cueFlash

Decks

Search
Join Mailing List

Glossary of Law &

Economics
Part I
Start Studying! Add Cards

Login / Register
Report a Bug

Request a Feature

Discussion Group

cueFlash > Decks > Law & Economics Part I

Share

Adam owns a Chevy worth $3000 to him.

Deck Info
Blair inherits $5000 and decides to buy
the car from Adam. After inspecting the
Description
car he decides that the pleasure of owning
it is worth $4000 to her. What is the threat Tags
value? Total value of noncooperative
economics
solution? W
law
This is a cooperative game. Threat
Other Decks By This User
value is $3000 for Adam and $5000 for
Sign Language 2
Blair.
SQL Server 7 - DBCC
$8000 noncooperative total.
SQL Server 7 - BCP
Value of Cooperative solution = $4000
SQL Server 7 - Database Options
(value of the car to Blair) + $1500 (the
SQL Server 7 - Session Level Options
SQL Server 7 - Security
amount that Blair retains of her original
Spanish/English Colors
$5000) + 3500 (the amount recieved by
SQL Server 7 - Misc
Adam for the car) = $9000. The
SQL Server 7 - Misc 2
cooperative surplus is $9000 - $8000 =
SQL Server 7 - Locking
$1000
What is threat value?
Payoffs to the parties in the noncoperative solution (value if the bargaining/exchange
failed).
Each player must recieve at least the threat value or there is no advantage to
cooperating.
Adam owns a Chevy worth $3000 to him. Blair inherits $5000 and decides to buy the
car from Adam. After inspecting the car he decides that the pleasure of owning it is
worth $4000 to her. Suppose Adam receives a bid of $3200 from a third party named
Clair
After receiving the bid from Clair, Adam values the car at $3200, which is the
opportunity cost of selling it to Blair. (Recall that opportunity cost is defined as the
value of the next best use, which is, in this case, selling the car to Clair.) Adams
threat value vis--vis Blair is now $3200. The surplus from cooperating with Blair

falls to $800. A reasonable solution is for Blair to buy the car for $3,600, leaving
Adam with $3,600 and no car and Blair with a car worth $4,000 to her and $1,400 in
cash.
Arthur Alleges that Betty borrowed a valuable kettle and broke it so he sues to recover
its value, which is $300. The facts are very confusing. Betty contends that she did not
borrow a kettle from Arthur; even if it is proven that she borrowed a kettle f
a. Arthurs threat value is his expected net gain from trial. Because the value of the
kettle is $300, because he has a 50% probability of winning, and because the trial
will cost him $50, the expected net value of a trial is $300(0.5) - $50 = $100.
b. Bettys threat value is her expected loss from trial. Because the value of the kettle
is $300, because she has a 50% probability of losing, and because the trial will cost
her $50, the value to her of a trial is -$300(0.5) - $50 = -$150 - $50 = -$200.
Inefficiency
The same (or fewer) inputs could be used to produce a greater (or the same) total
output.
Economies of scale
Occur when the cost per unit (or average cost of production) declines as the total
amount of output increases.
Natural monopolies have the falling unit costs at every level of production, even very
large levels. Therefore, a large producer can sell at a lower price than a smaller
producer.
social contract
The result of parties bargaining together over the terms for establishing a
government to recognize and enforce property rights. They are motivated by the
realization that there are economies of scale in protecting property (national
defense vs. private militias).
state of nature
corresponds to the threat values of the noncooperative solution, which prevails if
parties cannot agree.
Transaction costs
Encompass all the impediments to bargaining (ie communication, etc).
1) search costs
2) bargaining costs
3) enforcement costs
Subtract from surplus to get the net value of cooperating.
Coase Theorem
When transaction costs are zero, an efficient use of resources results from private

bargaining, regardless of the legal assignment of property rights.

