DU Law and Economics Discussion

ECON 2212LAW & ECONOMICS
ECON 2212 – WEEK 5
1
Contracts
Economic Analysis of Contracts
• Why do we need an economic analysis of contracts?
• Traditional doctrinal analysis has several
problems:
• Bargain theory suggests that only those
contracts that are part of a reciprocal promise
should be enforced.
• Non-bargain promises should not be
enforced.
• Every bargain promise should be enforced,
even the trivial bargain and the very hard
bargain.
ECON 2212 – WEEK 5
2
Contracts
Economic Analysis of Contracts
• Why do we need an economic analysis of contracts?
• But courts have routinely enforced non-bargain
promises.
• And have routinely voided bargain promises that
were deemed to be too harsh.
• Not only do courts not actually follow the bargain
theory, they should not follow that theory.
• Economic analysis provides a normative theory of
contractual enforcement that also does a reasonably
good job of positively predicting what courts will
actually do.
ECON 2212 – WEEK 5
3
Contracts
Economic Theory of Contract
• Why do people write contracts?
• A means of furthering the legitimate goals of two
parties who desire to engage in a mutually
beneficial transaction that will take time to
complete.
• Cooperation, commitment, and coordination.
ECON 2212 – WEEK 5
4
Contracts
Economic Theory of Contract
• Why do we need contracts?
• “the essence of the free-market economy is the
ability of private parties to enter into voluntary
agreements that govern the economic exchange
between them”
ECON 2212 – WEEK 5
5
Contracts
Economic Theory of Contract
• Key Questions:
• 1. What promises should be enforced?
• 2. What should be the remedy for breaching
enforceable promises?
ECON 2212 – WEEK 5
6
Contracts
Economic Theory of Contract
• A contract has value because it creates a
commitment. It couples the promisor to perform an
action which, without commitment, they would not ex
post choose to do.
• With complete contingent contracts, we wouldn’t
need to talk about “breach”, because every possible
contingency, including non-performance, could be
specified in the contract.
ECON 2212 – WEEK 5
7
Contracts
Economic Theory of Contract
• Deferred transactions (not just bargains).
• To be distinguished from a “spot transaction.”
• The transaction is not instantaneous. It will require
time to pass before it is completed.
• That passage of time greatly increases the
transaction costs of the contemplated transaction.
• Circumstances might change, making the value
of performance less than originally
contemplated or compromising the ability of one
or both parties to complete the promised
performance.
ECON 2212 – WEEK 5
8
Contracts
Economic Theory of Contract
• Will the other side do what she said she would do?
• Each party needs to rely on the other. That is, to
make pre-performance expenditures in reliance
upon the other side’s completing her part of the
transaction.
• Purchasing drapes for the house that one
intends to take possession of in the Spring.
• Hiring an architect to draw up plans for the
building that will be constructed with the gift that
a loyal alumnus plans to give to the university.
ECON 2212 – WEEK 5
9
Contracts
Economic Theory of Contract
• Will the other side do what she said she would do?
• Without assurance that these pre-performance
expenditures will bear fruit, parties will be reluctant
to engage in them. And that may be inefficient.
• Parties who commit to one transaction might have
foregone others. They will most meaningfully
make that commitment if they are reasonably
certain that they will not be disappointed.
• The parties need to coordinate throughout the time
that it takes to complete the transaction. They
need to be told if circumstances have changed.
ECON 2212 – WEEK 5
10
Contracts
Economic Theory of Contract
• Risk allocation.
• Risk of loss from non-performance or delayed
performance.
• Ideally the parties should undertake to allocate this
risk between or among themselves.
• And presumably it is in both or all of their
interests to allocate this risk to the cheaper
preventer of or insurer against each frustrating
contingency.
• Every frustrating contingency?
ECON 2212 – WEEK 5
11
Contracts
Economic Theory of Contract
• Information exchange.
• The value of performance may depend crucially on
the information that the parties exchange before
the formation of the contract and during its
pendency.
• One party may only want to sell his farm to
someone who intends to farm.
• One party may attach special value to performance
beyond the easily measured objective value.
• Fraud.
ECON 2212 – WEEK 5
12
Contracts
Economic Theory of Contract
• Information exchange.
• But recall that informational asymmetry is a
significant problem for arm’s-length transactors.
• Inducing people to reveal truthful information in
a timely fashion.
• Moreover, there are circumstances in which
resources will be more efficiently used if parties
are allowed to keep information secret.
• Can parties adequately distinguish information that
should be disclosed from information that might
better be kept secret?
ECON 2212 – WEEK 5
13
Contracts
Economic Theory of Contract
• All of these issues seem clear, but what does it have
to do with the law?
• Why is law helpful to secure the commitment,
cooperation, and coordination in a consensual
agreement?
• It is not clear that law is necessary for the
successful completion of mutually beneficial
deferred transactions.
• Presumably the parties could secure the benefits
of consensual agreements through either their own
devices or the help of third parties.
ECON 2212 – WEEK 5
14
Contracts
Economic Theory of Contract
• Contract law may be seen as a device for lowering
the transaction costs of forming and completing
consensual agreements.
