Contract•Designing contracts

–A common interest in efficient contracts–How to make a contract efficient

•Enforcing and interpreting contracts–What contracts should be enforced?

•The case for freedom of contract•The problems of duress

–How to fill in the blanks in interpreting contracts–Preventing opportunistic breach

•By contract design•By reputational enforcement•By legal penalties for breach

–Permitting efficient breach

Designing Contracts• Parties have a common interest

– In maximizing the size of the pie– And can then argue over dividing it– Since any change that produces net benefits

• Can be combined with a change of price• That makes it beneficial to both sides

• We maximize the pie by– Making it in the interest of each party to make those choices – That produce the largest total benefit for the parties, which we do– By making the chooser bear costs and receive benefits of choice– And constraining his choice when we can’t.

• A strategy constrained by– What people know

• Are these windows of good quality?• Bought at a good price?• How costly would it be to do better in either dimension?

– And what they can observe– And control

Applies to all Dimensions

• What happens if one party breaches• Allocation of risk between the parties

– Who do we want to give the incentive to prevent to? Moral Hazard

– Who best knows the risk? Adverse selection– Who can best spread the risk? Risk aversion

• Fixed price vs cost vs cost plus …– Fixed price for building your house– Gives contractor an incentive to keep down costs– Also to reduce quality if he can get away with it– So fixed price if quality is easily specified and enforced

• …

What contracts should be enforced?• Why not simply enforce all contracts as

written?– Court may wish to impose its preferences– Court must decide if there is a contract and

what it says– Court must fill in the blanks

• Case for freedom of contract– Parties want an efficient contract, and– Using ambiguity to impose court’s preferences– Leads to writing longer contracts– So fill in blanks with what parties would have

agreed to.

Case Against Freedom of Contract• Monopoly

– In the simple case, the argument still holds, but …– There may be terms that increase monopoly profit but …– On net make the parties worse off. How?

• “Unequal bargaining power”– Leads to efficient contracts, with prices favoring the party in a strong

position– Courts are poorly suited to redistribute income– Lost in the desert. My life’s earnings for water?

• Odd case where unlimited freedom of contract• Increases the price I can pay, which • Hurts me in a bilateral monopoly bargain

• Real Duress– Your money or your life– Case for and against enforcing the contract

• Less Real Duress: Bargaining for a tow on a sinking ship

Real Duress• Mugger

– “$100 or I’ll kill you”"Will you take a check?"Should I be able to stop payment?

• Tradeoff– If the contract is enforceable, I get out alive, but …– Mugging is more profitable, so …– More likely to happen

• In some cases, the first effect might be the more important– Prisoner giving his parole in wartime, or – A peace treaty to end a war

The sinking ship case• $10,000,000 ship, $100,000 to save it

• Bilateral monopoly bargain

• Price that gives the right incentive to save?– $10,000,000. Tug gets the full benefit– And so will bear any cost to increase the chances

of saving that is worth bearing

• Price that gives the right incentive to avoid needing a tug?– $100,000– The cost the ship imposes when it starts sinking

somewhere where a tug can save it

Right rule for sinking ships?• We have been here before

– Coasian double causation– The gain from saving a sinking ship– Is jointly produced by ship owner’s risk and– Tug’s expenditures on being there to save

• Put the incentive where it does most good– Mostly on the tug if his supply is elastic (high price)– Mostly on the ship if his is (low price)

• Freedom of contract?– No reason to expect the efficient result– Bilateral bargaining with large range is costly– Let admiralty court decide “fair price?”

In a Fully Coasean world• We can optimize on both margins

– Tug boat pays the ship to take risks– Ship pays the tugboat to be there if needed– Two parties bargain to the efficient outcome

• Research project– Look at the actual market for salvage– To see if contracts in advance– Solve these problems– Bilateral monopoly bargain costs perhaps

solved by preagreed salvage rates?

Water in the Desert Again

• Price=value of my life– Gives him the right incentive to be out in the desert

with water to give people dying of thirst, but …– Gives me too much incentive to be careful not to get

into that situation

• Just like the tugboat case

Contracts of Adhesion• Fancy name for form contracts

– Suggests they are illegitimate, since– Not bargained– But the economic argument doesn’t require bargaining

• Three models of control– Democracy– Fighting: The bargaining process– markets

• Consider the virtues of competitive dictatorship– The arrangement we use for hotels, restaurants– I have no vote in how they are run, – Don’t bargain over the menu, but – Absolute control on whether I buy their services

Why use form contracts?

