Tuesday, We Asked the Question of What Promises the Law Should Enforce, and Introduced
Econ 522 – Lecture 11 (Oct 11 2007)
Tuesday, we asked the question of what promises the law should enforce, and introduced contract law as the attempt to answer that question.
- We talked about one early attempt to answer that question, the bargain theory of contracts, and some of the problems with it.
- We showed an example of an agency game, where my inability to commit to a future action led to a breakdown in cooperation…
- …we said that the first purpose of contract law is to enable cooperation, by turning games with noncooperative solutions into games with cooperative solutions…
- …and we argued that efficiency generally requires a promise to be enforceable if both the promisor and the promisee wanted it to be enforceable when it was made
- We saw an example of how asymmetric information can inhibit trade…
- …and claimed that the second purpose of contract law is to encourage the efficient disclosure of information
- We discussed the fact that efficiency sometimes requires breaching a contract…
- …and said that the third purpose of contract law is to secure optimal commitment to performing…
- …and argued that setting the promisor’s liability equal to the promisee’s benefit – expectation damages – accomplishes this goal
- We discussed the idea of reliance, that is, investments made by the promisee to increase their benefit from the promise…
- …and said that the fourth purpose of contract law is to secure the optimal level of reliance…
- …and then we ran out of time.
Today, I want to go back over the example of efficient breach, since I think I went through that a bit fast… do an example of reliance… then move on to default rules and mandatory rules
I want to quickly go back to the example of efficient breach, since I felt like we went through it too quickly. Suppose that I build airplanes, and you contract to buy one from me. You value the airplane at $500,000. We agree on a price of $350,000. It will simplify the example if we assume you paid me up front; so let’s assume this contract was money-for-a-promise: you already paid up front and I promised to deliver a plane. (This doesn’t really matter much, it just makes all the numbers positive.)
The rule for efficient breach is:
If [ Promisor’s Cost ] > [ Promisee’s Benefit ] Efficient to breach
If [ Promisor’s Cost ] < [ Promisee’s Benefit ] Efficient to perform
Since the promisee’s benefit is known to be $350,000, it is efficient to perform whenever the cost of building the airplane is below $350,000, and efficient to breach whenever the cost is above $350,000.
Since the promisor only looks at his own private cost and benefit when deciding whether to breach or perform,
If [ Promisor’s Cost ] > [ Liability ] Promisor will breach
If [ Promisor’s Cost ] < [ Liability ] Promisor will perform
In the case of perfect expectation damages, the promisor’s liability would be the amount of benefit the promisee would have received, which is $350,000; this leads to the promisor performing whenever the cost of building the airplane is less than $350,000, which is exactly what efficiency would require. Setting the promisor’s liability at any other level would lead to some instances of either inefficient breach (if liability were too low) or inefficient performance (if liability were too high).
On to reliance. You’ll recall that reliance is any investment the promisee makes that increases the value of performance. So you contract to buy my painting, and go buy a frame for it; or you contract to buy an airplane from me, and you start building a hangar.
Since reliance increases the value of the promise to you, it increases my liability for breach under the concept of expectation damages as we’ve defined them. (That is, if I break the promise, I’m responsible for making you as well off as you would have been if I had kept my word; so if you’ve built a hangar, now I have to reimburse you for the value of the plane with a hangar, rather than without a hangar.) So reliance increases my losses under breach. But you don’t take that into account when deciding how much to invest in reliance, so there is no guarantee that the level of reliance will be efficient.
We’ll use the same example – you contract to buy a plane from me. You value the plane at $500,000, and agree to pay $350,000 for it. Let’s assume that this time, the bargain is promise-for-a-promise – you agree to pay on delivery. And there are perf exp damages.
Now you have the option of building yourself a hangar. Building a hangar costs $75,000, and increases the value of owning a plane from $500,000 to $600,000.
Suppose that it’s most likely that building the plane will cost me $250,000; but that there’s some probability p that it will instead cost $1,000,000. Clearly, if it costs $1,000,000, I won’t build it; I’ll just breach the contract and accept that I have to pay you damages.
Let’s look at what happens in each case.
First, suppose the cost of the plane is $250,000, so I build it. Our payoffs (in thousands):
If you relied (built the hangar): you get 600 – 75 – 350 = 175
I get 350 – 250 = 100
If you didn’t rely (build)you get 500 – 350 = 150
I get the same 350 – 250 = 100
Now look at the case where the cost of sheet metal went through the roof and I choose to breach. Assuming I owe perfect expectation damages as we’ve defined them – that is, enough to make you as well off as if I’d performed…
If you relied (built the hangar): Your surplus would have been 600 – 350 = 250 from the plane, so I owe you 250 in damages
And you paid 75 to build the hangar
So you end up with payoff of 175
I get –250 (since I have to pay you 250 in damages)
If you didn’t rely (build)Your surplus would have been 500 – 350 = 150, so I owe you 150 in damages, which is your payoff
I get –150 after paying you damages
So whether or not I perform, you get 175 if you relied, 150 if you didn’t. So clearly, reliance makes you better off.
