CONTRACTS – Terms And Conditions October 17, 2006

CONTRACTS – Terms And ConditionsOctober 17, 2006


• COLOUR CODE FOR GRAPHS• Marginal Cost Curve for Agent (firm, individual)

under a strict liability rule• Marginal Cost Curve for Agent (firm, individual)

under a no liability rule• Marginal Cost Curve for Agent (firm, individual)

under a negotiated contract that follows the Theoem of Coase

• Demand Curve for the Agent’s output• Marginal Revenue Curve


• COLOUR CODE FOR GRAPHS (con’t)• Average Cost Curve for Agent (firm, individual) with

no transaction costs• Average Cost Curve for Agent (firm, individual) with

transaction costs• Profit of Agent (firm, individual) • Portion of profit traded in exchange for property

rights • Portion of profit lost due to a trade in property rights• Portion of profit lost due to transaction costs


• Review of Coase Theorem • Exceptions To Coase Theorem

• Transaction Costs - October 17, 2006» Rules that reduce transaction costs

• Asymmetric Information – October 24, 2006» Rules that compensate for market failure

• Empty Core - October 31, 2006

CONTRACTS – Terms And Conditions October 17, 2006

Review The Theorem Of Coase

CONTRACTS – Terms And Conditions

.

Agent 2 has the exclusive use to its property rights

Agent 1 creates a harmful

nuisance that hurts

Agent 2 economically.


• While cooperation between the agents determines when optimal use or the most efficient use of an asset will occur, what determines what that level of efficiency will be?

• Technology


• Social surplus increases under

the contract. • No party can be

worse off.

• Agent 1

S

DP

a1

PM

PMC

SMC

CMC


• Social surplus is improved to the most efficient or optimal amount irregardless of which agent has the property rights.

• Agent 2

S

DP

a1

PM

PMC

SMC

CMC


Theorem of Coase What rule applies makes no difference to the optimal level of efficiency.

It is the cooperation of the parties that makes the difference. (Cooter, p. 87)


• Agent 2

S

DP

a1

PM

• Agent 1

S

a1

CMC

Maximum Joint Social Surplus


Theorem of Coase (continued)

Productive or allocated transfer of surplus leads to a more efficient use of the asset

Redistributive transfer of surplus causes no change to the efficient use of the asset

Distribution of the social surplus varies in accordance with which agent has the property rights.


Theorem of Coase (continued):

The improvement in social surplus involves the elimination of incompatible uses through bargaining.

LEAST COST PRINCIPLE applies as the next example shows.


• Theorem of Coase (continued):• If it is cheaper for the farmer to build a

fence around his property, than for the rancher to hire a rustler, than the fence will be built.

• Note the LEAST COST PRINCIPLE is a corollary of the Theorem of Coase in these examples.


Set of Cost Minimizers

Set of Profit Maximizers


• Theorem of Coase (continued):• Note the application of the “cheaper”

technology reconciled a “incompatible use” with a compatible use.

• Efficiency requires limiting the use to the party that values the property most – higher utility or higher profits - efficiency rule

• (Cooter – p. 88)


• The elimination of incompatible uses through bargaining underlies much of the theory behind urban geography and urban planning

• Former Irwin Toy factory - Toronto


• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1

S

DP

a1

MC1

PPC

PM

LATCLATC


Theorem of Coase (continued):

Property rights may be traded for a price.

Each Agent does not have an incentive to defect

CONTRACTS – Terms And Conditions Nash Equilibria

• Prisoners dilemna works against a collusive duopoly

• Prisoners dilemna could be “solved” in a collusive

externality agency

P.O.E

N.E

P.O.E

and N. E

CONTRACTS – Terms And Conditions Nash Equilibria

• Cournot Duopoly • Negative ExternalityAxes

a2

E

Iso-Profit Curve For Agent 1


CONTRACTS – Terms And Conditions October 17, 2006

Coase Theorem Short Run

CONTRACTS – Terms And ConditionsShort Run

• Why the Theorem of Coase might be true in the short run, but not the long run

• (See Cooter, p. 90, for a fuller explanation)



SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

LATCLATC

CONTRACTS – Terms And ConditionsStrict Liability Rule

.

