George Mason School of Law Contracts I C

George Mason School of Law Contracts I C. Bargaining Gains F. H. Buckley fbuckley@gmu. edu 1

Asset Purchase Agreement o This Agreement (the “Agreement’) is entered into as of the ___ day of September, 2017, between Sehler Inc. (“Sehler”), a corporation incorporated under the laws of ____, located at _____, and Beyer Inc. (“Beyer”), a corporation incorporated under the laws of ______, located at ______. 2

Who signs for the parties? o And how do you know who they are? 3

Theoretical Introduction 1. Last day: Benthamite utilitarianism and the economic case for contract enforcement 2. Is that all there is? 4

Benthamite Principles Jeremy Bentham 5 Sir George Jessel

Today 1. Contract Law as a solution to the threat of defection in PD Games 2. Coasian bargains and trust 3. Modeling Bargaining gains: a. Detrimental and Beneficial Reliance b. Edgeworth Box Function 4. Defining Efficiency Criteria 6

Getting to Cooperation in PD games Player 2 Player 1 7 Cooperate Defect Cooperate 3, 3 -1, 4 Defect 4, -1 0, 0

Defection dominates for Player 1 Cooperate Player 1 Defect 8 Cooperate Defect 3 -1 4 0

Defection dominates for Player 2 9 Cooperate Defect Cooperate 3 4 Defect -1 Player 2 0

The game’s “solution” Player 2 Cooperate Defect 10 0

Two kinds of PD problems o Sins of commission n Overfishing n Excessive pollution 11

Two kinds of PD problems o Sins of omission n Failure to exploit bargaining gains o Eg. Dueling, war 12

Two kinds of PD problems o Sins of omission n Failure to contribute to public goods (External benefits plus beneficiaries can’t be excluded) o o o 13 National Health? Education? National Parks? Films on the Internet? Online magazine content?

Getting to Cooperation in PD games o So what do we do about that? n A governmental solution n Maybe it’s not so bad after all… n A Coasian solution 14

Getting to Cooperation in PD games o A government solution: Let the state enforce cooperation n Boston Commons n environmental laws n taxation and national defense 15

Getting to Cooperation in PD games o Maybe it’s not so bad after all… n De minimis non curat lex n The private provision of public goods o E. g. , wikipedia, volunteer firemen 16

Getting to Cooperation in PD games o A Coasian solution n Cut a deal 17

But what if contracts aren’t enforced: The “Market for Lemons” o Akerlof, The Market for Lemons, 84 Q. J. Econ. 488 (1970) 18

Let’s say you want to buy a 1956 Ford… 19

Promises without contract law o Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5, 000 (“beauts”) 20

Promises without contract law o Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5, 000 (“beauts”) o The seller tells you it’s a beaut 21

Promises without contract law o Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5, 000 (“beauts”) o The seller knows which kind of car he has but you can’t tell them apart 22

Promises without contract law o Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5, 000 (“beauts”) o The seller knows which kind of car he has but you can’t tell them apart o What would you pay for one? 23

Promises without contract law o Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5, 000 (“beauts”) o The seller knows which kind of car he has but you can’t tell them apart o The trick: Seller’s willingness to sell is a signal n Akerlof, The Market for Lemons, 84 Q. J. Econ. 488 (1970) 24

Promises without contract law o Of the 1956 Fords, half are worth nothing (“lemons”) and the other half are worth $5, 000 (“beauts”) o The seller knows which kind of car he has but you can’t tell them apart o Question: Is the seller satisfied with this result? 25

So why do lemons markets exist? o Craigslist ad: 1956 Ford Fairlane – 1956 ford customline - $6000 (Riverdale) Good condition! Brand new interior seats and door panel Posted 14 days ago 26

Craigslist on the subject of lemons o Offers to ship a vehicle are virtually 100% fraudulent o Never use Western Union or wire transfer to pay for goods - only a scammer will ask for this, and any funds sent will be lost o Do not buy vehicles sight-unseen, regardless of low price. The vehicle does not exist, and any money you send will be lost. o Stories about divorcees or departing servicemen needing to sell quickly at a low price are generally fraudulent 27

So why do lemons markets exist? 28

So why do lemons markets exist? o Sometimes one doesn’t need a warranty. n One can verify the quality of the goods 29

So why do lemons markets exist? o Sometimes one doesn’t need a warranty. n Discounted prices 30

But that apart, a trust problem 31

Promising as a Problem of Trust o Promisor wants to persuade promisee to trust him o To do so, promisor must be able to make a credible commitment not to defect 32

Hobbes on Bare Promises Hobbes, Leviathan 14. 18 (1651) 33 o If a covenant be made wherein neither of the parties perform presently, but trust one another, in the condition of mere nature (which is a condition of war of every man against every man) upon any reasonable suspicion, it is void… o For he that performeth first hath no assurance the other will perform after, because the bonds of words are too weak to bridle men's ambition, avarice, anger, and other passions, without the fear of some coercive power; which in the condition of mere nature, where all men are equal, and judges of the justness of their own fears, cannot possibly be supposed. And therefore he which performeth first doth but betray himself to his enemy.

