Types of Damages - Economics of Law - Lecture Notes, Study notes of Economics and Law

Download Types of Damages - Economics of Law - Lecture Notes and more Study notes Economics and Law in PDF only on Docsity! Econ 522 – Lecture 13 (Oct 21 2008) With the Tuesday, Nov. 4 presidential election drawing near, we would like to ask your help in promoting civic engagement by encouraging UW-Madison students to register and vote… Most students who are U.S. citizens, will be 18 years of age on or before Election Day, and have been a resident of Wisconsin for at least 10 days prior to registering are eligible to vote. Students may register to vote in person with the Madison city clerk from now until Nov. 4 or at their polling place on Election Day. Students who have moved since they originally registered need to re-register. If students plan to register in person at the clerk's office or at the polls, proof of residence is required to register and is important to bring to the polls. For students in University Housing, a UW-Madison ID is acceptable. Also, despite persistent rumors, registering to vote has no impact on a student's insurance, financial aid or student status. These rumors are totally false. So, to sum up… do your homework, study for the midterm, and vote. Docsity.com Last Thursday, we looked at the different types of remedies a court could impose for breach of contract. In particular, we considered: • Expectation damages, designed to replace the value of performance • Opportunity cost damages, designed to replace the value of the next-best alternative forgone by the promisee • Reliance damages, designed to only replace the value lost by the promisee due to reliance • Specific performance – requiring the promisor to honor the promise rather than imposing damages Today, we’ll look more carefully at the different incentives created by each, and in particular how they influence the following three decisions: • the promisor’s decision to perform or breach • the promisor’s investment in performing, and • the promisee’s investment in reliance Put aside the question of reliance for the moment, and suppose that performance of the promise will have a fixed benefit for the promisee. The fact that the two parties agreed to the contract in the first place implies they believed this benefit was likely to greater than the cost to the promisor of performing. However, as we’ve already discussed, circumstances may change after the promise is made, in a way that makes the promisor less keen to keep his promise. (The price of building the airplane may go up, or my rich cousin may appear and value my painting more highly than you do.) There are two ways for me to get out of my promise: I can renegotiate with you, getting you to “let me off the hook,” presumably in exchange for some money. Or I can breach our contract and live with the consequences, most likely the damages that a court imposes. Think back to nuisance law. Recall that when an entitlement (say, the right to breathe clean air) was protected by injunction, the parties could still bargain for it – the polluter could offer the neighbor enough money to be willing to live with the pollution. When an entitlement was protected by damages, the polluter could instead simply pollute and pay whatever damages were ordered. We found that when transaction costs were low, either remedy would lead to efficiency; but since the two remedies changed the noncooperative outcome (the threat point) for each side, they led to different allocations of surplus. On the other hand, when transaction costs were high, the two remedies could lead to different results. Docsity.com An increase in the cost of performance is referred to as an unfortunate contingency. On the other hand, I may be less keen to keep my promise because I discover another buyer who values my product more than you do. This is referred to as a fortunate contingency. Earlier, we saw the example where you contracted to buy my painting, but my rich cousin appeared and valued it much more highly than you did. We can do the same exercise as before with the different remedies, and see the same thing – with low transaction costs, any remedy will lead to efficient breach, but with different allocations of surplus. This is done in the book (p. 267). Once again, specific performance is the most advantageous to the buyer, and higher damages are better for the buyer than lower damages. One further point that we mentioned earlier but didn’t talk much about: efficient signing. We saw that with expectation damages, when my costs remain low and I perform, I get a profit of $100,000 (the price you pay, $350, minus the costs I incur, $250). And when my costs jump up and I breach, I owe $150,000. If the probability my costs rise is small enough, that’s no big deal – I take the risk of owing you expectation damages, because my profits in the cases where I don’t breach are large enough that it’s worth the risk. But if the probability my costs rise is high, then my expected profit from this contract is negative. For example, suppose the probability of a dramatic rise in costs is ½. Then my expected payoffs from agreeing to build you the airplane are ½ (100,000) + ½ (-150,000) = -25,000 So now there’s