Corollary: When transaction costs are high enough to prevent bargaining, the
efficient use of resources will depend on how property rights are assigned. (now
care about efficiency of the law)
Suppose that a railroad runs beside a field in which commercial crops are grown. The
railroad is powered by a steam locomotive that spews hot cinders out of its
smokestack. From time to time those cinders land on the crops nearest to the track
and burn t
If transaction costs are zero, then the initial distribution of property rights over land
will not bar the efficient outcome. The efficient solution will be reached whether the
law protects the farmer or allows the railroad to emit sparks. However, if the costs of
bargaining are high, then the efficient solution may not necessarily be reached. One
scenario under which high bargaining costs may exist is when there are a multitude
of actors on either side of the conflict.
Some commentators thought that the Coase Theorem might be true in the short run but
not in the long run. In the example of the farmer and the rancher, changing the use of
fields takes time. For example, to convert a field from graxing land to farmland, t
Think about how short-run contracting differs from long-run contracting. Do the
higher costs in the long-run involve anything other than higher transaction costs?
That is, if the costs of searching, bargaining, and enforcing contracts was zero in the
long-run, then the Coase theorem should still hold.
Invariant Coase Theorem
The invariance principle is a strong version of the Coase theorem and states that
not only does any initial endowment lead to an efficient outcome, but that the same
outcome will be reached no matter what the initial endowment.
endowment effect
the divergence between buying and selling price (the price varies depending on the
initial assignment of ownership).
social norms vs. the law
The formal, legal rules of society are most effective when they are compatible with
the informal social norms of everyday life. Informal norms often arise in situations
where high transaction costs of contracting exist. Instead of relying on government to
lay the ground-rules of economic interaction, people in long-term stable
relationships form rules of the game that are specific to their situation. The loss of
reputation of actors that cheat in a game with repeated play is often a sufficient
enforcement mechanism in long term contracts.
Haggling over price.
bargaining transactional cost
Collecting the monthly payments for the purchase of a car.
enforcement transactional cost

Taking time off work for the buyer and seller to meet.
search transactional cost
Purchasing an advertisement in the "classified" section of the newspaper.
search transactional cost
The buyer asking the seller questions about the car's ignition system.
search transactional cost
Factors affecting the Cost of Transaction.
Lower vs. Higher
1) Standardized good or service VS Unique good or service
2) Clear, simple rights VS Uncertain, complex rights
3) Few parties VS Many parties
4) Friendly parties VS Hostile parties
5) Familiar parties VS Unfamiliar parties
6) Reasonable behavior VS Unreasonable behavior
7) Instantaneous VS Delayed exchange
8) No contingencies VS Numerous contigencies
9) Low cost of monitoring VS High cost of monitoring
10) Cheap punishments VS Costly punishments
Normative Coase Theorem
Structure the law so as the remove the impediments to private agreements.
(Examples: lowering transcational costs to encourage private exchange
Normative Hobbes Theorem
Structure the law so as to minimize the harm caused by failures in private
agreements.
To minimize the resulting harm, the law should allocate property rights to the party
who values them the most. The law makes exchange of rights unnecessary and thus
saves the cost of transaction.
How can the law increase efficiency when transaction costs are positive?
1) Lubricate private exchange by lowering transaction costs (Normative Coase)
2) Allocate rights to the party that values them the most (Normative Hobbes) If rights
were allocated efficiently an exchange of rights would produce a negative surplus
(will not occur).
How do you find out the most efficient outcome for two parties?
When the joint-profits (at each parties together) in that situation are the highest.
injunction
court orders you to stop an activity.
Cooperative surpluse
Joint-profits from cooperation - joint profits from threat value (non-cooperation)
Explain Calabresi's Theory of Transaction Costs.