Contract Law as a solution Leviathan 34

Contract Law as a solution o Suppose that the defector is penalized through sanctions so that the incentive to defect disappears. 35

PD games before Contract Law Player 2 Player 1 36 Cooperate Defect Cooperate 3, 3 -1, 4 Defect 4, -1 0, 0

PD Games after damages for breach Player 2 Player 1 37 Cooperate Defect Cooperate 3, 3 2, -3 Defect -3, 2 0, 0

What is collectively rational is now individually rational Player 2 Player 1 38 Cooperate Defect Cooperate 3, 3 2, -4 Defect -4, 2 0, 0

So why do people fail to contract? 39

So why do people fail to contract? o Illegal contracts o Eg. Divorce waivers, security interests in consumer goods 40

So why do people fail to contract? o Illegal contracts o Transaction cost barriers o o 41 Information processing problems Too many parties Emergencies Agent misbehavior

So why do people fail to contract? o Illegal contracts o Transaction cost barriers o Rule of Law Problems n Imperfect enforcement in corrupt countries n Or countries with inefficient enforcement mechanisms 42

Transparency International Corruption Perceptions Index 43

Corruption and the rule of law Deputy Mayor of Moscow Vladimir Resin sporting a $360, 000 wristwatch 44

Country corruption and NYC parking tickets for UN diplomats Source: Raymond Fishman and Edward Miguel, Corruption, Norms and Legal Enforcement: Evidence from Diplomatic Parking Tickets, 115 Journal of Political 45

Modeling Bargaining Gains o o o 46 Indifference Curves The Budget Line Consumer Choice Beneficial Reliance The Edgeworth Box Function Pareto-Superiority and Pareto. Optimality

Two dimensional Commodity Space: Every point represents a combination of the two commodities Y axis Commodity y 0 47 Commodity x X axis

Two dimensional Commodity Space: Every point represents a combination of the two commodities Y axis Y* 0 48 • A X* X axis

The Commodities: Dollars in Two Time Periods Dollars in Time 1 Y* 0 49 • A X* Dollars in Time 2

Commodity space: Dollars consumed in two time periods Dollars in Time 1 More of both 0 50 Dollars in Time 2

The Budget Line: Allocating $100 between two periods Dollars in Time 1 100 The budget line in red represents every trade-off of $100 in two periods 0 51 100 Dollars in Time 2

Two different time preferences (Which is right? ) 52

The Budget Line: Allocating $100 between two periods Dollars in Time 1 100 Grasshoppers Ants 0 53 100 Dollars in Time 2

Indifference Curves: Preferences about Consumption Dollars in Time 1 An indifference curve represents a set of trade-offs to which the subject is indifferent 0 54 Dollars in Time 2

Subject is willing to give up $BC in Time 2 for $AB in Time 1 Dollars in Time 1 A B 0 55 C Dollars in Time 2

A C: Subject is willing to give up $BC in Time 2 for $AB in Time 1 Dollars in Time 1 A B 0 56 C Dollars in Time 2 = “is indifferent to”

Indifference Curves: Preferences about Consumption Dollars in Time 1 Convexity (curve bends inward) assumes decreasing marginal utility 0 57 Dollars in Time 2

Decreasing marginal utility: We’ll always want more, but will enjoy each new scoop less and less 58

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Indifference Curves: Preferences about Consumption Dollars in Time 1 One is better off the further one gets from the origin 0 60 Dollars in Time 2

More is better: I 2 > I 1 Dollars in Time 1 More is better I 2 I 1 0 61 Dollars in Time 2

Ordinal Utility: We can’t say how much better I 2 is than I 1 Dollars in Time 1 I 3 I 2 I 1 0 Dollars in Time 2 62

Ordinal Utility: We can’t say how much better I 2 is than I 1 Ordinal numbers: First, second, third 63

Ordinal Utility: We can’t say how much better I 2 is than I 1 Ordinal numbers: First, second, third Cardinal numbers: 1, 2, 3 64

