Contract Law and Markets
In Chapter 3 we examined situations in which transactions costs were low. We focused on the ability of parties to bargain around legal rules, which rendered those rules irrelevant for efficiency and, in certain cases, also irrelevant for production decisions (although not irrelevant for the distribution of wealth). In these situations, we assumed that a body of contract law or rules was in place, so that any agreements between the parties were enforceable and were in fact enforced. Under these assumptions, the efficiency properties of economic outcomes are not so much reliant on the nature of legal rules as they are on the existence of some legal framework and some set of rules, as well as a set of rules regarding contracts.
In the second class of situations (Chapters 4 and 5), we examined settings where bargaining was prohibitively expensive. In these situations, the efficiency of economic outcomes was heavily reliant on the design of the legal rules which governed those outcomes. Some rules yielded efficient outcomes, and some did not. If transaction costs are high and legal errors are made, then the analysis in Chapters 4 and 5 suggests that there could be significant efficiency consequences. Since no bargaining was assumed to take place in Chapters 4 and 5, contract law was irrelevant.
Chapter 6 examined an intermediate class of situations, where consumers could (perhaps imperfectly) assess the attributes of the good before they purchased it. Under a no liability rule, we saw that if consumers' perceptions of the harmfulness of the good are accurate, then the pursuit of profit and the forces of competition induce firms in competitive markets to provide the efficient level of care, even though the legal rule does not oblige them to do so.
This chapter brings these separate strands together and examines situations where transaction costs are sufficiently low for parties to engage in some contracting over outcomes, but where such contracting may be incomplete because transaction costs, while low, are not zero. In these situations, contracts may not be self-enforcing and may not completely specify what will occur in certain circumstances. The possibility of opportunistic behaviour and the lack of a complete contingent contract creates a potential role for a body legal rules - contract law - to determine what should happen when breaches of contract occur, and what compensation for breach of contract should be paid. These rules in turn create incentives for parties to act in certain ways.
The chapter is structured as follows. Section 8.2 presents a simple framework for assessing the incentives and welfare effects of breaches of contract by buyers and sellers in a competitive market setting. Section 8.3, which is based on the insights of Klein and Leffler (1981), studies the incentives for sellers and buyers to breach their contractual obligations if they are involved in a long-lived economic relationship, when there are no formal punishments for such breaches. Section 8.4 develops a model of damages for breach of contract which mirrors the approach to accident law taken in Chapters 6 and 7. The analysis shows that a negligence-type rule for breaches of contract induces both buyers and sellers to fully internalise the social costs of their actions and behave efficiently.