• For example, contract law might, through its rules
and standards, alert parties to the risks that need to
be allocated, the information that needs to be
exchanged, and the need for commitment,
coordination, and cooperation.
• Importantly, by providing a set of remedies for
unexcused breach of an agreement, contract law
helps make commitment possible.
ECON 2212 – WEEK 5
15
Contracts
Economic Theory of Contract
• The development of contract law might be seen as
one of the great inventions of the modern world.
• Sir Henry Maine: the thrust of modern legal history
can be summed up as the movement “from status
to contract.”
• No longer must you know or be related to those
with whom you do business.
• Contract expands the possible range of business
partners.
ECON 2212 – WEEK 5
16
Contracts
Economic Theory of Contract
• These “off the rack” rules might be provided by third
parties or by seasoned attorneys or by repeat
transactors.
• Indeed, this is happening in international business
transactions.
• However, governmental provision of contract law
assists the great majority of transactors (who may not
have access to private enforcement or be unaware of
the pitfalls of deferred transactions) to form and
complete successful agreements.
ECON 2212 – WEEK 5
17
Contracts
Economic Theory of Contract
• How does contract law seek to facilitate mutually
beneficial transactions and lower the transaction
costs of forming and completing those transactions?
ECON 2212 – WEEK 5
18
Contracts
Economic Theory of Contract
• Through mandatory and default rules.
• A default rule is one that will be in force unless the
parties to a consensual agreement agree to
change it.
• Note the analogy to default settings on personal
computers.
• A mandatory rule is one that binds the parties and
that they may not change, even if both of them
prefer to do so.
ECON 2212 – WEEK 5
19
Contracts
Economic Theory of Contract
• Default rules.
• Majoritarian defaults.
• Chooses as default terms those that the vast
majority of transactors would prefer.
• Thereby lowers transaction costs for the vast
majority of transactors.
• Puts the burden on a minority of transactors to
incur transaction costs.
ECON 2212 – WEEK 5
20
Contracts
Economic Theory of Contract
• Default rules.
• Punitive defaults.
• Ayres and Gertner on gap-filling.
• A means of inducing parties to do something
that they ought to do by penalizing one of them
for failing to do so.
• Example:
• Void a contract that fails to specify a quantity
term.
• Imputes a “reasonable price” if the parties fail
to specify a price term.
ECON 2212 – WEEK 5
21
Contracts
Economic Theory of Contract
• Mandatory rules
• Paternalism.
• The decisionmaker needs protection against
himself.
• Persistent and systematic cognitive biases.
ECON 2212 – WEEK 5
22
Contracts
Contracting Law
• Contracting becomes important when there is a
temporal element implementing exchange over time.
• The first purpose of contract law is to enable parties
to convert games with inefficient solutions into games
with efficient solutions.
• The second purpose is to encourage the efficient
disclosure of information.
ECON 2212 – WEEK 5
23
Contracts
Contracting Law
• Bargain theory of contracts:
• “a promise is enforceable if it is given as part of a
bargain”
• 3 key elements:
• Offer
• Acceptance
• consideration
ECON 2212 – WEEK 5
24
Contracts
Contracting Law
• Each Bargain involves reciprocal inducement
• The promise gives something to induce the
promisor to give the promise.
• Promisee gives consideration
• Promises lacking consideration are unenforceable
• Should unfair bargains be enforced?
• Bargain theory doesn’t describe what we want a
theory of efficient contracting to do.
ECON 2212 – WEEK 5
25
Contracts
Formation Defences
• Coercion or duress.
• Why void a promise elicited by coercion or duress?
• A mandatory rule or a default rule?
ECON 2212 – WEEK 5
26
Contracts
Formation Defences
• Incompetency.
ECON 2212 – WEEK 5
27
Contracts
Formation Defences
• Fraud or misrepresentation.
ECON 2212 – WEEK 5
28
Contracts
Formation Defences
• Duty to disclose
• Should the law compel information revelation?
• Or should the law protect the incentive to develop
information by not compelling revelation?
• Caveat emptor: “Let the buyer beware.”
• An inducement to invest in precontractual
information-gathering.
• The prevailing rule is to require disclosure of latent
defects.
ECON 2212 – WEEK 5
29
Contracts
Formation Defences
• Mutual mistake.
• To be distinguished from unilateral mistake.
ECON 2212 – WEEK 5
30
Contracts
Formation Defences
• Unconscionability
• Court evaluates the procedures by which the
contract was formed to see if there was excessive
advantage-taking.
• Court investigates the substance of the terms and
evaluates them for reasonableness.
• Standard form contracts.
ECON 2212 – WEEK 5
31
Contracts
Formation Defences
• Controversy about whether particular terms are
examples of unconscionable or efficient behavior.
• Procedural and substantive unconscionability.
• Termination-at-will clauses in franchise contracts.
• Add-on clauses in consumer finance contracts.
ECON 2212 – WEEK 5
32
Contracts
Formation Defences
• The crucial economic characteristic of each example
of an unconscionable contract is a situational
monopoly.
• Distinguish from a simple monopoly.