When there are obstacles to cooperation (i.e., high transaction costs), the more
efficient remedy is the award of compensatory money damages.
Where there are few obstancles to cooperation (i.e., low transaction costs), the
more efficient rememdy is the award of an injunction against the defendant's
interference with the plantiff's property.
Updated version: Where there are few obstacles to cooperation (i.e., low
transaction costs), the more efficient remedy is the award of an injunction when the
plantiff can estimate the defendant's compliance costs more readily than the
defendant can estimate the plantiff's damages.
Public goods
1. Nonrival - consumption doesn't prevent someone else from consuming
2. Nonexclusive - costly to exclude anyone else from enjoying the benefit if one
person does.
free riders
people who do not pay for the consumption of a public good.
When should something be privately owned?
It is efficient for thinks that are rival and exclusive to be privately owned.
When will resources be allocated efficiently?
When obstacles to bargaining are low. Property law fosters voluntary exchange by
removing these.
What can be privately owned?
Private ownership is appropriate when there is rivalry and exclusion of goods
(otherwise should be a public good).
How are ownership rights established?
To share the benefits of increased productivity (discourage theft, reduce the cost of
protecting goods).
What may owners do with their property?
Common law approximates a system of maximum liberty, which allows any use of
property by its owner that does not interfere with other people's property.
What are the remedies for the violation of propert rights?
Injunctive rememdy is preferred for private bads with low transaction costs for
private bargaining. Conversely, the damage remedy is preferred for public bads
with high transaction costs that preclude private bargaining.
Intellectual Property Law
the four principle areas of law create property in information
1) Patent system
2) Copyright system
3) Trademark system
4) Trade secrets

Patent system
establishes ownership rights to inventions and other technical improvements.
Copyright system
grants ownership rights to authors, artists, and composers.
Trademark system
establishes ownership for distinctive commercial marks or symbols.
Trade secrets
deals with business practices in which commerical enterprises have property
interests.
Two characteristics that make transactions in information different from ordinary
private goods.
Nonappropriability and credibility.
nonappropriability
the difficulty or impossibility of enforcing a private property right. non-exclusive
nature of intellectual property leads to an undersupply to the market.
purpose of intellectual property law
one remedy for problem of nonappropriability. Inventor may try to obtain a patent,
copyright or trademark.
rule of first possession.
First in time, first in right. By now there are few opportunites to claim unpossessed
land or water, but rule important for intangible properties, such as inventions.
When will a society privatize a resource?
When the boundary maintence costs less than the waste from overuse of the
resource. Invention of barbed wire lowered boundary costs in the West.
inalienable
something of yours that you cannot lose by specified means (such as sale).
Prohibits exchange even if efficient.
Nuisance
harmful externality
What is property?
A bundge of rights:
1) Posession
2) Use
3) Exclusive
4) Transfer (sell)
Why do we have property rights?
1) Wasted cost trying to exclude
2) More efficient if done by the state
3) Creating rights can give rise to surplus (which can be divided)
What is the benefit of private (not communal) property?

Allows internalized externalities to avoid the "tragedy of the commons".

If fish is a common good, can over-fish to extinction. If you own the pond, you'll bear
the costs yourself, so you will not over-fish and you will take care of the pond.
You bear all the costs and benefits.
What are the costs of private property?
1) Administrative
2) Physical (demarking property)
3) Enforcement (threat of punishment)
When do you create private property rights?
When the MC=MB, when the cost of establishing is not greater than the benefits.
consideration
What the promisee gives the promisor to induce the promise.
The farmer pays $25 to get a grasshopper killer (promised).
reciprocal inducement
promisee gives something to induce the promisor to give the promise and the
promisor sgives the promise as the indcuement to the promisee.
promisor
person who gives a promise
promisee
person who recieves a promise. Promisee induces the promisor to give the
promise with a consideration.
Bargain Theory:
What makes a promise enforceable?
Promises secured by condsideration are enforceable and promises lacking the
consideration are unenforceable.
Nephew who got good grades did not give anything as an inducement for his rich
uncle's round-the-world promise.
Bargain Theory:
What should the remedy for breach of enforceable promises?
Expectation damages - the expected value of the bargain.
Rusty Chevy vs. Cadillac - difference in value between the two.
Farmer - value of the crops destroyed by grasshoppers.
Bargain Theory
Promises are enforceable if consideration. Remedy for breach of enforceable
promise is the expectation damages.
What do enforceable promises do?
Decrease uncertainity and risk (will goods be delivered or paid for).
Describe the agency game in contracts.

