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Law & Economics Part I

Terms

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What is threat value?
Payoffs to the parties in the noncoperative solution (value if the bargaining/exchange failed).

Each player must recieve at least the threat value or there is no advantage to cooperating.
Arthur Alleges that Betty borrowed a valuable kettle and broke it so he sues to recover its value, which is $300. The facts are very confusing. Betty contends that she did not borrow a kettle from Arthur; even if it is proven that she borrowed a kettle f
a. Arthur’s threat value is his expected net gain from trial. Because the value of the kettle is $300, because he has a 50% probability of winning, and because the trial will cost him $50, the expected net value of a trial is $300(0.5) - $50 = $100.

b. Betty’s threat value is her expected loss from trial. Because the value of the kettle is $300, because she has a 50% probability of losing, and because the trial will cost her $50, the value to her of a trial is -$300(0.5) - $50 = -$150 - $50 = -$200.
Inefficiency
The same (or fewer) inputs could be used to produce a greater (or the same) total output.
Economies of scale
Occur when the cost per unit (or average cost of production) declines as the total amount of output increases.

Natural monopolies have the falling unit costs at every level of production, even very large levels. Therefore, a large producer can sell at a lower price than a smaller producer.
social contract
The result of parties bargaining together over the terms for establishing a government to recognize and enforce property rights. They are motivated by the realization that there are economies of scale in protecting property (national defense vs. private militias).
state of nature
corresponds to the threat values of the noncooperative solution, which prevails if parties cannot agree.
Transaction costs
Encompass all the impediments to bargaining (ie communication, etc).

1) search costs
2) bargaining costs
3) enforcement costs

Subtract from surplus to get the net value of cooperating.
Coase Theorem
When transaction costs are zero, an efficient use of resources results from private bargaining, regardless of the legal assignment of property rights.

Corollary: When transaction costs are high enough to prevent bargaining, the efficient use of resources will depend on how property rights are assigned. (now care about efficiency of the law)
Suppose that a railroad runs beside a field in which commercial crops are grown. The railroad is powered by a steam locomotive that spews hot cinders out of its smokestack. From time to time those cinders land on the crops nearest to the track and burn t
If transaction costs are zero, then the initial distribution of property rights over land will not bar the efficient outcome. The efficient solution will be reached whether the law protects the farmer or allows the railroad to emit sparks. However, if the costs of bargaining are high, then the efficient solution may not necessarily be reached. One scenario under which high bargaining costs may exist is when there are a multitude of actors on either side of the conflict.
Some commentators thought that the Coase Theorem might be true in the short run but not in the long run. In the example of the farmer and the rancher, changing the use of fields takes time. For example, to convert a field from graxing land to farmland, t
Think about how short-run contracting differs from long-run contracting. Do the higher costs in the long-run involve anything other than higher transaction costs? That is, if the costs of searching, bargaining, and enforcing contracts was zero in the long-run, then the Coase theorem should still hold.
Invariant Coase Theorem
The invariance principle is a strong version of the Coase theorem and states that not only does any initial endowment lead to an efficient outcome, but that the same outcome will be reached no matter what the initial endowment.
endowment effect
the divergence between buying and selling price (the price varies depending on the initial assignment of ownership).
social norms vs. the law
The formal, legal rules of society are most effective when they are compatible with the informal social norms of everyday life. Informal norms often arise in situations where high transaction costs of contracting exist. Instead of relying on government to lay the ground-rules of economic interaction, people in long-term stable relationships form “rules of the game” that are specific to their situation. The loss of reputation of actors that cheat in a game with repeated play is often a sufficient enforcement mechanism in long term contracts.
Haggling over price.
bargaining transactional cost
Collecting the monthly payments for the purchase of a car.
enforcement transactional cost
Taking time off work for the buyer and seller to meet.
search transactional cost
Purchasing an advertisement in the "classified" section of the newspaper.
search transactional cost
The buyer asking the seller questions about the car's ignition system.
search transactional cost
Factors affecting the Cost of Transaction.
Lower vs. Higher
1) Standardized good or service VS Unique good or service
2) Clear, simple rights VS Uncertain, complex rights
3) Few parties VS Many parties
4) Friendly parties VS Hostile parties
5) Familiar parties VS Unfamiliar parties
6) Reasonable behavior VS Unreasonable behavior
7) Instantaneous VS Delayed exchange
8) No contingencies VS Numerous contigencies
9) Low cost of monitoring VS High cost of monitoring
10) Cheap punishments VS Costly punishments
Normative Coase Theorem
Structure the law so as the remove the impediments to private agreements.

