Notes

There is a large literature on the economics of contract law. This chapter has covered the basics. Shavell (1980) and Rogerson (1984) are the classic papers analysing the economic effects of damage measures for breach of contract. The presentation of the economics of damage measures in this chapter draws on the framework of Benoit and Kornhauser (2002). Klein and Leffler (1981) examine the incentives to provide high-quality goods in a competitive market setting in the absence of damage measures for breach of contract. Pashigian (1998) contains a useful summary of the Klein-Leffler model.

Exercises

1. A buyer and a seller are contemplating signing a contract for the delivery of a good. They agree on a price of P > 0 for the good. The seller does not know what his costs will be, although he does know the likelihood with which various costs will occur. The table below lists the possible costs for the seller and the probability with which they arise.

Cost

Probability

20

  • 1
  • 3

50

  • 1
  • 3

90

  • 1
  • 3

Suppose that, after the contract is signed, the buyer can make a reliance investment decision. If the buyer invests rL = 4 and the contract is performed, then the buyer receives a return of VL = 47. If the buyer invests rH = 20 and the contract is performed, then the buyer receives a return of VH = 80.

  • (a) Briefly explain the concept of an efficient breach of contract. If the buyer invests rL = 4, how frequently should the seller breach the contract, assuming he behaves efficiently? If the buyer invests rH = 20, how often should the seller breach, assuming he behaves efficiently? Assuming the seller behaves efficiently, what is the joint expected value of the contract if the buyer invests rL = 4? Assuming the seller behaves efficiently, what is the joint expected value of the contract if the buyer invests rH = 20? Assuming the seller behaves efficiently, what is the efficient level of reliance investment by the buyer?
  • (b) Define and briefly explain the remedies of expectation damages, reliance damages and restitution damages in contract law. Taking the reliance investment by the buyer as given, which of these damage measures induce efficient breach decisions in the above setting? Explain.
  • (c) Suppose that in the above example, the parties know that in the event of a breach by the seller, the court will award expectation damages to the buyer. Under this legal rule, in the above example, will the buyer choose the efficient level of reliance investment? How does the buyer's reliance decision depend on the price, p? What is the joint value of the contract under expectation damages? If the parties know that in the event of a breach by the seller, the court will award expectation damages to the buyer, what range of prices must p lie between for them to even agree to sign a contract?
  • 2. Suppose there is a single monopoly firm that produces a single good, Q. The ordinary demand curve for this good is:

where P is the price of the good and Q is the quantity demanded. Suppose that marginal costs of production are constant and equal to c = 0.

(a) What is the Pareto-optimal price and quantity? How much profit does the firm earn if it charges this price?

Now suppose that the good is potentially harmful to consumers. Let 0 < l < 1 be the consumer's expected dollar loss per unit of the good consumed. The firm can completely eliminate these losses by taking care when it produces each unit of the good. The firm's per-unit cost of care is k < l. Consumers are assumed to be unable to take care, and cannot observe the firm's choice of care before they purchase the product.

  • (b) Is it efficient for the firm to take care?
  • (c) Suppose that there is a no liability rule in place, but that the firm and the consumer are engaged in a long-lasting commercial relationship which starts at time t = 0 and lasts into the indefinite future (that is, forever).

In each period, consumers purchase a quantity of the good and must consume it; the good is non-durable. In each period the firm can choose to produce safe goods or potentially harmful goods. The problem for consumers is that they cannot observe the level of care taken by the firm in that period until after they have purchased the good (the good is an experience good).

Assume that the firm can now offer the consumer a warranty in each period, which is just a costless written assurance by the firm that the good is safe and will not harm them. If such a warranty is provided at t = 0, then the consumer believes the firm and their demand curve for the good in period t = 0 is:

If the firm does provide a warranty, it has two choices at time t = 0:

• Take Care: The firm can honour its warranty and take care, incurring a per-unit cost of к > 0. It can still act like a monopolist and choose whatever price it wishes. If the firm honours its warranty, then it builds up its reputation: if it again provides a warranty in the next period (t = 1), then consumers will again believe them and will again have the same demand curve, Q = 1 - P.