First player decides to put assets in control of the second player. The second player
decides whether to cooperate or appropriate. Cooperation is productive (profitable,
surplus from trade). The parties divide the product of cooperation between them, so
both of them benefit. Appropriation is redistributive, benefits the second player at
the expense of the first player.
Enforceable contracts makes cooperation more likely because of damages penalty
for appriopriation.
Contract law enables people to cooperate by converting games with
noncooperative solutions into games with cooperative solutions.
restated - enable people to convert games with inefficient solutions into games with
efficient solutions.
What is the purpose of contract law?
1) enable people to cooperate by converting games with noncooperative solutions
into games with cooperative solutions.
restated - enable people to convert games with inefficient solutions into games with
efficient solutions.
Enforceable contracts makes cooperation more likely because of damages penalty
for appriopriation.
2) encourage the efficient disclosure of information within the contractual
relationship
3) secure optimal commitment to performing.
4) secure optimal reliance.
5) the court should respond to gaps in the contract by allocating obligations
efficiently and adjusting the price reasonably.
6) foster enduring relationships, which solve the problem of cooperation with less
reliance on contracts.
What promises should be enforced?
if both parties wanted it to be enforceable when it was made. They want it
enforceable so that the promisor can credibly commit to performing. A credible
commitment to performing enables the parties to cooperate, and cooperation is
efficient.

Efficiency sometimes requires enforcing a promise even though one of the parties
did not want enforceability when the promise was made (deceiving the other).
Perfect expectation damages
what you would have recieved if the other party did not breach the contract (the
expected value of the bargain). -X party that breeched contract, +X to party that
didn't breach.
Cost of performing is 1.5
Subtract that amount from that parties outcome in a zero cost situation.
What are the implications of breaching contracts?
Not always bad. If the cost of performing for a party is higher than a breech of
contract, then the breech is more efficient. (ideal remedy would be perfect
expectation damages for efficient performance and breach - both parties prefer it).
What is the best damage award for breach of contract?
perfect expectation damages, both parties prefer it and allows for efficient breach of
contract.
What is the affect of incorrectly calculated damages?
Damages below the best level cause the promisor to breach too often, which makes
the promisee reluctant to make a contract. Damages above the best level require
the promisor to perform when it is too costly, which makes the promisor reluctant to
make a contract.
Explain the actual and ideal breach of contracts.
Actual performance and breach by self-interested, short-sighted promisor:
breach if promisor's cost of performing > promisor's liability for breaching
perform if promisor's cost of performing < promisor's liability for breaching
optimal performance and breach:
efficient breach if promisor's cost of performing > promisee's benefit from
performing
efficent to perform if promisor's cost of performing < promisee's benefit from
performing
Reliance
a change in the promisee's position induced by the promise.
(Farmer expanded a barn in anticipation of a good grasshopper killer)
The change increases the promisee's value of performance of contract, but a
breach more costly to the promisee.
Max payoff to both players
Efficiency. Add the sum of each cell and pick the highest one (max payoff to both
players)

Expected net payoff for the parties

Take the sum of a cell (ie both perform contract) and multiply it by the probability of it
happening.
Overeliance
causes excessive harm from breach. The law can discourage overreliance by
limiting recoverable damages. The law should compensate a victim for losses up to
a point equal to the loss from optimal reliance. Consequently, the promisee has a
strong incentive to avoid overrelying.
Explain why compensating the victim of breach for expectation damages causes
efficient performance breach, whereas compensating the victim of breach for
excessive reliance may cause innefficient performance and breach.
if the breachee receives compensation for excessive reliance, then breachees have
an incentive to over-rely, which is inefficient. From the point of view of the breacher,
the liability for excessive reliance by the breachee may induce performance when
breach is more efficient.
ex ante risks vs ex post losses
ex ante - refers to the risk of future losses faced by the parties when they negotiate a
contract.
ex post- refer to the losses that actually materialize after making the contract.
How do you minimize transaction costs of contracts?
cost of allocating a risk > cost of allocating a loss X probability of a loss --> leave
gap
cost of allocating a risk < cost of allocating a loss X probability of a loss --> fill gap
What are imputed terms?
terms to the contract that the parties would have agreed to if they had bargained
over all the relevant risks.
Who is the most efficient risk bearer?
the party with the lowest cost of bearing the risk.
What is contract regulation?
when law disregards or changes terms in a contract.
What is an efficient contract?
Each resource is allocated to the party who value it the most; each risk is allocated
to the party who can bear it at least cost; and the terms of the contract exhaust the
possibilities for mutual gain by cooperation between the parties.
According to the Coast Theorem, parties will negotiate an efficient/perfect contract
when transaction costs are zeo.
When is a contract imperfect?
Parties are irrational or transaction costs are positive.
What are excuses for breaking a contract?
1) duress - dire contraints, forced into contract