no way I’d agree to the contract in the first place. This is the point we mentioned before – expectation damages lead to efficient breach, but they may lead to inefficient signing. (If I’m the only airplane manufacturer available, it’s still efficient for us to sign this contract – it generates positive expected surplus – but under expectation damages, I would not sign this contract.) (This does suggest that, even if expectation damages make a sensible default rule, it’s efficient for parties to be able to specify a different damages rule in the contract – that is, even if expectation damages are often efficient, they are not always efficient, so there’s no reason for them to be mandatory…) Docsity.com So that’s breach. What’s left is investment in reliance, which we’ve already talked a bit about; and investment in performance, which we haven’t. The book makes a big deal out of “the paradox of compensation,” which is basically what we already talked about earlier: the remedy for breach sets an incentive for both the promisor and the promisee, and it’s generally impossible to set both of these incentives efficiently at the same time. (The particular conflict they look at here is the way that reliance figures into expectation damages.) Let’s go back to the airplane example once again, and again assume that, once you contract to buy my plane, you consider building yourself a hangar. But this time, rather than just a decision to build or not build, there is a whole range of different-quality hangars you could elect to build. Suppose that, for any investment of x dollars, you can build a hangar that will enhance the value of having a plane by 600 sqrt(x), but is worthless without a plane. Investment Value of Hangar x 600 sqrt(x) 100 6,000 Large tarp held up by some rope connected to a telephone pole – still keeps some rain off the airplane 10,000 60,000 Basic plywood frame, canvas roof 40,000 120,000 Metal poles, rigid roof 160,000 240,000 Functional heating 640,000 480,000 Designer hangar with working Starbucks Recall that whatever investment is made in reliance pays off when the promise is kept, but is lost when the promise is broken. Suppose that expectations damages include the benefits anticipated based on reliance investments. Then the buyer would maximize 500,000 + 600 sqrt(x) – 350,000 – x since he gets the same benefit whether or not the seller breaches; solving this gives the first-order condition 600/2sqrt(x) – 1 = 0  x = 300^2 = 90,000 so the buyer, when insulated from the risk of breach, invests $90,000 in a reasonably nice hangar, giving anticipated benefit of 600 sqrt(90,000) = 180,000. What is the efficient level of reliance? The total social gain from the contract is 500,000 + 600 sqrt(x) – 250,000 – x Docsity.com without breach, and –x with breach (the reliance investment is lost, and other than that, all that happens is transfers). Suppose the probability of breach is p; then the expected social benefit is (1-p) (500,000 + 600 sqrt(x) – 250,000 – x) + (1 – p)(–x) which leads to an efficient level of reliance equal to 90,000 (1-p)^2. So for any p > 0, damages which include benefits from reliance lead to overreliance, that is, investment in reliance that is higher than what would be efficient. On the other hand, suppose expectation damages did not include the benefits of reliance. Then the buyer maximizes (1-p) (payoff without breach) + p (payoff with breach) = (1-p) (500,000 + 600 sqrt(x) – 350,000 – x) + p (150,000 – x) = 150,000 + (1-p) 600 sqrt(x) – x which leads to the same (efficient) level of reliance. So if the level of damages includes the gains from reliance, this leads to overreliance; if the level of damages excludes the gains from reliance, this leads to efficient reliance. (Recall that Cooter and Ulen hoped for damages which included the gains only from “efficient” reliance, which is a nice idea but incredibly hard to measure after the fact…) But we also know that if the level of damages exclude the gains from reliance, and the buyer relies anyway, that this will lead to inefficient breach. That is, since the seller’s liability from breach is lower than the buyer’s gain from performance, there will be some instances where the seller breaches even though efficiency requires performance. We said before that with no transaction costs, this problem can be solved: when breach would be inefficient, the parties can contract around it. Since it’s generally very clear whether a party has breached a contract or not, this shouldn’t be a particular problem. Docsity.com = 430,000 – 430,000 ½ e^(-z/40000) – z To maximize this, we take the derivative: 430,000 ½ 1/40,000 e^(-z/40000) – 1 = 0 Pr(breach) = 40,000/430,000 So given that level of reliance, the efficient level of investment in performance is enough to reduce the chance of breach to 40,000/430,000. Which we just saw is exactly what the seller would do when he’s liable for expectation damages which include the benefit from reliance! To sum up, the efficient level of investment leads to a 40,000/430,000 chance of breach. Damages which are set equal to D lead to a self-interested promisor to allow a probability of breach of 40,000/(D + 100,000). So when damages are set to 330,000 – damages