4000 CONTRACT LAW: GENERAL THEORIES Richard Craswell Professor of Law, Stanford Law School © Copyright 1999 Richard Cras...
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4000 CONTRACT LAW: GENERAL THEORIES Richard Craswell Professor of Law, Stanford Law School © Copyright 1999 Richard Craswell
Abstract When contracts are incomplete, the law must rely on default rules to resolve any issues that have not been explicitly addressed by the parties. Some default rules (called ‘majoritarian’ or ‘market-mimicking’) are designed to be left in place by most parties, and thus are chosen to reflect an efficient allocation of rights and duties. Others (called ‘information-forcing’ or ‘penalty’ default rules) are designed not to be left in place, but rather to encourage the parties themselves to explicitly provide some other resolution; these rules thus aim to encourage an efficient contracting process. This chapter describes the issues raised by such rules, including their application to heterogeneous markets and to separating and pooling equilibria; it also briefly discusses some noneconomic theories of default rules. Finally, this chapter also discusses economic and non-economic theories about the general question of why contracts should be enforced at all. JEL classification: K12 Keywords: Contracts, Incomplete Contracts, Default Rules
1. Introduction This chapter describes research bearing on the general aspects of contract law. Most research in law and economics does not explicitly address these general aspects, but instead proceeds directly to analyze particular rules of contract law, such as the remedies for breach. That body of research is described below in Chapters 4100 through 4800. There is, however, some scholarship on the general nature of contract law’s ‘default rules’, or the rules that define the parties’ obligations in the absence of any explicit agreement to the contrary. The phrase, ‘complete contingent contract’ is sometimes used to describe an (imaginary) contract that would spell out in complete detail the exact legal rights and duties of each party under every possible state of affairs. While no real contract ever achieves this level of completeness, the concept is still useful to define one endpoint of a spectrum of completeness. If any contract ever succeeded in reaching this endpoint, the law’s default rules would then be irrelevant, as no issue would ever arise that could not be settled by the terms of the contract itself. Indeed, the same is true 1
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of the interpretation of most other legal documents, such as wills (see Chapter 5830) or legislative enactments (see Chapter 9200). As long as legal documents fall short of this level of completeness, the law must have some set of presumptions or default rules, in order to resolve disputes that are not settled by the terms of the document itself. The law could, of course, simply refuse to enforce any contract (or any will, or any statute) that fell short of absolute completeness. But such a rule would itself be a ‘default rule’: it would be a legal rule defining the obligations (or lack of obligations) that result when a contract does not itself specify what rules should govern. As long as actual contracts fall short of full completeness, then, the existence of default rules is not so much a choice as a logical necessity. The only question is what the content of those default rules ought to be. In choosing the content of default rules for contractual relationships, it is often useful to distinguish default rules chosen to increase efficiency if they are allowed to remain in force (as discussed in Sections 2-4) from those chosen to increase efficiency if many parties contract around the default rule (discussed in Sections 5-9). In some cases, the steps required to contract around a default rule could themselves increase efficiency, by inducing one party to reveal private information (as discussed in Sections 6-8). In other cases, it may be too hard for the law to identify a single rule that would increase efficiency if allowed to remain in force, so the default rule may instead be selected purely for its simplicity or ease of administration (as discussed in Section 9). The choice between these approaches depends in part on the ability of courts or lawmakers to identify efficient default rules; this issue is addressed in Section 10. The possible effect of default rules on the parties’ own preferences is discussed in Section 11, while Section 12 discusses some non-economic theories of default rules. Finally, there is also a good deal of scholarship on the general question of when contracts ought to be enforceable, either through informal social sanctions or more by formal legal mechanisms. Section 16 introduces these issues, and discusses the choice of enforcement mechanisms. Sections 18-20 focus on the question of whether promises should be enforceable at all (whatever the mechanism), with Section 18 discussing noneconomic theories of enforcement and Sections 19-20 discussing the economic theories.
A. ‘Majoritarian’ or ‘Market-Mimicking’ Default Rules 2. Introduction to Majoritarian Default Rules One way to select a default rule is to identify the rule that would be most efficient if that rule were allowed to remain in place (for example, if the parties
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did not specify some other rule in their contract). For example, if the expectation measure of damages were determined to be the most efficient remedy for breach of contract, this approach to selecting a default rule would argue for making expectation damages the default remedy. Much of the economically-oriented research on specific topics of contract law falls into this category. For example, many analyses of the remedies for breach aim to identify the remedy that would produce the most efficient result if that remedy were allowed to govern the parties’ relationship (for example, if the parties’ contract did not stipulate that some other remedy would govern). The same is true of many analyses of implied excuses such as impracticability and mistake, or of other terms such as implied warranties. This work is described at more length in Chapters 4500 (unforeseen contingencies), 4600 (remedies), and 4700 (warranties). This section addresses only those issues common to all default rules of this sort.
3. Majoritarian Rules and Hypothetical Consent Default rules selected on this basis - that is, on the grounds of their efficiency if allowed to remain in force - are sometimes described as the rules that the parties themselves would have chosen, if they had taken the time to agree explicitly on a rule to govern their relationship. In most cases, parties to a contract have an interest in maximizing the efficiency of their relationship, so the rule the parties themselves would have chosen will be the same as the rule that would be most efficient if allowed to remain in place. Thus, default rules chosen on this basis have also been labeled ‘market mimicking default rules’, or default rules based on the principle of ‘hypothetical consent’. To be sure, if there are third-party effects, or if the parties to the contract are imperfectly informed or are subject to any other market failures, the rule that would be chosen by the actual parties might no longer coincide with the rule that would in fact be most efficient. For general discussions of the relationship between efficient default rules and hypothetical consent, see Posner and Rosenfield (1977, p. 89), Ayres and Gertner (1989, pp. 89-93), Coleman, Heckathorn and Maser (1989), and Craswell (1992). Section 4 discusses some additional complexities that arise in heterogeneous markets, in which the same rule would not be chosen by every pair of contracting parties. This basis for selecting default rules has been supported by two economic arguments, both of which involve transaction costs. (Some noneconomic arguments will be discussed in Section 12 below.) The first economic argument applies when it would be prohibitively expensive for the parties to make their contract more complete by specifying the rule they want to govern a particular contingency. This is especially likely for extremely low-probability
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contingencies, where the expected benefits of specifying a rule in advance are likely to be low. In such a case, any rule the law selects as a default rule will inevitably be left in place by the parties, so the only way to get the benefits of whatever rule is most efficient is to make that rule the default rule. The second economic argument applies if it would be costly, but not prohibitively expensive, for the parties to make their contract more complete by specifying their own rule. In such a case, selecting a default rule that matches whatever rule the parties prefer may save some parties from having to incur those transaction costs, thus producing all the benefits of the most efficient rule with lower total transaction costs. These arguments become more complicated, however, if a ‘marketmimicking’ default rule is being applied to a market that is imperfect in some respect. For example, if a remedy of expectation damages would in fact be most efficient, but if imperfect information has led the parties to believe that some other remedy would be more efficient, should the law adopt as its default remedy the one that is in fact most efficient, or should it adopt the less efficient remedy that the (imperfectly informed) parties would choose if left to their own devices? The transaction-cost argument discussed in the preceding paragraph could suggest that, if the cost of contracting around the default rule is sufficiently low that the parties are likely to do so, then the law might as well adopt the less efficient remedy as the default rule, because that is the remedy the parties will contract for anyway. Alternatively, if the costs of transacting around the default rule are so high that the parties are likely to leave the default rule in place, perhaps the law should adopt the remedy that in fact is most efficient, as that will give the parties the benefit of the more efficient rule. But this latter approach is complicated by the fact that the identity of the rule that is most efficient (if allowed to remain in force) may itself change if the parties are imperfectly informed, or if there are other market imperfections. Moreover, in some cases the presence of information asymmetries or other market imperfections may call for an entirely different approach to the selection of default rules, in which the default rules are intentionally chosen not to be left in force by many parties. This approach is discussed below in Sections 5-9.
4. Majoritarian Rules in Heterogeneous Markets Market-mimicking or ‘majoritarian’ default rules raise additional issues in markets characterized by heterogeneity, where different rules would be efficient for different contracting pairs. If a single default rule must be chosen to govern all contracts in such a market, the rule selected will determine which contracting pairs can do best by leaving the default rule in place and which pairs could potentially do better by incurring the transaction costs needed to
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specify some other rule. It is sometimes assumed that the most efficient single default rule would be that which was most efficient for most of the contracting pairs (hence the label ‘majoritarian’ default rule, coined by Ayres and Gertner, 1989). But if transaction costs differ across heterogeneous parties, this conclusion actually depends on the exact levels of transaction costs that each member of each contracting pair would have to incur to contract around whatever default rule the law adopts (see Ayres and Gertner, 1989, pp. 112115). If different rules would be efficient for different contracting pairs, the law must also to decide the extent to which its default rules should be ‘tailored’, or customized to match the rule that would be most efficient for each individual contracting pair (see Ayres, 1993; Goetz and Scott, 1985; Baird and Weisberg, 1982). If the law adopts a single, untailored default rule, that will be most efficient for only some of the contracting pairs: all other pairs will have to incur either (1) the transaction costs of contracting around the default rule, or (2) the efficiency loss from leaving in place a default rule that is less than efficient for their contract. A set of default rules tailored to each individual contracting pair can in theory eliminate or reduce these costs, but such ‘tailoring’ will usually introduce other costs. For instance, individually tailored rules will usually be more complex, thus increasing the drafting costs that must be incurred by the legislature or other lawmaking body. Moreover, it is often impossible to spell out a complete set of individually tailored rules in advance, so the law will instead have to rely on vague standards to be applied by courts on a case-bycase basis (for example, an implied excuse in cases where performance is no longer commercially ‘reasonable’). Vague standards such as these usually entail higher litigation costs; they also introduce the possibility of case-by-case error in the application of the standard, and may make it hard for the parties to predict what rule will be applied to their relationship. In short, the question of how finely to tailor a default rule - and, indeed, whether to tailor it at all raises most of the same issues that are raised whenever the law faces a choice between specific rules and vague standards (see Chapter 9000).
B. ‘Information-Forcing’ or ‘Penalty’ Default Rules 5. Introduction to Information-Forcing Default Rules In many transactions, the two parties begin with differing amounts of information. In some cases, they may be differently informed about the relevant legal rules, or about the risks involved in the transaction. They may also be differently informed about the characteristics of the other party - for example, the seller may not know how much the buyer will lose if the seller’s product turns out to be defective. Differences such as these are often referred to as
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‘information asymmetries’. While information asymmetries are often addressed directly through disclosure regulations and the like (see Chapter 5110), they can also have implications for the law’s choice of default rules. Section 6 below discusses cases where the two parties are differentially informed about the governing legal rule. Sections 7-8 then discuss cases where the two parties are differentially informed about some other aspect of the transaction.
6. Forcing Information about the Legal Rule In some cases, the choice of default rule may help correct one party’s information about the legal rule itself. For example, suppose that the default remedy for breach provides for only a small monetary payment. Suppose also that the seller (the potential breacher) knows this, but the buyer (the potential nonbreacher) does not. Suppose that the buyer instead thinks, incorrectly, that the law’s default rule provides for a very large payment in the event of breach. If left uncorrected, this information asymmetry could lead to either of two problems. First, if a larger remedy would be more efficient for this contracting pair, they may not alter their contract to provide for the larger and more efficient remedy, because the buyer will think that he or she already has the benefit of a larger remedy. Second, even if the smaller remedy provided by the default rule is in fact most efficient for this contracting pair, the buyer’s ignorance about the actual rule may keep him or her from optimally adapting his or her behavior to that rule. For example, the buyer may purchase insufficient insurance, or take insufficient precautions to reduce the losses that would be caused by breach. (The effect of legal remedies on the incentives governing decisions such as these is discussed at more length in Chapter 4600.) By contrast, suppose now that the default rule were changed to provide for a very large payment in the event of breach. If this remedy is left in place, that is, if the parties do not contract around it), then both parties will optimally adapt their behavior: the buyer will adapt because this rule matches what he or she thinks the rule is; while the seller will adapt because, by hypothesis, he or she is correctly informed about whatever the default rule is. And if this default remedy is not left in place (that is, if the parties contract around it by stipulating a smaller remedy), the act of stipulating some other remedy should serve to inform the buyer about what remedy will apply in the event of breach. Indeed, if the default rule is one that the parties will be certain to contract around - for example, if it is chosen to be highly unfavorable to whichever party is better informed about the law - that will virtually ensure that the other party will also become correctly informed about the resulting rule, by the very process of stipulating to some other rule in their contract. Hence, these default rules are sometimes described as ‘information forcing’ rules (Scott, 1990, p. 609), or as
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‘penalty defaults’ slanted against the better-informed party to induce him or her to contract around the default rule (Ayres and Gertner, 1989, p. 97). A number of analyses of particular topics in contract law have recommended default rules chosen on this basis, or have suggested that actual legal rules could be understood as serving this function. See, for example, Ayres and Gertner (1989, pp. 98-99, 104-106), Goldberg (1984, pp. 295-296), Muris (1983, p. 390), Verkerke (1995, pp. 885-890), Isaacharoff (1996, pp. 1793-1795). One difficulty raised by default rules slanted against the better-informed party is that it may not be clear which party is better informed. This raises another ‘tailoring’ question of the sort discussed above in Section 4: should the party against whom the default rule is slanted be determined in advance for a broad category of cases, or individually on a case-by-case basis? Another difficult issue, even in cases where it is clear which party is least well-informed, concerns the comparison between the benefits and the costs of correcting the information asymmetry. The benefit of correcting the asymmetry will vary from case to case, depending on the information involved, so it is difficult to generalize. The costs of correcting the asymmetry clearly include the direct costs of contracting around the original default rule (which will depend in turn on the procedures that are required to contract around a default rule, as discussed in Section 14 below). The costs of correcting the asymmetry also depend on the risk that the parties will simply forget to contract around, thereby unintentionally leaving in force a default rule that was chosen not to be efficient for these contracting parties.
7. Forcing Information about the Other Contracting Party In many markets there is heterogeneity among the potential parties on a single side of a proposed transaction. For example, sellers may differ in the reliability of their products, or buyers may differ in the losses that they would suffer if the product they purchase fails to perform. At the outset of the transaction, this information is often known to one party but not to the other - for example, each buyer may already know how much loss he or she would suffer, but sellers may have no way of knowing how much any individual buyer has at stake. This is another example of information asymmetry. When this asymmetry is present, contract law’s default rules can again create incentives for one party to take actions that will reveal information to the other party. For example, if the default remedy for breach of contract provides for only a small monetary payment, buyers who would lose a larger amount in the event of breach may have an incentive to try to contract around that rule, by negotiating for a clause stipulating a larger payment in the event of breach. By contrast, if the default remedy is already set at a larger payment, buyers who
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would lose less may be the ones with an incentive to contract around that rule, by negotiating for a smaller stipulated damage to get a more favorable price). In other words, the choice of default rule will determine which set of buyers buyers with little at stake, or buyers with lots at stake - have an incentive to try to contract around the default rule. As a result, sellers may be able to infer something about the amount that any given buyer has at stake by observing whether that buyer does or does not try to contract around the default rule. And if buyers also differ in the gains they would get from transacting around the default rule, or in the costs they would face in doing so, the resulting equilibrium may depend critically on which default rule the law adopts. (The welfare consequences of these differences are discussed below in Section 8.) These differences are often analyzed using signaling models from game theory (see generally Chapter 0550). If sellers have no information about how much any given buyer would lose in the event of breach, the result may be a pooling equilibrium in which all buyers are charged an identical price. But if this asymmetry can somehow be overcome, the result may be a separating equilibrium in which buyers who face large losses in the event of breach will have a right to collect those losses, but will pay a higher price (to compensate the seller for its greater potential liability), while buyers who face lower losses will pay a lower price. One way to achieve this separating equilibrium is to select a default rule that induces one of these classes of buyers to signal the amount they have at stake, by their actions in trying to contract around the default rule. For formal models of this effect see, for example, Ayres and Gertner (1989, 1992), Johnston (1990), Allen and Gale (1992), Hviid (1996).
8. Information-Forcing and Economic Welfare Unfortunately, it is often difficult to assess the welfare implications of default rules that produce separating equilibria. Part of the difficulty is that, while there will usually be efficiency gains from eliminating this information asymmetry, that will not always be the case. Gains could arise if information about each individual buyer’s potential losses may let some sellers make customized adjustments to the reliability of their products. Gains could also arise if this information let sellers calculate a price that better reflected the true risk of selling to that particular buyer, thus sending buyers the correct signals about whether to purchase that product (see Ayres and Gertner, 1989; Quillen, 1988). In some cases, though, information about the buyer’s potential losses may be of no relevance to sellers - as, for instance, when sellers operate mass businesses that cannot practicably adjust their actions or prices for individual buyers (Danzig, 1975; Eisenberg, 1992, pp. 591-596). In such markets, there will be no efficiency gains at all from curing the information asymmetry. In
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still other markets, there may be positive gains from curing the asymmetry but those gains may not outweigh the costs of communicating the necessary information (Bebchuk and Shavell, 1991). Moreover, even when net efficiency gains are possible, the parties’ private incentives may lead them to act in a way that fails to achieve those gains. For example, if buyers face a price-discriminating monopolist who can charge higher prices to buyers who have more at stake in a particular transaction, buyers may be reluctant to do anything to reveal the amount they have at stake for fear of having to pay a higher price (Wolcher, 1989; Johnston, 1990; Ayres and Gertner, 1992). In other cases, some buyers may get private benefits (such as a more favorable price) by distinguishing themselves from other buyers, thus leading to socially excessive signaling (Rea, 1984; Aghion and Hermalin, 1990). At present, it is difficult to generalize about when the signaling or separating effects of a default rule will improve overall efficiency (see Hviid, 1996).
9. ‘Formalities’ as Default Rules Still another approach to selecting default rules aims entirely at ease of administration. That is, rather than trying to identify the default rule that would (1) be most efficient if left in place, or would (2) induce an efficient disclosure of information, this approach aims for default rules that are easily administered by courts, and easily learned and understood by contracting parties. In an influential early article, Fuller (1941) coined the term ‘formality’ to refer to rules designed to induce parties to specify their intentions in a way that could easily be recognized by courts. In this respect, Fuller’s rules were designed to force the parties to disclose information to the court, rather than (or in addition to) forcing one party to disclose information to the other contracting party. For example, if the parties to a contract fail to specify the quantity of goods they intend to convey, many jurisdictions refuse to enforce any obligation whatsoever, thus implicitly filling the gap with a quantity of ‘zero’ (see Ayres and Gertner, 1989, pp. 95-96). This default rule clearly is not designed to match what any contracting pair would have intended anyway. Instead, its purpose is to induce each pair to contract around the default rule by specifying the quantity they prefer, thus sparing the court from having to guess about the parties’ preferred quantity. Thus, unlike majoritarian or market-mimicking default rules, formalities are not necessarily intended to be left in place by the parties. Unlike other ‘penalty’ or ‘information-forcing’ rules, however (see Sections 5-8), formalities need not be slanted against any particular party. For example, the default rule for contracts that fail to specify any quantity of goods could just as easily be set at any specific number, not necessarily zero. True, a default rule of ‘zero’ has certain administrative advantages over any other number: there
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is no way to breach an obligation to deliver a quantity of zero, and hence no need to ever measure damages. Still, the essential feature of a formality is merely that some number be fixed in advance and be easily learnable by the parties, so that they can determine whether they will have to specify some other number in their contract. The formality could even be set at the number that most parties would prefer (if that number were known), thus giving it one feature in common with a market mimicking or majoritarian default rule. The only key is that, since formalities are chosen for their simplicity and ease of administration, they will necessarily be ‘untailored’ in the sense defined earlier in Section 4. As a result, no matter what specific rule is adopted as the default formality, many (perhaps most) contracting pairs will find it in their interest to specify some other rule in their contract. Because formalities are designed to be easily administered, they will at least have the virtue of reducing litigation costs in all cases when the parties fail to specify some other rule in their contract, so the default rule remains in effect. This same ease of administration may also minimize another component of transaction costs: the cost to the parties of becoming informed about the legal rule, and of predicting how that rule might be applied. Also, if the formality is not chosen to be deliberately unfavorable to either party, it may reduce the costs imposed when parties forget to specify some other rule in their contract: in this way, formalities may reduce the cost of remaining uninformed about the law. (These two effects have offsetting influences on parties’ incentives to become informed about the law.)
C. Other Issues in Designing Default Rules 10. Default Rules and Institutional Capabilities The preceding sections have discussed three bases on which default rules might be selected: market-mimicking or majoritarian defaults (Sections 2-4), information-forcing or penalty defaults (Sections 5-8), and pure formalities (Section 9). The choice among these various approaches depends in part on the competence and capabilities of legal institutions. For example, the first two approaches - market mimicking or majoritarian defaults, and informationforcing or penalty defaults - place obvious demands on those institutions, either to identify the rule that would in fact be most efficient (if left in place) for most contracting pairs, or to identify the default rule that would induce the most efficient disclosure of information. These demands are only increased if either of these approaches is to be adopted on a relatively ‘tailored’ basis, requiring the legal decision makers to assess the effect on individual markets or even individual contracting pairs. Thus, it is obviously an oversimplification to
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analyze how either of these approaches would work if it were to be administered by an omniscient legal decision maker. The real question is how well either of these approaches will work when administered by actual courts and legislatures. Two views of this question have developed in the contracts literature. The first begins by positing that certain rules - often, the rules that would have been efficient in a first-best world with perfect legal institutions - are simply beyond the capability of real legal institutions. This assumption is often made when the rule in question depends on information that, although observable by one or even both of the parties, cannot be demonstrated or verified publicly in court. For example, if the default remedy for breach were based on the net profits the breacher made, this would require a court to be able to measure the breacher’s revenues and costs, which might in some cases require more accounting expertise than real courts possess. Scholars often posit that such a rule would be unworkable in order to focus their analysis on alternative rules: rules that, while they might be less efficient in a first-best world, place fewer demands on the court or other legal decisionmaker (for example, Hermalin and Katz, 1993). For a general discussion and defense of this approach, see Schwartz (1992, pp. 279-280, 1993, pp. 403-406). By simply positing that certain rules are ‘unworkable’, though, these scholars implicitly assume an unfavorable balance between (1) the sum of all costs that would be imposed if courts tried to apply the unworkable rule, with the large number of errors that would entail; and (2) the sum of all costs associated with whatever rule is second-best. Other scholars have attempted a more finely-grained analysis by explicitly modeling the costs associated with judicial implementation of an unworkable rule. However, those costs depend in part on the nature and the probability of various errors courts might make in applying such a rule, and there is no consensus (and, regrettably, no empirical data) on how best to model such an error function. For two applications of this approach to contract issues, see Hadfield (1994), Hermalin and Katz (1991) and Allen and Gale (1992). The general discussion of legal errors and uncertain rules in other bodies of law (see Chapter 0790) is also relevant here.
11. Default Rules and Preference Formation In some situations, the law’s choice of default rules could alter contracting parties’ beliefs or preferences, thereby changing the value of the costs and benefits associated with different rules. For example, if the law adopts an implied warranty making sellers liable for all defects in their products (unless explicitly disclaimed), this could conceivably lead buyers to increase the value they place on such a warranty. At the same time, the adoption of the opposite default rule (no implied warranty) might lead buyers to the opposite view, if it
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caused them to reduce the value they place on such a warranty. In that event, it would be possible for either default rule (an implied warranty, or the absence of an implied warranty) to be left in place by the parties, if the law’s adoption of each default rule changed the parties’ preferences sufficiently. It would also be possible for both default rules to be perfectly efficient, at least when judged by the preferences the parties would have once the law adopted either default rule. The possibility that default rules might influence parties’ preferences is only just beginning to be explored. Experimental tests of this possibility can be found in Schwab (1988) and Korobkin (1998); the latter also discusses many of the potential policy implications. (Other experimental work regarding the effect on preferences of legal rules generally is discussed in Chapter 0570). Brief discussions of the implications for default rules in particular can also be found in Charny (1991, pp. 1835-1840); and in Schwartz (1993, pp. 413-415), who refers to default rules with this effect as ‘transformative default rules’.
12. Non-Economic Theories of Default Rules While default rules have received less attention in scholarship outside of law and economics, there are several non-economic theories that deserve mention. For general discussions in the legal literature, see Charny (1991), Barnett (1992), and Burton (1993). The first, and least well-developed (at least as a general theory), depends on the identification of certain rules as morally superior, as a sort of ‘merit good’. That is, just as it is sometimes argued that all citizens ought to have certain goods (education, health care, and so on), it is sometimes said that all citizens ought to have certain contract rights, such as the right to complete compensation in the event of a breach; or that the law should especially promote certain kinds of relationships, such as those based on long-term cooperation. Arguments of this sort could be particularly compelling if the law’s choice of default rule influenced citizens’ own beliefs about the value of certain relationships, as discussed above in Section 11. A second non-economic theory rests on the idea of hypothetical consent. There is an entire family of non-economic theories that traces the binding force of contracts to individual autonomy, and to the fact that the contractual obligation was freely chosen by the contracting party (see Section 17 below). To be sure, these theories might seem to have little to say about the content of default rules, which (by definition) fill in the content of obligations that were not explicitly chosen by the parties (see Craswell 1989a). However, some have argued that, even in the absence of explicit consent, a party should still be bound to the rule that he or she would have consented to if he or she had explicitly negotiated an agreement on that point. Interestingly, this argument
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converges with the market-mimicking or majoritarian approach discussed earlier in Sections 2-4. As a result, some economically-oriented scholars have sought to rest their recommendations on this philosophic position, as well as on more conventional economic grounds (for example, Schwartz, 1988, pp. 357-360). In the philosophical literature, however, it is disputed whether this invocation of hypothetical consent carries any of the moral force of ‘real’ consent, or whether it adds anything to standard efficiency arguments. For discussions in the legal literature of this issue, see Barnett (1992), Charny (1991), Coleman, Heckathorn and Maser (1989), Craswell (1992), and the exchanges between Coleman (1980a, 1980b) and Posner (1980, 1981). In the philosophical literature, useful discussions include Scanlon (1982), Gauthier (1986), and Brudney (1991). A third non-economic approach suggests that default rules should be designed to mimic the norms or customs that are already observed, either in the community at large or in the parties’ prior relationship. This approach is often employed in the ‘relational contract’ theory usually identified with Ian Macneil (1978, 1980, 1981); see also Brown and Feinman (1991), Feinman (1993), and Craswell (1993b). In addition, some scholars working from philosophical theories of individual autonomy and consent have seen the prevailing norms and customs as acceptable sources of default rules, at least in the absence of any explicit agreement to the contrary (Barnett, 1992; Burton, 1993). In particular cases, this approach could of course converge with any of the economic theories discussed here, depending on whether the norms or customs happened to be efficient (see the general discussion in Chapter 0800). Among the issues raised by this approach are questions about the manner in which the norms or customs are to be identified (see Bernstein, 1996, pp. 1787-1795; Craswell, 1998), and about the ability of courts or other legal decisionmakers to properly carry out this identification (see Section 10 above).
D. Contracting Around Default Rules 13. Displacing Default Rules by Agreement A default rule, by definition, leaves parties free to specify some other rule to govern their relationship if they so choose. There is, however, very little scholarly analysis of the steps the parties must take if they wish to specify some other rule. Most scholars implicitly assume that specifying some other rule would require a valid provision to that effect in a valid contract. This could suggest that the rules governing those steps can be left to the law of contract formation and contract interpretation, two bodies of law that are addressed at more length in Chapters 4300 and 4400.
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Unfortunately, those bodies of law are themselves among the least analyzed portions of contract law. Moreover, the choices made by a legal system in selecting the rules of contract formation and interpretation can both be influenced by, and exert an influence upon, the choice of the original default rule. Sections 14 and 15 briefly discuss some of the interactions between these sets of rules.
14. Procedural Requirements for a Valid Agreement Any attempt to displace a default rule will normally have to satisfy (at a minimum) all the requirements of an enforceable contract. For example, depending on the legal regime, the agreement may (or may not) have to be in writing, and it may (or may not) have to be supported by consideration. These requirements, and the other rules governing contract formation, are discussed at more length in Chapter 4300. Should there be extra procedural requirements for parties who wish to contract around a default rule? If the default rule is presumptively valid, and especially if it is presumptively valid for moral or other non-economic reasons, it might be argued that parties who wish to choose a presumptively less valid rule should have to take extra steps, if only to ensure (and to demonstrate to a court) that this is what the parties really intend. For example, it might be argued that one party should not be able to displace a default rules by means of a single clause buried in a 30-page document that the other party will not normally bother to read. Arguments of this sort are often made in connection with standard form contracts and the legal doctrine of unconscionability (see Chapter 4100). Some of the links with standard default rule analysis are noted briefly in Craswell (1993a, pp. 12-14). Indeed, arguments of this sort may fit best in connection with informationforcing or penalty default rules. As discussed earlier (see Section 6), such rules may be deliberately designed to induce the better-informed party to contract around the default rule, in the hope that the process of contracting around the rule will itself give the other party more information about the rights that he or she now has. The efficacy of this approach, however, depends on whether the process of contracting around the rule really does inform the other party - and this, in turn, depends on the procedures that are required to contract around the rule. Again: if a default rule can be altered merely by inserting a clause in a 30page contract that nobody ever reads, the process of contracting around the default will not inform the other party at all. On the other hand, extra procedural requirements will usually increase the transaction costs required to contract around the default rule. For example, if altering a default rule requires the clause in question to be pointed out and
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explained to the other party, the process of contracting around the default might indeed increase the other party’s information. However, this requirement may also be costly to satisfy, especially if a single contract alters a large number of default rules, and if the other party has no desire to sit through a lengthy set of explanations. In that event, the cost of altering the default rules via this procedure might turn out to be effectively prohibitive, so many parties would end up leaving the original default rules still in force. If so, this would require reevaluation of the original decision to select a default rule that was designed not to be left in force (that is, a default rule that was chosen to be inefficient precisely in order to induce the parties to contract around it). In this way, the rules governing the process of contracting around a default rule can themselves affect the principles on which the original default rule should be chosen.
15. Interpreting Contractual Terms that Alter a Default Rule Contracting parties often use language which appears to address an issue that would otherwise be governed by a default rule, but which is vague or ambiguous, and thus requires interpretation. For example, imagine a contract providing that the remedy to be paid in the event of a breach should be an amount that would ‘reasonably compensate’ the nonbreacher. Should the courts treat this vague language as leaving a gap in the contract, to be filled by the normal default remedy? Or should they instead apply some other set of principles? In conventional legal terminology, default rules are said to apply only when there is an actual gap in the contract, while questions of vague contractual language are usually described as questions of interpretation. There is, however, no consensus (and very little theory) on what should count as a ‘gap’ (see Ayres and Gertner, 1989, pp. 119-120). Fortunately, this distinction often will not matter, because the approaches used to interpret contracts (see Chapter 4400) have much in common with the approaches used to select default rules. In many cases, for example, vague or ambiguous language is interpreted so as to fit whatever the parties probably would have agreed to if they had discussed the matter, thus producing the same result as the majoritarian or marketmimicking default rules discussed in Sections 2-4 (see also Goetz and Scott, 1985). In other cases, vague or ambiguous language is interpreted against the party who drafted it, just as in the case of a penalty or information-forcing default rule designed to induce more careful and explicit communication (see Sections 5-9). Notice, though, that some decision must still be made to determine when the parties have taken enough steps to make their language sufficiently clear to avoid the rule construing ambiguities against the drafter, or when their language is sufficiently clear to avoid being interpreted in accordance with the
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court’s idea of what most parties would have wanted. This is the question of precisely how far the parties must go to contract around an otherwise applicable default rule (or, in this case, around an otherwise applicable rule of interpretation). As discussed in Section 14, whatever requirements the law adopts here will have to be considered in deciding what default rule (or what interpretive presumption) to adopt in the first place.
E. The Enforceability of Contracts Generally 16. Introduction to Theories of Enforceability The analysis of default rules takes it as given that contracts are enforceable, and concerns itself with determining the content of the enforceable obligation. This Section addresses the opposite issue: given a contract of (let us assume) definite content, when should that contract be legally enforceable? One branch of this question asks whether contracts should be enforced by a legal system, or whether non-legal enforcement mechanisms might be superior (see, for example, Bernstein, 1992, 1996; Charny, 1991). Non-legal enforcement mechanisms could include arbitration panels or trade association boards that function much like a court, except for not being backed by official state sanctions. They could also involve much less formal mechanisms, such as the threat of withholding business from anyone who had broken a promise in the past. In both of these respects, they are similar to the non-legal mechanisms that might be used to enforce any other obligation (see Chapters 0780 and 0800), with which this literature has much in common. By contrast, most of the literature on whether contracts ought to be enforced typically abstracts from the choice of the enforcement mechanism, and focuses instead on the question of whether (and why) contracts ought to be enforced by any mechanism whatsoever. Non-economic theories are discussed briefly in Section 17 below, followed by a discussion of the law and economics literature in Sections 18-19.
17. Non-Economic Theories of Enforceability Moral philosophers have written extensively about the question of whether (or why) a promise should be morally binding. Some of their theories rest on utilitarian accounts that have much in common with the economic theories; these will be discussed in Sections 18-19. This section focuses instead on the non-utilitarian or non-instrumental accounts. In the legal literature, general
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surveys of these accounts can be found in Atiyah (1981), Barnett (1986), Craswell (1989a, pp. 491-503), and Gordley (1991). One family of theories derives the obligation to keep one’s promise from considerations of individual freedom and moral autonomy. For example, Fried (1981) argues that if the law did not allow individuals to bind themselves with respect to their future conduct, it would thereby fail to respect the individuals’ status as autonomous moral agents. (For a variant account of when individual autonomy requires that promises be enforced, see Barnett, 1986.) These accounts do not imply that promises ought to be kept in every circumstance: this theory, like all of the others discussed in this section, allows for the possibility of a set of implied conditions or implied excuses. Instead, the goal of these theories is to explain why promises are prima facie binding, and this family of theories rests that binding force on the promise’s status as the voluntary commitment of a autonomous moral agent. Another, different set of theories rests the obligation to keep a promise on the substance of what has been promised. Perhaps the best-known theories in this set focus on harm to others: if one’s promise has led others to change their behavior in reliance on the promise, so that they would now be injured if the promisor failed to perform, that promise is binding because it is wrong to harm other agents. Making a promise and then failing to keep it might also be seen as a form of lying, for such a promisor has misled others about the future. Other theories in this set focus on reciprocity or restitution: if one has received a benefit and promised to pay for it, that promise is binding because it is only right to pay for the benefits one has received (Atiyah, 1981, pp. 34-36). Under some theories, the fairness of the terms of the promise is also relevant to whether the promise is binding (for example, Gordley, 1995). Under any of these substance-based theories, the promise’s status as the voluntary commitment of a free moral agent is less significant, for the agent is (in some sense) promising to do what he or she ought to be doing anyway. Indeed, under many of these theories, if there is no independent reason for the agent to perform the action - for example, if the agent has received no benefits, and if no one has yet relied on the promise - the obligation to keep the promise is seen as weaker or non-existent. These theories thus have difficulty explaining why the obligation should be stronger in the case of an individual who has made a promise than it is in the case of an individual who has acted identically but has explicitly disclaimed any promise (for example, ‘I think I’m going to do x, but I warn you that I’m not promising to do it, so you should rely only at your own risk’, or ‘you can confer those benefits on me if you want, but I warn you now that I have no intention of paying you anything for them’). Atiyah (1981, pp. 184-202) has argued that an explicit promise could serve as evidence, perhaps even conclusive evidence, that the underlying obligation really is a just one that ought to be enforced. If one asks why an individual’s
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promise ought to be given such evidentiary weight, however, it is difficult to avoid falling back either on autonomy-based explanations of the sort discussed earlier in this section, or on utilitarian theories of the sort to be discussed in Sections 18 and 19.
18. Economic Theories of Free Exchange Economic theories of why promises should be enforced can be divided into two categories. One set of theories, to be discussed in this section, focuses on the utility created by the eventual performance of the promise. The other set, to be discussed in Section 19, focuses on the utility created by the ex ante incentives that the promise sets up. The first economic argument for enforcing promises rests on the utility that will be produced when the promise is eventually performed. Since voluntary transactions generally increase the welfare of all parties to the transaction, whenever a promise is voluntary it could be argued that welfare will usually be increased if the promise is carried out. Viewed in these terms, the economic argument for enforcing promises is very similar to the economic argument for free exchange and free markets generally (see Chapter 5000). This argument, however, could imply that a promise should not be binding if conditions have changed sufficiently that the promised transaction would not increase both parties’ welfare. For example, if a promisor’s costs have increased to the point where it is no longer efficient for him or her to perform the promise, this theory could suggest that the promisor ought to be released with no obligation to pay any damages at all, because this particular efficiency rationale for enforcing promises no longer applies. Under this theory, the only way to save the prima facie obligation to keep one’s promises (even after conditions have changed) is to argue for the virtues of a general rule over a case-by-case inquiry into the efficiency of any given transaction - in philosophical terms, by shifting from act-utilitarianism to rule-utilitarianism. That argument, in turn, must rest on empirical claims about the ability of courts to determine whether and when performance of the promise was still efficient. More generally, there is an important difference between permitting free exchange and permitting (or enforcing) binding promises. An exchange can take place instantaneously, but a promise necessarily involves a commitment to act in a certain way at some time in the future. Once this temporal element is recognized, it can be seen that enforcing promises does not simply transfer existing goods from one owner to another. Instead, the enforcement of promises creates a new good: it allows people to exchange ‘wheat to arrive on September 1' (for example), where without a binding promise they could only exchange actual bushels of wheat. Viewed in these terms, the economic case for enforcement rests on the proposition that this new good (that is, the good
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represented by a future commitment) is a socially useful good which people frequently will want to exchange. To explain why such a commitment is useful and valuable, economists have focused more on the ex ante effects created by such a commitment, as discussed in Section 19 below.
19. Economic Theories of Advance Commitments Most economic justifications for enforcing promises have focused on the ex ante effects that would be created by a general rule of enforceability. In essence, these economic theories analyze promises as effectuating a present transfer not of goods and services, but of rights and duties. (For a similar view expressed in non-economic terms, see Barnett, 1986, pp. 291-300.) Such a transfer of rights and duties may itself produce efficiency gains, independently of whether it is efficient to actually carry out the promise. The efficiency gain that is analyzed most often stems from the effect on the promisee’s incentive to rely on the promised behavior (see Goetz and Scott, 1980). If the law denied promisees any compensation whenever a promisor could show that performance of the promise had become inefficient, this would shift more of the risk of a change in conditions to the promisee, and thus would reduce the promisee’s incentive to rely. To be sure, if the law instead guarantees that promisees will be compensated whenever the promisor fails to perform, this could create incentives for excessive reliance on the part of the promisee (see the discussion of reliance incentives in connection with remedies for breach in Chapter 4600). If the incentives for excessive reliance can be constrained by other legal doctrines, however, the net effect on the promisee’s reliance incentives could still be positive. The argument that enforceability is needed to induce one party to take the risky step of beginning his or her own performance (when the other party’s return performance is not due until later) is really a special case of this argument, since beginning performance is one of the many ways in which parties may rely on a contract. More generally, there are many other ex ante effects that could be produced by a rule requiring compensation even when conditions have changed to make performance unprofitable. If the promisor and promisee differ in their attitudes toward risk, a rule requiring compensation may achieve a better allocation of risk between the two parties (see, for example, Polinsky, 1983). A rule requiring compensation may also increase the promisor’s incentive to tell the truth about the conditions that will affect his or her performance, thus increasing the promisee’s information about those conditions (see Shavell, 1991; Craswell, 1989b; Katz, 1996, pp. 1289-1291). A compensation requirement may also give the promisor an incentive to affect those conditions directly, if the probability of performance rests on factors that are within the
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promisor’s control. Generally speaking, all of the economic analysis of efficient remedies for breach (see Chapter 4600) is relevant here, since to make a promise enforceable is to set a non-zero remedy for the promise’s breach. The less-developed economic analysis of the conditions under which formation of a binding contract should be inferred (see Chapter 4300) is also relevant here.
Acknowledgments Richard Craswell is a professor of law at the Stanford Law School. Jack L. Goldsmith, Eric A. Posner, Cass R. Sunstein, and two anonymous referees provided helpful comments. Financial support was provided by the Lynde and Harry Bradley Foundation and the Sarah Scaife Foundation at the University of Chicago Law School.
Bibliography on Contract Law: General Theories (4000) Aghion, Philippe and Hermalin, Benjamin (1990), ‘Legal Restrictions on Private Contracts can Enhance Efficiency’, 6 Journal of Law, Economics, and Organization, 381-409. Allen, Franklin and Gale, Douglas (1992), ‘Measurement Distortion and Missing Contingencies in Optimal Contracts’, 2 Economic Theory, 1-26. Ayres, Ian (1993), ‘Preliminary Thoughts on Optimal Tailoring of Contractual Rules’, 3 Southern California Interdisciplinary Law Journal, 1-18. Ayres, Ian and Gertner, Robert (1989), ‘Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules’, 99 Yale Law Journal, 87-130. Ayres, Ian and Gertner, Robert (1992), ‘Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules’, 101 Yale Law Journal, 729-73. Baird, Douglas G. and Weisberg, Robert (1982), ‘Rules, Standards and the Battle of the Forms: A Reassessment of “2-207”, 68 Virginia Law Review, 1217-62. Barnes, David W. and Stout, Lynn A. (1992), Economics of Contract Law, Minneapolis, West Publishing. Barnett, Randy E. (1992), ‘The Sound of Silence: Default Rules and Contractual Consent’, 78 Virginia Law Review, 821-911. Bebchuk, Lucien Ayre and Shavell, Steven (1991), ‘Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v. Baxendale’, 7 Journal of Law, Economics, and Organization, 284-312. Bernstein, Lisa (1992), ‘Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry’, 21 Journal of Legal Studies, 115-57. Bernstein, Lisa (1993), ‘Social Norms and Default Rule Analysis’, 3 Southern California Interdisciplinary Law Journal, 59-90. Bernstein, Lisa (1996), ‘Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms’, 144 University of Pennsylvania Law Review, 1765-1821.
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Birmingham, Robert L. (1968), ‘Legal and Moral Duty in Game Theory: Common Law Contract and Chinese Analogies’, 18 Buffalo Law Review, 99-117. Brown, Patricia A. and Feinman, Jay M. (1991), ‘Economic Loss, Commercial Practices, and Legal Process: Spring Motors Distributors, Inc. v. Ford Motor Company’, 22 Rutgers Law Journal, 30160. Charny, David (1990), ‘Nonlegal Sanctions in Commercial Relationships’, 104 Harvard Law Review, 375-467. Charny, David (1991), ‘Hypothetical Bargains: The Normative Structure of Contract Interpretation’, 89 Michigan Law Review, 1815-79. Coleman, Jules, Heckathorn, Douglas D. and Maser, Steven M. (1989), ‘A Bargaining Theory Approach to Default Provisions and Disclosure Rules in Contract Law’, 12 Harvard Journal of Law and Public Policy, 639-709. Craswell, Richard (1989a), ‘Contract Law, Default Rules, and the Philosophy of Promising’, 88 Michigan Law Review, 489-529. Craswell, Richard (1989b), ‘Performance, Reliance, and One-Sided Information’, 18 Journal of Legal Studies, 365-401. Craswell, Richard (1992), ‘Efficiency and Rational Bargaining in Contractual Settings’, 15 Harvard Journal of Law and Public Policy, 805-37. Craswell, Richard (1993a), ‘Property Rules and Liability Rules in Unconscionability and Related Doctrines’, 60 University of Chicago Law Review, 1-65. Craswell, Richard (1993b), ‘The Relational Move: Some Questions from Law and Economics’, 3 Southern California Interdisciplinary Law Journal, 91-114. Craswell, Richard (1998), ‘Do Trade Customs Exist?’, in Krauss, Jody and Walt, Steven (eds), The Jurisprudential Foundations of Corporate and Commercial Law, Cambridge, Cambridge University Press. Craswell, Richard and Schwartz, Alan (eds) (1994), Foundations of Contract Law, New York, Oxford University Press. Danzig, Richard (1975), ‘Hadley v. Baxendale: A Study in the Industrialization of the Law’, 4 Journal of Legal Studies, 249-84. D’Ursel, Laurent (1985), ‘L’Analyse Économique du Droit des Contrats (Economic Analysis of Contract Law)’, 14 Revue Interdisciplinaire d’Etudes Juridiques, 45-88. Eisenberg, Melvin Aron (1992), ‘The Principle of Hadley v. Baxendale’, 80 California Law Review, 563-613. Farber, Daniel A. (1983), ‘Contract Law and Modern Economic Theory’, 78 Northwestern University Law Review, 303-339. Feinman, Jay M. (1983), ‘Critical Approaches to Contract Law’, 30 UCLA Law Review, 829-60. Feinman, Jay M. (1990), ‘The Significance of Contract Theory’, 58 University of Cincinnati Law Review, 1283-1318. Feinman, Jay M. (1993), ‘Relational Contract and Default Rules’, 3 Southern California Interdisciplinary Law Journal, 43-58. Gillette, Clayton P. (1993), ‘Cooperation and Convention in Contractual Defaults’, 3 Southern California Interdisciplinary Law Journal, 167-88. Gillette, Clayton P. (1990), ‘Commercial Relationships and the Selection of Default Rules for Remote Risks’, 19 Journal of Legal Studies, 535-81. Goetz, Charles J. and Scott, Robert E. (1980), ‘Enforcing Promises: An Examination of the Basis of Contract’, 89 Yale Law Journal, 1261-1322.
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Goetz, Charles J. and Scott, Robert E. (1985), ‘The Limits of Expanded Choice: An Analysis of the Interactions Between Express and Implied Contract Terms’, 73 California Law Review, 261-322. Goldberg, Victor P. (ed) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press. Goldberg, Victor P. (1984), ‘An Economic Analysis of the Lost-Volume Seller’, 57 Southern California Law Review, 283-97. Hadfield, Gillian K. (1994), ‘Judicial Competence and the Interpretation of Incomplete Contracts’, 23 Journal of Legal Studies, 159-84. Harris, Donald (1983), ‘Contract as Promise - A Review Article Based on Contract as Promise: A Theory of Contractual Obligation by Charles Fried’, 3 International Review of Law and Economics, 69-77. Harris, Donald and Veljanovski, Cento G. (1984), ‘The Use of Economics to Elucidate Legal Concepts: The Law of Contract’, in Daintith, Terence and Teuber, Gunther (eds), Law and the Social Sciences, Florence, European University Institute. Hermalin, Benjamin E. and Katz, Michael L. (1991), ‘Moral Hazard and Verifiability: The Effects of Renegotiation in Agency’, 59 Economica, 1735-1753. Hermalin, Benjamin E. and Katz, Michael L. (1993), ‘Judicial Modification of Contracts Between Sophisticated Parties: A More Complete View of Incomplete Contracts and Their Breach’, 9 Journal of Law, Economics, and Organization, 230-255. Hillman, Robert A. (1988), ‘The Crisis in Modern Contract Theory’, 67 Texas Law Review, 103-136. Holderness, Clifford G. (1985), ‘A Legal Foundation for Exchange’, 14 Journal of Legal Studies, 321344. Horwitz, Morton J. (1974), ‘The Historical Foundations of Modern Contract Law’, 87 Harvard Law Review, 917-956. Hviid, Morten (1996), ‘Default Rules and Equilibrium Selection of Contract Terms’, 16 International Review of Law and Economics, 233-45. Johnston, Jason Scott (1990), ‘Strategic Bargaining and the Economic Theory of Contract Default Rules’, 100 Yale Law Journal, 615-64. Köhler, Helmut (1989), ‘Zur Ökonomischen Analyse der Regeln über die Geschäftsgrundlage (On the Economic Analysis of the Rules of the Implicit Basis of a Contract)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Allokationseffizienz in der Rechtsordnung, Berlin, Springer, 148-162. Korobkin, Russell (1998), ‘The Status Quo Bias and Contract Default Rules’, 83 Cornell Law Review, 608-87. Kronman, Anthony T. (1980), ‘Contract Law and Distributive Justice’,89 Yale Law Journal, 472-511. Kronman, Anthony T. (1985), ‘Contract Law and the State of Nature’, 1 Journal of Law, Economics and Organization, 5-32. Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little, Brown and Company. Lowry, S. Todd (1976), ‘Bargain and Contract Theory in Law and Economics’, 10 Journal of Economic Issues, 1-22. Macneil, Ian R. (1978), ‘Contracts: Adjustment of Long-Term Economic Relations Under Classical, Neoclassical, and Relational Contract Law’, 72 Northwestern University Law Review , 854-905.
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Macneil, Ian R. (1980), The New Social Contract: An Inquiry Into Modern Contractual Relations, New Haven, Yale University Press. Macneil, Ian R. (1981), ‘Economic Analysis of Contractual Relations: Its Shortfalls and the Need for a “Rich” Classificatory Apparatus’, 75 Northwestern University Law Review, 1018-63. Marini, Giovanni (1990), Promessa ed Affidamento nel Diritto dei Contratti (Promise and Reliance in Contract Law), Napoli, Jovene. Perron, Edgar du (1990), ‘De Rechtseconomische Analyse van het Verbintenissenrecht (A Law-andEconomics Analysis of the Law of Obligations)’, 39 Ars Aequi, 770-776. Poughon, Jean-Michel (1990), ‘Une Constante Doctrinale: l’Approche Economique du Contract’, 12 Droits. Revue Française de Théorie Juridique, 47-59. Romani, Franco (1985), ‘Appunti sull’ Analisi Economica dei Contratti (Notes about the Economic Analysis of Contract Law)’, Quadrimestre, 15-29. Schwab, Stewart J. (1988), ‘A Coasean Experiment on Contract Presumptions’, 17 Journal of Legal Studies, 237-268. Schwartz, Alan (1992), ‘Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies’, 21 Journal of Legal Studies, 271-318. Schwartz, Alan (1993), ‘The Default Rule Paradigm and the Limits of Contract Law’, 3 Southern California Interdisciplinary Law Journal, 389-419. Scott, Robert E. (1990), ‘A Relational Theory of Default Rules for Commercial Contracts’, 19 Journal of Legal Studies, 597-616. Simpson, A.W.B. (1979), ‘The Horwitz Thesis and the History of Contracts’,46 University of Chicago Law Review, 533-601. Symposium, ‘Default Rules and Contractual Consent’, 3 Southern California Interdisciplinary Law Journal, 1-444. Verkerke, J. Hoult (1995), ‘An Empirical Perspective on Indefinite Term Employment Contracts: Resolving the Just Cause Debate’, 1995 Wisconsin Law Review, 837-917. Wang, William K.S. (1982), ‘Reflections on Contract Law and Distributive Justice: A Reply to Kronman’, 34 Hastings Law Journal, 513-527. Witt, Ulrich (1986), ‘Evolution and Stability of Cooperation without Enforceable Contracts’, 39 Kyklos, 245-266. Wonnell, Christopher T. (1986), ‘Contract Law and the Austrian School of Economics’, 54 Fordham Law Review, 507-543.
Other References Atiyah, P.S. (1979), The Rise and Fall of Freedom of Contract, Oxford, Clarendon Press. Atiyah, P.S. (1981), Promises, Morals, and Law, Oxford, Clarendon Press. Barnett, Randy E. (1986), ‘A Consent Theory of Contract’, 86 Columbia Law Review, 269-321. Brudney, Daniel (1991), ‘Hypothetical Consent and Moral Force’, 10 Law and Philosophy, 253-70. Buckley, F.H. (1988), ‘Paradox Lost’, 72 Minnesota Law Review, 775-827. Burton, Steven J. (1993), ‘Default Principles, Legitimacy, and the Authority of a Contract’, 3 Southern California Interdisciplinary Law Journal, 115-66. Coleman, Jules L. (1980a), ‘Efficiency, Exchange, and Auction: Philosophic Aspects of the Economic Approach to Law’, 68 California Law Review, 221-49.
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Coleman, Jules L. (1980b), ‘Efficiency, Utility, and Wealth Maximization’, 8 Hofstra Law Review, 509-51. Fried, Charles (1981), Contract as Promise: A Theory of Contractual Obligation, Cambridge, Massachusetts, Harvard University Press. Fuller, Lon L. (1941), ‘Consideration and Form’, 41 Columbia Law Review, 799-824. Gauthier, David Peter (1986), Morals by Agreement, Oxford, Clarendon Press. Gordley, James (1991), The Philosophical Origins of Modern Contract Doctrine, Oxford, Clarendon Press. Gordley, James (1995), ‘Enforcing Promises’, 83 California Law Review, 547-614. Isaacharoff, Samuel (1996), ‘Contracting for Employment: The Limited Return of the Common Law’, 74 Texas Law Review, 1783-1812. Katz, Avery (1996), ‘When Should an Offer Stick? The Economics of Promissory Estoppel in Preliminary Negotiations’, 105 Yale Law Journal, 1249-1309. Muris, Timothy J. (1983), ‘Cost of Completion or Diminution in Market Value: The Relevance of Subjective Value’, 12 Journal of Legal Studies, 379-400. Perloff, Jeffrey M. (1981), ‘Breach of Contract and the Foreseeability Doctrine of Hadley v. Baxendale’, 10 Journal of Legal Studies, 39-63. Polinsky, A. Mitchell (1983), ‘Risk Sharing Through Breach of Contract Remedies’, 12 Journal of Legal Studies, 427-44. Posner, Richard A. (1980), ‘The Ethical and Political Basis of the Efficiency Norm in Common Law Adjudication’, 8 Hofstra Law Review, 487-507. Posner, Richard A. (1981), ‘A Reply to some Recent Criticisms of the Efficiency Theory of the Common Law’, 9 Hofstra Law Review, 775-94 Posner, Richard and Rosenfield, Andrew M. (1977), ‘Impossibility and Related Doctrines in Contract Law: An Economic Analysis’, 6 Journal of Legal Studies, 83-118. Quillen, Gwyn D. (1988), ‘Contract Damages and Cross-Subsidization’, 61 Southern California Law Review, 1125-41. Rea, Samuel A. Jr (1984), ‘Arm-Breaking, Consumer Credit and Personal Bankruptcy’, 22 Economic Inquiry, 188-208. Scanlon, Thomas (1982), ‘Contractualism and Utilitarianism’, in Sen, Amartya and Williams, Bernard (eds), Utilitarianism and Beyond, Cambridge, Cambridge University Press. Schwartz, Alan (1988), ‘Proposals for Products Liability Reform: A Theoretical Synthesis’, 97 Yale Law Journal, 353-419. Shavell, Steven (1991), ‘An Economic Analysis of Altruism and Deferred Gifts’, 20 Journal of Legal Studies, 401-21. Wolcher, Louis E. (1989), ‘Price Discrimination and Inefficient Risk Allocation Under the Rule of Hadley v. Baxendale’, 9 Research in Law and Economics, 9-31.
4100 CONTRACTUAL CHOICE Scott E. Masten Louis and Myrtle Research Professor of Business and Law, University of Michigan Business School © Copyright 1999 Scott E. Masten
Abstract This chapter discusses alternative theories of contract choice and design with special emphasis on (i) the interaction between contract design and contract enforcement and (ii) the explanatory power of alternative theories. After discussing the primary functions of contract, the entry reviews the assumptions and implications for contract design of the three dominant approaches to contracting in economics. An overview of the empirical literature on contracting and contractual choice identifies the main empirical regularities and their relation to the theory. A final section addresses implications for contract law and enforcement and directions for future research. JEL classification: D23, K12, D82 Keywords: Contracting, Contract Enforcement, Incentives, Transaction Costs
1. Introduction A contract, at its most basic level, is a legally enforceable agreement. Although economists - and occasionally lawyers - have used the term more expansively to describe essentially any transaction, the term contract as used in this chapter is reserved for formal, legal commitments to which each party gives express (though not necessarily written) approval and to which a particular body of law applies. ‘Breaching a contract’ differs from ‘canceling an order’, to use Stewart Macaulay’s (1963, p. 61) dichotomy. Ultimately, what distinguishes a contract from a mere transaction is the opportunity contracts afford transactors to invoke the formal dispute resolution machinery and coercive power of the state to enforce promises. Besides distinguishing true contracts from ‘implicit contracts’ or self-enforcing agreements, this definition of contract highlights the fundamental link between contract design, on the one hand, and contract enforcement, on the other: the choice of contract terms will depend in part on the legal rules and enforcement policies transactors expect courts to follow while, at the same time, the enforcement practices of efficiency-minded courts will depend on what courts perceive as the purpose and impediments to 25
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contracting. In short, the analysis of contract law and enforcement presupposes a theory of contracting behavior, and vice versa. Despite this interdependence, the literatures on contract design and contract enforcement have largely developed independently of one another. Economic theories of contracting, for the most part, give little explicit attention to enforcement issues, the presumption being that courts will see to it (subject only to verifiability constraints) that whatever terms contracting parties arrive at are fulfilled. Indeed, enforcing contracts as written is the court’s only function in mainstream contract theory (see, for example, Tirole, 1994). This judicial deference to contracts in economic theory contrasts with the far more intrusive role of courts in economic analyses of contract law, in which courts are called on to adjudicate disputes, fill gaps, and devise and implement default rules. Perspectives on contracting can be divided into three broad categories. The first consists of formal models associated with the principal-agent and asymmetric information literature, including theories of both complete and incomplete contracting; the second covers perspectives on contracting implicit in the law and economics literature on contract law and enforcement; while the third consists of what has come to be known as relational contracting theory, an approach often associated with transaction cost economics. Dimensions along which the theories differ include the functions of contracting, the impediments to contracting, and the role of courts and their implications for legal rules and contract enforcement. Last but not least, the theories differ in their ability to explain and predict actual contracting behavior.
2. Why Contract? As the definition in the introduction suggests, the essence of contract is commitment. Without some form of assurance that others will, when the time comes, uphold their end of a bargain, individuals will be justifiably reluctant to make investments, forego opportunities, or take other actions necessary to realize the full value of exchange. To be sure, reputation considerations - the prospect that trading partners will withhold future cooperation - often provide that assurance (Telser, 1980), especially in business transactions (Macaulay, 1963). But where the size or credibility of nonlegal sanctions is insufficient to constrain opportunism, contracting offers an additional recourse: by contracting, transactors expose themselves to legal sanctions for failing to honor their commitments. Beyond this basic commitment-enhancing function, contract theorists generally associate three broad motives with contracting: risk transfer, incentive alignment, and transaction cost economizing. In pure insurance or risk-transfer transactions, the objective is to shift risk to the less risk-averse
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transactor or ‘low-cost risk bearer’ (Cheung, 1969; Stiglitz, 1974). In incentive contracts, the aim is to align the parties’ (commonly, a principal and agent) individual incentives to take actions or reveal private information with their joint-surplus maximizing interests (for example, Hart and Holmstrom, 1987). Finally, transaction cost economists emphasize the use of contracts to reduce various costs of transacting, especially, ex post bargaining and ‘hold-up’ costs in transactions supported by relationship-specific investments (Williamson, 1975, 1979; Klein, Crawford, and Alchian, 1978) and ex ante sorting and search costs in contexts where additional information serves merely to redistribute rather than expand the available surplus (Kenny and Klein, 1983; Goldberg, 1985). While the essence of contracting is commitment, the design and interpretation of contractual agreements will depend on which of these three motives dominates.
3. Formal Economic Theories of Contractual Choice The search for contract terms that yield efficient outcomes is the subject of a prodigious theoretical literature in economics. The customary starting point for that inquiry is the complete contingent claims contract associated with the work of Arrow and Debreu (see, for example, Hart and Holmstrom, 1987). Although originally conceived as an analytical tool for modeling competitive equilibrium rather than as a theory of contracting per se (see Guesnerie, 1992), the efficiency properties associated with contingent trade in the Arrow-Debreu framework made complete contingent claims contracts - contracts specifying the physical characteristics, date, location, and price of a commodity for every future state of nature - appealing to contract theorists as an archetype against which to compare more realistic agreements: Arrow-Debreu complete contingent claims contracts represent what transactors would write in an ideal world free from ‘imperfections’. Mainstream contract theories developed specifically to analyze actual contracting practices fall into two categories depending on the nature and source of the ‘real world’ imperfections they emphasize. So-called complete contract theory analyzes the efficiency and contract design implications of the inability of courts to verify particular events or outcomes. Departures from the Arrow-Debreu ideal in complete contract theory thus derive from imperfections or limitations of adjudicators at the contract execution stage. Incomplete contract theory, in contrast, is concerned with the design and efficiency consequences of imperfections arising during contract formation, specifically, the limited capacity of transactors to anticipate, identify and describe optimal responses to future events.
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3.1 Complete Contracting The cornerstone of complete contract theory is the recognition that courts may not be able to verify some contingencies or outcomes and that contracting parties, therefore, may not be able to condition performance on every relevant contingency. The concern posed by nonverifiability is that, with the court no longer able to determine whether some aspect of promised performance has occurred, transactors stand to gain by strategically withholding information or by altering their behavior in ways that yield private benefits but reduce joint gains. In the standard terminology, the propensity to deviate from joint-surplus maximizing behavior in the presence of asymmetric information is called moral hazard when the distortion involves actions or information revelation ex post, and adverse selection where ex ante private information leads only those transactors with less desirable characteristics to transact (the so-called ‘lemons’ problem). The problem of contract design in the complete contracting framework consists of discovering a contingent payment schedule, or sharing rule, that is incentive compatible, that is, that satisfies the requirement that the contract leave the party with discretion over the unverifiable action at least as well off acting in the parties’ joint interests as taking any other feasible action. When only one party’s actions affect outcomes and that party is risk neutral, a contract that makes that party the residual claimant (and distributes expected gains to the other via a fixed payment) will be efficient. Nontrivial design tradeoffs arise when aligning one party’s incentives results either in inefficient risk sharing (if that party is also the more risk averse of the two) or in inefficient incentives for the other party (the case of double-sided moral hazard). In the latter settings, first-best outcomes will generally not be feasible. (Reviews of this literature can be found in Hart and Holmstrom, 1987, and Furubotn and Richter, 1998, among other sources.) Although contracts designed to elicit voluntary performance of unverifiable actions depart from the Arrow-Debreu ideal in leaving gains from trade potentially unrealized relative to the cooperative (nonstrategic) outcome, economists generally regard contracts optimally designed to deal with information asymmetries as complete in the sense that such agreements (i) still fully specify each party’s performance obligations for every possible contingency, and (ii) yield the best possible outcome given the information available to the courts at the time the agreement is carried out and thus ‘never need to be revised or complemented’ (Holmstrom and Tirole, 1989, p. 68). Despite the variety of settings in which risk sharing, moral hazard and adverse selection are potentially important (see below), complete contract theory’s performance as a positive theory has been disappointing. Aside from the broad prediction that efficient sharing rules will balance incentives for one party against inefficient risk bearing by that party or the incentives of trading
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partners, asymmetric information models yield few testable hypotheses. One reason for this is the ‘extreme sensitivity’ of optimal incentive schemes to slight changes in the relation between actual performance and verifiable information (Hart and Holmstrom, 1987, p. 105). Complete contract theory also fails to account for the observed simplicity of sharing rules in most real world contracts. Whereas the theory admits potentially detailed and complex payment rules specifying each party’s performance obligations for every possible contingency (in the case of discrete contingencies) and elaborate nonlinear pricing rules (in the continuous case), actual contracts incorporate few if any explicit contingencies and generally use simple, typically linear, pricing schemes (Holmstrom and Hart, 1987; Bhattacharyya and Lafontaine, 1995). Complete contract theory has also been faulted for its inability to distinguish between, and therefore account for the choice between, contracting and other institutional and organizational forms such as property rights and the firm. 3.2 Incomplete Contracting Contract theorists consider a contract incomplete, or to contain a ‘gap,’ if performance of the actual terms of the agreement would leave gains from trade unrealized given the information available to the parties and the courts at the time performance takes place (see, for example, Holmstrom and Tirole, 1989, p. 68; Tirole, 1994, p. 18). Under the assumption that transactors possess unlimited foresight and cognition, such an omission could never occur. Incomplete contract theory relaxes the extreme rationality assumption of complete contract theory and assumes that the limits on rationality that make courts less than fully omniscient apply to contracting parties as well: sophisticated but boundedly rational transactors will omit contingencies when the costs of anticipating, devising optimal responses to, and drafting provisions for improbable events outweigh the expected gains in efficiency from doing so. Departures from the Arrow-Debreu ideal may thus arise in incomplete contract theory from failures of the contracting parties to foresee and provide for contingencies in formulating their agreement, instead of or in addition to the inability of courts to verify performance. The prospect that contracts might leave gains unrealized raises an issue for the analysis of incomplete contracting that is not germane to complete contracting, namely, how, if at all, contracting parties respond to opportunities for mutually advantageous ex post adjustment. Two types of models can be distinguished: those that permit renegotiation ex post, and those that do not. (a) Models without Renegotiation Although linearity restrictions on sharing rules have often been imposed by complete contract theorists for tractability rather than theoretical or empirical reasons, exogenous restrictions on feasible contracts will, except under special conditions, lead to ex post inefficiencies.
