ECO320H1 Chapter Notes - Chapter 8: Longrun, Decision Rule, Ex-Ante

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23 Nov 2014
ECO 320
Textbook Notes
Chapter 8: An Economic Theory of Contract Law
The bargain theory of contracts set forth the bargain principle, which states when
contracts should be enforceable.
oA promise is legally enforceable if it is given as part of a bargain;
otherwise, a promise is unenforceable.
Bargaining is a dialogue on value to agree on a price.
oThe dialogue has three elements:
It is what is given to the promisor by the promisee to
induce the promise.
Consideration may be monetary, in goods, in services, or
may be another promise.
The promisee gives something to induce the promisor to
give the promise, and the promisor gives the promise as
inducement to the promisee.
Without consideration, a promise cannot be enforced.
The promise to give a pure gift, which is not induced by the promise of something
in return, is not enforceable under the bargain theory.
Without a “meeting of the minds”, there is no offer and no acceptance, just a
failure to communicate.
oI.e. you offer to sell something and I accept to buy something else.
The bargain theory holds that courts should determine whether a bargain
occurred, not inquire into whether the bargain was fair.
oIf later on you claim that the promise is unfair, the courts will not enforce
it if you bargained for the terms (i.e. you chose the terms so it is your
Extremely one-sided bargains may not be enforced.
oA fair promise is one whose value of consideration is equal in value to the
If courts were only to enforce fair contracts, courts would be forced
to determine the value of consideration/promises for everyone,
which involves a lot of subjectivity.
I.e. you are unlikely to tell the court the true value of
something to you and different people value certain things
relatively more/less than others.
The bargain theory suggests the remedy for a breach of contract is to give the
promisee the benefit of the bargain.
oIn other words, the promisee should be given the benefit he or she would
have obtained from performance of the promise.
It is what can be reasonably expected from performance.
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oAka expectation damages.
Counterfactual values are difficult to compute.
oI.e. hard to establish the value one places on a car.
The bargain theory is not always what is followed in courts.
oIn certain situations, both parties want a promise to be enforceable,
however, under bargain theory, they are not due to a lack of consideration.
I.e. in the case where a dealer agrees to sell a car for $X if the offer
is accepted within a week
the buyer doesn’t want to waste
time thinking about the offer if it can’t be enforced and the seller
wants the offer enforced so that the buyer contemplates the offer.
A legal theory that frustrates the desires of the people affected by the law can be
called dogmatic.
oA legal theory that satisfies the desires of the people affected by the law
can be called responsive.
oResponsive theory maximizes the well-being of people, whereas a
dogmatic theory sacrifices the well-being of people in favour of other
This is why courts will enforce firm offers and gift promises, even
though consideration is lacking (they prefer responsive).
The bargain theory suggests that all promises be enforced so long as there was a
oCourts on the other hand will not always follow this rule (i.e. if one party
was deceptive, the court will not enforce the promise).
The bargain theory of contract is not a good theory of contracting because it is
both overinclusive and underinclusive.
in arguing for the enforceability of contracts that, on
most other grounds, ought not to be enforced.
in not arguing for the enforceability of promises
that both parties truly want enforced.
Enforceability of a contract usually makes the parties better off, as measured by
their desires, without making anyone worse off (Pareto efficient).
Economic efficiency usually requires enforcing a promise if the promisor and the
promisee both wanted enforceability when it was made.
Promises are typically made for deferred exchanges.
oDeferred exchanges: transactions that involve the passage of time for their
Enforcing contracts facilitates cooperation between two parties.
oI.e. in the case where a person must pay upfront for goods that will be
delivered later
the buyer wants the contract enforced in order to
ensure the seller will perform or that there is a remedy should the seller
breach; the seller, in turn, wants the promise to be enforceable so that the
buyer is induced to make the purchase.
Agency game:
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oFirst player chooses whether or not to put a valuable asset under the
control of the second person.
oIf the first player does choose to do this, the second player has the choice
to cooperate and share in the eventual profit, or appropriate the asset put
under their control.
a cooperative surplus can be
achieved (i.e. earning a return on the invested asset).
transfers the asset from
ownership of the first player to the second player.
oUnder the situation with no enforceable contract, the second player has the
incentive to appropriate (receives 1 while the investor loses 1) and thus the
investor, sensing the second player will appropriate, will not invest.
oUnder the situation with an enforceable contract, the second player does
not have the incentive to breach the contract because they will have to pay
expectation damages if he does and since the first player receives the same
positive payoff regardless of what the second player does, he will invest
and the second player will cooperate.
The first purpose of contract law is to enable people to cooperate by converting
games with noncooperative solutions into games with cooperative solutions.
oThe solution to the nonenforceable contract situation results in no
investment and no profit for either party, whereas the solution in the
enforceable contract situation is to invest and cooperate, which generates
profits; the first purpose can thus be restated as:
Converting games with inefficient solutions into games with
efficient solutions.
A party may need to commit not to make certain choices in order to induce the
other party to cooperate.
oI.e. the second party above needs to commit to not appropriating for the
first party to invest.
A promise usually should be enforced if both parties wanted it to be enforceable
when it was made.
oEnforceability allows the agent to credibly commit to performing and the
principal has sufficient trust to put an asset under the agents control.
Whether a sharp-dealing promisor decides to perform/breach depends on the net
benefits of performance
, the net benefits of breaching
, and liability
faced as a result of breaching
Npx ≥ Nbx Lbx → perform
Npx<NbxLbx breach
The efficient action of the promisor (breach/perform), assuming only two parties
are affected by the contract, depends on the net benefits from performance of both
the promisor and promisee.
oEfficiency requires the maximization of the joint profits of the two people:
Npx+Npy ≥ Nb x+Nby → perform
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