IV. Contracts
    A. The economics of contracts

    Final comment regarding
    1. Aligning incentives

    "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

    a. risk aversion

    2 income options
    Option 1: I = $50K
    Option 2: Heads = $100K; Tails = $0K
Expected income (EI) = PrH x +100K + PrT x -50K
            = .5 x (+100K) + .5 x (0K)
            = $50K
    Result: I = EI

Preference?     Assumption: diminishing marginal utility of income (DMUI)     (1) DMUI => risk aversion     Risk aversion => individuals prefer the prospect of a certain income to the prospect of an uncertain income with the same expected monetary value

    I = EI => U(I) > EU(EI)
where
    EU(EI) = Pr1 U(I1) + (1-Pr1) U(I2)

    (2) risk aversion => people are willing to pay to avoid risk

    risk premium = the difference between expected but uncertain income and an equally preferred certain income
    = maximum you would pay to avoid a risk
    illustrate in the diagram

    Key results
    (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)

    b. allocating contract risks

    "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

    Exs: Who should be responsible for absorbing costs if...

    --a Coca-Cola bottle blows up? (F69)

    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

    --a product doesn't work as advertised?

    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)

    --a partially completed custom-ordered house burns down?

    fixed-price contract: "Ordinarily, a fixed-price contract is intended to assign to the performing party the risk of problems encountered in performance." (P107)

    "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:

    --a partially completed custom-ordered house is destroyed by earthquake?
    "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)
    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)

    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)

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