(Examples: lowering transcational costs to encourage private exchange
Normative Hobbes Theorem
Structure the law so as to minimize the harm caused by failures in private agreements.

To minimize the resulting harm, the law should allocate property rights to the party who values them the most. The law makes exchange of rights unnecessary and thus saves the cost of transaction.
How can the law increase efficiency when transaction costs are positive?
1) Lubricate private exchange by lowering transaction costs (Normative Coase)
2) Allocate rights to the party that values them the most (Normative Hobbes) If rights were allocated efficiently an exchange of rights would produce a negative surplus (will not occur).
How do you find out the most efficient outcome for two parties?
When the joint-profits (at each parties together) in that situation are the highest.
injunction
court orders you to stop an activity.
Cooperative surpluse
Joint-profits from cooperation - joint profits from threat value (non-cooperation)
Explain Calabresi's Theory of Transaction Costs.
When there are obstacles to cooperation (i.e., high transaction costs), the more efficient remedy is the award of compensatory money damages.

Where there are few obstancles to cooperation (i.e., low transaction costs), the more efficient rememdy is the award of an injunction against the defendant's interference with the plantiff's property.

Updated version: Where there are few obstacles to cooperation (i.e., low transaction costs), the more efficient remedy is the award of an injunction when the plantiff can estimate the defendant's compliance costs more readily than the defendant can estimate the plantiff's damages.
Public goods
1. Nonrival - consumption doesn't prevent someone else from consuming
2. Nonexclusive - costly to exclude anyone else from enjoying the benefit if one person does.
free riders
people who do not pay for the consumption of a public good.
When should something be privately owned?
It is efficient for thinks that are rival and exclusive to be privately owned.
When will resources be allocated efficiently?
When obstacles to bargaining are low. Property law fosters voluntary exchange by removing these.
What can be privately owned?
Private ownership is appropriate when there is rivalry and exclusion of goods (otherwise should be a public good).
How are ownership rights established?
To share the benefits of increased productivity (discourage theft, reduce the cost of protecting goods).
What may owners do with their property?
Common law approximates a system of maximum liberty, which allows any use of property by its owner that does not interfere with other people's property.
What are the remedies for the violation of propert rights?
Injunctive rememdy is preferred for private bads with low transaction costs for private bargaining. Conversely, the damage remedy is preferred for public bads with high transaction costs that preclude private bargaining.
Intellectual Property Law
the four principle areas of law create property in information
1) Patent system
2) Copyright system
3) Trademark system
4) Trade secrets
Patent system
establishes ownership rights to inventions and other technical improvements.
Copyright system
grants ownership rights to authors, artists, and composers.
Trademark system
establishes ownership for distinctive commercial marks or symbols.
Trade secrets
deals with business practices in which commerical enterprises have property interests.
Two characteristics that make transactions in information different from ordinary private goods.
Nonappropriability and credibility.
nonappropriability
the difficulty or impossibility of enforcing a private property right. non-exclusive nature of intellectual property leads to an undersupply to the market.
purpose of intellectual property law
one remedy for problem of nonappropriability. Inventor may try to obtain a patent, copyright or trademark.
rule of first possession.
First in time, first in right. By now there are few opportunites to claim unpossessed land or water, but rule important for intangible properties, such as inventions.
When will a society privatize a resource?
When the boundary maintence costs less than the waste from overuse of the resource. Invention of barbed wire lowered boundary costs in the West.
inalienable
something of yours that you cannot lose by specified means (such as sale).

Prohibits exchange even if efficient.
Nuisance
harmful externality
What is property?
A bundge of rights:
1) Posession
2) Use
3) Exclusive
4) Transfer (sell)
Why do we have property rights?
1) Wasted cost trying to exclude
2) More efficient if done by the state
3) Creating rights can give rise to surplus (which can be divided)
What is the benefit of private (not communal) property?
Allows internalized externalities to avoid the "tragedy of the commons".
If fish is a common good, can over-fish to extinction. If you own the pond, you'll bear the costs yourself, so you will not over-fish and you will take care of the pond.
You bear all the costs and benefits.
What are the costs of private property?
1) Administrative
2) Physical (demarking property)
3) Enforcement (threat of punishment)
When do you create private property rights?
When the MC=MB, when the cost of establishing is not greater than the benefits.
consideration
What the promisee gives the promisor to induce the promise.