• Don't Take Care: The firm breaks the commitment made in its warranty and does not take care, and so does not incur the per-unit cost of к > 0. It can still act like a monopolist and choose whatever price it wishes. Consumers must consume the potentially dangerous good and cannot sue for damages or breach of contract. If the firm chooses this strategy and fails to take care after it has provided a warranty to do so, then its reputation is immediately destroyed: consumers never believe them again, and the demand curve for all subsequent periods (t = 1, 2, 3,...) is:

irrespective of whether the firm provides a warranty or not in those subsequent periods.

You may again assume that к < l. The firm discounts future profits at the rate 0 < S < 1 (this means that the firm is indifferent between receiving $S today and $1 tomorrow).

  • (d) At time t = 0, what is the discounted present value of the firm's profits if it provides a warranty, acts as a monopolist and follows the Take Care strategy? What is the net present value of the consumer surplus if the firm chooses this strategy?
  • (e) At time t = 0, what is the discounted present value of the firm's profits if it provides a warranty, acts as a monopolist and follows the Don't Take Care strategy? What is the net present value of the consumer surplus if the firm chooses this strategy?
  • (f) Which strategy maximises the net present value of aggregate welfare? Explain.

Consider the following statement:

'If the firm is sufficiently patient (if 8 is sufficiently high), then it will choose the strategy that maximises the net present value of aggregate welfare.'

  • (g) Is the statement True, False or Uncertain? If the statement is true, find the level of 8 that makes the firm indifferent between the two strategies. If the statement is false or uncertain, explain why.
  • 3. (An application to employment contracts). Unfair dismissal laws impose fines on employers for firing workers in certain circumstances, and in some circumstances prevent employers from firing workers altogether. This question asks you to consider the efficiency properties of some common law alternatives to unfair dismissal laws.

Suppose that an employer and a worker are contemplating signing a contract for the completion of a task by the worker at some point in the future. They agree on a wage w > 0 that the employer will pay the worker if the task is carried out. The employer has the option of firing the worker, in which case the task is not carried out and the wage is not paid.

After the employment contract is signed, the worker makes some reliance investment of r > 0 (for example, he may move cities in order to take up the new job). If he is not dismissed, the value of this reliance investment is V(r) > 0, where V'(r) > 0 and V"(r) < 0. If he is dismissed, the value of this reliance investment is zero.

In this setting, assume that performance of the contract is the choice of the employer. He can either perform the contract by having the worker to carry out the task and pay him the agreed wage, or he can breach the contract by dismissing (firing) the worker before the task is carried out, and refuse to pay the worker the agreed wage.

The problem for the parties is that neither the employer nor the worker know exactly how good the worker will be at the task. Let p be the employer's possible profit level (not including the wage payment w) when the worker completes the task. The parties regard p as a random variable which can take on n different values, with probabilities p = Pr(n = ni), where 0 < p < 1 and ^p = 1.

The true value of p is not revealed until after the contract is signed and the worker makes his reliance investment. For example, the worker could turn out to be extremely good, implying a high value of p for the employer. In such a case, the employer would not want to fire the worker and would be happy to get p in return for paying the worker the agreed wage of w.

On the other hand, the worker might reveal himself to be a complete disaster at the job, implying a low or even a negative value of p for the employer. In such a case, the employer may want to fire the worker instead of receiving a low value of p and paying the worker the agreed wage of w.

(a) In this context, explain what a complete employment contract would look like. Why might the parties not be able to (or not wish to) sign a complete employment contract?

For the remaining parts of this question, assume that complete employment contracts cannot be signed.

(b) In this setting, it is ever efficient for the employer to dismiss the worker? From an efficiency point of view, how frequently should the employer dismiss the worker? Explain.

  • (c) Assuming the employer dismisses the worker only when it is efficient to do so, what is the efficient level of reliance investment by the worker?
  • (d) Recall the three damage measures for breach of contract that we studied in this chapter. Apply these damage measures to this employment contract setting. Which of these legal rules induce the employer to make efficient dismissals? Which of these legal rules induce the worker to make efficient reliance investment decisions?
  • (e) Explain, with reference to the rule in Hadley v. Baxendale, how you would design efficient unfair dismissal laws. What should be the appropriate goal of such laws - higher employment levels, higher wages, higher profits, or something else? What sort of information would you need to design such laws?
 
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