• Suppose there is a drought and only one wellowner retains water. The owner charges
monopoly prices for water.
ECON 2212 – WEEK 5
33
Contracts
Formation Defences
• Frustration of purpose.
• Impossibility of performance.
• Commercial impracticability.
• The unifying economic principle: efficient risk
allocation.
• Did the parties allocate the risk?
• If not, was this risk foreseeable at reasonable
cost?
• Who is the cheaper preventer of or insurer against
this particular frustrating contingency?
ECON 2212 – WEEK 5
34
Contracts
Remedies
• Efficient breach of contract.
• “Market” remedies.
• Diminished reputation.
• Party-designated remedies.
• Liquidated or stipulated damages.
• Court-imposed remedies.
• Expectation damages.
• Specific performance.
ECON 2212 – WEEK 5
35
Contracts
Remedies
• A failure to perform a contractual promise is
efficient if no one is worse off than she or he
would have been from performance and at least
one person is better off from non-performance
than from performance.
• Remedies should be structured so that they
encourage performance when that is efficient and
breach when that is efficient.
ECON 2212 – WEEK 5
36
Contracts
Remedies
• A myopic, self-interested promisor will breach the
contract if the cost of performing > liability for
breach.
• Efficiency required the promisor to not perform
when:
• Cost of performing > promise’s benefit from
performing
• So we set efficient incentives for performance
and breach when liability for breaching =
promise’s benefit from performing.
ECON 2212 – WEEK 5
37
Contracts
Goals of Remedies
• (To encourage optimal performance and breach.)
• To encourage optimal reliance.
• We do not want too much reliance; there may be
a moral hazard problem if reliance expenditures
form part of the remedy.
• To encourage optimal contract formation.
• Whether contracts are formed and the terms and
conditions agreed to may depend crucially on the
remedies available.
• Consider whether actual losses or “reasonably
foreseeable” losses are the basis of the contract
remedy.
ECON 2212 – WEEK 5
38
Contracts
Market Remedies
• If an individual or firm breaches a contract
without excuse and is a repeat player in the
market, then the market may impose a
reputational loss on them.
• For this to be an efficient remedy, the
reputational loss would have to (1) induce breach
only when it is more efficient than performance
and (2) confer a benefit on the innocent party
such that he or she was indifferent between
performance and breach.
• Even if loss of reputation does adequately deter,
it does not necessarily confer a benefit on the
breachee.
ECON 2212 – WEEK 5
39
Contracts
Types of Damages
• Expectation Damages
• Puts in same position as if they had performed
Contract
• Reliance Damages
• Restore position as if they had not signed
Contract
• Restitution Damages
• Where, in reliance on a promise, a plaintiff has
provided some benefit to a default, who has
failed to perform their promise. Court requires
defaulting party to relinquish the value they
have received to prevent unjust enrichment.
ECON 2212 – WEEK 5
40
Contracts
Types of Damages
• Expectation Damages
• It is the general intention of the law that, in
giving damages for breach of contract, the
party complaining should, so far as it can be
done by money, be placed in the same position
as he would have been in if the contract had
been performed.
ECON 2212 – WEEK 5
41
Contracts
Expectation Damages
• The standard remedy for breach of contract is legal relief, an
award of compensatory money damages.
• What amount of damages constitutes an efficient remedy?
• Expectations damages—the “benefit of the bargain,” the gain
that the innocent party anticipated from completion of the
contract.
• Why is this measure efficient?
• Because the innocent party will be indifferent between
performance and breach, and if the breacher knows she must
pay expectation damages as the “price” for engaging in breach,
she will only breach if the benefit to her of doing so exceeds the
price she must pay to the innocent party.
ECON 2212 – WEEK 5
42
Contracts
Expectation Damages
• For example, if the innocent party is a buyer, the “benefit of
the bargain” is the consumer surplus that she or he
anticipated.
• If that is the measure of damages, then the buyer gets the same
benefit whether the contractual promise is performed or not.
• So, if the buyer valued a house at $200,000 and had a
contract to purchase it for $180,000. The seller breaches;
the buyer is entitled, under expectation damages, to $20,000.
• There are profound difficulties in measuring consumer
surplus.
• For that reason courts frequently use other, more tractable
measures of damages than expectation damages in the event of
seller breach.
ECON 2212 – WEEK 5
43
Contracts
Expectation Damages
• If the innocent party is a seller, the “benefit of the bargain” is
the lost profits on the transaction.
• The “lost-volume seller” problem. Did the seller truly lose a
sale? Or was there another buyer who immediately stepped
into the breacher’s place and purchased the goods?
• Should the reliance expenditures of the innocent party form
part of the award of damages for breach?
ECON 2212 – WEEK 5
44
Contracts
Expectation Damages
• The equitable remedy—an order by the court to the breacher
to perform the contractual promise.
• The law in Canada is that specific performance is the
unusual remedy, available only in the event of breach of a
contract to sell a unique item (for which, the theory goes,
money/damages cannot possibly be a substitute).
• Available only in instances of anticipatory repudiation.