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Accordingly, linear principal-agent contracts will in general be incomplete. (Not surprisingly, therefore, considerable effort has been applied to identifying the conditions under which linear contracts are sufficient for efficient outcomes; see, for example, Holmstrom and Milgrom, 1987; Bhattacharyya and Lafontaine, 1995.) Early principal-agent models mainly dealt with opportunities for mutually advantageous adjustment within linear contracts by ignoring them; contract terms were presumed to be definitive and immune to ex post bargaining, and any ‘residual loss’ from imperfect adjustment to changing events considered a component of ‘agency costs’ (Jensen and Meckling, 1976, p. 308; see also Matthewson and Winter, 1985; Allen and Lueck, 1992, 1993.) Because of their greater tractability and more realistic starting assumptions, linear agency models have been more successful than complete contract theories at generating predictions and explaining observed contracts. Settings in which moral hazard and adverse selection are likely to pose problems for contracting parties are numerous, and many relationships can be cast in principal-agent terms. Linear principal-agent models have been the primary framework for analyzing contract terms in franchising (Matthewson and Winter, 1985; Lal, 1990), agricultural share-cropping (Stiglitz, 1974; Eswaran and Kotwal, 1985), and product warranties (Priest, 1981; Cooper and Ross, 1985), among other settings. The linear agency model has also recently been extended to analyze multi-task settings in which agents perform either multiple activities or a single activity with multiple dimensions (Holmstrom and Milgrom, 1991). Formal tests of agency model predictions have proved difficult, however. The optimal sharing parameter that is the primary focus of these models depends on factors such as the relative risk aversion of the principal and agent and the relative effects of their actions on joint surplus. Because these factors are difficult or impossible to measure, acceptance of the model often turns on accepting the modeler’s risk preference and marginal productivity assumptions (Stigler and Becker, 1977; Allen and Lueck, 1995). More generally, heavy reliance by agency theorists on risk aversion to explain observed contracting practices has been criticized, especially in the context of commercial transactions, for diverting attention from other potentially more important considerations (see Williamson, 1985b, pp. 388-389; Goldberg, 1990). (b) Models with Renegotiation More recent models of incomplete contracting generally assume that transactors can negotiate to take advantage of any ex post gains on the grounds that (i) unrealized gains from trade create an incentive to renegotiate, and (ii) contract law generally allows modification of contract terms by mutual consent. Incorporating renegotiation into the analysis, however, requires a model of bargaining, a perennial difficulty for economic theory. The formal literature on incomplete contracting has generally circumvented that problem by assuming that the parties costlessly negotiate to
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the cooperative (Nash) outcome (Grossman and Hart, 1986; Hart and Moore, 1988; Lutz, 1995). The assumption of costless renegotiation assures ex post efficiency and thereby eliminates any role for contracts in establishing ex post incentives. Benefits may nevertheless accrue to contracting if either (i) transactors are risk averse or (ii) efficiency requires unverifiable ex ante investments. Even though the parties are free to modify their agreements by mutual consent, the ability of either party to enforce the contract’s original terms establishes the threat points in any subsequent negotiation. Hence, by contracting, transactors are able to influence the distribution of ex post surpluses and, thereby, the allocation of risk and expected return on investments. Incomplete contract theory has permitted formal analysis of alternative organizational and institutional arrangements, especially the existence and locus of property rights (for example, Grossman and Hart, 1986; Hart and Moore, 1990) for which the complete contract framework was unsuitable. In the eyes of some theorists, however, the gains in analytical scope come at the cost of generality. While sympathizing with the view that individuals are not capable of dealing with unlimited complexity, purists complain that, in the absence of an accepted model of bounded rationality, restrictions on feasible contract forms are unavoidably arbitrary and ad hoc (for example Tirole, 1994, pp. 15-17; Hart and Holmstrom, 1987, pp. 133, 148).
4. Contracting in Law and Economics In most respects, conceptions of contracting in law and economics conform to those in economic theory more generally. Like mainstream economics, the law and economics literature conceives of contracting as a device for communicating substantive performance objectives. As Goetz and Scott (1985, p. 265) describe it, contracting parties seek first ‘to negotiate a subjective understanding about the combination of underlying substantive rights that form the basis for mutually beneficial trade. What remains is an instrumental problem, that of formulating contractual terms that mirror the desired exchange.’ Like incomplete contract theory, law and economics also recognizes that limitations of language and foresight generally prevent transactors from drafting all-encompassing agreements, of which Arrow-Debreu contingent claims contracts are again the archetype (for example, Shavell, 1984; Schwartz, 1992a, 1992b; Ayres and Gertner, 1992, p. 730). As a consequence of these imperfections, contracts often contain gaps that leave performance under the contract potentially inefficient, thus creating opportunities for efficiencyenhancing adjustments. Where law and economics and economic treatments of incomplete contracting diverge is in the manner through which adjustments come about. In economic contract theories, courts mechanically enforce contract terms, and
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adjustments, if any, are accomplished through costless renegotiation. In law and economics, the courts, rather than the transactors, evaluate opportunities for adaptation and implement the necessary contractual modifications. In the typical scenario, one of the parties will find performance at the contractually specified price unprofitable and attempt to escape his contractual obligations, leading the other party to bring suit to enforce the contract. If the contract is incomplete and ex post bargaining is prohibitively costly, requiring performance as specified in the agreement will be inefficient on at least some occasions. By, instead, enforcing the contract in a way that corrects such defects, courts will enhance efficiency, first, by increasing the efficiency of performance ex post and, second, by reducing the need for transactors to formulate detailed agreements, and hence the cost of contracting, in the first place. In general, the law and economics literature on contract advises courts to complete incomplete contracts with terms the parties ‘would have bargained for’ themselves had the costs of anticipating and incorporating provisions for the event at hand been sufficiently low (see Chapters 4400 Implied Terms Interpretation; 4500 Unforeseen Contingencies - Risk Allocation; and 4600 Remedies). Since what the parties would have bargained for in the absence of imperfections encountered during contract formation is a complete contract, courts are essentially charged with discovering and implementing rules that yield the efficient outcome given the information available to (that is, verifiable by) the court (see Schwartz, 1992a, p. 281). Overall, law and economics offers a richer characterization of background legal rules and the role of courts in enforcing contracts from which economic theories of contracting could benefit. At the same time, legal scholarship on contracting can be faulted for not being more explicit about the purposes of contracting and the ramifications of contract law for contracting behavior. As Rubin (1996) observes, ‘When American legal scholars speak of “contracts” they typically do not mean contracts at all, but rather judicial decisions ... involving disputes about contracts. Contracts themselves, the transactions that create them, and the business decision to comply with them, renegotiate them, or breach them have rarely surfaced in the academic study of [contract]’ (as quoted in Williamson, 1996).
5. Relational Contracting Despite substantial differences in the roles they ascribe to courts, law and economics and economic contract theory operate under the ‘legal centralist’ assumption that courts perform their assigned functions in ‘an informed, sophisticated, and low-cost way’ (Williamson, 1983, p. 520). But whereas that function in economic theories of contracting entails enforcing explicit
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provisions, law and economics assigns courts the much more demanding responsibility of discovering contracting parties’ ‘real’ intentions and identifying opportunities for and implementing efficiency-enhancing adjustments. As Oliver Williamson (1985b, p. 201) has remarked, ‘Judgement based on detailed ex post knowledge of the particulars, including an examination of the magnitude of the profitability consequences that accrue, will often be the only way to ascertain whether an adjustment is warranted’ (compare Ayres and Gertner, 1989, pp. 116-117; Scott, 1990, pp. 600-601). The prescription that courts fill gaps in incomplete contracts with what the parties would have bargained for effectively presumes that courts possess such knowledge and the expertise to perform the substantive calculations the transactors would themselves have had to make to determine efficient performance. Law and economics’ confidence in the efficacy of court ordering and its emphasis on substantive performance contain a paradox, however: if courts are able to fill gaps accurately and costlessly, why would transactors ever incur the time and expense of drafting definite performance obligations in the first place? Instead, transactors could just indicate a vague intention to transact and let the courts fill in the details thereafter. In a world in which contract formation is costly and adjudication costless, a perfectly indefinite agreement, rather than comprehensive Arrow-Debreu bargains, becomes the ideal contract (see Charny, 1991, pp. 1840-1841). If transactors do specify definite performance obligations, it must be to reduce the cost or inaccuracy of court ordering. Explicit integration of adjudication costs into the analysis of contracting has two immediate implications for contract design. First, where transactors design contracts to avoid court ordering, the presumption that contract terms define the substantive outcomes the transactors wish to see take place is no longer justified. Transactors might reasonably prefer contract provisions that leave gains from trade unrealized, or that relegate sufficiently worthwhile adjustments to renegotiation or other forms of self help, over terms that specify the efficient course of action but increase the costs or likelihood of litigation. In such circumstances, express terms may have only an indirect, and possibly even a contradictory, relation to the parties’ substantive aims (for example, Masten and Snyder, 1993, pp. 60-63). Second, the existence of judicial imperfections opens the door to conduct designed to contrive cancellation, evade performance, or otherwise force a renegotiation of the existing terms. Unlike moral hazard, which is a passive response to price signals within an existing agreement, such behavior aims to exact a de jure modification of terms previously agreed to. Among the tactics available to a party seeking a redistribution of the gains from trade are suing for trivial deviations, ‘working to rule,’ and withholding relevant information in hopes of inducing breach (see Muris, 1981; Williamson, 1983, p. 526; Goldberg, 1985; Masten, 1988b). Contracts from this perspective do not so
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much define the terms of trade as determine the process through which the terms of trade are ultimately arrived at (Macaulay, 1985). As Victor Goldberg (1976, p. 428) has described it, the emphasis shifts from devising ‘a detailed specification of the terms of the agreement to a more general statement of the process of adjusting the terms of the agreement over time-the establishment, in effect, of a “constitution” governing the ongoing relationship’. Inasmuch as both regard contract terms as starting points for future negotiations, relational and incomplete contract theories bear a passing resemblance. The difference, however, is that renegotiation in the relational framework is costly and unilateral preservation of the contract’s original terms (including price) is neither certain nor free. An essential element of contract design, therefore, becomes structuring the relationship in a way that reduces the incentive to engage in wasteful efforts to evade performance or force a renegotiation (compare Williamson, 1983; Goldberg, 1985; Klein, 1992, 1995, 1996; Masten, 1988b). Contract terms will also be used to affect the extent of court ordering. Indefinite contracts that use terms such as ‘best efforts’, ‘gross inequity’, or ‘substantial performance’ to describe contractual obligations leave the parameters of acceptable performance ultimately to the courts. By contrast, contracts that specify precise performance obligations, define sanctions (such as liquidated damages or termination), and allocate discretion to invoke those sanctions unilaterally, shift the locus of decision making and adjustment, to the extent courts defer to written terms, from the courts to the transactors. Finally, a process orientation also highlights the interaction between judicial enforcement policies and contract design. To the extent that deviations between contract terms and transactors’ substantive intentions reflect efforts to economize on adjudication costs, judicial efforts to complete ‘incomplete’ agreements may frustrate rather than foster the parties’ intentions. The ability of contracting parties to achieve process objectives - to reduce court ordering through the use of more precise language, for example - depends on the extent to which courts are willing to defer to written terms.
6. Empirical Evidence on Contractual Choice Several reviews of the empirical literature on contracting have been published, the most recent of which are Shelanski and Klein, 1995; Crocker and Masten, 1996; Lyons, 1996, and Lafontaine and Slade, 1997, 1998. The following identifies some of the most prominent findings and regularities and their relation to the theories discussed above.
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6.1 Contracting and Contract Duration One of the most firmly established regularities in the empirical literature on contracting is the association between relationship-specific investments (or reliance) and the use and duration of contractual agreements. An early and well-known example is Joskow’s (1987) econometric analysis of the duration of nearly 300 coal contracts. Exploiting regional differences in the characteristics of coal and transportation alternatives and variations in contract quantity, Joskow’s study showed the duration of coal contracts to be significantly correlated with measures of physical- and site-specificity and dedicated assets. A more recent study of engineering subcontracting practices in the United Kingdom by Lyons’ (1994) suggests that specificity affects not only the duration of contracts but the decision to contract in the first place. The engineering firms and subcontractors in Lyons’ sample were significantly more likely to adopt formal contracts, over more flexible but less secure informal agreements, where investments in relationship-specific physical and human capital left the subcontractor vulnerable to ex post opportunism. Empirical research has also identified a correlation between long-term contracting and specificity in natural gas (Crocker and Masten, 1988); petroleum coke (Goldberg and Erickson, 1987); and ocean shipping contracts (Pirrong, 1993), among others. Contracting appears less attractive as a way of protecting reliance or relationship-specific investments, however, where the alternative to contracting is integrated ownership and production. Empirical research on integration decisions reveals a consistent preference for integration over contracting as the specificity of investments increases (for overviews, see Joskow, 1988; Shelanski and Klein, 1995; Crocker and Masten, 1996; and Chapter 0530 New Institutional Economics). Contracting thus appears to be only an imperfect response to the hazards posed by relationship-specific investments. Empirical research suggests, moreover, that the costs and limitations of contracting grow with the complexity and uncertainty of the transaction. In Lyons’ (1994) study of engineering transactions, for example, firms were less likely to use formal contracts for advanced technology projects than for relatively simple procurements. Meanwhile, Goldberg and Erickson (1987) and Crocker and Masten (1988) found that contract duration in petroleum coke and natural gas contracts decreased in periods of increased uncertainty, contrary to what would be expected if risk-sharing were the primary motive for contracting. Research on the determinants of make-or-buy decisions suggests that uncertainty and complexity diminish the attractiveness of contracting relative to integration as well (for example, Masten, 1984; Anderson and Schmittlein, 1984). Though clearly an important determinant, the protection of specific investments is not the sole motive for contracting. Unsupported assertions to the contrary notwithstanding, relationship-specific investments in franchising appear to be modest and unimportant as a motive for franchise contracting (see
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Lafontaine and Slade, 1997, 1998). Indeed, the viability of some contractual arrangements, such as franchising and equipment leasing, may depend on assets actually being redeployable at reasonably low cost (Klein, 1995; Masten and Snyder, 1993). Case studies have also shown benefits of contracting to accrue to the desire to control free-riding on the provision of information or services (for example, Rubin, 1978; Masten and Snyder, 1993) and to avoid unproductive search and sorting costs (Kenney and Klein 1983; Gallick, 1984). 6.2 Contract Design (a) Incentive Provisions The empirical literature offers broad support for the proposition that transactors choose contract terms to promote efficient adaptation and mitigate transaction costs. In contemporaneous studies of natural gas contracting, Masten and Crocker (1985) and Mulherin (1986) found that take-or-pay percentages in natural gas contracts varied with the alternative value of gas reserves, supporting an incentive interpretation over the alternative view that take-or-pay provisions serve distributional or risk-sharing purposes (for example, Hubbard and Weiner, 1986). Case studies describing the use of minimum purchase requirements for coal (Carney, 1978) petroleum coke (Goldberg and Erickson, 1987), and bauxite (Stuckey, 1983), among other products, corroborate this finding (see Masten, 1988a, pp. 91-92, for a discussion). In a related study, Crocker and Masten (1988) found that the prospect of inefficient adaptation associated with distortions in the size of take-or-pay provisions significantly reduced the willingness of parties to engage in long-term contracting. Incentive considerations also appear to be influential in determining sharing arrangements. Lafontaine (1992), for example, found that royalty rates across franchises tend to vary with the relative importance of franchisor and franchisee effort. Observed correlations between uncertainty and royalty rates (and the use of franchised versus company outlets) are inconsistent with the standard assumption of franchisee risk aversion, however. (Reviews of the empirical literature on franchise contracting can be found in Lafontaine and Slade, 1997, 1998). Risk sharing as a motive for contracting has fared poorly in other settings as well. Allen and Lueck (1992), for instance, conclude that the incidence of crop-share versus fixed-rent contracts between farmer-tenants and landowners are unrelated to the riskiness of crops. Similarly, Leffler and Rucker (1991) reject risk sharing as an explanation for why timber track owners and harvesters sacrifice the incentive advantages of lump-sum relative to royalty contracts in favor of the hypothesis that the use of royalty contracts on relatively remote and heterogeneous timber tracks reflects the desire to avoid wasteful pre-bid inspection under lump-sum contracts. Finally, Holmstrom and Milgrom (1991) interpret Anderson’s (1985) and Anderson and Schmittlein’s (1984)
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finding that importance of non-selling activities and difficulty measuring performance of sales agents explain manufacturer reliance on low-powered incentives as evidence that measurement costs in multitask settings are a critical determinant of the intensity of incentives in contractual relations (see also, Slade, 1996). (b) Relational Contracts Whereas most of the empirical contracting literature focuses on standard price and quantity provisions, research on relational contracting has sought to account for the widespread use of contracts that leave important terms like price and quantity indeterminate. Examples of such provisions include price renegotiation and ‘market out’ provisions in natural gas contracts (Crocker and Masten, 1991), ‘gross inequity’ provisions in long-term coal contracts (Joskow, 1985), termination-at-will and best-efforts clauses in franchise agreements (Hadfield, 1990), substantial performance requirements in construction contracts (Goetz and Scott, 1981), and other ‘open term’ agreements (for example, Gergen, 1992). Large-scale analyses of relational contract provisions have focused on methods of price adjustment. Crocker and Masten (1991), for instance, conclude from their study of price adjustment in natural gas contracts that circumstances favoring the use of long-term, fixed-quantity agreements favor the adoption of relatively indefinite price adjustment provisions over formulaic adjustment mechanisms that, although less costly to implement, are more likely to induce efforts to evade performance obligations in extreme situations. As Goldberg and Erickson (1987) note, greater reliance on renegotiation provisions in fixed versus variable quantity contracts is difficult to reconcile with incentive alignment motives. Crocker and Reynolds’ (1993) study of jet engine procurement contracts also found that price adjustment was likely to become less definite as performance horizons lengthened and technological uncertainty increased, while contractor litigiousness and the absence of alternative engine suppliers favored more definite price terms. The available evidence thus generally supports the notion that transactors’ choice of contract terms reflects a tradeoff between the specification costs and rigidities associated with specifying detailed performance obligations in uncertain or complex transactions, on the one hand, and the greater flexibility but higher expected cost of establishing the terms of trade ex post in less definite relational contracts.
7. Implications and Directions Economic research on contracting is important to both legal scholarship and practice. Contracting is a - perhaps the most - fundamental institution of legal as well as economic interaction (compare Williamson, 1996). At a practical level, the study of contracting stands to inform lawyers and lawmakers about
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the objectives of contracting parties and the sources of contractual failures. For lawyers, such knowledge can provide insights with which to help clients design more effective agreements. For legislatures and courts, understanding the functions and limitations of contracting is crucial to the formulation of appropriate legal rules and their application in individual cases. As noted previously, whether and how courts intervene in contractual relations will depend on the theory of contracting behavior to which they subscribe. Theories that place confidence in the ability of parties to effect private orderings either through ex ante specification of contingent performance or through low-cost, ex post negotiation will favor a policy of passive judicial enforcement, whereas theories that emphasize the behavioral and cognitive impediments to ex ante alignment and ex post negotiation without similar regard for the cognitive limitations of judges will tend to favor more active enforcement and intervention by the courts. As various commentators have noted, official contract law, as reflected in the United States in Section 2 of the Uniform Commercial Code and Restatement (2nd) of Contracts, has moved increasingly toward favoring more active judicial enforcement. Where once courts were discouraged from using extrinsic evidence in interpreting contractual obligations, modern contract law endorses an active enforcement policy, encouraging courts to interpret contractual agreements ‘in light of surrounding circumstances’. Despite this widely-noted shift, however, the evidence is that courts have been far from uniform in their approach to contract enforcement. In practice, courts as a group neither universally seek to discover the parties’ true intentions from the context of their agreement - as the Code and Restatement recommend - nor consistently defer to written terms (Goetz and Scott, 1985, p. 307; Schwartz, 1992a). Such variations, moreover, cannot be explained entirely by philosophical differences among courts; judicial enforcement policies appear to vary systematically across disputes, courts tending to enforce franchise and distributorship agreements more passively than contracts for intermediate goods between manufacturers and suppliers (see Hadfield, 1990, pp. 978-990; Schwartz, 1992a, pp. 271, 304-305; Farnsworth, 1990, p. 556). Further research on variations in judicial enforcement policies and the dimensions along which they vary is likely to shed additional light on the functions and limitations of contracting. Although there are indications that recent research on contractual choice has already begun to influence how courts think about contracting and resolve contract disputes (see, for instance, PSI Energy v. Exxon Coal, USA, 991 F.2d. 1265 (1993)), much more needs to be done before positive theories of contracting can provide a solid basis for normative prescriptions. Such basic questions as why transactors choose super-compensatory liquidated damages have yet to receive a fully satisfactory explanation. More subtle but important issues like the effects of contractual protections on the willingness of
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transactors to make relationship-specific investments are just beginning to receive scrutiny (for example, Saussier, 1998). Although theoretical tensions are likely to persist between those who value axiomatic rigor and those willing to invoke empirical regularities to develop testable predictions, on one issue at least, the two approaches appear to be converging, namely, that further progress on understanding contracting requires a better appreciation of the interactions of contract design and contract enforcement and the process functions of contracting (compare Tirole, 1994).
Acknowledgments Financial support from the Center for Research on Contracting and the Structure of Enterprises is gratefully acknowledged.
Bibliography on Contractual Choice (4100) Allen, Douglas W. and Lueck, Dean (1992), ‘Contract Choice in Modern Agriculture: Cropshare versus Cash Rent’, 35 Journal of Law and Economics, 397-426. Allen, Douglas W. and Lueck, Dean (1993), ‘Transaction Costs and the Design of Cropshare Contracts’, 24 Rand Journal of Economics, 78-100. Allen, Douglas W. and Lueck, Dean (1995), ‘Risk Preferences and the Economics of Contracts’, 85 American Economic Review, 447-451. Anderson, Erin (1985), ‘The Salesperson as Outside Agent or Employee: A Transaction Cost Perspective’, 4 Management Science, 234-254. Anderson, Erin and Schmittlein, David (1984), ‘Integration of the Sales Force: An Empirical Examination’, 15 Rand Journal of Economics, 385-395. Ayres, Ian and Gertner, Robert (1989), ‘Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules’, 94 Yale Law Journal, 96-114. Ayres, Ian and Gertner, Robert (1992), ‘Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules’, 101 Yale Law Journal, 729-73. Baird, Douglas G. (1990), ‘Self Interest and Cooperation in Long-Term Contracts’, 19 Journal of Legal Studies, 535-596. Bernstein, Lisa (1996), ‘Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms’, 144 University of Pennsylvania Law Review, 1765-1821. Bhattacharyya, Sugato and Lafontaine, Francine (1995), ‘Double-Sided Moral Hazard and the Nature of Share Contracts’, 26 RAND Journal of Economics, 761-781. Carney, E.M. (1978), ‘Pricing Provisions in Coals Contracts’, in Rocky Mountain Mineral Law Institute, New York, Matthew Bender, 197-230. Charny, David (1990), ‘Nonlegal Sanctions in Commercial Relationships’, 104 Harvard Law Review, 373-467. Charny, David (1991), ‘Hypothetical Bargains: The Normative Structure of Contract Interpretation’, 89 Michigan Law Review, 1815-1879.
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Cheung, Steven N.S. (1969), ‘Transaction Costs, Risk Aversion, and the Choice of Contractual Arrangements’, 12 Journal of Law and Economics, 23-46. Cooper, Russ, and Ross, Thomas W. (1985), ‘Product Warranties and Double Moral Hazard’, 16 Rand Journal of Economics, 103-113. Crocker, Keith J. and Lyon, Thomas P. (1994), ‘What do “Facilitating Practices” Facilitate?: An Empirical Investigation of Most-Favored-Nation Clauses in Natural Gas Contracts’, 34 Journal of Law and Economics, 297-322. Crocker, Keith J. and Masten, Scott E. (1988), ‘Mitigating Contractual Hazards: Unilateral Options and Contract Length’, 19 Rand Journal of Economics, 327-343. Crocker, Keith J. and Masten, Scott E. (1991), ‘Pretia Ex Machina? Prices and Process in Long-Term Contracts’, 34 Journal of Law and Economics, 69-99. Crocker, Keith J. and Masten, Scott E. (1996), ‘Regulation and Administered Contracts Revisited: Lessons from Transaction-Cost Economics for Public Utility Regulation’,9 Journal of Regulatory Economics, 5-39. Crocker, Keith J. and Reynolds, Kenneth J. (1993), ‘The Efficiency of Incomplete Contracts: An Empirical Analysis of Air Force Engine Procurement’, 24 Rand Journal of Economics, 126-146. Eswaran, M. and Kotwal, A. (1985), ‘A Theory of Contractual Choice in Agriculture’, 75 American Economic Review, 352-67. Farnsworth, Alan (1990), Contracts (2nd edn), New York, Little, Brown, and Company. Furubotn, Eirik G. and Richter, Rudolf (1998), Institutions and Economic Theory: The Contribution of the New Institutional Economics. Ann Arbor, The University of Michigan Press. Gallanter, Marc (1981), ‘Justice in Many Rooms: Courts, Private Ordering, and Indigenous Law’, 19 Journal of Legal Pluralism, 1-47. Gallick, Edward C. (1984), Exclusive Dealing and Vertical Integration: The Efficiency of Contract in the Tuna Industry, Bureau of Economics Staff Report to the Federal Trade Commission, excerpted in Masten, Scott E. (ed), Case Studies in Contracting and Organization,Oxford, Oxford University Press. Gergen, Mark P. (1992), ‘The Use of Open Terms in Contract’, 92 Columbia Law Review, 997-1081. Goetz, Charles J. and Scott, Robert (1981), ‘Principles of Relational Contracts’, 67 Virginia Law Review, 1089-1151. Goetz, Charles J. and Scott, Robert (1983), ‘The Mitigation Principle: Toward a General Theory of Contractual Obligation’, 69 Virginia Law Review, 967-024 Goetz, Charles J. and Scott, Robert (1985), ‘The Limits of Expanded Choice: An Analysis of the Interactions between Express and Implied Contract Terms’, 73 California Law Review, 261-322. Goldberg, Victor P. (1976), ‘Regulation and Administered Contracts’, 7 Bell Journal of Economics, 426-448. Goldberg, Victor P. (1980), ‘Relational Exchange, Economics and Complex Contracts’, 23 American Behavioral Scientist, 337-352. Goldberg, Victor P. (1985), ‘Price Adjustment in Long-Term Contracts,’ 1985 Wisconsin Law Review, 527-543. Goldberg, Victor P. (1990). ‘Aversion to Risk Aversion in the New Institutional Economics’, 146 Journal of Institutional and Theoretical Economics, 216-222. Goldberg, Victor P. and Erickson, John R (1987), ‘Quantity and Price Adjustment in Long-Term
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Contracts: A Case Study in Petroleum Coke’, 31 Journal of Law and Economics, 369-398. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Grossman, Sanford J. and Hart, Oliver D. (1986), ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration’, 94 Journal of Political Economy, 691-719. Guesnerie, Roger (1992), ‘The Arrow-Debreu Paradigm Faced with Modern Theories of Contracting: A Discussion of Selected Issues Involving Information and Time’, in Werin, L. and Wijkander, H. (eds), Contract Economics, Cambridge, MA, Basil Blackwell. 12-41 Hadfield, Gillian K. (1990), ‘Problematic Relations: Franchising and the Law of Incomplete Contracts’, 42 Stanford Law Review, 927-992. Hallagan, William (1978), ‘Self-Selection by Contractual Choice and the Theory of Sharecropping’, 9 Bell Journal of Economics, 344-354. Hart, Oliver D. and Holmstrom, Bengt (1987), ‘The Theory of Contracts’, in Bewley, T.R. (ed), Advances in Economic Theory, Fifth World Congress, Cambridge, Cambridge University Press, 369-398. Hart, Oliver D. and Moore, John (1988), ‘Incomplete Contracts and Renegotiation’, 56 Econometrica, 755-785. Hart, Oliver D. and Moore, John (1990), ‘Property Rights and the Nature of the Firm’, 98 Journal of Political Economy, 1119-1158. Holmstrom, Bengt and Milgrom, Paul (1987), ‘Aggregation and Linearity in the Provision of Intertemporal Incentives’, 55 Econometrica, 303-328. Holmstrom, Bengt and Milgrom, Paul (1991), ‘Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design’, 7 Journal of Law, Economics, and Organization, 24-52. Holmstrom, Bengt, and Tirole, Jean (1989), ‘The Theory of the Firm’, in Schmalensee, Richard and Willig, Robert D. (eds), Handbook of Industrial Economics, New York, Elsevier Science Publishing, 61-133. Hubbard, R. Glenn and Weiner, Robert J. (1986.), ‘Regulation and Long-Term Contracting in U.S. Natural Gas Markets’, 35 Journal of Industrial Economics, 31-79. Hubbard, R. Glenn and Weiner, Robert J. (1991), ‘Efficient Contracting and Market Power: Evidence from the U.S. Natural Gas Industry’, 3 Journal of Law and Economics, 25-68. Jensen, Michael C. and Meckling, William H. (1976), ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, 3 Journal of Financial Economics, 305-360. Johnston, Jason Scott (1990), ‘Strategic Bargaining and the Economic Theory of Contract Default Rules’, 100 Yale Law Journal, 615-664. Joskow, Paul L. (1985), ‘Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generation Plants’, 1 Journal of Law, Economics and Organization, 33-79. Joskow, Paul L. (1987), ‘Contract Duration and Relationship-Specific Investments: Evidence from Coal Markets’, 77 American Economic Review, 168-185. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Joskow, Paul L. (1988), ‘Asset Specificity and the Structure of Vertical Relationships: Empirical Evidence’, 4 Journal of Law, Economics, and Organization, 98-115. Joskow, Paul L. (1988b), ‘Price Adjustment in Long-Term Contracts: The Case of Coal,’ 31 Journal
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of Law and Economics, 47-83. Joskow, Paul L. (1990), ‘The Performance of Long-Term Contracts: Further Evidence from Coal Markets’, 21 Rand Journal of Economics, 251-274. Kaufman, Patrick J. and Lafontaine, Francine (1994), ‘Costs of Control: The Source of Economic Rents For McDonald’s Franchisees’, 37 Journal of Law and Economics, 417-543. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Kenney, Roy W. and Klein, Benjamin (1983), ‘The Economics of Block Booking’, 26 Journal of Law and Economics, 497-540. Klein, Benjamin (1980), ‘Transaction Cost Determinants of “Unfair” Contractual Arrangements’, 70 American Economic Review, 356-362. Klein, Benjamin (1992), ‘Contracts and Incentives: the Role of Contract Terms in Assuring Performance’, in Werin, Lars and Wijkander, Hans (eds), Contract Economics, Cambridge, MA, Basil Blackwell, 149-173. Klein, Benjamin (1995), ‘The Economics of Franchise Contracts’, 2 Journal of Corporate Finance , 9-37. Klein, Benjamin (1996), ‘Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships’, 34 Economics Inquiry, 444-463. Klein, Benjamin, and Leffler, Keith B. (1981), ‘The Role of Market Forces in Assuring Contractual Performance’, 89 Journal of Political Economy, 615-641. Klein, Benjamin, and Murphy, Kevin M. (1988), ‘Vertical Restraints as Contract Enforcement Mechanisms’, 31 Journal of Law and Economics, 265-297. Klein, Benjamin, and Saft, Lester F. (1985), ‘The Law and Economics of Franchise Tying Contracts’, 28 Journal of Law and Economics, 345-361. Klein, Benjamin, Crawford, R.A. and Alchian, Armen A. (1978), ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Proces’, 21 Journal of Law and Economics, 297-326. Knoeber, Charles R. (1982), ‘An Alternative Mechanism to Assure Contractual Reliability’,12 Journal of Legal Studies, 333-343. Laffont, Jean-Jacques, and Tirole, Jean (1988), ‘The Dynamics of Incentive Contracts’, 56 Econometrica, 1153-1175. Lafontaine, Francine (1992), ‘Agency Theory and Franchising: Some Empirical Results’, 23 Rand Journal of Economics, 263-283. Lafontaine, Francine (1993), ‘Contractual Arrangements as Signaling Devices: Evidence from Franchising’, 9 Journal of Law, Economics, and Organization, 256-289. Lafontaine, Francine and Masten, Scott E. (1995), ‘Franchise Contracting, Organization, and Regulation’, special issue of the Journal of Corporate Finance. Lafontaine, Francine and Slade, Margaret E. (1997), ‘Retail Contracting: Theory and Practice’, 65 Journal of Industrial Economics, 1-25. Lafontaine, Francine and Slade, Margaret E. (1998), ‘Incentive Contracting and the Franchise Decision’, National Bureau of Economic Research Working Paper 6544. Lal, R. (1990), ‘Improving Channel Performance through Franchising’,9 Marketing Science, 299-318. Leffler, Keith B. and Rucker, Randal R. (1991), ‘Transaction Costs and the Efficient Organization of Production: A Study of Timber-Harvesting Contracts’, 99 Journal of Political Economy, 1060-1087. Libecap, Gary D. and Wiggins, Steven N. (1984), ‘Contractual Responses to the Common Pool:
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Prorationing of Crude Oil Production’, 74 American Economic Review, 87-98. Lutz, Nancy A. (1995), ‘Ownership Rights and Incentives in Franchising’, 2 Journal of Corporate Finance, 103-131. Lyons, Bruce R. (1994), ‘Contract Specific Investment: An Empirical Test of Transaction Cost Theory’, 3 Journal of Economics and Management Strategy, 257-278. Lyons, Bruce R. (1996), ‘Empirical Relevance of Efficient Contract Theory: Inter-Firm Contracts’, 12 Oxford Review of Economic Policy, 27-52. Macaulay, Stewart (1963), ‘Non-Contractual Relations in Business: A Preliminary Study’, 28 American Sociological Review, 55-70. Macaulay, Stewart (1985), ‘An Empirical View of Contract’, 1985 Wisconsin Law Review, 465-482. Macneil, Ian R. (1974), ‘The Many Futures of Contracts’, 47 Southern California Law Review, 691-816. Masten, Scott E. (1984), ‘The Organization of Production: Evidence from the Aerospace Industry’, 27 Journal of Law and Economics, 403-417. Masten, Scott E. (1988a), ‘Minimum Bill Contracts: Theory and Policy’, 37 Journal of Industrial Economics, 85-97. Masten, Scott E. (1988b), ‘Equity, Opportunism, and the Design of Contractual Relations’, 144 Journal of Institutional and Theoretical Economics, 180-195. Masten, Scott E. (1996), Case Studies in Contracting and Organization, New York, Oxford University Press. Masten, Scott E. and Crocker, Keith J. (1985), ‘Efficient Adaptation in Long-Term Contracts: Take-or-Pay Provisions for Natural Gas’, 75 American Economic Review, 1083-1093. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press. Masten, Scott E. and Snyder, Edward A. (1989), ‘The Design and Duration of Contracts: Strategic and Efficiency Considerations’, 52 Law and Contemporary Problems, 63-85. Masten, Scott E. and Snyder, Edward A. (1993), ‘United States v. United Shoe Machinery Corporation: On the Merits’, 36 Journal of Law and Economics, 33-70. Reprinted in Masten, Scott E. (ed) (1996), Case Studies in Contracting and Organization, Oxford, Oxford University Press; and 26 The Journal of Reprints for Antitrust Law and Economics, 1997. Matthewson, G. Frank, and Winter, Ralph A. (1985), ‘The Economics of Franchise Contracts’, 28 Journal of Law and Economics, 503-526. McAfee, R. Preston and Schwartz, Marius (1994), ‘Multilateral Vertical Contracting: Opportunism, Nondiscrimination, and Exclusivity’, 84 American Economic Review, 210-230. Milgrom, Paul and Roberts, John (1992), Economics, Organization and Management. Englewood Cliffs, NJ, Prentice Hall. Mulherin, J. Harold (1986), ‘Complexity in Long-Term Contracts: An Analysis of Natural Gas Contract Provisions’, 2 Journal of Law, Economics, and Organization, 105-117. Muris, Timothy J. (1981), ‘Opportunistic Behavior and the Law of Contracts’, 65 Minnesota Law Review, 575-580. Palay, Thomas M. (1984), ‘Comparative Institutional Economics: The Governance of Rail Freight Contracting’, 13 Journal of Legal Studies, 265-87. Palay, Thomas M. (1985), ‘Avoiding Regulatory Constraints: Contracting Safeguards and the Role of Informal Agreements.’ 1 Journal of Law, Economics, and Organization, 155-176.
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4200 LONG-TERM CONTRACTS AND RELATIONAL CONTRACTS Morten Hviid University of Warwick, Department of Economics © Copyright 1999 Morten Hviid
Abstract This chapter discusses the literature on long-term contracts and relational contracts. The central issues in the literature on long-term contracts are the effects of renegotiation and what these contracts can accomplish over and above a series of short-term contracts. The literature on relational contracts focuses on how self-enforceable terms can be supported without the use of enforceable contracts. Among the possible answers to this are repetition and norms. JEL classification: C72, D82, K12 Keywords: Long-Term Contracts, Renegotiation Proofness, Relational Contracts, Repeated Games, Norms
1. Introduction For contracts of a non-trivial duration, contract law faces the dilemma of, on the one hand, offering a means of commitment and, on the other, allowing for sufficient flexibility to adjust to changes in the environment. ‘This tension between the need to fix responsibilities at the outset and the need to readjust them over time permeates the long-term contractual relationship’ (Baird, 1990, p. 586). This tension is basic to both long-term and relational contracts. This entry discussed two classes of contracts, long-term contracts and relational contracts. Although closely related, neither is a subset of the other. Completely state-contingent long-term contracts are clearly not relational. Incomplete long-term contracts would in most cases be relational, although, as pointed out by Eisenberg (1995), they need not be. As regards relational contracts, ‘[t]wo features largely define what lawyers mean by a relational contract: incompleteness and longevity. Relational contracts govern continuing relations’ (Schwartz, 1992b, note 1, p. 271). However, as pointed out in Goetz and Scott (1981) a relational contract need not be a long-term contract, although in most cases it would be. 46
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The two literatures appear to address different issues and hence will be discussed separately below. The central issues in the literature on long-term contracts seems to be the effects or renegotiation as well as what can be accomplished by such contracts over and above what can be achieved by a series of short-term contracts. The literature on relational contracts assume that contract terms are not used and focus on how repeated interaction and social norms can ensure that obligations between parties can become self-enforceable.
A. Long-Term Contracts 2. Long-Term Contracts: General Summaries of the literature can be found in Bolton (1990), Hart (1987), Hart and Holmstrom (1987) and most recently in Salanié (1997, chs 6 and 7). For a recent survey focusing solely on labor contracts, see Malcolmson (1997). Following Salanié (1997, p. 150), a dynamic (long-term) contract is complete if ‘all variables that may have an impact on the conditions of the contractual relationship during its whole duration have been taken into account when negotiating and signing the contract’. This definition rules out any unforeseen contingencies which may arise during the duration of the contract. However, it does not rule out asymmetric information. If, for example, the principal can never observe the effort of an agent, the contract cannot stipulate a level of effort. According to the above definition, the contract is still complete if no information of future relevance will become available later on in the life of the contract. Some authors, such as Hart (1995) refer to this as a comprehensive contract, because ‘there will never be a need for the parties to revise or renegotiate the contract as the future unfolds’ (Hart, 1995, p. 22). For an early demonstration that long-term complete contracts can enable valuable commitment, see Grout (1984). In the case where complete contracts can be written, full commitment is always valuable, since a contract with full commitment can always mimic the outcome of any other contract with less commitment by committing to the same actions as lead to the outcome for the latter contract, see Salanié (1997, pp. 144-146). Commitment to a contract can either be broken by a unilateral deviation, namely breach, or multilateral deviation, namely renegotiation. In case of breach, one party has access to the legal system to either enforce the contract or to award damages. When using the legal system is costless, whether breach is actually possible depends on the breach remedies used by the court. If the remedy is specific performance, the contract can only be varied by mutual consent. If, as is more commonly the case, the remedy is expectation damages,
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one party can always decide to breach and pay the damages (see Chapter 4600 Contract Remedies: General). In the case of a multilateral deviation where both parties want to vary the contract term, it is in general not possible to hold the parties to the original contract by legal means. ‘[B]oth parties’ commitments are only as strong as their contracting partners’ desire to hold them to their original promises’ (Jolls, 1997, p. 203). Since commitment is valuable when complete contracts can be written, losses may occur if renegotiation at any point during the life of the contract cannot be prevented. Although Jolls (1997) does offer some suggestions for enforcing terms which both parties would later agree to vary, it would appear that renegotiation is difficult to rule out legally. This then leads to a focus on contracts which are renegotiation proof (see Dewatripont, 1989 and Bolton, 1990). One reason why there may be scope for renegotiation is that ex ante efficiency may require ex post inefficiency. For example, in order to separate out workers with different levels of unobservable productivity, the menu of contracts offered to the workers will generally not imply that all types get their first-best contract. However, once their type has been inferred from their choice of contract, it is (ex post) efficient to renegotiate these contracts. Doing so may make a renegotiated contract of a type A worker more attractive for a type B worker than the contract which ex ante was designed for type B and the original menu will no longer be fully separating. Thus removing the ex post inefficiencies may remove the incentives which ensured that the contract was ex ante efficient.
3. Renegotiation As pointed out among others by Bolton (1990, p. 304) ‘[i]t turns out that the role of and issues raised by renegotiation are somewhat different when the contracting problem is set in an environment of asymmetric information as opposed to an environment of symmetric but unverifiable information.’ The difference between the two cases relates to whether some ex post inefficiencies remain when renegotiation is possible. Asymmetric Information For the case of adverse selection, the value of commitment is very clear. Consider a dynamic contract between a principal and an agent, where initially the productivity of the agent is not known to the principal. In any separating equilibrium, the productivity of the agent will be known to the principal after the first period. For the ‘bad’ type of agent, separation involves a distortion leading to a lower utility in every period of the contract than would be the case if his true type was known. If the true type is really the bad type, the distortion
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can be removed after the first period when the agent’s type is known for sure. Hence if renegotiation is possible, it will take place - the contract is not robust against renegotiation. Moreover, since both parties want to renegotiate, it is difficult to see how the legal system can prevent this happening. Papers such as Dewatripont (1989) turn the focus on contracts which are renegotiation-proof, that is, contracts where there is never an incentive to renegotiation. With comprehensive contracting this is possible, because any incentive to renegotiate later could have been foreseen at the time of agreeing the original contract. As is shown in Dewatripont (1989), Hart and Tirole (1988), Laffont and Tirole (1987, 1990) the possibility of renegotiation slows down the speed of revelation. Essentially this is caused by a trade-off between speedy revelation and the damaging incentive to renegotiate. Moral Hazard For the case of moral hazard, the literature is less well developed. Fudenberg and Tirole (1990) consider a principal-agent model where there is a gap in time between the agent taking a hidden action and the outcome of this being known. If the principal can infer the agent’s action before the outcome is known, a renegotiation which perfectly insures the agent is optimal. However, if the agent realizes this, the incentive structure of the original contract is blunted. As in the case of adverse selection, information revelation has to be slowed down. In the moral hazard case this is achieved by the agent randomizing over its choice of action. The essential lesson from this model is that if renegotiation is possible after effort has been chosen, then the principal cannot make the agent choose the optimal effort for sure. Hence renegotiation again leads to an efficiency loss. Related papers in this area are Chiappori et al. (1994) and Ma (1991). Symmetric but Unverifiable Information Consider a contract on future trade between two parties. Because the information and hence the state of nature is unverifiable by a third party, a contract cannot be conditioned on this state. However, because information is symmetric, any negotiation of the sharing of the surplus in such a state will, given the symmetry of information, be efficient. Problems arise because the ex post sharing of the surplus need not be ex ante efficient. Contracts which are proof against renegotiation can still improve upon an allocation without any long-term contract by designing the environment of the renegotiation in the unverifiable state. Hart and Moore (1988) show how the ex ante contract can be constructed to affect the bargaining power of the two parties ex post. However, this literature is not as yet well developed, but other papers in this area are Aghion, Dewatripont and Rey, (1990) and Bolton (1990).
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4. Unforeseen Contingencies Because unforeseen contingencies may arise during the life of the contractual relationship, there is a need to fill in the consequent gap between obligations. Gap filling in general is discussed in Chapter 4000 (Contract Law). Renegotiation may be valuable as one would expect the contracting parties to be able to fill the gap at a lower cost than a third party, partly because the contracting parties can be assumed to have better information. As in the case of symmetric but unverifiable information, long-term contracts may allow the parties to at least partly design the environment under which the (re)negotiation takes place. In terms of modeling unforeseen contingencies, there is not as yet an agreed approach. What is clear is that at least for contract issues, simply treating unforeseen contingencies as events which occur with probability zero is not generally appropriate. If the contingency occurs with probability zero, the expected cost of not providing for it in a long-term contract is also zero, and hence the more flexible short-term contract would not appear to offer any advantage due to any unforeseen contingencies. For a survey of the state of the art as well as a discussion of incomplete contracts, see Dekel, Lipman and Rustichini (1998). The theory of residual control rights, developed in Grossman and Hart (1986) and Hart and Moore (1990), see also Hart (1995), offers one way in which we can approach the problem of modeling unforeseen contingencies. Residual control rights determine who has the right to decide on how a particular asset should be used whenever an unforeseen contingency occurs. Thus even if the actual event cannot be described, rules for who fills in the gap for a particular class of events can be described (see also Kreps, 1990). In general, in the case of unforeseen contingencies, the ability to renegotiate or put differently, contractual flexibility, may be efficiency enhancing rather than an added constraint.
5. Short-Term vs. Long-Term Contracts With asymmetric information, the possibility of renegotiation slows down info2mation revelation. This is equally true in the case where only a series of one-period (or spot) contracts can be signed, an effect known as the ratchet effect (see Freixas, Guesnerie and Tirole, 1985). What are then the fundamental differences between short-term and long-term contracts? The literature suggests that the performance of long-term contracts may differ from a series of short-term contracts for a number of reasons. The (transaction) costs of negotiating and policing one long-term contract may be lower than negotiating a series of short-term contracts. Long-term contracts
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may enable income smoothing if this is not available via credit markets. If regenotiation can be avoided, they also offer better commitment. Informational asymmetry may also favor long-term contracts. For a general discussion, see Hart and Holmstrom (1987). It is fairly obvious that differences in transaction costs may lead to differences in the performance of long-term and short-term contracts. Not only may the actual costs of writing the contracts be different, but if renegotiation is costly, the commitment aspect of long-term contracts may also be strengthened. This area does not appear to be well developed but see Dye (1985). In a principal-agent model of asymmetric information Malcomson and Spinnewyn (1988) show that, in the absence of renegotiation, long-term contracts can improve on short-term contracts only if they commit either the principal or agent to a payoff in some future circumstance which is lower than what could be obtained from a short-term contract negotiated if that circumstance occurs. Thus the long-term contract has to have some commitment value in order to be preferred to a series of short-term contracts. Similar results are obtained in Allen (1985). In the special case where the contracting parties have perfect information, Crawford (1988) shows that short-term contracting distorts investment decisions only when the efficient plan involves mainly sunk cost investment and the relationship plays a consumption smoothing role. In this case the main role for long-term contracts is to serve as a substitute for an efficient credit market. In a pure moral hazard principal-agent model, Chiappori et al. (1994) demonstrate that two conditions are necessary in order that there is no difference between what can be achieved by an optimal long-term contract and a series of spot contracts. Firstly, the long-term optimum must be renegotiation proof. This reduces the commitment value of a long-term contract. However, this is not sufficient. In addition, the spot contracts should provide efficient consumption smoothing. When the agent does not have access to credit markets, spot contracting does not allow for consumption smoothing and hence spot contracts cannot implement the long-term contract. However, if the agent has access to credit markets and the principal can monitor this, we do get spot implementation, a result also found in Fudenberg, Holmstrom and Milgrom (1990), Malcomson and Spinnewyn (1988) and Rey and Salanié (1990). The case where the agent has access to capital markets but where the access cannot be monitored is more complicated because the spot contract may involve more smoothing that the renegotiation-proof long-term contract. If consumption smoothing is a strong reason for preferring long-term contracts over short-term contracts, one might expect that in labor markets, the lower the wage, the more likely would be long-term employment contracts. This does not seem to be the case in reality. For this reason, Fudenberg, Holmstrom and Milgrom (1990) assume away any imperfect capital market
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influences and focus on problems caused by asymmetric information. They consider long-term contracts that cannot be renegotiated and set out the circumstances under which these have a value above a series of spot contracts or a contract which is renegotiation proof. Due to the asymmetric information, two types of adverse selection, which imply a value to the commitment of a long-term contract, can arise. The first case arises if the preferences of the principal and the agent over future contingent outcomes are not common knowledge. As was noted above, if more information about the agent becomes available over time, there may be scope for renegotiation. The second case arises when the outcome on some date $t$ conveys information on actions taken by the agent prior to that date. At date $t$, the principal, on the basis of this new information, may wish to punish or reward the agent for the past actions. However this is not possible if there is not a binding long-term contract. One of the main contributions of this paper is to make precise when there would be a benefit to ruling out renegotiation. The existing literature has demonstrated that even if renegotiation cannot be ruled out, long-term contracts may still dominate a series of short-term contracts. At the same time, the benefit of long-term contracts would be much enhanced if renegotiation could be at least limited.
6. Empirics Despite the huge problems of getting data, a substantial number of empirical studies have considered long-term contracts. A general survey and evaluation can found in Lyons (1996). An incomplete list of empirical case studies of long-term contracts include among others: Chisholm (1993) (the movie industry), Crocker and Lyon (1994), Crocker and Masten (1988, 1991) and Masten and Crocker (1985) (the design and duration of long-term contractual relationships for natural gas), Galassi (1992) (share contracts in early Renaissance Tuscany), Goldberg (1985a) (aluminium), Goldberg and Erickson (1987) (petroleum coke), Joskow (1985a, 1988, 1990) (contacts between electricity generators and coal suppliers), Lafontaine (1992) (franchising), Lyons (1994) (small subcontractors making specific inputs for customers in the engineering industry), Palay (1984) (rail freight).
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B. Relational Contracts 7. Relational Contracts: General The relational move appears to grow out of the empirical work by Macaulay (1963) with the origin of the term relational contract usually traced to MacNeil (1974). Given the impact of this work, it is surprising how few replications have been carried out to date. The best known of these is Beale and Dugdale (1975), but see also Kenworthy, Macaulay and Rogers (1996) and Esser (1996). The lack of replication is a concern because the modest sample sizes in these studies imply that the results are not generally statistically significant. For example, Macaulay’s sample was 68 businessmen and lawyers representing 43 companies and 6 law firms whereas Beale and Dugdale’s sample was 33 individuals in 19 firms of engineering manufacturers. Although in both cases the authors are careful to point out the potential weaknesses of their data, studies which rely on their results for motivation are less careful to point this out. The main empirical observation of relevance to the relational contract literature was that firms within the same industry tended to resort to neither contract terms nor contract law to settle disputes about obligations. Although persuasive, neither Macaulay (1963) nor Beale and Dugdale (1975, p. 47) offer any tests of statistical significance. Beale and Dugdale (1975, p. 47) do offer an insight into when the result did not hold, namely when firms in the sample were transacting with ‘outsiders’. ‘Firms frequently stated that they would take much greater care when contracting with relatively unknown parties, especially those outside the engineering trade’ (Beale and Dugdale, 1975, p. 47). From these studies it would appear that contracts have little relevance where the parties ‘knew’ each other. To aid a discussion of the contribution of relational contract scholarship, a clear definition of what is a relational contract would be helpful. However, although several have to date been offered, most of which are discussed in Eisenberg (1995), none appear to be universally accepted. Goetz and Scott (1981) argue that what makes a contract relational is that there are states of the world where obligations cannot ex ante be defined. ‘A contract is relational to the extent that the parties are incapable of reducing important terms of the arrangement to well-defined obligations. Such definitive obligations may be impractical because of the inability to identify uncertain future conditions or because of inability to characterize complex adaptations adequately even when the contingencies themselves can be identified in advance’ (Goetz and Scott, 1981, p. 1091). The central role for the relationship between the contracting parties for the duration of the contract would appear to be the manner in which a gap is filled.
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MacNeil, in a series of papers (MacNeil, 1974, 1978, 1981a, 1987a), highlights the importance of two principles of behaviour: solidarity and reciprocity. ‘Getting something back for something given neatly releases, or at least reduces, the tension in a creature desiring to be both selfish and social at the same time; and solidarity - a belief in being able to depend on another permits the projection of reciprocity through time’ (MacNeil, 1987a, pp. 274-275). The importance of these have been tested in Kaufmann and Stern (1988), who study how firms react to breach by a trading partner. They demonstrate how firms are initially very forgiving in order to maintain the relationship, but that once they judge that the partner has acted opportunistically, their attitude changes dramatically. For a discussion of this and other empirical work on relational contracts, see Lyons (1996, pp. 45-49). Relational contract theory can be seen as an attempt to generate a model able to explain when transacting parties do not resort to contracts and by what means they ensure that each party fulfils their obligations. The theory focuses on the relationship between the ‘contracting’ parties and posits that this leads to cooperation and to implicit obligations being self-enforcing. In the extreme, no formal contract is needed to ensure that all gains from a particular transaction are realized. The theory rests on repeated interaction within a particular well-defined group together with a set of norms governing the behaviour of the group members. Whereas the literature on long-term contracts focuses on the problems which arise because of incompleteness and the potential for renegotiation, the theory of relational contracts focuses on the relationship between the contracting parties which ensures that opportunistic behaviour does not arise. Unless we assume that individuals are naturally cooperative, the next step is to determine how cooperation might emerge anyway.
8. Endogenous Cooperation One way to understand the observations in Macaulay (1963), as well the attempts to define a relational contract, is as follows. If having the reputation of either keeping to a contract term, or modifying or bargaining to fill a gap in good faith, is sufficiently important (or valuable), the law is not needed to enforce this term. Reputation is valuable either when interacting with the same individual on several occasions or when interacting sequentially with several individuals. In a relational contract, the parties rely on each other to behave in a cooperative manner for the duration of the contract, rather than exploiting any opportunity which may come along. ‘Parties who enter contracts desire coordinated, and hence cooperative, actions on the part of their contracting opposites. Therefore, the principal measure of the success of our contract law is whether it in fact induces cooperation’ (Baird, 1990, p. 584).
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The remainder of this section considers briefly how and when cooperation can occur endogenously among, to follow MacNeil, creatures desiring to be both selfish and social at the same time. The discussion makes clear how norms can play an important role in this theory. The Folk Theorem and Repeated Games Repeated games consider the possibility of achieving cooperation through self-enforcing (possibly tacit) agreements. These are discussed more extensively in Chapter 0550 (Game Theory Applied to Law), see also Baird, Gertner and Picker (1995) and Hirshleifer (1994). Consider a game where the non-cooperative Nash equilibrium is Pareto dominated by another outcome. This is, for example, the case in the Prisoner’s Dilemma, or in a game where A must decide whether or not to lend B money and B must subsequently decide whether or not to pay A back. If the parties could write a binding contract, they could clearly implement a better outcome for both. If that is not the case, any (tacit) agreement to cooperate must be self-enforceable. Repeated interaction may enable cooperation, because of the potential for a current deviation to be punished in the future. For this to work, four conditions must be met. Any deviation must be observable and it must be punishable. This punishment must be credible so that it is clear that when required the punishment will be carried out, and the parties must be patient in the sense that the future matters to them. The folk theorem for repeated games, loosely speaking, states that if the players are sufficiently patient and the game is repeated for a sufficient number of periods, the players can cooperate to obtain a better outcome than the non-cooperative Nash equilibrium of the one-period game. Put differently, the short-term gain from deviation is more than offset by the present discounted value of the future punishment. The folk theorem generalizes to many different settings. Cases where there are uncertainty, informational asymmetries, differences in the identity of the players, overlapping generations of players and random matching between players can all give rise to folk theorem-type outcomes. Thus, for example, the repeated interaction does not have to be between the same two individuals over time. In order to cooperate, the parties have to ‘agree’ on two issues: which cooperative outcome should be support and which punishment should be used in case of a deviation. Although this agreement could be tacit, when we are talking about contractual relationships it is more natural to think of this as an explicit agreement. Not only are there typically many outcomes which could be supported, but each outcome may also be supportable by many different forms of punishment. Of the latter, the best known are Tit-for-Tat (each player in this period does what the other player did in the last period), the (Grim) Trigger Strategy (deviation is followed by non-cooperation in all future periods) and
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Stick and Carrot (severe punishment followed by forgiveness). Because there are many different potential punishments, norms may pay a crucial role in selecting which path is used. This is particularly important where the cooperation is between many different individuals over time. If A is willing to cooperate with or trust B because B cooperated with many other individuals in the past it is important that A understands if and when B is being punished. For more on this see Chapter 0780 (Non-legal Sanctions). Thus the theory would predict that cooperation is more likely between fairly homogeneous groups. There are cases where repetition does not admit cooperation. The most notable case is when the number of periods over which the game is played is finite and known, where the equilibrium of the one-period game is unique and where the exact characteristics of the players are known to all players. In the last period defection will occur because there is no future in which to punish this. But then cooperation in the penultimate period cannot be supported by a combination of a credible promise of cooperation in the last period combined with a threat of defection in the last period as a punishment. Much is made of this in Jolls (1997). However, if just one of the three conditions is violated, cooperation may emerge. If there is an uncertainty about whether this period is the last, then there is still a potential future and hence a future punishment to worry about if a player decides to deviate. If the stage game has multiple equilibria, cooperation may be possible because a credible threat consisting of the ‘worst’ equilibrium can be issued. If there is some small chance that one of the players is not a rational economic actor at all, but is an irrational type who will cooperate regardless, the rational type may prefer to maintain a reputation for being irrational. Some of the punishments which supports cooperative outcomes harm both the guilty and the innocent. In such cases, the innocent has an incentive to accept any request for forgiveness, which would destabilize the cooperative agreement as deviations from cooperation are not punished. Although there is no formal contract, this problem is one of renegotiation resembling that encountered in long-term contracts. A social norm entailing punishment for cheaters would clearly support cooperation. On the other hand, a social norm of forgiveness would not. Relational Contracts and Repeated Games Scott (1987b) represents an early, if incomplete, attempt to model long-term contracts as a repeated game. Unfortunately the paper does not fully utilize the then available theory on repeated games. Scott recognises that cooperation may arise without any contracts at all and points out that legal rules can affect both the formation of the contract (‘the initial risk allocation’) and later adjustments to the contract, but argue that the greater effect is on the initial risk allocation. This effect comes via implied terms and express invocations. Scott highlights
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the importance of norms, in particular the norm of ‘reciprocity’. The analysis is summarized as follows: Contracting parties use a mix of legal and extralegal mechanisms, as well as patterned and individualized responses, to ameliorate the information and enforcement deficits that threaten emergent patterns of cooperation. Nevertheless, contractual breakdowns are inevitable. Patterns of cooperation in contractual relationships are inherently unstable, especially where one party is threatened with substantial losses (or tempted with substantial gains). Where necessary adjustments are of lesser magnitude, however, social norms aimed at introducing long-term cooperation will often prompt adjustment, and legal rules provide appropriately remote, but harsh, deterrents and incentives. (Scott, 1987b, p. 2049)
Other attempts to model relational contracts using repeated games are found in Baird (1990), Baird, Gertner and Picker (1995), Campbell and Harris (1993), Hviid (1996, 1998) and, for an example of the use of experimental methods, Hackett (1994). One insight from the theory of repeated games is that successful cooperation does not necessarily involve observing either deviations or punishments. This does not reduce the importance of the punishment because it is what keeps opportunism in check. Contract law potentially affects the available punishments, their severity and the gains from deviation. Hadfield (1990) notes that in franchise contracts courts consistently fill gaps to the benefit of one side of the contract (the franchisor). This may severely hamper the ability of the franchisor to credibly promise to act in good faith. Contract terms also affect the ability to punish. The severity of the punishment can be increased by leaving the contract more incomplete than necessary (see Bernheim and Whinston, 1998; Hviid, 1998). Other examples are terms implying expensive third-party arbitration, rights to terminate the contract (for example, franchises), or demands of performance under the contract. All these terms can make non-cooperative behaviour potentially costly. Thus contract law and contract terms may matter even in relational contracts which are substantially relying on self-enforceable agreements and where the law is not seen to be used. Repetition may not in itself be sufficient to ensure cooperation. In some cases this depends on the available institutions. An interesting combination of repeated games and institutional design as a means to overcome incentives for short-term opportunistic behaviour is found in Greif, Milgrom and Weingast, (1994). They model the emergence of merchant guilds in the late medieval period as a response to the incentives of the ruler of a trade centre to opportunistically appropriate rents from some of the traders. In their model repetition as such is insufficient to ensure cooperative behaviour by a ruler because the ruler can abuse individual traders, whose threat of punishing the
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ruler by staying away from the centre is non-credible if most of the other relevant traders do not know about the abuse and hence continue to use the trading centre. Strong merchant guilds can credibly initiate a collective punishment (a boycott for a given period) by coordinating the actions of its members. One relevant lesson for relational contract theory is that institutions may still matter. Moreover, the institution of the guild had an effect even if a boycott was never observed in the same way that legal institutions may have an effect even if they are never seen to be active. Finally, what might on the face of it appear to be a mixture of relational and written contracts has been considered in Klein (1996), who argues that court enforcement and private enforcement need not be alternative contract enforcement mechanisms, but may be complements. The former may on its own generate too much rigidity, making it possible for one party to ‘hold-up’ the other when conditions change radically (one has to think of such radical changes as being insufficient to excuse performance, but radical enough that they were not covered by the original contract). The latter generates too much flexibility. The idea of Klein (1996) is that private enforcement creates a range of self-enforcement. So long as the change to the environment does not place the gains from a hold-up outside what can be negated by private punishment, the hold-up will not occur. Court-enforceable contract terms can be used to change this range, either by extending it, by shifting it, or by affecting the probability distribution over the value of a hold-up. It is in this way that court and private enforcement becomes complementary. It is worth noting that unless the definition of a relational contract is weakened, it does not seem that the framework in Klein (1996) provides an economic justification for relational contracts since the contract terms which have been agreed must be enforced, that is, there is nothing relational about that part of the contract. Moreover, if the courts fail to enforce the terms of a contract literally, then this may paradoxically create more scope for hold-ups.
