Arises once a transaction between 2 parties begins
Per Posner: opportunism (P93,95)
(1) = monopoly seller's surplus-maximizing
optimum
(2) = monopsony buyer's surplus-maxmimzing optimum
III. Contracts
Property: elaborated the
notion of ownership that we glossed over in micro theory
Enriched our perception
Contract: we must revise the
fundamental context we used in micro theory
With contracts, we do not operate in an environment of perfect
competition.
At the outset, we can shop for a competitive contract, but once we
enter into a contractual relationship, the environment is one-on-one.
It's not a situation we dealt with in micro theory
As usual, general purpose: to assess and promote the efficiency of contracts and contract law
topic areas:
the economics of contract
making contracts--does a contract exist?
enforcing contracts--does the contract deserve to be enforced?
interpreting contracts--what are its terms; how should missing terms be
inferred?
breaking contracts--what should be done when someone breaches a
contract?
A. The economics of contracts
Why do people
make enforceable contracts?
Why not do everything on the spot market?
Some transactions take time
Recall with property:
assigning rights affects distribution of wealth => can use property law for goals other
than efficiency
Contract law: "concerned with facilitating the voluntary movement
of property rights into the hands of those who value them most" (P31)
Redistribution is much less feasible with contracts: Contracts are a
"setting of low transaction costs, and therefore a judicial failure to discover the
efficient solution can be retified in the future through a drafting change." So
"contract law cannot readily be used to achieve goals other than efficiency."
(P98)
Purposes of
contracts:
--Aligning incentives
--Allocating risk
1. Aligning incentives
a. The bilateral monopoly problem
Ex: I take you up to Alaska on my boat to help me harvest
salmon.
We get to our remote fishing location and proceed to work out
the wage
|
Bilateral monopoly = monopoly seller facing a monopsony buyer Arises once a transaction between 2 parties begins Per Posner: opportunism (P93,95) (1) = monopoly seller's surplus-maximizing
optimum |
|
|
Result: inefficient and incompatible incentives
Remedy? Make an enforceable contract ex ante
b. The principal-agent problem
relational
contract: one party (the principal) delegates actions to another (the agent)
common agents in contracts:
lawyers, accountants, brokers, trustees
the problem: incompatible incentives--maximize welfare subject
to contract constraints
game theory ((F,ch.8) Price theory coverage and explanation of solution concepts.)
Ex:
Investor-broker: i = 4%
investment: $100 in Yr0 --> $112 in Yr1
$2 for the broker / $10 for the investor
Case 1: No enforceable contract:
| Broker (agent, promisor) | |||||
| a. Perform | b. Breach | ||||
| Investor (principal promisee) |
1. Don't invest | a1 | \
0 \ 4 \ |
b1 | \
0 \ 4 \ |
| 2. Invest | a2 | \ 2 \ 10 \ |
b2 |
\ 100 \ -100 \ |
|
Outcome: Row 1--don't invest
Case 2:
Enforceable contract--guarantee returns:
Agent has a fiduciary duty: must treat the principal as an alter ego.
(P114)
| Broker | |||||
| a. Perform | b. Breach | ||||
| Investor | 1. Don't invest | a1 | \
0 \ 4 \ |
b1 | \
0 \ 4 \ |
| 2. Invest | a2 | \ 2 \ 10 \ |
b2 |
\ -10 \ 10 \ |
|
Outcome: Cell a2--invest + perform
So who gains from enforceable contracts? Both parties
Why might the promisor perform even without enforceable contracts?
reputation: "may be the most important method for enforcing
agreements in our society, although not the one of most interest to lawyers." (F145)
-- works well when "the amounts at stake are small, the issues
simple, and the parties are engaged in repeat dealings." (F145)
Ex: "Trusted private arbitrators": Diamond industry in NY,
"dominated by orthodox Jews, forbidden by their religious beliefs from suing each
other." The trustworthy rabbi mitigated disputes. Helps explain why "particular
trades are sometimes dominated by a single close-knit ethnic group." (F146)
"commercial arbitrator": each party "posts a bond with
[a] third party ... we both trust." the 3rd party arbitrates. (F147)
has the advantage of
providing market incentives to judge correctly (good arbitrators get rehired)
reputation incentive:
"someone known not to perform his side of bargins will find it difficult to find
anyone willing to make exchanges with him in the future...."
but... in some contexts, reputation does not work.