ECON 2212 – WEEK 5
45
Contracts
Types of Damages
• Reliance Damages
• Where it is possible to award the expectation
interest, such as in cases where it is difficult to
enumerate the expectation, a plaintiff may
elect to have damages assessed by reliance
interest (that is, expenditures made in reliance
on the contract being performed).
ECON 2212 – WEEK 5
46
Contracts
Types of Damages
• Restitution Damages
• In contrast to expectation and reliance
interests, restitution comes down to whether
there can be a recovery of gains made from a
breach of contract and not the losses of the
victim.
• Foundation – whether an unjust enrichment
occurred.
ECON 2212 – WEEK 5
47
Contracts
Types of Damages
• Buyer contracts to pay p for good of value v,
given reliance r. Net value = V – r- p
• Expectation Damages = V (if p+r have been
spent)
• Reliance Damages = p+r
• Restitution Damages = p
• If Seller can perform at cost c, welfare is
maximized if seller pforms only when V >C
ECON 2212 – WEEK 5
48
Contracts
Party-Designated Remedies
• The parties may designate the remedies that
either party will bear if it breaches the contract.
• “Liquidated damages” or “stipulated damages.”
• Are agreed to as part of the negotiations to
form the contract.
• Why would parties stipulate damages rather
than leave their determination to a court in the
event of breach?
ECON 2212 – WEEK 5
49
Contracts
Express Remedies
• Sometimes contract itself stipulates the remedy for breach (i.e.
liquidated damage clauses)
ECON 2212 – WEEK 5
50
Contracts
Party-Designated Remedies
• Why would parties stipulate damages rather than
leave their determination to a court in the event
of breach?
• They may distrust the ability of the courts to
compensate them accurately for their losses
from breach.
• Why would parties distrust courts to set
damages correctly?
• Suspicion about protection of subjective value
that one party places on performance.
• Stipulating to large damages as a signal.
ECON 2212 – WEEK 5
51
Contracts
Liquidated Damages
• Standard analysis and prevailing doctrine is that
parties should only be allowed to stipulate to an
amount that is a reasonable approximation to the
actual losses from non-performance.
• Any amount that appears to be punitive will not be
enforced.
• So, one cannot stipulate to pay three times the
innocent party’s actual losses.
• Or $1,000 per day for every day beyond the agreedupon completion date.
ECON 2212 – WEEK 5
52
Contracts
Liquidated Damages
• Why the limitation on stipulated damages to a reasonable
approximation to actual losses from non-performance?
• Presumably only the courts should be allowed to punish.
Private parties should not have this power over one another.
• An economic argument against excessive damages: they
might induce performance when breach is more efficient.
• Suppose that A would like B to paint the exterior of her house in
August. The painting industry is highly competitive. The going
price for painting a similarly sized house is $500.
• A agrees to pay B $500 to paint her house but insists on a
$1,000 payment to her from B if he breaches the contract to
paint her house.
ECON 2212 – WEEK 5
53
Contracts
Liquidated Damages
• Now suppose that C approaches B and asks him to paint his
house in August of this coming year. C’s house is about the
same size as A’s but because he has a wedding coming up
and expects houseguests in September, C places a higher
value on getting his house painted than A places on her
house being painted. Specifically, C is willing to pay A $750
to paint his house.
• In the normal run of affairs, B would announce to A that he
intends to breach his contract to paint her house in favor of
painting C’s house. If B agrees to “cover” his breach by
finding a substitute painter to paint A’s house for the same
price ($500) or even a little less, then his breach of the
contract with A would be efficient. No one would be worse off
from breach than they would be from performance and at
least one person would be better off. (Who would be better
off after the breach?)
ECON 2212 – WEEK 5
54
Contracts
Liquidated Damages
• But here because of the stipulated damages clause requiring
B to pay A $1,000 in the event of non-performance, B cannot
breach the contract. He will inefficiently perform when he
should have breached.
• But even with the stipulated damages clause B may not perform.
• Why?
• Suppose that B goes to A and says, “Look, I want to breach. And
I’m prepared to pay you $125 if you’ll release me from the obligation
to perform the house painting job.”
• Suppose A says, “No dice. Why should I accept $125? If you
breach, you owe me $1,000.”
• What does B reply?
ECON 2212 – WEEK 5
55
Contracts
Liquidated Damages
• B threatens to perform!
• He explains that if he performs, all A is going to get is a
painted house. However, if she takes the proffered $125,
she’ll get a painted house for, in essence, $375.
• A will either (a) recognize the logic of this argument and
release B in exchange for $125 (or more) or (b) not release B
and, instead, insist on B’s painting her house.
• Either (a) or (b) could be efficient.
• (a) is efficient if A attaches no subjective value to B’s
painting her house.
• (b) is efficient if A attaches a subjective value to B’s
painting her house that is greater than $250.
ECON 2212 – WEEK 5
56
Contracts
Expectation Damages
• Calabresi and Melamed, applied to breach of contract.
• Transaction costs are low. There are no search costs,
minimal negotiation costs, and minimal enforcement
costs. The parties can bargain to an efficient result in the
event of breach.