9. Concluding Remarks The impact of the relational contract theory on the economic literature on incomplete long-term contracts as well as mainstream law appears to date to have been relatively modest. This may partly be because ‘it is impossible to locate, in the relational-contract literature, a definition that adequately distinguishes relational and non-relational contracts in a legally operational way - that is, in a way that carves out a set of special well-specified contracts for treatment under special well-specified rules’ (Eisenberg, 1995, p. 291; see also Craswell and Schwartz, 1994, p. 199). If this is not the case, there appears little point to making the distinction and given the lack of a common jargon
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between economics and law, it is not clear what would be achieved by relabelling contracts. The main contribution of the relational contract theory so far would appear to be to highlight the potential importance of the relationship between the contracting parties and the social groups to which these belong, including the importance of norms and non-legal sanctions. However, the success or failure of transacting does not solely depend on the relationship between the contracting parties, because contracts also play a significant role. A fruitful way to look at contracts would be as a combination of legally enforceable and self-enforceable obligations. This recognises that whereas some obligations need to be self-enforceable because third parties cannot verify the facts giving rise to a particular obligation, others need to be self-enforceable because of the (transactions) space costs of using the legal system. Moreover, in order to cope with unforeseen contingencies, the parties may either rely on each other to handle the new situation in good faith, or, by using the contract to allocate residual control rights, place the onus on a particular party. The paper by Klein (1996) is a promising step in that direction, offering the possibility of a more balanced view between incomplete contract theory and relational contract theory.
Acknowledgements I would like to thank David Campbell, Bruce Lyons and an anonymous referee for helpful comments on the first draft. They are naturally blameless for any remaining errors and shortcomings.
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4300 CONTRACT FORMATION © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
Bibliography Collected by the Editors Adams, Michael (1984), ‘Ökonomische Analyse des Gesetzes zur Regelung des Rechts der Allgemeinen Geschäftsbedingungen’, in Neumann, M. (ed.), Ansprache, Eigentums- und Verfügungsrechte, Berlin, Duncker and Humblot, 655-680. Adams, Michael (1986), ‘Zur Behandlung von Irrtümern und Offenbarungspflichten im Vertragsrecht (On Mistake and Information Revelation Duties in Contract Law)’, 186 Archiv für die Civilistische Praxis, 453-489. Barnes, David W. and Stout, Lynn A. (1992), Economics of Contract Law, Minneapolis, West Publishing. Barnett, Randy E. and Becker, Mary E. (1987), ‘Beyond Reliance: Promissory Estoppel, Contract Formalities, and Misrepresentation’, 15 Hofstra Law Review, 443 ff. Baudenbacher, Carl (1983), ‘Echtliche Grundprobleme der Allgemeinen Geschäftsbedingungen (Standard Term Clauses: Basic Problems of Economic, Liability and Procedural Law)’, in Zurich, Schulthess (ed.), Wirtschafts- schuld- und verfahrens. Bessone, Mario (1984), ‘Gli “standards” dei Contratti di Impresa e l’Analisi Economica del Diritto (The ‘Standards’ in Contracts and Economic Analysis)’, Giurisprudenza di merito, 982-987. Birmingham, Robert L. (1988), ‘The Duty to Disclose and the Prisoner’s Dilemma:’, William & Mary Law Review, 249-283. Bishop, William (1980), ‘Negligent Misrepresentation through the Economists’ Eyes’, 96 Law Quarterly Review, 360-379. Bishop, William (1981), ‘Negligent Misrepresentation: An Economic Reformulation’, in Burrows, Paul and Veljanovski, Cento G. (eds), The Economic Approach to Law, London, Butterworths, 167-186. Bouckaert, Boudewijn and Schäfer, Hans-Bernd (1995), ‘Mistake of Law and the Economics of Legal Information’, in Bouckaert, Boudewijn and De Geest, Gerrit (eds), Essays in Law and Economics II: Contract Law, Regulation, and Reflections on Law and Economics, Antwerpen, Maklu, 217-245. Braunstein, Michael (1989), ‘Remedy, Reason, and the Statute of Frauds: A Critical Economic Analysis’, Utah Law Review, 383-431. Campbell, David (1997), ‘The Relational Constitution of Contract and the Limits of Economics: Kenneth Arrow on the Social Background of Markets’, in Deakin, Simon and Michie, Jonathan (eds), Contracts, Co-operation and Competition: Studies in Economics, Management and Law, Oxford, Oxford University Press, 529-596. Caruso, Daniela (1991), ‘Note in tema di danni precontrattuali (Nota a Cass., 11 maggio 1990, n. 4051, Bellucci c. Min. difesa) (Notes about Precontractual Damages)’, 1 Il Foro Italiano, 188-200. Caruso, Daniela (1991), ‘Relazioni Precontrattuali e Teoria dei Giochi (Precontractual Relations and Game Theory)’, Quadrimestre, 810-832.
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Caruso, Daniela (1993), La Culpa in Contrahendo - L’Esperienza Statunitense e Quella Italiana (Culpa in Contrahendo - The American and Italian Experience), Milano, Giuffrè. Castermans, A.G. (1989), ‘Schadevergoeding bij Dwaling (Damages for Misrepresentation)’, Rechtsgeleerd Magazijn Themis, 136-146. Castermans, A.G. and Notermans, R. (1985), ‘Naar een Economische Analyse van de Mededelingsplicht bij Dwaling (Towards an Economic Analysis of the Duty to Inform in Misrepresentation Law)’, BW-krant Jaarboek 1985, BW-NBW: twee sporen, één weg, Leiden, Rijksuniversiteit Leiden, 141-155. Chisholm, Darlene C. (1996), ‘Continuous Degrees of Residual Claimancy: Some Contractual Evidence’, 3 Applied Economics Letters, 739-741. Coleman, Jules, Heckathorn, Douglas D. and Maser, Steven M. (1989), ‘A Bargaining Theory Approach to Default Provisions and Disclosure Rules in Contract Law’, 12 Harvard Journal of Law and Public Policy, 639-709. Craswell, Richard (1988), ‘Precontractual Investigation as an Optimal Precaution Problem’, 17 Journal of Legal Studies, 401-436. Craswell, Richard (1996), ‘Offer, Acceptance and Efficient Reliance’, 48 Stanford Law Review, 481-553. Curnes, Ellen J. (1987), ‘Protecting the Virginia Homebuyer: A Duty to Disclose Defects’, 73 Virginia Law Review, 459-481. Daintith, Terence C. (1987), ‘Oprettelse og Anvendelse af Langfristede Kontrakter (The Creation and Use of Longterm Contracts)’, in Blegvad, Britt-Mari and Collin, Finn (eds), Virksomheden Mellem ¢konomi og Jura (The Firm between Law and Economics), Samfundslitteratur. Dalzell, John (1942), ‘Duress by Economic Pressure’, 20 North Carolina Law Review, 237-277. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 67-72. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, 188-193. De Geest, Gerrit (1995), ‘Contracting by Way of Non-Simultaneous Assent: An Economic Analysis of Irrevocable Offers, Clauses for the Benefit of a Third Party, Assignments and Testaments’, in Bouckaert, Boudewijn and De Geest, Gerrit (eds), Essays in Law and Economics II: Contract Law, Regulation, and Reflections on Law and Economics, Antwerpen, Maklu, 9-27. Diamond, Peter A. and Maskin, Eric (1979), ‘An Equilibrium Analysis of Search and Breach of Contract, I: Steady States’, 10 Bell Journal of Economics, 282-316. Diamond, Peter A. and Maskin, Eric (1981), ‘An Equilibrium Analysis of Search and Breach of Contract II: A Nonsteady State Example’, 25 Journal of Economic Theory, 165-195. Dnes, Anthony W. (1995), ‘The Law and Economics of Contract Modifications: The Case of Williams v. Roffey’, 15 International Review of Law and Economics, 225-240. Duggan, A.J. (1982), ‘An Economic Analysis of Standard Form Contracts’, in Cranston, Ross and Schick, Anne (eds), Law and Economics, Canberra, Australian National University, 145-162. Duggan, A.J. (1995), ‘Silence as Misleading Conduct: An Economic Analysis’, in Richardson, Megan and Williams, Philip (eds), The Law and the Market: Essays in Honour of Maureen Brunt, Melbourne, The Federation Press, 195-223.
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Eisenberg, Melvin Aron (1979), ‘Donative Promises’, 47 University of Chicago Law Review, 1-33. Eisenberg, Melvin Aron (1982), ‘The Bargain Principle and its Limits’, 95 Harvard Law Review, 741-801. Epstein, Richard A. (1975), ‘Unconscionability: A Critical Reappraisal’, 18 Journal of Law and Economics, 293-315. Feeny, David, Berkes, Fikret, McCay, Bonnie J. and Acheson, James M. (1990), ‘The Tragedy of the Commons: Twenty-Two Years Later’, 18(1) Human Ecology, 1-19. Fishman, Michael J. and Hagerty, Kathleen M. (1990), ‘The Optimal Amount of Discretion to Allow in Disclosure’, 104 Quarterly Journal of Economics, 427-444. Fuller, Lon L. (1941), ‘Consideration and Form’, 41 Columbia Law Review, 799 ff. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 40-45. Gallo, Paolo (1992), ‘Errore sul Valore, Giustizia Contrattuale e Trasferimenti Ingiustificati di Ricchezza alla Luce dell’Analisi Economica del Diritto (Mistake on Value, Contractual Justice and Unjust Enrichment)’, Quadrimestre, 656-703. Goldberg, Victor P. (1977), ‘Competitive Bidding and the Production of Pre-contract Information’, 8 Bell Journal of Economics, 250-261. Hatzis, Aristides N. (1997), The Absence of Theory: Common vs. Civil Contract Law, paper presented at the XIVth Annual Conference of the European Association of Law & Economics, held at Barcelona, September 4-6, 1997. Hatzis, Aristides N. (1998), An Economic Theory of Greek Contract Law, Ph.D. Thesis, University of Chicago Law School. Holm, Hakan J. (1995), ‘Computational Cost of Verifying Enforceable Contracts’, 15 International Review of Law and Economics, 127-140. Johnston, Jason Scott (1990), ‘Strategic Bargaining and the Economic Theory of Contract Default Rules’, 100 Yale Law Journal, 615-664. Katz, Avery (1990a), ‘The Strategic Structure of Offer and Acceptance: Game Theory and the Law of Contract Formation’, 89 Michigan Law Review, 215-295. Katz, Avery (1990b), ‘Your Terms or Mine: The Duty to Read the Fine Print in Contracts,’, 21 Rand Journal of Economics, 518-537. Katz, Avery (1993), ‘Transaction Costs and the Legal Mechanics of Exchange: When Should Silence in the Face of an Offer be Construed as Acceptance?’, 9 Journal of Law, Economics, and Organization, 77-97. Katz, Avery (1996), ‘The Economics of Promissory Estoppel in Preliminary Negotiations’, 105 Yale Law Journal, 1249-1309. Koboldt, Christian (1991), ‘Kommentar on Schanze, Stellvertretung und ökonomische Agentur-Theorie’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer, 76-86. Koch, Harald (1981), ‘Die Ökonomie der Gestaltungsrechte. Möglichkeiten und Grenzen der ökonomische Analyse des Rechts am Beispiel von Kündiging und Anfechtung (The Economics of Dispositive Right. Possibilities and Limits of the Economic Analysis of Law)’, in Bernstein, H., Drobnig, U. and Kötz, H. (eds), Festschrift für Konrad Zweigert zum 70. Geburtstag, Tübingen, Mohr, 851-877. Kornhauser, Lewis A. (1976), ‘Unconscionability in Standard Forms’, 64 California Law Review, 1151 ff.
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Kostritsky, Juliet P. (1989), ‘Illegal Contracts and Efficient Deterrence: A Study in Modern Contract Theory’, 74 Iowa Law Review, 115-163. Krauss, Michael I. (1986), ‘L’affaire Lapierre: vers une Théorie Economique de l’Obligation Quasi-Contractuelle (The Lapierre Case: Toward an Economic Theory of the Quasi-Contractual Obligation)’, 31 McGill Law Journal, 683-721. Kronman, Anthony T. (1978), ‘Mistake, Disclosure, Information, and the Law of Contracts’, 7 Journal of Legal Studies, 1-34. Kull, Andrew (1992), ‘Reconsidering Gratuitous Promises’, 21 Journal of Legal Studies, 39-65. Lehmann, Michael (1980), ‘Die Untersuchungs- und Rügepflicht des Käufers in BGB und HGB. Rechtsvergleichender Überblick - ökonomische Analyse (The Duty to Examine and Notify a Defect in the German Civil and Commercial Code. A Comparative Survey - Economic Analysis)’, Wertpapiermitteilungen, 1162-1169. Lehmann, Michael (1981), Vertragsanbahnung durch Werbung (Contract Formation by Advertising), München, Beck. MacNeil, Ian R. (1984), ‘Bureaucracy and Contracts of Adhesion’, 22 Osgoode Hall Law Journal, 5-28. Mather, Henry (1982), ‘Contract Modification under Duress’, 33 North Carolina Law Review, 615-658. Miceli, Thomas J. (1995), ‘Contract Modification when Litigating for Damages is Costly’, 15 International Review of Law and Economics, 87-99. Orlic, V. Miodrag (1993), Zakljucivanje Ugovora (Conclusion of Contracts), Institut za uporedno pravo, Beograd. Ott, Claus (1991), ‘Vorvertragliche Aufklärungspflichten im Recht des Güter- und Leistungsaustausches (Precontractual Obligation to Provide Information in the Law)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer, 142-162. Ott, Claus (1995), ‘Comment: Contracting by Way of Non-Simultaneous Assent in the German Civil Code’, in Bouckaert, Boudewijn and De Geest, Gerrit (eds), Essays in Law and Economics II: Contract Law, Regulation, and Reflections on Law and Economics, Antwerpen, Maklu, 29 ff. Pacces, Alessio and Pardolesi, Roberto (1997), ‘Clausole Vessatorie in Crisi d’Identità. Appunti di Analisi Economica del Diritto (The Identity Crisis of Unfair Terms. Remarks of Economic Analysis of Law)’, in Furgiuele (ed.), Diritto privato, Padova. Parisi, Francesco (1987), Il Contratto Concluso Mediante Computer (The Formation of Contracts Via Computer), Cedam. Png, Ivan Paak-Liang and Lee, T.K. (1990), ‘The Role of Instalment Payments in Contracts for Services’, 21 Rand Journal of Economics, 83-99. Posner, Eric A. (1995), ‘Contract Law in the Welfare State: A Defense of the Unconscionability Doctrine, Usury Laws, and Related Limitations on the Freedom to Contract’, 24 Journal of Legal Studies, 283-319. Posner, Eric A. (1996), ‘Norms, Formalitiies, and the Statute of Frauds: A comment on “Discovering Contract”’, 145 University of Pennsylvania Law Review, 1971-1986. Posner, Richard A. (1977), ‘Gratuitous Promises in Economic and Law’, 6 Journal of Legal Studies, 411-426. Rasmusen, Eric and Ayres, Ian (1993), ‘Mutual and Unilateral Mistake in Contract Law’, 22 Journal of Legal Studies, 309-343.
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Robinson, Thorton (1983), ‘Enforcing Extorted Contract Modifications’, 68 Iowa Law Review, 699-707. Roth, Gabriel (1977), ‘Der Schutzzweck richterlicher Kontrolle von AGB’ (The Protection Goal of the Judicial Control of Standard Term Clauses)’, 4(2) Österreichische Zeitschrift für Wirtschaftsrecht, 32-37. Rottenberg, Simon (1985), ‘Mistaken Judicial Activism: Proposed Constraints on Creditor Remedies’, 4 Cato Journal, 335-350. Reprinted in Dorn, James A. and Manne, Henry G. (eds), Economic Liberties and the Judiciary, Fairfax, George Mason University Press, 1987, 335-349. Schanze, Erich (1991), ‘Stellvertretung und ökonomische Agentur-Theorie - Probleme und Wechselbezüge (The Law of Agency and Agency Theory - Problems and Relations)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Ökonomische Probleme des Zivilrechts, Berlin, Springer, 60-75. Scheppele, Kim Lane (1988), Legal Secrets, Equality and Efficiency in the Common Law, Chicago, University of Chicago Press, 363 p. Schwartz, Alan (1977), ‘A Re-examination of Nonsubstantive Unconscionability’, 63 Virginia Law Review, 1053-1083. Shavell, Steven (1991), ‘An Economic Analysis of Altriusm and Deferred Gifts’, 20 Journal of Legal Studies, 401-421. Smith, Janet Kiholm and Smith, Richard L. (1990), ‘Contract Law, Mutual Mistake, and Incentives to Produce and Disclose Information’, 19 Journal of Legal Studies, 467-488. Spier, Kathryn E. (1992), ‘Incomplete Contracts and Signalling’, 23 (3) Rand Journal of Economics, 432-443. Stout, Lynn A. and Barnes, David D. (1992), Economics of Contract Law, Minneapolis, West Publishing. Trebilcock, Michael J. (1976), ‘The Doctrine of Inequality of Bargaining Power: Post-Benthamite Economics in the House of Lords’, 26 University of Toronto Law Journal, 359-385. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 78-92. Trebilcock, Michael J. (1980), ‘An Economic Approach to the Doctrine of Unconscionability’, in Reiter, Barry J. and Swan, John (eds), Studies in Contract Law, Toronto, Butterworths. Trebilcock, Michael J. (1988), ‘The Role of Insurance Considerations in the Choice of Efficient Civil Liability Rules’, 4 Journal of Law, Economics, and Organization, 243-265. Trebilcock, Michael J. and Dewees, Donald N. (1981), ‘Judicial Control of Standard Form Contracts’, in Burrows, Paul and Veljanovski, Cento G. (eds), The Economic Approach to Law, London, Butterworths, 93-119. Villa, Gianroberto (1988), ‘Errore Riconosciuto, Annullamento del Contratto ed Incentivi alla Ricerca di Informazioni (Known Mistake, Contract Avoidance and Incentives Towards Acquisition of Information)’, Quadrimestre, 286-300. Wils, Wouter P.J. (1993), ‘Who Should Bear the Costs of Failed Negotiations? A Functional Inquiry into Precontractual Liability’, 4 Journal des Economistes et des Etudes Humaines, 93-134.
4400 IMPLIED TERMS AND INTERPRETATION IN CONTRACT LAW George M. Cohen Edward F. Howrey Research Professor of Law, University of Virginia School of Law © Copyright 1999 George M. Cohen
Abstract This chapter examines the economic arguments for textualism and contextualism, the two primary methodologies used by courts to determine the intentions of contracting parties with respect to their performance obligations. Textualism, which is rooted in the idea of complete contracting, calls for a more restrictive approach to implied terms and interpretation than contextualism, which is rooted in the idea of incomplete contracts. The primary conclusions are that, as in other areas of contract law, the choice between the two interpretive methodologies depends on the transaction costs of drafting, the relative likelihood of court error, and the risks of opportunistic behavior. Neither methodology dominates so much that it should be uniformly employed, which is consistent with how courts actually behave. JEL classification: K12 Keywords: Contracts, Completeness, Interpretation, Implied Terms, Opportunism, Contextualism, Textualism
1. Introduction Questions of how courts interpret, and should interpret, contract terms and when courts imply, and should imply, terms to which the contracting parties have not explicitly agreed, loom large in contract disputes and in the legal literature on contract law. Law and economics scholars, however, have written far more extensively on other topics in contract law than on these questions. For example, Judge Posner’s treatise has no section specifically discussing interpretation or implied terms, and discusses contractual good faith in only two paragraphs (Richard Posner, 1998, pp. 103, 126). Other leading textbooks also have no discussion of interpretation or implied terms. One possible explanation for this discrepancy is that there is little need for research specifically on interpretation and implied terms because much of the economic analysis of other areas of contract law carries over straightforwardly to these
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questions. An alternative explanation is that economic analysis has less to say about interpretation methods than it does about other questions in contract law. This article, which will summarize and expand on the literature that does exist, aims to demonstrate that economic analysis has a good deal to say about interpretation questions, but the issues are complex and there are many fruitful avenues for further research. The argument that there is no real need for a separate economic analysis of interpretation and implied terms stems from the fact that the delineation of the topic is based on legal rather than economic considerations. In contract law, interpretation usually refers to problems arising from express contract terms that are reasonably susceptible of more than one meaning. Implied terms are those that are added to, or place limits on, expressly stated terms. The two are closely related, yet not identical. For example, if a contract contains a ‘best efforts’ clause, determining what that clause requires is a question of interpretation; if the contract contains no such clause, courts may have to decide whether to imply a best efforts obligation, and if they do, they have to determine the content of that obligation. On the other hand, some questions of interpretation do not involve questions of implication, for example, a dispute over the meaning of the word ‘chicken’. In some sense, all contract disputes involve questions of interpretation and implied terms. For example, force majeure clauses - usually discussed in the context of the (implied) impossibility defense - present questions of interpretation, and most contract formation, excuse, and damage rules are ‘implied terms’. But contract law has generally used the labels ‘interpretation’ and ‘implied terms’ more narrowly, to refer to questions of contract performance, rather than questions of formation, excuse, defense, or remedy. That is, the legal issue addressed by these doctrines is whether one or more parties have performed as the contract requires, or have breached. Thus, I will assume for purposes of this discussion that the parties have made an enforceable contract, there are no changed circumstances or ‘mistakes’ sufficient to give rise to an excuse claim, the applicable remedies in the event of breach are accepted, and there are no third-party effects. How do courts decide - and how should they decide - what the performance obligations are and whether the parties have met them?
2. Complete or Incomplete Contracts Economic analyses of contract law have tended to start with the idealized concept of a ‘complete’ contract, though this term has perhaps engendered more confusion than clarity. Traditionally, a complete contract has referred to one that provides a complete description of a set of possible contingencies and
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explicit contract terms dictating a performance response for each of these contingencies (Al-Najjar, 1995; Hart and Moore, 1988). Contingencies include changes in ‘exogenous’ economic variables, such as a production cost increase. But they also include ‘endogenous’ behavioral responses, such as falsely claiming a cost increase or seeking refuge from a now-disadvantageous bargain behind a contract term intended to serve a different purpose. Economic analyses generally conclude that if a contract is complete, there is no beneficial role for a court other than to enforce the contract according to its terms; that is, incompleteness is a necessary, though not sufficient, condition for an active court role in interpretation and implied terms. But because no real-world contracts are fully complete in this sense, the concept of completeness does not get us very far. The concept can be rescued in one of three ways. One way is to view completeness as a useful benchmark, similar to perfect competition. Just as some markets are close enough to being perfectly competitive that the perfect competition model is a useful predictor, so some contracts may be complete enough that no reasonable interpretation or implied term questions arise. The law refers to these contracts as ‘integrated’. But tying completeness to integration simply reduces to a tautology the statement that a complete contract obviates the need for interpretation or implied terms. The question is how do courts know when a contract is complete in this sense. One way courts can know a contract is complete is if the parties tell them. Thus, a second way to rescue completeness is to recognize that contracting parties can make a contract complete by using general ‘catchall’ clauses that state what happens in all unspecified states of the world (Hermalin and Katz, 1993, p. 236; Hadfield, 1994, p. 160, n.5). For example, a catchall clause might state: ‘The price term will be x, and will apply regardless of any change in circumstances or conduct by either party’. Alternatively, the parties could state their general desire not to have courts interpret or imply terms. But although contracting parties often use general clauses such as merger clauses, which direct a court to apply a particular interpretive methodology (that is, do not look beyond the writing), they do not seem to use catchall clauses that are broad enough to make contracts complete. Of course, clauses that are not stated as catchalls could be - and sometimes are - interpreted that way, but, to lawyers at least, if not economists, that act of interpretation then requires justification (Hadfield, 1994, p. 160). Even clauses that are stated as catchalls might require interpretation (Charny, 1991). Moreover, contracting parties often use contracting clauses that are the exact opposites of completeness catchalls: general clauses such as ‘good faith’ or ‘best efforts’ clauses signal contracting incompleteness, as opposed to completeness (Hadfield, 1994, p. 163). A third way to rescue completeness, more common in formal economic modeling, is to tie the concept of completeness to the efficient use of available
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information. A complete contract is one that makes full use of the private information available to the contracting parties (Hermalin and Katz, 1993, p. 235). The point of this definition is to make clear that parties can write efficient contracts that do not expressly specify the response to every contingency, yet obviate the need for court intervention (Hermalin and Katz, 1993, p. 242). But the fact that parties may in a simplified model be able to write ‘economically complete’ contracts does not answer the question of whether in a given legal dispute they have in fact written one. And the ability of private parties to write economically complete contracts in the real world is unclear. We do not seem to see, for example, contracts of the type described by Hermalin and Katz, in which the contract leaves the quantity and price unspecified, then after some period one party names the price and the other names the quantity. Perhaps the costs of writing these contracts (including the costs of strategic circumvention) are too high. Perhaps the current enforcement regime interferes with, or discourages, the parties, writing of such contracts, though this seems unlikely. It seems fair to say, however, that many if not most contracts are incomplete, or at least the question of their completeness is itself a legitimate question for judicial interpretation. The incompleteness may be intended by both parties, which creates so-called ‘relational contracts’ (Goetz and Scott, 1981), or ‘fiduciary contracts’ (Easterbrook and Fischel, 1983, p. 438). It may result from unintended ‘formulation error’ which occurs when, as a result of defective contractual instructions, the occurrence of some contingency produces surprising consequences (Goetz and Scott, 1985, p. 267, n. 11). It may result from strategic withholding of information by one party. Or incompleteness may result from court error. Whether a contract that the parties think is complete, but is misinterpreted by a court, should in fact be viewed as an ‘incomplete’ contract depends on how completeness is defined. If completeness is defined with reference to the obviation of interpretive questions, the definition must assume that completeness means that a contract’s terms are ‘unambiguous’, that is, the contract terms represent a confluence of the parties’ intentions and the court’s ability to interpret those intentions correctly (unless the contract is somehow self-enforcing). Incomplete contracts may be efficient contracts, even if the incompleteness is unintended. The costs of contractual completeness would often exceed the benefits, just as the costs of reducing crime or pollution or accidents to zero would exceed the benefits. Incomplete contracts will tend to be efficient when contracts are relatively complex, that is, when there are a large number of low-probability contingencies that could affect the value of contractual performance, and the efficient responses to those contingencies vary greatly and so cannot easily be specified in advance (Hadfield, 1994, p. 165, n.15). In these cases the transaction costs of negotiating, drafting, monitoring, and enforcing a complete contract are high.
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More generally, in the language of institutional economics, a complete contract is only one form of ‘governance mechanism’ for guiding the behavior of contracting parties (Al-Najjar, 1995). Alternative governance mechanisms include the courts and extralegal enforcement, such as social sanctions and reputation. In this approach, incomplete contracts will tend to be efficient whenever governance mechanisms superior to a detailed contract exist, that is, whenever the opportunity costs of completeness are high. In fact, contrary to the usual economic approach, the actual historical development of contracts is probably best described as starting as incomplete as possible, then becoming more complete and formal as governance mechanisms other than the written contract proved to be inadequate. The question of contract interpretation and implied terms is really a question of when the courts are a superior governance mechanism. Courts may be able through interpretation and implied terms to provide necessary flexibility - efficient adjustments to contingencies - that an incomplete contract otherwise lacks. Courts may also be superior to nonlegal institutions such as reputation because reputation effects may be weak due to such things as cognitive dissonance, optimism about the ability of a party with a poor reputation to change, the difficulty of knowing when a contracting partner has behaved badly, and the last period problem. In general, the role for courts in interpreting contracts and implying terms increases as contracts become more efficiently incomplete.
3. Incomplete Contracts and Contractual Intent Now suppose the contract is incomplete, as are most contracts that are the subject of litigation. What should a court do? The economists’ (and courts’) usual assumption is that courts should follow the intentions of the parties, but to admit incompleteness is to admit that the intention of the parties is uncertain, or at least disputed (some would say nonexistent). The next best solution is to adopt the term - or interpretive methodology - the parties would have chosen had they bargained over the matter, that is, presumed or hypothetical intent. But how is presumed intent determined? There are two general possibilities on which economic analyses have focused (Hadfield, 1992, 1994, p. 161). First, courts might presume that complete contracting is both feasible and desirable. This presumption has both a positive and a negative component. On the positive side, the express terms of the contract are presumed to be the best approximations of the parties’ intentions and deemed to create a complete contract. This strategy is usually referred to as textualism. On the negative side, if parties fail to write a complete contract, the incompleteness is presumed to be inefficient, whether unintended
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or strategic, and the court’s approach should be to deter this behavior and encourage complete contracting. This strategy is a variant of what has come to be known as penalty defaults (Ayres and Gertner, 1989), which is itself a variant of an old idea in the Austrian School of economics that individuals should bear the consequences of their actions so that they become more rational over time (for example, Wonnell, 1986, p. 520). The second general approach involves a presumption that contractual incompleteness is unavoidable and/or desirable, due to limitations of money, time, comprehension and foresight (Hadfield, 1992, p. 259). The courts then fill in the gaps by presuming the parties intended to contract with reference to some standard external to the written contract. Courts might presume parties contracted with reference to their current (course of performance) or prior (course of dealing) conduct, or to the conduct and understandings of similarly situated parties (trade usage or custom or business mores). Strategies that focus on these presumptions, which are featured predominantly in the Uniform Commercial Code, are usually referred to as contextualist. Alternatively, courts might presume the parties contracted with the expectation that courts would fill in any gaps with a joint maximizing term that would have been written by rational parties under conditions of low transaction costs (Goetz and Scott, 1981). In practice, the joint maximization strategy will often dissolve into contextualism, as courts lack the data necessary to do pure joint maximization. It is important to remember that all of these strategies involve presumptions. It is all too easy for courts or proponents of a particular strategy to criticize the alternatives as failing to hew closely enough to the parties’ intentions, when in fact the parties’ intentions in incomplete contracts are at least uncertain, and the question is which strategy is more likely to be successful at approximating these intentions. For example, suppose a buyer rejects goods delivered late after the market price drops below the contract price. A court might be called upon to decide whether to imply a good faith limitation on the buyer’s ability to reject. A textualist might argue no on the ground that such an implication would be contrary to the parties’ intentions as expressed in the time of delivery term. But the parties’ intentions - whether actual or hypothetical - may well be that a good faith obligation should be implied rather than that the time of delivery term should be interpreted as absolute. A proposition that textualism, contextualism, penalty defaults, or joint maximization best represents the parties’ intentions needs to be defended. Economic analysis can help to identify the conditions under which the various interpretive strategies are more likely to approximate the parties’ intentions, and whether courts are better off pursuing a pure interpretive strategy or a mixed one.
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4. Default versus Mandatory Rules and Contractual Intent The recognition of incomplete contracting and the uncertainty of contractual intent renders problematic another distinction that has played an important role in economic discussions of contracts, namely default rules versus mandatory rules. The term ‘default rule’ refers to several different characteristics: (1) if the parties specify some contract term, the court will enforce that term; (2) if the parties fail to specify some contract term, the court will fill in the gap and supply one; and (3) if the parties fail to specify some contract term but do not want the court to fill in the gap, the court will honor that intent (that is, the gap-filling rule itself is a default). UCC § 2-305 on open price terms is a good example of a rule that satisfies all three characteristics. Default rules are usually contrasted with mandatory rules, which term can also refer to three characteristics. Mandatory rules can refer to situations in which the court knowingly: (1) imposes a term that contradicts a term the parties specified; (2) refuses to fill in a gap that the parties left when the parties wanted the court to fill the gap; and (3) fills in a gap that the parties did not want the court to fill in. When economists refer to mandatory terms, they usually mean the first sense, that is the court rejecting a term the parties specified. An example would be a liquidated damage clause deemed to be a penalty, or a term deemed to be unconscionable. The usual critique of mandatory terms is that because they disregard the intentions of the parties, the parties who prefer these terms will be made worse off. For example, if a court imposes a stronger performance obligation on an obligor than the parties intended, then future obligors will extract a higher price, which is more than the obligee wanted to pay (else he would have paid for it originally) (for example, Easterbrook and Fischel, 1993, p. 431). This critique makes sense if contracts are assumed to be complete. But once we allow for the possibility of efficiently incomplete contracts and unclear intent, it becomes much more difficult to distinguish mandatory rules from default rules. Take, for example, the implied duty of good faith, or the duty of loyalty in fiduciary contracts. Are these defaults or mandatory rules? That depends on how well one thinks the duty of good faith tracks contractual intent. If one believes that parties may write incomplete contracts for which they expect courts to fill in the gaps, the duty of good faith or the duty of loyalty might easily be viewed as a default. If the parties want a particular obligation that conflicts with what courts ordinarily view as good faith or loyalty, and they specify that obligation, courts will generally enforce it. This is the view espoused by Easterbrook and Fischel (1993). On the other hand, if one believes that courts use the duty of good faith or the duty of loyalty to fill in gaps that the parties did not want to be filled, or to reject obligations the parties thought they had fully specified, then the duty of good faith looks more like a mandatory term. UCC § 1-102(3) evidences this ambivalence about the good faith obligation.
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The mirror image issue is presented by the doctrine of certainty, which says that courts may sometimes decline to fill gaps the parties have left in contracts. The doctrine could be viewed as a default if one is willing to presume that when the parties have left ‘too many’ gaps for the courts to fill, they do not have contractual intent, and if they do have such intent they will override the default by filling in the terms themselves. Alternatively, the doctrine could be viewed as a mandatory rule if one assumes that the courts use it to refuse to fill in gaps when the parties wanted them to. The point is that the labels ‘default’ and ‘mandatory’ are conclusions that can mask the assumptions being made about contractual completeness and intent, and so do not by themselves resolve the questions of implied terms and interpretation.
5. Unintended or Strategic Incompleteness: Encouraging Better Contracting If the contracting parties wanted to write a complete contract but failed in some way, the failure can be viewed as analogous to an accident in tort law. The accident may occur because one or both parties failed to take cost-effective ‘contract-based precautions’ (Cohen, 1992, p. 949). Alternatively, one of the parties might make a contract incomplete to serve his strategic bargaining interests by withholding information. In either case, courts can use the doctrines of interpretation and implied terms to encourage the parties to ‘facilitate improvements in contractual formulation’ (Goetz and Scott, 1985, p. 264). One way to encourage better contracting is to encourage more complete contracts, that is, the greater use of express written terms. If a court is willing to ‘insure’ parties through flexible interpretations and implied terms it creates a classic moral hazard problem: the parties have less incentive to write good contracts themselves, for example contracts with more precise language. Doctrines such as the parol evidence rule encourage parties to write more complete contracts by giving more weight to the written document and limiting the extrinsic evidence courts can consider. Strict application of these doctrines may thereby increase the accuracy of contract enforcement (reduce contractual accidents) by reducing the interpretive risks of relying on extrinsic evidence (Eric Posner, 1998, p. 546). As in tort law, the goal of encouraging better contracting makes economic sense if the precautions are cost-effective. That will be the case if one or both of the contracting parties face low ex ante transaction costs of drafting and monitoring express contract terms that successfully specify performance obligations in response to different regret contingencies, as well as if the expected losses from interpretive accidents are high (Eric Posner, 1998, pp. 543-547). Moreover, courts must be able to identify accurately situations in
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which precautions are cost-effective. Usually, the best courts can do is to use proxies to make reasonable comparative judgments. In particular, in investigating precautions, courts can compare the capabilities of contracting parties and they can compare the contract in dispute to other litigated contracts (Eric Posner, 1998, pp. 553-561). In comparing contracting parties, courts might conclude that one contracting party is the ‘least cost avoider’, or in this case the ‘cheaper contract drafter’, namely the party in a better position to clarify a term or to identify what should happen in the event of some contingency. This approach explains such interpretive rules such as contra proferentum, which encourage the party in the better position to draft a more complete contract to do so. Similarly, if one of the parties is a repeat contractor or is assisted by legal counsel and the other is not (as in many consumer contracts), imposing liability on the repeat and represented contractor in cases of contractual ambiguity or incompleteness will encourage that party to improve the terms of its contracts. In addition, if one of the parties has an informational advantage, imposing liability on that party could encourage similarly situated parties in the future to reveal the information. But there may not always be a ‘cheaper contract drafter’, or if there is, the necessary precautions might not be cost-effective. Such might be the case, for example, with a party who commits a ‘scrivener’s error’ in a written contract, especially if the error is one that the other party could reasonably have noticed. The alternative of comparing similar contracts rather than contracting parties can also yield some useful guidelines. For example, one piece of relevant evidence about ex ante transaction costs would be how common a particular term is in similar contracts. The more common a term, the more likely the costs of contracting over that term are low. Courts can then presume that most parties who wanted such a term would have contracted expressly for it and those who have not can be deemed negligent or strategic. Alternatively, one might argue that transaction costs are low for relatively ‘simple’ contracts or for ‘crucial’ terms. But even if courts are able through comparative analysis to identify simple contracts or common or crucial terms, there is a further difficulty: ease of contracting may not be a sufficient justification for imposing liability. The reason is that encouraging better contracting does not necessarily mean encouraging greater contractual completeness; it may mean encouraging greater contractual incompleteness through reliance on implied terms. Under a majoritarian default approach to implied terms, courts would minimize transaction costs by choosing the mix of express and implied terms that most contracting parties would want. The majority of contracting parties might want courts to use implied terms, especially in well-developed markets, because they believe that will save on the costs of contracting, even if the transaction costs of contracting are relatively low. Alternatively, the majority of contracting parties might believe that relying solely on express terms - even those that
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simply try to mimic implied terms - might be less reliable than relying on well-established implied terms either in conjunction with or instead of express terms; that is, they might fear court misinterpretation more than court misimplication. The only contracting parties who should be encouraged to contract more explicitly under this approach are those who have ‘idiosyncratic’ preferences. Thus, the fact that parties fail to contract expressly (or unambiguously) for a given term - even a common or crucial one - may simply be an expression of intent to be bound by the majoritarian understanding of that obligation. An example of the majoritarian default approach is the rule that contracting parties ‘in the trade’ are bound by trade usages, even if they did not know about them. This rule encourages the parties in a trade to develop such usages (which are majoritarian understandings) and to familiarize themselves rapidly with these usages, hence reducing the need for heavily lawyered documents (Warren, 1981). Thus, implied terms serve as a public good, a standard set of contract terms that parties either accept or reject. The same majoritarian approach could also apply to the interpretation of express terms. The ‘plain meaning rule’ could be viewed as a way of encouraging contracting parties to learn the common (one might even say implied) meaning of words, thus reducing the need for and costs of elaborate definition and explanation. Of course, the majoritarian approach to encouraging better contracting itself presents problems. For example, identifying the majoritarian default seems to call for an empirical inquiry, which courts are often ill-equipped to make, though to the extent that there is a recognized trade usage, or a course of dealing or course of performance, this problem is mitigated. Verkerke (1995) attempts to remedy this problem in the context of employment contracts by surveying employers about the discharge terms contained in their employment documents. He found that 52 percent of employers reported that their employment documents specified an ‘at will’ provision (the prevailing default), 15 percent reported that their documents contain a ‘just cause’ provision, and 33 percent reported that they do not have documents that address the issue explicitly (Verkerke, 1995, p. 867). He also found that larger firms and firms from more ‘liberal’ jurisdictions are more likely to contract explicitly for the at will rule. From these data, Verkerke concludes that the at will default is the majoritarian default. A more cautious conclusion would be that a broadly defined just cause provision is not a majoritarian default, but given the limitations many states have put on the at will doctrine and the possibility of unwritten (or written, but narrow) qualifications on the right to discharge, whether the majoritarian default is the strong form of the at will doctrine expressed in many employer documents or a more limited form is less clear. An additional problem with the majoritarian default approach is the need to determine when the parties have contracted around the default. Goetz and Scott (1985) argue that it is often difficult for courts to tell whether parties are
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using express terms to trump (opt out of) implied terms or merely to supplement them. That is, it may be difficult for courts to tell in a particular case whether the parties intended to incorporate implied terms by writing an incomplete contract, or whether they intended the express terms they used to create a complete contract; thus, the contractual ‘accident’ results from the parties’ unintended failure to resolve the tension between the express terms and implied terms. The more courts favor and encourage implied terms and common usages, the more costly it becomes for the parties who want to contract out of those terms to do so. As discussed above, ostensible default rules begin to look more like mandatory rules. The courts’ choice of interpretive strategy, therefore, may affect not only the parties’ incentives to contract more expressly, but also their ability to contract around the implied default rule. Goetz and Scott argue that the more likely it is that contracting parties will be unhappy with the court’s implied terms and interpretations - the more heterogeneous contracting parties are likely to be - the more inefficient an expansive approach to implied terms and interpretation will be. In contrast, where contracting parties are more likely to engage in homogeneous and repetitive transactions - that is, where the transactional variance is low - the more likely a contextual approach will be efficient because it will foster the development of more standardized terms by trade groups, lawyers, and the parties themselves. One could also justify the contextual approach in such cases on the ground that in ‘conventional’ contracts, court error is likely to be low (Eric Posner, 1998, pp. 553, 556). Implementing this notion is often more difficult than stating it, however. For example, Goetz and Scott suggest that in well-developed markets courts should generally allow context evidence to supplement express terms, but should generally not allow context evidence to override the plain meaning of express terms (Goetz and Scott, 1985, pp. 313-315). Eric Posner has recently criticized this argument on the ground that there is no theoretical justification for having a flexible approach with respect to incompleteness (implied terms) but a strict approach with respect to ambiguity (interpretation of express terms) (Eric Posner, 1998, pp. 559-560). On the one hand, it should not matter whether the parties use, for example, a best efforts clause or leave one out and let the court imply it; if the courts consider extrinsic evidence in one case, they should do so in the other. On the other hand, the ‘plain meaning’ of a best efforts clause requires a kind of context evidence, namely the general understanding of the clause. Thus, there may be no inconsistency in having a flexible approach to incompleteness and a plain meaning approach to ambiguity: both favor allowing a certain type of contextual evidence, namely general contextual evidence. The problem arises when the contextual evidence being considered is not general but specific to the contracting parties, such as course of dealing, course of performance, or prior negotiations. Here a flexible
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approach to incompleteness would allow the specific context evidence to trump the general, but the plain meaning rule would have the general context evidence trumping the specific. At this level of generality, Posner’s argument seems correct. Although one could imagine cases in which a court might want to use a flexible approach to incompleteness and a strict approach to ambiguity, it is difficult to make any general statements about such cases; in fact, one could just as easily imagine cases in which a strict approach to implied terms and a flexible approach to ambiguity would be appropriate. Goetz and Scott’s argument about the plain meaning rule perhaps should be read as limited to express terms that are commonly understood as general trumping terms that override implied terms, such as merger clauses, disclaimers, or clauses granting one party broad discretion. If the parties go to the trouble of using such a general trumping term, then arguably that should be a sufficient signal of their idiosyncracy. But even this interpretation is unsatisfactory because, as with the at will term discussed above, it may not be clear whether the parties simply intended to use the trumping clause to reject an overly broad implied term or whether they also meant it to convey the full measure of the parties’ obligations to the exclusion of all extrinsic evidence. The discussion in this section so far has assumed that ex ante transaction costs are low. The higher the ex ante transaction costs of drafting and monitoring become, the less likely it will be efficient for a court to adopt restrictive rules of interpretation and implied terms that encourage parties to contract more explicitly, because it will not be cost-effective for the parties to do so. Reliance on the types of contextual evidence discussed above now becomes relatively more cost-effective as the accuracy of the written contract declines. If courts take too restrictive a view of interpretation and implied terms, the development of cost-saving interpretive devices might be discouraged in favor of more complete, but costlier, writings (Burton, 1980, p. 373). Alternatively, too few contracts might be formed ex ante, as the promisor’s costs rise to cover an anticipated remedy that the promisee does not value at this cost. And too much performance might occur ex post, as the promisor performs even when the cost of doing so exceeds the value of performance (Easterbrook and Fischel, 1993, p. 445). Once again, stating the general principle may be easier than applying it. Classic examples of high-transaction costs contracts are principal-agent contracts usually referred to as ‘fiduciary’. These contracts typically involve complex tasks for which the principal cannot easily measure the agent’s effort or outcome, thus making express contracting difficult (Cooter and Freedman, 1991a, p. 1051; Easterbrook and Fischel, 1993, p. 426). Other examples include contracts between unsophisticated parties or long-term contracts. Even in high-transaction cost contracts, however, a more restrictive approach to interpretation and implied terms might be appropriate if the contracting parties’
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preferences with respect to certain obligations are likely to be idiosyncratic, or equivalently if the relevant context evidence is less reliable (Eric Posner, 1998, pp. 557-558). By the same token, the same concerns raised by high-transaction cost contracts might exist even in ordinary sales contracts. For example, if a contract allows for a 10 percent variation in the quantity for the (unstated) purpose of avoiding liability over loss during transportation, a question might arise whether the seller could take advantage of this provision to deliberately increase or decrease the quantity as the market price drops or rises. Although one could say that the buyer could contract to prevent such behavior by, say, limiting the application of the quantity variation provision to losses suffered in transit (Gillette, 1981, p. 655), it may be quite difficult to draft such a clause. What should happen, for example, if both a market price change and damage to the goods occur? What about damage to the goods before and after transit? Is it always desirable to have the parties provide explicitly for all these contingencies? The point is that a given contract may be viewed as low-transaction cost for some purposes and high-transaction cost for others.
6. Deterring Opportunistic Behavior Getting the mix of express and implied contracting terms right - that is, encouraging the optimally complete written contract - is only one consideration (and perhaps not the most important) that courts do or should face when deciding questions of interpretation or implied terms. A second approach to the question of how courts should interpret contracts and when they should imply terms focuses not on encouraging efficient contracting, but on deterring opportunistic contractual behavior (though obviously the two overlap). Opportunism can be broadly defined as deliberate contractual conduct by one party contrary to the other party’s reasonable expectations based on the parties’ agreement, contractual norms, or conventional morality (Cohen, 1992, p. 957). Alternatively, opportunism is an attempted redistribution of an already allocated contractual pie, that is a mere wealth transfer (Muris, 1981; compare Burton, 1980, p. 378). For example, a contract may require B to paint A’s portrait ‘to A’s satisfaction’ (Richard Posner, 1998, pp. 103-104). This provision allows A to reject the portrait even if others like it if it does not suit A’s taste. But if A rejects the portrait for reasons other than unhappiness with the painting’s quality - say because A remarries a spouse who does not want A’s portrait in the house - A acts opportunistically. The problem of opportunistic behavior is perhaps the key justification for court intervention in contracts. In general, ‘the threat of opportunism increases transaction costs because potential opportunists and victims expend resources perpetrating and protecting against opportunism’, which ‘do not help produce
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a commodity or service that the contracting parties mutually value’ (Muris, 1981, p. 524). More specifically, opportunistic behavior makes complete contracting extremely difficult. Even if contracting parties could anticipate all of the possible changes in economic variables, they would have a much harder time anticipating and protecting against opportunistic behavior by the other party. At the extreme, the more one contracting party is willing to contemplate the possible opportunistic behavior of his contracting partner, the less likely he will be to want to contract with that partner at all. Some degree of trust is necessary for contracting to occur. More important, many seemingly airtight contract terms can seem awfully leaky once a clever lawyer and a highly motivated client get through analyzing them. Just as cartel members can often find ways to cheat on cartels involving the most standardized products, so disappointed contractors can often find a way to act opportunistically in the most standardized contracts. Because contracting parties cannot solve all problems of opportunism on their own, courts can reduce transaction costs by imposing liability on the ‘most likely opportunist’. But there are difficulties with using courts to deter opportunism. In particular, opportunism is often ‘subtle’, that is, difficult to detect or easily masked as legitimate conduct (Muris, 1981, p. 525). Contract performance disputes arise when one party becomes unhappy with the contract. This unhappiness may stem from the occurrence of a risk that party had contractually agreed to bear. However, the disappointed party might be able to exploit some contract term to claim that the other party had breached or to allow the contested behavior, even though the term was intended to handle another situation. Alternatively, the disappointed party might be able to exaggerate or misrepresent the extent of a contingency that might excuse his performance, and so escape his contractual obligations. The problem that subtle opportunism poses for courts is often surmountable. In the fiduciary context, courts adopt, via the duty of loyalty, a strong presumption of wrongful misappropriation by an agent when that agent has a conflict of interest, engages in self-dealing, or withholds information from the principal (Cooter and Freedman, 1991a, p. 1054). More broadly, opportunism may be more possible whenever one party has a significant information advantage over the other. In other contexts, courts can find ‘objectively verifiable circumstances that act as surrogates for the existence of opportunism’ (Muris, 1981, p. 530). On the one hand, when the contract assigns a particular risk to one of the parties, and that risk materializes, the court should be skeptical of attempts by that party to escape his obligations via a different contract term. The classic example is a change in market price. If a buyer in a requirements contract suddenly experiences a large drop in ‘requirements’ after the market price has fallen below the contract price, or a large increase in requirements after the market price has risen above the contract price, the court
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should suspect opportunism or, in legal terms, a violation of the implied obligation of good faith. On the other hand, whereas a change in market price suggests opportunism, a change in economic circumstances either not contemplated by the contract or whose risk the contract places on the party seeking strict enforcement, suggests a lack of opportunism. To return to the requirements contract example, if the buyer’s requirements decrease or increase because of a change in costs or technology subsequent to the contract, the buyer’s behavior is likely not opportunistic (is in good faith) because the very purpose of the requirements contract is to assign some risk of variation in the buyer’s needs to the seller. Another example of objectively verifiable circumstances on which courts can focus is ex post transaction costs. If the market for substitute performance is thick, opportunism is less likely (Goetz and Scott, 1983). Opportunism can occur only when it is costly to switch to a new contracting partner, that is, when at least one party has made sunk, specific investments. Although this test may be useful in establishing general presumptions, it is of limited help in deciding specific cases. Litigated cases tend to be precisely those in which ex post transaction costs are likely to be high; otherwise, the cases would be settled. Although opportunism is often discussed as an ex post problem, opportunism can occur ex ante as well. For example, under a strict parol evidence rule, a party might intentionally make oral statements that the other party understands and relies on as part of the contract, then leave the provision out of (or put a contradictory provision in) the writing. One common situation is where a party tells the other to ignore the terms on the back of the first party’s forms, then later tries to enforce those terms. On the other hand, under a more flexible parol evidence rule, a party might intentionally ‘pad’ the negotiation record with statements that party knows will be rejected by the other party both orally and in writing, in the hopes that the first party can later convince the court that these statements were in fact part of the contract (a common practice in legislative history) (Eric Posner, 1998, pp. 564-565). This latter form of opportunism helps explain why courts tend to be much more skeptical of evidence that the parties can easily manipulate - especially prior negotiations - than evidence over which the parties have less control especially common usages. It may also explain the motivation behind the use of merger clauses as well as one reason why they should not be interpreted too broadly. It is difficult for a party to predict in advance which negotiation tidbit the other side might seize on later (Eric Posner, 1998, p. 572), so it is necessary to write a broad clause that excludes them all. The same is not true for less manipulable evidence, but it might be difficult to specify all such evidence in writing in advance, especially in a single ‘anti-merger’ clause. It is important to recognize once again that the opportunism approach is dependent on determining contractual intent, which is often uncertain. Stating that courts do and should deter opportunism does not by itself explain how
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courts do and should resolve the question of how to determine contractual intent; it simply opens the question up. Professor Muris, who first articulated the opportunism approach to good faith, recognized that to apply the approach courts need to consider ‘risk allocation’, which is a question of ‘interpretation’ that is ‘analytically prior to [the question] of opportunism’ (Muris, 1981, pp. 561-562, n.110). Nevertheless the opportunism approach may have something to say about how courts should go about determining intent. First, courts should hesitate to interpret a contract in such a way as to permit conduct that would ordinarily be understood as opportunistic. Second, courts should hesitate to attribute to contracting parties an intention not to have courts police against opportunistic behavior (compare Muris, 1981, p. 573, n.138). Because contextualism and textualism are both useful for deterring different types of opportunism, we should therefore expect - and we find - that courts are never completely committed to one or the other.
7. The Problem of Joint Fault or Multiple Contingencies In many contractual disputes, there are often precautionary steps that both parties could have taken to have avoided or mitigated the contractual loss. We have already considered one such precaution - drafting a better contract. Quite separate from the costs of drafting better terms are the costs of reducing the likelihood of, or harm from, some risk ex ante, and of mitigating losses ex post. Parties seeking to have the court imply or interpret a term in their favor may be attempting to avoid a risk that the contract assigned to them or to extricate themselves from a vulnerable position of their own making, which they could have avoided at low cost. In these cases, courts may have to make judgments about the relative fault of both parties to decide whose behavior it is more important to deter in a particular case. In particular, if one party is the least cost avoider of some contingency while the other party regrets the contract for other reasons and is opportunistically seeking to avoid its obligations, courts face a ‘negligence-opportunism tradeoff’ (Cohen, 1992, pp. 983-990). To take a classic example, suppose a builder promises to use a particular brand of pipe in building a house but inadvertently substitutes a different, but functionally equivalent brand, a fact not discovered by the owner until the house is nearly completed. The owner refuses to make the final payment on the house. The court must choose between placing liability on the negligent builder or the potentially opportunistic owner. There is an economic case to be made that opportunism - if sufficiently proved - is more costly behavior and deterrence of that behavior should take priority (Cohen, 1992). On the other hand, the more likely it is that the builder ‘built first and asked questions later’ (Goldberg,
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1985, p. 71), the more willing courts should be to find for the owner by implying a condition. To take another example of the negligence-opportunism tradeoff, suppose that a buyer rejects goods delivered late after a market price drop and the seller sues. There are two contingencies here: the price drop and the late delivery. The contract assigns the risk of the price drop to the buyer and the late delivery to the seller. Textualism will not resolve this dispute: either the price term or the time of delivery term cannot be read absolutely. It is not sufficient to say that only the seller has breached, because what constitutes a breach and the consequences of that breach are precisely what is at issue. Nor can it be said that only the seller could take precautions here because neither party could do anything about the price drop and the buyer did not cause the delay in delivery. If the buyer’s rejection is viewed as opportunistic behavior, then refraining from such behavior could be viewed as a ‘precaution’. Depending on the circumstances, there is an economic argument to be made for implying a good faith ‘limitation’ on the buyer’s ability to escape its obligations.
8. Court Error One of the main criticisms of courts’ taking too contextualist an approach to interpreting and implying contractual terms is the problem of court error and incompetence. At one extreme, if courts make no errors in importing contextualist evidence, then such evidence should always be allowed, at least if the cost of producing such evidence is not too high. At the other extreme, if courts make too many mistakes in interpreting or implying terms, then textualism becomes superior if the transaction costs of contracting are lower than the expected savings resulting from fewer court errors (Eric Posner, 1998, pp. 542-544). If courts make the methodological error of choosing contextualism in situations of high court error, then the parties will respond by attempting to contract around the court’s rules through detailed language or broad merger clauses, by avoiding courts (for example, arbitration) or contracts (for example, vertical integration), or by engaging in inefficient contractual behavior to adjust to the court’s erroneous legal standard. But the problem of court error does not necessarily favor textualism. In the first place, as Hadfield (1994) has argued, the feared inefficient responses to court error may not occur. Developing a formal model of good faith clauses in intentionally incomplete contracts in the presence of probabilistic court error, Hadfield concludes that the possibility of court error does not always caution against court intervention. If courts are of such low competence that the parties cannot reduce their marginal liability by improving their contractual efforts in a cost-justified way (that is, liability is essentially strict), then the parties will not change their behavior under the contract and will adjust to the anticipated
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court error by adjusting the price of the contract rather than by declining to contract. On the other hand, if courts are of higher, but still limited, competence, then enforcement of good faith clauses may lead to greater joint profits for the parties than nonenforcement. This will occur if the court error does not have too severe an adverse effect on the parties’ incentives, and if the private mechanisms for inducing optimal effort without court enforcement are relatively weak. In addition, Hadfield argues that courts of low competence should not follow bright line rules or precedent, but instead should use standards. By bright line rules she means rules requiring a certain level of conduct that is independent of changing economic conditions; for example, a bright line rule might say to a supplier in an output contract that to act in good faith it cannot reduce its output to zero unless continued production puts the firm on the verge of bankruptcy. By standards she means required actions that vary depending on the economic circumstances, such as a rule that says an agent subject to a best efforts clause must adopt reasonable sales methods. Bright line rules thus correspond to textualism, whereas standards correspond to contextualism. Bright line rules may compound rather than ameliorate court error by a court of limited competence, because a bright line rule setting forth a required action will so often be ‘wrong’. Thus, parties will respond to a bright line rule either by ignoring it or by conforming their behavior to the inefficient safe harbor established by the rule. Standards, by contrast, are more likely to encompass the ‘efficient’ response because courts using standards will set the minimum required action low and set the safe harbor high. Thus, contracting parties are likely to realize that their marginal liability can be reduced through increases in cooperative effort (because courts are likely to notice and take those efforts into account), and so the parties will be encouraged to take steps in the direction of optimal behavior. The point is that the presence of court error does not preclude the desirability of court flexibility. A similar argument might apply even outside the relational contract context. The argument for textualism here is that if transaction costs are low, court error will be minimized because the parties will be encouraged to put more terms in the writing. Textualist courts will interpret this writing more accurately than contextualist courts, which will sometimes erroneously rely on contextual evidence in addition to the writing (Eric Posner, 1998, pp. 545-546). The argument assumes that transaction costs include, as has been suggested above, not merely the cost of drafting, but the cost of drafting in such a way that courts make fewer interpretive mistakes. But low drafting costs may not be sufficient to ensure that court error is reduced under textualism. If, for example, drafting costs decrease (as they probably have due to technological progress) so that it is relatively easy for parties to add more terms to their writings, court error could in fact increase if more detailed contracts are more likely to have conflicting terms or courts are more likely to misinterpret a term to cover a
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particular contingency the parties did not intend to cover. Another aspect of court error that some argue supports textualism is error in interpretive methodology, namely the choice between textualism and contextualism itself. The contracting parties may prefer textualism and express that preference through, for example, merger clauses. But if courts make errors in determining the parties’ intentions generally, they will also err in determining the parties’ methodological preference. Courts may therefore choose contextualism too often (Eric Posner, 1998, pp. 547-548, 570-571). But once again, this conclusion depends on the assumption that if courts use textualism (this time to decide the parties’ methodological preference) they will err less often because the costs to the parties of accurately expressing their methodological intentions are low. One would think, however, that the costs to the parties of drafting a particularized methodological term are quite high. Methodological preference is only a second-order concern for the parties. It is difficult for the parties to predict how court error will likely impact the wide variety of possible disputes they might have, and methodological preference terms have no contractual use to the parties outside of litigation. As a result, it is not obvious a priori that choosing a textualist approach minimizes court error. Suppose, for example, that the parties generally prefer a textualist approach and expect interpretation x of some term. There are actually three ways the court could err. The court could take a contextual approach but reach interpretation x. Or the court could take a textual approach and reach interpretation y. Or the court could take a contextual approach and reach interpretation y. Although the parties prefer the textualist approach, it might be more important to them that the court gets the term right, however the court does it. If courts are more likely to choose the desired interpretation x using a contextual approach and interpretation y using a textual approach - either because the parties underestimate the courts’ competence with respect to that term or because their expressed preference for textualism inaccurately conveys the parties’ correct estimate of the courts’ competence in this instance - then error costs could be reduced if the court ‘mistakenly’ used a contextual approach. To give a simple numerical example, suppose the court can choose either a textualist or contextualist methodology. If it chooses textualism, the likelihood of interpreting the term the way the parties want is 0.4; if it chooses contextualism, the likelihood of interpreting the term the way the parties want is 0.6. Suppose further that ex ante the parties would value the court’s using textualism and choosing x at 100; would value the court’s using contextualism and choosing x at 80; would value the court’s using textualism and choosing y at 50; and would value the court’s using contextualism and choosing y at 10. Thus, the parties prefer textualism to contextualism, but prefer the right outcome more. The expected value if the court uses a textualist approach is (0.4 @ 100) + (0.6 @ 50) = 40 + 30 = 70. The expected value if the court uses a
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contextualist approach is (0.6 @ 80) + (0.4 @ 10) = 48 + 40 = 88 > 70. The point is that the possibility of court error does not always argue in favor of textualism. Both textualist and contextualist methodologies lead to court error. The real question is which methodology has the lowest error rate and at what cost. It is hard to answer this question in the abstract. This may help to explain why courts do not - and never will - use pure interpretive methodologies, but tend to switch back and forth depending on the circumstances.
9. Summary and Future Research To a large degree, the economic approach to interpretation and applied terms parallels the approach in other areas of contract law. Court intervention is most justifiable when transaction costs are high and the likelihood of court error is low. Transaction costs include not only the ex ante costs of drafting in such a way as to reduce court error, but the ex post costs associated with sunk specific investments that make possible opportunistic behavior, as well as the costs of alternative governance institutions such as extralegal sanctions. Most of the economic arguments that suggest a restrictive court approach to interpretation and implied terms have counterarguments. Therefore the institutional and contractual context matters greatly in deciding what approach efficiency-minded courts should take. The literature to date has mapped out the broad contours. Future work will have to do the hard digging. That means paying more attention to why people write the contracts they do and the circumstances that motivate nonperformance.
Bibliography on Implied Terms and Interpretation in Contract Law (4400) Al-Najjar, Nabil I. (1995), ‘Incomplete Contracts and the Governance of Contractual Relationships’, 85 American Economic Review Papers and Proceedings, 432-436. Barnes, David W. and Stout, Lynn A. (1992), The Economics of Contract Law, St Paul, MN, West Publishing Co. Burton, Steven J. (1980), ‘Breach of Contract and the Common Law Duty to Perform in Good Faith’, 94 Harvard Law Review, 369-403. Burton, Steven J. (1981), ‘Good Faith Performance of a Contract within Article 2 of the Uniform Commercial Code’, 67 Iowa Law Review, 1-30. Cohen, George M. (1992), ‘The Negligence-Opportunism Tradeoff in Contract Law’, 20 Hofstra Law Review, 941-1016. Cooter, Robert D. and Freedman, Bradley J. (1991a), ‘The Fiduciary Relationship: Its Economic Character and Legal Consequences’, 66 New York University Law Review, 1045-1075. Reprinted in Pardolesi, Roberto and Van den Bergh, Roger (eds) (1990), Law and Economics, Some Further Insights: 7th European Law and Economics Association Conference, Rome, Sept. 3-5, 17-50.