But then the question is, is reliance efficient? That depends on how likely I am to breach. If you rely, our combined expected payoffs are
(1–p) (175 + 100) + p (175 – 250) = 275 (1–p) – 75 p = 275 – 350 p
If you didn’t rely, our combined expected payoffs are
(1-p) (150 + 100) + p (150 – 150) = 250 – 250 p
So the total social gain from you building the hangar is
(275 – 350 p) – (250 – 250 p) = 25 – 100 p
So it turns out that when p < ¼, reliance is efficient – it increases our combined payoffs. When p > ¼, reliance is inefficient – it decreases our combined payoffs.
This is indicative of a more general idea: when the probability of breach is low, more reliance tends to be efficient; when the probability of breach is high, less reliance tends to be efficient.
But if my damages cover your benefit whether or not it’s efficient, then you don’t care about the risk of breach – you end up just as well off whether or not I breach. So you’ll clearly choose the higher level of reliance, whether it’s efficient or not. This will sometimes lead to overreliance – more reliance than is efficient.
So how do we fix this? Cooter and Ulen adjust their definition of perfect expectation damages in the following way:
Perfect expectation damages restore the promisee to the level of well-being he would have had, had the promise been kept, and had he relied the optimal amount.
(This is why they attach the word “perfect” to expectation damages)
Thus, the promisee is rewarded for efficient reliance – this increases his payoff from performance of the promise, and also increases his payoff from breach, since it increases the amount of damages he receives. But the promisee is not rewarded for excessive reliance – overreliance – since damages are limited to the benefit he would have received given the optimal level of reliance.
It’s a nice idea, but it seems like it would be very hard in general for a court to determine after the fact what the optimal level of reliance was. (It might also be hard for the promisee to know this, since he may not know the probability of breach.)
What is actually done in practice? One important legal doctrine is to limit liability to a level of reliance that is “foreseeable”. That is, reliance is “foreseeable” if the promisor could reasonably expect the promisee to rely that much under the circumstances. Reliance is unforeseeable if it would not be reasonably expected. American and British law tend to define overreliance as unforeseeable, and therefore noncompensable.
An example given in the book is a telegraph company failing to transmit a stockbroker’s message, resulting in millions of dollars in losses. The telegraph company could not reasonably expect the stockbroker to rely that heavily on one message, and so would not be liable for the extent of the losses.
Another example: the rich uncle’s nephew, when he was promised a trip around the world, went out and bought “a white silk suit for the tropics and matching diamond belt buckle”. After the uncle refuses to pay for the trip, the nephew sells the suit and belt buckle at a loss, and sues his uncle for the difference. The court might find the silk suit foreseeable reliance, but the diamond belt buckle unforeseeable, and only award him the loss on the suit. (The book points out that “in American law, gift promises are usually enforceable to the extent of reasonable reliance.”)
Reliance is part of the issue in the famous case of Hadley v Baxendale, a precedent-setting English case decided in the 1850s. Hadley ran a mill. The crankshaft broke, forcing the mill to shut down until it was fixed. Hadley contracted with Baxendale to transport the crankshaft to engineers who would fix it – it was supposed to be delivered in a day. Baxendale delivered it a week later than promised, and Hadley sued for the profits he lost during that extra week in which the mill was shut down.
The ruling was that the lost profits were not foreseeable – the court specifically listed several circumstances in which a broken crankshaft would not force a mill to shut down – and that Baxendale was only liable for damages he could reasonably have foreseen. However, this isn’t just a question of reliance; part of the issue is that Hadley knew about the urgency of getting the crankshaft fixed quickly, but did not tell Baxendale. We’ll come back to this question of information shortly.
default rules
If transaction costs are 0, then the two sides to a contract could spell out exactly what should occur in every possible contingency – what happens if the cost of sheet metal rises, what happens if my uncle wants my painting, what happens if a shipment is delayed, and so on. This would make contract law much simpler – courts could simply enforce the letter of the contract, since nothing was left unclear.
However, in reality, some circumstances are impossible to foresee; and even if they weren’t, the cost and complexity of writing a contract to deal with every possibility would make perfect contracts unworkable.
Risks or circumstances that aren’t specifically addressed in a contract are called gaps; default rules are rules that the court applies to fill in these gaps.