• To save costs– With millions of customers, takes a lot of

lawyers– To bargain a contract for each

• To control employees– If the Avis desk clerk can set the rate– How do you keep him from taking bribes?

• Why not?– Argument for efficient terms still holds– Since you have to get the customer to sign

If We Accept Freedom of Contract• The problem of interpreting contracts• Is the same as the problem of designing them• Find out what terms maximize the summed

gain– Write them if you are a party– Add them if you are a court filling in blanks

• For instance: Risk allocation– Who can best prevent: Moral hazard.

– Who best knows: Adverse selection

– Who can best spread the risk

– All of these are both drafting issues and filling in the blanks issues

Himalayan photographer• I spend $100,000 photographing in the

Himalayas– Come back, drop off my film at Walmart– Which loses or spoils it– Should they be liable for the loss?

• Being liable makes them very careful, but …– How careful do we want them to be– With another customer’s pictures of his dog?

• What we want is the right incentive

• What would Coase say about this problem?

More Reasons Not To Enforce• Third Party Effects

– Parties maximize their summed gain– Ignore gains or losses to others, so …– We don’t enforce

• Performance contracts for assassins• Contracts not to testify in court (except …)• Cartel agreements (in the U.S.)

• Contracts by “irrational” parties– Children or …– The insane– Or, at one time, women

• A fine line between protecting people and• Restricting them

Breach• Preventing opportunistic breach

– By contract design– By reputational enforcement– By penalty

• Permitting efficient breach– Either by special casing it, or – Pigouvian tax, aka– Expectation damages

• Efficient incentives for choices affected by the risk of breach– Whether to sign the contract– How much to rely on the other party’s performance

Contract design• Opportunistic breach happens because

– At some point in the process, one side– Is better off stopping, keeping what it has– Than going on to completion

• I hire you to build a house on my property– If I pay you at the beginning, it is in your interest to take the

money and run, if you can get away with it.– If I pay you at the end, it is in my interest to keep the house and

not pay– So I pay you in installments during the construction– Arranged so there is no point at which either of us gets a large

benefit from breach• Problem: We can’t perfectly predict the pattern of costs

– One solution: Increase the net cost of breach– By creating hostages--damage to one party– Not matched by gain to the other– For details, see my “China to Cyberspace”

Reputation• A lot of contract enforcement is

– Via reputational penalties– Repeat dealings with one customer– Or prospect of dealings with others he knows

• This requires two conditions– Cheating once doesn’t gain enough to make it worth losing

future opportunities– Interested third parties can find out you cheated at low cost– If they cannot, victim doesn’t report you, since third parties

won’t know which one was at fault

• Ways of creating those conditions– Post a bond for the first– Use arbitration to lower information cost to third parties

• They don’t have to know the facts of the dispute, just• That the arbitrator you agreed to says you are wrong

Expectation Damages• Make the other party as well off as if no breach

• Correct incentive to breach, but …

• What about reliance expenditure?– I can produce a million widgets at $2.10/widget– Or retool for a million dollars, produce at $1/widget– But if you cancel your order, my million is down the

drain

• Too much incentive to rely, since– If you breach, my reliance expenditure is wasted– But you have to compensate me for it– And I am the one deciding whether to make it.

Reliance Damages

• Make the other party as well off as if no contract

• Too much incentive to breach– Since breaching party does not have to

compensate– The other party for its lost profits

• Too much incentive to rely, since– If you breach, my reliance expenditure is wasted– But you have to compensate me for it– And I am the one deciding whether to make it.

Adverse Selection

• So to solve the adverse selection problem– We should put the cost to us due to breach on me– Now you don’t care--and I know.