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Cooter, Robert D. and Freedman, Bradley J. (1991b), ‘An Economic Model of the Fiduciary’s Duty of Loyalty’, 10 Tel Aviv Studies in Law, 297 ff. Easterbrook, Frank H. and Fischel, Daniel R. (1993), ‘Contract and Fiduciary Duty’, 36 Journal of Law and Economics, 425-446. Gergen, Mark P. (1995), ‘A Defense of Judicial Reconstruction of Contracts’, 71 Indiana Law Journal, 45-99. Gillette, Clayton P. (1981), ‘Limitations on the Obligation of Good Faith’, 1981 Duke Law Journal , 619-665. Goetz, Charles J. and Scott, Robert E. (1983), ‘The Mitigation Principle: Toward a General Theory of Contractual Obligation’, 69 Virginia Law Review, 967-1024. Goetz, Charles J. and Scott, Robert E. (1985), ‘The Limits of Expanded Choice: An Analysis of the Interactions between Express and Implied Contract Terms’, 73 California Law Review, 261-322. Goldberg, Victor P. (1985), ‘Relational Exchange, Contract Law, and the Boomer Problem’, 141 Journal of Institutional and Theoretical Economics, 570-575. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 67-71, 126-127. Graham, Daniel A. and Peirce, Ellen R. (1989), ‘Contract Modification: An Economic Analysis of the Hold-Up Game’, 52(1) Law and Contemporary Problems, 9-32. Hadfield, Gillian K. (1992), ‘Incomplete Contracts and Statutes’, 12 International Review of Law and Economics, 257-259 . Hadfield, Gillian K. (1994), ‘Judicial Competence and the Interpretation of Incomplete Contracts’, 23 Journal of Legal Studies, 159-184. Hart, Oliver D. and Moore, John (1988), ‘Incomplete Contracts and Renegotiation’, 56 Econometrica, 755-785. Hansmann, Henry and Kraakman, Reinier (1992), ‘Hands Tying Contracts: Book Publishing, Venture Capital Financing, and Secured Debt’, 8 Journal of Law, Economics and Organization, 628-655. Hermalin, Benjamin and Katz, Michael L. (1993), ‘Judicial Modification of Contracts Between Sophisticated Parties: A More Complete View of Incomplete Contracts and Their Breach’, 9 Journal of Law, Economics and Organization, 230-255. Kahan, Marcel (1994), ‘The Qualified Case Against Mandatory Terms in Bonds’, 89 Northwestern University Law Review, 565 ff. Kahn, Charles and Huberman, Gur (1989), ‘Default, Foreclosure, and Strategic Renegotiation’,52 Law and Contemporary Problems, 49-61. Muris, Timothy J. (1981), ‘Opportunistic Behavior and the Law of Contracts’, 65 Minnesota Law Review, 521-590. Narasimhan, Subha (1986), ‘Of Expectations, Incomplete Contracting, and the Bargain Principle’, 74 California Law Review, 1123-1202. Posner, Eric (1995), ‘Contract Law in the Welfare State: A Defense of the Unconscionability Doctrine, Usury Laws, and Related Limitations on Freedom to Contract’, 24 Journal of Legal Studies, 283-319. Posner, Eric (1998), ‘The Parol Evidence Rule, the Plain Meaning Rule, and the Principles of Contractual Interpretation’, 146 University of Pennsylvania Law Review, 533-577. Snyderman, Mark (1988), ‘What’s So Good About Good Faith? The Good Faith Performance Obligation in Commercial Lending’, 55 University of Chicago Law Review, 1335-1370.
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Verkerke, J. Hoult (1995), ‘An Empirical Perspective on Indefinite Term Contracts: Resolving the Just Cause Debate’, 1995 Wisconsin Law Review, 837-918. Warren, Elizabeth (1981), ‘Trade Usage and Parties in the Trade: An Economic Rationale for an Inflexible Rule’, 42 University of Pittsburgh Law Review, 515-582. Williamson, Oliver E. (1985), ‘Assessing Contract’, 1 Journal of Law, Economics and Organization, 177-208.
Other References Ayres, Ian and Gertner, Robert (1989), ‘Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules’, 99 Yale Law Journal, 87-130. Charny, David (1991), ‘Hypothetical Bargains: The Normative Structure of Contract Interpretation’, 89 Michigan Law Review, 1815-1879. Goetz, Charles J. and Scott, Robert E. (1981), ‘Principles of Relational Contracts’, 67 Virginia Law Review, 1089-1150. Posner, Richard A. (1998), Economic Analysis of Law, Boston, MA, Little, Brown and Co. Wonnell, Christopher T. (1986), ‘Contract Law and the Austrian School of Economics’, 54 Fordham Law Review, 507-543.
4500 UNFORESEEN CONTINGENCIES. RISK ALLOCATION IN CONTRACTS George G. Triantis University of Virginia School of Law © Copyright 1999 George G. Triantis
Abstract Contracts allocate risks by providing for future contingencies with variable degrees of specificity: they partition future states of the world more or less finely and set obligations for each state in the form of prices, quantity, remedies for breach, and so on. The partitioning may be conditioned on quantitative or qualitative factors. Refined qualitative partitioning based on verifiable outcomes can exploit comparative advantages in precaution-taking and in hedging or diversification. The expected benefit from refined partitioning of remote contingencies may not be worth the contracting costs. In these cases, the court may promote efficient risk-bearing activity by setting the parties’ obligations in these states of the world ex post, as long as the court’s determination in each state is predictable. JEL classification: K12, D81 Keywords: Incomplete Contracts, Uncertainty, Risk Allocation, Unforeseeability, Commercial Impracticability, Contract Remedies
1. Introduction When the occurrence of an unforeseeable event would cause a promisor to bear an unexpectedly large loss in performing her contractual obligation, the parties might renegotiate and modify the promisor’s contract. In most cases, the law will enforce their agreement as modified. However, even in default of such adjustment, a set of common law doctrines may offer relief to the promisor. The unexpected loss triggering the relief might be an increase in the cost of performance (out-of-pocket or opportunity cost) or a decrease in the value of the reciprocal obligation of the promisee. The common law doctrines of impossibility and commercial impracticability release the promisor from her obligation on the grounds of an unforeseeable supervening event that increases the cost of either literal performance or damages liability to a level beyond the anticipated range of values at the time of contracting. The doctrine of frustration excuses when the supervening event impairs the ‘purpose’ of the
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agreement: in other words, the value that would be realized from the reciprocal performance of the other party. Mutual mistake about the subject matter of the contract excuses performance when new information comes to light that moves the value of the exchange to either party outside the range mutually anticipated by the parties at the time of contracting. Finally, under the rule in Hadley v. Baxendale, a promisor who breaches is released from liability for losses of the promisee that were unforeseeable. Thus, the release of contract obligations under these various common law doctrines hinges not only on whether the parties provided for the risk in their contract, but also on the unforeseeability of the contingency responsible for the threatened unexpected loss. Law and economics scholarship has examined at great length the efficiency of contractual allocations of risk in incomplete contracts. A subset of this literature has struggled with the relevance of unforeseeability in this analysis. This essay provides a review of the significance of the risk of unforeseeable contingencies in commercial contracting and the common law of contracts. The chapter begins with an outline of the means and ends of risk allocation in contracts and the determinants of a contract’s specificity in partitioning future states of the world (in economic terms, the contract’s completeness). The contractual allocation of risks has significant efficiency consequences because it sets investment incentives for each party (resource allocation) and exploits differences in their respective risk-bearing capabilities (risk-sharing). Contracts allocate risks in larger or smaller bundles that may be defined qualitatively or quantitatively. The price, quantity or remedy term of a contract may shift to the buyer the risk of cost increases within specified ranges. Or, these terms may be conditioned on outcomes produced by specified causes. Either the quantitative ranges or the qualitative causes may be broadly or narrowly defined (Triantis, 1992). Comparative advantages in precautions or risk-bearing may be exploited more fully when contracts partition future states of the world more finely. However, the higher contracting and verification costs of refined risk allocation may offset the expected benefits. In particular, the more remote the risk, the heavier the discount on the benefit from specific allocation and the less likely is a net benefit from specific treatment of risks. Most law and economics scholars treat the risk of unforeseeable contingencies as the limiting instance of remote risks: by definition, the cost of specifying ex ante the contractual obligations in the unforeseeable state of the world exceeds the expected benefit. Indeed, modern doctrinal statements of the excuses of frustration, impossibility and impracticability reflect this approach by referring to ‘the occurrence of an event [or contingency] the non-occurrence of which was a basic assumption on which the contract was made’, which seems to encompass those risks to which the parties attached a probability of near zero (Restatement (Second) of Contracts §§261, 265; Uniform Commercial Code §615). In these cases, the courts may promote efficient risk-bearing activity by setting the parties’
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obligations ex post, particularly if their determination is conditioned on verifiable outcomes and predictable.
2. Contract Partitions and Incompleteness Parties enter into executory contracts instead of present exchanges for two principal reasons: (1) to protect and thereby encourage relationship specific (or reliance) investments which increase the value of their exchange and (2) to transfer risks and thereby to exploit comparative advantages in risk-bearing. Accordingly, a distinction may be drawn between two types of contracts that define opposite ends of a spectrum: (1) exchanges of goods and services for which close substitutes are readily available in thick markets (‘market’ contracts) and (2) exchanges for which there are no such substitutes because of specific investments made by either or both parties before the exchange is complete (‘off-market’ contracts). By definition, the investment of a party to a market contract is not specific to the relationship; the availability of market substitutes protects the investing party from opportunism (Klein, Crawford and Alchian 1978; Williamson 1979). The gain from executory market contracts derives from the allocation of market risks, not the actual delivery of goods or services or the protection of reliance investments. The parties contract to exploit comparative advantages in risk-bearing that are due to differences in their respective degrees of risk aversion and in their ability to hedge or shift risks in their other contracts and activities. In contrast, off-market executory contracts both protect specific investments and allocate risks associated with uncertainty in the environment and the imperfect information of the parties. The allocation of risks in these contracts has a significant impact on various important investment decisions: the parties’ investment in information prior to contracting, the promisor’s decision to perform or breach, the promisee’s specific (reliance) investments, and either party’s precautions against the probability and impact of adverse risks that threaten the value of the exchange. Because of its impact on resource allocation, the task of allocating risks in off-market contracts is more complex than in market contracts. Enforcement of off-market contracts is also more difficult because of the obstacle of verification: the cost of proving breach and damages to a third-party enforcer, typically a court. Thus, each party has a greater temptation to avoid performing obligations that threaten to inflict large losses. Consequently, the parties may wish to dampen incentives to chisel by sharing risks more evenly under the contract and thereby reducing the variance in the returns of each party (Goldberg, 1985). Without attempting to describe fully the various tensions that exist among the objectives of risk allocation, this essay reviews contract terms, such as price and remedies, that partition the
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future according to qualitative or quantitative factors. This review sets the stage for a discussion of how foreseeability is relevant in the common law of contracts. Consider the following sales contract. Seller agrees to manufacture and deliver a specific good to Buyer one year later. Buyer maximizes the value of the good to him at delivery (V) by making a reliance investment of R. The cost to Seller of making and delivering the good is C. To keep the discussion simple, assume that Seller has no other use for the good, no third party would bid for the good and the exchange has no external effect on third parties. Therefore, the social gain (or loss) from the completed exchange is the difference: V - R - C. The parties contract under uncertainty and with imperfect information about the state of the world that will materialize at the time of delivery. V and C are stochastic and their respective distributions are neither perfectly positively nor perfectly negatively correlated. The latter assumption allows the parties to have conflicting interests with respect to the decision to terminate their contract. At the time of contracting, Seller and Buyer observe the same joint distribution of V and C, although the actual values at the time of contracting is private information. The terms of the contract divide the gain (or loss) from the exchange (V - R - C) between Buyer and Seller and the parties may decide to condition the division on the state of the world existing at delivery. A complete contingent contract would specify the parties’ obligations in each possible state of the world and the division of the gain (or loss) from the contract in each state. An efficient complete contingent contract sets optimal investment incentives and sharing of risks over each state of the world. Each state can be defined in both quantitative and qualitative terms: by the realized values of V and C and the factors that produced V and C. The motivating premise for contracts law and economics scholarship is that contracting and verification costs make complete contingent contracts infeasible. Shavell states that incompleteness is efficient to the extent that the bargaining costs are high to provide for that contingency, the contingency has a low probability of occurring, the cost of verifying its occurrence is high and the cost of settling disputes is low in the event that the contract does not provide for the contingency (Shavell, 1984). In practice, contracts are incomplete because they group states of the world into more broadly framed partitions (Schwartz, 1992). In the sales contract described above, for example, the terms governing price, quantity and remedy for breach would typically establish the rights and obligations of the parties according to more or less broadly framed quantitative states of the world. At one extreme, for example, if the contract has fixed price and quantity, and is specifically enforced, the contract does not distinguish between different outcomes: each party’s obligation is the same regardless of the realized state.
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3. Quantitative Partitions: Price and Remedy 3.1 Price To isolate the comparison among fixed and flexible price terms, assume for the moment that contracts are specifically enforced. On the one hand, a fixed price provides a certain revenue to the seller and a certain contractual obligation to the buyer. On the other hand, a flexible price can provide a hedge against fluctuations in the seller’s cost of performance or the buyer’s valuation of performance. As a general matter, the contract price may offset risks created by other contracts and activities of either party. This point is demonstrated by Polinsky in his comparison of fixed and spot prices in market contracts (Polinsky, 1987). To the extent that fluctuations in spot prices reflect changes in cost conditions in the industry that are experienced by the seller, a spot price contract reduces the risk of the seller (and shifts cost risk onto buyer). Conversely, to the extent that spot price fluctuations are driven by demand-side conditions that reflect changes in the value of the good to buyers, a spot price transfers the risk of such value fluctuations to the seller. Thus, Polinsky says: a spot price contract will ... tend to insure the seller against production cost ncertainty...although the upward slope of the industry supply curve and the less than perfect correlation between the seller’s costs and shifts in the industry supply curve reduces the value of a spot price contract as insurance against production cost uncertainty... A fixed price contract would insure the seller against... demand side uncertainties [that cause shifts in the industry demand curve]...A spot price contract will tend to insure the buyer against valuation uncertainty, while a fixed price contract will insure the buyer against supply side uncertainties. (Polinsky, 1987, p. 29)
Spot price contracts condition only on the revealed spot market price at the time scheduled for delivery. Other distinctions among states of the world existing at that time - such as idiosyncratic increases in seller’s costs - are ignored either because there are no benefits to such further partitioning or because the contracting and verification costs of doing so outweigh the benefits. In the absence of a spot market for a close substitute or in cases where the spot price provides a poor fit because of idiosyncracies of the seller or buyer, other flexible price terms may be more closely tailored to the conditions of the seller or buyer to achieve the desired allocation of risk. For example, the price may be adjusted by reference to the realized values or determinants of C and V (for example cost plus or royalty contracts) or to accessible indices correlated with the cost or value of performance (Joskow, 1988). Alternatively, the contract may provide that a price must be reset upon the occurrence of certain
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contingencies (Joskow, 1988). Each alternative has its own shortcomings. Realized values of C and V are often private information and not observable or verifiable. In longer term contracts, indices can fall out of line with C or V as easily as spot market prices. Yet, the renegotiation of off-market contracts raise the prospect of opportunistic appropriation of quasi-rents (Williamson, 1979). 3.2 Remedies The effect of the standard breach of contract remedies on investment incentives is well known. Under assumptions of perfect enforcement (including no insolvency risk) and no renegotiation, expectation damages set socially efficient performance incentives for the promisor, while reliance and restitution measures lead to moral hazard and excessive breach by the promisor. Specific performance produces insufficient breach. Expectation and reliance damages encourage too much reliance expenditure by the promisee (Shavell, 1980). Although the mitigation rule requires the promisee to take all reasonable loss avoiding measures after the breach occurs, information about the reasonableness of the promisee’s actions is difficult to verify. In contrast, restitutionary damages or no recovery (under a doctrine of excuse, for instance) are superior in inducing efficient amounts of reliance and mitigation by the promisee (Bruce, 1982; Goldberg, 1988). Thus, when the promisor’s liability cannot be conditioned on efficient investment levels on the part of each party because of contracting and verification costs, there is a tension between the goals of setting the correct incentives for the promisor and for the promisee. The next paragraph describes a further complication that arises when one or both of the contracting parties are averse to bearing risks. Breach of contract remedies allocate the risk of fluctuations in C and V. For example, suppose the contract has a fixed price that is payed in advance and consider the risk borne by the seller. If the contract is specifically enforced, then the seller bears the risk of fluctuations in C. If the sanction for breach is the payment of damages, the measure of damages (D) serves to divide the risks between the parties. For any given level of V, the seller bears the risk of cost fluctuations in the range C < D; the buyer risks losing V − D if C > D. Unless damages are punitive, neither party bears the risk of C > V; this is the range of efficient breach. Fluctuations in V matter to the seller if damages are a function of V (for example, under the expectation measure): the seller bears the risk of V when the cost of performance is greater than the fixed price. The correlation between C and V therefore is also significant to the seller. For example, if C and V are negatively correlated, a rise in C and fall in V may induce the buyer to repudiate the contract and thereby release the seller from her obligation. Thus, the standard breach of contract remedies divide the joint distribution of C and V and thereby establish incentives for breach, reliance, and investment in precautions against adverse changes in C or V. They can also exploit
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differences in the risk preferences of the parties. For example, a seller insures the buyer against the risk of cost increases under remedies of specific performance and expectation damages, which is an efficient risk-sharing arrangement if the seller is risk-neutral and the buyer is risk averse and does not hold a hedge against that risk (Polinsky, 1983; Shavell, 1984). If the remedy is conditioned on C and V (or their proxies), significant tradeoffs exist between the goals of efficient investment incentives and optimal risk-sharing. If the seller is risk averse, the measures of damages that optimize the sharing of cost risk create a moral hazard of underperformance by the seller. Of course, in other cases, only one of the performance or risk-sharing goals are relevant: for example, if the seller is risk-neutral (expectation damages are efficient) or if the seller is risk averse but has no control over the cost of performance (some measure less than expectation is efficient, depending on the buyer’s risk aversion). White suggests that discharge under an excuse doctrine should be analyzed under a unified approach as a breach sanctioned by damages equal to zero. She demonstrates that zero damages produce optimal risk-sharing only in very exceptional circumstances and always encourage excessive breach (White, 1988). However, the advantage of discharge comes from the effect on the buyer’s investment incentives, particularly reliance and precaution expenditures, which she removes from her analysis (Bruce, 1982; Goldberg, 1988). The role of these incentives becomes more salient when the allocation of risk by cause is discussed in Section 4. Even if a contract addresses risks only in quantitative terms, it might condition the remedy (as opposed to the calculation of damages) on the realized value of C. Instead of one measure of damages (for example expectation), the contract might provide for two measures depending on whether the cost of production falls within one region or another of the distribution. For example, if breach occurs when C < min (C',V) then the promisor pays expectation damages; if breach occurs when C > C' > V, then the promisor’s obligation is discharged. Even though optimal risk-sharing is the only objective (because C' > V), it is not clear that this partitioning of future states creates a superior risksharing arrangement, even if the seller is risk averse and the buyer is riskneutral. Even a risk-neutral buyer will offer to pay a lower price for the good when he faces the prospect of undercompensation in the event of breach. Therefore, in the region of the distribution of C when the seller is not excused, expectation damages will be larger than under a regime of single damages measure. This increases the variance of returns for the seller in that region, while decreasing it within the region of discharge. One would require more information about the seller’s utility function to know whether she would prefer this risk profile (Sykes, 1990). The theoretical discussion of the incentive and risk-sharing effects of remedies usually assumes perfect enforcement. If this assumption is relaxed, the benefits of the various remedies are compromised. The parties may set payment
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terms to achieve the allocation of risks that would be achieved by price and remedies in perfect enforcement. A payment or performance schedule allows either party to walk away from the contract at any point in time with a roughly adequate allocation of gains and losses. For example, Goldberg suggests that ‘there are a large number of reasons why a particular contract might not be completed and one way to protect one’s interests is to assure that at each point in time, the performance rendered and compensation received are not too far out of whack’ (Goldberg, 1988, pp. 113-114). Kull makes a similar point in discussing cases decided under the doctrine of frustration. Under the contract in Fibrosa S.A. v. Fairbairn Lawson Combe Barbour, the buyer promised to pay one-third of the price of textile machinery with its order and the balance against shipping documents. Kull suggests that the parties intended to allocate the risk of loss caused by the frustrating event (the German invasion of Poland) by allowing the seller to keep one-third of the price in the event of the buyer’s breach. This is a reasonable interpretation of the intention of parties who opt for a self-enforcing contract by letting losses lie where they fall. Indeed, a contract might assign the entire risk of the contract to the buyer by requiring full payment in advance or to the seller by providing for payment only upon delivery (Kull, 1991). White demonstrates that advance payments are efficient where negative damages (from buyer to breaching seller) are optimal because of the seller’s risk aversion, but the parties believe that a court would be more likely to allow the breaching seller to retain a deposit than to order negative damages (White, 1988).
4. Qualitative Partitioning of Remedies In the foregoing discussion, the obligations of the parties and the sharing of the returns from the exchange are conditioned on the realized values of V and C, or their respective quantitative proxies. In deciding how finely to partition the joint distribution of these variables, the parties weigh the benefit of more tailored risk allocation against the correspondingly higher costs of contracting and verification. The other dimension over which the parties may contract is qualitative: the cause of fluctuations in the cost and value of performance. Qualitative partitioning may be preferred because of the enhanced efficiency of risk allocation by cause or the lower contracting and verification costs. Force majeure clauses release the promisor upon the occurrence of specified events that impair the value of her contract. Common law doctrines of excuse are triggered when an unforeseeable event occurs that causes performance to be impossible or commercially impracticable, or that frustrates the value of the reciprocal performance. The discussion in this part focuses on the contractual specification of risk by cause and the next part addresses the judicial treatment of unspecified remote risks through the doctrines of excuse.
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4.1 Precautions Suppose that contingency x and contingency y can each cause the same increase in the cost of performance and have the same probability of occurring at the time of the contract. What reasons might justify allocating the risk of x to the seller (for example specific enforcement or expectation damages) and the risk of y to the buyer (for example excuse or remedy of restitution)? The cause of the increase in cost does not affect the optimal performance/breach decision or the efficient level of reliance. It is, however, relevant to efficient precautions and risk-sharing. Posner and Rosenfield set the framework for the analysis of efficient risk allocation in their influential article on the common law doctrines of excuse. The superior risk bearer is the party who is in the best position to accomplish the following measures: to minimize the probability of the adverse contingency, to minimize the extent of the loss to the promisee resulting from nonperformance either before it occurs (precaution) or after (mitigation), or to insure (by self or with third parties) against the residual risk of the loss that cannot be feasibly avoided (Posner and Rosenfield, 1977). The relative ability of each party to bear or insure against the residual risk is significantly more difficult to determine than the comparative advantage in taking precautions against the risk, and so we set aside the former for the moment. Comparative advantages in the taking of precautions are related almost by definition to the cause of the threatened loss from an increase in cost or decrease in the value of the contract. The question is not only whether it is feasible to partition by cause, but how specifically to do so. A cost increase may be due to a natural disaster (general cause), which may be a tornado, earthquake, flood or drought (specific cause). To the extent that the risk is endogenous, there may be benefits to specific allocation because it sharpens the assignment of responsibility for precautions. Irrigation systems are effective precautions against droughts, but not tornadoes. Of course, obligations may be conditioned not on the contingency but directly on the precautionary actions of the parties. For example, damages liability of the breaching promisor may be conditioned on the reasonableness of the actions of the parties under the circumstances (Shavell, 1980). This approach is signficantly less common in contracts than torts (Cooter, 1985; Cohen, 1994). Contracting parties might condition damages liability on the failure of the seller to take reasonable precautions against cost increases and the reasonable precautions of the buyer (including efficient level of reliance). However, as noted earlier, contracts are rarely written in these terms because reasonable behavior is typically based on unverifiable information - particularly because the ex ante probability of breach is difficult to prove ex post at trial. The cost of verifying information concerning actions before breach or repudiation explains why contracts condition on contingencies rather than the actions of the parties. The mitigation requirement in contract law does limit the
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recovery of the promisee to the loss that could not be avoided by reasonable measures taken only after the promisee learns of the promisor’s repudiation or breach. Although verification problems undermine the effectiveness of the mitigation rule in this regard, at least the assessment of the ex ante probability of breach is not a factor. There is some evidence that judges may choose between expectation and reliance measures of damages based on their assessment of the reasonableness of the conduct of the promisor and promisee in any given case (Cohen, 1994). However, complete discharge of obligations under the doctrines of excuse is conditioned on the occurrence of events, rather than the actions of the parties (as long as the event in question was not due to the fault of the promisor). 4.2 Residual Risk Posner and Rosenfield suggest that the ability to bear residual risk (after all cost effective precautions are taken) is a function of cost of appraising the risk, the transaction cost of obtaining third party insurance and the degree of risk aversion. As noted above, a party might also self-insure by hedging its risk under the contract against other contracts and activities. Corporate parties often have elaborate webs of commercial and financing contracts that spread and transfer the risks of their activities. Indeed, the rules of debtor-creditor relations provide important risk allocations that should be integrated into the discussion of risk-sharing in commercial contracts. If the cost of performance rises to a level such that the seller cannot perform, she breaches and becomes liable for damages. However, if the seller becomes insolvent as a result, the buyer will recover only a fraction of these damages. Even in the case where expectation damages are awarded, the buyer bears the risk of a cost increase that threatens its seller’s solvency and shares this risk with other unsecured creditors of the seller (Triantis, 1992; Treblicock, 1994). Thus, the ability to take precautions against a given risk is likely to be of greater significance than the ability to bear residual risk in the identification of the superior risk bearer in a contract. In addition, one party may be in a better position to hedge specifically the risk of a dramatic increase in the cost of performance that hinges on a specific cause. If, for example, the cause is an exogenous increase in fuel cost and the buyer of the good owns oil fields or shares in oil companies, the buyer may be the superior risk bearer even if risk averse (Triantis, 1992). The contingency itself may inflict a loss on the seller beyond the liability for contract breach. For example, suppose the seller is a farmer who contracts to deliver crops grown on his land for a fixed price. A natural disaster - flooding destroys those crops. At the same time, the market price for the crops has increased substantially since the time of contracting as a result of the disaster. If the seller is not excused, she bears two losses: the loss of crops and the liability resulting from the increase in the market price of the crops. If the seller is risk averse, it may be efficient to pass on the second loss to another party,
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such as the buyer. The parties may signal that they intend this result when they provide for the sale of crops grown on a particular tract of land (Posner and Rosenfield, 1977; Sykes, 1998). Another instance of this approach is the rule that the destruction of identified goods prior to delivery, without fault of either party, discharges contractual obligations (U.C.C. 2-613; Taylor v. Caldwell, where lease of a music hall was rendered impossible because destroyed by fire). In theory, the point may be generalized to any case in which the promisor makes a substantial specific investment toward performance that is lost when she is compelled by circumstances to breach. If the promisee has incurred less significant reliance costs, excuse might provide a more even sharing of the losses caused by the occurrence of the contingency. The reason that excuse is not generally available in these cases may be that a promisor’s wasted investment is less verifiable than the physicial destruction of an asset (for example lost crops or identified goods). In some cases, the superior risk bearer is easy to identify. For example, the risk of a cost increase from a given cause should shift to the buyer if the seller cannot affect its probability or the loss suffered by the buyer as a result of nonperformance, if the buyer has at least as good information about the probability and magnitude of loss as the seller and if the buyer is risk-neutral or can hedge the risk of loss against its risk exposure from other activities. As several commentators have noted, however, the various factors determining risk-bearing advantage may well point to different parties and the task of determining the superior risk bearer overall may be very complicated (White, 1988; Treblicock, 1988). This reflects similar tensions discussed above with respect to the choice of remedies for breach, but complicated here because of the focus on specific causes and effects.
5. Judicial (ex post) Partitioning The discussion describes loosely the complex task of risk allocation in commercial contracts. An important part of it is deciding how to partition future states of the world. As Sykes demonstrated in the case of a regime of excuse conditioned on C > C' (see above), the benefits from fine partitions of quantitative outcomes in contracts are questionable and therefore the unforeseeability of the tails of the relevant distributions is not likely to be a concern. On the other hand, when a contract partitions according to the qualitative cause of contingencies, the remoteness of the contingency matters. The benefit of dealing with the specific cause must be discounted by its low probability. In addition, by definition, the parties have less experience with low probability events and therefore information is more costly. As a result, the
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benefit of addressing a remote risk may not be worth its cost (Gillette, 1985, 1990). At the same time, however, some causes tend to be more verifiable than the realized quantitative measures of cost or value of performance. All other things equal, it is less feasible for the parties to incur the cost of allocating remote risks specifically. They therefore would bundle them in more broadly framed risks, in much the same manner as travellers budget unexpected incidentals without identifying them specifically (Gillette, 1985; Triantis, 1992). As uncertainty resolves during the term of the contract and remote risks become more likely or materialize, the benefit from more specific allocation becomes correspondingly greater in order to reduce or avoid the risk in the most cost-effective manner. Recontracting in light of the new information is likely to be impeded by transaction costs and strategic behavior. The common law, industry custom or contract provisions (for example gross inequities provision requiring renegotiation in good faith) may address these obstacles by imposing duties on both parties to cooperate in adjusting the terms of their bargain. There is some debate about the extent to which the law should require cooperative adjustment to preserve the value of the exchange (Gillette, 1990; Scott, 1990). Moreover, if a dispute should arise at a later date, a court will be presented with the difficult task of distinguishing between efficient modifications and those obtained by strategic behavior (Aivazian, Treblicock and Penny, 1984). However, the issue of consensual adjustment of contracts is covered elsewhere in the encyclopedia. Posner and Rosenfield suggest that the courts can complete the contract with respect to those remote risks the parties could not foresee at the time of contracting, according to the principles of efficient risk allocation (Posner and Rosenfield, 1977). The benefit of specific allocation may be reproduced if a court later allocates ex post the once-remote risk, but only if the ruling is predictable. The judicial allocation of losses cannot yield the intended efficiency benefits of efficient precaution and insurance unless it can be predicted ex ante (Kull, 1991; Triantis, 1992). As discussed above, the superior risk bearer analysis must play with sets of criteria that often cut in opposite directions and call for information that is often unverifiable. (Treblicock, 1988; Schwartz, 1992). As a result, parties may well contract ex ante to avoid the additional risk of judicial intervention or may overinvest in precautions. (Triantis, 1992; Trebilcock, 1994). In an important recent article, Schwartz argues that common law excuse rules conditioned on unobservable or unverifiable information will be unusable by courts and rejected by future contracting parties (Schwartz, 1992). The concern with conditioning judicial allocation of risk on verifiable factors, in particular, seems to be a persuasive explanation for the greater inclination of the courts to excuse performance in cases where it has become impossible (for example by the destruction of the subject matter or because of government regulation) rather than impracticable. (Schwartz, 1992). As a normative matter, the courts should intervene to
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allocate remote risks when the incompleteness of the contract is due only to contracting costs, and not to obstacles of verification.
Bibliography on Unforeseen Contingencies. Risk Allocation in Contracts (4500) Adams, Michael (1986), ‘Der Irrtum über Künftige Sachverhalte. Anwendungsbeispiel und Einführung indie ökonomische Analyse des Rechts (Error about Future Facts)’, RECHT, Zeitschrift für Juristische Ausbildung und Praxis, 14-23. Adams, Michael (1986), ‘Zur Behandlung von Irrtümern und Offenbarungspflichten im Vertragsrecht (On Mistake and Information Revelation Duties in Contract Law)’, 186 Archiv für die Civilistische Praxis, 453-489. Aivazian, Varouj A., Trebilcock, Michael J. and Penny, Michael (1984), ‘The Law of Contract Modifications: The Uncertain Quest for a Benchmark of Enforceability’, 22 Osgoode Hall Law Journal, 173-212. Reprinted in Goldberg, Victor P. (ed.), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 1989, 207. Ashley, Stephen S. (1975), ‘The Economic Implications of the Doctrine of Impossibility’, 26 Hastings Law Journal, 1251-1276. Barnes, David W. and Stout, Lynn A. (1992), Economics of Contract Law, Minneapolis, West Publishing. Bellantuono, Giuseppe (1995), ‘Polizza Fideiussoria, Reticenza e Obblighi d Informazione (Performance Bond, Non-Disclosure and Duties of Information)’, V Il Foro Italiano, 1905-1909. Birmingham, Robert L. (1969), ‘A Second Look at Suez Canal Cases: Excuse for Nonperformance of Contractual Obligations in the Light of Economic Theory’, 20 Hastings Law Journal, 1393-1416. Brinig, Margaret F. and Alexeev, Michael V. (1995), ‘Fraud in Courtship: Annulment and Divorce’, 2 European Journal of Law and Economics, 45-63. Bruce, Christopher J. (1982), ‘An Economic Analysis of the Impossibility Doctrine’, 11 Journal of Legal Studies, 311-323. Centner, Terence J. and Wetzstein, Michael E. (1987), ‘Reducing Moral Hazard Associated with Implied Warranties of Animal Health’, 68 American Journal of Agricultural Economics, 143-150. Centner, Terence J. and Wetzstein, Michael E. (1988), ‘Reducing Moral Hazard Associated with Implied Warranties of Animal Health: Reply’, 70 American Journal of Agricultural Economics, 413-414. Chami, Ralph (1996), ‘King Lear’s Dilemma: Precommitment versus the Last Word’, 52 Economics Letters, 171-176. Chami, Ralph and Fischer, Jeffrey (1996), ‘Altruism, Matching and Nonmarket Insurance’, 34 Economic Inquiry, 630-647. Chisholm, Darlene C. (1993), ‘Asset Specificity and Long-Term Contracts: The Case of the Motion-Pictures Industry’, 19 Eastern Economic Journal, 143-155. Chisholm, Darlene C. (1996), ‘Continuous Degrees of Residual Claimancy: Some Contractual Evidence’, 3 Applied Economics Letters, 739-741.
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Chisholm, Darlene C. (1997), ‘Profit-Sharing versus Fixed-Payment Contracts: Evidence From the Motion Pictures Industry’, 13 Journal of Law, Economics, and Organization, 169-201. Cohen, George M. (1994), ‘The Fault Lines in Contract Damages’, 80 Virginia Law Review, 1225 ff. Cooter, Robert (1985), ‘Unity in Tort, Contract, and Property: The Model of Precaution’, 73 California Law Review, 1 ff. Craswell, Richard (1988), ‘Precontractual Investigation as an Optimal Precaution Problem’, 17 Journal of Legal Studies, 401 ff. Eidenmüller, Horst (1995), ‘Neuverhandlungspflichten bei Wegfall der Geschäftsgrundlage (Renegotiation Duties Following a Fundamental Change of Circumstances)’, 16 Zeitschrift für Wirtschaftsrecht, 1063-1071. Farnsworth, Allan E. (1968), ‘Disputes over Omission in Contracts’, 68 Columbia Law Review, 860 ff. Frech, H. Edward III and Decanio, Stephen J. (1993), ‘Vertical Contracts: A Natural Experiment in Gas Pipeline Regulation’, 149 Journal of Institutional and Theoretical Economics, 370-392. Gemtos, Petros A. (1976), ‘Antimetopises tou Plethorismou os Oikonomikon kai Nomikon Provlema. Sygchronos Symvole eis ten Diereunesin ton Themeliakon Scheseon ton Pragmatologikon kai ton Kanonistikon Epistemon (The Treatment of Inflation as an Economic and Legal Problem. Contemporary Contribution to the Examination of the Fundamental Relations between the Positive and Normative Sciences)’, 30 Harmenopoulos, 830-846. Gillette, Clayton P. (1985), ‘Commercial Rationality and the Duty to Adjust Long-Term Contracts’, 69 Minnesota Law Review, 521 ff. Gillette, Clayton P. (1990), ‘Commercial Relationships and the Selection of Default Rules for Remote Risks’, 19 Journal of Legal Studies, 535 ff. Goldberg, Victor P. (1985), ‘Price Adjustment in Long-Term Contracts’, Wisconsin Law Review, 527-543. Reprinted in Speidel, Summers and White (1987), Commercial Law: Teaching Materials, fourth edition. Goldberg, Victor P. (1988), ‘Impossibility and Related Excuses’, 144 Journal of Institutional and Theoretical Economics, 100-116. Hansmann, Henry B. and Kraakman, Reinier H. (1992), ‘Hands-Tying Contracts: Book Publishing, Venture Capital Financing, and Secured Debt’, 8 Journal of Law, Economics, and Organization, 628-655. Hasen, Richard L. (1990), ‘Comment, Efficiency Under Informational Asymmetry: The Effect of Framing on Legal Rules’, 38 UCLA Law Review, 391 ff. Hatzis, Aristides N. (1998), An Economic Theory of Greek Contract Law, Ph.D. Thesis, University of Chicago Law School. Herrmann, Harald (1988), ‘Vertragsanpassung - Ein Problem des Freiheitsschutzes nach Vertragsschluß (Contract Adaptation - A Problem of Liberties’ Protection after Contract Conclusion)’, JURA, 505-511. Hurst, Thomas R. (1976), ‘Freedom of Contract in an Unstable Economy: Judicial Reallocation of Contractual Risks under UOC’ Section 2-615', 54 North Carolina Law Review, 545-583. Johnsen, D. Bruce, and (1995), ‘The Quasi-Rent Structure of Corporate Enterprise: A Transaction Cost Theory’, 44 Emory Law Journal, 1277 ff.
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Joskow, Paul L. (1977), ‘Commercial Impossibility, the Uranium Market and the Westinghouse Case’, 6 Journal of Legal Studies, 119-176. Joskow, Paul L. (1988), ‘Price Adjustments in Long-Term Contracts: The Case of Coal’, 31 Journal of Law and Economics, 47 ff. Klein, Benjamin, Crawford, Robert G. and Alchian, Armen A. (1978), ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Process’, 21 Journal of Law and Economics, 297 ff. Koller, Ingo (1979), Die Risikozurechnung bei Vertragsstörungen in Austauschverträgen (The Risk Allocation of Contract Disturbances in Bilateral Contracts), München, C.H. Beck, 474 p. Kornhauser, Lewis A. (1983), ‘Reliance, Reputation, and Breach of Contract’, 26 Journal of Law and Economics, 691 ff. Kronman, Anthony T. (1979), ‘Mistake, Disclosure, Information, and the Law of Contracts’, 7 Journal of Legal Studies, 1 ff. Kull, Andrew (1991), ‘Mistake, Frustration, and the Windfall Principle of Contract Remedies’, 43 Hastings Law Journal, 1 ff. Mackaay, Ejan and Fabien, Claude (1983), ‘Le Droit Civil aux Prises avec l’Inflation (Civil Law on Prices with Inflation)’, Revue de Droit de McGill, 284-334. Mackaay, Ejan and Fabien, Claude (1984), ‘Civil Law and the Fight against Inflation - A Legal and Economic Analysis of the Quebec Case’, 44 Louisiana Law Review, 719-754. Miceli, Thomas J. (1995), ‘Renegotiation of Listing Contracts, Seller Opportunism, and Efficiency: an Economic Analysis’, 23 Real Estate Economics, 369-383. Miceli, Thomas J. (1995), ‘Contract Modification when Litigating for Damages is Costly’, 15 International Review of Law and Economics, 87-99. Mousseron, Jean-Marc (1987), ‘La Gestion des Risques par le Contrat (Risk Management by Contract)’, Revue trimestrielle de Droit Civil, 481 ff. Pardolesi, Roberto (1996), ‘Regole di Default e Razionalità Limitata: per un (Diverso) Approccio di Analisi Economica al Diritto dei Contratti (Default Rules and Bounded Rationality: for a (Different) Economic Approach to Contract Law)’, Rivista Critica del Diritto Privato, 451-466. Perloff, Jeffrey M. (1981), ‘The Effects of Breaches of Forward Contracts Due to Unanticipated Price Changes’, 10 Journal of Legal Studies, 221-235. Phillips, Jenny (1978), ‘Comments on Posner’s and Rosenfield’s Paper’, in Skogh, Göran (ed.), Law and Economics. Report from a Symposium in Lund, Lund, Juridiska Föreningen, 95-96. Polinsky, A. Mitchell (1983), ‘Risk Sharing through Breach of Contract Remedies’, 12 Journal of Legal Studies, 427-444. Polinsky, Mitchell A. (1987), ‘Fixed Price versus Spot Price Contracts: A Study in Risk Allocation’, 3 Journal of Law, Economics, and Organization, 27-46. Posner, Richard A. and Rosenfield, Andrew M. (1977), ‘Impossibility and Related Doctrines in Contract Law: An Economic Analysis’, 6 Journal of Legal Studies, 83-118. Reprinted in Skogh, Göran (ed.) (1978), Law and Economics. Report from a Symposium in Lund, Sweden, 24-26 August 1977, Lund, Juridiska Föreningen, 57-94. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, 200-212. Rasmusen, Eric and Ayres, Ian (1993), ‘Mutual and Unilateral Mistake in Contract Law’, 22 Journal of Legal Studies, 309-343.
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Ribhegge, Hermann (1994), ‘Ökonomische Theorie des Effizienten Vertragsbruchs und die Normativen Grundlagen der Ökonomischen Theorie des Rechts (The Economic Theory of Efficient Breach of Contracts and the Normative Foundations of the Economic Analysis of Law)’, 11 Homo Oeconomicus, 113-141. Schwartz, Alan (1976), ‘Sales Law and Inflations’, 50 Southern California Law Review, 1 ff. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 138-142. Schwartz, Alan (1992), ‘Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies’, 21 Journal of Legal Studies, 271 ff. Schwartze, Andreas (1988), ‘Die Beseitigung des Wegfalls der Geschäftsgrundlage: Zur wirtschaftlichen Effizienz und zur juristischen Konsistenz eines ökonomischen Modells’ (The Abolition of the Frustration of Contract: On Economic Efficiency and Legal Consistency of an Economic Model)’, Recht und Risiko, 155-170. Scott, Robert E. (1990), ‘A Relational Theory of Default Rules for Commercial Contracts’, 19 Journal of Legal Studies, 597 ff. Seita, Alex Y. (1984), ‘Uncertainty and Contract Law’, 46 University of Pittsburgh Law Review, 75-148. Shavell Steven (1980), ‘Damages Measures for Breach of Contract’, 11 Bell Journal of Economics, 466 ff. Shavell Steven (1984), ‘The Design of Contracts and Remedies for Breach’, 20 Quarterly Journal of Economics, 121 ff. Smith, Janet Kiholm (1987), ‘Trade Credit and Informational Asymmetry’, 42 Journal of Finance, 863-872. Smith, Janet Kiholm and Cox, Steven R. (1985), ‘The Pricing of Legal Services: A Contractual Solution to the Problem of Bilateral Opportunism’, 14 Journal of Legal Studies, 167-183. Smith, Janet Kiholm and Smith, Richard L. (1985), ‘A Theory of Ex Post Versus ex ante Price Determination’, 23 Economic Inquiry, 57-67. Smith, Janet Kiholm and Smith, Richard L. (1990), ‘Contract Law, Mutual Mistake, and Incentives to Produce and Disclose Information’, 19 Journal of Legal Studies, 467-488. Speidel, Richard E. (1980), ‘Excusable Nonperformance in Sales Contracts: Some Thoughts About Risk Management’, 32 South Carolina Law Review, 241 ff. Speidel, Richard E. (1981), ‘Court-Imposed Price Adjustements Under Long-Term Supply Contracts’, 76 Northwestern University Law Review, 369-422. Spier, Kathryn E. (1992), ‘Incomplete Contracts and Signalling’, 23 (3) Rand Journal of Economics, 432-443. Spindler, Gerald (1988), ‘Geschäftsgrundlage und Steuerrechtsänderungen (Changes of tax law and their impact on long term contracts - an economic analysis)’, in Finsinger and Simon (eds), Recht und Risiko. Juristische und ökonomische Analysen, München, Florentz, 288-325. Stout, Lynn A. and Barnes, David D. (1992), Economics of Contract Law, Minneapolis, West Publishing. Sykes, Alan O. (1990), ‘The Doctrine of Commercial Impracticability in a Second-best World’, 19 Journal of Legal Studies, 43-94. Sykes, Alan O. (1998), ‘Impossibility Doctrine in Contract Law’, in Newman, Peter (ed.), The New Palgrave Dictionary of Economics and the Law, London, Macmillan.
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Trebilcock, Michael J. (1988), ‘The Role of Insurance Considerations in the Choice of Efficient Civil Liability Rules’, 4 Journal of Law, Economics, and Organization, 243 ff. Trebilcock, Michael J. (1994), The Limits of Freedom of Contract, Cambridge, Cambridge University Press. Triantis, Alexander J. and Triantis, George G. (1998), ‘Timing Problems in Contract Breach Decisions’, 41 Journal of Law and Economics, 163 ff. Triantis, George G. (1992), ‘Contractual Allocation of Unknown Risks: A Critique of the Doctrine of Commercial Impracticability’, 42 University of Toronto Law Journal, 450-483. Trimarchi, Pietro (1989), ‘Der Wegfall der Geschäftsgrundlage aus allokativer Sicht - Kommentar (The Frustration of Contract from an Allocative Perspective - Commentary)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Allekationseffizienz in der Rechtsordnung, Berlin, Springer, 163-167. Trimarchi, Pietro (1991), ‘Commercial Impracticability in Contract Law: An Economic Analysis’, 11 International Review of Law and Economics, 63-82. Vandegrift, Donald (1997), ‘Decision Costs, Contract Excuse and the Westinghouse Commercial Impracticability Case’, 4 European Journal of Law and Economics, 41-54. Veljanovski, Cento G. (1988), ‘Impossibility and Related Excuses: Comment’, 144 Journal of Institutional and Theoretical Economics, 117-121. Walt, Steven (1990), ‘Expectations, Loss Distribution and Commercial Impracticability’, 24 Indiana Law Review, 65 ff. Warren, Elizabeth (1981), ‘Trade Usage and Parties in the Trade: An Economic Rationale for an Inflexible Rule’, 42 University of Pittsburgh Law Review, 515 ff. White, Michelle J. (1988), ‘Contract Breach and Contract Discharge due to Impossibility: A Unified Theory’, 17 Journal of Legal Studies, 353-376. Williamson, Oliver E. (1979), ‘Transaction Cost Economics: The Governance of Contractual Relations’, 22 Journal of Law and Economics, 233 ff. Wladis, John D. (1988), ‘Impracticability as Risk Allocation: The Effect of Changed Circumstances Upon Contract Obligations for the Sale of Goods’, 22 Georgia Law Review, 503 ff.
Cases Fibrosa S.A. v. Fairbairn Lawson Combe Barbour, Ltd., 143 App. Cas. 32 (1942) Hadley v. Baxendale, Ex. 341, 156 Eng. Rep. 145 (1854) Taylor v. Caldwell, 122 Eng. Rep. 309 (K.B. 1863)
4600 CONTRACT REMEDIES: GENERAL Paul G. Mahoney Professor of Law and Albert C. BeVier Research Professor, University of Virginia School of Law © Copyright 1999 Paul G. Mahoney
Abstract This chapter surveys and analyzes the substantial literature on optimal remedies for contract breach in a variety of settings. It begins with a standard analysis of the behavioral effects of expectation and reliance damages, then discusses the application of these damage measures in a world where courts are not perfectly informed about the parties’ valuations of the contract. When valuation problems are extreme, courts may turn to alternative remedies such as specific performance, or parties may attempt to solve the problem themselves through liquidated damages clauses. The chapter considers whether these solutions to the valuation problem alleviate or exacerbate opportunistic behavior by the parties. It also highlights the recent contributions that game theory and options theory have made to the understanding of remedial choices. JEL classification: K12 Keywords: Contract Damages, Remedies
1. Introduction The principal remedy for breach of contract in Anglo-American law is an award of money damages. The preferred measure of damages is the expectation measure, under which the promisee receives a sum sufficient, in theory, to make him indifferent between the award and the performance. Other damage measures, and other remedies such as specific performance and rescission, are available in special circumstances. This chapter discusses the basic design of the remedial system.
A. The General Problem 2. Sanctions and Incentives A contract is an exchange of promises or an exchange of a promise for a present performance, and the parties enter into it because each values the thing 117
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received more than the thing foregone. These values are based on expectations about the future because some or all of the contractual performance will occur in the future. When the future diverges from what a party expected, he may conclude that the performance he will receive under the contract is no longer more valuable than the performance he must provide. He has, in the terminology of Goetz and Scott (1980), experienced a ‘regret contingency’ and now would prefer not to perform and not to receive the promised performance from the other party. Absent a system of contract remedies, a party who regrets entering into a contract will not perform unless he fears that the breach will result in sanctions by the other party (who might have required security for the performance) or by third parties (who might revise their opinion of the breacher and reduce their economic and/or social interactions with him accordingly). The economic function of contract remedies, then, is to alter the incentives facing the party who regrets entering into the contract, which will directly affect the probability of performance and indirectly affect the number and type of contracts people make, the level of detail with which they identify their mutual obligations, the allocation of risks between the parties, the amount they invest in anticipation of performance once a contract is made, the precautions they take against the possibility of breach, and the precautions they take against the possibility of a regret contingency. An administratively simple system of remedies would aim to reduce the probability of breach to near zero. That could be achieved by the routine (and speedy) grant of injunctions against breach backed by large fines for disobeying the injunction or by imposing a punitively large monetary sanction for breach. This would give promisees a high degree of confidence that the promised performance will occur and induce a high level of investment in anticipation of performance. In the standard parlance, this would be a ‘property’ rule because it would entitle the promisee to the performance except to the extent the promisor is able to negotiate a modification on terms acceptable to the promisee.
3. Efficient Contracts and Efficient Nonperformance Were it possible to enter into complete state-dependent contracts (that is, contracts that identified every possible contingency (state) and specified the required actions of the parties for each), parties would be willing to be bound to contracts even were the sanction for breach punitive. Such contracts would require performance in some states but excuse it in others, in such a way that each party would be willing ex ante to be absolutely bound to perform the required actions in all states. Shavell (1980) defines a ‘Pareto efficient complete contingent contract’ as a complete state-dependent contract to which no mutually beneficial modifications could be made, viewed at the time of
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contracting. We will call such contracts ‘efficient’. In doing so, we will assume unless otherwise stated that the parties are risk neutral, each party’s objective is to maximize his wealth, post-contractual renegotiation is prohibitively costly, performance is all or nothing (that is, partial performance is not possible), and the contracts do not create uncompensated gains or losses for third parties. Under what conditions would an efficient contract excuse performance? Shavell demonstrates that the contract would require performance in all circumstances except those in which nonperformance would result in greater joint wealth. An example will illustrate the point. Imagine that Seller agrees to manufacture and sell to Buyer a machine that Buyer will use in its own manufacturing process. The value of the machine to Buyer is $300; however, Buyer has an opportunity to make certain alterations to his manufacturing plant, at a cost of $50, which will increase the value of the machine to $375. Such investments by a promisee in anticipation of performance are called ‘reliance expenditures’ or ‘reliance investments’ in the literature, and we will use the terms interchangeably. Assume for the moment that the future can be represented as a set of two possible states; Seller’s production cost is $200 in one state and $400 in the other. An efficient contract would require Seller to make the machine in the low-cost state but not in the high-cost state. In the high-cost state, the joint wealth of the parties is greater if Seller does not perform than if it does. This can be seen by comparing the cost of performance to Seller ($400) with the benefit to Buyer ($300 or $375, depending on whether Buyer makes the reliance investment). The contract price is irrelevant as it is transferred from Buyer to Seller and does not affect their joint wealth. Both parties can be made to prefer this contract to one that requires performance in both states. They can allocate between themselves the extra wealth created by the efficient contract, and there will be some allocations under which each party’s expected gain exceeds the expected gain from the contract that always requires performance. By choosing such an allocation, each party will be better off at the time of contracting and willing to be bound to perform or not perform as required. In the literature, a breach that occurs in circumstances in which an efficient contract would excuse performance is called an ‘efficient breach’.
4. Barriers to Efficient Contracting; Remedies as a Substitute for Efficient Contracts To reiterate, faced with an efficient contract, courts would have the simple task of requiring strict adherence to its terms. Unfortunately, the writing of efficient contracts is no easy task. It is costly to bargain over remote contingencies and the parties may lack the foresight to deal with all possible states. Moreover, the
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parties may not have equal access to the information necessary to tell which state occurs. In the above example, Seller may know whether the cost of manufacturing the machine is $200 or $400, but Buyer may have no way to verify Seller’s assertion. Given these barriers to efficient contracting, the law faces a more complex problem than that of compelling adherence to efficient contracts. Instead, it must take incomplete contracts and augment them by damage measures that induce behavior that mimics reasonably closely the behavior that an efficient contract would require. A particular damage measure can be termed ‘efficient’ with respect to a particular decision if it creates an incentive for the relevant party to make the same decision it would under an efficient contract. Because standard damage measures allow a promisor to breach and pay compensatory (rather than punitive) damages, they are called ‘liability’ rules in contrast to property rules as defined above.
5. Other Approaches An alternative framework for the design of damage measures is offered by Barton (1972). He poses the problem as one of designing damage measures that would induce the parties to make the same decisions regarding performance or breach, and reliance prior to performance or breach, that they would make were the parties divisions of a single, integrated firm and had the sole objective of maximizing the value of the firm. Shavell and Barton each show that the objective of an efficient regime of contract damages is to cause the parties to maximize their joint wealth, although one might prefer Shavell’s conceptual approach on the grounds that Barton’s assumes away the problem by positing a wealth-maximizing firm. A more recent perspective on contract damages is to consider money damages as an option under which, for example, Seller may purchase Buyer’s entitlement to Seller’s performance. The option expires on the date fixed for performance and its strike price is the damage award (which may from the parties’ perspective be a random variable). The value of the option is reflected in the contract price (see Mahoney, 1995; Ayres and Talley, 1995). This literature derives from the more general use of option theory to analyze decision making under uncertainty (see Dixit and Pindyck, 1994). We will make occasional reference to the options perspective below.
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B. The Standard Damage Measures 6. A Taxonomy of Damage Measures The preferred measure of contract damages is the amount of money that will make the promisee indifferent between performance and damages. It should be noted at the outset that this formulation of the measure of damages is not fully accurate; there are a number of limiting doctrines, discussed in Chapter 4620, that often reduce money damages below the promisee’s subjective valuation of the performance. There is also some evidence that courts award greater damages for breaches that appear opportunistic (see Cohen, 1994). As courts express it, however, the preferred measure of damages is the amount necessary to put the aggrieved party in the same position as if performance had occurred, which is known as the expectation measure. Fuller and Perdue (1935) provide the standard taxonomy of contract damage measures. They identify three different ‘interests’ of the promisee that are affected by a breach - expectation, reliance, and restitution - and state that the most common damage measures provide compensation for one of the three. The expectation interest is measured by the net benefit the promisee would receive should performance occur, as described above. The restitution interest consists of any benefit the promisee has provided the breaching party. For example, if a seller agrees to make monthly deliveries of a commodity in return for fixed payments due 60 days after each delivery and the buyer repudiates the contract after receiving and retaining two deliveries but making no payments, restitutionary damages would restore to the seller the value of the delivered goods. The reliance interest is measured by the promisee’s wealth in the pre-contractual position. Reliance damages provide compensation both for any benefit conferred on the breaching party and for any other reliance investments made by the promisee in anticipation of performance to the extent such investments cannot be recovered. In most instances, the restitution measure will provide the lowest recovery and the expectation measure the highest. One complication is how to treat other contractual opportunities that Buyer passed up in order to enter into the contract with Seller. Analytically, these seem similar to reliance investments and are often treated as such. In a competitive market, where Buyer could have entered into another contract at an identical price had he not contracted with Seller, the reliance measure and the expectation measure will converge approximately. ‘Approximately’, because the value of the alternative contract is a function of the probability that it will be performed (see Cooter and Eisenberg, 1985) and of the damage remedy if it is not performed, and thus the problem is somewhat circular. When analyzing the difference between expectation damages and reliance damages below, we will assume that they
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differ and that Buyer’s expectation interest exceeds his reliance interest. We will also assume that the reliance interest equals or exceeds the restitution interest, although we will relax that assumption in Section 12 below.
7. Incentives Within an Existing Contract: The Decision to Perform or Breach The expectation measure leads to efficient decisions to perform or breach an existing contract, given a fixed level of reliance (see Barton, 1972; Shavell, 1980; Kornhauser, 1986). This can be illustrated using the example set out above. Assume that the contract price for the machine is $250 and that Buyer makes an irrevocable decision to invest $50 in reliance, an investment that has no value absent the contract. When production costs are $200, Seller will manufacture the machine and Buyer will pay $250 for it. Buyer then obtains a machine worth $375 to him for a total expenditure (contract price plus reliance expenditure) of $300. The transaction increases Buyer’s wealth by $75. When production costs are $400, Seller will breach. The expectation measure seeks to make Buyer as well off as if Seller had performed. Seller’s breach relieves Buyer from his obligation to pay the contract price. Accordingly, if Seller pays Buyer damages of $125, Buyer will be in the same position as if Seller had performed, having paid out a non-recoverable $50 in reliance and received $125, for a net increase in wealth of $75. So long as Buyer is awarded $125 in the event of breach, Seller will breach only when the cost of performance exceeds $375, the value of the performance to Buyer. Compare this result to that obtained under the reliance measure. Under the reliance measure, Seller must compensate Buyer for his $50 reliance investment. Assume for a moment that there is a third possible state under which Seller’s cost of production is $350. Performance would be efficient because its value to Buyer exceeds its cost to Seller. Seller will perform given expectation damages, because the damage award of $125 exceeds the net loss from performance ($350 cost minus the $250 contract price). Given reliance damages, however, Seller will breach and pay $50 rather than perform at a loss of $100. More generally, it is obvious that given expectation damages, only when the production cost reaches $376 will Seller become better off by breaching and paying damages then by performing and losing the difference between his production cost and the contract price. The expectation measure, unlike the reliance measure, causes Seller to internalize fully the effect on Buyer’s wealth of Seller’s decision to perform or breach.
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8. Incentives within an Existing Contract: The Decision to Rely While the expectation measure produces efficient decisions to breach given reliance, it does not produce efficient levels of reliance. In general, expectation damages result in excessive reliance expenditures, because they cause Buyer to act as if performance were always forthcoming. In the example, Buyer will always spend $50 to increase the value of performance from $300 to $375, because either (1) the performance will be forthcoming or (2) Buyer will be compensated for the lost $375 in value. In the high-cost state, however, the parties’ joint wealth would be greater if Buyer refrained from investing. Seller would be liable for damages of $300 less the $250 contract price, or $50. By contrast, if Buyer relies, he receives $125 in damages as shown above and increases his wealth by $75 net of the reliance expenditure. Unlike the no-reliance case, where Buyer gains $50 and Seller loses $50, here Buyer gains $75 and Seller loses $125. The difference reflects the fact that the $50 expenditure is wasteful in the high-cost state. Expectation damages, then, do not cause Buyer to internalize fully the effect on Seller’s wealth of Buyer’s decision to make a reliance investment. The reliance measure is subject to the same objection. Under the reliance measure, Buyer will recover $50 if it invests that amount in reliance. Once again, Buyer’s investment decision will be made as if the investment is not risky, even though it is (because performance is inefficient in some states). Indeed, reliance damages create a perverse incentive for Buyer in some circumstances. Assume for a moment that Seller’s production cost is $310. Under the reliance measure, Seller will pay damages of $50 rather than perform and suffer a loss of $60 ($310 minus the $250 contract price). Breach deprives Buyer of a $75 gain (showing again that any measure of damages less than the expectation measure induces inefficient breach decisions). Buyer may be able to avoid breach, however, by making an additional (and we will assume wasteful) reliance expenditure of $11. Now reliance damages amount to $61, and Seller performs. Thus the excessive breach problem can be cured in part, but at the cost of excessive reliance. In general, as Shavell (1980) demonstrates, the reliance measure will result in greater (inefficient) reliance expenditures than the expectation measure. There is no measure of damages that results both in efficient decisions to perform or breach and efficient decisions to make or not make reliance expenditures. However, expectation damages do better than reliance damages at inducing efficient breach decisions, and do no worse than reliance damages at inducing efficient reliance decisions. Accordingly, given the various assumptions outlined above, the expectation measure is preferable on efficiency grounds. The analysis to this point has assumed risk neutrality. A risk-averse Buyer would have additional cause to prefer the expectation measure, because it eliminates variability from Buyer’s outcome. At the same time, the expectation measure introduces greater variability into Seller’s outcome than does the
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reliance measure. It is accordingly possible that where both parties are risk averse, they may find that a sum of damages greater than the reliance measure but less than the expectation measure offers the highest joint utility level. The precise formulation of the damage amount would depend on the parties’ comparative levels of risk aversion (see Polinsky, 1983). It seems plausible that courts have not tried to alter damage measures to accommodate risk aversion (except to the extent specific performance can do so, as discussed in Section 10 below) because of the administrative and error costs that would result. The analysis has also assumed that renegotiation at the time of breach is prohibitively costly. Were negotiation costless, the damage rule would be irrelevant, as the parties would in all cases bargain to Pareto efficient breach/performance and reliance decisions, as per the Coase Theorem (Coase, 1960). In the more plausible situation where renegotiation is costly but not always prohibitively so, the choice of remedy is necessarily more difficult. Some critics have therefore argued that much of the literature on damage remedies is beside the point, as the choice of remedies should be informed principally by an analysis of transaction costs (see Friedmann, 1989; MacNeil, 1982). Friedmann analyzes potential transaction costs in a variety of contractual settings and argues that over compensatory remedies (remedies that provide compensation to the promisee in excess of the expectation interest) will generally be efficient.
9. Incentives at the Stage of Contract Formation Friedmann and MacNeil are surely correct to argue that a better understanding of the costs of postcontractual renegotiation is necessary for making efficient remedial choices. It is also, however, worth paying attention to the effect of remedies on precontractual negotiations. The price Seller will require to enter into a contract is increasing in the damage measure. Returning to our example, when Buyer makes a $50 reliance expenditure and Seller breaches, again assuming no opportunity costs, Buyer’s wealth decreases by $50. Buyer can be no worse off from entering into the contract so long as the remedy for breach is at least $50. Will Buyer be willing to pay more for the more generous expectation measure, and will Buyer and Seller prefer the resulting contract to one that provides for reliance damages only? As Friedman (1989) notes, the difference in remedies affects the contract price, the quantity contracted, and the quantity actually consumed, with effects that vary with market structure and utility functions. In general, however, the range of contract prices for which the contract increases both parties’ wealth will be greater under a reliance measure than an expectation measure. That is, the reliance measure will create a greater bargaining range, which might increase the number of contracts entered into.
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The choice of remedies where precontractual as well as postcontractual incentives are analyzed remains an underdeveloped area. Friedman (1989) provides a formal analysis of expectation and reliance for two contexts in which those measures diverge. The first is the case of a breaching buyer who has contracted to purchase from a monopolist selling at a single price. The second is the case of a breaching buyer in a competitive market where the seller does not know its production cost in advance but the buyer does. Friedman demonstrates that neither damage remedy dominates the other under those conditions. Friedman’s analysis is limited, however, by his assumption that reliance is fixed and exogenous. The situations he analyzes, moreover, have the desired formal characteristics (expectation and reliance measures diverge) but are probably not very common. A possible alternative would be to start by assuming that the expectation and reliance measures diverge without specifying market structure in detail. A model could then be developed in which the choice between expectation and reliance damages affects the structure of the contract, the decision to breach, and the decision to rely. The equilibrium and comparative statics of such a model might shed light on the type of market conditions under which expectation or reliance damages would be more nearly optimal. It would also be valuable to consider carefully whether there are plausible conditions under which the cost of negotiating around an inefficient damages measure at the time of contracting is greater or less than the cost of renegotiating at the time of performance.