The farmer pays $25 to get a grasshopper killer (promised).
reciprocal inducement
promisee gives something to induce the promisor to give the promise and the promisor sgives the promise as the indcuement to the promisee.
promisor
person who gives a promise
promisee
person who recieves a promise. Promisee induces the promisor to give the promise with a consideration.
Bargain Theory:
What makes a promise enforceable?
Promises secured by condsideration are enforceable and promises lacking the consideration are unenforceable.

Nephew who got good grades did not give anything as an inducement for his rich uncle's round-the-world promise.
Bargain Theory:
What should the remedy for breach of enforceable promises?
Expectation damages - the expected value of the bargain.

Rusty Chevy vs. Cadillac - difference in value between the two.
Farmer - value of the crops destroyed by grasshoppers.
Bargain Theory
Promises are enforceable if consideration. Remedy for breach of enforceable promise is the expectation damages.
What do enforceable promises do?
Decrease uncertainity and risk (will goods be delivered or paid for).
Describe the agency game in contracts.
First player decides to put assets in control of the second player. The second player decides whether to cooperate or appropriate. Cooperation is productive (profitable, surplus from trade). The parties divide the product of cooperation between them, so both of them benefit. Appropriation is redistributive, benefits the second player at the expense of the first player.

Enforceable contracts makes cooperation more likely because of damages penalty for appriopriation.

Contract law enables people to cooperate by converting games with noncooperative solutions into games with cooperative solutions.

restated - enable people to convert games with inefficient solutions into games with efficient solutions.
What is the purpose of contract law?
1) enable people to cooperate by converting games with noncooperative solutions into games with cooperative solutions.

restated - enable people to convert games with inefficient solutions into games with efficient solutions.

Enforceable contracts makes cooperation more likely because of damages penalty for appriopriation.

2) encourage the efficient disclosure of information within the contractual relationship

3) secure optimal commitment to performing.

4) secure optimal reliance.

5) the court should respond to gaps in the contract by allocating obligations efficiently and adjusting the price reasonably.

6) foster enduring relationships, which solve the problem of cooperation with less reliance on contracts.
What promises should be enforced?
if both parties wanted it to be enforceable when it was made. They want it enforceable so that the promisor can credibly commit to performing. A credible commitment to performing enables the parties to cooperate, and cooperation is efficient.

Efficiency sometimes requires enforcing a promise even though one of the parties did not want enforceability when the promise was made (deceiving the other).
Perfect expectation damages
what you would have recieved if the other party did not breach the contract (the expected value of the bargain). -X party that breeched contract, +X to party that didn't breach.
Cost of performing is 1.5
Subtract that amount from that parties outcome in a zero cost situation.
What are the implications of breaching contracts?
Not always bad. If the cost of performing for a party is higher than a breech of contract, then the breech is more efficient. (ideal remedy would be perfect expectation damages for efficient performance and breach - both parties prefer it).
What is the best damage award for breach of contract?
perfect expectation damages, both parties prefer it and allows for efficient breach of contract.
What is the affect of incorrectly calculated damages?
Damages below the best level cause the promisor to breach too often, which makes the promisee reluctant to make a contract. Damages above the best level require the promisor to perform when it is too costly, which makes the promisor reluctant to make a contract.
Explain the actual and ideal breach of contracts.
Actual performance and breach by self-interested, short-sighted promisor:
breach if promisor's cost of performing > promisor's liability for breaching
perform if promisor's cost of performing < promisor's liability for breaching

optimal performance and breach:
efficient breach if promisor's cost of performing > promisee's benefit from performing
efficent to perform if promisor's cost of performing < promisee's benefit from performing
Reliance
a change in the promisee's position induced by the promise.