• Only in the event of high transaction costs—say,
performance is physically impossible—should the court
award compensatory damages.
• This suggests that specific performance ought to be the
default contract remedy.
• Less need to protect subjective value on performance
and, therefore, lower costs of forming a contract.
• Less concern with reliance expenditures.
• But a duty to mitigate losses from breach?
ECON 2212 – WEEK 5
57
Contracts
Expectation Damages
• Suppose that D has rented an apartment from E for a term of
five years at $500 per month or $6,000 per year.
• D announces at the end of year two that he intends to breach
the contract.
• Suppose that the lessor, E, is entitled to specific
performance. Might there not be an inefficiency in that E will
have no incentive to re-let the property for the remaining
three years of the lease? Rather, E might simply seek to
collect $18,000 from D.
• Under expectation damages E would have a “duty to mitigate”
his losses. As a result, he might have to show that he attempted
to re-let the premised for the remaining term of the lease but was
only able to get $400 per month.
ECON 2212 – WEEK 5
58
Contracts
Expectation Damages
• So, E would, under damages, be entitled to receive
only (500 – 400) x 36 = $3,600.
• Would there be no incentive to mitigate under
specific performance?
• Suppose that the rental agreement prohibited D
from subletting the apartment.
• Will there be a substitute renter? Who will find
him or her? What will he pay? Could both D
and E be better off than with no mitigation?
ECON 2212 – WEEK 5
59
Contracts
Incomplete Contracts
• Economics may have introduced valuable scholarly values and
terms.
• But it has failed to explain such central concepts as expectation
damages, the non-enforceability of liquidated damages, the
central functions of consideration and promissory estoppel, and
the duty to disclose.
• And economic analysis provides little guidance to contract
reform—the variables that it designates as crucial are largely
unobservable.
ECON 2212 – WEEK 5
60
Contracts
Risk Allocation, Insurance and Remedies for
Breach
• Remedies for breach have the effect of allocating various risks
between the two parties
• Expectation damages leaves the buyer fully insured
• If buyers are risk averse, and sellers risk neutral, this will
allocate risk optimally – but there are other possibilities.
Expectation damages will no longer be optimal.
ECON 2212 – WEEK 5
61
Contracts
Punitive Damages
• Money awarded to the claimant in civil litigation to punish the
defendant and to deter the defendant and others from engaging
in unlawful conduct in the future. Punitive damages must bear a
reasonable relationship to the harm caused by the defendant’s
actions, and are reserved only for situations in which the
defendant acted intentionally, recklessly or with gross
negligence in causing the claimant’s harm. Punitive damages
are awarded to the claimant in addition to compensatory
damages.
ECON 2212 – WEEK 5
62
ECON 2212
LAW & ECONOMICS
ECON 2212 – WEEK 6
1
Contracts
Economic Theory of Contract
• Key Questions:
• 1. What promises should be enforced?
• 2. What should be the remedy for breaching
enforceable promises?
ECON 2212 – WEEK 6
2
Contracts
Contracting Law
• Bargain theory of contracts:
• “a promise is enforceable if it is given as part of a
bargain”
• 3 key elements:
• Offer
• Acceptance
• consideration
ECON 2212 – WEEK 6
3
Contracts
Contracting Law
• Each Bargain involves reciprocal inducement
• The promise gives something to induce the
promisor to give the promise.
• Promisee gives consideration
• Promises lacking consideration are unenforceable
• Should unfair bargains be enforced?
• Bargain theory doesn’t describe what we want a
theory of efficient contracting to do.
ECON 2212 – WEEK 6
4
Contracts
Types of Damages
• Expectation Damages
• Puts in same position as if they had performed
Contract
• Reliance Damages
• Restore position as if they had not signed
Contract
• Restitution Damages
• Where, in reliance on a promise, a plaintiff has
provided some benefit to a default, who has
failed to perform their promise. Court requires
defaulting party to relinquish the value they
have received to prevent unjust enrichment.
ECON 2212 – WEEK 6
5
Contracts
Types of Damages
• Expectation Damages
• It is the general intention of the law that, in
giving damages for breach of contract, the
party complaining should, so far as it can be
done by money, be placed in the same position
as he would have been in if the contract had
been performed.
ECON 2212 – WEEK 6
6
Contracts
Expectation Damages
• The standard remedy for breach of contract is legal relief, an
award of compensatory money damages.
• What amount of damages constitutes an efficient remedy?
• Expectations damages—the “benefit of the bargain,” the gain
that the innocent party anticipated from completion of the
contract.
• Why is this measure efficient?
• Because the innocent party will be indifferent between
performance and breach, and if the breacher knows she must
pay expectation damages as the “price” for engaging in breach,
she will only breach if the benefit to her of doing so exceeds the
price she must pay to the innocent party.
ECON 2212 – WEEK 6
7
Contracts
Expectation Damages
• For example, if the innocent party is a buyer, the “benefit of
the bargain” is the consumer surplus that she or he
anticipated.
• If that is the measure of damages, then the buyer gets the same
benefit whether the contractual promise is performed or not.