C. Alternative Damage Measures 10. Specific Performance Disappointed promisees are not in all cases limited to an award of damages; under appropriate circumstances, they may seek the equitable remedy of specific performance. A decree of specific performance requires the breaching party to perform according to the contract. The principal criterion for awarding specific performance is a demonstration that money damages are insufficient to compensate the promisee for the lost performance. Traditionally, this was most often found when the breaching party was a seller who had agreed to sell a ‘unique’ good. Real estate has long been presumed in many jurisdictions to be unique, while other goods such as artworks and heirlooms are often found to be unique. Specific performance is analogous to a punitive sanction that seeks to deter breach absolutely. In order for it to have that effect, we must assume that renegotiation is costly. It would then seem clear that expectation damages are preferable to specific performance, because the latter would sometimes result
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in performance even though nonperformance would result in greater joint wealth. On the other hand, it should be clear that the assumption that courts can adequately calculate a sum of money sufficient to make the promisee indifferent between damages and breach is not always accurate, particularly where cover is not possible. In such circumstances we must rely on a lost surplus measure of damages, and the calculation of Buyer’s consumer surplus is necessarily subjective. This is not a fatal objection if we believe that courts will guess correctly on average, but if they systematically underestimate Buyer’s surplus, the monetary remedy will result in too much breach, just as specific performance results in too much performance. Kronman (1978) started the law and economics debate on specific performance by employing a framework similar to that of the prior paragraph. He notes that specific performance is a property rule in the sense defined in Section 2 above; it effectively assigns the promisee an absolute entitlement to the goods from the moment the contract is made. This does not make sense in most instances because renegotiation (meaning a transfer of the property right back to the promisor) is costly and the result will be an inefficiently high level of performance. The danger of undercompensation, which would result in an inefficiently low level of performance, is normally lower because there is often a substitute price available. When, however, there is no substitute price available (the case of ‘unique’ goods), the danger of under compensation likely outweighs the cost of renegotiation. Accordingly, the legal rules, in a rough manner, promote efficiency. Schwartz (1979) argues that undercompensation is not merely an isolated problem limited principally to goods for which there is no obvious substitute, but is built into the structure of money damages. The reluctance of courts to award damages that are uncertain, difficult to measure, or unforeseeable (see Chapter 4620), or to provide compensation for emotional harm resulting from a breach, makes money damages systematically under compensatory. Schwartz argues that the resulting inefficiencies are likely greater than those resulting from renegotiation costs, and accordingly that specific performance, rather than money damages, should be the default remedy. Bishop (1985) adopts a similar analytic approach but argues that both Kronman and Schwartz have overgeneralized their arguments. He breaks down contract breaches into a number of categories depending on the identity of the breaching party (buyer or seller), the type of contract, and the alternative transactions available to buyer and seller. He also identifies another cost of awarding specific performance. Because the value of a specific performance award (including the amount the promisor will pay to be released from performance) will in some cases exceed the value of performance to the promisee, the promisee will be tempted to behave opportunistically in hopes of causing a breach and satisfying the conditions for specific performance. Bishop
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argues that in some categories the problem of excessive breach resulting from undercompensation will dominate, and in others the problem of excessive performance resulting from renegotiation costs and opportunism will dominate. The relative magnitudes of the inefficiencies generated by costly renegotiation and undercompensation are ultimately empirical questions and to date the literature does not provide data from which we could confidently identify the preferred remedy. Accordingly, Mahoney (1995) takes a different approach to the problem, using the option methodology outlined above. The methodology is first employed to confirm the argument made by Craswell (1988) that were renegotiation costless and money damages perfectly compensatory, risk-averse contracting parties would always prefer money damages to specific performance. The intuition is that entering into a contract with a money damages remedy is analogous to holding a hedged position in a commodity, whereas the identical contract with a specific performance remedy is analogous to holding an unhedged position. The variance of possible outcomes is greater for both parties with the unhedged contract and they will accordingly prefer money damages. In the face of costly renegotiation and undercompensation, we can still make some sense of the case law using the option heuristic. Many contracts involving ‘unique’ goods are prompted by the desire of the buyer to speculate on the future value of the land, artwork, and so on, and speculation involves holding an unhedged position. Thus buyer and seller would likely prefer specific performance. Other cases in which specific performance has been consistently awarded (long-term contracts to supply a fuel input to a public utility or other regulated entity) can be explained by noting that the buyer is likely more risk averse with respect to price fluctuations than is the seller, and specific performance better accommodates that distinction.
11. Liquidated Damages We began the analysis of damages by arguing that court-awarded damages function as a substitute for complete state-dependent contracts. The court’s application of an efficient damages rule creates appropriate incentives to perform or not perform, rely or not rely, and so on, and thereby saves the parties the trouble of drafting their contract to provide for all contingencies. Some parties, however, choose to create a tailor-made incentive structure by specifying the amount of damages payable in the event of breach. Courts have adopted a skeptical attitude toward these so-called liquidated damages clauses. In general, courts will enforce a liquidated damages clause only if (a) at the time of contracting, the damage that the promisee will suffer in the event of breach (that is, the promisee’s expectation) is uncertain, and (b) the amount of liquidated damages is both a reasonable estimate of (the mean of) those
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damages and not disproportionate to the actual (ex post) damages. A larger amount is called a ‘penalty’ and is unenforceable. This attitude is puzzling to most law and economics scholars. Absent some reason to believe that one or both parties misunderstood the terms of the agreement, we would normally assume that they went to the trouble to specify liquidated damages because the resulting contract is Pareto superior to a contract that calls for the ordinary court-awarded damages. The courts’ approach might increase the net wealth of the parties, but only if the existence of a penalty is strong evidence that the contract does not represent the parties’ actual intent, perhaps because one defrauded the other. The focus of scholarship in the area, therefore, has been to ask under what circumstances rational, well-informed parties would agree to a penalty clause. Goetz and Scott (1977) note, in terms similar to those of the later specific performance debate, that damages measures do not adequately compensate for the subjective value the promisee attaches to performance, particularly when close substitutes for the performance are unavailable or the timing of the performance is critical. In those circumstances, normal damage measures will lead to excessive breach. The promisee could purchase third-party insurance that would pay off in the event of breach in an amount sufficient to make him whole. In some circumstances, however, the probability of breach is determined not just by exogenous variables beyond the parties’ control, but also the level of care taken by the promisor. For example, a delivery service can affect the probability of timely delivery by the level of care it takes with the package. In such circumstances, the promisor can insure more cheaply than a third-party because the promisor can alter its level of care in response to the insurance clause. In other circumstances, the promisor may be better informed about the probability of breach than a third-party insurer. The delivery service, for example, may be better informed than the promisee or any third-party insurer about the breakdown rate of its trucks. In such cases, the promisor can use its willingness to agree to a penalty clause as a means of credibly signaling a low probability of breach. It is accordingly not true that the mere existence of a penalty clause is a strong indicator of fraud or mistake; there are plausible conditions under which a penalty clause would make both parties better off. Schwartz (1990) supplements this analysis by considering the effects of a penalty clause on pre-contractual incentives. He notes that the price that the promisor will charge is increasing in the damage measure. To the extent promisees insist on inefficiently large penalties, therefore, they will either pay too much or enter into too few contracts. The promisee accordingly has an incentive to demand a penalty clause only when it would increase the joint wealth of the parties.
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Other commentators have argued that penalty clauses can create externalities. Aghion and Bolton (1987), for example, demonstrate that a supply contract containing a penalty clause for buyer’s breach can restrict entry by competing sellers. We might at first conclude that buyer would have no incentive to agree to a contract that limited competition from other sellers. A well-designed penalty, however, will merely redistribute wealth from the new entrant to the contractual buyer and seller. To see why, assume a contract between Buyer and Seller with a contract price of $200, and Seller’s cost of performance is $150. At a later time, Entrant appears, who can provide the good for $100. Seller’s expectation damages will be $50, so absent a penalty Buyer can profitably breach if Entrant offers a price of $149 or less. Assuming that Entrant does not face competition, Entrant will demand a price of $149. Now imagine that Buyer must pay a penalty of $80 upon breach. Now it is not profitable for Buyer to breach unless Entrant offers a price of $119 or less. Entrant can still profitably sell at that price, and will do so. Thus the penalty transfers wealth from Entrant to Seller (which Seller can agree ex ante to share with Buyer). Aghion and Bolton’s analysis works only if Entrant has market power. The externality arguments for the most part are not sufficiently general to provide a compelling explanation for the judicial hostility toward penalty clauses. Moreover, while they can provide support for part of the judicial approach (disallowing liquidated damages that are not a fair ex ante estimate of actual damages), they cannot explain the failure to enforce liquidated damages that are excessive ex post.
12. Rescission/Restitution Courts divide contract breaches into ‘partial’ and ‘total’ breach. A partial breach gives the promisee the right to seek a remedy but not to refuse his own performance. The classic example is when a builder constructs a house that contains a minor deviation from the agreed architectural plan. The builder must compensate the owner for the difference in value (in theory, the difference in subjective value to buyer, but it will usually be difficult to convince a court that this differs substantially from the difference in market value). The owner may not, however, refuse to accept delivery of the house and to pay the agreed price. A total breach, by contrast, permits the promisee to refuse to render his own performance. In effect, a total breach permits the promisee to rescind the contract. As courts express it, a promisee can respond to a total breach by seeking expectation damages or by rescinding and seeking recovery of any value he has provided to the breaching promisor. The latter alternative is equivalent to the restitution measure of damages (although in some circumstances the promisee
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may seek return of the performance in specie rather than its monetary equivalent). Restitution is also a remedy in quasi-contractual situations, such as when parties partly performed a contract that is voidable for mutual mistake, but the following discussion will be limited to restitution damages as a remedy for breach. In the typical case, expectation damages will exceed restitutionary damages and the promisee will seek the former. There are two instances, however, in which we would expect the promisee to seek the latter. The first is when the promisee is risk averse and prefers the certainty of the return of money or property that he has given the promisor to the uncertainties of a jury’s assessment of his expectation and the additional litigation costs that would be incurred in the attempt. The second is when the contract was a losing deal for the promisee, so that his expectation is negative. Where the promisee has provided something of value to the promisor that cannot be easily returned, but can be valued in a judicial proceeding, the promisee may be better off receiving that value in cash than receiving the promised performance. This might be thought a remote possibility, but it occurs in a number of reported cases. The textbook example is one in which a builder agrees to build a house for an owner and the builder’s costs turn out to be greater than expected, making the contract a losing one for the builder. The owner, however, later decides it does not want the house and repudiates the contract when the house is partly completed. The builder’s expectation is negative because of the unexpectedly high costs of construction, so the builder seeks restitution. Restitution in this instance is measured by the value the builder has conferred on the owner, or the market value of the nearly-completed house. By hypothesis, this exceeds the contract price. When promisees have attempted to recover reliance damages for a losing contract, courts have concluded that the expectation measure puts an upper bound on the recovery (see L. Albert & Son v. Armstrong Rubber Co.). By contrast, some courts have permitted a promisee to recover restitution damages in excess of expectation (see Boomer v. Muir). This seeming inconsistency has been largely ignored in the law and economics literature. The most useful discussions appear in a symposium issue of the Southern California Law Review in 1994. In it, Kull (1994) provides an analysis of restitution that is similar in many respects to Bishop’s analysis of specific performance. Money damages are not always an adequate substitute for performance and the damage calculation is in any event uncertain. Thus where the promisee has provided something of value to the promisor that can easily be returned, the promisee may prefer to rescind the transaction, putting both parties back in the pre-contractual position. For example, the promisee may have paid in advance for a good or service that the promisor fails to provide. Taking litigation costs into account, the promisee may prefer to rescind the transaction and retrieve the
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advance payment. One example of a situation in which it seems likely that rescission and restitution will minimize the costs associated with breach is where a seller delivers goods that do not conform to the contractual specifications. The perfect tender rule, recognized under the common law and the Uniform Commercial Code, permits a buyer to reject nonconforming goods even if the variation is minor. As noted by Priest (1978), the administrative costs involved in calculating the difference in value between the goods as delivered and as promised will likely exceed the cost of returning the goods to Seller and money to Buyer. The costs associated with salvaging the nonconforming goods might also be minimized by the perfect tender rule, as in many instances it will be cheaper for Seller to find another purchaser for the goods than it will be for Buyer to adapt the goods to Buyer’s own use. On the other hand, where the contract is a losing one for the promisee and the promisee has conferred a benefit on the promisor that cannot easily be returned, the remedy of rescission and restitution is potentially over compensatory. Kull argues that the threat of opportunistic behavior (that is, socially wasteful efforts to exploit an inefficient remedy to obtain an unbargained-for benefit) will be substantial for such contracts. The promisee can turn a loss into a gain by inducing breach by the promisor (or convincing a court that mutual uncooperativeness constituted or resulted from such a breach). By contrast, the perfect tender rule permits a buyer to behave opportunistically by unreasonably claiming that goods are defective when their market value has declined, but because the goods can be returned to Seller, the parties are spared the additional cost of a court proceeding to determine their value.
D. Calculation of Expectation and Reliance Damages 13. A Categorization of Approaches to Calculating Damages There is consensus that the expectation measure is in most circumstances superior to reliance or restitution damages. A separate but no less important question is how expectation and reliance are to be defined and measured in typical contractual settings. Parties’ valuations are often unknown to one another and to the court, and promisees have an incentive to overstate their valuations, making the calculation of expectation damages difficult in some settings. Cooter and Eisenberg (1985) present a very helpful categorization and analysis of alternative calculation methods. They identify five broad categories and note that the calculation of money damages in reported cases usually falls into one of these categories. They are:
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(i) Substitute Price. Often there is a spot market for the contractual performance at the time and place that performance was due, most obviously if the performance consists of the delivery of a marketable commodity. In such an event, Buyer can respond to Seller’s breach by cover, or the purchase of the commodity on the spot market. (Seller can respond to a breach by Buyer by selling on the spot market.) The difference between the contract price and the price at which cover occurred or could have occurred is then a measure of the cost of making Buyer (or Seller) indifferent between the contract and the substitute performance. We should note, however, that the substitute price measure can be overcompensatory when a promisee chooses not to cover but instead to sue for the difference between the contract price and the spot price. That choice itself suggests that the promisee may value the commodity at less than its market price. (ii) Lost Surplus. When cover is unavailable, Buyer’s expectation can be thought of as the lost consumer surplus from the contract. In our ongoing example, if Buyer cannot cover, he loses the difference between his valuation of the machine ($300 or $375, depending on reliance) and the $250 contract price. The analysis of Seller’s lost producer surplus from Buyer’s breach is analogous. The lost surplus measure is feasible only when a court can obtain credible evidence of the promisee’s valuation. (iii) Opportunity Cost. If a market exists for the performance, Buyer could have entered into a contract to buy the machine from any one of a number of competing sellers. The value to Buyer of the best alternative contract available at the time of the contract with Seller is an important component of his reliance. This value cannot be measured objectively because Buyer did not enter into this hypothetical contract and we do not know whether the hypothetical contractual party would have performed. Assuming that the probability of performance of the alternative contract is high, however, then the difference between the spot price at the time and place of breach and the price of the foregone contract is a good measure of reliance (augmented by any out-of-pocket expenditures in reliance on the contract with Seller). In a competitive market, the next-best price and the contract price should be the same, and the opportunity cost measure will equal the substitute price measure (a conclusion consistent with Fuller and Perdue’s conclusion that expectation and reliance damages are equal in a competitive market). (iv) Out-of-Pocket Cost. This is the amount of reliance investment, less any salvage value of that investment. Out-of-pocket cost is the most common measure of reliance damages; a more complete measure of reliance damages is out-of-pocket cost plus opportunity cost. (v) Diminished Value. So far we have ignored partial performance. In the real world, however, performance is often rendered but is defective or incomplete. In such cases an appropriate measure of Buyer’s lost expectation is the
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difference between Buyer’s valuation of the promised performance and his valuation of the actual performance. As these alternative methods of calculation should make clear, the measure of damages is usually straightforward and uncontroversial where cover is possible. The accepted measure of damages in such cases is the difference between the cover price and the contract price, which is easy to apply and provides appropriate incentives regarding the decision to perform or breach. The difficult questions arise when there is no perfect substitute for the performance (or there is room for debate about whether the substitute is adequate) or where the manner or timing of the breach causes harm that cannot be remedied by cover. We will provide two examples of cases that arise frequently and that have been the much discussed in the literature, in which there is debate over the appropriate means of measuring the non-breaching party’s expectation.
14. Example 1: Anticipatory Repudiation Common law judges and scholars initially found anticipatory repudiation - a definitive statement by a promisor, made prior to the time for performance, that he intended to breach - extraordinarily vexing. Some concluded that any such statement must be without legal effect; the performance was due on a particular date and breach could therefore only occur on that date (Williston, 1901). Courts eventually came to the view that the promisee could treat the repudiation as a breach (Hochster v. De La Tour), but found it more difficult to decide how damages should be measured. The most famous early case, Missouri Furnace v. Cochrane, held that the appropriate measure was the difference between the contract price and the spot price at the time specified for performance. The Uniform Commercial Code, by contrast, encourages prompt cover, presumably in the futures market. As noted by Jackson (1978), the legal literature on anticipatory repudiation from the early part of this century is voluminous. Jackson argued that in applying the Uniform Commercial Code’s provisions on cover to anticipatory repudiation, courts should fix damages at the difference between the contract price and the futures price at the time of repudiation. He noted that the Missouri Furnace method is systematically overcompensatory. Imagine, for example, that Seller breaches a contract to supply a commodity in the future and that the spot and futures prices at the time of repudiation are higher than the contract price. Over a large number of contract breaches, however, the spot price at the time of performance will sometimes be higher, and sometimes lower, than the contract price (in present value terms). Whenever it is lower, Buyer will not bring a damages action because he has been made better off by the breach. He is under no obligation to share this gain with Seller. When the spot price is higher than the contract price, Buyer will
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recover the difference between the two. Averaged over a large number of contracts, buyers in the aggregate receive more than would be required to make them as well off as they were under the contract. Awarding the difference between the contract price and the futures price, by contrast, puts each buyer in the position he occupied prior to the repudiation and at a lower average cost to sellers. We might simplify Jackson’s argument by noting that the Missouri Furnace rule replaces a forward contract by an option with a strike price equal to the forward price. Because the value (prior to expiration) of an option with a strike price of X is always greater than the value of a forward contract with a contract price of X, the Missouri Furnace damage measure is overcompensatory.
15. Example 2: The Lost-Volume Seller Sellers in a competitive market have often argued that the Substitute Price measure of damages, which awards them the difference between the contract price and the spot price, is undercompensatory. In many instances, there is little or no difference between the contract price and the spot price, and accordingly the damage award is trivial. Sellers contend, however, that they are not ‘made whole’ by selling in the spot market; the seller had the capacity to sell to both the substitute buyer and the original buyer at the market price, and the breach reduced their sales volume by one unit. Thus in place of two sales and two profits, they have received only one sale and one profit. Courts have often awarded the so-called ‘lost-volume seller’ an amount of damages equal to its ordinary profit on one sale. In the well-known case of Neri v. Retail Marine Corp., Retail Marine, a dealer in boats, agreed to sell a boat to Neri at a fixed price. Retail Marine ordered the boat from the manufacturer but Neri repudiated the contract. Retail Marine sold the boat to another customer for the same price and successfully sued Neri for the profit it would have made on the sale to him. The court concluded that Retail Marine, as a dealer, had an ‘inexhaustible’ supply of boats, and Neri’s breach deprived it of a profitable sale. There is a substantial law and economics literature on the lost-volume seller. An early contribution appeared in an anonymous student-written comment (Anonymous, 1973). The comment noted that in a perfectly competitive market, each seller would choose output by equating marginal cost with demand and the demand curve would be presumed horizontal. At the chosen output, the firm’s marginal cost would be rising and therefore any additional sale would be at a cost in excess of the price. Because the seller could not, in fact, satisfy additional buyers at the market price, the breach and resale would create no ‘lost volume’ in a perfectly competitive market. A seller with market power (that is, one facing a downward-sloping demand curve) might be able to make additional sales at a profit. However, by hypothesis, such a seller
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could eliminate the ‘lost volume’ by reducing its price and making an additional sale. Thus the standard contract price minus cover price measure would fully compensate such a seller. Goetz and Scott (1979) provide an additional argument against awarding lost profits to the retailer who has market power. They note that the breach removes the breaching buyer as a competing seller. The buyer presumably breaches because it no longer wants the good at the contract price. In lieu of breaching, however, the buyer could complete the purchase and then resell the good. This resale, if made in the same market in which the retailer operates, shifts the demand curve facing the retailer to the left by one unit. Once again, if we compare the retailer’s position after the breach to its position assuming no breach but resale by buyer, there is no lost volume. Goldberg (1984) disputes Goetz and Scott’s analysis. He first argues that the observation that a non-breaching buyer could sell in competition with the retailer is unrealistic. In fact, he argues, the buyer, lacking expertise, would have to engage the services of a retailer. The retailer’s usual markup is a reasonable estimate of the fee the retailer would charge for his services. Accordingly, the award of lost profit to the retailer approximates the result that would obtain if the buyer purchased and resold. Goldberg also argues that it is inaccurate to say that the retailer ‘saves’ the marginal cost of a sale when the original buyer breaches and then incurs that marginal cost when the substitute buyer appears. He contends that the retailer’s cost of servicing an additional buyer consists principally of the cost of ‘fishing’ for a buyer, or convincing the marginal buyer to purchase (represented, perhaps, by costs of advertising, wages paid to salespeople, and so on). That cost is irretrievably lost once a contract is concluded with the original buyer and must be incurred again in order to induce another buyer to purchase. More recently, Scott (1990) argues that Goldberg’s equation of marginal cost with the cost of ‘fishing’ is inaccurate; for some goods, the cost of delivery and preparation for delivery are significant, and those costs are not incurred twice when a buyer defaults. Cooter and Eisenberg (1985) provide an analysis similar to Goldberg’s, but focus on the seller with market power. They argue that many sellers hold price at a constant level reflecting expected demand and marginal cost over some period, rather than constantly adjusting price to reflect realized demand. Such sellers can lose volume in a particular period. Goldberg also notes that consumer demand is decreasing in the damage measure. Accordingly, were the legal rule to shift suddenly from a substitute price damages measure to one awarding lost profits, the demand curve facing the retailer would shift downward, offsetting the benefit of the higher damage awards. Whether consumers and producers would prefer the resulting contract to one that provides only substitute price damages again depends on comparative levels of risk aversion.
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It appears that the literature on the lost-volume seller is at an impasse. The identification of the best damages rule turns on complex and contestable claims about market structure. A better avenue of inquiry would be to pay attention to actual contractual practice. Many sellers of custom goods require non-refundable deposits, which in effect contracts for a lost-profits measure. Other sellers (such as many computer retailers) permit a buyer to return an item for a full refund for some period after delivery, which in effect contracts for an even more lenient approach than the substitute price measure. It seems likely that greater ground will be gained by empirical analysis of the characteristics of markets in which varying cancellation/return policies are used than by further refinements of the theoretical arguments.
E. Conclusions 16. The Puzzle of Overcompensatory Remedies and Some Suggestions for Further Research Most of the prior analysis could be summed up as follows: when courts and contracting parties are well-informed about each party’s valuation of the contract, money damages measured by the promisee’s valuation (or expectation) provide reasonably good incentives for efficient pre- and post-contractual behavior. Problems arise, however, when there are significant informational asymmetries between the parties and/or between each party and the court. Such asymmetries raise two pervasive issues in contract law. The first is subjective value. The existence of potentially over compensatory remedies such as specific performance, liquidated damages and restitution can be attributed to judicial recognition that money damages measured by the promisee’s expectation will sometimes undercompensate, because courts use objective indicators of value that may diverge from the promisee’s subjective valuation. Only a few brief attempts have been made, however, to explore subjective value as a unifying theme in contract remedies (see De Alessi and Staaf, 1989; Muris, 1983). The second issue is opportunism. The possibility that a remedy, although designed to be perfectly compensatory, will in fact undercompensate (overcompensate) may encourage the breaching party (non-breaching party) to use the defect in the remedy to gain bargaining leverage over the other party. The risk of opportunism is the likely reason why courts have not responded to the problem of subjective valuation by instituting overcompensatory remedies across the board. A worthwhile avenue for additional work would be a careful comparison of the ways in which courts have or have not managed to reduce the risk of opportunism across a range of remedial choices. A promising approach to this
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question appears in the liability rule versus property rule literature. When neither party knows the other’s true valuation of the contract, each has an incentive to over- or understate his valuation in an attempt to capture as much as possible of the gains from contract modification or cancellation. The result is to make agreement more costly. The costs imposed by asymmetric information, which we will call ‘bargaining costs’, are a subset of the cost of reaching a deal. The key question is whether the choice of remedy affects bargaining costs. A specific application to liquidated damages is offered by Talley (1994). He uses the mechanism design branch of game theory to analyze the effects of different enforcement rules on bargaining costs, concluding that enforcement of liquidated damages that exceed actual damages ex post creates significant bargaining costs. By refusing to enforce penalty clauses, courts may make it more likely that the parties will bargain to an efficient outcome. The argument is unique in offering a plausible economic justification of the ex post component of the liquidated damages rule. Ayres and Talley (1995), employ game theory to argue that bargaining costs are generally lower under liability rules than under property rules. The intuition is as follows. Going back to our contract between Seller and Buyer, imagine that Seller wishes to breach, and believes Buyer’s valuation of the contract to be uniformly distributed on the interval [$300, $400]. Consider a rule that provides for damages of $500 in response to Seller’s breach. Buyer’s offer to rescind the contract for a payment of $400 would provide Seller with no new information - Seller already knows that Buyer’s valuation is no greater than $400. Now consider a rule providing for damages of $350. Buyer might now conceivably offer to cancel the contract in return for a payment from Seller (if Buyer’s valuation is less than $350), or it might offer Seller a payment to forego breach (if Buyer’s valuation is more than $350). Thus the type of offer that Buyer makes conveys information about its valuation and ameliorates the bargaining costs resulting from asymmetric information. Johnston (1995) offers an analogous argument to show that bargaining costs can be lower under a ‘standard’, in which an entitlement is dependent on a discretionary judicial determination, than under a ‘rule’, in which the entitlement is more precisely defined. Kaplow and Shavell (1995) criticize Ayres and Talley’s analysis on the grounds that it is not a marginal analysis. They argue that in most contexts in which bargaining is impossible or prohibitively costly, liability rules will dominate property rules for the reasons outlined in our discussion of expectation damages above. Thus for liability rules to dominate property rules where bargaining is possible does not prove that they generate lower bargaining costs; the latter point would be proved conclusively only if liability rules dominate property rules to an even greater extent where bargaining is possible than where it is impossible.
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It is perhaps unfortunate that the game-theoretic analysis of bargaining costs has been used principally to analyze the relative efficiency of liability and property rules. The more general question is the design of remedies that will create optimal incentives for the parties to reveal their actual valuations or other private information about the state of the world. A liability rule (that is, a rule under which the damage award may be greater or less than the promisee’s valuation) might create superior incentives compared to a property rule (that is, one under which the damage award is at or beyond the endpoint of the promisee’s valuation), but we should be able to make similar comparisons between different liability rules. The discussion to date has covered liability and property rules generally, whether located within the law of property, torts and contract. There is accordingly room for a more focused look at bargaining costs in contractual settings, with an additional emphasis on ex ante mechanisms other than judicially-crafted damage rules that might help to reduce ex post bargaining costs.
Acknowledgements Paul G. Mahoney thanks Eric Talley and two anonymous referees for helpful comments.
Bibliography on Contract Remedies: General (4600) Anonymous (1973), Comment: Microeconomics and the Lost-Volume Seller, 24 Case Western Reserve Law Review, 712 ff. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 1979, 213-220. Aghion, Philippe and Bolton, Patrick Bolton (1987), ‘Contracts as Barriers to Entry’, 77 American Economic Review, 388-401. Ayres, Ian and Talley, Eric L. (1995), ‘Solomonic Bargaining: Dividing a Legal Entitlement To Faciliate Coasean Trade’, 104 Yale Law Journal, 1027-1117. Barton, John H. (1972), ‘The Economic Basis of Damages for Breach of Contract, 1 Journal of Legal Studies, 277-304. Bishop, William (1985), ‘The Choice of Remedy for Breach of Contract’, 14 Journal of Legal Studies, 299-320. Reprinted in Goldberg, Victor P. (ed.), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 1989, 122-125. Coase, Ronald H. (1960), ‘The Problem of Social Cost’, 3 The Journal of Law and Economics 1-44. Cohen, George M. (1994), ‘The Fault Lines in Contract Damages’, 80 Virginia Law Review, 1225-1349. Cooter, Robert D. and Eisenberg, Melvin Aron (1985), ‘Damages for Breach of Contract’, 73 California Law Review, 1432-1481.
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Craswell, Richard (1988), ‘Contract Remedies, Renegotiation, and the Theory of Efficient Breach’, 61 Southern California Law Review, 629-670. De Alessi, Louis and Staaf, Robert J. (1989), ‘Subjective Value in Contract Law’, 145 Journal of Institutional and Theoretical Economics, 561-577. Dixit, Avinash K. and Pindyck, Robert J. (1994), Investment Under Uncertainty, Princeton, New Jersey, Princeton University Press. Friedman, David D. (1989), ‘An Economic Analysis of Alternative Damage Rules for Breach of Contract’, 32 Journal of Law and Economics, 281-310. Friedmann, Daniel (1989), ‘The Efficient Breach Fallacy’, 18 Journal of Legal Studies, 1-24. Fuller, Lon L. and Perdue, William (1935), ‘The Reliance Interest in Contract Damages’, 46 Yale Law Journal, 52-98. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 77-79. Goetz, Charles J. and Scott, Robert E. (1977), ‘Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach’, 77 Columbia Law Review, 554-594. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 194-207. Goetz, Charles J. and Scott, Robert E. (1979), ‘Measuring Sellers’ Damages: The Lost-Profits Puzzle’, 31 Stanford Law Review, 323-373. Goetz, Charles J. and Scott, Robert E. (1980), ‘Enforcing Promises: An Examination of the Basis of Contract’, 89 Yale Law Journal, 1261-1300. Goldberg, Victor P. (1984), ‘An Economic Analysis of the Lost-Volume Retail Seller’, 57 Southern California Law Review, 283-298. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press, 106-113. Jackson, Thomas H. (1978), ‘“Anticipatory Repudiation” and the Temporal Element in Contract Law: An Economic Inquiry into Contract Damages in Cases of Prospective Nonperformance’, 31 Stanford Law Review, 69-119. Johnston, Jason S. (1995), ‘Bargaining Under Rules versus Standards’, 11 Journal of Law, Economics and Organization 256-281. Kaplow, Louis and Shavell, Steven (1995), ‘Do Liability Rules Facilitate Bargaining? A Reply to Ayres and Talley’, 105 Yale Law Journal 221-233. Kornhauser, Lewis A. (1986), ‘An Introduction to the Economic Analysis of Contract Remedies’, 57 Colorado Law Review, 683-725. Kronman, Anthony T. (1978), ‘Specific Performance’, 45 University of Chicago Law Review, 351-382. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds), The Economics of Contract Law, Boston, Little Brown, 181-194. Kull, Andrew (1994), ‘Restitution as a Remedy for Breach of Contract’, 67 Southern California Law Review, 1465-1518. Macneil, Ian R. (1982), ‘Efficient Breach of Contract: Circles in the Sky, 68 Virginia Law Review 947-969. Mahoney, Paul G. (1995), ‘Contract Remedies and Options Pricing’, 24 Journal of Legal Studies; 139-63. Muris, Timothy J. (1983), ‘Cost of Completion or Diminution in Market Value: The Relevance of Subjective Value’, 12 Journal of Legal Studies, 379-400. Reprinted in Goldberg, Victor P. (ed.) (1989), Readings in the Economics of Contract Law, Cambridge, Cambridge University Press,
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128-132. Polinsky, A. Mitchell (1983), ‘Risk Sharing through Breach of Contract Remedies’, 12 Journal of Legal Studies, 427-444. Priest, George L. (1978), ‘Breach and Remedy for the Tender of Nonconforming Goods Under the Uniform Commercial Code: An Economic Approach’, 91 Harvard Law Review, 960-1001. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 167-175. Schwartz, Alan (1979), ‘The Case for Specific Performance’, 89 Yale Law Journal, 271-306. Schwartz, Alan (1990), ‘The Myth that Promisees Prefer Supracompensatory Remedies: An Analysis of Contracting for Damage Measures’, 100 Yale Law Journal, 369-407. Scott, Robert E. (1990). ‘The Case for Market Damages: Revisiting the Lost Profits Puzzle’, 57 The University of Chicago Law Review, 1155-1202. Shavell, Steven (1980), ‘Damage Measures for Breach of Contract’, 11 Bell Journal of Economics, 466-490. Talley, Eric, L. (1994), ‘Contract Renegotiation, Mechanism Design, and the Liquidated Damages Rule’, 46 Stanford Law Review, 1195-1243. Williston, Samuel (1901), ‘Repudiation of Contracts’, 14 Harvard Law Review, 317-331 (Part I), 421-441 (Part II).
Cases Hochster v. De La Tour, 118 Eng. Rep. 922 (Q.B. 1853). Missouri Furnace v. Cochrane, 8 F. 463 (C.C.W.D. Pa. 1881). Neri v. Retail Marine Corp., 30 N.Y.2d 393 (1972). L. Albert & Son v. Armstrong Rubber Co., 178 F.2d 182 (2d Cir. 1949). Boomer v. Muir, 24 P.2d 570 (Cal. App. 1933).
4610 PENALTY CLAUSES AND LIQUIDATED DAMAGES Gerrit De Geest Professor at the University of Ghent Researcher at the Economic Institute/CIAV, Utrecht University
Filip Wuyts, M.Sc. © Copyright 1999 Gerrit De Geest and Filip Wuyts
Abstract This chapter surveys the economic literature on stipulated damages. In the literature there seems to be a consensus that liquidated and underliquidated damages should be respected. Liquidated damages can be a rational option, especially if parties have more information about the possible losses than judges. Underliquidated damages may can serve as a technique to let parties share the risk of increased production costs. Penalty clauses, on the other hand, have been the subject of a fierce controversy for a long time. Most authors seem to defend the prohibition of penalty clauses. Yet it can be argued that they should be allowed under some conditions. JEL classification: K12 Keywords: Stipulated Damages, Underliquidated Damages, Remedies, Breach of Contract
1. Introduction Sometimes parties to a contract ex ante agree upon how much compensation will have to be paid should one of them breach the contract. These stipulated damages are called ‘liquidated damages’ when they are ex ante reasonable estimations of the true losses. They are called p) monetary units. A defective item causes him a loss of F/l. The utility function U is defined over the monetary income. It expresses the risk aversion of the consumer and therefore increases with decreasing rates: U' > 0, U'' < 0. The expected utility is:
EU = (1 − ()@U(q − p) + (@U(q − p − F / l + w) Assuming a constant profit on the side of the suppliers, the product price becomes dependent on the magnitude of the promised warranty: p = p(w). A Pareto-optimal allocation requires marginal utility to be identical in situations both with and without a product defect. We therefore have: w* = l. This resource allocation will be achieved automatically in the long run in a competitive market, see Figure 1 for illustration. Every point of the diagram represents a price-warranty combination. Price-warranty combinations along the vertical axis insure the seller against product risks because no warranty compensation has to be paid at all, whereas the buyer will be fully insured if a combination from the vertical line w = l is taken. Free market entry drives the product price down to unit cost level: c + (@w. The straight line V = 0 represents this zero-profit level. The slope of this zero-profit line depends on the failure probability of the product. It is steep if the probability of failure is high, and relatively flat if the probability is low. The tangency point between the indifference curve EU1 and the zero-profit line represents the competitive equilibrium. This equilibrium is stable. A firm considering a smaller warranty level has to be aware that the consumers will look for lower prices in case of lower warranty levels. Reducing the warranty level from l to l' lowers the firm’s cost and therefore the product price by (@(l − l'). For such an offer a risk-neutral consumer would bid for a price which is (@(l − l') monetary units smaller. He would therefore be indifferent with respect to the choice of either offer. Risk-averse consumers would not only fear the pure monetary effect, but also the risk exposure which is caused by the now only partial warranty. Therefore they would refuse the new offer. Our first result is: warranties protect risk-averse consumers against manufacturing flaws. The consumers prefer a ‘full’ warranty, unrestricted in magnitude and duration.
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Figure 1 Insurance against product defects
3. Warranties as a Signal of Quality Signalling literature can be traced back to Spence (1973) who wrote an article on ‘Job Market Signalling’. Grossman (1981, p. 479) argued that ‘when firms have tools available which they can use to convey information they will do so’. With warranties we have such a tool of information transfer. Assume there are two types of manufacturers. Type L produces at low unit costs cL but has a large rate of defective units (L, whereas type H has higher unit costs cH but a smaller quota of defective items (H. Let us assume that the customers know about the average market failure rate, but keep them uninformed about the firm-specific quota. Let us suppose furthermore that there are enough potential suppliers of each type to satisfy the demand within the whole market. When offering the product without a warranty, firms of type L would get the whole market demand at price p = cL, because the customers are not able to distinguish between these two types of firms. It is not useful for customers to buy at price p = cH. By charging this price, low quality firms may pretend to sell items of high quality. Firms of type H may start to advertise, in order to inform the consumers about the high quality of their products. Similarly to statements about price, as long as the right to make untrue statements is not sanctioned, advertising signals can be imitated by low quality suppliers (however, in a long-term relationship advertising may signal quality. For more information on this topic
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(see Nelson, 1974; Schmalensee, 1978; Kihlstrom and Riordan, 1984; Milgrom and Roberts, 1986). It is because of the legal system that warranty commitments become credible signals. Putting aside those cases in which a firm is dissolved before the defects of its sold products are revealed, the legal order enforces warranty claims. Therefore, a firm which promises a warranty has to be aware of the resulting warranty costs in the future. Since low-quality suppliers face higher defect rates, they have to expect higher warranty costs. It is therefore cheaper for firms of type H than for firms of type L to use the warranty signal. Hence, they will do so and offer a full warranty, which is preferred most by the buyers anyway. Nevertheless, when they observe the supplementary warranty of competing high-quality suppliers, firms of type L will also offer a warranty. The competitive outcome as to which type of producer finally succeeds in serving the market then depends on the answer to the question : will the higher warranty costs of low quality firms be lower than the original differences in unit costs of production? Referring to the model of the previous paragraph, we know that risk-averse consumers prefer being fully insured against the monetary loss of a product defect: w = l. They favour a full warranty when contracting with either type H or L firms. Their expected utility therefore equals: EUi = U(q − pi) If and only if pH < pL, which means that cH + (H @ l < cL + (L @ l , firms of type H will be able to serve the market. Look at Figure 2 for an illustration. The diagram includes the zero-profit lines of two representative firms of type L and H. The point of intersection determines a specific partial warranty provision. Given this warranty provision, both firms face the same costs. Expanding the warranty further, the sharper warranty-cost increase for firms of type L creates a competitive disadvantage: the additional warranty costs in comparison to high-quality suppliers exceed the original unit cost difference. Therefore according to this example - firms of type H offer their products at the cheapest price. The tangency point A between the zero-profit line VH and the indifference curve EUH represents market equilibrium. Notice that the diagram contains two overlaying systems of indifference curves. The system EUH informs us about the expected utility of representative customers if they contract with firms of type H, the system EUL informs us about contracts with type L. The intersecting curves EU ' and EU represent the L
H
same level of expected utility. Since they intersect at a full-warranty price, consumers do not care about the firm-specific defect rate. Under full warranty the same price leads to the same expected utility, irrespective of which type of firm will sell. To distort the equilibrium, low-quality firms therefore have to
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make an offer in the south-eastern area of the EU L' curve. Since such offers would cause losses, firms of type L refrain from doing so. Therefore the tangency point A characterizes a stable competitive equilibrium. Figure 2 Signalling high quality
The outcome is Pareto-optimal. Since the consumers prefer to be insured, the tangency points A and B are the only candidates for a Pareto optimum condition under the restriction of zero profits. A dominates B because the expected utility of the representative consumer is higher with lower prices. The assumptions of the original model can be altered in several respects: 1. The individual losses differ. Risk-averse consumers prefer a warranty coverage which compensates for their individual losses. Firms will then come up with offers varying in warranty coverage. Low-quality firms serve customers with small individual losses, whereas high-quality firms serve the more sensitive customers. The outcome is Pareto-optimal. It does not deviate from an outcome that would occur, if firms had truthfully disclosed their failure rate and offered an insurance against defective items (see Spence, 1977, p. 570). 2. A monopolist serves the market. The monopolist will increase warranty coverage as long as the marginal buyers’ willingness to pay increases with this coverage (Grossman, 1981, p. 475). Problems arise in cases where the individual losses differ: the social planner will look at inframarginal buyers to control warranty coverage, whereas the monopolist observes the marginal buyers’ willingness to pay (Spence, 1975). 3. The market structure is oligopolistic. Gal-Or (1989) showed that the informational content of warranties is limited, as multiple equilibria may exist.
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4. Warranties as an Incentive to Invest in Quality It was Priest (1981, pp. 1307-1319) who emphasized the ‘Investment Theory of Warranty’. According to his interpretation a warranty is a device which controls the efforts taken by the manufacturer and the consumer to maintain a functioning product. The only relevant variable in a unilateral case - as discussed here - is the effort of the manufacturer to keep the failure rate optimal. Similar to the situations in the previous paragraphs, the customers are interested in being fully insured against the loss caused by a potential product breakdown: w = l. The seller, who, by assumption, is also the manufacturer, thus internalizes the buyer’s potential losses. The manufacturer therefore has to choose a level of quality investment x* which minimizes unit costs of production plus expected losses:
c(x) + ((x)@l Assuming c'(0) = 0, c' > 0, c'' > 0, (' < 0, ('' > 0, there is an optimal positive level of quality investment. This level will be chosen by the manufacturer. His investment will thereby be guided by the following consideration: the effect of a quality investment is to reduce the defect rate. Evaluated in monetary terms, this effect has to be weighed against avoided losses. For any additional quality investment to be taken, the loss-reducing effect has to be larger than the costs of this investment. 5. Underestimated Failure Rates Spence (1977, p. 563) already showed that no warranties will be offered in a competitive market where risk-neutral customers systematically underestimate the failure rate (. In case of risk-averse consumers only a partial warranty will be offered. Let r(() be the failure rate which is perceived by the buyers: r(() < (. Expected utility can then be expressed as: EU = [1 − r(() @ Uq − p(w)] + r(() @ U[q − p(w) − l + w] Maximization with respect to w then leads to the outcome: U ′ ( q − V − c + (1 − Π ) ⋅ w − l ) U ′ (q − V − c − Π ⋅ w )
=
[1 − r ( Π )] r ( Π ) >1 [1 − Π ] Π
Hence the representative consumer prefers a partial warranty: w* < l . Figure 3 illustrates the special case in which the underestimation of the failure rates leads to the outcome that consumers are no longer interested in warranties. The slope of the zero-profit line VL = 0 indicates the true quota of defective items of supplier L. However, consumers expect a failure rate that
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corresponds to the slope of zero-profit line VL' = 0 . They believe that the quota is one third of the true quota. Clearly, their system of indifference curves has to be constructed according to the wrongly assumed quota. The first-best choice of these consumers would be a price-warranty combination as is shown by point P with a full warranty. However, these customers have to realize that the desired contract is not offered in the market. Offering this contract would create losses for firm L, because the true rate of defective items is higher than the customers expected. The minimum price firm L would claim for a full warranty contract is determined by point Q. The representative consumer values this offer with expected utility EU ' and concludes that there is a more valuable L
contract (utility EU L' ' ) without a warranty indicated by point T. Figure 3 Underestimated Failure Rates
Given this situation, we now assume that high-quality firms of type H are also in the market and sell the same product with a smaller rate of defective items. The corresponding system of indifference curves is characterized by the EUH-lines. Compared with firms of type L the offer of the H type is of higher social value, because the full-warranty price of these firms determined by point R is less than the full-warranty price of firm L determined by point Q. Consequently, it is to be expected that firms of type H serve the market. However, just as the customers underestimate the rate of defective items of
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firms L, the rate of defective items of firms H is underestimated by a factor of '
3 (see line VH = 0). The current offer of firms L, selling the product without a warranty as indicated by point T, leads to utility EU L'' . The full-warranty contract indicated by S creates the same utility. Moreover, S is also a point on the indifference curve EU H'' . Therefore we have: EU L'' = EU H'' . The curve EU H'' intersects the ordinate at a price level which is less than cH. Consequently, as cH is the minimum price firms H have to charge for their goods without a warranty, the consumers expect that the utility of the offer characterized by point U is less than EU L'' . So, offer T is preferred to U. The awkward consequence of this example is that the consumers choose the wrong firms and the wrong warranty contracts. Therefore, we have to ask the question, whether the amount market failure can be corrected. Basically there are three ways of legal interference. The most restrictive kind of intervention is to introduce a mandatory legal warranty over the typical lifetime of a product. However, this type of interference should only be applied in situations where the rate of failure is exclusively determined by the firm. If it is also influenced by inherent attributes of failure inclination on the side of the buyer (Wilson, 1977; Rothschild and Stiglitz, 1976), by the intensity of use (Emons, 1989a) or by buyers’ care (Priest, 1981; Kambhu, 1982; Cooper and Ross, 1985) then partial warranties would be better. The second type of legal intervention is a disclosure rule which obliges the sellers to reveal the true failure rate before the purchase is made (Grossman, 1981). I expect that a third alternative will solve the problem with lower social costs: if firms are allowed comparative advertising, then the firm discriminated against will undertake the job to inform the buyers about the true quota of failure.
B. Warranties in a Bilateral Context 6. Warranties in a One-Shot Relationship Observations in reality contradict the picture of long-lasting, fully compensating warranties (see Priest, 1981, p. 1319, for a detailed empirical investigation of warranty contracts). Warranties are always limited in duration. Mostly, the warranty periods cover only part of the lifetime of a product. Often the warranty periods are restricted to one year. Warranties which last for three or more years can rarely be found, although the lifetime of consumer durables often exceeds ten years.
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With respect to the scope of warranties - German standard form contracts predominantly specify subsequent improvement or subsequent delivery - one often detects clauses which exclude the warranty with regard to certain uses or which make the validity of the warranty dependent on the buyer’s intermediate input. Exclusions in warranties are typical for retailing and commercial uses. Often these exclusions are directed against aggressive use or the non-compliance with regular maintenance. Commonly, the operation of certain fragile parts falls under the warranty but the warranty coverage expires if attempts are made to open the product. On the other hand, parts housed deep within the product, inaccessible to the consumer’s influence, are often protected by an extended warranty. This short overview makes it clear that the organization of warranty contracts is essentially determined by the consumer’s potential influence on parts of the product. However, the consumer’s influence on the failure rate has not yet been investigated. Therefore, we have to extend the analysis to bilateral warranty problems, situations in which both parties, the manufacturer as well as the user, control the product’s failure rate. According to the investment theory of Priest (1981) every bilateral warranty problem is a mixture of different unilateral problems and hence can be reduced to its elementary ingredients. This view presupposes that it is a certain type of defect which points to the responsibility of, respectively, the seller or buyer. If this approach was correct, then the optimal warranty contract would have to stipulate a full warranty for those product risks which are under the control of the manufacturer and a full warranty exclusion for those risks which are under the control of the consumer. However, in addition to the elementary unilateral problems and their combinations, there is a real bilateral problem which cannot be decomposed. The optimal control of many of the product risks calls for a certain combination of seller’s and buyer’s care. Take for instance the case of a car engine. Its safe functioning requires the necessary mechanical and electronical adjustments on the part of the manufacturer as well as responsible behavior on the part of the driver. The breakdown probability increases if any of the parties fail to perform their duties. The problem of bilateral investments is addressed in articles by Kambhu (1982), Cooper and Ross (1985), Mann and Wissink (1988), Emons (1988). All these models assume that warranty promises are enforceable. Clearly, if warranties could not be enforced, sellers would cheat on the warranty and the outcome would be minimum product quality. Therefore, I also assume an enforceable warranty. Let the damage function d be dependent on the manufacturer’s quality investments x and the consumer’s costs of care-taking y:
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d(x, y) = ((x, y) @ l Let furthermore: (x < 0, (xx > 0, (y < 0, and (yy > 0. The representative consumer is risk-neutral. Let us assume that his willingness to pay for an intact item is q and that his utility is measured in money terms and equals his willingness to pay. Then the expected utility is: EU = q − ( @ (l − w) − y − p The seller’s profit is:
V = p − x − (@w Maximization of the joint surplus with regard to x and y leads to the following first order conditions: − (x(x, y) @ l = 1
and − (y(x, y) @ l = 1 Now we have to answer the question whether the parties will control their quality and maintenance as described with the first order conditions. Thereby we assume two steps of decisionmaking. During the first step the parties compete, when unobserved by the other party, and choose a certain level of investment. Afterwards they cooperate, when fixing a warranty compensation which maximizes the joint surplus. For the first step the following first-order conditions are relevant: − (x(x, y) @ w = 1
and − (y(x, y) @ (l − w) = 1 A comparison with the Pareto conditions reveals a degree of tension. Pareto optimal quality investments of the manufacturer require a warranty level of w = l, whereas Pareto optimal care-taking of the consumers presupposes a level of w = 0. Therefore, a joint surplus-maximizing allocation is impossible (compare Cooper and Ross, 1985, p. 107), and a ‘second best’ solution will be the outcome. Let the functions x+(y, w) and y+(x, w) describe which level of investments a party will choose given the warranty promise w and the investment of the other party x or y, respectively. Let the pair [xE(w), yE(w)] denote the point of intersection of both functions. It represents the Nash equilibrium of the noncooperative part of the game. When jointly arriving at a conclusion about the level of the warranty, both parties anticipate their reciprocal pattern of unobserved behavior (Cooper and Ross, 1985, p. 109). They consequently maximize their joint surplus under the restriction of the Nash equilibrium, described above: max EU + V = q − Π ⋅ l − x − y w
subject to x = x° ( w)
and
y = y° ( w)
The first-order condition requires:
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xE'(w) @ [ − (x(x, y) @ l − 1] + yE'(w) @ [ − (y(x, y) . l − 1] = 0 According to the first-order conditions of unobserved party behavior we have: − (x(x, y) = 1/w and − (y(x, y) = 1/(l − w), respectively. Therefore the first-order condition is: l l x° ' ( w) − 1 + y° '( w) − 1 = 0 w l−w
On condition that xE' > 0 and yE' < 0 the outcome will always be a partial warranty which, on the one hand, is greater than zero, but, on the other hand, is less than l. If the degree of warranty coverage w/l converges to one, the first term of the above equation vanishes. The derivative is therefore negative. If the degree of coverage converges to zero, the second term disappears. Hence the derivative is positive. However, as is indicated by the equations of party behavior, the conditions of xE' > 0 and yE' < 0 are not always fulfilled. Its validity depends on the magnitude and the sign of (xy (complementary or substitutionary investments). The outcome of the bilateral model is: 1. Parties who feel unobserved when carrying out their product investments normally agree to a partial warranty. 2. This voluntary agreement solves the bilateral problem in a suboptimal manner. Kambhu (1982) raises the question whether or not it is possible to design legal rules which solve the problem of suboptimal incentives. He starts from the assumption that any warranty rule has to be ‘balanced’, which means that the seller, in making the warranty payment , loses the same amount of money as the buyer gets. According to Kambhu (1982) no legal warranty rule exists which offers both parties the Pareto-optimal incentives. This result becomes quite clear if one considers the restrictions under which the legislator has to develop the warranty rule. He has to accept that the legal consequence of the rule cannot depend on unobservable constituent facts. Deviating from the above analyses, Emons (1988) examines the case of a voluntary warranty in which the quality investments of the manufacturer and the consumer’s precautional measures do not continuously vary. He distinguishes two levels of f respectively, quality investments and care-taking. His conclusions are: if risk-averse consumers in a competitive market benefit from a full warranty more than from an incentive-compatible warranty, only a second-best solution is feasible, because the consumers will exert a low level of care. However, if the benefit of full insurance is lower and if the incentive-compatible warranty is extensive enough not to destroy the seller’s
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quality-assuring incentive, then the levels of quality and care will be optimal. The last result of Emons (1988) is crucially predetermined by the assumption of discontinuous variables. With continuous variables a full warranty coverage is necessary to assure the optimal quality investment of the seller. However, this coverage will eliminate the consumer’s incentive to handle the good carefully. Mann and Wissink (1988) discussed the case of a voluntary money-back warranty. The buyer is allowed to return the product within a period specified beforehand. The authors conclude that under extreme conditions the double-sided moral-hazard problem is solved by the first-best levels of care-taking. However, the assumptions of the model used are not realistic. On the one hand, the authors implicitly presuppose a very short period of exchange. This is assumed because buyers do not derive any benefit from the use of the product. On the other hand, the model presupposes that within this period the buyers detect all possible shortcomings of the product. So it seems that the authors really investigate the case of a search good.
7. Warranties in a Long-Term Relationship: The Model The outcome of the above analysis is that in a one-shot relationship with enforceable warranties the first-best levels of parties’ investments in quality and care-taking, respectively, cannot be achieved in general. This section now aims to examine the question whether the market outcome will improve if buyers purchase from sellers who have a good reputation. Deviating from the analysis of the last paragraph I assume unenforceable warranties. This assumption, which complicates the incentive problem, is used to show how reputation really works. Consumer durables are the type of goods for which warranties are most important. Consumers remember the experiences they had with typical brands. These experiences are shared with other customers by word-of-mouth communication. Therefore, companies which have sold brands that customers disliked, may lose part of their reputation and therefore future sales. The mere possibility of future losses may give the seller the incentive to make adequate quality investments. The following model (see Wehrt, 1995b) assumes a perfect competitive market. A multitude of sellers offer the same product with different warranty commitments in the market. However, the brands differ with respect to the unobservable quality investments and therefore varying failure probabilities. Consumers also influence the failure probabilities by their care investments. Satisfied consumers award their sellers with a certain reputation. This reputation is earned, if during the previous period the seller at least delivered the quality he had signalled with the price beforehand and if he kept the given
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warranty promise. A firm’s reputation in period t is therefore a function of the quality-warranty package of the previous period: Rt = (xt-1, wt-1). The earned reputation allows the firm to ask a price in the next period which corresponds to its reputation: pt(Rt) = pt(xt-1, wt-1). Firms which have never earned a reputation or which have abused it are avoided by the consumers. A reputational equilibrium can be defined by four conditions (compare Shapiro (1983)): 1. Every buyer chooses the quality-warranty package and the level of care-taking which maximizes his consumer surplus. 2. Buyers’ expectations come true: a seller whom the buyers expect to meet a certain level of quality investments and to keep his warranty promise, performs in this way: (xt, wt) = Rt = (xt-1, wt-1). 3. In every partial market defined by a certain level of promised quality and warranty, supply equals demand. 4. Market entrance and market exit are not profitable. The consumers are assumed to behave in a risk-neutral way. They can be distinguished by their willingness to pay q and the certain loss l that a breakdown of the purchased item causes. Thus the expected utility is: EUql = q − ( @ (l − w) − y − p where q 0 [0, 4), l 0 [0, q] According to the first equilibrium condition, a consumer of type ql maximizes his expected utility with respect to the variables y, x, w. Therefore, we have three marginal conditions: − (y(xql ,yql ) . (l − wql ) = 1
− (x(xql ,yql ) . (l − wql ) = px
((xql ,yql ) = pw The optimal values of the three variables yql, xql, wql do not vary with respect to a consumer’s willingness to pay q, but as the appearance of the individual loss l in the first two conditions shows, they depend on l. Consumers with identical individual losses are members of the same class. They prefer a certain level of quality, warranty and own care-taking. Therefore, a firm with a certain reputation serves the consumers of a certain class. The reputational equilibrium also requires that sellers have no incentive to abuse their reputation once it has been built up. A seller who exploits his reputation earns profits only during the next period. After that period the customers will avoid him. Therefore that seller’s profit is
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V1 = p(x, w) − x0, where x0 determines the cost of the minimum quality. If the firm keeps its reputation Rt permanently, it will earn profits during all the subsequent periods. Using the interest rate r, the discounted future profits can be stated as:
V2 = {p(x, w) − x − (@w} @ (1 + r) / r Defending the reputation requires profits V2 to be at least as high as profits V1. Therefore we have:
p(x, w) > x + (@w + r {x + (@w − x0} In the above, the term in the third position of the inequality stands for the quality premium the seller earns from complying with his reputation. On the other hand, according to equilibrium condition 4, the profitability of market entrance has to be prevented. A seller who enters the market will earn the following stream of profits:
V3 = x0 − x − (@w + {p(x, w) − x − (@w} / r These profits are not allowed to exceed zero. Thus the above inequality has to hold with ‘ 0]. All injuries caused by the product have a monetary equivalent of L that is suffered by risk-neutral buyers who are identical and unable to influence the risk of injury. In light of these assumptions, the total cost or ‘full price’ P of the product is given by (1) P = p + s + r(s)L. If perfectly informed consumers bear the injury cost L in the event of accident, they pay a purchase price of p + s for the product but recognize that this cost is increased by the expected accident cost r(s)L. Consequently, consumers make their purchase decisions on the basis of the full price P rather than the price they pay to purchase the product, so consumer demand QD = QD(P). Sellers then compete by offering the amount of safety and warranty coverage that minimize P. Under these conditions, it does not matter whether a perfectly informed consumer or the seller is liable for the injury (for example, Hamada, 1976). If the consumer is liable, the seller must choose the amount of safety investments to minimize P, which from equation (1) implies that the seller chooses the amount s* defined by 1 = − r'(s*)L. (2) In other words, the seller invests in safety until the last dollar spent reduces expected injury costs by one dollar. Such a product is optimally safe. If the seller is fully liable for the consumer's injuries, it sells the product and warranty at a price of p + s + r(s)L = P. Once again, the seller must minimize the full price, so it chooses the optimal amount of safety investment s*. Whether the consumer or producer is liable for the product-caused injury therefore does not affect product safety or the full price.
3. The Significance of Imperfectly Competitive Markets An early, influential justification for tort regulation was based on the notion that manufacturers can take advantage of their market power by supplying unsafe products (Priest, 1985). However, the results obtained from the basic model are unaffected if the market is not perfectly competitive (for example, Epple and Raviv, 1978). A seller’s market power can be represented by the amount it can increase the product’s full price above the competitive level. By
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increasing the product price by this amount, the seller increases its profits per sale by that same amount. Alternatively, by reducing safety investments below the optimal level s*, the seller can also increase the product’s full price as each $1 of reduced safety investment necessarily increases expected accident costs r(s)L by more than $1. This strategy does not affect the seller’s profits per sale, however, because the product must sell for a reduced price equal to the unit cost of p + s (any price above cost is equivalent to an increase in the product price). Hence a monopolist can make higher profits by selling perfectly informed consumers an optimally safe product at a supracompetitive price. Similar reasoning shows that if it would be efficient for the seller to bear full liability under the warranty, then a monopolist would maximize profits by offering a full warranty while selling the product at a supracompetitive price (for example, Heal, 1977). It is possible, though, for market structure to affect product safety. The basic model assumes a constant marginal cost of safety investment (the term s) per unit of product. Consequently, a manufacturer’s decision regarding safety investments does not depend upon its output level (as reflected by equation (2) above), implying that product safety will be unaffected by the reduced quantity of output that occurs in imperfectly competitive markets. Many product risks are likely to depend upon the quantity of products sold or consumed by an individual, however. As Marino (1988a, 1988b) points out, toxic chemicals may present a health hazard due to their cumulative effect on consumers. Conversely, consumers may develop a tolerance from cumulative exposure, thereby reducing the risk. The higher prices, and reduced consumption, of products sold in imperfectly competitive markets would affect these kinds of product risk. In addition, when the cost of safety investments depends upon a manufacturer’s output level, the amount of safety investments made by a monopolist depends on the cross-effects of safety investments and output on the monopolist’s costs (Spulber, 1989, pp. 407-410). Whether sellers in imperfectly competitive markets supply products that are insufficiently safe therefore is a difficult empirical question. But if such market failures exist, they probably are better addressed by the antitrust laws.
4. The Role of Consumer Information About Product Risk The analysis so far has assumed that consumers are perfectly informed of risk, an assumption typically made by early economic analyses of products liability (for example, McKean, 1970a; Oi, 1973). But as Goldberg (1974) argued, product safety becomes a regulatory problem only if consumers are inadequately informed. Subsequent economic analyses focused on the effects of imperfect information. When imperfectly informed consumers are liable for their injuries, they
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must estimate their expected injury costs, denoted E[r(s)L], and hence the full price, denoted E[P]. Consequently, equation (1) above is changed to E[P] = p + s + E[r(s)L]. (1') In this setting, a seller must minimize E[P] if consumers are to buy its product, so sellers choose the amount of safety investment s that minimizes E[P]: 1 = − E[r'(s)L]. (2') Thus, when consumers are imperfectly informed of product risk, the seller invests in safety until the last dollar spent on safety reduces the consumer’s estimate of expected injury costs by one dollar (Spence, 1977). If consumers underestimate the decrease in expected injury costs, they will undervalue risk reduction and demand less than the optimal amount of safety; that is, if − E[r'(s)L] < − r'(s)L, then s < s*. A similar result occurs when consumers cannot observe manufacturer safety investments, because consumers who cannot tell the difference between a low-risk and high-risk product treat the differential in safety as if − E[r"(s)L] = 0 when in fact − r'(s)L > 0. Manufacturers have no incentive to incur the higher cost of producing the low-risk product, so they supply only high-risk products, an outcome analogous to the ‘lemons problem’ analyzed by Akerlof (1970). Imperfect information need not result in overly unsafe products. If consumers overestimate the way in which increased safety investments reduce risk, they will attribute too great a value to safety investments and demand more than the optimal amount of safety. Although this outcome is inefficient, it seems unwise to construct a regulatory regime, with its attendant administrative costs, in order to reduce product safety. Hence there is a pressing need to regulate market transactions only if consumers undervalue safety investments.
5. Market Mechanisms that Promote Product Safety Landes and Posner (1987, pp. 280-281) argue that it is too costly for consumers to obtain perfect information about product risks, and imperfectly informed consumers tend to underestimate the small risks ordinarily posed by products, causing them to undervalue safety investments. In assessing this argument, we must recognize that the cost consumers incur to get risk-related information, and their need for it, depends upon a variety of market mechanisms. For example, manufacturers have an incentive to provide optimally safe products if there is a large enough proportion of well-informed ‘shoppers’ in the market (Schwartz and Wilde, 1983a). The information held by some consumers therefore may benefit others who undervalue product safety. Similarly, consumers who communicate among themselves by ‘word of mouth’
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advertising may increase the amount of high-quality goods in the market (Rogerson, 1983). Consumers also can purchase product-related information from intermediaries, and such information may come from sellers. Brand names, for example, are a method sellers use to implicitly guarantee superior quality (Klein and Leffler, 1981), because product quality must be sufficiently high if the seller is to attract repeat purchases (for example, Shapiro 1982, 1983). For the same reason, sellers can convey indirect information about product quality through advertising and prices (Milgrom and Roberts, 1986). The way in which price signals quality is highly dependent on the market context, however, as in some settings low prices signal high quality, whereas in other settings high prices signal high quality (Tirole, 1990, pp. 110-12). In addition, prices signal product quality only if consumers have at least some brand-specific information about quality, although this information need not be perfect (Wolinsky, 1983). As long as consumer experience with a product brand provides enough information so that consumers are more likely to believe the brand is of high quality when in fact it is, high-quality firms will attract more customers (Rogerson, 1983). The need to protect their reputation or brand name may force sellers to provide more safety than is suggested by the analysis in the prior section. Nevertheless, it is unlikely that unregulated market transactions will yield optimally safe products when consumers are imperfectly informed of product risk. A seller’s reputation can remain intact even though its product is not optimally safe, because consumers often have little or no ability to learn from product use about the product’s safety characteristics. Many risks are latent and do not become manifest for years (like carcinogens). In addition, many safety characteristics are not observable during normal product use (such as whether a motor vehicle is optimally designed to minimize the risk of injury for different types of accidents). Given the very low probabilities of most product-caused injuries and the fact that optimally safe products typically pose some risk of injury, very little information will be conveyed by a consumer’s experience of ‘no accident’ or ‘accident’. For example, suppose an unsafe product doubles the risk of injury from 1 in 10,000 to 2 in 10,000. Based upon their experience, it could take consumers a long time (involving numerous iterations of Bayesian updating) to discover the increased risk. Another problem is that the price-quality relationship depicted by signalling models is based on equilibrium conditions for products that vary in one dimension of quality. Even within the confines of such a simplified market, it is doubtful that consumers ordinarily will have enough information about the market context to draw the correct inferences about product safety. And once one allows for the (realistic) possibility of disequilibria in markets for products that are heterogeneous in more than one dimension, it becomes even less likely that consumers will be able to obtain good information about product safety from
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prices. Indeed, one empirical study found that price might serve as a quality signal for only one type of product - frequent but unimportant purchases (Caves and Greene, 1996). Given the limited amount of information provided by market mechanisms, it is puzzling why sellers do not voluntarily disclose risk-related information, particularly since such disclosures would be credible due to the legal prohibition against fraud. Because only high-quality sellers would benefit from voluntary disclosure, consumers could infer from the fact of nondisclosure that a seller is not offering an optimally safe product. All sellers therefore would have to disclose, forcing them to provide optimally safe products. It is possible that high-quality sellers do not voluntarily disclose risk-related information because consumers tend to overreact to negative information about products (see the sources cited in A. Schwartz, 1988, p. 381). Consequently, any seller that discloses risk-related information could cause consumers to believe that its product is unsafe, so high-quality sellers are better off by not disclosing. Burrows (1992) provides other reasons why sellers might not voluntarily disclose information about product risk, and Geistfeld (1997) explains why a system of voluntary disclosure would function much like a tort regime of negligence.