(Farmer expanded a barn in anticipation of a good grasshopper killer)

The change increases the promisee's value of performance of contract, but a breach more costly to the promisee.
Max payoff to both players
Efficiency. Add the sum of each cell and pick the highest one (max payoff to both players)
Expected net payoff for the parties
Take the sum of a cell (ie both perform contract) and multiply it by the probability of it happening.
Overeliance
causes excessive harm from breach. The law can discourage overreliance by limiting recoverable damages. The law should compensate a victim for losses up to a point equal to the loss from optimal reliance. Consequently, the promisee has a strong incentive to avoid overrelying.
Explain why compensating the victim of breach for expectation damages causes efficient performance breach, whereas compensating the victim of breach for excessive reliance may cause innefficient performance and breach.
if the breachee receives compensation for excessive reliance, then breachees have an incentive to over-rely, which is inefficient. From the point of view of the breacher, the liability for excessive reliance by the breachee may induce performance when breach is more efficient.
ex ante risks vs ex post losses
ex ante - refers to the risk of future losses faced by the parties when they negotiate a contract.
ex post- refer to the losses that actually materialize after making the contract.
How do you minimize transaction costs of contracts?
cost of allocating a risk > cost of allocating a loss X probability of a loss --> leave gap
cost of allocating a risk < cost of allocating a loss X probability of a loss --> fill gap
What are imputed terms?
terms to the contract that the parties would have agreed to if they had bargained over all the relevant risks.
Who is the most efficient risk bearer?
the party with the lowest cost of bearing the risk.
What is contract regulation?
when law disregards or changes terms in a contract.
What is an efficient contract?
Each resource is allocated to the party who value it the most; each risk is allocated to the party who can bear it at least cost; and the terms of the contract exhaust the possibilities for mutual gain by cooperation between the parties.

According to the Coast Theorem, parties will negotiate an efficient/perfect contract when transaction costs are zeo.
When is a contract imperfect?
Parties are irrational or transaction costs are positive.
What are excuses for breaking a contract?
1) duress - dire contraints, forced into contract
2) necessity ($50000 for bottle of water in the desert or you die, don't have to pay up)
3) impossibility (dire contraint after the promise) - factory burns down so can't fill order
What are contract transaction costs?
1. spillover
2. information
3. monopoly
When do judges regulate contracts?
the farther the facts depart from the dieal of perfect rationality and zeo transaction costs, the stronger the case for judges' regulating the terms of the contract by law.
principle vs agent
principle - first player who risks funds
agent - control's the principles funds.
Types of damages
expectation damges - baseline uninjured state is the promisee's position if the actual contract had been performed

reliance damages - the uninjured state is the promisee's position if no contract had been made.

Opportunity cost damages - the uninjured stae is the promisee's position if the best alternative contract had been performed.

expectation > opportunity > reliance
perfect compensation
means a sum of money sufficient to make the victim of an injury equally well off with the money and with the injury as he or she would have been without the money and without the injury.
surplus of sucessful negotiation
The sum of a cell with negotiation minus the sum of the cell without negotiation.
How do injunctions affect bargaining?
They favor the party with the injunction, but with low transaction costs, don't affect efficiency.
Paradox of compensation
1) In order for the injurer to internalize costs, he must fully compensate the victim.
2) In order for the victim to internalize costs, she must recieve no compensation for her injuries.
3)In private law, compensation by the injurer equals compensation recieved by the the victim.
4) Therefore, private law cannot internalize costs for the injurer and the victim as required for efficiency.
Paradox of compensation in contracts law
1) In order for the promisor to internalize the benefits of precaution, he must fully compensate the promisee for breach.
2)In order for the promisee to internalize the costs of reliance, she must recieve no compensation for breach.
3) In contract law, compensation paid by the promisor for breach equals compensation recieved by the promisee
4) Therefore, contract law cannot internalize costs for the promisor and promisee as required for efficiency.

This predicts that compensating the victims of a breach will cause them to over-rely.
Contract Solutions to the Paradox of Compensation
Efficient incentives often require internalization of marginal costs, not internalization of total costs.
Sophisticated damages measures cause the promisee to internalize the marginal cost of reliance, but not necessarily the total cost of reliance (125 profit over-rely, 100 profit normally, damages set at 100).
Damages invarient with respect to reliance:
1)Foreseeable reliance equals the amount the promisor could reasonably expect the promisee to take in the circumstances (imposes a cap on damages for breach of contract). If foreseeable reliance equates with optimal reliance, then efficient incentives.
2) Stipulating an exact amount of damges in the contract is a common mechanism used to prevent over-reliance.
Foreseeable
A way damages invarient with respect to reliance (can solve over-reliance problem):
Foreseeable reliance equals the amount the promisor could reasonably expect the promisee to take in the circumstances (imposes a cap on damages for breach of contract). If foreseeable reliance equates with optimal reliance, then efficient incentives.