Agent 2 has the exclusive use to its property rights


nuisance that hurts




SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

LATCLATC

Strict Liability Rule

CONTRACTS – Terms And ConditionsStrict Liability Rule - Short Run


SS = MC2

DP

a1

MC2 SATC SATC

PPC

PM

LATCLATC


CONTRACTS – Terms And Conditions Short Run - Strict Liability Rule

PRINCIPAL Agent 1 Offers a Bribe or a Transfer Payment To Agent 2

AGENTAgent 2 promises to endure the pollution in exchange for the payment which makes it better off

promisepayment

CONTRACTS – Terms And ConditionsShort Run - Strict Liability Rule


SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

LATCLATC


CONTRACTS – Terms And ConditionsShort Run - Strict Liability Rule


SS = MC2

DP

a1

MC2 SATC SATC

PPC

PM

LATCLATC


CONTRACTS – Terms And Conditions Short Run - No Liability Rule

.

Agent 2 loses the exclusive use to its property rights to protect it against pollution


nuisance that hurts




SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

LATCLATC

No Liability Rule



SS = MC2

DP

a1

MC2 SATC SATC

PPC

PM

LATCLATC

No Liability Rule

CONTRACTS – Terms And Conditions No Liability Rule

PRINCIPAL Agent 2 Offers a Bribe or a Transfer Payment To Agent 1

AGENTAgent 1 promises to cutback production or incur the expense of pollution abatement

promisepayment

CONTRACTS – Terms And ConditionsShort Run - No Liability Rule


SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

LATCLATC

No Liability Rule

CONTRACTS – Terms And ConditionsShort Run - No Liability Rule


SS = MC2

DP

a1

MC2 SATC SATC

PPC

PM

LATCLATC

No Liability Rule


Exceptions to the Theorem of CoaseTransaction Costs - Fees

CONTRACTS – Terms And ConditionsTransaction Costs

• Rules that reduce transaction costs • Default rules are developed by courts to

reduce transaction costs. • For example, if A1 knows how much it

will have to pay A2 for breach of contract, it will not incur the cost of consulting a lawyer or losing in court (paying the legal fees of the winner)

• (Cooter – p. 267)

CONTRACTS – Terms And ConditionsTransaction Costs – Legal Fees

What are transaction costs?

•Fees paid to lawyers to draft a contract

CONTRACTS – Terms And Conditions Transaction Costs – Legal Fees

• When bargaining costs are low, the efficient use of assets or resources results from private negotiation irregardless of what the legal rules are

• When bargaining costs are high, the efficient use of assets or resources results from which legal rules is chosen

• (Cooter – p. 89)


• Which legal rule should be chosen in this case?

• Choose the legal rule that favours the party that “most values” the asset or resource.

• This is an application of the NORMATIVE HOBBES THEOREM

• (Cooter – p. 98)

CONTRACTS – Terms And ConditionsStrict Liability Rule – Short Run


SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

SATC + TC LATC

Transaction Costs

CONTRACTS – Terms And Conditions Strict Liability Rule – Long Run


S

DP

a1

PPC

PM

LATC


CONTRACTS – Terms And Conditions No Liability Rule – Long Run


S

DP

a1

MC2

PPC

PM

PM

LATC

No Liability Rule

MC2


• Cournot Duopoly • Negative ExternalityAxes

a2

E




• Prisoners dilemna works against a collusive duopoly

P.O.E

N.E

• Prisoners dilemna works against negative externalities under the exceptions to the Theorem of Coase

N.E

P.O.E


Exceptions to the Theorem of CoaseTransaction Costs - Enforcement

CONTRACTS – Terms And ConditionsTransaction Costs - Enforcement

What are transaction costs?

