Law and Economics-Charles W. Upton Market Failures Market Failures The Edgeworth Box Harry Sally Apples Bananas A B The Contract Curve Recall the Edgeworth Box. Market Failures The Edgeworth Box Harry Sally Apples Bananas A B The Contract Curve The purpose of contract law is to facilitate bargaining to reach the Contract Curve.. Market Failures The Edgeworth Box Harry Sally Apples Bananas A B The Contract Curve But, as we all know, there are occasions when bargaining does not reach the contract curve.. Market Failures Fifth Principle of Contract Law Deal with Market Failures. Market Failures Minors and Incompetents Contracts between minors and incompetents are invalid. Market Failures Minors and Incompetents Contracts between minors and incompetents are invalid. Of course, a contract can be enforced iffi if is in the best interest of the minor. Market Failures Minors and Incompetents Why does the law emancipate people at 18? Market Failures Minors and Incompetents Why does the law emancipate people at 18? Why not? It used to be 21. And, under some conditions, minors can petition for early emancipation. Market Failures Minors and Incompetents So, if you reach a deal with a child to pay him $10,000 if a coin toss comes up heads 10 times in a row, and the child agrees to pay you $1,000,000 otherwise, reach for your checkbook. Market Failures Duress Contracts made under duress are invalid. Market Failures Duress Contracts made under duress are invalid. If John holds a gun to Sam00 head and force Sam to assign an agreement, the agreement is invalid. Market Failures Duress Contracts made under duress are invalid. If John holds a gun to Sam00 head and force Sam to assign an agreement, the agreement is invalid.. Suppose a labor negotiator says 00gree to this contract or we go on strike00 That contract is valid. Market Failures A Distinction with a Difference In the first case, a redistribution of wealth is at stake. If we validated the agreement, we give John an incentive to spend time threatening people, which is socially unproductive. In the second case, this is part of bargaining to reach the contract curve. Here, wealth creation is under way. Market Failures A Distinction with a Difference In the first case, a redistribution of wealth is at stake. If we validated the agreement, we give John an incentive to spend time threatening people, which is socially unproductive. In the second case, this is part of bargaining to reach the contract curve. Here, wealth creation is under way. The Coase Theorem implies that the parties, left alone will reach the contract curve. Threats and blusters are part of normal negotiating tactics. Market Failures Contracts made out of Necessity Sam runs out of Gas in the desert, and John offers him gas for $50,000. Market Failures Contracts made out of Necessity Sam runs out of Gas in the desert, and John offers him gas for $50,000. This is a contract made out of necessity, and the law will not allow it. Market Failures Contracts made out of Necessity Sam runs out of Gas in the desert, and John offers him gas for $50,000. This is a contract made out of necessity, and the law will not allow it. But suppose John offers him gas for $10 a gallon. This, the law may well allow. There must, after all, be an incentive for people to aid stranded motorists. The problem is one of the right incentive. Market Failures Contracts against Public Policy Not allowed, presumably because they are socially undesirable. Market Failures Contracts against Public Policy John contracts with Sam to kill Harry, and does so. Sam refuses to pay. Market Failures Contracts against Public Policy John contracts with Sam to kill Harry, and does so. Sam refuses to pay. John sues (ignore the problem that John00 lawsuit constitutes a confession to murder). Market Failures Contracts against Public Policy John contracts with Sam to kill Harry, and does so. Sam refuses to pay. John sues (ignore the problem that John00 lawsuit constitutes a confession to murder). John is out of luck, for the contract violates public policy (murders are an externality. Market Failures A Gambling Debt John, an Ohio resident, goes to Vegas, and borrows $10,000 to play blackjack. John goes bust, returns to Ohio and refuses to pay the casino the $10,000. The casino is out of luck. Casinos are against public policy in Ohio. Market Failures Other Reasons A Union signs an agreement to work for Acme Widgets for $15 an hour. It further agrees that if it reaches a deal to work with Baker Widgets for less, the rate for Acme drops to $1 an hour. Unenforceable, for there is an obligation to negotiate with Baker in good faith. Market Failures Cartels Acme Widgets and Baker Widgets sign an agreement to set up a cartel. Unenforceable, because Cartels violate public policy. Market Failures The Secret of the A My contract to offer you the A is void, because it is a fraud. There is social value in your studying because it adds to your human capital. Just giving you an 0000for $100 is counterproductive because it cheapens the certification value of a KSU degree. Market Failures