6. Do Consumers Undervalue Product Safety? As the previous discussion suggests, individuals often process risk-related information in a manner that does not correspond to the standard economic model of decisionmaking. A substantial literature on cognitive psychology seeks to understand how individuals assess risks (for example, Kahneman, Slovic and Tversky, 1982). Based on these studies, A. Schwartz (1988, 1992) concludes that consumers tend to overestimate product risks, whereas Latin (1994) concludes that consumers usually underestimate risk and thus undervalue product safety. Both agree these studies find that individuals tend to overestimate risks that are brought to their attention (which may explain why sellers do not voluntarily disclose risk-related information). Latin, however, persuasively argues that most product risks are not salient because product-caused injuries are a rare occurrence for most individuals, leading consumers to infer (erroneously) from the more common or representative experience of safe product use that risk is not present or worth worrying about. Consequently, as Landes and Posner claimed, imperfectly informed consumers tend to underestimate product risks. Although consumer understanding of product risk is relevant to the regulatory problem, it should also be recognized that consumers can undervalue product safety even if they are perfectly informed of product risks. Suppose consumers are risk averse and find it worthwhile to purchase a fully compensatory health insurance policy. Suppose also that the product-caused
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injury would be fully covered by this policy. Insurance companies ordinarily do not adjust premiums to reflect the riskiness of products purchased by their policyholders (Hanson and Logue, 1990). As the consumer’s health insurance premium is unaffected by her consumption choices, neither it nor the expected cost of injury (which is fully insured) are relevant to the consumer’s purchase decision. The full price to the consumer consequently is given by P = p + s, and sellers minimize this full price by setting s = 0. Simply put, fully insured consumers have no need for risk reduction, so it does not pay for sellers to invest in product safety. Of course, this example is extreme (because insurance policies rarely provide full coverage), but the conclusion is general: fully informed consumers will undervalue product safety when they can externalize some of their injury costs onto an insurance company.
7. Product Warranties and the Use of Seller Liability to Promote Safety As discussed in Section 2, when the seller is fully liable for product-caused injuries, the price at which the product sells on the market equals the full price, forcing the seller to provide the cost-effective amount of product safety. In these circumstances, imperfectly informed consumers only need to find the product that sells for the lowest price in order to get the optimally safe product. Seller liability therefore remedies the consumer’s informational problem in a straightforward way, creating the possibility that imperfectly informed consumers might be able to rely on warranties to obtain optimally safe products. For example, assume as in Grossman (1981) that the manufacturer is the least-cost insurer and that consumers are unable to observe manufacturer safety investments. In this setting, insurance costs are minimized if the manufacturer provides a warranty that fully compensates the consumer for any product-caused injuries. A manufacturer that provides full warranty coverage must also provide an optimally safe product in order to minimize the market price (which equals the full price) of its product. A manufacturer that does not provide the optimally safe product therefore would signal this fact to consumers due to the product’s higher market price, so to avoid this outcome such a manufacturer cannot offer a full warranty. Imperfectly informed consumers would infer this type of behavior, though, and assume that products without full warranty coverage must not be optimally safe. Manufacturers accordingly have no choice but to offer imperfectly informed consumers optimally safe products with full warranty coverage. Thus, when sellers are the least-cost insurers, imperfectly informed consumers can use product warranties to attain efficient outcomes: by choosing warranties that impose full liability on sellers, consumers can ensure that
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products will be optimally safe and insurance costs will be minimized. Full warranties (or seller liability in tort) might not result in such equilibria, though, if sellers purchase insurance to cover their liability under the warranty. A study directed by the US Department of Commerce found that liability insurance in the 1970s was rarely priced in a manner that reflected the degree of risk posed by the manufacturer-policyholder’s products (Inter-Agency Task Force on Products Liability, 1977). Although such insurance reduces the manufacturer’s incentive to invest in product safety (as the increased accident costs do not increase premiums), developments in the liability-insurance market have significantly restored this incentive. Based on estimates of firms’ total liability costs, Priest (1991) found that self-insurance costs accounted for 4.9 percent of the total in 1970 and increased to 51.7 percent in 1979. The amount of uninsured risk exposure faced by firms probably increased in the 1980s. Moreover, products liability insurance policies now commonly rely on pricing elements that are responsive to the level of risk posed by the policyholder’s products (G. Schwartz, 1990, pp. 320-321). Hence there are good reasons for expecting that the prospect of liability gives sellers an incentive to invest in safer products.
8. Are Product Sellers the Least-Cost Insurer? Despite the safety benefits of seller liability, warranties that make sellers fully liable for product-caused injuries are unlikely to be efficient because sellers rarely are the least-cost insurer for all product risks. Although manufacturers are likely to have a comparative advantage in insuring against some risks, like those involving repair of complicated machinery, consumers typically will have a comparative advantage in insuring against other risks (Priest, 1981). In particular, risk-averse consumers ordinarily will have a comparative advantage in insuring against many of the risks associated with physical injury, because the cost consumers incur in making their own insurance arrangements ‘first-party insurance’ - often is lower than the cost sellers incur in making insurance arrangements to cover product-caused injuries suffered by consumers - ‘third-party insurance’. In part, first-party insurance is cheaper because it is more capable of minimizing the costs of moral hazard and adverse selection (Epstein, 1985; Priest, 1987). The primary reasons for the cost differential between the two insurance mechanisms stem from the event that triggers coverage and the scope of coverage. Coverage under many first-party insurance policies, such as health insurance, is triggered by the fact of loss (like medical expenses), making the cause of injury irrelevant in most cases. The fact of injury or loss usually is easy to prove (submitting bills), so policyholders typically do not have to hire a lawyer to receive insurance proceeds. By contrast, the third-party insurance
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supplied by product sellers is triggered only if the product caused the injury. Often, many products are causally implicated in an accident, and a potentially contentious factual inquiry may be needed to resolve the liability question (Geistfeld, 1992). Some items of damages, particularly those pertaining to pain-and-suffering damages and future economic loss, are also costly to determine. The resultant litigation expenses increase the cost of third-party insurance, which probably explains why the administrative costs of third-party insurance per dollar of coverage exceed the administrative costs of first-party insurance (Geistfeld, 1992, pp. 639-642). With respect to the scope of coverage, third-party insurance provides compensation for pain-and-suffering injuries whereas first-party insurance typically does not. It might be inefficient for consumers to insure against pain-and-suffering injuries (for reasons given in Section 20 below). If so, it would be more efficient for consumers to suffer these injuries without compensation (a form of first-party insurance), providing another cost advantage for first-party insurance. In other respects, the scope of coverage provided by third-party insurance is not extensive enough, as it does not cover losses unrelated to product use. To cover these contingencies (like medical expenses due to illness), individuals need to purchase other insurance. But since first-party insurance coverage is usually triggered by the fact of loss rather than its cause, individuals who have such insurance might receive double compensation when injured by products: the first-party insurer is obligated to pay whenever the policyholder suffered an insured-against loss; and the seller is obligated to pay (due to the collateral-source rule) even though the consumer received other insurance proceeds. Double recovery can be avoided if the first-party insurer exercises a contractual or statutory right to indemnification out of the tort recovery received by the policyholder, but the separate legal proceeding often is complicated and expensive due to the need to determine which part of the tort award or settlement is covered by the policy. For this and other reasons, many insurers do not exercise this right. Insurance provided by product sellers therefore may be an inefficient form of double insurance or otherwise increase the administrative cost of first-party insurance policies, providing another reason why consumers may reduce their insurance costs if they disclaim seller liability under the warranty. Sellers therefore will typically not be the least-cost insurer for all product risks. Hence, imperfectly informed consumers ordinarily will not be able to rely on full warranty coverage to ensure that products are optimally safe and insurance costs are minimized. It is still an open question, though, whether tort regulation would be efficiency-enhancing.
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9. The Regulatory Problem To account for differences in the cost faced by consumers and manufacturers in insuring against product losses, LI will denote the consumer’s cost of compensating the injury and LW the seller’s cost of compensating the injury under the product warranty. Whether the seller is liable for the injury may affect product safety, so the seller’s safety investment will be denoted by sI when the consumer insures against the injury and by sW when the seller is liable under the warranty. Finally, we will assume that any insurance costs faced by the consumer equal the actuarially fair amount r(sI )LI . (The other extreme - the case in which premiums do not depend on risk - was discussed in Section 6.) There are two possible full prices to consider: PI = p + sI + r(sI )LI .
(3)
(4) PW = p + sW + r(sW)LW. Consumers will disclaim seller liability when doing so would reduce the full price (that is, when PI < PW), and otherwise will purchase full warranty coverage (when PI > PW). To illustrate how the difference in insurance costs affects the analysis, suppose consumers are unable to observe manufacturer safety investments. For reasons given in Section 4, manufacturers will set sI = 0. Consumers, however, will infer such behavior on the manufacturer’s part, recognizing that the full price is given by PI = p + r(0)LI . By contrast, when the manufacturer is fully liable under the warranty, it provides an optimally safe product. Hence PW = p + sW* + r(sW*)LW. Even though product safety increases when the manufacturer is fully liable under the warranty (sW* > sI = 0), if the consumer has a comparative advantage in compensating the injury (LI < LW), it is possible that PI < PW. Consumers therefore may be better off with the less-safe products and reduced insurance costs than with the safer products and more expensive insurance provided by full product warranties. Thus, there often is a tradeoff between safety and insurance considerations when consumers are imperfectly informed: although increasing the amount of seller liability can lead to safer products, it is also likely to increase the average cost of compensating an injury. This inefficiency does not necessarily create a need for tort regulation, however (Geistfeld, 1995a). As long as imperfectly informed consumers can accurately compare PI and PW, as in the example just given, they will choose warranties that strike the appropriate balance between the costs and benefits of seller liability. At best, a tort rule could achieve a similar balance, but more likely it will not. Inefficiencies in product markets therefore need not create an efficiency-enhancing role for tort liability.
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Imperfectly informed consumers will not choose appropriate warranties, though, when they underestimate product risk and thus underestimate the product’s full price. (If E[r(s)] < r(s), then E[PI ] < PI .) In this case, consumers sometimes choose warranties that disclaim manufacturer liability when it would be inefficient do so (that is, when E[PI ] < PW < PI ). A tort rule that imposes full liability on sellers would be efficiency enhancing in this situation. It is also possible, however, that consumers disclaim manufacturer liability when it would be efficient to do so (because E[PI ] < PI < PW). Consequently, tort regulation is not necessarily efficiency enhancing when consumers underestimate product risk. The type of market failure that might justify tort regulation accordingly depends upon conditions that cause consumers to disclaim seller liability when it would be inefficient to do so. This conclusion is not affected by extending the analysis to include the possibility that consumers can affect the risk of injury by exercising care while using the product. As long as sellers cannot observe the amount of consumer care, full warranty coverage is likely to reduce the consumer’s incentive to take costly efforts to avoid (the fully insured) injury. Yet, the reduction in warranty coverage reduces the manufacturer’s incentive to make costly safety investments, so the warranty must balance conflicting safety and insurance considerations (Cooper and Ross, 1985a; Emons, 1988). Holding manufacturers liable in tort for product-caused injuries does not solve the informational problem, however, so this form of tort regulation cannot improve upon a warranty that efficiently allocates liability given the informational constraint. An additional consideration arises if consumers have different risk profiles due to differences in product use, abilities to reduce risk for a given level of care, or damages. Although ‘low-risk’ and ‘high-risk’ consumers may demand products of different qualities, manufacturer liability can force sellers to provide only one level of quality. According to Oi (1973), that outcome is inefficient because low-risk (that is, low-damage) consumers are forced to subsidize high-risk consumers. Absolving sellers of liability would eliminate this inefficiency, because sellers could then provide products of different quality at different prices in a manner that sorts low-risk and high-risk consumers into the appropriate product markets. However, Ordover (1979) shows that in order for such separating equilibria to occur, low-risk consumers must differentiate themselves from high-risk consumers by purchasing incomplete warranty coverage. There may be cases in which the benefits of successful differentiation are less than the benefits of mandated seller liability. Hence tort regulation is not necessarily inefficient even though some consumers would be better off without such regulation.
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10. The Choice Between Negligence and Strict Liability We have been analyzing seller liability in terms of a rule that holds sellers strictly liable for injuries caused by product use. Most product accidents are governed by a rule of negligence, however, which makes sellers liable for injuries caused by products that are not reasonably safe. According to the economic interpretation of negligence, a product is not reasonably safe if it contains less than the optimal amount of safety s* defined by equation (2) above. Because each dollar of safety investment below s* increases expected accident (and thus liability) costs by more than one dollar, sellers minimize total costs by making total safety investments equal to s*. Thus, a negligence standard that is properly defined and perfectly enforced gives sellers an incentive to supply optimally safe products, the same incentive created by strict liability. Negligence differs from strict liability in that consumers under a negligence rule bear liability for injuries caused by optimally safe products, giving them the opportunity to enter into insurance arrangements that minimize the cost of injury compensation. In theory, then, a negligence regime can yield optimally safe products while enabling consumers to minimize insurance costs. Nevertheless, negligence will not lead to efficient outcomes, when consumers are imperfectly informed of product risk (Shavell, 1980; Polinsky, 1980). Because sellers are not liable for injuries caused by their (optimally safe) products, the product sells for p + s*. Consumers in a negligence regime therefore need to estimate expected injury costs r(s*)LI in order to determine the product’s full price P. Consumers who underestimate product risk will underestimate the full price, increasing their demand above the amount they would choose if they were perfectly informed. Thus, even though products are optimally safe, consumers will purchase too many products (and there will be too many firms in the industry). This overconsumption increases the total number of injuries above the efficient amount whenever optimally safe products pose a positive risk of injury. Another problem with a negligence rule is that it often will be difficult (and expensive) for the plaintiff to show that the product should have been made differently. Consider, for example, the complicated issues that must be resolved in order to determine whether a product is optimally designed. The cost of litigating these issues may undermine the safety incentives of negligence liability. Prior to filing suit, injured consumers who are not well-informed about manufacturer safety investments often will be unable to determine whether the product is reasonably safe. These consumers (or their contingent-fee attorneys) may be unwilling to incur the cost of proceeding with the lawsuit, enabling some manufacturers with suboptimally safe products to escape liability. Under these conditions, a proportion of manufacturers choose to be negligent (Simon, 1981).
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Another reason for expecting that the negligence standard will not be perfectly enforced stems from the possibility that judges and juries will make mistakes. The complicated issues in products liability cases (many of which are discussed below) make court error possible. Hylton (1990) shows that a negligence standard with court error and costly litigation can lead to over- or underdeterrence. Overdeterrence can occur because sellers of optimally safe products may be held liable due to court error. By increasing product safety, the seller decreases the risk of injury, thereby reducing the likelihood that it will be subjected to a lawsuit and an erroneous imposition of liability. But even though court errors can increase product safety, the increased legal uncertainty has deleterious effects (also discussed later). Moreover, overdeterrence may involve the withdrawal of socially beneficial products from the marketplace. Strict liability, by contrast, is less costly for plaintiffs and easier for courts to administer, which increases the likelihood that it will be perfectly enforced. In addition, strict liability can lead to the efficient level of risk even though consumers are imperfectly informed. Hence strict liability has a better potential for reducing product risk. Negligence, on the other hand, allows for a greater range of insurance arrangements and accordingly has more potential to reduce the average cost of compensating an injury. The choice between negligence and strict liability therefore reflects the same safety-insurance tradeoff described earlier: increased seller liability (that is, strict liability) is likely to increase safety and per-injury insurance costs, whereas decreased seller liability (negligence) is likely to reduce safety and the average cost of compensating an injury.
11. Empirical Studies of the Effect of Seller Liability on Product Safety Whether seller liability reduces product risk is a difficult empirical question, because the available accident data are not sufficiently refined and the injury rate is affected by a number of other factors such as changes in technology and the composition of products and users. Indeed, data limitations undermine the conclusions one can draw from attempts to measure the impact that seller liability has had on product safety. For example, Priest (1988a) compares the amount of products liability litigation to death rates and the rate of product-related injuries requiring emergency room treatment, concluding that the expansion in litigation had no discernible effect on accident rates. Although Priest acknowledges that the study is exploratory, Huber and Litan (1991, p. 6) assert that it raises ‘serious doubts that the benefits of expanded seller liability have been large’. But as Dewees, Duff and Trebilock (1996, p. 203) point out, Priest’s study does not necessarily show anything about the relationship between seller liability and accident rates. The accidents in the study could be caused by a number of factors unrelated to manufacturer safety investments.
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Moreover, increased seller liability should reduce the number of ‘defective’ (suboptimally safe) products, but the injury data are not segregated into accidents involving defective and nondefective products, making it difficult to draw useful conclusions from the study. For example, the prior level of tort liability could have significantly increased the number of nondefective products on the market. Greater consumption of these nondefective products (due to increased wealth, for example) could increase the overall injury rate, even though the expansion in seller liability reduced product risk by reducing the amount of defective products on the market. Higgins (1978) relies on accidental fatalities in the home as a proxy for product-caused injuries. The econometric analysis finds that producer liability reduces the frequency of these accidents in states with low levels of educational attainment and increases it in states with high levels. If low educational attainment corresponds to imperfectly informed consumers, this study partially supports the claim that producer liability increases safety when consumers are not well informed of risk. However, in addition to the previously mentioned problems of relying on such aggregated accident data, this study is problematic because it measures the impact of producer liability in a state by reference to the year when its highest court expanded producer liability by eliminating the contractual requirement of privity. It is doubtful that this expansion in seller liability was significant enough to produce observable results, particularly since the numerous exceptions to the privity doctrine meant that sellers were already exposed to considerable liability for injuries suffered by victims with whom there was no direct contractual relationship. Graham (1991) attempts to determine the relationship between products liability and passenger-car death rates. The regression does not detect any beneficial impact of liability on aggregate death rates, with the extent of liability measured by an index based on the annual number of crashworthiness cases reported in the LEXIS database. Measuring liability rules by published judicial opinions is particularly problematic, however, because most lawsuits are settled prior to trial. A very effective liability rule, for example, could cause all cases to settle, giving sellers a strong incentive to reduce risk. Yet Graham’s model would not impute this risk reduction to the liability rule. Moreover, MacKay (1991) argues that federal regulations of automobile design have forced all manufacturers toward a common standard, which undermines the attempt to derive a simple causal link between products liability and traffic accidents. Other studies have circumvented these data problems (and created others) by asking producers how their behavior has been influenced by liability. Eads and Reuter (1983) conducted interviews with nine large manufacturers, concluding that products liability significantly influences product-design decisions. Based on interviews with 101 senior-level corporate executives from the largest publicly held companies in the United States, Egon Zehnder
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International (1987) found that over half of these companies had added safety features as a result of liability concerns. About 20 percent of the companies chose not to introduce new products on account of products liability. Two other studies conducted by the Conference Board surveyed risk managers and CEOs of major corporations, finding that products liability concerns led to significant safety improvements while also causing a significant number of firms to discontinue product lines or not introduce new products (Weber, 1987; McGuire, 1988). The Egon Zehnder survey is probably the most reliable due to its excellent response rate; the Conference Board surveys had poor return rates and may have been influenced by a variety of biases (G. Schwartz, 1994a, pp. 408-410). A different approach to evaluating the effects of seller liability examines the impact of prominent products liability lawsuits on stock prices. Viscusi and Hersch (1990) find that news stories reporting on products liability suits significantly decrease a firm’s stock value. Similarly, Jarrell and Peltzman (1985) (criticized by Hoffer, Pruitt and Reilly, 1988) and Rubin, Murphy and Jarell (1988) find that safety-related administrative actions (product recalls) substantially reduce stock prices. In all of these studies, adverse publicity concerning product safety costs the firm more due to the reduced stock value than does the associated liability or recall costs. These findings suggest that firms suffer a loss of reputation when there is an adverse event (litigation or administrative action) pertaining to the safety of its product. As described earlier, a firm’s reputation for safety is important when consumers are not well-informed of product risk. These studies therefore indirectly confirm that individuals are not perfectly informed of product risks. Moreover, the loss in stock value gives firms an additional incentive to avoid products liability litigation, providing another reason for believing that seller liability increases safety.
12. The Impact of Tort Liability on Innovation The political debate regarding products liability reform in the US has often involved the claim that tort liability reduces innovation and consequently undermines the competitiveness of domestic products in a global economy. Although tort liability probably has reduced some types of innovation, the welfare effects of that reduction are unclear. Moreover, tort liability has also induced beneficial innovation, making it even more difficult to assess the net impact of tort liability on innovation. Tort liability can increase a producer’s cost, relative to a rule of no liability, by forcing the firm to increase its safety investments. Tort liability also requires that firms make disclosures in product warnings so that imperfectly informed consumers can better estimate accident costs (see Section 18 below). Insofar as tort liability increases safety investments and consumer estimates of accident
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costs, there is an increase the product’s full price. Consequently, tort liability is likely to encourage safety innovations much in the same way that other cost-driven price increases, such as those stemming from labor scarcity, induce innovation. An increase in cost enhances the profitability for the firm of any innovation which reduces that cost. The resultant increase in firm demand for such technical change should produce more innovation, a theory of technical change called ‘induced innovation’. This theory has substantial analytical and empirical support for innovations unrelated to product safety (Thirtle and Ruttan, 1987). There is no apparent reason why the theory is not also applicable to safety innovations. For example, an optimal research and development (R&D) program without a fixed budget will expend resources until the marginal cost of additional research equals the marginal benefit. The benefit depends on the potential cost savings from the research, savings that are increased as firms face increased tort liability. Expansions in tort liability therefore should increase R&D expenditures for safety technologies. This conclusion is consistent with the analytical results obtained by Daughety and Reinganum (1995), and the empirical study by Egon Zehnder International (1987) which found that over half of the surveyed companies had increased their R&D expenditures as a result of liability concerns. Insofar as the increased R&D expenditures have yielded more safety innovations, tort liability has promoted safety innovation. A liability rule that increases the product’s price can also have a negative effect on innovations unrelated to product safety. Assuming that the increased price reduces consumer demand, both theory (Binswanger, 1974) and historical evidence (Schmookler, 1966) indicate that the reduced profitability of the product line discourages innovation. But insofar as the change in demand reflects consumer response to a product price that more accurately reflects accident costs, the reduced innovation may be welfare enhancing. Viscusi and Moore (1991a, 1991b, 1993) study the effect of liability costs on innovation, finding that firms with new products have higher liability insurance costs. Econometric analysis shows that increased seller liability increases safety incentives, but at some point further increases in liability reduce innovation by making new products unprofitable (ibid., 1991b, 1993). One study (1993) shows that 10 industry groups were at or near this threshold in the mid-1980s, indicating that the incentive effects of seller liability vary across industries. This variable effect is confirmed by case studies of different industries regarding the impact of tort liability on innovation (Ashford and Stone, 1991; Craig, 1991; Graham, 1991; Johnson, 1991; Lasagna, 1991; Martin, 1991; Swazey, 1991). Products liability can also affect innovation due to its influence on the structure of business organization. If a firm suspects that a product may pose risks that are long term and likely to result in widespread injury, it has an incentive to avoid paying damages by divesting production tasks that involve
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such products. To insulate itself from legal liability, the parent company must divest early in the R&D stage. This dynamic is consistent with an empirical study of the US economy which found that increased seller liability appears to have increased the number of small corporations in hazardous sectors between 1967 and 1980 (Ringleb and Wiggins, 1990; see also Merolla, 1998). The cost of innovation for products involving such risks will be increased by the need to divest an operation that can more cost-effectively (absent liability concerns) be administered within a single organization. The increased cost in turn provides some disincentive for innovation.
13. The Relationship Between Tort Liability and the Market for Liability Insurance A report published by the US Attorney General’s Tort Policy Working Group concluded that increased tort liability was a major cause of the so-called ‘liability insurance crisis’ that occurred in the mid-1980s (US Department of Justice, 1986). The liability-insurance market was in turmoil during this period: premium revenues tripled and the supply of coverage severely contracted (Viscusi, 1991a). It is not evident why a contraction in the liability-insurance market would be caused by legally mandated expansions in seller liability, however, as expansions in tort liability should increase the demand for liability insurance. This conundrum has attracted much attention, leading to a number of different explanations for the liability-insurance crisis (surveyed in American Law Institute, 1991a, pp. 66-97). For our purposes, the most interesting finding to emerge from this literature pertains to the way in which legal uncertainty affects the cost of liability insurance. A standard liability-insurance policy covers a product seller’s legal liability for personal injury or property damage that ‘occurs’ to third parties during the policy year. Often a number of years pass before legal liability is incurred by the policyholder (who is then indemnified by the insurer). During the period between the issuance of the policy, manifestation of injury, and conclusion of the lawsuit, any changes in tort law may affect the costs the insurer will incur under the policy. Thus, in order to forecast its expected costs for a group of policies, a liability insurer needs to predict how tort standards, damage rules, and insurance law (like the interpretation of an ‘occurrence’) will change over time. In periods of legal stability, the insurer can be fairly confident about its predicted liability exposure. However, as Abraham (1987) and Trebilcock (1987) emphasize, there were various sources of legal uncertainty that liability insurers faced in the 1980s, making it difficult to predict the likelihood or magnitude of covered losses. In theory, this increased uncertainty increased the variance of the insurer’s expected loss and thus the cost of bearing that risk
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(Venezian, 1975). Empirical studies also show that legal uncertainty increases the cost of liability insurance. Kunreuther, Hogarth and Meszaros (1993) surveyed actuaries, underwriters and insurers, finding that they will add an additional cost above the expected value of loss when there is uncertainty (or ‘ambiguity’) regarding the probability or magnitude of the insured-against loss. Similarly, in an econometric study involving a large number of insurance policies issued during 1980-84, Viscusi (1993a) concludes that risk ambiguity tended to exert a positive influence on actual premium rates, controlling for the regulated rate. Winter (1991) provides a theoretical explanation for why this uncertainty can also affect the industry supply of liability insurance. It seems likely, then, that any increased legal uncertainty created by the tort system contributed to the liability-insurance crisis in the 1980s. In response to this and an earlier insurance crisis in the 1970s, a number of states enacted legislation limiting a seller’s tort liability. Most of these measures also reduced legal uncertainty (for example, by placing caps on the most unpredictable elements of damages). Viscusi (1990a) finds that both the profitability and availability of liability insurance were enhanced during 1980-84 by prior legislative reforms that limited firms’ liability. Viscusi et al. (1993) find that the reforms adopted by the states between 1985 and 1988 reduced liability costs and the premiums for liability insurance. This study also concludes that its findings are consistent with the possibility that the fact of comprehensive reform is more consequential than its components. One way to explain such an outcome is that the enactment of legislative reform reduces legal uncertainty by indicating that the legal climate is not hospitable to expanded tort liability for product sellers. In such a climate, liability insurers may be more confident that they will not be exposed to unanticipated expansions in legal liability, thereby reducing the cost of legal uncertainty that is built into premiums for liability insurance. But even if the reductions in seller liability mandated by these legislative reforms reduced liability costs and premiums, it does not follow that the reforms were efficient. Croley and Hanson (1991) argue that the rise in liability-insurance costs reflected a more efficient level of deterrence due to the internalization of costs that had been externalized prior to the expansion of seller tort liability. Indeed, due to the higher cost of third-party insurance, increased seller liability should have a pronounced effect on insurance costs. Moreover, because increased tort liability will decrease demand when consumers underestimate risks (see Sections 10 and 11 above), Manning’s (1996) empirical finding that tort liability reduced consumer demand for childhood vaccines does not necessarily establish, as he claims, that consumers place no value on this form of tort insurance. Instead, the relevant question for policy purposes is whether the increased insurance costs of tort liability, and any decline in consumer demand, are justified by a reduction in product risk.
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14. Introduction to the Economic Analysis of Products Liability Doctrines Depending on the issue involved, the current products liability regime in the US relies upon contracting, negligence, or strict liability to allocate liability for product-caused injuries. The prior analysis of the costs and benefits of these methods therefore can be used to analyze the efficiency properties of various products liability doctrines. Consequently, the ensuing discussion will delineate the role of contracting, negligence, and strict liability while raising a number of previously undiscussed considerations relevant to the economic analysis of products liability law. Epstein (1980) provides a more comprehensive overview of products liability law and discusses the economic implications of various doctrines. The American Law Institute (1991b) provides more extensive economic analysis of the main products liability doctrines. Although this focus on US law is limiting, the doctrines to be disscused have influenced the development of products liability laws in other countries, particulary the European Community and Japan.
15. The Focus of the Legal Inquiry and Its Implications for the Choice of Liability Rules Sellers are liable for their negligent conduct resulting in product-caused injuries. In the vast majority of states and the European Community, sellers are also liable for injuries caused by product ‘defects’. Although this rule is commonly called ‘strict products liability’, it is not the same as strict liability because liability depends upon the existence of a defect. In most states, defect is defined by reference to the product itself. As discussed in the ensuing sections, the choice between negligence and strict liability follows from the definition of defect and is not based on the efficiency properties of these tort rules. Other states and the European Community define defect by reference to consumer expectations. Although it is easier to give this approach an economic interpretation, it too does not rely upon efficiency considerations in making the choice between negligence and strict liability. More precisely, the consumer expectations test can operate like a rule of strict liability, since an optimally safe product is defective if it does not conform to consumer expectations. This outcome occurs when consumers underestimate risk, as products will always be more dangerous than consumers expect them to be. Conversely, when consumers are well-informed of product risk, the product always conforms to consumer expectations and consequently absolves the seller from tort liability. The consumer expectations test therefore limits tort liability to the cases in which it has the greatest potential to be
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efficiency-enhancing (when consumers underestimate risk), but it does not rely upon an economic rationale for its choice of strict liability over negligence.
16. Manufacturing Defects Manufacturing defects are physical deviations from a product’s intended design, thereby implicating the quality control of manufacturing and inspection processes. These processes usually cannot be made perfect, so some products containing manufacturing defects will reach the marketplace. Whenever such a defect causes physical injury, the seller is liable even if it employed the most efficient quality-control measures. Defining defect by reference to the product accordingly results in a rule of strict liability for these cases. Jurisdictions that rely on the consumer expectations test also employ strict liability for these cases by assuming that consumers do not expect a product to contain a manufacturing defect. Most agree that strict liability is the better rule for these cases. G. Schwartz (1979, pp. 459-462), for example, argues that most manufacturing defects are attributable to negligence, but it often will be difficult for plaintiffs to prove that the seller or one of its agents did not use appropriate quality-control measures. Thus, even though negligence in principle would eliminate tort liability whenever increased deterrence is not desirable - that is, when efficient quality-control measures already are being used - the benefit in these few cases is less than the costs that would be created for all cases if the plaintiff had to prove that the defect was caused by inadequate quality control. Strict liability may also be more efficient because it gives sellers a better incentive to foster advances in technology that reduce the incidence of manufacturing defects (Landes and Posner, 1985).
17. Design Defects A product that conforms to the manufacturer’s design specifications is defective if the design is defective. Unlike manufacturing defects, which can be determined by reference to deviations from product design, there is no readily available definition of design defect. Consequently, courts had to develop such a definition. Many jurisdictions define defect by reference to consumer expectations. This test, however, suffers from an inherent ambiguity. The inquiry could address consumer expectations of product risk. As previously noted, because consumers who underestimate risks will always find a product to be more dangerous than they expect, sellers are subjected to liability even if the product
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design satisfies the cost-benefit test. This logic explains the controversial result in Denny v. Ford Motor Company, and is consistent with the rule that consumer expectations justify holding sellers strictly liable for manufacturing defects. Alternatively, the inquiry could address consumer expectations of product safety. Consumers who underestimate risk ordinarily expect less safety than is contained in a product. For example, consumers who are unaware of risk expect there to be no safety investments, implying that any amount of product safety surpasses consumer expectations, even if the product is less safe than would be efficient. That consumer expectations tend to establish a safety standard below that of the cost-benefit test was recognized in the influential case Barker v. Lull Engineering Company. Whether consumer expectations should be defined by reference to risk or safety is an issue that can only be resolved by determining why consumer expectations matter, an issue that courts have not adequately addressed. The choice between risk and safety does not matter, though, for jurisdictions that define defectiveness by reference to reasonable consumer expectations. A reasonable consumer expects that sellers would reduce product risk in the most cost-effective manner. Hence a product design does not conform to consumer expectations only if the seller failed to take measures that efficiently reduce product risks. The consumer expectations test therefore can be turned into a negligence test for design defects. Note, though, that the logic needed to justify a negligence rule for design defects is inconsistent with the rationale for making sellers strictly liable for manufacturing defects, since reasonable consumers also expect that sellers ordinarily are unable to eliminate all manufacturing defects. The other approach for defining a design defect is based on the risk-utility test. The traditional formulation of this test is not limited to the factors relevant to the issue of whether the product design efficiently minimizes product risk (A. Schwartz, 1988; Viscusi, 1990b). However, the Restatement (Third) of Torts: Products Liability states that ‘the test is whether a reasonable alternative design would, at reasonable cost, have reduced the foreseeable risks of harm posed by the product, and if so, whether the omission of the alternative design ... rendered the product not reasonably safe’ (American Law Institute, 1997, p. 19). The risk-utility test therefore has evolved into a cost-benefit test. Because this test absolves sellers from liability (there is no defect) when the design efficiently minimizes risk, these cases, in effect, are governed by a negligence rule. The biggest problem with a negligence standard for design defects relates to the court’s ability to evaluate the technical engineering issues involved in product design (Henderson, 1973; A. Schwartz, 1988). An erroneous finding of design defect is particularly problematic, because tort liability potentially attaches to the entire product line. Consequently, any legal uncertainty in this area will have significant repercussions, suggesting that design-defect litigation
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has significantly influenced developments in the market for liability insurance (Viscusi, 1991b). Courts could avoid these difficult issues by defining defectiveness on the basis of relative safety, but that type of approach is unlikely to yield efficient outcomes (Boyd and Ingberman, 1997a). First consider a rule which holds that a product is not defectively designed if it conforms to industry custom. Because conformance to custom immunizes firms from tort liability, custom reflects market equilibria absent tort regulation. As such equilibria are often characterized by inefficiently low safety levels, adherence to custom is not ordinarily sufficient to establish that the product is properly designed (see Section 9 above). Now consider an alternative rule that defines a product as being defectively designed whenever a safer product is available on the market (‘state of the art’). A seller whose product is defective under this definition is fully liable for all injuries, so it usually minimizes costs by choosing the efficient amount of safety. The seller, however, could avoid liability altogether by increasing its safety investments above the efficient amount if doing so would make its product safer than others on the market. This liability rule therefore might give sellers an incentive to provide an inefficiently high amount of safety. Hence efficient safety levels ordinarily will not be obtained if courts determine defectiveness solely on the basis of relative safety considerations pertaining to custom or state of the art. The difficulty of determining whether a product is defectively designed has led the courts to limit the scope of tort liability for design defects. Usually courts are unwilling to consider whether a product is defective no matter how it is designed, recognizing that they cannot competently evaluate the total costs and benefits of a product except in the most extreme cases (Henderson and Twerski, 1991). For example, courts will not consider whether a subcompact car is defectively designed merely because larger (more expensive) cars are safer. Instead, design-defect litigation tends to involve modifications to existing product lines (like redesigning the gasoline tank in a subcompact car to reduce risk). Limiting the scope of tort liability in this manner allows the market to determine the viability of product lines (subcompact cars versus larger, safer cars), which enhances the likelihood that product lines can be varied to better satisfy consumers with different preferences. Under strict liability, by contrast, manufacturers make design choices by reference to the average consumer, thereby reducing the variety of product lines offered in the market and the likelihood that heterogeneous consumers can find products that closely match their preferences (Oi, 1973).
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18. Warning Defects A product can be defective because it does not adequately warn or instruct the consumer about product risks. As was true for design defects, the courts had to develop a definition for this type of defect, with most choosing to define warning defects in terms of a cost-benefit or risk-utility test. In principle, to satisfy this test the warning must provide the minimal amount of information necessary for the representative consumer to estimate the product’s full price, which can occur only if the warning increases the consumer’s information by describing unavoidable material risks and cost-effective methods of use that reduce risk (Geistfeld, 1997). Courts have recognized that warnings which satisfy these criteria are not defective and accordingly absolve the seller of liability, even if the warning did not disclose a risk that injured the plaintiff. The liability standard for warning defects therefore operates like a rule of negligence. By contrast, the consumer expectations test functions like a rule of strict liability for nondisclosed risks that are not sufficiently appreciated by the ordinary consumer. One implication of this approach is that the seller is liable even if the risk was not scientifically knowable at the time of sale. In order to make this and other cost-related considerations relevant to the liability determination, the test must adopt the expectations of a consumer who reasonably expects sellers to disclose risks whenever it would be cost-effective to do so. At present, the most problematic aspect of this form of tort liability relates to the cost of disclosure. A warning is defective if it does not disclose, sufficiently describe, or properly emphasize the risk which caused injury. Even if the benefit of a proposed warning alteration is slight, courts often find the warning to be defective on the ground that the cost of the requested disclosure is minimal or nonexistent (Henderson and Twerski, 1990). This is a mistake. Empirical studies have found that the amount and format of hazard information contained in a product warning affects consumers’ ability to recall the information, so that added disclosures can reduce the effectiveness of other disclosures in the warning (for example, Magat and Viscusi, 1992). Additional disclosures also increase the time consumers must spend to read warnings. Because these costs of disclosure are not sufficiently recognized by the courts, sellers have an incentive to disclose more than the optimal amount of risk information, thereby reducing the effectiveness of the warning for most consumers. For example, upon reading disclosures that offer little or no benefit, most consumers may rationally decide that the cost of reading the entire warning is not worth the effort. Some courts have recognized that the risk-utility test for warnings should account for information-processing costs. This position is taken by the Restatement (Third) of Torts: Products Liability (American Law Institute,
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1997, p. 32). Indeed, ignoring the way in which information costs affect consumer behavior is inconsistent with the various rules regarding an adequate warning (Geistfeld, 1997, p. 328). As virtually all jurisdictions have adopted these rules, there is ample precedent for courts to rely upon information costs when evaluating warnings. If they do, jury instructions can be formulated that would significantly improve the likelihood that jurors will properly evaluate warnings (ibid, pp. 329-37), although some argue that jurors and judges cannot competently evaluate information-processing costs (Latin, 1994, p. 1284). Another reason for believing that the warning doctrine is not currently producing efficient outcomes pertains to the method of disclosure. The most effective form of risk communication probably involves symbols and common formats (A. Schwartz, 1992; Viscusi, 1993b). The public-good nature of effective risk communication may require a regulatory rather than judicial solution. For this reason, strict liability is unlikely to result in efficient warnings, contrary to the argument of Croley and Hanson (1993). Cooter (1985) shows that strict liability may lead to inefficiently strong warnings because the manufacturer only considers how disclosure affects profits rather than social welfare. This result is hard to understand, however. For risks that are unavoidable or inherent in the product, disclosure will not reduce risk (or liability costs) unless it induces the buyer not to purchase the product. In some situations, disclosure would induce only high-risk buyers to opt out of the market, so the seller could reduce average liability costs by disclosing. But if disclosure does not reduce average liability costs, the seller has no incentive to disclose even when disclosure would be efficient. By contrast, when disclosure pertains to care that the consumer must exercise in order to reduce risk, the strictly liable seller has an incentive to disclose the efficient amount of information - that which minimizes average liability (injury) costs. Strict liability also gives sellers an incentive to discover the efficient amount of information (Shavell, 1992). But since sellers are liable for risks that were not scientifically knowable at the time of sale, strict liability could result in inefficient outcomes. Firms that otherwise are financially viable may be forced into bankruptcy by unanticipated liability costs that could not have been discovered by a cost-effective R&D program (A. Schwartz, 1985). Negligence avoids this problem, but different formulations of the negligence rule are possible and not all of them induce sellers to acquire the efficient amount of information (Shavell, 1992). And because plaintiffs often will have a hard time proving that a seller was negligent for not having discovered information, sellers apparently do not have a sufficient incentive to research product risk (Wagner, 1997).
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19. Defenses Based on Consumer Conduct In most states and the European Community, recovery is reduced for plaintiffs whose misuse of the product combined with the defect in causing the injury. Whether ‘comparative fault’ is less efficient than barring the plaintiff from recovery depends upon a variety of factors (Shavell, 1987, pp. 83-104), but it seems unlikely that comparative fault reduces the consumer’s incentive to use the product properly under ordinary circumstances. Survey evidence shows that for product-associated injuries that are serious but do not result in latent injuries, long-term institutionalization, or death, only 7 percent of victims in the US take action to initiate a liability claim if the injury did not occur at work, and 16 percent take action if the injury occurred at work (Hensler et al., 1991, p. 127). For the vast majority of cases, then, individuals do not expect to recover any damages from the seller, so comparative fault plays little, if any, role in the individual’s decision regarding product use. Denying recovery to those individuals who misused the product for other reasons, or due to inadvertence, would reduce the seller’s incentive to invest in product safety. This seems to be a large price to pay in exchange for the occasional benefit of denying recovery to those plaintiffs who intentionally misused the product because they expected to receive some compensation from the seller, particularly since the compensation that such individuals receive depends upon proof of defect and is likely to be substantially reduced by comparative fault principles. A more worrisome question is whether a product that is nondefective in normal use can become defective when misused. Many jurisdictions require sellers to design products to account for foreseeable misuse. Landes and Posner (1987, pp. 299-301) argue that this doctrine could be efficient if properly limited. Difficult issues also surround the defense of assumption of risk, which in some jurisdictions bars a plaintiff from recovering. The defense could be efficient if it limits seller liability to those cases in which consumers are not well-informed of risk. But merely because a consumer is aware of a risk does not imply that she is well-informed, particularly since perfect information involves an understanding of how different safety configurations affect risk (and price). Moreover, availability of the defense gives sellers an incentive to make design defects visible or to disclose the risk in the warning. Latin (1994) argues that warnings ordinarily are less effective at reducing risk than are design changes.
20. Nonmonetary Damages Plaintiffs can recover monetary damages for nonmonetary injuries such as pain and suffering. These damages may be inefficient. Nonmonetary injuries alter the individual’s utility function (the victim receives less utility for any given
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level of wealth following the accident), which can affect the marginal utility of wealth in different ways. These different effects are important, because an individual maximizes welfare by purchasing insurance (a transfer of money from the noninjured state to the contingent, injured state) until the marginal utility of wealth in the ‘injury’ and ‘no injury’ states of the world are equalized. For nonmonetary injuries that increase the marginal utility of wealth, individuals prefer a positive amount of insurance compensation. The insurance proceeds reduce the marginal utility of wealth in the injured state so that it equals the marginal utility of wealth in the noninjured state. But for injuries that decrease the marginal utility of wealth (like when the victim is comatose), negative insurance is efficient, as the individual would be better off by transferring money from the injured state (unconscious) to the noninjured state (healthy and conscious), where more utility can be derived from each dollar (Cook and Graham, 1977). Because consumers (potential victims) do not prefer to pay for insurance against these kind of injuries, fully compensatory tort awards for nonmonetary injuries may be inefficient. Survey evidence is consistent with this view (Calfee and Winston, 1993). Many point to pain-and-suffering damages as a primary source of inefficiency in the current system (for example, Danzon, 1984; Calfee and Rubin, 1992; A. Schwartz, 1988). One proposed remedy is to eliminate tort damages for nonmonetary injuries (thereby eliminating the insurance inefficiency) while requiring that firms pay a fine to the state equal to the amount needed for efficient deterrence (Shavell, 1987; Polinsky and Che, 1991). Eliminating pain-and-suffering damages within the current system is unlikely to be efficient, however. The absence of widespread first-party insurance for these injuries does not necessarily indicate a lack of consumer demand, but could stem from supply-side problems related to the cost of moral hazard and adverse selection (Croley and Hanson, 1995). Moreover, the analysis which shows that pain-and-suffering damages are inefficient unrealistically assumes that there is no deterrence value to the tort award; that consumers are optimally insured against all other tortiously caused injuries; and that sellers are forced to internalize the cost of all tortiously caused nonmonetary injuries. Revising the analysis to account for more realistic assumptions shows that pain-and-suffering tort damages in the current system could be efficient if courts were to instruct juries on how to calculate the appropriate award, which is based on consumer willingness to pay to eliminate the risk (Geistfeld, 1995b).
21. Punitive Damages Punitive damages have become a focal point in the debate over products liability reform in the United States, even though they are awarded infrequently
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(Daniels and Martin, 1990; Rustad, 1992). Punitive damages can be efficient when victims with valid legal claims do not sue, enabling sellers to escape liability in some cases (Cooter, 1989a). For example, if only 50 percent of all victims sue, compensatory damages must be doubled if the seller is to internalize the full cost of injury. Punitive damages can also be used to deter sellers from sending misleading signals of product quality (Daughety and Reinganum, 1997). The optimal adjustment to the compensatory damages award can be positive or negative, however, because it depends upon a variety of other factors such as the possibility of court error (Polinsky and Shavell, 1989), the impact of litigation costs on social welfare (Polinsky and Rubinfeld, 1988), insolvency (Knoll, 1997), and risk aversion (Craswell, 1996). It is doubtful that punitive damage awards are set on the basis of these economic considerations, as juries typically are given little or no instruction on how to compute the appropriate award. It is also doubtful that punitive damages are awarded when it would be efficient to do so (American Law Institute, 1991b, pp. 243-248). The legal standards governing the availability of punitive damage awards have been substantially, if not wholly, influenced by intentional torts (for which punitive damages were available under the early common law). These standards create problems in the products liability context, where the critical issue is not whether the manufacturer’s actions were deliberate (they usually are), but whether the manufacturer knew it was selling a defective product. By focusing on deliberate conduct rather than on the seller’s awareness of defect, the inquiry can easily lead to unwarranted punitive damages. If hindsight shows that the manufacturer erred in concluding that the cost of a safety improvement outweighed the benefit of risk reduction, then even if the manufacturer thought the product was optimally safe, the legal standard for punitive damages may be satisfied. In choosing not to decrease risk out of cost concerns, the manufacturer engaged in ‘wanton’ or ‘wilful’ conduct that ‘consciously disregards the rights or safety of others’. Any type of cost-benefit balancing involving the risk of injury therefore might be subjected to punitive damages, so manufacturers in design-defect cases often are unwilling to admit that they made safety decisions on the basis of cost considerations (G. Schwartz, 1991a). This is a perverse result given that the legal test for design defects relies on cost-benefit balancing, and indicates that the punitive damages standard undermines the accuracy of legal determinations of design defect.
22. The Enforceability of Contractual Waivers of Seller Liability Contract terms that disclaim a seller’s liability for product defects ordinarily are not enforceable unless the disclaimer pertains to cases in which a product damages itself, causing economic loss such as lost profits, but does not cause
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personal injury or damage to any other property. Contracting probably is a more efficient way to allocate these damages (‘economic losses’), because buyers have better control over and information regarding the magnitude of loss (Jones, 1990). Moreover, allowing sellers to disclaim liability for economic loss is unlikely to have significant deterrence effects, as the seller remains liable for any physical injury or property damage caused by the product defect. In some jurisdictions, sellers can also disclaim liability for physical loss if the buyer is a commercial party. These buyers tend to be sophisticated and knowledgeable about the consequences of risk allocation, so contracting in these situations is more likely to be efficient. A number of scholars argue that it would be efficient if courts were to enforce a greater variety of contractual limitations of seller liability (for example, Epstein, 1989; Rubin, 1993). But unless the contracting process is structured to give consumers risk-related information, these proposals raise the same safety-insurance tradeoff presented by any proposal to limit a seller’s tort liability. One way contracting can increase risk-related information is if the enforceability of a disclaimer is conditioned on the requirement that the seller provides a separate price quotation of its liability costs under a rule of strict liability. Such a price tells consumers something about the product’s safety and enables them to compare safety across brands (Geistfeld, 1988; A. Schwartz, 1988). Nevertheless, imperfectly informed consumers are still likely to disclaim seller liability when it would be inefficient to do so (Geistfeld, 1994). Giving consumers the opportunity to sell their ‘unmatured tort claims’ to third parties also has interesting possibilities (Cooter, 1989b; Choharis, 1995), although this reform may also lead to inefficient reductions in seller liability (A. Schwartz, 1989a). But even though these proposals do not resolve the regulatory problem, measures like them that enhance information and facilitate contracting are a promising approach to efficient reform (A. Schwartz, 1995).
23. Directions for Future Research It is commonplace to say that more empirical research is needed, but developments over the past decade provide a good opportunity for studying the relationship between tort liability and injury rates. Prior empirical studies of this issue suffer from the common problem of being unable to adequately define when seller liability expanded by an amount significant enough to be captured by statistical analysis. The evolutionary nature of common-law change makes such a definition elusive. The change in liability standards has been more abrupt since the mid-1980s, however, as the insurance crisis has spawned numerous reforms that limit seller liability. Because these widespread reforms occurred over a short period of time and were the result of legislative
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enactment, the timing of the change in liability can be readily defined, which should make it easier to uncover any statistical relationship between seller liability and injury rates. Regarding issues amenable to theoretical analysis, it would be useful to discover whether prices signal product safety under market conditions that are more realistic than those previously studied. A pressing issue concerns the relationship between liability and innovation, which relative to its importance is the most understudied aspect of products liability. There are also a number of products liability doctrines that have not been subjected to rigorous economic analysis. For example, an issue of present concern relates to the conditions under which suppliers of raw materials should be liable for injuries caused by the final product. Those who grapple with the issue have done so largely without the benefit of economic analysis, making it difficult to understand how lawmakers could place much reliance on efficiency considerations in deciding how to resolve the issue. Absent more widespread economic analysis of the range of doctrines that comprise products liability, it seems likely that efficiency considerations will continue to exert an uneven influence on the development of this area of the law.
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Speir, John P. (1990), ‘Efficiency Implications of the Sindell-Rexall Rule’, 10 Cato Journal, 603-607. Spence, A. Michael (1975), ‘Monopoly, Quality and Regulation’, 6 Bell Journal of Economics, 417-429. Spence, A. Michael (1977), ‘Nonprice Competition’, 67 American Economic Review, 255-259. Spence, A. Michael (1978), ‘Consumer Misperception, Product Failure and Product Liability’, 44 Review of Economic Studies, 561-572. Spulber, Daniel F. (1989), Regulation and Markets, Cambridge, MA, MIT Press. Swazey, Judith P. (1991), ‘Prescription Drug Safety and Product Liability’, in Huber, Peter W. and Litan, Robert E. (eds), The Liability Maze: The Impact of Liability Law on Safety and Innovation, Washington, DC, The Brookings Institution, 291-333. Sykes, Alan O. (1989), ‘Reformulating Tort Reform (Book Review of Peter Huber, “Liability: The Legal Revolution and Its Consequences”)’, 56 University of Chicago Law Review, 1153 ff. Symposium (1970), ‘Products Liability: Economic Analysis and the Law’, 38 University of Chicago Law Review, 1-141. Thoman, Lynda (1994), ‘Strict Liability and Negligence Rules when the Product is Information’, 44 Economic Letters, 205-213. Tietz, Gerald F. (1993), ‘Strict Products Liability, Design Defects and Corporate Decisionmaking: Greater Deterrence Through Stricter Process’, 38 Villanova Law Review, 1361-1460. Tirole, Jean (1990), The Theory of Industrial Organization, Cambridge, MA, The MIT Press. Trebilcock, Michael J. (1987), ‘The Social-Insurance-Deterrence Dilemma of Modern North American Tort Law: A Canadian Perspective on the Liability Insurance Crisis’, 24 San Diego Law Review, 929-1002. Trebilcock, Michael J. (1990), ‘Comment (on Viscusi, ‘The Performance of Liability Insurance in States with Different Products-Liability Statutes’)’, 19 Journal of Legal Studies, 845-849. Twerski, Aaron D. (1983), ‘The Role of the Judge in Tort Law: From Risk-Utility to Consumer Expectations: Enhancing the Role of Judicial Screening in Product Liability Litigation’, 11 Hofstra Law Review, 861 ff. US Department of Justice Tort Policy Working Group (1986), Report on the Causes, Extent, and Policy Implications of the Current Crisis in Insurance Affordability and Availability, Washington, DC, Government Printing Office. Venezian E.C. (1975), ‘Insurer Capital Needs Under Parameter Uncertainty’, 42 Journal of Risk and Insurance, 19 ff. Viscusi, W. Kip (1984), Regulating Consumer Product Safety, Washington, DC, American Enterprise Institute for Public Policy Research. Viscusi, W. Kip (1985), ‘Consumer Behavior and the Safety Effects of Product Safety Regulation’, 28 Journal of Law and Economics, 527-553. Viscusi, W. Kip (1986), ‘The Determinants of the Disposition of Product Liability Claims and Compensation for Bodily Injury’, 15 Journal of Legal Studies, 321-346. Viscusi, W. Kip (1988a), ‘Product Liability and Regulation: Establishing the Appropriate Institutional Division of Labor’, 78 American Economic Review. Papers and Proceedings, 300-304.
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Viscusi, W. Kip (1988b), ‘Product Liability Litigation with Risk Aversion’, 17 Journal of Legal Studies, 101-121. Viscusi, W. Kip (1988c), ‘Pain and Suffering in Product Liability Cases: Systematic Compensation or Capricious Awards?’, 8 International Review of Law and Economics, 203-220. Viscusi, W. Kip (1989a), ‘Toward a Diminished Role for Tort Liability: Social Insurance, Government Regulation, and Contemporary Risks to Health and Safety’, 6 Yale Journal on Regulation, 65-107. Viscusi, W. Kip (1989b), ‘The Interaction between Product Liability and Workers’ Compensation as Ex Post Remedies for Workplace Injuries’, 5 Journal of Law, Economics and Organization, 185-210. Viscusi, W. Kip (1989c), ‘Prospective Reference Theory: Toward an Explanation of the Paradoxes’, 2 Journal of Risk and Uncertainty, 235-264. Viscusi, W. Kip (1990a), ‘The Performance of Liability Insurance in States with Different Products-Liability Statutes’, 19 Journal of Legal Studies, 809-836. Viscusi, W. Kip (1990b), ‘Wading Through the Muddle of Risk-Utility Analysis’, 39 American University Law Review, 573-614. Viscusi, W. Kip (1991a), ‘The Dimensions of the Product Liability Crisis’, 20 Journal of Legal Studies, 147-177. Viscusi, W. Kip (1991b), Reforming Products Liability, Cambridge, MA, Harvard University Press. Viscusi, W. Kip (1991c), ‘Product and Occupational Liability’, 5(3) Journal of Economic Perspectives, 71-91. Viscusi, W. Kip (1993a), ‘The Risky Business of Insurance Pricing’, 7 Journal of Risk and Uncertainty, 117-139. Viscusi, W. Kip (1993b), Product-Risk Labelling: A Federal Responsibility, Washington, DC, American Enterprise Institute for Public Policy Research. Viscusi, W. Kip and Hersch, Joni (1990), ‘The Market Response to Product Safety Litigation’, 2 Journal of Regulatory Economics, 215-230. Viscusi, W. Kip and Magat, Wesley A. (1987), Learning About Risk: Consumer and Worker Responses to Hazard Information, Cambridge, MA, Harvard University Press. Viscusi, W. Kip and Moore, Michael J. (1991a), ‘Rationalizing the Relationship between Product Liability and Innovation’, in Schuck, Peter H. (ed.), Tort Law and the Public Interest: Competition, Innovation, and Consumer Welfare, New York, W.W. Norton & Co., 105-126. Viscusi, W. Kip and Moore, Michael J. (1991b), ‘An Industrial Profile of the Links between Product Liability and Innovation’, in Huber, Peter W. and Litan, Robert E. (eds), The Liability Maze: The Impact of Liability Law on Safety and Innovation, Washington, DC, The Brookings Institution, 81-119. Viscusi, W. Kip and Moore, Michael J. (1993), ‘Product Liability, Research and Development, and Innovation’, 101 Journal of Political Economy, 161 ff. Viscusi, W. Kip, Magat, Wesley A. and Huber, Joel (1987), ‘An Investigation of the Rationality of Consumer Valuations of Multiple Health Risks’, 18 Rand Journal of Economics, 465-479. Viscusi, W. Kip, Zeckhauser, Richard J., Born, Patricia and Blackmon, Glenn (1993), ‘The Effect of 1980s Tort Reform Legislation on General Liability and Medical Malpractice Insurance’, 6
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Journal of Risk and Uncertainty, 165-186. Wade, John W. (1983), ‘On the Effect in Product Liability of Knowledge Unavailable Prior to Marketing’, 58 New York University Law Review, 734-764. Wagner, Wendy E. (1997), ‘Choosing Ignorance in the Manufacture of Toxic Products’, 82 Cornell Law Review, 773-855. Ward, John O. (1988), ‘Origins of the Tort Reform Movement’, 6(3) Contemporary Policy Issues, 97-107. Weber, Nathan (1987), Product Liability: The Corporate Response, New York, Conference Board. Weicher, John C. (1981), ‘Product Quality and Value in the New Home Market: Implications for Consumer Protection Regulation’, 24 Journal of Law and Economics, 365-397. Weinrib, Ernest J. (1985), ‘The Insurance Justification and Private Law’, 14 Journal of Legal Studies, 681-687. Welling, Linda (1991), ‘A Theory of Voluntary Recalls and Product Liability’, 57 Southern Economic Journal, 1092-1111. Wheeler, Malcolm E. (1984), ‘The Use of Criminal Statutes to Regulate Product Safety’, 13 Journal of Legal Studies, 593-618. Wilde, Louis L. (1992), ‘Comparison Shopping as a Simultaneous Move Game’, 102 Economic Journal, 562-569. Williams, Stephen F. (1993), ‘Second Best: The Soft Underbelly of Deterrence Theory in Tort’, 106 Harvard International Law Journal, 932 ff. Williamson, Oliver E. (1995), ‘Legal Implications of Imperfect Information in Consumer Markets: Comment’, 151 Journal of Institutional and Theoretical Economics, 49-51. Winter, Ralph A. (1988), ‘The Liability Crisis and the Dynamics of Competitive Insurance Markets’, 5 Yale Journal on Regulation, 455-499. Winter, Ralph A. (1991), ‘The Liability Insurance Market’, 5(3) Journal of Economic Perspectives, 115-136. Wolinsky, Asher (1983), ‘Prices as Signals of Product Quality’, 50 Review of Economic Studies, 647-658. X (1987), ‘Note: Designer Genes That Don’t Fit: A Tort Regime for Commercial Releases of Genetic Engineering Products’, 100 Harvard Law Review, 1086-1105. X (P.M.K. and W.J.S.) (1983), ‘Note: Enforcing Waivers in Products Liability’, 69 Virginia Law Review, 1111-1152.
Other References Binswanger, Hans P. (1974), ‘A Microeconomic Approach to Induced Innovation’, 84 Economic Journal, 940-58. Schmookler, Jacob (1966), Invention and Economic Growth, Cambridge, MA, Harvard University Press. Thirtle, Colin G. and Ruttan, Vernon W. (1987), The Role of Demand and Supply in the Generation and Diffusion of Technical Change, Chur, Harwood Academic Publishers, 173 p.
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Cases Barker v. Lull Engineering Company, 573 P.2d 443 (Cal. 1978) Denny v. Ford Motor Company, 87 N.Y.2d 248 (N.Y. 1995)
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5200 PRICE REGULATION: A (NON-TECHNICAL) OVERVIEW Janet S. Netz Department of Economics, Purdue University © Copyright 1999 Janet S. Netz
Abstract This chapter surveys the literature on various forms of price regulation. After explaining why natural monopolies should be regulated, I describe rate of return regulation, the traditional approach to regulating prices. I then discuss the resulting problems, primarily the incentive of the firm to overinvest in capital. I discuss peak load pricing and Ramsey-Boiteux pricing as regulatory mechanisms for multi-product firms. I then describe more recent attempts to design regulatory mechanisms that are not subject to the types of disincentives associated with cost-based price regulation. These forms of regulation include price-cap and profit-sharing regulatory mechanisms. I also discuss the regulation of networks, where a regulated firm competes with rivals and supplies them with an essential input, generally access to a network. I conclude by describing how regulation has been practiced. JEL classification: L51, K23 Keywords: Price Regulation, Price-Cap Regulation, Incentive Regulation
A. Overview 1. Introduction Economists have long recognized that the market outcome for natural monopolies leaves much to be desired. In particular, price is higher and output is lower than the social optimum. Recognition of this problem, among other issues, has led to a long history of attempts to regulate natural monopolists and to a vast literature discussing the problems of attempts at regulation. (Regulation has been enacted for a variety of other reasons, as well. For example, regulation may be motivated by distribution concerns, as the market outcome for natural monopolies redistributes surplus away from consumers to producers. In other cases regulation may occur at the behest of the firms themselves, who may be seeking protection from too much competition (see Chapter 5000 General Theories of Regulation for a discussion of the political
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and economic forces that have led to regulation). The goal of this survey is to lay out the economic (efficiency) problems caused by natural monopolies, the various forms of regulation that have been attempted, and their economic effects. The chapter is organized as follows. In Section 2, I present the basic issue: that is, why regulate at all? I focus on the natural monopoly problem, though much price regulation occurs outside industries that are natural monopolies. I briefly discuss examples of price regulation that move the outcome towards the social optimum. This section can be skipped by those familiar with the theory of natural monopolies. Perhaps the most widely used early form of price regulation was really rate-of-return regulation, which I describe in Section 3. Though under this model the regulator specifies an allowed rate-of-return, in practice rate-of-return regulation is implemented when the regulator specifies the allowed prices that a regulated firm may charge that the regulator estimates will give the firm the allowed rate-of-return. As summarized in Section 4, Averch and Johnson (1962) show that such an approach to regulation encouraged the utility to overinvest in capital and to expand into other markets in order to increase its rate base and hence increasing the aggregate amount of profits it could earn subject to the regulatory constraint. In Section 5, I describe extensions to the Averch-Johnson model, as well as summarize empirical estimation of these negative effects. In Section 6, I discuss the multi-product regulated firm. While many of the issues discussed in Part B in the context of a single-product firm apply, the fact that firms produce many products complicates regulation. The largest complication arises because of the existence of common costs; that is, costs that are used to produce more than one product. The issue is discussed in Section 7. In Sections 8 and 9. I discuss two of the most common approaches to regulating a multi-product firm, peak-load pricing and Ramsey-Boiteux pricing. I conclude Part by discussing how the resulting price structure can cause the regulatory regime to be unstable (unsustainable.) Regulation theory has more recently focused on designing regulatory mechanisms that do not provide the utility with the adverse incentives described above. In Part D, I consider alternative forms of price regulation that fall under the rubric ‘incentive regulation’, focusing on price-cap regulation in Sections 12 and 13 and on other forms of incentive regulation such as profitsharing in Section 14. In Section 15 I highlight some of the attempts to compare incentive regulation to other forms of regulation, both in terms of their welfare effects and on the feasibility of implementation. Section 16 discusses the few empirical attempts to measure the impact of incentive regulation. In Part E, I discuss one of the most recent developments in regulation: regulation of access pricing in situations where an incumbent firm provides access to an essential facility, generally a physical network, to rivals. I conclude in Part F by discussing price regulation in practice, including the several recent waves of deregulation.