include the benefit from reliance – the investment in performance is efficient. When damages are lower, the seller will underinvest in performance, leaving the risk of breach inefficiently high. (When damages are higher than this, the seller will overinvest in performance.) So what have we found? Making the seller liable for reliance – that is, increasing expectation damages to include benefit due to reliance – leads the seller to invest efficiently in performance; but it leads the buyer to overinvest in reliance. On the other hand, making the seller not liable for reliance – leaving expectation damages where they were without reliance – leads to efficient reliance, but leads to underinvestment in performance. (We saw before that even if expectation damages do not include reliance, the buyer still chooses to rely some, just less; so D < benefit, and the seller underinvests in performance.) So like we saw last week with the sailboat example from Friedman, the level of damages leads to multiple different incentives; and it’s impossible to come up with a level of damages that makes everyone behave efficiently. Docsity.com anti-insurance The textbook discusses one rather clever solution to this problem. It’s not all that realistic, but it is clever, and it’s worth mentioning. We saw that, in order for you to invest the efficient amount in reliance, you need to receive damages that do not include the benefit from reliance. And we saw that, in order for me to invest the efficient amount in performance, I need to owe damages that do include the benefit from reliance. How can we can accomplish both these things? Well, we can set the level of damages that I pay to be different from the level of damages that you receive! You and I have this friend, Bob. Bob likes money. So we go to Bob and say, hey Bob, here’s a deal for you. I’m planning to build a plane. He’s planning to buy the plane. He’s probably going to want to build a hangar. I might end up not building the plane. Here’s what we need you to do. In the event that he builds a hangar and I don’t build the plane, I’m going to give you the value of the plane with the hangar; and you’re going to give him the value of the plane without the hangar; and you’re going to keep the rest for yourself. OK? And Bob says, “cool!” This is called “anti-insurance”. Rather than buying insurance from a third party, you and I are basically entering into this additional contract where if things go bad, I owe Bob some additional money, beyond what I pay you. By doing this, we set both our incentives correctly, so we get efficient reliance and efficient investment in performance. Now obviously, Bob is happy to do this for free. But now we go to our other friend Carol, and say, Hey, Carol. Here’s a deal we’re offering. Give us $5 now, and if he builds a hangar and I don’t deliver a plane, you’ll get the difference between the value of the plane with the hangar and without the hangar. And Carol realizes this is worth more than $5, so she says, “sure.” Docsity.com But now we go back to Bob, and we offer him the deal at $10 instead. And if we make Bob and Carol compete for this deal, we should be able to get them to pay a fair amount for it up front. If they’re risk averse, of course, they’ll need to be compensated for taking on some risk; but if we have a risk-neutral friend who’s smart enough to understand the probabilities and figure out what each of us will do given our incentives, we can get them to give us the full value of the anti-insurance deal ahead of time, and divide it up among ourselves. So this way, we can give ourselves incentives for efficient reliance and efficient investment in performance at the same time. There are other ways to get around the problem. We already introduced the notion of basing damages, not on the benefit expected under the actual level of reliance, but on the benefit expected under the hypothetical “efficient” level of reliance. If we write this into the contract (and are able to calculate it correctly), then we can use expectation damages with reliance to set the seller’s incentives correctly, while still not causing the buyer to over-rely. This could either be done explicitly in the contract – we agree that I have to pay expectation damages up to the value you would receive from a $60,000 hangar but not more than that – or it could be imposed by the court after the fact. As we mentioned before, what courts actually do, rather than basing damages on actual or on efficient reliance, is to base damages on foreseeable reliance. That is, they base damages on what the promisor could reasonably expect the promisee to do, not what he actually did. This was the decision in Hadley: since the shipper could not reasonably expect the miller to rely so heavily, he was not liable for the lost profits. (Most millers at the time had more than one crankshaft., so a broken shaft would not typically lead to shutdown.) Of course, under the doctrine of foreseeable reliance, if Hadley had told Baxendale that his mill was closed until repairs were made, then Baxendale would be liable for lost profits due to delay; by informing Baxendale of the reliance, Hadley would have made it foreseeable, and therefore compensable. Docsity.com