• So, if the buyer valued a house at $200,000 and had a
contract to purchase it for $180,000. The seller breaches;
the buyer is entitled, under expectation damages, to $20,000.
• There are profound difficulties in measuring consumer
surplus.
• For that reason courts frequently use other, more tractable
measures of damages than expectation damages in the event of
seller breach.
ECON 2212 – WEEK 6
8
Contracts
Expectation Damages
• If the innocent party is a seller, the “benefit of the bargain” is
the lost profits on the transaction.
• The “lost-volume seller” problem. Did the seller truly lose a
sale? Or was there another buyer who immediately stepped
into the breacher’s place and purchased the goods?
• Should the reliance expenditures of the innocent party form
part of the award of damages for breach?
ECON 2212 – WEEK 6
9
Contracts
Expectation Damages
• The equitable remedy—an order by the court to the breacher
to perform the contractual promise.
• The law in Canada is that specific performance is the
unusual remedy, available only in the event of breach of a
contract to sell a unique item (for which, the theory goes,
money/damages cannot possibly be a substitute).
• Available only in instances of anticipatory repudiation.
ECON 2212 – WEEK 6
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Contracts
Types of Damages
• Reliance Damages
• Where it is possible to award the expectation
interest, such as in cases where it is difficult to
enumerate the expectation, a plaintiff may
elect to have damages assessed by reliance
interest (that is, expenditures made in reliance
on the contract being performed).
ECON 2212 – WEEK 6
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Contracts
Types of Damages
• Restitution Damages
• In contrast to expectation and reliance
interests, restitution comes down to whether
there can be a recovery of gains made from a
breach of contract and not the losses of the
victim.
• Foundation – whether an unjust enrichment
occurred.
ECON 2212 – WEEK 6
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Contracts
Types of Damages
• Buyer contracts to pay p for good of value v,
given reliance r. Net value = V – r- p
• Expectation Damages = V (if p+r have been
spent)
• Reliance Damages = p+r
• Restitution Damages = p
• If Seller can perform at cost c, welfare is
maximized if seller pforms only when V >C
ECON 2212 – WEEK 6
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Contracts
Party-Designated Remedies
• The parties may designate the remedies that
either party will bear if it breaches the contract.
• “Liquidated damages” or “stipulated damages.”
• Are agreed to as part of the negotiations to
form the contract.
• Why would parties stipulate damages rather
than leave their determination to a court in the
event of breach?
ECON 2212 – WEEK 6
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Contracts
Express Remedies
• Sometimes contract itself stipulates the remedy for breach (i.e.
liquidated damage clauses)
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Contracts
Party-Designated Remedies
• Why would parties stipulate damages rather than
leave their determination to a court in the event
of breach?
• They may distrust the ability of the courts to
compensate them accurately for their losses
from breach.
• Why would parties distrust courts to set
damages correctly?
• Suspicion about protection of subjective value
that one party places on performance.
• Stipulating to large damages as a signal.
ECON 2212 – WEEK 6
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Contracts
Liquidated Damages
• Standard analysis and prevailing doctrine is that
parties should only be allowed to stipulate to an
amount that is a reasonable approximation to the
actual losses from non-performance.
• Any amount that appears to be punitive will not be
enforced.
• So, one cannot stipulate to pay three times the
innocent party’s actual losses.
• Or $1,000 per day for every day beyond the agreedupon completion date.
ECON 2212 – WEEK 6
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Contracts
Liquidated Damages
• Why the limitation on stipulated damages to a reasonable
approximation to actual losses from non-performance?
• Presumably only the courts should be allowed to punish.
Private parties should not have this power over one another.
• An economic argument against excessive damages: they
might induce performance when breach is more efficient.
• Suppose that A would like B to paint the exterior of her house in
August. The painting industry is highly competitive. The going
price for painting a similarly sized house is $500.
• A agrees to pay B $500 to paint her house but insists on a
$1,000 payment to her from B if he breaches the contract to
paint her house.
ECON 2212 – WEEK 6
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Contracts
Liquidated Damages
• Now suppose that C approaches B and asks him to paint his
house in August of this coming year. C’s house is about the
same size as A’s but because he has a wedding coming up
and expects houseguests in September, C places a higher
value on getting his house painted than A places on her
house being painted. Specifically, C is willing to pay A $750
to paint his house.
• In the normal run of affairs, B would announce to A that he
intends to breach his contract to paint her house in favor of
painting C’s house. If B agrees to “cover” his breach by
finding a substitute painter to paint A’s house for the same
price ($500) or even a little less, then his breach of the
contract with A would be efficient. No one would be worse off
from breach than they would be from performance and at
least one person would be better off. (Who would be better
off after the breach?)
ECON 2212 – WEEK 6
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Contracts
Liquidated Damages
• But here because of the stipulated damages clause requiring
B to pay A $1,000 in the event of non-performance, B cannot
breach the contract. He will inefficiently perform when he
should have breached.
• But even with the stipulated damages clause B may not perform.
• Why?
• Suppose that B goes to A and says, “Look, I want to breach. And
I’m prepared to pay you $125 if you’ll release me from the obligation
to perform the house painting job.”