• Something might happen that will make it in your interest to breach your contract with me– Unfortunately, you don’t know how likely it is– And I do

• If you will be liable (expectation or reliance)– My willingness to sign doesn’t depend on the

probability– Yours does--but you don’t know the probability– And I have an incentive to pretend it’s low

Liquidated Damages

• Could make the other party as well off as if no breach– If the amount can be estimated in advance– In which case there is

• Correct incentive to breach

• Correct incentive to rely, since– My compensation doesn’t depend on whether I

relied– So any wasted reliance reduces my net

One Sided Contracts

• I offer a $100 reward for my lost cat– You find the cat, return it to me– Next day you notice a reward sign, ask for the money– I reply that there was no contract, since you never accepted it– A contract is supposed to require a meeting of minds

• What is the effect of holding that such an offer is binding?– More incentive to return lost cats

• if you don’t know whether there is a reward• You still know that if there is one, you can collect it. But …• The probability that there is one depends on how often rewards are offered• And …

– The cost of offering a reward is higher• Since you may have to pay people who didn’t see the sign first• So fewer offers

– So the net effect could be more lost cats returned or fewer

• Either way, how do we decide if the effect is good or bad?

PS: Speculation and Fraud• Is it fraud if I

– Sign a contract when I know things– That you don’t know and– If you knew, you wouldn’t sign?

• Eliminates the usual argument that – Contracts should be enforced because they benefit both

parties– Looks like rent seeking, but

• Lets me gain by generating valuable information– Speculation prevents famine– But the speculator’s gain does not measure the social

benefit– So we might get too much or too little speculation– What we want are not “incentives” but “the right incentives.”

Dealing with People Online• The technology makes it possible to combine anonymity and

reputation– Public key encryption as a way of maintaining anonymity

– And digital signatures as a way of proving identity• Either your realspace identity, or …

• Your cyberspace identity

• I.e. that you are the online persona with a particular reputation.

• My legal eagle business plan

• For quite a lot of people, anonymity might be a plus– Lets you opt out of the state legal system—which contracts often try to do.

– Protects you in places where security of property is low• Do you want to be a programmer known to be making $50,000/year

• In China, or Burma, or Indonesia, or …

• You might be worried about either private seizures—kidnapping your kids, say

• Or public ones.

– Might let you evade taxes or regulations at home.

Reputational Enforcement• If it is hard to know which party to a dispute is telling the truth

– Interested third parties will distrust both—either might be lying– So it isn't in your interest, when cheated, to complain– So reputational enforcement doesn't work

• Arbitration is a way of lowering the information cost to third parties– If we went to a respected arbitrator, or one we agreed on advance– And he ruled in my favor, and you didn't go along– You are probably the bad guy

• Cyberspace version– We agree to a contract, both digitally sign it. Contract includes the public key of

the arbitrator we agree will rule on disputes– You think I’m cheating, submit the case to the arbitrator– He rules that I owe you $5000. If I don’t pay– He writes a statement about my renegging on my agreement, signs it, gives it to

you– You post it and the signed contract somewhere with my name all over it, so

anyone interested in me will find it– And, by checking that I signed the contract and the specified arbitrator signed

the verdict, will know I agreed and renegged.

Solutions• In a world of certainty we ought to be able to structure payment and performance to

prevent breach– In an uncertain world, where costs and benefits may change, it's hard– We can reduce my incentive to breach by my giving you a deposit – But that increases my incentive to breach

• One solution is to use a hostage instead of a deposit– I give you something—my son, my trade secret—that

• it costs me a lot to lose• but benefits you only a little to keep

– Which pushes down my benefit from breach a lot, yours up a little

• Another is to put the incentive to breach on the party who has reputational reasons not to– You are going to do some work for me online—write a program, say

• If you are a repeat player with reputation, I pay in advance• If I am, I pay for the program when it is delivered

– Arguably, this explains the one sided nature of many real contracts• It is in the interest of both parties to avoid expensive litigation• The seller is a repeat player with a reputation, the buyer is not• So substitute reputational enforcement for court enforcement

Other Ways of Not Needing Courts• If you don’t have reputation, rent someone’s

– I pay money to an escrow agency, you give them the goods

– I inspect the goods. If they live up to their description

– The agency gives me the goods, you the money

– We don’t need a reputation--the agency does

• So far as possible, arrange the contract so that the result you want is the one that happens with no court intervention– Caveat emptor is an example

– More generally, combine possession, ownership and responsibility• The property becomes mine when you hand it over to me

• After which I have no claims against you for what happens to it

• Or what it is