2) necessity ($50000 for bottle of water in the desert or you die, don't have to pay
up)
3) impossibility (dire contraint after the promise) - factory burns down so can't fill
order
What are contract transaction costs?
1. spillover
2. information
3. monopoly
When do judges regulate contracts?
the farther the facts depart from the dieal of perfect rationality and zeo transaction
costs, the stronger the case for judges' regulating the terms of the contract by law.
principle vs agent
principle - first player who risks funds
agent - control's the principles funds.
Types of damages
expectation damges - baseline uninjured state is the promisee's position if the
actual contract had been performed
reliance damages - the uninjured state is the promisee's position if no contract had
been made.
Opportunity cost damages - the uninjured stae is the promisee's position if the best
alternative contract had been performed.
expectation > opportunity > reliance
perfect compensation
means a sum of money sufficient to make the victim of an injury equally well off with
the money and with the injury as he or she would have been without the money and
without the injury.
surplus of sucessful negotiation
The sum of a cell with negotiation minus the sum of the cell without negotiation.
How do injunctions affect bargaining?
They favor the party with the injunction, but with low transaction costs, don't affect
efficiency.
Paradox of compensation
1) In order for the injurer to internalize costs, he must fully compensate the victim.
2) In order for the victim to internalize costs, she must recieve no compensation for
her injuries.
3)In private law, compensation by the injurer equals compensation recieved by the
the victim.
4) Therefore, private law cannot internalize costs for the injurer and the victim as

required for efficiency.

Paradox of compensation in contracts law
1) In order for the promisor to internalize the benefits of precaution, he must fully
compensate the promisee for breach.
2)In order for the promisee to internalize the costs of reliance, she must recieve no
compensation for breach.
3) In contract law, compensation paid by the promisor for breach equals
compensation recieved by the promisee
4) Therefore, contract law cannot internalize costs for the promisor and promisee as
required for efficiency.
This predicts that compensating the victims of a breach will cause them to over-rely.
Contract Solutions to the Paradox of Compensation
Efficient incentives often require internalization of marginal costs, not internalization
of total costs.
Sophisticated damages measures cause the promisee to internalize the marginal
cost of reliance, but not necessarily the total cost of reliance (125 profit over-rely,
100 profit normally, damages set at 100).
Damages invarient with respect to reliance:
1)Foreseeable reliance equals the amount the promisor could reasonably expect
the promisee to take in the circumstances (imposes a cap on damages for breach
of contract). If foreseeable reliance equates with optimal reliance, then efficient
incentives.
2) Stipulating an exact amount of damges in the contract is a common mechanism
used to prevent over-reliance.
Foreseeable
A way damages invarient with respect to reliance (can solve over-reliance problem):
Foreseeable reliance equals the amount the promisor could reasonably expect the
promisee to take in the circumstances (imposes a cap on damages for breach of
contract). If foreseeable reliance equates with optimal reliance, then efficient
incentives.
See Hardley v. Baxendale.
How does Hadley reduce transaction costs?
High reliance promisses now want to make the revelation known so that they could
recover higher damges if something goes wrong.
Low-reliance promisees make that revelation so that the contract is a lower price
than the high reliance promisees.
Default rules
fill gaps in contracts in order to reduce transaction costs
Regulations

prescribe terms for contracts to correct market failure.