• Suppose A says, “No dice. Why should I accept $125? If you
breach, you owe me $1,000.”
• What does B reply?
ECON 2212 – WEEK 6
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Contracts
Liquidated Damages
• B threatens to perform!
• He explains that if he performs, all A is going to get is a
painted house. However, if she takes the proffered $125,
she’ll get a painted house for, in essence, $375.
• A will either (a) recognize the logic of this argument and
release B in exchange for $125 (or more) or (b) not release B
and, instead, insist on B’s painting her house.
• Either (a) or (b) could be efficient.
• (a) is efficient if A attaches no subjective value to B’s
painting her house.
• (b) is efficient if A attaches a subjective value to B’s
painting her house that is greater than $250.
ECON 2212 – WEEK 6
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Contracts
Expectation Damages
• Calabresi and Melamed, applied to breach of contract.
• Transaction costs are low. There are no search costs,
minimal negotiation costs, and minimal enforcement
costs. The parties can bargain to an efficient result in the
event of breach.
• Only in the event of high transaction costs—say,
performance is physically impossible—should the court
award compensatory damages.
• This suggests that specific performance ought to be the
default contract remedy.
• Less need to protect subjective value on performance
and, therefore, lower costs of forming a contract.
• Less concern with reliance expenditures.
• But a duty to mitigate losses from breach?
ECON 2212 – WEEK 6
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Contracts
Expectation Damages
• Suppose that D has rented an apartment from E for a term of
five years at $500 per month or $6,000 per year.
• D announces at the end of year two that he intends to breach
the contract.
• Suppose that the lessor, E, is entitled to specific
performance. Might there not be an inefficiency in that E will
have no incentive to re-let the property for the remaining
three years of the lease? Rather, E might simply seek to
collect $18,000 from D.
• Under expectation damages E would have a “duty to mitigate”
his losses. As a result, he might have to show that he attempted
to re-let the premised for the remaining term of the lease but was
only able to get $400 per month.
ECON 2212 – WEEK 6
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Contracts
Expectation Damages
• So, E would, under damages, be entitled to receive
only (500 – 400) x 36 = $3,600.
• Would there be no incentive to mitigate under
specific performance?
• Suppose that the rental agreement prohibited D
from subletting the apartment.
• Will there be a substitute renter? Who will find
him or her? What will he pay? Could both D
and E be better off than with no mitigation?
ECON 2212 – WEEK 6
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Contracts
Incomplete Contracts
• Economics may have introduced valuable scholarly values and
terms.
• But it has failed to explain such central concepts as expectation
damages, the non-enforceability of liquidated damages, the
central functions of consideration and promissory estoppel, and
the duty to disclose.
• And economic analysis provides little guidance to contract
reform—the variables that it designates as crucial are largely
unobservable.
ECON 2212 – WEEK 6
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Contracts
Risk Allocation, Insurance and Remedies for
Breach
• Remedies for breach have the effect of allocating various risks
between the two parties
• Expectation damages leaves the buyer fully insured
• If buyers are risk averse, and sellers risk neutral, this will
allocate risk optimally – but there are other possibilities.
Expectation damages will no longer be optimal.
ECON 2212 – WEEK 6
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Contracts
Punitive Damages
• Money awarded to the claimant in civil litigation to punish the
defendant and to deter the defendant and others from engaging
in unlawful conduct in the future. Punitive damages must bear a
reasonable relationship to the harm caused by the defendant’s
actions, and are reserved only for situations in which the
defendant acted intentionally, recklessly or with gross
negligence in causing the claimant’s harm. Punitive damages
are awarded to the claimant in addition to compensatory
damages.
ECON 2212 – WEEK 6
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Contracts
Contracting Law
• Each Bargain involves reciprocal inducement
• The promise gives something to induce the
promisor to give the promise.
• Promisee gives consideration
• Promises lacking consideration are unenforceable
• Should unfair bargains be enforced?
• Bargain theory doesn’t describe what we want a
theory of efficient contracting to do.
ECON 2212 – WEEK 6
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Contracts
Gap Filling
• Gaps can be:
• Inadvertent – explosion closes an airport – contract is silent
on the issue.
• Deliberate – “rational gaps” (risk is remote)
• Negotiating the allocation of this risk imposes transaction costs
with certainty, whereas leaving a gap is cheaper (and the
transaction costs will only have to be incurred if the event
occurs).