See Hardley v. Baxendale.
How does Hadley reduce transaction costs?
High reliance promisses now want to make the revelation known so that they could recover higher damges if something goes wrong.
Low-reliance promisees make that revelation so that the contract is a lower price than the high reliance promisees.
Default rules
fill gaps in contracts in order to reduce transaction costs
Regulations
prescribe terms for contracts to correct market failure.
Incompetence
Competent people must protect the interests of incompetent contractual partners or assume liability for failing to do so.

The law assigns liability for harm suffered by incompetent contractual partners to the competent people who can avoid the harm at least cost.
Why have contracts?
cooperative bargaining is productive. Both parties usually expect to gain from the bargain. Both parties want enforecability to secure a credible commitment to cooperate (to create surplus to divide).
Duress
types of contrained choice

a dire contraint. Usually involves extracting a promise by a threat, usually redistributes wealth from one person to the other (one party gains, one party loses). One party wants enforceability of a coerced promise, and the other does not. Allocation is inefficient. Failed coercion can destroy (threat to destroy something valuable to the victim).

A promise extracted as the price to cooperate in creating value is enforceable, and a promise extracted by a threat to destroy value is unenforceable.
Necessity
types of contrained choice

like duress, a promise given under a dire contraint. Duress is a dire contraint imposed on the promisor by the promisee, while necessity is a dire contraint imposed on the promisor by someone other than the promisee (cause could be promisor, thrid party or bad luck).

With duress, the promisee threatens to destroy by acting. With necessity, the promisee threatens to destroy by not acting, specifically not rescuing.
Impossibility
types of contrained choice

with duress and necessity, the dire contraint preceds the promise. Sometimes dire contraint follows the promise and prevents performance.

a contigency destroyed a basic assumption on which the contract was made (factory would not burn down, painter would live, etc) and make performance impossible.

if efficient, assigns the liability to the party who can bear the risk that performance becomes impossible at least cost (risk should be assigned to parties who can take precautions, sprinklers, to reduce it at least cost).

If a party can't take precautions, then assigned risk to party who can spread it at the least cost, by insurance or other means.
Frustration of Purpose
type of transaction cost (informational)

default rule to allocate losses caused by contingencies that make performance pointless.

If a contigency makes performance pointless, assign liability to the party who bear the risk at least cost.
Mutual Mistake About Facts
type of transaction cost (informational)

Contigency materializes before the parties sign the contract, without them knowing (forest fire)

If a contigency makes performance pointless, assign liability to the party who could bear the risk at least cost.
Mutual Mistake About Identity
buyer and seller have different objects in mind, so their "minds do not meet".

No true agreement to exchange. If courts enforced it, it would be involuntary (destroys value, negative surplus, inefficient)
unilateral mistake
Withhold enforcement from contracts involving involuntary exchange (mutual mistake), and enforce contracs that reward discovery and unite knowledge with control.

Productive information can be used to create more wealth (enforcement). In contrast, redistributive information does not create more wealth (no enforcement).

Information aquired fortuitously (no enforcement) is by chance while information acquired actively, by investing resources in the acquisition of information is enforceable.
Which information contacts should be enforced?
Contracts based upon one party's knowledge of productive information - especially if that knowledge was the result of active investment - should be enforced, whereas contracts based upon one party's knowledge of purely redistributive information or fortuitously acquired information should not be enforced.

Enforce most contracts based on difference in mixed information (productive and redistributive).
Duty to Disclose
Contracts based on the failure to disclose safety information undermine one purpose of contract law (unite knowledge and control).

When bargaining a contract to a contract, the parties should divulge safety information.
Fraud and Misrepresentation
If parties to a contract that fraud is a ground for voiding the agreement, then they can rely on the truthfulness of the information developed in negotiations for the contract. This saves the parties the cost of verifying material statements, lowering costs of concluding cooperative agreements.
Fill in Forms: Contracts of Adhesion
standard form contracts indicate the existence of monopoly, which deprives buyers of bargaining power. However, court practive is unjustified when sellers use standard-form contracts to increase the efficiency of exchange (reduce product differentiation and cost of price comparisions AND reduce transaction costs).
procederal unconscionability
consumer ignorant of critical terms in retailer's contract.

Create incentive to communicate meaning of contract terms.

deny enforcement unless bargaining process communicates crucial information.

Deck Info

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