It is dependent on reliable information about who was in the wrong
The promisor might be old; the contract could be very large; or s/ he
can function w/o contracts in the future. (P94)
Ex: long-term guaranteed contracts in sports
Result: welfare-improving
bargains fail to occur w/o enforceable contracts
Ex: "E may be willing to guarantee the superior durability of his
shirt, but, if his promise is not legally enforceable, consumers may doubt the honesty of
his claim" (P94)
The
fundamental function of contract law (and
recognized as such at least since Hobbes' day) is to deter contracting parties from behaving opportunistically, in order to encourage the optimal timing of economic
activity and (the same point) obviate costly self-protective measures." (P94)
opportunism is not always obvious--paint a self-portrait "to
customer's satisfaction." Court will not enforce payment, since terms implied
customer satisfaction was necessary. (P95)
"Good-faith performance--which means in this context not trying to take advantage of the vulnerabilities created by the sequential character of contractual performance--is an implied term of every contract." (P95)
2. Allocating risk
We live in a world of
uncertainty (Ref: Friedman, Price Theory, choice under uncertainty (F64))
Some risks are out of our control: fires, floods, earthquakes
For many risks, we can mitigate damages: nonflammable roof shingles,
raised foundations, bolted foundations
But we also assume many risks: build homes in forests, on hillsides,
near earthquake faults
Contracts are affected by
unforeseen contingencies (P)
Who should bear the risk if something goes wrong?
"Legal rules allocate risk." (F63)
2 methods for
minimizing loss in contracts (P105)
prevention
insurance
"Insurance is one way of dealing with
unforeseen contingencies, and contracts are often a method of insurance." (P97)
prevention and insurance overlap in practice, so we need to cover our attitudes for risk before proceeding
Risk
aversion =>
(i) people pay more for a contract that allows them to transfer risk
(ii) people buy insurance contracts that pool risks
insurance pools risk and
thereby eliminates it (by the law of large numbers)
"Transferring risk does not eliminate it, but pooling risk
does." (F64)
"one
simple rule for allocating risks: Put the incentive where it does the most good." (F72)
some losses are
preventable, so assigning risk efficiently can increase prevention
(1) explicit contract
Ex: "extended service contract" -- shifts risk to the party which can avoid it more cheaply. (F69)
(2) implicit contract
Ex: Why have companies like Coca-Cola switched from glass to plastic for soda bottles?
--a Coca-Cola bottle blows up? (F69)
Ex1: implied warranty against hazards: provides an incentive for Coca Cola to provide safe packaging
preventable loss -- cost-effective to avoid
Coke switched to plastic bottles
--Who absorbs costs if a product doesn't work as
advertised?
a carpet shampoo that can't clean your
particularly dirty carpet
Ex2: implied warranty of fitness for intended use: seller is cheaper insurer since seller can pool risks that a defect occurs, so can charge more for the product by accepting the risk. (P106)
--Who is responsible if a partially completed custom-ordered house burns down?
Ex3: fixed-price
contract: "Ordinarily, a fixed-price
contract is intended to assign to the performing party the risk of problems encountered in
performance." (P107)
Ex: cost of materials for Oxy residence hall
"The manufacturer
warrants those and only those dimensions of performance that are primarily within his
control rather than the buyer's." Ex: fire at
warehouse before delivery. (P97)
WI hired Bentley to build wings for capital. sued when they collapsed.
state lost since bentley had followed architect plans, and plans were faulty. state could
have prevented loss more cheaply by more careful selection of architect. 97n: bentley v.
state. 73 Wis. 416, 41 N.W. 338 (1889) (P97)
impossibility:
Who pays to rebuild a partially completed
custom-ordered house that gets destroyed by earthquake?
ex1: oil companies found liable
for losses due to oil undelivered because of the outbreak of war in the Middle East
ex2: difficult soil is no excuse
for breaking a water drilling contract; blight is an excuse for failing to deliver
contracts to a grain elevator (though futures contracts may change the picture).
(P107)
"If the promisor
is the cheaper insurer, the fact that he could not have prevented the event that prevented
him from performing should not discharge him." (P106)
force majeure ("greater force") clause: specifies the circumstances in which failure to perform will be excused. (P107)
--promisor
dies partway through a personal services contract?
discharge is normally allowed for personal service contracts in event
of death, unless the promisor could have reasonably foreseen it. (P107)