• So to minimize transaction costs:
• If cost of allocating a risk > E (cost of allocating a loss)
• Leave a gap
• If cost of allocating a risk < E (cost of allocating a loss) • Fill the gap ECON 2212 – WEEK 6 29 Contracts Gap Filling By Courts • Courts can fill gaps by: • Imputing a term to the contract. • As if the parties had negotiating when they did not • “Impute the terms to the Contract that the parties would have agreed if they had bargained over all the relevant risk” • Courts can replace inefficient default terms with efficient default terms. Meaning, the law can save money for contracting parties by supplying efficient default terms to fill gaps in contracts. • Contract may specify something different from what the courts would have filled in. ECON 2212 – WEEK 6 30 Contracts Gap Filling • Risks are easier to negotiate than losses. • Example, to allocate risk of a strike costs $25 ex ante, but once the strike occurs it costs $500 to allocate the loss. • So if probability of the event occurring = 5% • Expected Cost = 5%*500 = $25. Parties are therefor indifferent between filling or leaving the gap. ECON 2212 – WEEK 6 31 Contracts Practice Problem • Spud Co. is a dealer in potatoes. Chip Co. makes potato chips. On Monday, Spud and Chip enter into a contract in which Spud agrees to deliver 100 bushels of potatoes to Chip on Friday; Chip agrees to pay Spud $2.00 per bushel. • Spud’s cost of growing and delivering potatoes = $100 • Chip’s cost of converting potatoes into chips = $100, $25 of which must be spent on Friday morning before the potatoes are delivered and which cannot be recovered if no potatoes arrive. • If no potatoes arrive on Friday, Chip must wait until Monday to call around to alternative suppliers to purchase potatoes. The price of potatoes on this “spot market” is $3.00 per bushel. The price of potato chips is $4.00 per bushel. • Assume that Chip paid at the time the contract was signed. • Just before delivering the potatoes at noon on Friday, Spud receives a frantic phone call from Babette, a chef at a local pub. Her potatoes are rotten, and she needs 100 bushels immediately and is willing to pay $5.00 per bushel. • Is breach efficient? CONTRACTS PRACTICE PROBLEM 32 Contracts Practice Problem • Spud Co. is a dealer in potatoes. Chip Co. makes potato chips. On Monday, Spud and Chip enter into a contract in which Spud agrees to deliver 100 bushels of potatoes to Chip on Friday; Chip agrees to pay Spud $2.00 per bushel. • Spud’s cost of growing and delivering potatoes = $100 • Chip’s cost of converting potatoes into chips = $100, $25 of which must be spent on Friday morning before the potatoes are delivered and which cannot be recovered if no potatoes arrive. • If no potatoes arrive on Friday, Chip must wait until Monday to call around to alternative suppliers to purchase potatoes. The price of potatoes on this “spot market” is $3.00 per bushel. The price of potato chips is $4.00 per bushel. • Assume that Chip paid at the time the contract was signed. • Just before delivering the potatoes at noon on Friday, Spud receives a frantic phone call from Babette, a chef at a local pub. Her potatoes are rotten, and she needs 100 bushels immediately and is willing to pay $3.00 per bushel. • Is breach efficient? CONTRACTS PRACTICE PROBLEM 33 Contracts Practice Problem • Spud Co. is a dealer in potatoes. Chip Co. makes potato chips. On Monday, Spud and Chip enter into a contract in which Spud agrees to deliver 100 bushels of potatoes to Chip on Friday; Chip agrees to pay Spud $2.00 per bushel. • Spud’s cost of growing and delivering potatoes = $100 • Chip’s cost of converting potatoes into chips = $100, $25 of which must be spent on Friday morning before the potatoes are delivered and which cannot be recovered if no potatoes arrive. • If no potatoes arrive on Friday, Chip must wait until Monday to call around to alternative suppliers to purchase potatoes. The price of potatoes on this “spot market” is $3.00 per bushel. The price of potato chips is $4.00 per bushel. • Assume that Chip has agreed to pay for the potatoes at the time of delivery. On Thursday, Chip is shut down for a health code violation and has no use for the potatoes. If Chip performs, the potatoes will go to waste. If Chip breaches, it will refuse to accept delivery and Spud can sell to a third party for $1.50 a bushel. • Is breach efficient? Under what measures of damages will efficient breach be achieved? CONTRACTS PRACTICE PROBLEM 34 Contracts Practice Problem • Spud Co. is a dealer in potatoes. Chip Co. makes potato chips. On Monday, Spud and Chip enter into a contract in which Spud agrees to deliver 100 bushels of potatoes to Chip on Friday; Chip agrees to pay Spud $2.00 per bushel. • Spud’s cost of growing and delivering potatoes = $100 • Chip’s cost of converting potatoes into chips = $100, $25 of which must be spent on Friday morning before the potatoes are delivered and which cannot be recovered if no potatoes arrive. • If no potatoes arrive on Friday, Chip must wait until Monday to call around to alternative suppliers to purchase potatoes. The price of potatoes on this “spot market” is $3.00 per bushel. The price of potato chips is $4.00 per bushel. • Suppose Chip is in a location that is hard to find. Spud has spent money in reliance on the contract. • $10 of Spud’s delivery costs is spent getting precise directions. The remaining $90 is cost of production and delivery. CONTRACTS PRACTICE PROBLEM 35 Contracts Practice Problem • Chip can take the following steps to minimize or eliminate the risk of being shut down for health code violations: • If Chip gets shut down, Chip will breach the Contact, in which case Chip’s cost will equal expenditure on precaution plus damages to Spud. If Chip breaches, Spud will lose the $10, and then Spud will pay $100 in production and delivery costs for potatoes selling for $150. Under which measure of damages (restitution, reliance, expectation) will Chip engage in efficient precaution? CONTRACTS PRACTICE PROBLEM 36