Incompetence
Competent people must protect the interests of incompetent contractual partners or
assume liability for failing to do so.
The law assigns liability for harm suffered by incompetent contractual partners to the
competent people who can avoid the harm at least cost.
Why have contracts?
cooperative bargaining is productive. Both parties usually expect to gain from the
bargain. Both parties want enforecability to secure a credible commitment to
cooperate (to create surplus to divide).
Duress
types of contrained choice
a dire contraint. Usually involves extracting a promise by a threat, usually
redistributes wealth from one person to the other (one party gains, one party loses).
One party wants enforceability of a coerced promise, and the other does not.
Allocation is inefficient. Failed coercion can destroy (threat to destroy something
valuable to the victim).
A promise extracted as the price to cooperate in creating value is enforceable, and
a promise extracted by a threat to destroy value is unenforceable.
Necessity
types of contrained choice
like duress, a promise given under a dire contraint. Duress is a dire contraint
imposed on the promisor by the promisee, while necessity is a dire contraint
imposed on the promisor by someone other than the promisee (cause could be
promisor, thrid party or bad luck).
With duress, the promisee threatens to destroy by acting. With necessity, the
promisee threatens to destroy by not acting, specifically not rescuing.
Impossibility
types of contrained choice
with duress and necessity, the dire contraint preceds the promise. Sometimes dire
contraint follows the promise and prevents performance.
a contigency destroyed a basic assumption on which the contract was made
(factory would not burn down, painter would live, etc) and make performance
impossible.

if efficient, assigns the liability to the party who can bear the risk that performance
becomes impossible at least cost (risk should be assigned to parties who can take
precautions, sprinklers, to reduce it at least cost).
If a party can't take precautions, then assigned risk to party who can spread it at the
least cost, by insurance or other means.
Frustration of Purpose
type of transaction cost (informational)
default rule to allocate losses caused by contingencies that make performance
pointless.
If a contigency makes performance pointless, assign liability to the party who bear
the risk at least cost.
Mutual Mistake About Facts
type of transaction cost (informational)
Contigency materializes before the parties sign the contract, without them knowing
(forest fire)
If a contigency makes performance pointless, assign liability to the party who could
bear the risk at least cost.
Mutual Mistake About Identity
buyer and seller have different objects in mind, so their "minds do not meet".
No true agreement to exchange. If courts enforced it, it would be involuntary
(destroys value, negative surplus, inefficient)
unilateral mistake
Withhold enforcement from contracts involving involuntary exchange (mutual
mistake), and enforce contracs that reward discovery and unite knowledge with
control.
Productive information can be used to create more wealth (enforcement). In
contrast, redistributive information does not create more wealth (no enforcement).
Information aquired fortuitously (no enforcement) is by chance while information
acquired actively, by investing resources in the acquisition of information is
enforceable.
Which information contacts should be enforced?
Contracts based upon one party's knowledge of productive information - especially

if that knowledge was the result of active investment - should be enforced, whereas
contracts based upon one party's knowledge of purely redistributive information or
fortuitously acquired information should not be enforced.
Enforce most contracts based on difference in mixed information (productive and
redistributive).
Duty to Disclose
Contracts based on the failure to disclose safety information undermine one
purpose of contract law (unite knowledge and control).
When bargaining a contract to a contract, the parties should divulge safety
information.
Fraud and Misrepresentation
If parties to a contract that fraud is a ground for voiding the agreement, then they can
rely on the truthfulness of the information developed in negotiations for the contract.
This saves the parties the cost of verifying material statements, lowering costs of
concluding cooperative agreements.
Fill in Forms: Contracts of Adhesion
standard form contracts indicate the existence of monopoly, which deprives buyers
of bargaining power. However, court practive is unjustified when sellers use
standard-form contracts to increase the efficiency of exchange (reduce product
differentiation and cost of price comparisions AND reduce transaction costs).
procederal unconscionability
consumer ignorant of critical terms in retailer's contract.
Create incentive to communicate meaning of contract terms.
deny enforcement unless bargaining process communicates crucial information.

Add Cards
You must Login or Register to add cards

Facebook Page
Discussion Group

Report a Bug
Request a Feature
Domain Registration (why?)