criminal law

• regulations

punish the combination of choice and outcome

• “negligence”

punish the outcome

• “strict liability”

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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

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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

–1,000–1,000–1,000Combined payoffs

–50,000–1,0000My payoff

49,0000–1,000Your payoff

I owe $50,000I owe $1,000I owe nothing

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Something to remember

distributionbut not

efficiency

efficiency

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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

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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

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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

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“Classic” legal theory of torts

Simple economic model to study incentives

Next week