YISS LE Lecture11

Yonsei University
Introductory example 1
International Summer School
Law and Economics

Lecture 11
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Introductory example 2 Contract: introduction

• What is a contract?
– enforceable promise
• Why do people make a contract?

– Cooperation
– Commitment
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Contract: main issues Classical bargain theory of contract

• A promise is legally enforceable if it is
1) What promises are enforceable? given as part of a bargain; otherwise, a
promise is unenforceable.
2) What should be a remedy if a contract is
breached? • Three conditions for a bargain
– Offer
– Acceptance
– Consideration: what the promisee gives the
promisor to induce the promise.
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Examples Bargain theory of contract: Part II
1) I offer to sell you a car for $1,000. • Remedy for breach of enforceable
You agree, and give me $100 as a deposit promises
(or you agree to pay me tomorrow). – Expectation damages, or
– Benefit of the bargain
2) I offer Western University a $1,000,000
donation. They accept. I give $50,000, • Expectation damages in introductory
then change my mind. examples
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Agency game without contract Agency game with contract
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The (first) purpose of contract law

is to enable people to cooperate by converting
games with non-cooperative solutions into
games with cooperative solutions.
• Making a contract commits the second player to

cooperate. Commitment is achieved by
foreclosing the opportunity to appropriate. The
opportunity to appropriate is foreclosed by the
high cost of liability.
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Contract with luck affecting
performance. Incentive to perform
• Performance is not always efficient.

– If the (social) costs of performance are high
relative to the (social) costs of breach, then
breach is efficient.
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Perfect expectation damages and

Incentive to rely upon contract
efficient breach
• Definition: Perfect expectation damages
• Definition: Reliance is a change in the
restore the promisee to the position that he or
promisee’s position induced by the promise.
she would have enjoyed if the promise had been
– The promisor invests in performing, and the promisee
kept. invests in reliance upon the promise. Investment may
take the form of money, time, effort, or forgone
• Result: Perfect expectation damages create opportunities.
incentives for efficient performance and breach. – Reliance increases the value of performance to the
promisee.
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Reliance Perfect expectation damages

• Reliance is not always efficient • Definition: Perfect expectation damages
– As (efficient) breach becomes more likely, restore the promisee to the position that he or
efficient reliance investment falls. she would have enjoyed if the promisee had
been kept and if reliance had been optimal.
– The law does not allow the victim of breach to recover
• Damages influence reliance investment. damages caused by over-reliance.
– Reconsider expectation damages. – The promisor must bear the usual costs of breach
(reasonably expected costs of breach), whereas the
promisee must bear the unusual (unforeseeable)
costs of breach.
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Hadley v. Baxendale (1854) Gaps in a contract
• The plaintiff was a miller. His mill had stopped because • Definition. Gaps are events not explicitly addressed in
of a breakage of the mill’s crankshaft. The plaintiff had the contract that affect obligations created by it.
contracted with the defendant, a common carrier, to take – unforeseeable events: inadvertent gaps
his broken crankshaft to a manufacturer to be used as a – remotely possible events: deliberate gaps
template to cast a new crankshaft. The defendant had (rational gaps)
delayed in shipping the crankshaft. As a result the
plaintiff had lost profits caused by the delay in having his • The court sometimes fill gaps by imputing a term to
mill made operational. the contract, which means acting as if the parties had
• The defendant argued that the plaintiff’s losses were too negotiated a term that they did not actually negotiate.
remote in that at the time of entering the contract the lost
profits could not have been contemplated by the parties.
The court held that the damages were too remote.
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Default terms Example

To minimize transaction costs of negotiating • The McGuire signs a contract with the Wabash
Construction company to build a house.
contracts by supplying efficient default terms and • At the time of contract, Wabash knows that the cost of
regulations. copper pipe in the house may soar by $2,000 with
probability 0.5. Assume that Wabash can hedge against
this risk for $400.
• Hypothetical bargain: Impute the terms to • Wabash does not hedge and the price of copper soars.
the contract that the parties would have agreed Wabash completes the construction of the house and
to if they had bargained over the relevant risk. sends the McGuires a bill for an additional $2,000.
– Note that 0.5 x 2,000 > 400
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Perfect contracts and

Incomplete contracts
market failures
• Sometimes, the court sets aside the • Contracting is costly.
explicit terms of a contract. When the law – Articulating every possibility is impossible.
disregards or changes the terms in a – Specifying contingencies is costly.
contract, we say that law regulates
contract. • Optimal contract balances the cost of
– A consumer waives a right to recover for contracting against the potential incentive
injuries caused by a defective product.
costs when contracts are imperfectly
– A sure means to kill grasshoppers. specified.
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Yonsei University

Law and Economics

Introductory example 2 Contract: introduction

• Why do people make a contract?

Contract: main issues Classical bargain theory of contract

Agency game without contract Agency game with contract

The (first) purpose of contract law

• Making a contract commits the second player to

• Performance is not always efficient.

Perfect expectation damages and

Reliance Perfect expectation damages

Default terms Example

– Note that 0.5 x 2,000 > 400

Perfect contracts and

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