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I make no claims that this is an exhaustive survey; indeed, in the interests of brevity, many subject areas will be almost completely omitted. Also, because other chapters in this encyclopedia cover the topics, I will omit discussion of: the theory of regulation, or why different forms of price regulation might be implemented (see Chapter 5000, General Theories of Regulation), as well as regulation in particular sectors (see Chapters 5660, Regulation of the Securities Market; 5700, Insurance Regulation; 5850, Regulation of Banking and Financial Markets; 5900, Transportation; 5930, Telecommunications; and 5940, Public Utilities). I attempt to balance discussion of the theoretical work that has been done in the area with empirical analysis of the effect of various types of price regulation mechanisms.
2. The Problem: Natural Monopolies As mentioned above, the market does not achieve production and allocative efficiency if technology is such that the industry structure is one of natural monopoly. In essence, a natural monopoly arises if technology and demand are such that it is cheaper for one firm to serve the market than for several firms to serve the market. (See Panzar, 1989, for a complete, technical discussion of the technology that lead to a natural monopoly. The conditions, especially for a multi-product firm, are considerably more complicated than the simple graph I present. (See Chapter 5400, Regulation of Natural Monopolies for a more complete discussion.) To illustrate the problem, consider Figure 1, which illustrates a natural monopoly arising from economies of scale over the relevant range of production for a firm that sells a single-product. Figure 1 Market Outcome versus Regulated Outcomes
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The average total cost curve (ATC) is shown to be everywhere declining (and hence the marginal cost curve, MC, is beneath the average total cost curve). Thus, the industry is a natural monopoly; any market structure involving several firms would involve the unnecessary duplication of fixed costs. Assume that the firm (and regulator) can charge only a single price; that is, price discrimination is not allowed. If the firm is not regulated, it will maximize profits by setting marginal revenue equal to marginal cost, leading to price PM and output QM. Productive efficiency requires producing at the minimum point of the average total cost curve; clearly the market outcome does not satisfy this condition. Allocative efficiency requires that production occurs where the marginal cost curve crosses the demand curve; again, the market outcome does not satisfy this condition. Relative to the social optimum, social welfare has been reduced by areas A, B, C and D (termed the deadweight loss). Price regulation can theoretically lead to the social optimum if regulators specify that price be set equal to PE, where the E subscript denotes ‘efficient’. (However, price regulation is not the only solution. See, for example, Demsetz, 1968, and Williamson, 1976, who discuss how competition for the market, rather than within the market, can lead towards the social optimum.) Then allocative efficiency is met. The outcome has moved towards productive efficiency; pure productive efficiency cannot be achieved simply because demand is not of sufficient magnitude for production to occur at the minimum average total cost curve. However, a firm that charges PE and produces at QE will not generate sufficient revenue to cover costs of production; in particular, the firm will be short by the amount of its fixed cost. Thus, the regulator must alter the regulatory mechanism in order that the firm remains in the market. To ensure that the market is served, the regulator might offer the firm a subsidy equal to its fixed costs. (The general equilibrium effects of the scheme used to raise the subsidy may distort other markets, so that efficiency in the regulated market may obtain at the expense of inefficiency in other markets.) (If a natural monopoly arises via subadditive costs as defined in Panzar, 1989, but without economies of scale over the entire range of production, then marginal cost pricing would not require a subsidy.) If provision of a subsidy is not politically feasible, the regulator may alternatively specify that the firm charge PF, the price where the average total cost curve crosses the demand curve (the F subscript indicates ‘feasible’). At this price the firm charges the lowest price possible, subject to the constraint that it cover all costs. This regulatory mechanism increases social welfare by areas A, B and C, relative to the market outcome. Society is still losing area D, but this may be acceptable relative to the political cost of providing the firm with a subsidy equal to the firm’s fixed costs. A variety of other pricing schemes are available that may be feasible and may succeed in achieving the social optimum. In general, these pricing
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schemes relax the assumption made above that the firm can charge only a single price. Consider, for example, an alternative scheme that may be available if price discrimination is allowed. The regulator could require the firm to sell at price PF to those consumers who are willing and who can afford that price, and charge PE to those customers who are willing and who can afford PE but not PF. Revenues earned from customers paying PF will cover the variable costs of serving them and all of the fixed costs; revenues earned from customers paying PE would cover the variable costs of serving them. Of course, a practical problem immediately arises. How could the firm classify consumers into the two pricing categories? No consumer would willingly admit that she was willing to pay the higher price. Furthermore, the product must be one that cannot be resold. If it could, then even if the firm could distinguish between types of consumers, the consumers facing the lower price would buy and resell to the consumers facing the higher price. Price discrimination can be adopted only in situations where the firm can identify customers by type and can prevent resale of the product. Alternatively, consider that a firm may charge different prices for different amounts of the good purchased. A common such scheme, called a two-part tariff, is one where each customer pays a monthly fixed price for access equal to the total fixed costs divided by the total number of customers and then the customer pays an additional fee equal to the marginal cost for each unit consumed. The fixed fee covers the fixed cost of operation and the per unit fee covers variable costs. Since total revenues cover total costs, the firm would not require a subsidy. This pricing scheme is efficient only if consumer surplus, which is the value the consumer places on consuming the product less the cost the consumer must pay, for the consumer with the smallest demand is greater or equal to the fixed price. Otherwise some consumers will exit the market, in which case the scheme does not achieve the social optimum. Other types of non-linear pricing exist, as well, which may or may not achieve, or have the objective of achieving, efficiency. For example, block pricing, where consumers pay one price for the first block of the product that they use (say, the first 500 kilowatt hours of electricity used), then a different price for the second and subsequent blocks. Standard or declining block pricing refers to declining prices for subsequent blocks, inverted block pricing refers to increasing prices for subsequent blocks. (Block pricing of either kind is a common feature of gas, electricity and water price structures.) If used alone, a declining block pricing scheme optimally charges a price on the first block sufficiently high to cover the fixed costs of operation and charges a price equal to marginal cost on subsequent demand. (This is simply a variation of the scheme described above where some consumers pay PF and some pay PE.) Alternatively, block pricing can be used in conjunction with a fixed fee of the type discussed above. In a declining block pricing scheme, efficiency may be
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enhanced over the two-part tariff described above if the two-part tariff has a sufficiently high fixed fee so as to induce some consumers to exit the market. In a declining block pricing scheme with a fixed fee (that is, a multi part tariff), the higher price on initial units can be used to reduce the fixed fee, which increases efficiency by inducing more customers to remain in the market. Inverted block pricing is incompatible with efficiency, and is generally adopted to redistribute income (as in many developing countries; Maddock and Castano, 1991, study the effects of the inverted block structure adopted in Medellin, Colombia for electricity rates on redistribution, the stated objective of the policy, and find that the policy is effective at redistributing income, though of course at a cost to efficiency) or to encourage conservation (as in several municipalities in California for water during the droughts of the 1980s; some succeeded in reducing demand so successfully that they were forced to raise rates in order to generate sufficient revenue to cover costs!). See Train (1991) for a full description of block pricing. In sum, price regulation of some form can increase social welfare relative to the market outcome. It is theoretically possible to achieve the social optimum, where the marginal cost and demand curves cross, though in practice it may only be possible to move towards the social optimum, not to achieve it.
B. Rate-of-return Regulation and its Problems, or the Unintended Consequences of Regulation 3. Introduction to Rate-of-return Regulation Price regulation, as practiced in the US, has often involved rate-of-return regulation. Under such regulation, the regulatory agency sets prices in such a way that the utility earns the allowed (‘fair’) rate-of-return on its investment. While this form of regulation is seemingly simple, and seems as if it would achieve feasible average cost prices, in practice average cost prices are not achieved because the regulatory mechanism gives the firms an incentive not to minimize cost. (In the simple analysis presented above, a competitive rate-ofreturn to the utility was built into the average total cost curve, as total costs must include an adequate return on investments. Thus, average cost pricing at PF is an example of rate-of-return regulation, where the allowed rate-of-return is equal to the competitive rate-of-return.) Before turning to the effects of regulation, I briefly describe the institutions that were adopted in the US to implement regulation (see Kaserman and Mayo, 1995, for a detailed description of the regulatory process). While historically most other countries chose public ownership as the common method for controlling natural monopolies, the US generally chose to separate the
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ownership of the firm from the government agencies that regulated them. (Utilities that serve the majority of demand are investor owned. Typically utilities are granted a franchise (monopoly) over a geographic area, and are subject to regulation.) Because of the movement towards privatization worldwide, the structure of the regulatory bodies may be of more general interest as other countries establish regulatory agencies to oversee newly privatized firms. In the US, local (retail) electricity and natural gas distribution, local phone service, and private water systems (this last is the most commonly municipally owned utility in the US), are regulated by an independent state public utility commission or PUC. (Long-distance phone rates (until very recently) and wholesale electricity and natural gas transactions are regulated in a similar manner, but by a federal agency, since under the US Constitution interstate transactions fall under the purview of the federal government.) State PUCs consist of from one to seven commissioners, who may be appointed (most commonly) by the governor with legislative approval or elected, depending on the state, and a professional staff. Prices are set to allow utilities to earn a fair rate-of-return on their capital investment. (The level and structure of prices may also be set to accomplish other goals, such as subsidizing some consumer groups over others.) Rulings by the US Supreme Court mandate that state PUCs provide regulated firms with a fair rate-of-return, whatever the PUCs other goals in setting prices may be. In Smyth v. Ames (169 US 466, 1898), the Court stated that ‘The company is entitled to ask for a fair return upon the value of that which it employs for the public convenience’. At the same time, the Court ruled that consumers deserved protection, as well: ‘while the public is entitled to demand ... that no more be extracted from it ... than the services are reasonably worth’. The Supreme Court ruled further in Federal Power Commission v. Hope Natural Gas Co. (320 US 591, 1944) that regulated firms are entitled to a ‘just and reasonable’ rate-of-return, so that the firm is able ‘to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risks assumed’. In order to set the price structure to generate the fair rate-of-return, the PUC first determines the utility’s revenue requirement, which consists of the sum of operating expenses, current depreciation, taxes, and the allowed rate-of-return times the rate base. The rate base is the value of assets, often measured as the original cost of equipment less accumulated depreciation. (This measure has the advantage of being easy to calculate, though a variety of other methods are used, often involving the replacement cost of capital.) The rate-of-return must be chosen high enough to raise capital, but low enough to prevent the use of market power. The PUC then forecasts demand and, based on the revenue requirement and the quantity forecast, the agency stipulates the prices that the regulated firm is
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allowed to charge. Often the utility proposes a rate structure and, based on information from a ‘test year’, typically the latest year for which the necessary data are available, demonstrate that the price structure would yield the revenue requirement. Ex post, depending on the rate-of-return actually earned by the utility, the firm or consumer groups or the regulatory agency may request or undertake a rate hearing to alter prices if the earned rate-of-return deviates substantially (in either direction) from the allowed rate-of-return. In addition, the staffs of the commissions often periodically monitor the firms’ performance, in which case they may request that the commission hold a new rate hearing. The method used to gather information and to decide new rates is rather like a court hearing. A variety of groups may give testimony, including the commission staff, the firm, consumer groups and rival firms. In some states consumers are formally represented at regulatory hearings by the Office of Public Utility Counsel. A rate hearing consists of the presentation of evidence to the commission. There are formal rules of procedure à la a judicial proceedings. The commission announces a hearing, then publishes the rules of discovery (that is, the rules by which parties are granted access to the factual data of other parties) and a timetable for the hearing. Typically, first the utility is required to file written testimony supporting its rate change. Then, typically 30 to 90 days later, other parties (rivals, consumers, and so on) are allowed to present testimony supporting or opposing the utility’s proposed rate change. Rate hearings often have two phases, the first determining the revenue requirement and the second designing the rates that will allow the utility to earn the revenue requirement. One area of contention regards costs incurred by the utility. Operating expenses are typically non-controversial. However, as shown in the next section, regulated firms have an incentive to invest in capital beyond the efficient level. Thus, public utility commissions determine whether costs, typically capital costs, are prudent. Typically, a firm that is expanding capacity will construct the new plant, and only once the construction is completed will the rate base change. If the new capital was automatically added to the rate base, then firms may have the incentive to invest in plants that are bigger than necessary in order to inflate the rate base and increase profits. Regulators have the authority to determine the prudence of expenditures on addition to capital. Prudence is determined by whether the capital is necessary to provide the service and whether it is cost effective relative to alternatives. The fact that capital investment may be disallowed encourages the firm to invest wisely. (Most states have to authority to require advance approval of capital budgets; yet even with advance approval, there is no guarantee that the investment will be allowed into the rate base.) The most commonly used example of disallowances involves the building of nuclear power plants. Public Utility Commissions have in fact allowed several utilities to go bankrupt as a result of
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disallowances.
4. The Averch-Johnson Model Averch and Johnson (1962) model the regulated firm as seeking to maximize profits subject to a constraint on the earned rate-of-return, and show that if the regulated rate-of-return is higher than the cost of capital (it must be equal to or higher than the cost of capital if the firm is going to produce at all), then the regulated firm (1) will not minimize costs and (2) may expand into other markets, even if it operates at a loss in these markets, and hence may drive competitive firms out of the market (or discourage them from entering). The firm will not minimize cost because, so long as the regulated return on capital is higher than the cost of capital, the firm makes a profit for each additional unit of capital. (Indeed, Baron, 1989, points out that the regulated firm would like the price to be set as low as possible, to increase the quantity sold. That gives the firm the opportunity to employ as much capital as possible, and every additional unit of capital employed gives the firm a profit.) This gives the firm an incentive to invest more in capital than is efficient given the actual cost of capital relative to other input prices. Consider, for example, an unregulated firm. This firm will, for each quantity produced, combine labor and capital (assuming these are the only inputs) in such a way that the last dollar spent on labor gives the same output value as the last dollar spent on capital. That is, each input is used until the cost of the last unit employed is equal to the revenues that can be earned with that input’s output. A regulated firm, on the other hand, not only earns revenues by selling the output produced by capital, but also on the capital itself. Hence, each unit of capital provides higher revenue to a regulated firm than to an unregulated firm, encouraging the regulated firm to employ a larger amount of capital than will an unregulated firm. The regulated firm then uses too much capital relative to labor, producing at higher than minimum cost. The degree to which a firm overcapitalizes depends on its ability to substitute between inputs. The more substitution the technology allows, the more inefficient a firm will be. Now consider a multi-product firm that may operate in several markets, assuming that the regulatory body allocates at least some of the capital used for production in the other markets to the firm’s rate base (as was commonly done in practice, given the problem of allocating common costs; see Section 7). Based on the same logic described above, the firm has an incentive to increase its use of capital, and now may do so in other markets. Suppose that in its initial market the regulated firm has invested in the optimal (from its point of view) amount of capital. The firm now considers investing in additional markets. As an extreme, suppose that this firm is not competitive in another
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market: that is, its costs are above rival firms. Then it will lose money on each unit that it sells in the market. However, suppose for each unit of capital that it uses to produce the profit- losing product, it earns revenue because it loosens the rate-of-return constraint. Then the firm will operate in the new market until the extra revenues earned per additional unit of capital are offset by the cost of capital, other inputs, and the loss from sales of the product. That is, a firm will operate in a second, non competitive market, so long as (s1! r2) x2, where s1 is the allowed rate-of-return in the original market, r2 is the cost of capital in the other market, and x2 is the amount of capital used in the other market that is allowed into the rate base, is less than the losses from operating in the market. (Averch and Johnson, 1962, argue that the descriptive evidence suggests that AT&T behaved along the lines predicted by their model in terms of both overinvesting in capital and moving into other markets.) Thus, not only will the firm’s input use be distorted in the regulated market, but inefficiencies can spill into competitive markets as competitive firms are driven out of business or are prevented from entering markets in which they have lower costs. (Braeutigam and Panzer, 1989, examine this issue more rigorously, arriving at the same conclusion.) In sum, rate-of-return regulation as practiced provides firms with the incentive to overinvest in capital, both in the regulated market itself, and by inefficient diversification into other markets.
5. Extensions, Reinterpretations and Tests of the Averch-Johnson Model The Averch-Johnson model led to a variety of work applying the basic idea to other settings. One intellectually unappealing aspect of the Averch-Johnson model is the fact that the regulator does not recognize the firm’s strategic response and hence modify the regulatory mechanism to mitigate the capital disincentives. Baron (1989) recasts the Averch-Johnson model in terms of a mechanism adopted to deal with the regulatory body’s incomplete information on the firm’s costs or on demand. If the regulator could observe the production function and factor prices, the regulator could set price equal to the efficient marginal cost (that is, the marginal cost that arises from the optimal use of capital relative to labor), thus eliminating the production inefficiency. However, suppose that the regulator does not observe the production function and/or factor prices. Then in essence, the regulator adjusts price as a function of the cost incurred by the firm. In Baron’s view, the Averch-Johnson outcome is plausible in a setting where the regulator and the firm have different information about costs and demand or the regulator cannot observe all actions of the firm. In such a setting, the Averch-Johnson approach could arise endogenously. Along similar lines, Woroch (1984) analyzes investment by firms using a non cooperative model of the firm regulator relationship, and
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allows the regulatory mechanism to arise endogenously as well. He allows firms to invest strategically. Woroch finds that achieving ‘credibility’ of regulation, which requires that the regulator issue a welfare maximizing response to the capital investment, may lead to an outcome that is indistinguishable from the Averch-Johnson model. In other words, the AverchJohnson model may be recast in different, perhaps more plausible, frameworks, but the disincentives caused by regulation may still arise. Bailey and Coleman (1971), Baumol and Klevorick (1970), Bawa and Sibley (1980), Davis (1973), Klevorick (1973) and Logan, Masson and Reynolds (1989) extend the Averch-Johnson model to incorporate regulatory lag. These authors recognize that, in practice, rate hearings occur with a lag after a change in cost or demand. Under regulatory lag, a firm can appropriate increased profits from cost reduction for the time period between the innovation and the rate hearing (and likewise, the firm absorbs any losses). This reintroduces to the firm the incentive to reduce costs, though the incentive is not as large as it would be if the firm appropriates gains from cost reductions forever. Encinosa and Sappington (1995) and Lyon (1991, 1992) examine a firm’s incentive to over- or under-invest in capital under a situation where regulators review a firm’s capital investments and can (and do) disallow some capital expenditures. The Averch-Johnson model was based on a more certain environment where the firm knows that it will earn the allowed rate-of-return on its entire capital investment. More recently, regulatory agencies have become tougher in allowing capital expenditures into the rate base. It has been typically accepted that regulatory hindsight, especially if regulators punish bad ex post outcomes rather than bad ex ante decisions, will lead to underinvestment in capital. Lyon (1991), on the contrary, finds that hindsight review can be used to reduce the firm’s tendency to build large, risky projects, moving the firm closer to the cost-minimizing input choice. In addition, Encinosa and Sappington (1995) find that rewards as well as penalties are optimal. Lyon (1992) examines prudency reviews in the context of contracts for variable inputs, and finds that prudency reviews will cause a firm to increase its capital stock and to rely more heavily on spot market purchases for variable inputs; while the firm earns lower profits, the welfare effects on consumers are ambiguous. The Averch-Johnson model has also been included a dynamic setting including adjustment costs of investment. For example, El-Hodiri and Takayama (1981) show that the long-run level of capital stock increases when a rate-of-return constraint is imposed. Moretto (1989) adjusts the AverchJohnson model in two dimensions: to incorporate an adjustment cost approach to investment and to allow for uncertainty over the revenue function. The Averch-Johnson effect may not obtain; it holds only when the rate of growth of the marginal adjustment cost is concave. In contrast to El-Hodiri and Takayama (1981) and Appelbaum and Harris (1982) but along the lines of
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Moretto (1989), Dechert (1984) adopts a dynamic adjustment-cost model and finds that underinvestment may obtain, in contrast to the Averch-Johnson overinvestment result. The factor driving is result is whether a firm is operating in the increasing return or decreasing return portion of average cost. (This holds for the static Averch-Johnson model as well.) Dechert (1984) argues that natural monopolies arise under economies of scale, in which case profits are not concave, at least not over the entire input range; in contrast, other Averch-Johnson models assume concavity of the profit function. (Note, however, that natural monopolies can obtain outside the increasing returns portion of the average total cost curve; see Panzar, 1989, for an explanation.) The importance of whether costs are increasing or decreasing may explain the mixed empirical evidence regarding the Averch-Johnson model. A fair bit of empirical work has been done trying to test the Averch-Johnson model, mostly focusing on electricity production. The results of these tests have been mixed. Nemoto, Nakanishi and Madano (1993) find that seven of nine Japanese electric utilities do significantly overinvest, while Tawada and Katayama (1990) find much weaker support for the Averch-Johnson effect in the same industry. Indeed, they find that production was efficient in some time periods, despite the form of regulation. In the US, Courville (1974), Hayashi and Trapani (1976)and Spann (1974) all find support for the Averch-Johnson effect in electric utilities. Hayashi and Trapani (1976) also find that tightening regulation increases the distortion. Boyes (1976), on the other hand, does not find support for the Averch-Johnson effect, also using data on electric utilities in the US. Hsu and Chen (1990) find empirical evidence of the presence of an Averch-Johnson effect for the Taiwan Power Company. Oum and Zhang (1995) find empirical support for the hypothesis that the introduction of competition in the US telephone industry induces incumbents subject to rate-ofreturn regulation to use capital closer to the optimal level, reducing the AverchJohnson effect. Thus, theoretical models support the Averch-Johnson findings of a tendency towards overinvestment in capital by firms subject to a rate-of-return constraint, though introducing some modifications of the framework in order to make it more realistic, such as regulatory lag and cost disallowances, mitigates the overinvestment effect to some extent. There is somewhat more empirical support for the Averch-Johnson effect than against it. As I will discuss in Part D, the form of regulation has changed a great deal, much of it in response to the debate over the Averch-Johnson overcapitalization effect in the face of rateof-return regulation.
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C. The Multi-product Regulated Firm 6. Introduction to Multi-product Issues The discussion thus far has focused on a single-product firm (except during the discussion that a regulated firm has an incentive to enter other markets in order to increase its rate base). In reality, of course, most regulated firms produce a variety of products. Even in the case of a single commodity, say electricity, it is more proper to think of the firm providing electricity during certain time periods. In other words, the market for electricity during the day is separate from the market for electricity during the evening and night-time. Before discussing various price mechanisms for regulating the multi-product firm, an important concept must be addressed: how to allocate common costs, that is, costs common to production of several products, to individual products? (If the goal of regulation is to maximize social welfare, that is, to achieve allocative and productive efficiency, separating costs across services is meaningless. It is generally done by regulators, however, when they have an interest in the distribution of surplus across groups; that is, regulators often desire to determine whether a given customer group is covering the costs of servicing them.) After describing the problem, I discuss two of the more commonly used regulatory mechanisms, peak-load pricing and Ramsey-Boiteux pricing.
7. The Common Cost Problem Consider an example, following Braeutigam (1989), where a firm produces two products with constant marginal costs of m1 and m2 and has total fixed costs F, giving a simple total cost function of TC = F + m1 y1 + m2 y2 . Analogously to the discussion of a single-product firm, the social optimum requires that each product be priced at its marginal cost; however, the firm will then not earn sufficient revenues to cover costs. Recall that a simple solution in the singleproduct case was to require that the firm price at average cost. The problem here is that the calculation of the average cost for each product necessitates a division of the fixed costs across the two products. While infinitely many ways exist to divide the fixed costs, some will lead to higher levels of social welfare than others. Thus the more interesting problem is how to allocate fixed costs in the optimal manner. In practice, a variety of weighting schemes have been used, including weighting by gross revenues, by physical output levels, or by directly attributable costs. (Directly attributable costs typically include all variable costs, and may also include some portion of fixed costs, if some fixed costs are associated with the production of only one of the products.) Alternatively,
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sometimes the Allais rule is used, where marginal cost proportional mark-ups are used, with the mark-up being determined in such a way as to raise sufficient revenue that the firm breaks even. Attributing costs in this manner is typically referred to as fully distributed cost. In practice, once the common cost is assigned to the different outputs, prices are set so that revenues from each output cover costs. There are several problems with this approach to dividing costs for a multiproduct firm, including the fact that such division is inherently arbitrary and, from an economic point of view, not very sensible. As summarized by Laffont and Tirole (1996), the drawbacks include the fact that, since it is cost-based, firms do not have a strong incentive to minimize costs; that the price structure is inappropriate as prices are too low for inelastic demand services and too high for elastic demand services (see the discussion of Ramsey-Boiteux pricing in Section 9); that it does not use non-linear pricing; and that some forms encourage inefficient entry. Economists have developed several pricing approaches to maximize social welfare given the constraint that the multi-product firm must break even. These pricing schemes do not require allocation of common costs. (Ex post one could calculate the proportion of the common cost that is paid for by each output; however, ex ante the only necessary information needed is the total amount of fixed cost.) I discuss two of the most common methods: peak-load pricing and Ramsey-Boiteux pricing.
8. Peak-load Pricing Peak-load pricing is a particular regulatory mechanism that is appropriate when the firm provides a non-storable good during different time periods and is constrained to choose a single capacity level. (See Crew, Fernando and Kleindorfer, 1995, for a survey on peak-load pricing theory.) Formulating prices for different time periods relates to the common cost problem: optimal prices depend on how much of the capacity cost, a common cost, is allocated to each time period. Consider the following simple model. A production period (a day or year) is divided into T equal increments. During each period t, xt units of a variable input are used. Let K denote the total amount of capital used. K is the common cost, the cost of the production facility that operates in all periods. Let yt = f(xt,K) represent the production function, and let Pt = Pt(yt) denote the inverse demand curve (the notation and example are based on Braeutigam, 1989). Steiner (1957) assumed that the production function was Leontief; in other words, yt = min(xt, K), where, for notational simplicity, I have assumed one unit of capital and one unit of the variable input produce one unit of output. (The qualitative results hold for an fixed proportion of capital to the variable
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input.) Let the cost of the variable input be given by b, and let ß be the rental cost of capital. Assuming that the firm is constrained by the regulatory authority to meet demand in all periods, it will choose capacity to equal the maximum amount demanded. Then the total cost function can be written as T
TC = b ∑ yt + β max yt t =1
In other words, total cost is equal to the cost of the variable input times the total amount of the variable input used in all time periods plus the rental cost of capital times the maximum output produced in any period. The social optimum requires that price be set equal to marginal cost in each period. Based on the total cost function, this means that the price in every nonpeak period is optimally set equal to the cost of the variable input, Pnon-peak = b. (Marginal cost in a non-peak period is given by dTC/dyt = b, the derivative of the first term in the cost function, since the second term does not contain output in any period except the peak period.) Price in the peak period is set equal to the cost of the variable input and the cost of capacity, Ppeak = b + ß. In other words, consumers during the peak period are responsible for both their variable costs and total capacity costs. Given that the technology exhibits constant returns to scale, peak-load pricing leads not only to the social optimum, but also allows the firm to earn sufficient revenues to cover total costs, obviating the need for a subsidy. However, Panzar (1976) shows that this result is not robust to changes in technology. Suppose that the production function is given in a general form as yt = f(xt, K), so that the firm can substitute to some extent between the variable and the capital inputs. The production function is assumed to be subject to diminishing returns (that is, increases in either input increase output, but at a declining rate). Let the total variable cost function be written as V(yt, b, K). This function gives the minimum total variable costs required to produce output yt, given input prices b and capacity K. First, pricing in each period is given by Pt = MV/Myt. This condition indicates that price in each period is equal to the marginal variable cost. In this case, prices in off peak periods will not be equal since marginal cost varies with output. For example, suppose that output in period 2 is larger than output in period 1. Given the assumptions on the production function that an increase in inputs increases output at a declining rate, the marginal variable cost will be higher in period 2 than in period 1, and therefore so will the price in period 2. Second, optimal pricing requires that S tt=1 MV/MK =!ß. This condition shows that the firm will choose capital such that the total variable costs saved equals the cost of employing the last unit of capital. The model using Leontief production did not have a second condition, because the firm had no choice in capital. The firm was required to produce enough to satisfy demand in each
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period (a regulatory constraint), and technology was such that satisfying the regulatory constraint dictated the amount of capital used. In the production function used here, the firm can substitute between the variable input and the capital input, choosing the cheapest ratio of the two, depending on their relative prices. Thus, while peak-load optimal prices can be derived from a more flexible production function, it no longer remains true that only the peak consumers pay for capacity costs. However, it remains true that peak-load pricing raises sufficient revenues to cover costs. The existence of uncertainty over demand or supply can complicate the application of peak-load pricing. Koschat, Srinagesh and Uhler (1995) derive peak-load prices when demand in different periods is stochastic and test the implications of the theory using data on local telephone service. They find that ignoring uncertainty in demand can lead to inefficient prices and inefficient industry-wide capacity choices. Perhaps most interestingly, they find that spot pricing of phone calls, so that prices are high during actual congestion rather than during times of expected congestion, can be considerably more efficient. Kleindorfer and Fernando (1993) also consider peak-load pricing under uncertainty in demand, but add to the analysis by considering uncertainty in supply as well, focusing particularly on electricity (where uncertainty in supply is a common problem). In this setting, the regulatory agency must account for a variety of costs that arise when supply and demand do not clear.
9. Ramsey-Boiteux Pricing The peak-load pricing mechanism described above, by assuming constant returns to scale, led to prices that were not only socially optimal, but under which revenues covered costs. Thus, peak-load prices are efficient and feasible. However, without constant returns to scale, marginal cost pricing will not raise sufficient revenue that the firm will cover total costs. As an alternative, Ramsey-Boiteux prices can be used to satisfy the constraints that the firm charge a single price for each product and that the firm raises enough revenue to cover total costs. (Ramsey, 1927, introduced this pricing scheme as an optimal form of taxation that raised the required revenues at the lowest deadweight loss cost. Boiteux, 1956, applied the idea to the determination of regulated prices.) Assuming the demands for the different products are independent, RamseyBoiteux prices are the solution to the following constrained maximization problem, max p CS ( y) + p ⋅ y − C( y, w ) s.t. p ⋅ y − C( y, w ) ≥ 0,
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where CS(y) is consumer surplus as a function of the entire output vector y; p is the price vector; and C(y, w) is total cost as a function of outputs and the vector of input prices w. The social planner (regulator) maximizes social welfare, defined as the sum of consumer surplus and firm profits, subject to the constraint that profits be non negative. Solving the maximization problem leads to the following relationship:
p i & Cy pi
i
eii '
p j & Cy pj
j
ejj,
œ i, j,
where Cyi is the marginal cost of product i, pi is the price of product i, and eii is the elasticity of demand for product i. This relationship, one of several formulations of the Ramsey-Boiteux pricing rule, shows that optimal prices are such that the price-cost margin multiplied by the product’s elasticity of demand be equal across all products produced by the firm. Thus, the price of the more inelastic good is higher than the price of the elastic good. How is it that prices set according to this pricing rule maximize social welfare, subject to the constraint that firms earn zero economic profits? (Dierker, 1991, formally proves that Ramsey-Boiteux prices are second best prices.) First, note that maximizing social welfare is equivalent to minimizing the deadweight loss. Then the optimality of Ramsey-Boiteux pricing can best be explained graphically. Figure 2 illustrates two related markets. In the upper panel, the firm is constrained to set the same price in each market. Price P is chosen such that the areas A and B equal the fixed costs faced by the firm, so that the firm just breaks even. In the lower panel, the firm is allowed to choose separate prices for each market, and the areas C and D also add up to fixed costs. The shaded areas in both panels are the deadweight loss arising from the fact that price deviates from marginal cost. The two shaded areas in the lower panel are in sum smaller than the two shaded areas in the upper panel, reflecting the fact that the prices chosen in the lower panel minimize the deadweight loss. Intuitively, this comes about because demand in the left panels is inelastic; thus, price can be increased in this market with a relatively small deadweight loss, since as price rises, demand does not decline too much. On the other hand, increasing price in the right panels where demand is elastic induces a large decline in quantity, and hence a large deadweight loss.
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Figure 2 Deadweight Loss with a Single Price (top panel) Deadweight Loss with Ramsey-Boiteux Prices (lower panel)
The description of Ramsey-Boiteux pricing presented above assumes that demand for the two products be independent. This may be an overly strong assumption, but the approach can be extended to the case where demands for the products are interdependent; see, for example, Dreze (1964), Rohlfs (1974) and Zajac (1974b). In this case, one must take into account the cross partial derivatives; that is, the impact of the price of one good on the quantity demanded of the other good(s). Dreze (1964) derives the Ramsey-Boiteux pricing rule when demand is not interdependent, and arrives at a pricing rule similar in form to that above. More precisely,
p i & Cy pi
i
(ei & eji) '
p j & Cy pj
j
(ej & eij),
œ i, j,
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where eij is the elasticity of good i with respect to the price of good j. In essence the net elasticity, ei ! eji, gives the effect of i’s price on its own demand less the effect on demand for the other product. (Note that this form of the RamseyBoiteux pricing rule reduces to the original form if the cross elasticities are zero. An alternative formulation of the Ramsey-Boiteux rule when demand is interdependent involves ‘superelasticities’, which account for substitution and complementarity among goods. See, for example, Laffont and Tirole, 1993.) Ramsey-Boiteux prices have also been derived in more complicated settings. For example, Horowitz, Seeto and Woo (1996) assume that costs are unknown to both the regulator and the firm. Passmore (1984) assumes demand is uncertain and that the firm chooses capacity simultaneously with prices. Berry (1992) incorporates risk in marginal cost. Braeutigam (1979b) incorporates competition in some products produced by the firm. Brock and Dechert (1983) and Braeutigam (1983) extend Ramsey-Boiteux pricing to a dynamic setting. The previous work has assumed that the regulator sets prices. But a Ramsey-Boiteux price structure may endogenously arise when firms choose prices, depending on the regulatory regime. Logan, Masson and Reynolds (1989) develop a regulatory mechanism under which the firm is allowed to choose prices subject to a rate-of-return constraint. Regulators review performance, and there is a higher probability that regulators will request a new rate hearing as the firm’s return deviates from the constrained rate. If regulators do not review negative returns too quickly relative to positive returns, the model predicts that the firm’s prices will converge to RamseyBoiteux prices and that productive efficiency will obtain. The model indicates that relatively simple regulatory mechanisms that do not require much information lead to Ramsey-Boiteux efficient prices. (As discussed in Section 12, price-cap regulation, in some circumstances, also leads firms to choose prices that converge to Ramsey-Boiteux prices.) A number of empirical studies have been undertaken to compare regulated prices to Ramsey-Boiteux prices; that is, to determine whether regulated prices are set at the optimal (from a constrained efficiency maximization point of view) level. Matsukawa, Madono and Nakashima (1993) examine pricing by Japanese electric utilities. They find that the prices do not satisfy the RamseyBoiteux pricing rule, and that moving towards Ramsey-Boiteux prices may require a large increase in residential electricity rates and a slight decrease in industrial electricity rates. Liu (1993) examines local telephone pricing in Taiwan and also finds that prices do not satisfy the Ramsey-Boiteux pricing rule. In the US, DeLorme, Kamerschen and Thompson (1992) find that electricity generated via nuclear power is not priced according to the RamseyBoiteux rule either, but rather that prices respond to political influences. To my knowledge, no empirical study has found regulated prices that conform to the Ramsey-Boiteux ideal. Perhaps the most obvious explanation
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is that regulators have a goal that is different from minimization of the deadweight loss subject to a break even constraint. For example, Sheehan (1991b) argues vehemently that Ramsey-Boiteux pricing is inappropriate for telecommunications regulation, in part because it does not protect ‘captive’ consumers from the use of market power. Friedlaender (1992) considers regulation of a firm that serves two markets, one of which is competitive so that prices are at marginal cost, and one of which is ‘captive’ so that consumers in this market have no alternative supplier. Then the captive sector bears the entire revenue burden. She applies her model to freight transportation by railroad, and shows that the application of Ramsey-Boiteux pricing would cause the price to captive coal shippers to rise to ‘socially unacceptable levels’ since they would be forced to bear the entire revenue requirement. Ashraf and Sabih (1992) extend the Ramsey-Boiteux model to incorporate ‘life-line’ rates (that is, the idea that all households should be able to afford a minimum amount of telephone service) and still find empirically that the pricing structure of electricity in Pakistan deviates from the amended Ramsey-Boiteux prices. Thus, while Ramsey-Boiteux prices have a number of desirable characteristics from a strict efficiency point of view, in practice efficiency and other concerns lead regulators to deviate from them, often to a substantial degree.
10. Non-linear Pricing and Sustainability Non-linear pricing (including two-part tariffs, block pricing, peak-load pricing, and Ramsey pricing) lead to issues of sustainability. That is, given non-linear pricing, can the regulated monopoly continue in existence? Two issues in particular arise: the likelihood of cream-skimming and of bypass. Cream-skimming refers to entry of firms into the high-profit markets served by the regulated monopolist. Without entry, the profits earned in one market are used to ‘subsidize’ prices in another market, either for efficiency reasons as in peak-load and Ramsey-Boiteux pricing or for fairness reasons as in business phone rates subsidizing residential rates. An entrant observes profits to be made in the high-price market, and may be induced to enter that market only. (This is named cream skimming because the entry skims the cream (high profits) and leaves the milk (low profits).) For example, in the US, MCI was interested only in entering the long distance market, from which AT&T was obtaining revenues to keep prices for local calls substantially below cost. (Note that such entry may not be efficient. Price in the high-profit market is above theincumbent’s marginal cost, allowing firms with higher marginal cost, but a marginal cost less than the regulated price, to enter the high-profit market.) In addition, high rates in some markets or during some time periods may
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induce consumers, typically large commercial consumers, to bypass the regulated monopoly and obtain the product elsewhere. (Cream skimming is often characterized as bypass, since, for example, MCI was able to bypass the long- distance network owned by AT&T.) Again, the regulated firm sees a reduction in revenues in the high price market that were used to subsidize rates in other markets. The existence of cream-skimming and bypass combine to make the regulated monopoly less financially viable, since they are deprived of a large source of revenue yet often continue to be obligated by regulators to provide service to at least some segments of the market at low prices. Regulators in such a situation must consider several questions. For example, how much bypass should be allowed? (Recall that regulators often control entry in these situations.) Which firms should be allowed to enter? How should prices be restructured in the face of entry and bypass? The theoretical literature discussing these issues is somewhat limited. Einhorn (1987) considers a case where the potential entrants have access to a bypass technology to which the regulated monopolist does not have access. He shows that the optimal pricing structure involves the monopolist charging a usage price below marginal cost to the largest users, that is, those users most likely to bypass the monopolist. (These consumers still generate net revenue to the firm since they also pay a fixed fee.) Curien, Jullien and Rey (1998) find, similarly to the earlier work, that smaller users are charged a price above marginal cost while larger users are charged a price less than marginal cost. When bypass is regulated, too little bypass occurs, while competitive bypass (that is, free entry) leads to too much bypass. In any case, distributional effects occur, with large users gaining at the expense of either small users or taxpayers, depending on how the loss of revenue is financed (by raising prices to small users or subsidizing the monopoly with tax dollars). Laffont and Tirole (1990a) consider optimal pricing strategies given the possibility of bypass under conditions of asymmetric information. They assume two sources of asymmetric information: that the firm cannot distinguish between high and low demand customers and that the firm has superior knowledge about its technology relative to the regulator. (Einhorn, 1990b, considers asymmetric information only in the latter dimension.) The first assumption prevents a charge to high-demand customers below marginal cost, as arises in Einhorn (1987) and Curien, Jullien and Rey (1998), because the customers cannot be typed, and hence third degree price discrimination is not an option. Laffont and Tirole (1990a) find that bypass should be prevented when the regulated monopolist is efficient, and support the finding of Einhorn (1987) and Curien, Jullien and Rey (1998) that charging high demand consumers a price below marginal cost is optimal since keeping these customers contributes towards covering fixed costs through the fixed fee of a two-part tariff. They also find that low-demand consumers may benefit from
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the possibility of bypass, if bypass constrains the monopolist (that is, the monopolist reduces prices in order to deter entry). Some empirical work has been done that is related to cream-skimming and bypass. One common theme has been regarding natural gas prices in regional markets. For example, De Vany and Walls (1996) and Walls (1994) find that local bypass and access to pipeline transportation lead to natural gas prices that move with field prices, as one would expect due to arbitrage. Parsons and Ward (1995) find that larger long-distance phone companies are more likely to bypass the local phone companies switched services than are smaller long-distance companies. Finally, Donald and Sappington (1995) find that as bypass activity increases, regulators are less likely to adopt incentive regulation (which is discussed in the next section), since bypass activity reduces the gains a regulated monopolist can attain by investing in cost reduction. This concludes the discussion of regulation as traditionally practiced in the US I now turn to the more recent advances in price regulation, where the UK has led the way as it moved from a system of largely nationalized firms to regulated, privatized companies.
D. Incentive Regulation 11. Introduction to Incentive Regulation In large part, the problems arising in the Averch-Johnson model are due to the fact that the regulated firms do not have an incentive to operate at minimum cost. (As discussed in Section A5, a variety of circumstances exist to mitigate the Averch-Johnson effect, such as regulatory lag and prudence reviews. However, while the deviation from cost-minimization may be reduced, in most if not all formulations of rate-of-return regulation it is not eliminated.) Prices are set such that revenues cover operating costs plus the allowed rate-of-return on investment. Thus, any cost savings will be passed on to consumers via a lower regulated price. Similarly, the firm need not worry about rising costs, because those costs will be covered with a higher regulated price. Part of the motivation behind incentive regulation is to provide the firm with the motivation to behave in a manner more consistent with the social optimum (Crew and Kleindorfer, 1996, present an overview of incentive regulation in the UK and the US). One of the earliest forms of incentive regulation, price-cap regulation, was designed to eliminate the cost disincentives other forms of price regulation had caused; an additional benefit arose because price-cap regulation reduces regulatory administrative costs (at least in theory). Thus, any cost savings are, at least in part, retained by the firm, reinstating the incentive of the firm to minimize cost. (On the other hand, because firms have more price flexibility,
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they also have a greater opportunity to exercise market power.) In addition, in a pure price-cap regime, the regulated market is effectively decoupled from other markets, eliminating the inefficient incentives firms subject to rate-ofreturn regulation face in regards to entering markets in which they are not competitive. Finally, price-cap regulation may have added benefits in industries where technology is changing rapidly. Maintaining rate-of-return regulation in such situations is administratively difficult, as the regulator must convene more frequent rate hearings and has less past information on costs on which to base pricing decisions. Price-cap regulation requires less information regarding technological change to implement. (This may explain why telecommunications regulation adopted price-cap regulation more quickly than other industries. Einhorn, 1991a; Mitchell and Vogelsang, 1997; and Sappington and Weisman, 1996a provide comprehensive treatment of incentive regulation in the telecommunications industry.) Price-cap regulation was adopted in the United Kingdom in 1984 to regulate the recently privatized telecommunications industry; the United Kingdom now applies this form of regulation to gas, electricity water, as well as telecommunications. (Beesley and Littlechild, 1989, and Armstrong, Cowan and Vickers, 1994 describe incentive regulation in the United Kingdom.) It has also been adopted for use in the US, primarily in telecommunications, at the state and federal level. By 1993, thirty states had adopted a form of price-cap regulation for some industries, though generally the mechanism included an aspect of profit-sharing, as discussed in Section 14. The FCC plan divided AT&T’s products among three baskets, each subject to a price-cap, in order to reduce or eliminate cross subsidization between the baskets. Several other countries have also adopted this form of regulation, including Australia, France, Hong Kong, the Netherlands, Mexico, Germany, Sweden and Denmark. To give an idea of how price-cap regulation works in general, consider the following scenario. The regulatory agency chooses two values in setting the price-cap. The initial price-cap is chosen, P0; then the regulator chooses an adjustment term, x, so that subsequent price-caps are equal to P0! x. The adjustment term may occur at any point in time specified by the regulator; often it is an annual adjustment. During the time the price-cap is in effect, the regulated firm may either choose a price below or equal to the price-cap. (Note that the firm is granted a high degree of pricing flexibility; in particular, the firm typically acquires substantial flexibility over the structure of prices. Thus, price-cap regulated firms are relatively free to abandon cross subsidies that may have been imposed under rate-of-return regulation. In the US, subsidies to, for example, rural areas, continue in a different form: telecommunications firms are taxed, the proceedings used for direct subsidization, rather than accomplishing subsidization via the price structure.) The firm can request a rate hearing, which it might do, for example, if its costs were higher than the
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price-cap. At some specified point in the future, either price-cap regulation continues with a hearing to establish a new price-cap, or the regulatory mechanism reverts to a rate-of-return approach.
12. Price-cap Regulation Cabral and Riordan (1989) set out a fairly simple model of price-cap regulation. (Vogelsang and Finsinger, 1979, derive a regulatory mechanism that is similar to price-cap regulation.) One of the key assumptions is that marginal cost is a function of an investment in cost reduction, denoted as e (for effort). A lag occurs between the investment in cost reduction and its realization, and the effect of e on cost reduction may be certain or uncertain, so long as higher effort increases the likelihood that marginal cost will fall. Let C denote the firm’s original marginal cost; the price-cap is P0! x and is set below C; and let M(C) denote the unconstrained monopoly price for a marginal cost of C. Then the price actually charged by the regulated firm, which is a function of the price-cap and of marginal cost and is denoted as B(P0! x,C), is equal to max {C, min{P0 ! x, M(C)}. If costs are above the price-cap, the firm asks the regulator for a rate hearing and essentially chooses to revert to rate-of-return regulation. If costs are below the price-cap, but not so low that the price-cap is not binding, then the firm prices at the cap. Finally, if costs are low enough that the monopoly price is less than the price-cap, M(C) < P0! x, then the firm prices at the monopoly price. The firm’s maximization problem with respect to investments in cost reduction can be written as
[(
)
] [(
)]
max e π ( P0 − x, e) = B P0 − x, C( e) − C( e) ⋅ D B P0 − x , C( e) − e,
where D[B] is the demand curve as a function of the price charged by the regulated firm. Cabral and Riordan (1989) derive several illustrative results. First, in the certainty case (that is, when the firm knows by how much marginal cost will be reduced for a given investment e), they show that if the price-cap is too tight, then the firm has no incentive to invest in cost reduction because the return to innovation is too small relative to the cost. Essentially the firm opts for rate-ofreturn regulation. Second, they show that if the price-cap is binding, then an increase in x, that is a tighter price-cap, marginally increases the investment in cost reduction. The increased incentive is caused by the fact that the tighter the price-cap, the more units the firm is selling; the aggregate increase in profits for a decline in marginal cost is higher than it would be for the same decline in marginal cost at a higher price-cap, since at the higher price-cap, a smaller quantity would be sold. In the case of uncertainty (that is, when the firm does not know the cost that will result from a given level of effort e), the results are
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not as tight. They are able to show that for low values of x, the optimal choice of effort increases as does x (that is, a tighter price-cap leads to more cost reduction). In summary, Cabral and Riordan (1989) show that a firm regulated under a price-cap mechanism will have an incentive to invest in cost reduction, depending on the level of the price-cap. However, if the price-cap is too low, the firm may have no incentive to invest in cost reduction. Clemenz (1991) extends the work of Cabral and Riordan (1989) by deriving the effect of price-cap regulation on consumers and by deriving the socially optimal price-cap. (Clemenz, 1991, notes that the impact on consumers is important since, unlike economists, regulators may place a higher weight on consumer welfare than producer welfare.) Cabral and Riordan’s (1989) basic results are confirmed: in a finite horizon model, price-cap regulation gives the firm larger incentives to reduce cost than does rate-ofreturn regulation and achieves higher social welfare. These conclusions are even stronger in an infinite horizon setting. Clemenz (1991) also shows that price-cap regulation is capable not only of raising welfare in general but also in increasing consumer surplus. Sibley (1989) and Lewis and Sappington (1989) derive the optimal regulatory policy in a given environment characterized by asymmetric information; the optimal regulatory mechanism is similar to price-cap regulation. Sibley (1989) assumes the firm has full information about technology and demand while regulators have no information; he also assumes that regulators can observe lagged expenditures by the firm, prices, and outputs. Sibley’s (1989) scheme is derived such that it leads to efficient pricing and input usage; the optimal scheme is remarkably similar to a price-cap regime. Lewis and Sappington (1989) present a model in which the regulated firm has private information about its capabilities and cost-reducing activities. The endogenously-determined optimal regulatory policy includes a form of pricecap regulation as a component (firms are offered a choice between price-cap regulation and a regulatory regime that shares gains with consumers). They suggest that while price-cap regulation may be superior in some environments, it may not be in others, and hence should be considered as part of the optimal regulatory regime. A number of papers have considered the effect of price-cap regulation on the structure of prices. In the multi-product setting, price-cap regulation is generally implemented by imposing a price index on a basket of goods, giving the firm the freedom to adjust the price structure. A possible additional benefit arising from price-cap regulation is that the firm will choose prices across products in a way that will lead prices to have a Ramsey-Boiteux structure, which allows the firm to cover costs in the most efficient manner (that is, at the smallest deadweight loss). Bradley and Price (1988) and Vogelsang (1989) have demonstrated this result. Others, however, have shown that the result is not general. For example, Neu (1993) finds that prices approach a Ramsey-
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Boiteux structure only in certain situations, such as under static conditions. By example he shows that under a number of parameter conditions relating to differential growth in demand, differential price elasticities, and different shares across services, prices will diverge from the Ramsey-Boiteux structure. Fraser (1995) finds that cost increases for a firm’s products can cause prices to diverge from the Ramsey-Boiteux structure if the cost increases or demand elasticities are not uniform. However, if additional cost changes do not occur and the previous period outputs are used as weights in the price-cap, then prices will converge to the Ramsey-Boiteux structure. He concludes that only when cost changes are recurring will price diverge from the Ramsey-Boiteux structure on a continuing basis. Bradley (1993) points out that, since the definition of commodity bundles is largely endogenous (for example, should day time rates end at 4pm, 5pm, or 6pm?) and under the influence if not sole discretion of the regulated firms, the definitions may be manipulated in such a way that Laspeyres quantity based price-caps may very well not lead to an efficient Ramsey-Boiteux price structure. (The role of indices is discussed in the next section.) Thus, price-cap regulation can give firms a larger incentive to invest in cost reduction than does rate-of-return regulation and the price structure may approach the second best Ramsey-Boiteux prices, and there is some evidence that price-cap regulation is, or can be, part of the optimal regulatory mechanism.
13. Problems and Extensions of Price-cap Regulation While the discussion above casts a positive light on price-cap regulation and its effects on innovation and efficiency, subsequent theoretical work and experience from the implementation of price-cap regulation suggest that it is not the panacea that it once seemed. Problems arise in terms of the proper calculation of the price index, the optimal pricing structure, the impact on quality, and the end game and renegotiation problems. Typically the price-cap is implemented as requiring that a price index of the different products be below the price-cap; at issue are the weights used to form the price index. Law (1993) shows that Laspeyres index price-cap regulation under revenue weights causes the firm to price in order to manipulate the weights in such a way that reduces consumer and increases producer welfare in the first period and may reduce consumer welfare in the second period. Foreman (1995) extends the analysis to indicate when and why such weight manipulation incurs. Suppose the price-cap is set in the following way
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pt i
i
pt&1
i
i
×
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pt&1 xt&1
i ji (pt&1 xt&1) i
# 1 % CPI & x,
where pti is the price of good i in period t, xti is the quantity sold of good i in period t, CPI is the consumer price index, and x is the productivity change. The second term in brackets is the weight; it is defined as last period’s revenues from good i as a fraction of last period’s total revenues. In essence, by considering the effect of price charged today on the index set tomorrow, the firm may be able to earn higher profits tomorrow. For example, by setting a low price for a service today, the weight on the service tomorrow will be reduced when demand is inelastic (as is typical for telecommunication services). The more inelastic demand, the more sensitive are relative revenue shares to small price changes. Even small price changes manipulate the weights sufficiently that profits increase but social welfare declines. He shows that replacing the revenue weights with quantity weights reduces the effect of weight manipulation, especially as demand becomes less elastic. (Further discussion of index issues is contained in Cowan, 1997; Diewert, 1993; and Vickers and Yarrow, 1988a.) Sappington and Sibley (1992) consider another type of index manipulation; they analyze the effect of price-cap regulation as the FCC planned to implement for AT&T on the firm’s incentive to engage in strategic, non-linear pricing. In their model, the firm sells a single-product and can use two-part tariffs. The price-cap index is represented as
pt %
Et Qt&1
# p0,
where E is the fixed part of the two-part tariff, p is the per unit charge, and Q is the quantity sold. In other words, average revenue in period t, based on prices charged in t and on quantities sold in t!1, must be below the price-cap. They show that incentives are created for the firm to offer a two-part tariff rather than a uniform price, and that such pricing can reduce consumers’ and total surplus. They identify two welfare-improving modifications. First, the index could be specified as a function of the quantities sold in the initial period (replace Qt!1 with Q0). This eliminates the incentive of the firm to reduce the usage charge today (increasing Qt!1) so that the fixed fee can be increased in the future. The second alternative, which increases welfare even more (and never
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reduces consumer surplus) is to require the firm to allow consumers the option to purchase under the original tariff terms before price-cap regulation was implemented. Armstrong and Vickers (1991) consider another aspect of the role of price structure in a price-cap regulatory scheme. They are interested in whether a multi-product monopolist should be allowed to price discriminate across customer classes, and find that the answer depends on whether a price-cap index is calculated using weights in proportion to demands at uniform prices or whether there is a cap applied to average revenue. Armstrong, Cowan and Vickers (1995) consider how a firm facing a price-cap based on average revenue sets the price structure. (Unlike Sappington and Sibley, 1992, the price-cap is based on prices and quantities this period, so the incentive to set prices this period with an eye to how it would affect the cap next period is eliminated.) They also consider a case where the firm must offer consumers the option of buying at the uniform price. The firm prefers the average revenue constraint to the option constraint, and, of course, likes uniform pricing the least. Consumers overall prefer the option constraint, while ranking the average revenue constraint the least. However, welfare under the various schemes is ambiguous. The effect of price-cap regulation on quality seems to be a potentially large problem since a decline in quality is in essence a disguised increase in price. (Fraser, 1994, reports that since July 1992, the Australian regulatory body AUSTEL has included quality of service in its evaluation of whether prices have risen in its regulation of Telecom Australia.) Fraser (1994) considers the effect of price-cap regulation on reliability of supply in electric supply; in other words, he incorporates possible changes in the degree of quality when a firm is regulated under a price-cap. He considers two regulatory regimes: in one, the regulator does not incorporate changes in reliability; and in the other, changes in reliability are incorporated into the price-cap. In the latter case, a weighted average of the change in price and the change in reliability must be less than the cap. When reliability is not included in the index, the firm may protect profits by lowering reliability if cost increases must be absorbed (the price-cap is binding). However, when the price-cap is not binding, the firm may increase reliability, given the positive relationship between reliability and price. Including reliability in the price index eliminates the problem of lower reliability when the price-cap is binding, but introduces a new problem of over pricing when the price-cap is not binding. Thus, whichever way the price-cap is formulated, price-cap regulation affects the quality of the service. Implementation of price-cap regulation has revealed two related, large problems: what is to prevent the regulator from renegotiating the regulatory compact, and how is the end game problem resolved. Part of the reason pricecap regulation works to achieve reductions in cost is by allowing the firm to keep (at least some of) the gains from cost reduction. For this incentive to
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work, the regulator must credibly commit not to intervene during the period in which the price-cap is to be in effect. However, such a commitment may not be credible, especially if profits from cost savings rise ‘too much’. If profits rise greatly, the regulatory agency may face pressure from consumer groups to revise the level of the price-cap. In the UK, the electricity distribution regulator decided in June 1995 to revise price-caps, only two months after they had been set, in part because of the gains in productivity (see Studness, 1995) and ‘previously unsuspected financial strength’. Thus, the commitment not to intervene for five years did not even last three months. If regulated firms believe that price-caps will be revised to appropriate the gain from cost savings, or even if there is a chance that revision may occur, then their incentive to invest in cost savings is reduced. Isaac (1991) considers the problems that may arise when a firm will be regulated under a price-cap for some known, finite period of time, after which rate-of-return regulation will be implemented. He identifies several potential end game problems. First, the firm may manipulate the system by shifting costs into the future. Second, the regulator faces two commitment problems: a commitment not to change the price-cap or intervene in price setting during the price-cap period, and also not use the rate review when moving to rate-ofreturn regulation to appropriate profits earned by the firm during the price-cap regime. (He discusses these problems in light of the experience of regulation of the Tucson Electric Power Company during the 1980s.) While several authors have identified these issues as potential problems, not much theoretical work has tackled the issue, with the exception of Armstrong, Rees and Vickers (1995). They derive a model of price-cap regulation with an endogenously determined length of time until the next review. (Most models assume that the price-cap lasts for an exogenously given amount of time and do not consider the effects of a future change in regime on behavior under the current regime.) They identify the following trade off: the longer the amount of time between reviews, the more likely it is the price will be low at the next review, as firms have a higher pay off to investing in cost reduction because they retain profits for a longer period, but the longer is the amount of time during which the price is high. The higher the initial cost when price-cap regulation is implemented, the more likely the former effect is to dominate the latter. They also demonstrate that demand elasticity and the effectiveness of investments in cost reduction are key determinants of the optimal interval between hearings. Weisman (1993) theoretically analyzes the effect of renegotiation on firm behavior. Given a non zero probability that the regulator will rewrite the regulatory contract and assuming that the probability increases in the regulated firm’s profits, the firm has an incentive to engage in pure waste. In that way the firm may be able to reduce the likelihood of the regulator imposing more stringent regulation. (Sappington, 1980, shows a similar result with respect to
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Vogelsang and Finsinger’s 1979 regulatory mechanism.) Thus, while price-cap regulation does have the benefit of increasing the incentive to firms to invest in cost reduction, it induces a variety of new problems. I now turn to other forms of incentive regulation that may offer improvements to straight price-cap regulation.
14. Alternative Forms of Incentive Regulation While price-cap regulation is the most commonly discussed and used form of incentive regulation, a few alternatives have been considered as well. The most common alternative is some form of profit-sharing, under which the firm retains some fraction of its profits and rebates the remaining fraction to consumers. Indeed, given the practical problems that arose under price-cap regulation in the UK, profit-sharing regulation was often put forward as a superior regulatory regime that should be adopted. Mayer and Vickers (1996) point out that many of the existing problems would remain under profit-sharing and other, more serious, problems would arise in addition. An alternative often used in the US is a combination price-cap/rate-ofreturn/profit-sharing approach to regulation. For example, most US states that have adopted price-cap regulation have included a provision whereby the firm is also subject to a rate-of-return constraint, the form of which Braeutigam and Panzar (1993) term ‘sliding scale’. (In 1992, 22 of 48 states with regional Bell operating companies used a form of sliding scale/price-cap regulation, while 19 states continued with traditional rate-of-return regulation.) Under these provisions, the firm is allowed pricing flexibility below the price-cap, provided that the rate-of-return is not above its cap. (In some states adjustments may be made if the firm’s rate-of-return falls below a floor, as well.) As the rate-ofreturn rises above the cap, the firm is entitled to a smaller and smaller portion of the increase in profits, typically refunding the rest to consumers. One immediate implication pointed out by Braeutigam and Panzar (1993) is that such an approach eliminates one benefit to price-cap regulation: savings in administrative costs. Under such a hybrid approach, the regulator will still need to calculate rates of return, with all its attendant problems. Lyon (1996b), using numerical techniques, shows that adding a profitsharing mechanism to price-caps always increases expected welfare relative to pure price-caps. Welfare may be increased by large amounts of profit-sharing and by allowing firms a greater share of gains than of losses. Profit-sharing is particularly beneficial if the firm’s initial costs are high and cost innovations are difficult to achieve. However, Weisman (1994) shows that the firm prefers profit-sharing to pure price-cap regulation. In essence, this form of regulation gives the regulatory agency an incentive not to take adverse actions against the
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firm, since such actions also harm the regulatory agency via the profit-sharing arrangement. Weisman (1993) considers a ‘modified price-cap’ regulatory regime, which he views as more accurately describing the type of price-cap regulation that has been implemented in the US. Under this regime, the regulator sets a price-cap in the regulated (‘core’) market and allows the firm to retain only part of the profits generated. However, the firm also operates in unregulated (‘non core’) markets as well. To undertake profit-sharing, costs must be allocated across the core and non core markets. Given the difficulty in allocating costs (see the discussion in Section C7), distortions are generated. This type of pricecap/profit-sharing regulation can reduce welfare compared to rate-of-return regulation applied to one market (which also requires that costs be allocated across regulated and unregulated markets). (Braeutigam and Panzar, 1989, early recognized that price-cap regulation can in principle cause a firm to produce efficiently in non core markets and enter these markets only if efficient. However, they analyze a regulatory regime of pure price-cap regulation without profit-sharing, so the problem of allocation of common costs is totally eliminated.)
15. Comparison of Incentive-based Regulation to Other Forms of Price Regulation Cabral and Riordan (1989) and Clemenz (1991) derive models of price-cap regulation and then proceed to compare the outcomes to several alternative regulatory regimes. Cabral and Riordan (1989) compare cost-based (rate-ofreturn) regulation with regulatory lag and price-cap regulation. Because there is regulatory lag in their formulation of cost-based regulation, the firm has some incentive to reduce cost. Any increase in profits between the time of cost reduction and the time of the new rate hearing are kept by the firm. However, the longer regulatory lag and the price flexibility increase the incentive to reduce costs relative to the incentive under rate-of-return regulation with regulatory lag. Cabral and Riordan (1989) also compare the level of price under the two alternatives. Under cost-based regulation, at each rate hearing the price is set to cover costs. If the price-cap is initially set below the price that would obtain under cost-based regulation (as it must if the firm is to have an incentive to reduce costs), then for a period prices will be lower under price-cap regulation than under cost-based regulation. However, in future periods the price under price-cap regulation may be higher. Continuing in the same vein, Pint (1992) considers two differences in pricecap regulation and rate-of-return regulation. She points out that, under pricecap regulation as implemented in the UK, hearings occur at fixed intervals and
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use all information available since the previous hearing, while under rate-ofreturn regulation as implemented in the US, hearings occur only when requested (typically by the firm) and utilize information from a single test year (usually the most recent year for which complete data is available). Assuming that regulation of either form is binding, the firm chooses the level of capital stock, the level of managerial effort (which reduces costs), and, under rate-ofreturn regulation, when to request a new rate hearing. Both forms of regulation lead to an over investment in capital and underinvestment in effort, especially during periods when cost data are gathered for hearings. Pint (1992) shows that rate-of-return regulation can be improved by using fixed intervals between hearings (continuingto use test year data) if the intervals are not too short, and the welfare gains are primarily realized by the firm. If data on costs since the last hearing are used in conjunction with fixed intervals, welfare increases dramatically, with gains going to consumers (indeed, profits fall). Thus, two aspects of price-cap regulation are seen to increase welfare. (Weisman, 1993, and Baron, 1991, also discuss the degree to which price-cap regulation in practice differs from rate-of-return regulation. Weisman, 1993, points out that in practice (in telecommunications in the US) price-cap regulation involves an element of cost-based regulation. As a result, greater distortions may arise under the hybrid form of regulation than result from pure cost-based regulation.) Several papers use simulation techniques to compare various regulatory regimes and the degree to which welfare may be increased. Schmalensee (1989a) considers a variety of regulatory regimes, including price-cap regulation, imposed on a risk-neutral, single-product monopolist. He considers what he terms linear regimes, which can be written as P = ? + ?(C ! a), where P is the regulated price, ? is the base price, ? the cost sharing fraction, C is observed cost, and a is the expected unit cost under the pre reform regulatory regime. That is, any change in cost is passed on linearly to price; the higher is ?, the more responsive price is to changes in cost. He finds that price-cap regulation is inferior to cost-based regulation over a wide range of plausible parameter values. While, as many have shown, price-cap regulation provides a higher incentive to invest in cost reduction, if uncertainty is sufficiently high, the price-cap must be set at such a high level to keep the firm profitable that welfare declines. Gasmi, Ivaldi and Laffont (1994) also use simulation techniques to compare welfare under a variety of regulatory regimes, including a price-cap mechanism and price-cap regulation in conjunction with profitsharing. They characterize their main findings as: (1) pure price-cap regulation leaves substantial rents to the firm; (2) introducing downward price flexibility improves the efficiency of price-cap regulation relative to Schmalensee’s (1989a) best linear regulatory regime; and (3) profit-sharing often yields welfare near the optimal regulated level by partially correcting the distribution distortion of a pure price-cap scheme.
