Economics 1450 Law and Economics Professor Daniel Berkowitz Spring 2005-2006

March 14, 2006

Problem Set 4

The problems are taken from Chapter 5. We will discuss these problems in class on March 21st and I will collect these problems at the end of that class. The exam will be on March 28th.

1. Micelli, pp. 158-160, problems 1-4. 2. How does the Hadley v. Baxendale ruling correct for the moral hazard problem of over-investment in reliance expenditures by buyers in a bilateral contract? 3. How might a commercial impracticability rule which uses damages for breach of contract when costs are sufficiently low (or reasonable) and charges no damages otherwise be used so that the buyer again makes the efficient level of reliance investment? 4. When should the court employ the Hadley v. Baxendale rule over a commercial impracticability ruling a breach of contract case? When should it go a commercial impracticability rule?

Selected Answers to Problem Set IV.

Micelli, chapter 5, problem 1. B = buyer, S = seller, and the contract is for a good that S must produce. V = value of performance to B, R = value of reliance investment to B, P = price (payable upon delivery), and V = $1,000, R = $100, P = $650, and cost is uncertain and can take on one of the three following values: C = {$700, $900, $1,100}. (a) It is only efficient for the buyer to breach the contract when C = $1,100 since this is greater than V = $1,000. (b) Expectation damages are D = V-P = $350, so here the seller only breaches when it is efficient. Under reliance damages, D = R = $100. So, here the buyer breaches when C > P + D = P + R = $750, which includes cost realizations of $900 and $1,000. So, there is excess breaching. Under zero damages, the seller will always breach, since all cost realizations C exceed P = 650$.

Micelli, chapter 5, problem 2. Suppose V is increasing in R:

R V

$100 $400 $200 $550, and P (payable upon performance) = $75.

(a) If the performance of the contract occurs with certainty, then R = $200 maximizes the buyer’s net value of the contract, since 550 – 200 = 350 > 400 – 100 = 300 > P = 75$. (b) In this case, D = 0. If the probability of breach of contract, 1-Pr = 0.5, then the expected returns from R are (0.5)*(V – R – P) + (0.5)(-R) = (0.5)(V-P) – 0.5P:

R = $100 => 0.5(V – P) - R = 0.5*($400 – $75) - $100 = 62.5$ R = $200 => 0.5(V – P) - R – 0.5*($550 - $75) - $200 = 37.5$,

Thus, ignoring damages, the lower reliance investment maximizes the buyer’s expected net return. (c) In the case of unlimited expectation damages, D = V-P for either level of reliance investment. If you check equations (5.7) and (5.8) in the book, this means that the buyers will maximize V – R – P, and choose R =$200. Thus, you get the efficient level of investment under CERTAINTY, which is inefficient (according to (b)) when there is uncertainty.

Micelli, Chapter 5, problem 3. In this case the defendant breached its contract and failed to send the message. The plaintiff sues for expectation damages of $7,000, while the defendant only wants to cover reliance damages of $27, which would cover the plaintiff’s costs of sending the message. The appropriate precedent for deciding this case is Hadley versus Baxendale (see Micelli), and the issue whether the plaintiff is asking for a reasonable level of damages and whether, in fact, the plaintiff over- invested in reliance and did not take into account the not so remote possibility that the code would not go through, say, because the code not be read properly or there was breakdown in systems (the book does not really provide enough information on just how to rule on this).Clearly the defendant is negligent, but the precedent makes clear that the damages awarded must be reasonable and therefore account for the possibility of a breach.

Micelli, Chapter 5, problem 4. V = $2,000 = value of machine to buyer who hires the manufacturer to build the machine for delivery on a particular date. P = $1,500 = price payable upon delivery. P2 = $2,500 = price that a second buyer is offers to pay. (a) From a social perspective, the second buyer should get it because he/she has the higher valuation. (b) Expected valuation damages w.r.t to the first buyer are D = V – P = $500. So, the seller breaches only when C > P + D = V = $2,000, which is the efficient breach condition. (c) Suppose that first buyer is aware of the second buyer’s offer and the two buyers can bargain. Then, the first buyer can simply have the machine built and resell it to the second buyer and pocket the additional $500. In both cases, the second buyers obtains the machine. (d) When there is a cash award, then the seller’s payoff is C – D = C – V = C – 2000$; and the first buyer gets the the resale value of P2 – P = 1000$. In the cash of settlement, the first buyer still get the resale value of 1000$, while the seller now gets P – C = 1,500$ - C. So, the seller is worse-off in the second case while the first buyer does just as well in either case.

