Law and Economics-Charles W. Upton

Market Failures

Market Failures

The Edgeworth Box

Harry

SallyApples

Bananas

AB

The Contract Curve

Recall the Edgeworth

Box.

Market Failures

The Edgeworth Box

Harry

SallyApples

Bananas

AB

The Contract Curve

The purpose of contract law is to facilitate

bargaining to reach the Contract Curve..

Market Failures

The Edgeworth Box

Harry

SallyApples

Bananas

AB

The Contract Curve

But, as we all know, there are occasions

when bargaining does not reach the contract

curve..

Market Failures

Fifth Principle of Contract Law

• Deal with Market Failures.

Market Failures

Minors and Incompetents

• Contracts between minors and incompetents are invalid.

Market Failures

Minors and Incompetents

• Contracts between minors and incompetents are invalid.

• Of course, a contract can be enforced iffi if is in the best interest of the minor.

Market Failures

Minors and Incompetents

• Why does the law emancipate people at 18?

Market Failures

Minors and Incompetents

• Why does the law emancipate people at 18? – Why not? It used to be 21.– And, under some conditions, minors can

petition for early emancipation.

Market Failures

Minors and Incompetents

• So, if you reach a deal with a child to pay him $10,000 if a coin toss comes up heads 10 times in a row, and the child agrees to pay you $1,000,000 otherwise, reach for your checkbook.

Market Failures

Duress

• Contracts made under duress are invalid.

Market Failures

Duress

• Contracts made under duress are invalid.– If John holds a gun to Sam’s head and force

Sam to assign an agreement, the agreement is invalid.

Market Failures

Duress

• Contracts made under duress are invalid.– If John holds a gun to Sam’s head and force

Sam to assign an agreement, the agreement is invalid..

– Suppose a labor negotiator says “agree to this contract or we go on strike”. That contract is valid.

Market Failures

A Distinction with a Difference

• In the first case, a redistribution of wealth is at stake. If we validated the agreement, we give John an incentive to spend time threatening people, which is socially unproductive.

• In the second case, this is part of bargaining to reach the contract curve. Here, wealth creation is under way.

Market Failures

A Distinction with a Difference

• In the first case, a redistribution of wealth is at stake. If we validated the agreement, we give John an incentive to spend time threatening people, which is socially unproductive.

• In the second case, this is part of bargaining to reach the contract curve. Here, wealth creation is under way.

The Coase Theorem implies that the parties, left alone will reach the contract curve. Threats and blusters are part of normal negotiating tactics.

Market Failures

Contracts made out of Necessity

• Sam runs out of Gas in the desert, and John offers him gas for $50,000.

Market Failures

Contracts made out of Necessity

• Sam runs out of Gas in the desert, and John offers him gas for $50,000.

• This is a contract made out of necessity, and the law will not allow it.

Market Failures

Contracts made out of Necessity

• Sam runs out of Gas in the desert, and John offers him gas for $50,000.

• This is a contract made out of necessity, and the law will not allow it.

• But suppose John offers him gas for $10 a gallon. This, the law may well allow.

There must, after all, be an incentive for

people to aid stranded motorists. The

problem is one of the right incentive.

Market Failures

Contracts against Public Policy

• Not allowed, presumably because they are socially undesirable.

Market Failures

Contracts against Public Policy

• John contracts with Sam to kill Harry, and does so. Sam refuses to pay.

Market Failures

Contracts against Public Policy

• John contracts with Sam to kill Harry, and does so. Sam refuses to pay.

• John sues (ignore the problem that John’s lawsuit constitutes a confession to murder).

Market Failures

Contracts against Public Policy

• John contracts with Sam to kill Harry, and does so. Sam refuses to pay.

• John sues (ignore the problem that John’s lawsuit constitutes a confession to murder).

• John is out of luck, for the contract violates public policy (murders are an externality.

Market Failures

A Gambling Debt

• John, an Ohio resident, goes to Vegas, and borrows $10,000 to play blackjack.

• John goes bust, returns to Ohio and refuses to pay the casino the $10,000.

• The casino is out of luck. Casinos are against public policy in Ohio.

Market Failures

Other Reasons

• A Union signs an agreement to work for Acme Widgets for $15 an hour.

• It further agrees that if it reaches a deal to work with Baker Widgets for less, the rate for Acme drops to $1 an hour.

• Unenforceable, for there is an obligation to negotiate with Baker in good faith.

Market Failures

Cartels

• Acme Widgets and Baker Widgets sign an agreement to set up a cartel.

• Unenforceable, because Cartels violate public policy.

Market Failures

The Secret of the A

• My contract to offer you the A is void, because it is a fraud.

• There is social value in your studying because it adds to your human capital.

• Just giving you an “A” for $100 is counterproductive because it cheapens the certification value of a KSU degree.

Market Failures

Other Reasons

• Failure to Disclose

Market Failures

Other Reasons

• Failure to Disclose– Acme Widgets knows of limits on its widgets

which it fails to disclose; consumers would have made different decisions if it knew these facts.

– Note, suppose you buy stock from me at $50 a share, payment to made in 3 months, and the stock falls to $25 a share. This contract is valid, for there was no failure to disclose.

Market Failures

Other Reasons

• Failure to Disclose

• Frustration of purpose– The coronation example

Market Failures

Other Reasons

• Failure to Disclose

• Frustration of purpose

• Mutual Mistake– The “good car”

Market Failures

Other Reasons

• Failure to Disclose

• Frustration of purpose

• Mutual Mistake

• Monopolies– The rule of reason exception

Market Failures

Impossibility

• A company hired to drill for water, hits granite.– The landowner is the efficient risk bearer.

Market Failures

Impossibility

• A company hired to drill for water, hits granite.– The landowner is the efficient risk bearer.

• A portrait painter dies before completing a commission.– The subject is the efficient risk bearer.

Market Failures

The Westinghouse Case

• In the 1970’s Westinghouse induced several utilities to build nuclear power plants with a promise to sell uranium at $8 to $10 a pound.– It had commitments to sell 40,000 tons.– The price went to $30 a pound, giving

Westinghouse a potential loss of $1.6 billion.

Market Failures

The Westinghouse Case

• In the 1970’s Westinghouse induced several utilities to build nuclear power plants with a promise to sell uranium at $8 to $10 a pound.

• Westinghouse reneged on the contracts on grounds of impossibility.

Market Failures

Asymmetric Information

• The strange case of Baron Rothschild.

• John sees that Sam has an old desk which John knows is worth $50,000 at an antique auction, and offers Sam, unaware of its value $1,000. Sam accepts, and later sues.– John had no obligation to disclose.

Market Failures

Asymmetric Information

• In one case, the information was unproductive. Allowing people to profit causes unproductive investments.

• In the case of the desk, the information was productive. Without the profit motive, John would have no incentive to move the desk from a low value to high value use.

Market Failures

A General Theme

Is the process designed to facilitate reaching the contract curve?

Market Failures

A General Theme

Is the process designed to facilitate reaching the contract curve?

Yes Enforceable, even though later some may think the deal unfair.

Market Failures

A General Theme

Is the process designed to facilitate reaching the contract curve?

Yes Enforceable, even though later some may think the deal unfair.

NoNot enforceable; we discourage socially unproductive activities.

Market Failures

End

©2004 Charles W. Upton