Gaps can be inadvertent or deliberate. Our contract to sell you my painting might not have addressed my uncle wanting the painting because I didn’t know he was coming to visit, or because I never would have imagined he would be so excited about it. On the other hand, we could have imagined that it was at least possible for the price of raw materials for building an airplane to go up significantly; however, we might have felt it was such a remote risk that it was not worth the time and effort to build it into the contract.
Cooter and Ulen point out the decision to leave a gap or fill it (specifically address a particular contingency) is the difference between the need to allocate a loss after it has occurred (ex post) versus the need to allocate a risk before it becomes a loss (ex ante). In the first case, allocating the risk, the cost of adding it to the contract is definitely incurred; in the second case, allocating a loss that has occurred, the cost of allocating the loss is only incurred when the loss occurs. Thus, it is often rational to leave gaps when the risk is very remote. (On the other hand, it is usually cheaper to allocate a risk ex ante than a loss ex post.)
So the courts must decide what “default rules” should apply to circumstances that are not addressed in a contract, that is, what rules should fill the gaps that are left in imperfect contracts. The next obvious question is: what should these default rules be?
Cooter and Ulen answer this question by going back to the Normative Coase Theorem: the law should be structured to minimize transaction costs. Since filling a gap in a contract requires some cost, the default rule should be the rule that most parties would want if they chose to negotiate over the issue. This way, most contracts will not have to address this particular rule – they can use the default rule – and therefore avoid additional transaction costs.
And the rule that most parties would want is whatever rule is efficient.
They give an example: a construction company has contracted to build a house for a family, and there is some risk of a worker strike at the company which would delay completion of the house. They suppose that the company can bear the risk of a strike at a cost of $60, and that the family can bear the risk at a cost of $20. (It might be cheaper for the family to bear the risk because they could stay with friends for a while if the house were delayed; if the company held the risk, it might have to pay for a hotel for the family.) (Also note that these numbers are low not because a strike would have low costs, but because a strike might be fairly unlikely, and so the expected cost is fairly low.)
If the risk were not addressed by the contract, the default rule would apply.
If the default rule were for the construction company to bear the risk, this would be inefficient in this case. The parties could create an additional $40 of surplus by overruling the default rule (addressing the risk). So as long as the transaction cost of allocating the risk were not too large, they would choose to do so, but incur this transaction cost.
On the other hand, if the default rule were for the family to bear the risk, they would not need to address the risk in the contract, and would not incur the transaction cost.
This brings Cooter and Ulen to their fifth pronouncement:
The fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules.
They also offer a simple rule for doing this:
Impute the terms to the contract that the parties would have agreed to if they had bargained over the relevant risk.
That is, figure out what terms the parties would have chosen if they had chosen to address a risk, and let those be the default rule.
Of course, you don’t want a lot of ambiguity in the law, so you don’t want the default rule to vary constantly with the particular circumstances of a given case; so what’s more practical to do is to set the default rule to the terms that most parties would have agreed to. This is called a “majoritarian” default rule. In circumstances where this is not the efficient rule, the parties are still free to contract around it, that is, to put terms in the contract that overrule the default rule.
Of course, if the parties had chosen to address a particular risk, it’s safe to assume that they would have allocated it efficiently – that is, as long as the parties were choosing to consider a risk, they would allocate it in the way that led to the highest total surplus, and then compensate the party who bears the risk for bearing it. Thus, this is what the court would need to do to figure out the efficient default rule: it should figure out the efficient allocation of risks, and then adjust prices in a reasonable way.
The book gives an example of this. Go back to the house construction example, but with different numbers. Suppose the family and the company sign a contract. The construction company knows that with probability ½, the price of copper pipe will go up in such a way as to increase the cost of construction by $2000. So in expectation, the cost of construction will be $1000 higher due to this risk. The company can hedge against this risk (by buying copper pipe in advance and then paying to store it somewhere) at a cost of $400. Assume that the family has no reason to know anything about the cost of copper pipes, and therefore does not anticipate the risk or have any way to mitigate it.
The company chooses not to hedge this risk, the price of copper pipes goes up, the company builds the house and bills the family $2000 more than they had expected. The family refuses to pay, and the case goes to court. The original contract does not mention the risk of soaring copper prices.
So how would the court address this? First, the court must decide to whom the contract would have allocated this risk, if it had addressed it. Then it must adjust prices to reflect this.
In this case, the cost of bearing the risk would be $1000 to the family (since they have no way to mitigate it), but $400 to the company (since hedging the risk is cheaper than bearing it). So the company is the efficient bearer of the risk; so an efficient contract would have allocated this risk to the company.