Consumption Decision: Uncle Ebenezer gives David $100 Time 1 100 I 1 I 2 I 1 I 3 0 65 100 Time 2

Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line Time 1 100 50 I 1 I 2 A I 2 I 1 I 3 0 66 50 100 Time 2

Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line Time 1 100 I 1 I 2 A 50 B I 2 I 1 B is not optimal I 3 0 67 50 100 Time 2

Consumption Decision: David has $100 and is best off at A Maximization subject to the constraint of the Budget Line Time 1 100 I 1 I 2 C C is not feasible A 50 B I 2 I 1 B is not optimal I 3 0 68 50 100 Time 2

Ebenezer gives David another $100: The Shift to a New Budget Line 200 I 100 50 69 0 A 50, 50 100

A new Consumption Decision Time 1 B 100, 100 I 200 50 A 50, 50 IDR 0 70 50 100 I 100 Time 2

A new Consumption Decision We didn’t have to end up at 100, 100. I just like round numbers … Time 1 B 100, 100 I 200 50 A 50, 50 IDR 0 71 50 100 I 100 Time 2

What happens when the donor promises to give in the future? o Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period o What Should David Do? 72

What happens when the donor promises to give in the future? o Uncle Ebenezer doesn’t have the $100 to give today but promises to give it to David in the next period o David’s election: to rely or not to rely on the promise in the first period 73

But now Uncle Ebenezer comes along: David’s election 74 t 0 Ebenezer t 1 David t 2 Ebenezer makes promise relies performs doesn’t perform doesn’t rely performs doesn’t perform

Four possibilities David Relies Performs Ebenezer Doesn’t Perform 75 Doesn’t Rely

The good scenario: David relies and Ebenezer performs David Relies Performs Ebenezer Doesn’t Perform 76 Doesn’t Rely

The good scenario: David relies and Ebenezer performs 200 B 100, 100 Reliance by David means he spends $100 of his own money in period 1 in the expectation he’ll get another $100 in period 2 I 200 50 A 50, 50 I 100 0 77 50 100 200

The good scenario: David relies and Ebenezer performs 200 Because Ebenezer performs, David has another $100 to spend in period 2 B 100, 100 I 200 50 A 50, 50 I 100 0 78 50 100 200

A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches David Relies Performs Ebenezer Doesn’t Perform 79 Doesn’t Rely

A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches David spends 100 in period 1 and because Ebenezer breaches David has nothing left to spend in period 2 Time 1 C 100, 0 D 50 B 100, 100 A 50, 50 I DR 80 0 50 100 I 100

A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches What do we need to give David to make him as well off as he would have been had the promise been performed? Time 1 C 100, 0 D 50 B 100, 100 A 50, 50 I DR 81 0 50 100 I 100

A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches Time 1 The Expectation Interest is CB, or $100 C 100, 0 D 50 B 100, 100 A 50, 50 I DR 82 0 50 100 I 100

A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches What do we need to give David to make him as well off as he would have been had he not relied? Time 1 C 100, 0 D 50 B 100, 100 A 50, 50 I DR 83 0 50 100 I 100

A bad scenario: Detrimental Reliance: David relies and Ebenezer breaches Time 1 The Reliance Interest is CD, or about $25 C 100, 0 D 50 B 100, 100 A 50, 50 I DR 84 0 50 100 I 100

Fool me once…: Non-reliance: What does David do if he assumes Ebenezer will breach? Time 1 100 50 I 1 B I 1 0 85 50 100 Time 2

Fool me once…: Non-reliance: David assumes Ebenezer will breach Time 1 100 50 Now David spends only $50 in period 1, and has $50 left over for period 2 I 1 B I 1 0 86 50 100 Time 2

David doesn’t rely and Ebenezer doesn’t perform David Relies Performs Ebenezer Doesn’t Perform 87 Doesn’t Rely

No harm, no foul? David Relies Performs Ebenezer Doesn’t Perform 88 Doesn’t Rely

But now suppose Ebenezer performs Time 1 100 50 I 1 B I 1 0 89 50 100 Time 2

David doesn’t rely, Ebenezer performs David Relies Performs Ebenezer Doesn’t Perform 90 Doesn’t Rely

Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs Where David is on Ebenezer’s performance 100 I 200 E 150, 50 50 David spends only 50 in period 1 91 Inoreliance 0 100 Goetz and Scott, 89 Yale L. J. 1261 (1980) 150

Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs Where David would have been had he relied 100 B 100, 100 I 200 E 150, 50 50 David spends only 50 in period 1 92 Inoreliance 0 100 Goetz and Scott, 89 Yale L. J. 1261 (1980) 150