Other Reasons Failure to Disclose Market Failures Other Reasons Failure to Disclose Acme Widgets knows of limits on its widgets which it fails to disclose; consumers would have made different decisions if it knew these facts. Note, suppose you buy stock from me at $50 a share, payment to made in 3 months, and the stock falls to $25 a share. This contract is valid, for there was no failure to disclose. Market Failures Other Reasons Failure to Disclose Frustration of purpose The coronation example Market Failures Other Reasons Failure to Disclose Frustration of purpose Mutual Mistake The 00ood car00/font> Market Failures Other Reasons Failure to Disclose Frustration of purpose Mutual Mistake Monopolies The rule of reason exception Market Failures Impossibility A company hired to drill for water, hits granite. The landowner is the efficient risk bearer. Market Failures Impossibility A company hired to drill for water, hits granite. The landowner is the efficient risk bearer. A portrait painter dies before completing a commission. The subject is the efficient risk bearer. Market Failures The Westinghouse Case In the 197000 Westinghouse induced several utilities to build nuclear power plants with a promise to sell uranium at $8 to $10 a pound. It had commitments to sell 40,000 tons. The price went to $30 a pound, giving Westinghouse a potential loss of $1.6 billion. Market Failures The Westinghouse Case In the 197000 Westinghouse induced several utilities to build nuclear power plants with a promise to sell uranium at $8 to $10 a pound. Westinghouse reneged on the contracts on grounds of impossibility. Market Failures Asymmetric Information The strange case of Baron Rothschild. John sees that Sam has an old desk which John knows is worth $50,000 at an antique auction, and offers Sam, unaware of its value $1,000. Sam accepts, and later sues. John had no obligation to disclose. Market Failures Asymmetric Information In one case, the information was unproductive. Allowing people to profit causes unproductive investments. In the case of the desk, the information was productive. Without the profit motive, John would have no incentive to move the desk from a low value to high value use. Market Failures A General Theme Is the process designed to facilitate reaching the contract curve? Market Failures A General Theme Is the process designed to facilitate reaching the contract curve? Yes Enforceable, even though later some may think the deal unfair. Market Failures A General Theme Is the process designed to facilitate reaching the contract curve? Yes Enforceable, even though later some may think the deal unfair. No Not enforceable; we discourage socially unproductive activities. Law and Economics-Charles W. Upton Long Term Relationships Market Failures Examples McDonald00 Franchises and McDonald00 Corporation A Franchise Relationship Market Failures Examples McDonald00 Franchises and McDonald00 Corporation A Bank Account A Fiduciary Relationship Market Failures Examples McDonald00 Franchises and McDonald00 Corporation A Bank Account Smith and Jones, Attorneys at Law Wilson Trucks, sole supplier of trucking services to Acme Widgets Relationship Business Market Failures Examples McDonald00 Franchises and McDonald00 Corporation A Bank Account Smith and Jones, Attorneys at Law Wilson Trucks, sole supplier of trucking services to Acme Widgets A Marriage Another long term relationship Market Failures Issues in Long Term Relationships Any contract is inherently incomplete. Going to court to resolve the issue will almost certainly result in the end of the relationship. Market Failures Issues in Long Term Relationships Any contract is inherently incomplete. Going to court to resolve the issue will almost certainly result in the end of the relationship. There are significant advantages in long term relationships. Significant incentives to engage in cooperative behavior Monitoring costs are significantly lower. Market Failures The Payoff Matrix Consider our investor 00entrepreneur example We omit the middle column and concentrate on the choice between performing and cheating. Market Failures The Payoff Matrix Absent enforcement, the entrepreneur always has an incentive to cheat. Market Failures The Payoff Matrix Absent enforcement, the entrepreneur always has an incentive to cheat. But enforcement and monitoring is costly. Market Failures The Payoff Matrix Absent enforcement, the entrepreneur always has an incentive to cheat. But enforcement and monitoring is costly. Can we avoid these costs? Market Failures Another Alternative The investor invests daily. If the entrepreneur performs, invest the next day. If he does not, wait three days before investing again Market Failures If the Entrepreneur performs, he gets repeat business and makes $500 per day. If he cheats, he only earns $333 per day. Market Failures Two Examples Automobile Companies purchase parts from different manufacturers. The Auto Company owns the specialized equipment. If the manufacturer does not perform, the Auto Company takes its equipment and walks away. Market Failures Two