• Enforcement Fees

» Fees paid to lawyers to go to court to enforce a broken contract and obtain remedies for their clients

CONTRACTS – Terms And ConditionsTransaction Costs – Enforcement

Formation Of Contracts

Principal Makes

An Offer To An Agent

Agent Accepts The Offer

Performance Of The Contract

Agent Sends A

Signal to the

Principal


• When A1 sues A2 in court, A2 will either argue• (a)there never was a contract in

the first place• (b) there was a contract, but A1

failed to perform its part of the contract

• What usually happens is some external change in A2 circumstances makes A2's position under the contract Pareto inferior, so that A2 wants out

CONTRACTS – Terms And Conditions Transaction Costs – Enforcement

INCAPACITYUnder 18Undischarged Bankrupt

Agent is not a utility or profit maximizer

LEGAL DEFENCE

ECONOMIC ANALYSIS

INCOMPETENCEMental illness

The competent A1 can protect the interests of incompetent A2 at least cost, so an “efficient” rule of contract assigns liability to A1 (Cooter – p. 268)


DURESS

The Agent’s income compatibility constraint is restricted or challenged in some way

LEGAL DEFENCE

ECONOMIC ANALYSIS

COERCION

A promise extracted by A1 from A2 by a threat reduces social surplus, so the “efficient” rule of contract declares such a promise unenforceable (Cooter p. 271)

Constraint:A1 threatens A2 if A2 does not sign the contract



LEGAL DEFENCE

ECONOMIC ANALYSIS

NECESSITY

Cooter agrees, in part, with Adam Smith's argument about why prices have to be higher (within reason) (Cooter - pp. 273-274)

Constraint:A1 extracts a “gouging” price due to A2's need


• Opportunistic types took advantage of the need and would sell a bottle for $200.00 or more!

• What did Smith recommend – let the market rule. Okay to make a dollar (or pound) off someone’s suffering – as long as the conduct is not fraudulent



LEGAL DEFENCE

ECONOMIC ANALYSIS

IMPOSSIBILITY

The “efficient” rule of contract assigns liability to the party who, at least cost, can bear the risk that performance becomes impossible (Cooter - p. 275)

Constraint:The contract cannot be performed


• Who is this party? • Cooter calls this party the “efficient”

risk bearer• Posner calls this party the “superior”

risk bearer• Posner extends the “least cost

principle” to a theory that most contrcts create implied insurance – some party is bearing the risk of loss

• (Posner, s. 4.5)



LEGAL DEFENCE

ECONOMIC ANALYSIS

ILLEGALITY

Transaction costs due to unenforceability apply


Exceptions to the Theorem of CoaseAsymmetric Information


Asymmetry Of Information

• In the Cournot duopoly example, what happens if both duopolists have identical costs, but only one of the agents knows this?



• The uninformed agent would have to guess on the rival’s costs.

• What if the uninformed agent “guesses wrong” and overestimates the rival’s costs?

CONTRACTS – Terms And Conditions Asymmetry of Information - Nash Equilibria

• Cournot Duopoly – Perfect Information

• Cournot Duopoly – Asymmetric InformationAxes

a2

E



a1



• The uninformed agent will “mistakenly” increase its production levels in the “wrong expectation” that its rival is cutting back.

• The “rival” will in fact cut back to save money.

• The “Nash equilibrium” moves to the right reflecting more production and lower social surplus.




a2

E



a1



• What if the uninformed agent “guesses wrong” and underestimates the rival’s costs?

• In effect, the uninformed agent “believes” its costs are higher, so it cuts back

• The “informed agent” will expand its production

• Nash equilibrium moves to the left




a2

E



a1

CONTRACTS – Terms And Conditions Asymmetry of Information – Search Costs and Disclosure

Laidlaw v. Organ

CONTRACTS – Terms And Conditions Asymmetry of Information - Disclosure

• Kronman applies the Least Cost Principle to derive the most “efficient” disclosure rule for contracts.

• Kronman, A., "Mistake, Disclosure, Information and the Law of Contracts", (1978) 7 Journal of Legal Studies 1


Asymmetry Of Information – Search Costs

• Productive or allocative information is information that, if disclosed, leads to a more efficient use of the asset

• Redistributive information is information that, if disclosed, causes no change to the efficient use of the asset (Cooter, pp. 281 – 282)

CONTRACTS – Terms And Conditions Asymmetry Of Information - Search Costs

Market failure due to moral hazard

LEGAL DEFENCE

ECONOMIC ANALYSIS

MISTAKE

Assumptions upon which the contract was made

MISREPRESENTATION

Inducing one of the parties to enter the contract

Transaction costs due to search costs apply

CONTRACTS – Terms And ConditionsAsymmetry Of Information - Search Costs

• Innocent Misrepresentation• Negligent Misrepresentation• Fraudulent Misrepresentation


Asymmetry Of Information - Search Costs • Mutual Mistake• With mutual mistake both parties have

the same fundamental misunderstanding about the nature of the contract.