Loss of Beneficial Reliance: David doesn’t rely and Ebenezer performs 100 B 100, 100 I 200 E 50 150, 50 Inoreliance 0 93 100 Goetz and Scott, 89 Yale L. J. 1261 (1980) 150

To Review… David Relies Performs Ebenezer Doesn’t Perform 94 Doesn’t Rely

Scenario I: David doesn’t rely and Ebenezer doesn’t perform David Relies Doesn’t Rely Performs Ebenezer Doesn’t Perform 95 David spends $50 now, $50 later (No Harm, No Foul)

Scenario II: David Relies and Ebenezer Performs David Relies Performs Ebenezer Doesn’t Perform 96 David spends $100 now, $100 later Doesn’t Rely

Scenario III: David relies and Ebenezer breaches David Relies Performs Ebenezer Doesn’t Perform 97 David spends $100 now, 0 later (Detrimental Reliance) Doesn’t Rely

Scenario IV: David doesn’t rely and Ebenezer performs David Relies Performs Ebenezer Doesn’t Perform 98 Doesn’t Rely David spends $50 now, $150 later

Modeling the Bargaining Game David Relies Performs Ebenezer Doesn’t Perform 99 Beneficial Reliance Doesn’t Rely

The problem of trust David Performs Ebenezer Doesn’t Perform 100 Relies Doesn’t Rely Beneficial Reliance Loss of Beneficial Reliance

Enforceable Contracts provide the gains associated with beneficial reliance 101

David is better off because he relied and Ebenezer is better off because he had a charitable motive 102

How are two people made better off when they exchange goods? 103

How are two people made better off when they exchange goods? After the bargain, same horse, same cow 104

Aristotle on Corrective Justice Does this assume zero-sum bargaining? • These names, both loss and gain, have come from voluntary exchange; for to have more than one's own is called gaining, and to have less than one's original share is called losing, e. g. in buying and selling and in all other matters in which the law has left people free to make their own terms; but when they get neither more nor less but just what belongs to themselves, they say that they have their own and that they neither lose nor gain. • Therefore the just is intermediate between a sort of gain and a sort of loss, viz. those which are involuntary; it consists in having an equal amount before and after the transaction. 105

Modeling a Bargain: Two Commodities: Mums and Roses Mums 0 106 Roses

Modeling a Bargain: Two Bargainers: Mary and Bess Mums Good Queen Mary 0 107 “Bloody” Bess Roses

Two bargainers Mums Mar y 108 Roses Bess Roses

Rotating Bess’s diagram I Mums Roses Bess Mary 109 Roses

Rotating Bess’s diagram II Mums ms u M Mary 110 Roses s se o R ss Be

Rotating Bess’s diagram III Mums Ros es Mary 111 Roses Mums Be ss

Rotating Bess’s diagram IV Roses Mums Bess Mary 112 Roses Mums

Rotating Bess’s diagram V Mums 0 Roses Mums 0 113 Bess Mary Roses

Edgeworth Box Function: Bargaining from endowment point A 0 A Mary 114 0 Bess

Edgeworth Box Function: Bargaining from endowment point A 0 Bess Rosesbess Mumsmary A Rosesmary 115 Mary 0 Mumsbess

Edgeworth Box Function: Bargaining from endowment point A 0 A 116 Mary 0 Bess

The Edgeworth Box Function permits us to define Efficiency Standards o Pareto-superiority o Pareto-optimality 117

Efficiency (Paretian) standards Vilfredo Pareto (1848 -1923) o Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off o Pareto-optimality: No further Paretosuperior transformations are possible 118

Pareto-Superiority B and C as Pareto-superior to A D and E as Pareto-inferior A E D C B Mary Coleman, 8 Hofstra L. Rev. 905 (1980) 119 Bess

Are all bargaining gains exploited at F? The bargaining “lens” shrinks through bargaining Bess A D Mary 120 E F B C

The bargaining “lens” shrinks through bargaining Bess A E F D Mary 121 B G C

Pareto Optimality At G no further Pareto-superior transformations are possible Bess A E F D Mary 122 B G C

The Contract Curve G is a point of tangency of the two sets of indifference curves Bess A E F D Mary 123 B G C

The Contract Curve All possible Pareto-optimal contracts at the points of tangency Bess A E D Mary 124 F B G C

Efficiency (Paretian) standards Vilfredo Pareto (1848 -1923) • Pareto-superiority: A transformation from A to B is Pareto-superior if at least one person is better off and no one is worse off • Pareto-optimality: No further Paretosuperior transformations are possible 125