Examples Automobile Companies purchase parts from different manufacturers. The Auto Company owns the specialized equipment. Employment relationships are long term. If an employee cheats, he loses his job; if he is disgruntled, the company suffers day after day. Market Failures Sixth Purpose of Contract Law Foster enduring relationships, which solve the problem of cooperation with less reliance on contracts. Market Failures But00/font> Try to repair the relationships or impose heavy penalties on those who cheat. Market Failures Two Examples Banks have a fiduciary duty to their customers. If they cheat, the courts come down hard on them. Market Failures Two Examples Banks have a fiduciary duty to their customers. If they cheat, the courts come down hard on them. Mr. and Mrs. Smith are getting divorced. They have two minor children. Try to repair the marriage Try to end the marriage as amicably as possible for the benefit of the children. Law and Economics-Charles W. Upton Remedies for Breach Market Failures Three Principles There are occasions when we want people to breach contracts. Market Failures Three Principles There are occasions when we want people to breach contracts. But they should pay damages as a deterrence to breach when it is not optimal. Market Failures Three Principles There are occasions when we want people to breach contracts. But they should pay damages as a deterrence to breach when it is not optimal. At the same time, we want to avoid over-reliance on contracts. Market Failures Some Measures of Damages Expectation Damages Restoring the injured party to where he would be had the contract been performed. Market Failures Three Measures of Damages Expectation Damages Reliance Damages Compensating the injured party for any out of pocket costs incurred because of the contract. That is, making him as well off as he would be without the contract. Market Failures Three Measures of Damages Expectation Damages Reliance Damages Opportunity Cost Restoring the injured party to where he could have been had he made another contract. Market Failures A Night at the Opera Acme Ticket Agency offers to sell John opera tickets at a price pa. Acme buys the tickets for pw. Acme breaches and John must pay a scalper ps. Market Failures A Night at the Opera Acme Ticket Agency offers to sell John opera tickets at a price pa. Acme buys the tickets for pw. Acme breaches and John must pay a scalper ps. Expectation damages John is out ps-pa. Market Failures A Night at the Opera Acme Ticket Agency offers to sell John opera tickets at a price pa. Acme buys the tickets for pw. Acme breaches and John must pay a scalper ps. Expectation damages Reliance Damages. John could have bought from Bijou for pb. Reliance damages are ps-pb. Market Failures A Night at the Opera Acme Ticket Agency offers to sell John opera tickets at a price pa. Acme buys the tickets for pw. Acme breaches and John must pay a scalper ps. Expectation damages Reliance Damages. Opportunity cost. John has prepaid for a limo for the evening. He is out pL. Market Failures The Cancelled Party John contracts with Sam for a party. Cost = $1000, Profit = $600. Market Failures The Cancelled Party John contracts with Sam for a party. Cost = $1000, Profit = $600. Before John cancels, Sam has bought $300 of food, which he resells for $200. Market Failures The Cancelled Party John contracts with Sam for a party. Cost = $1000, Profit = $600. Before John cancels, Sam has bought $300 of food, which he resells for $200. If Sam had not taken this job, he would have gotten a job with a profit of $450 Market Failures The Cancelled Party John contracts with Sam for a party. Cost = $1000, Profit = $600. Before John cancels, Sam has bought $300 of food, which he resells for $200. If Sam had not taken this job, he would have gotten a job with a profit of $450 Expectation damages = $700; the $600 lost profit and the $100 lost on the food. Market Failures The Cancelled Party John contracts with Sam for a party. Cost = $1000, Profit = $600. Before John cancels, Sam has bought $300 of food, which he resells for $200. If Sam had not taken this job, he would have gotten a job with a profit of $450 Expectation damages = $700; the $600 lost profit and the $100 lost on the food. Reliance damages = $100, what Sam lost on the food. Market Failures The Cancelled Party John contracts with Sam for a party. Cost = $1000, Profit = $600. Before John cancels, Sam has bought $300 of food, which he resells for $200. If Sam had not taken this job, he would have gotten a job with a profit of $450 Expectation damages = $700; the $600 lost profit and the $100 lost on the food. Reliance damages = $100, what Sam lost on the food. Opportunity Cost = $550, $100 for the food and $450 lost profit. Market Failures The Injured Hand Mr. Hawkins has a badly scared hand. A doctor persuades him, at age 18, to undergo an operation, which will make the hand perfect. Market Failures The Injured Hand Mr. Hawkins has a badly scared hand. A doctor persuades him, at age 18, to undergo an operation, which will make the hand perfect. He