2. How does the Hadley v. Baxendale ruling correct for the moral hazard problem of over-investment in reliance expenditures by buyers in a bilateral contract?

Now V(R), where V’ > 0 and V’’ < 0. Suppose that q = the reasonable chance that a contract will go forward, and 1 – q is the probability of a breach. Furthermore, suppose there are expectation damages rule applied for any level of reliance investment: D = V(R) – P. Thus, in this case, the seller breeches a contact if and only if this is efficient: C > V.

The socially optimally level of reliance investment is determined:

Choose R: Max q(V(R) – R – C) + (1-q)(-R) = Max q(V(R) – C) – R, so that

R* solves qV’(R) – 1 = 0 (you can show this using a graph, and just how this condition determines and R* that is lower than the condition V’(R) – 1 = 0.

Hadley-Baxendale, then, chooses R* that account for uncertainty and gives expectation damages to the plaintiff for R*” D(HB) = V(R*) – P.

In this case, then the potential plaintiff would choose R:

Max q(V(R) – R – P) + (1-q)(D(HB) – R)

Plug in for D(HB) and rearrange:

Choose R: Max q(V(R) – P) – R – (1-q)(V(R*))

Thus, R is chosen: qV’(R) – 1 = 0, and so efficient reliance investment is achieved!

Note that if expectation damages are awarded for any R, then the potential plaintiff maiximzes: q(V(R) – R – P) + (1-q)(D – R) = q(V(R) – R – P) + (1-q)(V(R) – R – P) =

(V(R) – R – P), and so the plaintiff would choose very upper end reliance: condition V’(R) – 1 = 0

3. See Micelli, pp. 142-144. The idea then is that there are 3 cost levels: 0 < cL < cM < cH, and 0 < cL < P < cM < V < cH. So, in this circumstance, it is socially efficient for the seller to breach when c = cH. When there are no damages (D=0), the seller breaches, however, when c = cM or cH on the grounds of commercial impracticability. Suppose that any cost outcome is equally likely: 1/3 = pr(cL) = pr(cM) = pr(cH). Then, the seller will breach 2/3rds of the time, but it is only socially efficient to breach 1/3 of the time. Suppose expectation damages are employed: D = V – P. In, this case, it is straightforward to show that seller will only breach 1/3 of the time (when c = cH). While this damage award then gets the seller to breach efficiently, it still creates the incentive for the buyers to over- invest in reliance investment. In particular, 1/3 of the time the seller breaches and so the buyer should choose R: Max 2/3(V(R) – P) – R, but with unconstrained expectation damages, the buyer chooses: Max V(R) – R – P, and over-invests. So, here we need some variation of expectation that implements both efficient breach and efficient reliance investment. The commercial impracticability rule does this by providing expectation damages at costs where contract enforcement is efficient (i.e. V > ci, for all i) and providing no damages when breach is efficient. In this case, then, D = V – P, for cL and cM, and D = 0, for c = cH. Thus, now the buyers chooses R: Max 2/3(V(R) – R – P) + 1/3(D – R). Note that 2/3 of the time the contract goes through so damages are irrelevant. The other 1/3 of the time, there is a socially efficient breach because c = cH > V, and D = 0. Thus, the buyer chooses R: Max Max 2/3(V(R) – R – P) - 1/3( R), and R is solved efficiently: 2/3V’(R) = 1. 4. This depends upon just which rule is easier for the court to implement. Choose HB when it is easier for the court to choose appropriate R and just how this affects V (value added). Choose commercial impracticability when it is easier for the court to choose threshold level costs at which breech is efficient: ci > V.