• In cases of mutual mistake, both parties may be excused from the contract

• (Kronman, p. 5)


Asymmetry Of Information - Search Costs

• Unilateral Mistake• Unilateral mistake goes to a mistaken

assumption by one of the parties upon which the contract was made


• Laidlaw, a wholesaler of tobacco, cannot move its supply due to the British bolockade of New Orleans

• This depresses the price• Organ knows that the blockade is

about to end


• Organ negotiates a contract with Laidlaw’s agent at a price favourable to a quick resale profit without making any illegal misrepresentation to the agent

• After the news becomes public, Laidlaw refuses to deliver the tobacco to Organ unless he agrees to pay a higher price

• Organ sues Laidlaw for delivery and wins• Laidlaw appeals to the U.S. Supreme

Court


• Chief Justice Marshall grants Laidlaw’s appeal, but only in so far as Laidlaw gets a right to a new trial in New Orleans


• Marshall emphasizes his opinion that Laidlaw is not likely to win at trial

• The contract was complete• Any “after the fact” economic

disadvantage to Laidlaw is not relevant unless there had been a misrepresentation, breach of trust or express proviso in the contract


• What is the most efficient contract rule?• The agent who acquires relevant

productive information at least cost or at a cost lower than that possible for the agent not in possession of the information – should disclose.

• If that agent does not disclose, it should be liable.


• The agent who acquires relevant productive information at greater cost or at the same cost as possible for the agent not in possession of the information – need not disclose

• The agent should not be liable if it does not disclose


• The agent who acquires relevant redistributive information irregardless of cost – need not disclose.

• If that agent does not disclose, it should not be liable.


• Based on the foregoing analysis, Kronman and Cooter believe the outcome in Laidlaw was inefficient.

• (Cooter, p. 283)


What happens if an express disclosure clause appears in a contract involving purely redistributive information?

• In 1987, Aivazian and McCabe concluded that the disclosure rule is best left as a matter of contract, not a matter of rigid common law or statute law.


• Provided that the way relevant contractual information arises is common knowledge to the agents, they will contract on this.

• If the relevant sources of information are themselves asymmetric, then resort must be made to a transactions cost approach.

• Aivazian, V. and McCabe, P., "The Duty of Disclosure in Contractual Relations", Law and Economics Workshop, December, 1987


• What is the most efficient contract rule if information is mixed?

• (For example both productive and redistributive information?)


• Does all economic relevant information fall under the categories of productive information or redistributive information or both?


• What if a home seller deliberately witholds information that the house he or she is selling is infested with termites?

• The efficiency rule would require disclosure, but the common law rule would not require disclosure. Why?


• Common law is predicated on the principle of “caveat emptor”

• Why?

• Justice Joseph Story – On Supreme Court with Marshall at the time Laidlaw v. Organ was decided. Would later defend the decision on the basis of “caveat emptor” – buyer beware


• The analysis of Justice Story’s views on caveat emptor and disclosure were incorporated into Canadian and English law in Smith v. Hughes by Lord Chief Justice Cockburn

• A painting of the Lord Chief Justice presiding at the perjury trial of Arthur Orton


• The Canadian courts give greater latitude to the possessor of productive information than those who follow Kronman’s “efficient disclosure rule” provided the possessor does not misrepresent the facts upon which a contract is formed.


• http://www.jus.unitn.it/cardozo/review/Contract/Musy-1995/musy1.htm

• http://www.niehs.nih.gov/kids/lyrics/battleof.htm

http://www.jus.unitn.it/cardozo/review/Contract/Musy-1995/musy1.htm

http://www.jus.unitn.it/cardozo/review/Contract/Musy-1995/musy1.htm

CONTRACTS – Terms And Conditions October 17, 2006

Documents

Transcript of CONTRACTS – Terms And Conditions October 17, 2006