forgoes an operation which would make the hand better, but not perfect. Market Failures The Injured Hand Mr. Hawkins has a badly scared hand. A doctor persuades him, at age 18, to undergo an operation, which will make the hand perfect. He forgoes an operation which would make the hand better, but not perfect. In fact the operation is a disaster. The scar is worse and hair begins to grow in the palm. Market Failures The Injured Hand Mr. Hawkins has a badly scared hand. A doctor persuades him, at age 18, to undergo an operation, which will make the hand perfect. He forgoes an operation which would make the hand better, but not perfect. In fact the operation is a disaster. The scar is worse and hair begins to grow in the palm. So, how much? Market Failures OG Quality of Hand A B O P A = After B = Before O = Other Procedure P = Perfect Hand Market Failures OG Quality of Hand A B O P Three indifference curves between other goods and quality of the hand. They go through different states of the hand. Market Failures OG Quality of Hand A B O P Reliance Damages Market Failures OG Quality of Hand A B O P Opportunity Cost Damages Market Failures OG Quality of Hand A B O P Expectation Damages Market Failures The Problems Expectation Damages are sometimes hard to measure What is the value of a perfect hand? They may lead to over-reliance. Law and Economics-Charles W. Upton More on Remedies Market Failures The Waffle Shop Yvonne owns a waffle shop. She wants to expand the shop and contracts with Xavier for an addition to be ready at the start of the school year. Market Failures The Waffle Shop Yvonne owns a waffle shop. She wants to expand the shop and contracts with Xavier for an addition to be ready at the start of the school year. Xavier has a problem. The more he spends on precaution, the greater the probability of the job being done. Market Failures The Waffle Shop Yvonne owns a waffle shop. She wants to expand the shop and contracts with Xavier for an addition to be ready at the start of the school year. But Yvonne also has a problem. She faces two revenue functions for September, depending on how much food she orders and whether Xavier is finished on time. Market Failures Assumptions X = Xavier00 expenditures on precaution Y = Amount of food Yvonne orders. Rnot(y) = Yvonne00 revenue function, not ready Rready(y) = Yvonne00 revenue function, ready P(x) = Probability of facility being ready Market Failures The correct problem to solve is to choose x and y to maximize p(x)Rready(y) + (1-p(x))Rnot(y) - y - x Market Failures The correct problem to solve is to choose x and y to maximize p(x)Rready(y) + (1-p(x))Rnot(y) - y - x Market Failures The correct problem to solve is to choose x and y to maximize p(x)Rready(y) + (1-p(x))Rnot(y) - y - x Market Failures The correct problem to solve is to choose x and y to maximize p(x)Rready(y) + (1-p(x))Rnot(y) - y - x Market Failures The correct problem to solve is to choose x and y to maximize p(x)Rready(y) + (1-p(x))Rnot(y) - y - x and that problem has a solution Market Failures p(x)Rready(y) + (1-p(x))Rnot(y) - y 00x p00x)[Rready (y) - Rnot (y)] - 1 = 0 p(x)R00 ready(y)+ (1-p(x))R00/i>not (y) -1 = 0 Market Failures p(x)Rready(y) + (1-p(x))Rnot(y) - y 00x p00x)[Rready (y) - Rnot (y)] - 1 = 0 p(x)R00 ready(y)+ (1-p(x))R00/i>not (y) -1 = 0 Let x* and y* be the optimal levels Market Failures If his damages are Rready (y*) - Rnot (y*) Xavier will minimize P(x) [Rready (y*) - Rnot (y*)]-x and come to the right solution Xavier Market Failures If her compensation is Rready (y*) - Rnot (y*) She will maximize p(x)Rready(y) + (1-p(x))Rnot(y) 00y + [1-p(x)] [Rready (y*) - Rnot (y*)] and come to the right solution Yvonne Market Failures Conclusion Use perfect expectation damages assuming reasonable reliance. If You can measure reasonable reliance Else people get interested in other alternatives Market Failures The Chart Can you measure expectation damages assuming reasonable reliance accurately? Yes Do it No Alternatives Market Failures Alternatives Can you measure opportunity cost damages assuming reasonable reliance accurately? Yes Do it No Alternatives Market Failures Alternatives Can you measure reliance damages assuming reasonable reliance accurately? Yes Do it No Alternatives Market Failures Alternative Damages Restitution Disgorgement Liquidated Damages Contract-specified damages Specific Performance Market Failures Alternative Damages Restitution Disgorgement Liquidated Damages Contract-specified damages Specific Performance Market Failures Alternative Damages Restitution Disgorgement Liquidated Damages Contract-specified damages Specific Performance Market Failures Alternative Damages Restitution Disgorgement Liquidated Damages Contract-specified damages Specific Performance Market Failures Alternative Damages Restitution Disgorgement Liquidated Damages Contract-specified damages Specific Performance Law and Economics-Charles W. Upton Summary Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures Market Failures End 漏2004 Charles W. Upton

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