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Several works have theoretically examined the performance of price-cap regulation with other types of regulation, and have found it useful to deviate from pure price-cap regulation. For example, performance may be enhanced by offering alternative regulatory mechanisms or alternative pricing schemes, respectively. Lewis and Sappington (1989) suggest that firms should be offered a choice between a variation on price-cap regulation and a profit-sharing form of regulation, with gains going to consumers. Sibley (1989) finds that the regulator uses slagged profits to design its own two-part tariff, and the firm will offer its two-part tariff as well as the regulator’s two-part tariff as an option to consumers. Finally, Schmalensee (1989a) finds that several regulatory mechanisms that are simpler than price-caps can achieve the same gains, particularly if the regulator weights consumer surplus highly. To recapitulate, theoretical work suggests that some form of incentive regulation can be used to improve the outcome relative to traditional cost-based methods of regulation. However, analysis also shows that, as implemented, incentive regulation often does not replace cost-based methods, and thus new problems arise. Whether incentive-based regulation is superiod to cost-based regulation in practice remains to be seen.
16. Empirical Analysis of the Effect of Incentive Regulation The increasing use of incentive-based regulation has provided economists with a wide range of natural experiments for empirically analyzing the effect of incentive-based regulation on prices, costs and welfare. (Sappington and Weisman, 1996b, concentrating on the telecommunications industry, identify some of the problems that can arise in attempting to do such empirical work, and suggest ways to avoid these problems.) Kridel, Sappington and Weisman (1996) review empirical work on incentive regulation in telecommunications, while Xavier (1995) provides a descriptive narrative of the impact of price-cap regulation in telecommunications, especially in Australia, the UK, and the US. In general, the results have been very encouraging. Productivity, investment in infrastructure, and new service offerings have increased. Prices have generally remained stable or declined slightly, and quality has not declined. However, there is no evidence that incentive-based regulation has led to reduced administrative costs. Face (1988) examines the use of price-cap regulation for Michigan Bell, estimating that costs savings in 1982 amounted to about $40 million relative to that which would have occurred under rate-of-return regulation. Majumdar (1997) focuses on the impact of incentive regulation on productivity for the case of US local exchange carriers. He finds that pure price-cap regulation leads to
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an increase in technical efficiency, but only with a lag; price-cap regulation in conjunction with profit-sharing leads to a smaller but immediate impact on technical efficiency; and finally that a pure profit-sharing scheme actually harms technical efficiency. Mathios and Rogers (1989) find that prices in states that regulated AT&T using a price-cap are 7 to 10 percent lower than in states that use rate-of-return regulation. They use variation in state regulatory mechanisms with a simple price-cap/not price-cap dummy variable. The results are sugges tive, but more detailed analysis taking into account the detailed differences in the different state regulatory mechanisms would be desirable. Despite the variety of problems identified by the theory regarding the implementation of incentive regulation, the empirical studies to date suggest that implementation has led to substantial gains.
E. Regulation of Networks 17. Introduction to the Issues As competition has been introduced into at least some areas of industries that have long been regulated, a new industry structure is arising. The new structure consists of a situation where a regulated firm controls an essential facility, generally a physical network, to which competitors must have access in order to compete with the regulated firm in at least some markets. For example, in the US much of the competition in local telephone service, at least initially, is expected to come from firms that lease access from the regulated local phone company on which the competitor can send calls. The question is how to appropriately price access to the essential facility. The first-best solution, marginal cost pricing, is generally not feasible because the regulated firm will not recover sufficient revenues to cover the fixed cost of providing the network. (Typically, provision of the network remains a regulated monopoly due to economics of scale.) Thus, the relevant question for economists and the regulator is how to efficiently structure prices subject to the constraint that the regulated firm cover its costs. Why is regulation necessary in this situation? The economic justification continues to be to reduce the deadweight loss that arises under monopoly. However, the issue is more complicated because the owner of the network competes with others in sectors that are potentially competitive. (When AT&T was broken up, the initial industry structure prohibited the regional operating companies (local service) from competing in these potentially competitive markets (long distance). With the Telecommunications Act of 1996 and deregulation of electricity in the US, the exclusion of network owners from the competitive sectors is declining.) A natural incentive arises for network owners to price access to the network in such a way to give itself an advantage in the
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competitive sectors. Another important issue regards the overall regulatory structure and how the competitive market/sector fits in. For example, if prices are high in some potentially competitive sectors in order to subsidize regulated sectors, as was done in the US with regard to long-distance and local service, respectively, then the effect of access/entry on the ability of the firm to maintain such price subsidies must be considered. Thus, the same sustainability issues discussed in Section 10 arise again. I now describe the work that has attempted to characterize the optimal access price.
18. Access Pricing Baumol and Sidak (1994a) describe the traditional (in the US until the early 1980s) approach for pricing access. Suppose that a regulated firm earns T from a particular service towards its overall revenue shortfall, defined as the difference between total incremental revenue less total incremental cost. Asuming that the price for the final product is fixed, the traditional approach assigns an access fee equal to the average incremental cost of providing access to the competitive firm plus a charge that would leave the regulated firm with its market share weighted share of T. That is, if upon granting access a firm is expected to keep two thirds of the market, then the total price for access will be such that the regulated firm earns in total two-thirds of T. However, in this situation the firm is not ade quately compensated for its common fixed costs. In addition, inefficient entry may occur. The entrant essentially does not have to cover as large a portion of fixed costs as does the regulated firm, and hence can still profitably enter even if its average incremental cost is higher than the regulated firms. To remedy the entry inefficiency induced by the traditional approach, Baumol, Sidak and Willig have proposed perhaps the most commonly known and used access pricing rule, the efficient component pricing rule (ECPR) or the Baumol-Willig rule. (The rule is generally attributed to Willig, 1979, and Baumol, 1983, and is extensively discussed by Baumol and Sidak, 1994a and 1994c. It has been used in the US by the Interstate Commerce Commission in the rail industry since the early 1980s, by the California Public Utilities Commission in local telephone service since 1989, and in New Zealand in the telecommunications industry since the early 1990s.) Essentially, the rule proposes that access to essential facilities should be priced at the direct cost of providing access plus the opportunity cost to the regulated firm of granting access to a competitor. The opportunity cost to the incumbent is the profit that would have been earned had the incumbent supplied the final product rather than the entering firms. One of the benefits of such a rule is that it leads to efficient entry. In other words, no firm will enter the competitive market unless its marginal cost is less than or equal to the marginal cost of the incumbent regulated firm. Kahn and Taylor (1994) point out an additional potential
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benefit. By including the regulated firm’s opportunity cost in the access charge, subsidies mandated by regulators can be maintained. (I call this a potential benefit since many of these cross-subsidies are not efficient. However, this is not always the case, as in Ramsey-Boiteux pricing.) For example, in the days of a common local and long-distance regulated firm, high prices in longdistance service were used to subsidize rates for local service. As discussed in Section 10, entry into the high-profit markets can make the regulatory regime unstable; access pricing under the ECPR can allow entry but sustain the regulatory regime by maintaining the contribution towards the fixed costs provided by that service. A number of critiques of the ECPR have arisen. In particular, several have questioned the generality of the rule, noting that its efficiency result is contingent on a number of rather strict assumptions. Baumol and Sidak (1994a) and Kahn and Taylor (1994) note that the ECPR gives the efficient solution to pricing access subject to the assumption that the price of the final product is subject to effective regulation or effective competition. Economides and White (1995) develop a rigorous model analyzing the efficiency of the ECPR in the case where the firm that controls the essential facility has market power in the potentially competitive market. They assume that the price for the final product is not regulated, and that the incumbent therefore is able to charge the full monopoly price. Their argument reduces to the point that entry of an inefficient firm, that is a firm with marginal costs above that of the regulated incumbent, can be socially beneficial if entry sufficiently reduces the deadweight loss that arises when the regulated monopolist prices above marginal cost for the final product, while the ECPR in this circumstance acts to protect the monopolist from any competitive challenge. Economides and White (1995) show that under Bertrand or Cournot competition in the final product market, the gain from increased competition can offset some degree of inefficiency on the part of the entrant. The criticisms of the ECPR highlight an important aspect of the debate: whether the ECPR is efficient depends crucially on the overall regulatory environment, technology, and demand. Is the price for the final product effectively regulated? Laffont and Tirole (1996) emphasize this point: ‘A discussion of an access rule without reference to the rest of the regulatory environment has limited interest. The quality of an access pricing rule depends on the determination of prices for the final products.’ Are products perfect substitutes? Is technology subject to constant returns to scale? It seems clear that the ECPR does not have the wide applicability first claimed. Indeed, many show that while the ECPR arises as a special case of the optimal access rule in certain circumstances, more often than not the optimal access rule may be higher or lower than the EPCR. Armstrong, Doyle and Vickers (1996) take the ECPR as their framework and analyze how the opportunity cost should be properly measured under
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different assumptions regarding demand and supply. They begin with the clear-cut case where the final product is homogeneous; inputs, including access, are used in fixed proportions; no bypass is possible, that is, access is a necessary input into production of the final product and cannot be obtained from any source except the incumbent; and the entrant is a price taker. They then relax some of these assumptions, allowing for product differentiation, variable proportions, and the possibility of bypass. They show that under these new assumptions, the optimal access charge is less than the access charge suggested by the ECPR, because under these assumptions the opportunity cost of access is reduced as the incumbent loses fewer final product sales given entry. However, they also point out that the optimal access charge can be interpreted as an extension of the ECPR, taking into account the ‘displacement ratio’, which is the change in the incumbent’s final product sales over the change in sales of access to competitors as the access price changes slightly. (They also show that, when incorporating the firm’s budget constraint, a positive RamseyBoiteux price must be added to the access charge, so that the optimal price subject to the budget constraint is higher than the ECPR access price.) They also show that, when the opportunity cost is analyzed properly, the informational demands of the ECPR are not as low as others have argued; in particular, proper calculation of the opportunity cost requires information regarding demand and supply elasticities. Armstrong, Doyle and Vickers (1998) consider access pricing in the situation where the price of the final product is not regulated, given that that is the direction in which many industries are headed. They find that, with linear demand and linear competitive supply, and no binding break-even constraint, the optimal price for access is set at marginal cost. More generally the relationship between the optimal access price and marginal cost is ambiguous. In essence the same trade-off identified in Economides and White (1995) is present: setting a high access price raises the price of the final product, resulting in the standard allocative inefficiency associated with monopoly pricing, but it reduces the margin available to competitors, reducing inefficient supply and increasing productive efficiency. Laffont and Tirole (1994) derive the optimal access price in a wide variety of situations and under pretty general conditions: degrees of effort exerted by the incumbent in operating the network, private information on the part of the incumbent regarding technology, various informational regimes, the presence and absence of government transfers, various degrees of market power on the part of the entrant, various regulatory regimes, and under the possibility of bypass. They also compare the optimal access price to that suggested by the ECPR. They identify the following assumptions as necessary to ensure the efficiency of the ECPR: (1) the regulated firm’s price for the final product is based on marginal-cost pricing; (2) the products produced by the regulated firm and the entrant are perfect substitutes; (3) production of the final product is
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characterized by constant returns to scale; (4) the entrant has no market power; and (5) the regulated firm’s marginal cost can be accurately observed. If any of these fail to hold, then the access price must be adjusted from the ECPR level to achieve efficiency. Larson and Lehman (1997) demonstrate that ECPR pricing can be derived as a special case of Ramsey-Boiteux pricing with interdependent demands, but also show that ECPR is not always efficient. In particular, in order for a Ramsey-Boiteux pricing structure to arise, the following assumptions must hold: (1) entrants must have a fixed proportions technology; (2) the essential facility must be strict, that is have a zero elasticity of substitutions for other inputs; (3) perfect competition must exist in the non essential inputs; (4) the regulated firm and entrants must face the same elasticity of demand for the final product; (5) the entrants set price at the level charged by the regulated firm; (6) Bertrand competition ensues in the downstream market, which in combination with assumption (5) results in equal market shares for the regulated firm and entrants; and (7) there is symmetry of weighted income effects. They then discuss the many reasons why these assumptions are likely to be violated. Finally, Laffont and Tirole (1996) consider a completely different approach to regulating interconnection. They suggest that access be regulated under a global price-cap. Under this approach, the price-cap would apply the weighted sum of price changes for final products and price changes for intermediate products sold to rivals, including access. They argue that one benefit is that it requires no more informational requirements than existing regulatory policies. The firm will adopt the optimal Ramsey-Boiteux price structure given its information about demand and cost; the regulator does not require information on marginal costs nor demand elasticities. (Ramsey-Boiteux prices obtain so long as all goods, including access, are included in the definition of the price cap and the weights are exogenously set at the level of output to be realized.) They also consider a global price-cap that also imposes the ECPR as a price ceiling on the access price, though the informational requirements of the ECPR are severe under more realistic assumptions, as shown by Armstrong, Doyle and Vickers (1998). The benefits identified by Laffont and Tirole (1996) from adding an ECPR price ceiling is to provide a better setting of the weights in the price-cap and to limit predatory behavior (the incumbent may increase the access price and reduce the final output price, squeezing out entrants) by tying the access and output prices. The theoretical work suggests that a general approach to pricing access at the direct marginal cost of access plus the opportunity cost is appropriate. However, it appears that calculating the opportunity cost is not as easy as originally proposed. In addition, the work illustrates the importance of taking into account the entire regulatory regime, including the regime covering the competitive sector. (I found no empirical work regarding access prices.)
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F. Conclusion 19. Regulation in Practice As regulation theory has advanced, especially in the last decade or two, regulation in practice has changed tremendously. The US saw immense deregulation occur beginning in the 1970s, mostly in industries that were never believed to be natural monopolies but had been regulated for other reasons. (For example, regulation of trucking in the US largely developed in order to protect regulation of railroads, which were thought to be natural monopolies.) In particular, deregulation occurred in railroad and trucking, air passenger transportation, natural gas, electricity, telecommunications, and cable television. (About the only move in the US in the opposite direction was the 1992 Cable Consumer Protection and Competition Act, which re regulated cable television in response to the increase in cable prices after deregulation in the Cable Communications Policy Act of 1984. It is not clear how regulation affected the quality adjusted price; Hazlett, 1993, for example, believes the quality-adjusted price declined under deregulation, while Otsuka, 1997, suggests that the quality- adjusted price was kept low under regulation. However, cable was rederegulated with the passage of the Telecommunications Act of 1996.) Other countries have seen an impressive move away from handling natural monopolies by nationalizing them to regulation of privatized firms. These countries, especially the United Kingdom, have led the way towards the use of incentive regulation. Not only has the US moved towards deregulation, but the form of regulation has been changing rapidly over the 1980s and 1990s. There is a general movement away from cost-based regulation towards incentive-based regulation, in an effort to achieve a better outcome. The United Kingdom led the way with adoption of price-cap regulation in 1984, after privatizing its telecommunications industry. Privatization of other industries spread the use of price-cap regulation to electricity, gas and water. Price-cap regulation in practice in the United Kingdom has included a bit of a mix of cost-based regulation. For example, gas, water and electricity utilities can pass on increases in costs of inputs outside their control. Nonetheless, this method of regulation has proved to be revolutionary, leading to changes in the approach to regulation in many countries.
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Acknowledgments I gratefully acknowledge the comments of Ken Boyer and of an anonymous referee. Their comments significantly improved the content and organization of the paper and extended the bibliography. Chris Haan, Vivian Lei and Aaron White provided valuable assistance in compiling the bibliography.
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5300 ANTITRUST LAW Patrick Van Cayseele Professor of Economics Katholic University of Leuven and F.U.N.D.P. Namur
Roger Van den Bergh Professor of Law and Economics Erasmus University Rotterdam and Utrecht University © Copyright 1999 Patrick Van Cayseele and Roger Van den Bergh
Abstract The first part of this chapter surveys the interaction of the economics of competition and antitrust in a somewhat historical perspective. The evolution of economic theories on competition can be divided into four stages: (1) the origins of competition: the dynamic concept of competition in classical economic literature and the static concept of competition in price theory, followed by the development of models of imperfect competition and monopolistic competition; (2) the structure-conduct-performance paradigm (Harvard School of Industrial Organisation); (3) the ‘antitrust revolution’ of the Chicago School and the related theory of contestable markets, and (4) the new industrial economics, making use of game theory and transaction cost analysis. The second part of this chapter investigates how far economic theory and concepts of industrial economics have had an influence on antitrust law. In the USA economic views on competition theory have had a much clearer impact on antitrust law: legal rules tend to change when the underlying economic theory changes. In Europe, competition law seems to be influenced more by political objectives than by economic theory; economic considerations are often either absent or outdated. The discussion of some leading antitrust cases illustrates the differences between the American and the European approach. JEL classification: K21 Keywords: Cartels, Competition, Structure, Conduct, Performance, Chicago School, Bounds Approach
1. Introduction The economics of competition and antitrust law have a long-lasting tradition of fruitful interaction. Since the very beginning of antitrust legislation, 467
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microeconomics has influenced the context as well as the implementation of the law. And as one of the great economists of this century, Lord Keynes, pointed out, practitioners always adhere to the theories of a defunct economist, leading contemporary economists to write papers on the inadequate or outdated application of economics on antitrust legislation. Nowadays, not only the economics of competition, but also the economics of information and the theory of economic federalism have exercised their influence. The field of economics of competition is currently called industrial organisation or industrial economics. This has, however, a much broader scope by also focusing on the economics of regulation, innovation and advertising, among others. For a leading textbook, see Tirole (1988), for an introduction, see Scherer and Ross (1990) or Carlton and Perloff (1994). The economics of information was recently recognised in the economics profession by awarding the Nobel prize to Vickrey and Mirrlees. The economics of information only could advance due to major breakthroughs in the field of noncooperative game theory under incomplete information. Nash, Selten and especially Harsanyi pioneered contributions in this area, for which they got the 1994 Nobel prize in economics. Game theory also made its way to the law (see Baird, Gertner and Picker (1994) and Phlips (1988, 1995) for pioneering contributions regarding antitrust economics. Applications of information economics to the law can be found in Levine and Lippman (1995). For a combined effort of information economics with the economic theory of (fiscal) federalism within the context of antitrust, see Smets and Van Cayseele (1995). The present contribution will try to survey the abovementioned interaction in a somewhat historical perspective. This contribution therefore is organised along the following table of contents: the next section sketches the antecedents and the very beginning. Then the old paradigm in industrial economics, together with its application to antitrust in a carefree era, is discussed. More troublesome was the application of these old industrial organisation theories to a number of antitrust cases in the 1970s and 1980s. The criticisms advanced by the Chicago School will receive special attention. The response by the new industrial economics (NIE) as well as the new empirical industrial organisation (NEIO) is put under scrutiny in the following sections. Then follows a description of the current situation in terms of academic research with respect to concentrations. Last but not least, in the final section we investigate what can be retrieved from all this research in legal practice. This structure to some extent follows Van Cayseele (1996), who engages in a similar survey from a pure industrial economics point of view, rather than focusing on antitrust.
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2. The Origins of Competition The roots of the concept of ‘competition’ are as old as economic science if the latter starts with the famous book The Wealth of Nations (see Smith, 1776, 1937). Even before that time the merits of and problems with competition often submerged in economic writings. In an overview, McNulty (1967) referred to the seventeenth-century mercantilist Johann Joachim Becher, writings by Turgot and Hume and to Sir James Stuart, who provided the most complete pre-Smithian analysis of competition. Smith, by anticipating the welfare theorems with his ‘invisible hand’ theory, generalised competition to a force driving economies to the very best outcomes that are feasible. The most frequently quoted passage in the book is: He [specifically each individual] generally, indeed neither intends to promote the public interest, nor knows how much he is promoting it… [He] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.
Subsequently economists have proved those theorems and showed their shortcomings (see the Nobel prize winners Arrow and Debreu). Parallel with those mathematical models of a general equilibrium nature - which sacrifice much of the institutional details of competition in real markets - economists have engaged in the mathematical modelling of market forces in much more institutional detail, including asymmetries in information, transaction costs and the concentration and use of power. As already argued in the introduction, these models were only recently recognised. What does classical economics then have as an implication for competition policy? According to classical economics, healthy competition signifies both reciprocal rivalry and the absence of government restrictions, such as the exclusive privileges which characterised the mercantilist period. The common law in relation to restraints of trade reflected the classical view of competition. Modes of conduct with limited individual freedom were condemned as restrictive to competition. Hence a widespread belief in the ‘laissez faire’ principle was held. Government intervention in general certainly would not improve upon the results of the competitive process although Smith himself was a believer of keeping entry into the market open. Competition was hailed as a process but limited government intervention sometimes would be necessary to allow for the process to work. Neoclassical economists continued to believe in the healthy effects of competition but somewhat shifted the interest from competition as a process to competition as a situation, as one later would say, a market structure. The necessary conditions to achieve a perfectly competitive outcome are: (i) the
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rivals must act independently or noncooperatively in today’s terminology; (ii) the number of rivals, potential as well as present, must be sufficient; (iii) the economic decision makers must possess knowledge of the market opportunities; (iv) there must be freedom to act on this knowledge; and (v) sufficient time must elapse for resources to flow in the directions desired by their owners with no restrictions on the magnitude of these flows. Although Stigler (1968) attributes these necessary conditions to Smith, the characterisation and implications of perfect competition and alternating market structure emerged most pronouncedly in this period. In particular, Edgeworth (1925) and Cournot ([1838], 1971) introduced pioneering contributions which until today remain at the heart of daily antitrust practice. A perfectly competitive market now was defined as a set of properties such as supply and demand exercised by a very large number of actors, free entry and exit, homogeneous products being traded on the market and zero search or transaction costs. The outcome of such a market is an efficient one in that no other outcome can achieve the same level of welfare for society. Yet it relies on many conditions which are unachievable, such as very large numbers of suppliers (in the presence of scale economies), no search costs (difficult to maintain in the few cases one has very many suppliers) and so on. The model of perfect competition therefore has to be seen as a yardstick against which other market structures are to be judged. In all instances in which this set of properties are not met, a case of market failure is seen to exist. For a long time, the mere existence of such market failures were seen to be sufficient reasons for government policies, such as antitrust laws or the creation of public utilities. Nowadays, this viewpoint has changed. A market failure is a necessary condition for government intervention, but not a sufficient one. The cost of government failures, for instance due to government officials and regulators being captured by private and social interest groups (as documented so well in the public choice literature and avocated by Stigler, 1971), has to fall short of the costs due to market failures. In general, antitrust policy, due to its distance vis-à-vis redistributive issues, and due to its permanent and ‘generic’ character is not an area of government intervention where one expects a lot of capture a priori (see De Bondt and Van Cayseele, 1985). Cournot and Edgeworth introduced models of imperfect competition. Cournot ([1838], 1971) explicitly took into account the possibility of only a few suppliers in the market. As shown by Novshek (1985), his model can replicate both the perfectly competitive outcome as well as the other extreme, that is, monopoly. While Cournot’s model still abstracts from the price formation process by assuming the existence of a Walrasian auctioneer, it substantially adds to realism due to the introduction of conjectures on behalf of the rivals. Recent research, for example by Kreps and Scheinkman (1983) sustains the Cournot model without the Walrasian assumption. But Davidson and
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Deneckere (1986) and Van Cayseele and Furth (1996a) demonstrate that the conclusion is very fragile. Edgeworth readily abandoned the abstractions of a price equilibrating process and allowed rivals to undercut each others’ price and engage in price warfare. While his conclusions as to cyclical behaviour of prices with periods of collusive pricing alternating with price wars could only be interpreted by means of game-theoretical models half a century later, another model of oligopoly had been conceived. Many textbooks in microeconomics deal with these models as the leading paradigm (see among others Pindyck and Rubinfeld, 1993, and Schotter, 1994). Meanwhile monopoly, as a market structure that occurs in reality and can be analysed, was also studied. Indeed, the quantitative contributions of economists such as Cournot and Edgeworth allowed for an estimation of the costs associated with monopoly. A clear definition of consumer and producer surplus by Marshall (1920) or Lerner (1934), as well as the recognition of deadweight losses associated with monopoly pricing, was an essential step into giving empirical content to the problem of monopoly. The estimates of the direct loss in welfare of course vary across nations and over time, but are in the range of 0.1 percent to as much as 9 percent. For the US, these estimates can be found in Harberger (1954) or Worcester (1973). Cowling and Mueller (1983) estimated the direct welfare effects in France. The indirect losses are due to rent-seeking phenomena, and can be in the order of magnitude of the direct effects. They, of course, have to be added and illustrate the need to work with models that capture the dynamic aspects of competition. These quite substantial amounts of losses certainly justify the operation of antitrust control, at least from an economic point of view. In addition to this concern with allocative efficiency, other reasons have been put forward to embrace antitrust enforcement. Each of these, however, is disputed. We therefore only mention them briefly. First, many believe that monopolies and cartels are less innovative than firms operating in competitive market structures. This is sort of the ‘opposite Schumpeterian assumption’. While this literature is vast, in particular the empirical studies trying to detect a link between concentration and innovation are highly inconclusive (for a survey see Van Cayseele, 1998). The abovementioned rent-seeking effects are particularly pronounced in the theoretical literature regarding the dynamics of innovation. This is quite natural as one realises that market structure will not only influence innovative activity, but that also the opposite is true. This begs the question whether incumbent monopolies will exploit innovative activities, for example by winning subsequent patents, to continue their position, or whether some kind of ‘leapfrogging’ will take place, where today’s market leaders are tomorrow’s followers, a paradigm nowadays acclaimed by Microsoft officials. A second belief which still is disputed is the following: monopolies and cartels, by being sheltered from competition, become lazy. This gives rise to
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organisational slack or X-efficiency (see Leibenstein, 1966, the critique by Stigler, 1976, and the reply by Leibenstein, 1978). Finally, many object to the transfer of wealth from consumers to firms with market power, or the shareholders beyond these firms. While the economic foundations for redistribution are seriously disputed, Lande (1982) believes that the principle reason behind the enactment of antitrust laws was to prevent these wealth transfers, implying political economy motivations for antitrust. Further relaxations of the perfectly competitive model occurred with the abandoning of the homogeneous goods assumption by, for example, Hotelling (1928), Chamberlin (1933) and Robinson (1964). By allowing for differences with respect to the products sold, each producer gets some monopoly power over those consumers who are addicted to his brand. Nonetheless, there may be many producers in the market, so that the focus here is not necessarily game-theoretic, that is, the recognition of mutual interdependency need not to be central, although contemporary contributions in the field of product differentiation all recognise this interdependency. In doing so, the economic models of product differentiation have provided the foundations to determine the relevant market, a concept used currently in antitrust legislation (see Van Cayseele, 1994). As reviewed by Friedman (1984), each and every of these departures from the competitive model proved to be path-breaking for the development of the field of oligopoly theory. A few decades and antitrust filibusters later, the socalled new industrial organisation would pick up from here. On the other hand, each of these departures also showed the tremendous richness in terms of modelling possibilities that exist for analysing competition in an industry, and hence the difficulties that will arise in constructing models of general relevance. As such it is difficult to formulate a legal approach that is theoretically correct, predictable and easy and inexpensive to administer for a majority of antitrust issues that can come up, although this has been tried, as the next section shows.
3. The Structure, Conduct, Performance Paradigm (S-C-P Paradigm) Each and every one of the original models of competition discussed in the previous section has a few items in common. First, the number of suppliers as those who have access to a certain technology is specified. Next, the consumers who have different tastes can make their choice over different brands. In general, the technology and tastes constitute market structure. Still this allows for many different outcomes unless a particular structure entails a certain type of conduct. This is what the S-C-P paradigm tried to achieve: a general theory that mapped common elements in the market structure of any industry into a performance indicator of that sector.
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The S-C-P paradigm was developed by Edward S. Mason (1949a) at Harvard University in the late 1930s and early 1940s. The original empirical applications of the new theory were by Mason’s colleagues and students, the most famous of whom was Joe S. Bain (1968). The paradigm implies that market results (the success of an industry in producing benefits for consumers, employment, stable prices, technological advancement and so on) in an industry are dependent on the conduct of sellers and buyers (as regards decision variables like advertising, R&D, and so on). Conduct, as mentioned, is determined by the structure of the relevant market. The structure of an industry depends on basic conditions, such as technology and preference structure. Government policy (antitrust policy, regulation, taxes, and so on) may affect the basic conditions, and hence the structure, conduct and performance of an industry. If true, research along this paradigm would allow any outsider to know profits and consumer surplus in any industry simply by plugging in the variables representing the market structure, at least if a significant and positive relationship was detected in the study. Hundreds of studies have attempted to link market structure to market performance. Concerning static performance (profits and consumer surplus), three major measures of market performance are used: (1) the rate of return, which is based upon profits earned per dollar of investment; (2) the price-cost margin, which should be based upon the difference between price and marginal cost, and is related to the Lerner index of monopoly power and (3) Tobin’s q, which is the ratio of the market value of a firm to its value based upon the replacement cost of its assets (for more details see Carlton and Perloff, 1994). The initial studies are by Bain (1951, 1956). In the latter publication Bain argues that profits are higher in industries with high concentration and high barriers to entry. Many studies followed, to name just a few: Schwartzman (1959), Levinson (1960), Fuchs (1961), Minhas (1963), Weiss (1963), Comanor and Wilson (1967), Collins and Preston (1969), Kamerschen (1969), and many others. Other performance criteria, such as the cyclical behaviour of price-cost margins or pricing behaviour as such have been carried out (see, respectively, Domowitz, Hubbard and Petersen, 1986, and Weiss, 1989). To examine how performance varies with structure, measures of market structure are needed. Industry concentration is typically measured as a function of the market shares of some or all of the firms in a market. The four-firm concentration ratio (CR4) is the sum of the market shares of the four largest firms. The eight-firm concentration ratio (CR8) focuses attention on the top eight firms in measuring concentration. Alternatively, market structure may be measured by using a function of all the individual firm’s market shares. The Herfindahl-Hirschman Index (HHI) is the sum of the squares of the market shares of every firm in the relevant market. Later, when the empirical Harvard tradition underlying the S-C-P paradigm was no longer tenable, the pioneering game-theoretic Cournot model was able to strike a link between the Lerner
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index and the HHI, which suddenly made it quite popular (see Scherer and Ross, 1990). The fact was already known to Stigler (1968). The concentration indices (CR4 or CR8 and the HHI) can be related to one another (see Weiss, 1969). Many studies indeed found a positive and significant relationship between market structure and performance, yet others casted doubt as to whether the relationship would hold for different sets of industries or in other eras. Nonetheless the paradigm condemns high degrees of concentration, especially if they are not the result of scale economies but of barriers to entry. Regarding market shares, some studies have made clear that substantial market shares are not evidence prima facie for the presence of market power. On the contrary, it seems to be the case that the resulting larger market shares are the result of superior efficiency, as predicted by a Cournot model with cost asymmetries. In the United States, the Harvard analysis became the cornerstone of competition policy in the 1960s and remained so until the neoclassical and neoinstitutional approaches began to win the upper hand in the mid 1970s. In the 1968 Merger Guidelines of the American Department of Justice it was stated that an analysis of market structure was fully adequate for showing that the effect of a merger, as spelled out in Section 7 of the Clayton Act, ‘may be substantially to lessen competition, or to tend to create a monopoly’. The Department announced that its merger policy would focus on market structure ‘because the conduct of the individual firms in a market tends to be controlled by the structure of that market’ (see also Section 7 below). An enforcement policy emphasizing a limited number of structural factors would not only produce adequate economic predictions for the showing of anticompetitive effects, but would also facilitate both enforcement decision making and business planning, and as such contribute to legal certainty. Such rudimentary decision making, however, also holds some dangers, for example in allowing firms to accomplish the target indirectly, by circumventing the limited number of structural factors. In some cases this will lead to the same outcome, at a higher cost, or at a counterproductive outcome, as claimed by Bittlingmayer (1985). Here the trade-off will need to strike a balance between the additional costs resulting from closing down all the loopholes vis-à-vis the advantage of a simple and transparant attack to antitrust. In many cases, the second order effects probably will not be important enough to tip the balance in favour of an extensive enlargement of the set of structural factors to be monitored, but we know industries can differ in many respects.
4. The Chicago School The antecedents of the new theories of competition have to be found in the original contributions discussed in Section 2 and, most importantly, to the
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presence and interaction of Director and Stigler at the University of Chicago in the 1950s. In 1942, Stigler had already written that ‘it is doubtful whether the monopoly question will ever receive much illumination from large scale statistical investigations’ (see Stigler, 1942). In the 1950s the economist Aaron Director, together with a lawyer, Edward Levi, taught anti-trust at the University of Chicago. According to Posner (1979), Director formulated his ideas mainly orally. Numerous authors since then have further elaborated on Aaron Director’s core ideas and published them in scholarly journals. Bork (1954) elaborated on the often misunderstood aspects of efficiency resulting from vertical integration and brought together many of the schools’ insights in The Antitrust Paradox: A Policy at War with Itself (1978). (This book gives a complete and orthodox overview of the doctrine of the Chicago School.) The problem of tie-in-sales was analysed by Bowman (1957). Predatory pricing was investigated by McGee (1958), while another hot issue overwhelmed with misconceptions, namely vertical price fixing, was the topic of a paper by one of Chicago’s leading scholars in microeconomics, industrial organisation and law and economics, Telser (1960). A good survey of the issues involved and the economic forces at work is Reder (1982). The Chicago School’s point of departure can be found in neoclassical price theory. The confrontation between the classical, dogmatic approach to anti-trust law and the microeconomic angle of attack gave rise to an extremely rich, new efficiency theory. The Chicago approach to competition policy is not merely the result of the rejection of government intervention in the economy, although the opposite view often occurs. On the contrary, Director reached his conclusions by analysing competition problems through price theory. Unlike the economists following the S-C-P paradigm (the Harvard School), who examine competition problems on the basis of observable phenomena (empirical research) and industry tales instead of having recourse to an economic theory, Director sought an explanation for practices observed in real markets which tallied with the maximisation of profits, utility and welfare. Of course, if firms can engage in actions which are anti-competitive and profitable, they will do so. But already in 1964, Stigler showed that it was often more profitable to stay out of cartels than to form them. This conclusion, however, has been both confirmed (see Salant, Switzer and Reynolds, 1983), and rejected (see Deneckere and Davidson, 1984), indicating that one has to carefully investigate the nature of the interactions that takes place in industry, as is done in the game-theoretic tradition, discussed below. In the Chicago tradition, concentration mostly will be the result of efficiency, hence if antitrust authorities interfere with an existing market structure, they are likely to cause inefficiencies, and reduce rather than enhance welfare.
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One of the most important attacks on the S-C-P doctrine of conducting antitrust policies was given again by Stigler when investigating the role of barriers to entry. Often the Harvard tradition argued that fixed costs were seen to lead to scale economies on the one hand, but also to barriers to entry on the other. Stigler defines a barrier to entry as ‘a cost of producing (at some or every rate of output) that must be borne by a firm which seeks to enter the industry but is not borne by firms already in the industry’. Barriers to entry are present only if the costs for firms entering the market turn out to be higher than the costs for the existing firms. If, for example, it costs $10,000,000 to build the smallest possible efficient factory having an economic life of ten years, then the annual costs for a new entrant will be only $1,000,000. The existing firms will be confronted with the same annual costs, at least if it is assumed that they also intend to replace their factories. Accordingly, there is no cost disadvantage for the new entrant (see Posner, 1979; Spence, 1980, or Schmalensee, 1983) for initial ideas regarding the importance of sunk rather than fixed costs. These ideas were the fundamentals of what later on became the contestable market defence for ATT, and the subsequent new theories of industry structure by Baumol, Panzar and Willig (1982) and Sutton (1991). In fact, what turns out to be important for understanding market structure are not fixed but sunk costs. The latter are defined as non-recoupable costs, or outlays one has to make in order to get in business, but which are without value if one exits. Entrants will not be stopped if the fixed cost - the factory in the example above - can get a new destination or can be sold on a second-hand market (see Section 5 below). In short, the Chicago tradition then is the bundling of several ingredients, which taken together tell us that the monopoly problem is not all that important. First of all, as a stylised fact, monopolies (or strong market concentration for that matter) do not occur all that often. Moreover, if they are present, they are either the result of scale economies in production and/or distribution - and hence efficient - or the result of barriers to entry. But in the latter case, they are transitory, for the freedom of entry will induce the presence of other players in the market, which compete and hence limit the market power of the initial monopolist. Persistency of market power therefore can only be the result of government itself, by the fact that many of its regulatory policies establish legal barriers to entry, hence creating public monopolies. In terms of conduct, the often alleged malpractices also are explained by efficiency. Vertical restraints may provide the appropriate incentives for dealers to invest in quality of service or to appropriately advertise the product in its region. Others if allowed to deal in this region would free-ride on these efforts, the final result being that the initial dealer would no longer undertake the necessary efforts to maintain an high quality of service for the product (see also Telser, 1960). Commodity bundling also may be the result of efficiency
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considerations rather than trying to exploit monopoly power (see Kenney and Klein, 1983). From 1970 on, the influence of Chicago economics on US antitrust policy gradually increased. This has led, together with the renewed role of the private sector in the economy, to a different implementation of the law, in the sense that mergers or particular types of conduct have caused less problems for the firms involved. Such an evolution was bound to trigger the comment that Chicago economics is ideologically biased. In addition there is the belief held sometimes in Europe that the majority of the economics profession agrees with the characterisation of the Chicago School as an ideology. This is of course wrong, since what matters is the methodology to study antitrust issues along the lines of price theory, which was pioneered by the Chicago School and has currently been embraced by all scholars in industrial organisation as the starting point of every sound antitrust case. As such, the Chicago learning is well established both within the economic discipline of modern industrial organisation and antitrust practice, at least in the US, although it would be premature to claim that all of the US antitrust action is in line with the Chicago tradition (see Van den Bergh, 1997, and Section 7 below for a relativisation. Nonetheless, the Chicago School influences antitrust policy. The Merger Guidelines were revised several times (in 1982, 1984 and 1992) to take account of developments in economic thinking concerning the competitive effects of mergers. In the 1992 Guidelines there is no longer an explicit reference to the S-C-P paradigm; there is also explicit scope for an ‘efficiency defense’, which clearly reflects the influence of the Chicago School (see also Section 7 below). In Europe the same acceptance holds for the academic profession which has been very active in the field of industrial organisation, not the least through the EARIE (European Association for Reseach in Industrial Economics) conferences which celebrate their 25th edition, and for which there is no American counterpart. In antitrust policy however, the gap is substantial. This has led often to inconsistent treatment of one and the same phenomenon over a variety of industries (see again Van den Bergh, 1997). A real danger of the Chicago price theory tradition comes from the exageration of some theoretical concepts that do not apply to the real world very often. To some, contestability theory is such an example. In the US, it has been mistakenly applied, for example, in the airline mergers (see Utton, 1995). The result has been that it has been somewhat discredited. While in general thrust and effects, it is very much in the Chigaco School tradition, the major difference with mainstream Chicago concepts seems to lie in the lack of a positive inclination: the contestable market model serves a normative purpose in that it merely shows that there exists a yardstick market structure in which antitrust policies are useless even in the presence of monopoly. As will become clear, the assumptions needed to obtain this conclusion are so restrictive that
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the contestable market model cannot make claims to be descriptive or positive theory. In the theory of contestable markets, the fact that the market structure is concentrated says nothing, of itself, about the degree of efficiency. Even with a high degree of concentration, allocative efficiency is not excluded because potential entrants exercise a controlling discipline. Perfect contestability produces a similar outcome to perfect competition: prices are equal to marginal costs, as required by the welfare theorems, but without having a substantial number of competitors in the industry. The players necessary to guarantee this result are found outside the industry. In a perfectly contestable market, entry is completely free and withdrawal costs absolutely nothing. (Free entry does not imply that entry costs absolutely nothing, or that it is easy, but rather that the entrant has no relative disadvantages compared with participants who are already active in the market.) Besides lacking empirical support, many contributions have pointed out that the contestable market model is very particular, and that nearly every change of the assumptions leads to dramatically different outcomes (see, for example, the very early critical review article by Brock, 1983, or the discussion in Schwarz and Reynolds, 1983). For example, if some costs are sunk the incumbent has already paid for them, and will have written them off instantaneously as they are worth nothing if the activity is stopped. Potential entrants find it appropriate to judge the profitability of market entry on the basis of the post entry competition (which will determine the profitability) and the costs they still have to sink. If competition is hard, profits will be too low to cover these costs, and potential entry will never discipline the incumbents for it will not occur. Implicitly, the contestable market model by assuming zero sunk costs therefore assumes that investments can be redeployed in another activity (complete lack of asset specificity), or resold on a second-hand market that is not prone to failures (see, however, Akerlof, 1970, and Van Cayseele, 1993). Another example of the vulnerability of the conclusions with respect to small changes in the assumptions has been investigated in game theoretic detail by Van Cayseele and Furth (1996a, 1996b). In these articles, it is shown that if merely one assumption, namely that consumers react faster to lower prices than producers, is changed by the reverse assumption, the outcome of the contestable market model completely changes. Instead of predicting the perfectly competitive outcome for an industry in which firms compete with one another in prices, the monopoly outcome results. Other examples which follow a strict game-theoretic methodology show that one change in the assumptions may be sufficient to get drastically different outcomes (see Ausubel and Deneckere, 1987). There, the assumption that non-durable goods are involved is changed into the production of durable goods. While Coase (1972) had
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argued that durable good monopolists had no market power, the contestable market model with a duopoly in durable goods yields monopoly outcomes. From an academic viewpoint, the Chicago price theory tradition has been surpassed in the last decade by the contributions game theory made to the field of industrial organization. In the next section, we enter in detail into the gametheoretic contributions which are important in the area of antitrust economics. For the moment, it is important to stress that these newer contributions have shown that it is quite possible to explain certain mergers and particular types of conduct not as the result of efficiency, but from a clear pursuit of gaining or keeping market power. However, it would be untrue to say that the newer game-theoretic contributions are at odds with the Chicago tradition. On the contrary, from a methodological viewpoint this new approach has pursued with the same rigor as price theory the analytical approach to understanding the operations of firms in an industry. However, by allowing for a richer set of strategies it has been shown that some of the conclusions reached by the Chicago tradition could indeed be the outcome, but at the same time that under slightly different assumptions (which some will argue more closely to reality), quite different conclusions result. What certainly is taken for granted is that both the advocates of laissez-faire (no antitrust) as well as those in favour follow mathematical modelling approaches which allow sharp inroads into the problem, just as price theory pioneered by Director, Stigler and others a few decades earlier.
5. The New Industrial Economics: Game Theory and Transaction Cost Analysis Game theory offers a rigorous analytical framework - like price theory - to analyse the competition of firms. Game theory requires being explicit on the set of players (firms), on their strategies, and on the advantages these strategies can bring to them (payoffs). It offers solution concepts that take into account firstmover advantages and credible commitments that firms can take. As such it is said to reflect much more real-world competition than any other body of theory. A general introduction of the achievements game theory was able to accomplish for competition policy is provided by Phlips (1988, 1995). Jacquemin (1997) provides examples of the links that game theory has regarding both the goals of competition policies and the anti-competitive practices that are unconceavable with such policies. In addition to the many valuable insights received from the Chicago tradition, game theory especially has contributed by explicating carefully the relevant strategies and considerations that need to be taken into account as well as by pointing out that perfect information is not always prevalent. This has serious implications for the working of a market. In some cases, including a
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more full description of the strategic possibilities has led to a reversal of the conclusion: an insight found within the Chicago tradition was turned upside down. In other cases, the conclusions of the Chicago School have been confirmed, in a richer and more realistic economic environment. An important example for antitrust is horizontal mergers. Stigler had already argued that mergers for a market power motive would not be formed as it is more profitable to stay out such a merger than to join it. Paradoxically, Salant, Switzer and Reynolds (1983) show that with a linear demand curve, constant marginal costs and firms competing in quantities, at least 80 percent of the firms in an industry have to be included in the merger in order for it to be profitable. Clearly, these are not the mergers that will show up, for antitrust authorities would quickly rule them out on the basis of the creation of dominant positions. This would imply that mergers are not likely to form, unless some important efficiency gains in terms of, for instance, production or distribution costs are made. But these are the mergers that need to be approved from a welfare point of view, hence antitrust authorities only have to bother with clearly dominant positions. But the result depends on one critical assumption: the competition is in quantities rather than in prices. It was shown by Deneckere and Davidson (1984) that all mergers are profitable even if they do not yield efficiency improvements in the latter case. Hence the conclusions are turned upside down by merely the change of one assumption. This has led those critical of game theory to claim that any conclusion or its reverse can be proved, while the defenders of game theory claim that the advantages definitely outweigh this disadvantage (see, for instance, the discussion between Fisher, 1989 and Shapiro, 1989). The latter includes the fact that game theory requires one to explicate all the assumptions made also on behalf of the rival players (which was not always done by price theory), as well as the richness in terms of institutional detail and hence the realism game theory has added to economic models. In Sleuwaegen and Van Cayseele (1997) still another reason is given, namely the fact that as more game theoretic analysis of industries become available, it becomes possible to operate along a decision tree approach and to guide antitrust authorities as to whether a detailed investigation of the proposed operation is necessary. Finally, and as shown in a seminal article by Kamien and Zang (1990), game theory allows one to do more. In the just mentioned controversy between Salant, Switzer and Reynolds, on the one hand, and Deneckere and Davidson, on the other, the mergers under consideration are all given exogenously. But it is possible to endogenise the formation of mergers by considering different coalitions that can be formed, and hence reduce the number of conceivable mergers to those that are feasible. Similar game-theoretic exercises endogenise the strategies in which the firms will compete with one another, or even the moves, hence explaining who leads and who follows (see Hamilton and Slutsky, 1990). Another development which seriously attenuates the critique on game-
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theoretic models is the bounds approach by Sutton (1991) (see also Section 6 below). A final advantage of game theory is that, by its analysis of bounded rationality, it opens the way to approaches which hitherto remained outside the mainstream of microeconomics, by the fact that pure price theory does not offer much room for search and transaction costs phenomena. Nonetheless, transaction cost theory has a longstanding tradition in the law and economics of antitrust (see Williamson, 1975, 1979). The central idea in transaction cost economics is that the market is not entirely free in the sense that certain operations (transactions) are not entirely costless. As such, the transaction cost approach superimposes frictions upon microeconomic price theory. Seen in this light, transaction cost analysis is more a complement to than a substitute for price theory. The point of departure in Williamson’s analysis is not the subject matter of the sale/purchase transaction (goods or services) but the transaction or transfer system itself. The transaction is an exchange between two or more individuals whereby they transfer ‘property rights’ (that is, rights to dispose of scarce resources, which may be limited not only by other individuals’ ownership rights but also by rules of legal liability and the provisions of competition law). Transactions differ perceptibly so far as costs are concerned and these differences in transaction costs influence the choice of the right organisational form or ‘governance structure’. The transaction cost approach is thus concerned with the costs which are necessary to maintain the economic system. To put it briefly: markets and firms are regarded as alternative instruments for implementing transactions (see Williamson, 1985, 1986). Colloquially, managers speak about the ‘make or buy’ decision. Indeed, whether a transaction to acquire a good or service is carried out over the market or within the firm depends on the relative efficiency of these two institutions. A hierarchical form of organisation may be superior to a market-based solution. The relative efficiency of the two forms is determined on the one hand by the costs of entering into and carrying out agreements in a market, and on the other hand by the characteristics of the individuals who are affected by the transaction. As such, the origins of transaction cost economics go back at least to Coase (1937), who in his classic essay laid the foundations for the new institutional economics. Markets and firms are indeed institutional forms, and their existence and survival are explained out of economic efficiency. The use of one mode or the other for a particular type of transaction directly follows from the relative costs of operating over one system or the other. As such, the laws which regulate and interfere with these institutions will also be judged in the long run by economic efficiency. If legal rules make it more difficult to operate over a particular institution (for instance competition policies which forbid vertically integrated firms), that institution will lose appeal and vanish, together with the law that regulated it.
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Transactions differ from each other in a number of respects: the uncertainty to which the transactions are exposed, the frequency with which the transactions are repeated (once, occasionally, regularly) and the extent to which transactions must be supported by transaction-specific investments (‘asset specificity’). By asset specificity Williamson means the extent to which suppliers and customers must make specific investments in order to be able to carry out the transactions. Transaction-specific investments bind the supplier and the customer closely together. If the supplier cannot readily exploit his specific investments elsewhere and the purchaser, because of his specific investments, cannot readily place his order elsewhere, the supplier and the purchaser are bound to each other for a substantial period of time. This leads to situations in which market participants are very much dependent upon each other (‘small numbers exchange’). The importance of transaction costs depends on human factors such as the limited possibility to solve complex problems and ‘opportunism’. Opportunism follows straightforwardly out of the pursuit of self-interest in environments characterised by incomplete information or the lack of repeated transactions, making it simply not worthwhile to care for reputation. As already argued above, game theory has allowed the investigation of such moral hazard problems. And more recently game theory also has allowed the analysis of bounded rationality phenomena (see Young and Foster, 1991). Transaction cost economics has important implications for antitrust policy. Certain market structures might be the result of transaction cost efficiencies, not the strive for market power. A welfare-maximising anti-trust law then must take into account these efficiency aspects. In the context of the control of concentrations it is necessary to consider what transaction cost savings will be prevented by a merger prohibition and whether these (possible substantial) costs are compensated by the anticipated advantages of more intensive competition. Vertical integration or vertical restraints can be the result of complex negotiations aiming at the reduction of transaction costs. As a conclusion for this section, it is clear that game theory has entered the field of industrial economics to remain as a dominant supplier of tools to analyse sectors and industries. For the moment, the problem is not that the new industrial organisation is not very accurate but, on the contrary, that for nearly each different sector studied the assumptions and solution concepts of the models have to be adapted. This is of course mainly a problem for the laymen who lack the game theoretical knowledge to analyse industries, or to judge the quality of studies done by others. The plethora of models around does not make it easy to pick a model and be sure that it is appropriate for the sector under investigation. But things are changing quickly as, from the empirical side, the new empirical industrial organisation and the bounds approach are providing a workable synthesis.
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6. The New Empirical Industrial Organisation and the Bounds Approach The new empirical industrial organisation has tried to resolve the problem of indeterminacy in the new industrial economics, by leaving it open as to what kind of conduct prevails in an industry. The general idea is that industry structural elements can be measured and modelled, hence one starts from theoretical models of a sector. As such, conduct which is much harder to know ex ante is left open to be determined empirically. The divergence of industries necessarily calls for sector-specific models. Usually the fundamental ingredients are specifications of supply and demand, modified and augmented with industry-specific features. Estimation based on time series analysis allows the identification of market power, that is to separate the effects of cost changes from mark ups. The new empirical industrial organisation is a great leap forward for antitrust practitioners, as it allows the simulation of the effects of mergers and the detection of collusive behaviour. Models for an increasing number of industries become available, as we have witnessed since the pioneering studies applications to the cigarette industry (see Sullivan, 1985), automobile industry (see Berry, Levinsohn and Pakes, 1995; and Verboven, 1996), steel industry (see Baker, 1989), soft drinks (see Gasmi, Laffont and Vuong, 1992), and many others. The problem with this approach is that models do not already exist for every sector. Hence, an open industry in terms of publishing and communicating data might face a study which is at the disadvantage of the sector, whereas in other sectors collusion is much more important, but remains unknown. Moreover, often these studies will have to rely on historical data, hence it might not be appropriate to study a merger today in view of conduct a few decades ago. On the other hand, the pioneering studies by Panzar and Rosse (1987) and Porter (1983) offer many perspectives in that they have been applied successfully to many sectors without too much re-modelling. A similar effort to find robust results, that is results that can be applied to every industry under consideration is Sutton (1991). This approach is even more generally applicable, at the expense however of having to incorporate some degrees of freedom as to what can happen. Typically, one will only be able to say within which boundaries a sector will move, without being precise as to where it will be. Or, only an upper and lower bound to concentration will result. As such, this approach tries to provide the foundations for the S-C-P paradigm, but immediately shows how shaky the traditional Harvard approach was when it claimed it could make exact predictions regarding the impact of market structural changes such as concentrations. While some claim that many factors that are identified to be important in explaining market structure and the evolution of concentration could have been written down without all the theoretical efforts by Sutton, the old Harvard
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approach simply never has done it. Moreover, the explicit game-theoretic foundations used by Sutton illustrate the importance of adequate modelling of product differentiation, commitment, sunk costs and so on. It also shows the exact relation in which those factors relate to one another. Indeed, the Harvard approach mostly has looked for causal relations between variables that all are endogenous if one truly understand the dynamics of competition. This is mainly due to feedback effects of market performance variables, a fact well known in the European tradition on industrial organisation (see Jacquemin and De Jong, 1977).
7. The Influence of Economics on Antitrust Law In the last part of this contribution it will be investigated how far economic theory and concepts of industrial economics have had an influence on antitrust law. It seems fair to say that American antitrust law has been influenced by a constantly increasing and ever more penetrating use of economic theory, whereas the influence of economics on European competition law has remained rather modest. At present there are remarkable differences between American and European law with respect to the treatment of some hot issues in antitrust, such as predatory pricing and merger control. These differences may be attributed to at least two reasons. The main goal of European competition law (Articles 85-86 EC Treaty and Regulation 4064/89) has always been the promotion of market integration. A similar goal is absent in American antitrust law, since the latter rules came into being when a common market was already established. It was mainly political necessity, rather than economic theory, that made an active competition policy necessary in the eyes of the authors of the EC Treaty. The elimination of market compartmentalisation caused by restrictions on competition was necessary in order to achieve the central objective of integrating national markets. This aim of market integration is essential for an understanding of the principal characteristics of European competition law. The emphasis put on market integration has enabled European policymakers to avoid a profound debate about the values or objectives underpinning the competition rules of the EC Treaty. Consequently, the view of the Chicago School that productive and allocative efficiency are the only objectives which may be taken into account in interpreting and applying antitrust law could not get a firm basis in Europe. To a large extent, European competition law is at the same stage of development as American antitrust law was in the 1960s (see Van den Bergh, 1996). However, there are some first signs of a greater willingness by the European Commission to make use of economic theory (for example, with respect to the analysis of vertical restraints (see European Commission, 1997, pp. 19-31). It would, however, be wrong to label the latest developments in Europe as a victory for economic efficiency. Compared to American antitrust law European competition law still is less
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consistent with an efficiency based approach. Neither the European Commission nor the Court of Justice are sufficiently receptive to economic arguments, so that decisions and judgements are often formalistic and based on reiteration or expansion of early case law. 7.1 United States of America Although there may be disagreement as to the origins of the oldest competition legislation - the American Sherman Act of 1890 - it is clear that the Act was based not only on political objectives but also on the dominant economic theory at the end of the nineteenth century (see Sullivan, 1991). The economic objectives of the Sherman Act can be traced back to classical economics, which define competition as a process of rivalry taking place between large and small competitors in open and accessible markets. Consequently, the Sherman Act prohibits all ‘contracts, combinations and conspiracies’ which hinder trade, together with business conduct aimed at achieving a monopoly position by excluding competitors. In neoclassical economic theory the concept of ‘perfect competition’ was developed. Perfect competition is a situation in which the possibility of competitive behaviour in the Smithian sense is ruled out by definition. To some European authors the concept became a blueprint for competition policy (see, for example, Eucken, 1949), but the model was not used as a policy guideline in the USA. The same is true for the early theories of imperfect competition (Robinson, 1933, 1964) and monopolistic competition (Chamberlin, 1933), which did not have a clear influence on American antitrust policy either. The influence of economics on antitrust law increased dramatically, once the Harvard School had articulated the basic perceptions of industrial organisation theory in the well-known SCP paradigm and claimed to be able to explain the relationships among these three variables. This, together with the emergence of the new competitive ideal of workable competition had a clear influence upon competition policy. The concept of workable competition came about as a result of the publication, in 1940, of John M. Clark’s classic article. Clark denied that the ideal of perfect competition could serve as a blueprint for competition policy. Furthermore, Clark emphasised that, in the long run, market imperfections were not bound to be injurious per se. Not all market imperfections should be eliminated by competition policy, for market imperfections can neutralise each other (the antidote theory). Clearly, antitrust authorities will enjoy broad discretionary powers if competition policy must not eliminate all persistent market imperfections but should instead judge only to what extent an industry is workably competitive. Discretionary powers of antitrust authorities are further increased when antitrust law is also supposed to include non-economic objectives, as was the case with the Harvard School’s view in the 1950s-1960s. A complete and orthodox description of the Harvard
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views at that time is provided in Kaysen and Turner (1959). Kaysen and Turner distinguished no less than four objectives of competition policy: to achieve favourable economic results; to create and maintain competitive processes; to prescribe norms of ‘fair conduct’ and to restrict the growth of large firms. These objectives are partly inconsistent with each other and thus provide for large discretionary powers to be exercised by antitrust authorities. The Harvard analysis became the cornerstone of competition policy in the 1960s and remained so until the neoclassical and neoinstitutional approaches began to win the upper hand in the mid 1970s. Nowadays very few antitrust scholars in the United States believe that non-economic factors should pay any role whatsoever in antitrust analysis. In the light of the relationship between market structure, market conduct and market results, competition law became an instrument for generating optimal outcomes by directly influencing market structure (merger control). If prices increase as a result of market concentration, then mergers must be closely scrutinized. In the 1968 Merger Guidelines of the American Department of Justice it was stated that an analysis of market structure was fully adequate for showing that the effect of a merger, as spelled out in Section 7 of the Clayton Act, ‘may be substantially to lessen competition, or to tend to create a monopoly’ (US Department of Justice, 1968). The Department announced that its merger policy would focus on market structure ‘because the conduct of the individual firms in a market tends to be controlled by the structure of that market’. Following the Harvard views, only in exceptional circumstances would structural factors not alone be conclusive (for example in the case of conglomerate mergers). With respect to horizontal mergers, the 1968 Merger Guidelines used the CR 4 ratio as market concentration measure: when the shares of the four largest firms amounted to approximately 75 percent or more, the market was regarded as highly concentrated. The Department announced that mergers should be challenged when the market shares of both the acquiring firms and the acquired firms exceeded a certain threshold: for example, in highly concentrated markets mergers between firms both accounting for approximately 4 percent of the market would be challenged; in less highly concentrated markets a 5 percent market share for both the acquiring and the acquired firm was used as the relevant threshold (US Department of Justice, 1968). The Chicago School acquired a strong influence on American antitrust policy from the 1970s onwards and reached the apogee of its influence in the 1980s. A number of examples appropriately illustrate the altered judgement on forms of market conduct which, until the Chicago School emerged, seemed to cause competition problems but which, through the renewed application of price theory, no longer give rise to problems. The Harvard School was very critical of vertical restraints; the orthodox view proposed a strict ‘per se illegality’ for vertical price-fixing and tying (Kaysen and Turner, 1959, pp. 148-160). The Chicago revolution began when, in 1960, Telser published an
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article on vertical restraints which has since become a classic. In this essay the free-rider problem played a central role in explaining vertical price-fixing (see Telser, 1960, and Marvel and McCafferty, 1984, who added a quality certification argument). The free-rider rationale is not only used in the analysis of vertical price-fixing but has been extended by the Chicago School authors to other intra-brand restraints such as the reservation of exclusive sales territories and exclusive sales channels (selective distribution, franchising). The most far-reaching proposal of Chicago scholars was to introduce ‘per se legality’ for restricted distribution (Posner, 1981). Protection against free-riding may also explain interbrand restraints, such as exclusive dealing. Exclusive territories address the free-riding of one dealer on the efforts of another, whereas exclusive dealing addresses the free-riding of one manufacturer on the efforts of another (see Marvel, 1982). In deciding about the lawfulness of vertical restraints the American Supreme Court has been influenced by the Chicago analysis. The assessment of vertical restraints has wavered back and forth between the rule of reason and per se unlawfulness. In 1963 a majority of the Supreme Court held that vertical restraints did not necessarily violate the antitrust laws and were therefore subject to a rule of reason test (White Motor Co. v. United States). Four years later, the Supreme Court enunciated a clear-cut, but formalistic, distinction between restraints imposed by a manufacturer who retained ownership of the goods in question, and those imposed by a manufacturer after parting with ownership. If a manufacturer parts with ownership over his product or transfers risk of loss to another, he may not reserve control over its destiny or the conditions of its resale (United States v. Arnold, Schwinn & Co.). Then in 1977 the Supreme Court made clear that ‘departure from the rule-of-reason standard must be based upon demonstrable economic effect rather than … upon formalistic line drawing’. In so holding the Court drew also on the academic writings of the Chicago School. It would be premature, however, to consider the case-law of the American Supreme Court as a victory for the Chicago School analysis. The readiness of the American judiciary to apply the rule of reason does not extend to minimum vertical price-fixing. With respect to maximum resale prices the rule only recently shifted from a per se prohibition to the reasonableness standard (State Oil v. Kahn, Slip op. at 5). In the United States the Chicago learning has clearly influenced the analysis of predatory pricing. In the Matsushita case (in which American manufacturers of consumer electronic products accused Matsushita of combining with other Japanese manufacturers to monopolize the American market through predatory pricing), the Supreme Court quoted a number of publications by disciples of the Chicago view in support of its rejection of price-undercutting as a rational (that is, profit-maximising) economic strategy. The Supreme Court emphasised that a campaign of predatory pricing can be rational only if, after the elimination of the target, there remains sufficient monopoly power to raise prices and thus
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generate additional income. Given that in the Matsushita case it was improbable that the purpose of the predatory pricing could be achieved, the majority concluded that the price-undercutters ‘competed for business rather than to implement an economically senseless conspiracy’ (Matsushita Elec. Indus. Co. v. Zenith Radio Co.). In recent American case-law economic arguments are playing an ever more important role, but the Supreme Court seems no longer willing to blindly follow the Chicago approach. Antitrust defences based on Chicago ideas may be rejected using counter-arguments which are similarly economic in nature and largely based on criticisms towards the assumptions underlying the Chicago analysis. The Kodak case provides an interesting example (Eastman Kodak Co. v. Image Technical Services, Inc. et al.). Independent service organisations complained that Kodak had limited the availability of its proprietary spare parts, thus monopolising the market for the servicing of Kodak equipment. Kodak’s defence was primarily based on the argument that if there was competition in the primary market, then aftermarket power should have little adverse effect on consumers. The argument was similar to the Chicago School’s view that it is not possible for a dominant firm to achieve monopoly profits twice: the so-called leverage hypothesis was rejected already in the early days of the Chicago School (see Bowman, 1957). If a manufacturer raises the price of maintenance services, it can only do this - so Kodak argued - at the expense of lowering the initial purchase price of the equipment. The Supreme Court rejected this Chicago-inspired argument and demonstrated that consumers were not able to calculate lifetime cost with any accuracy, either because necessary information was not available to them or because of ‘bounded rationality’. Thus the Supreme Court made clear that the Chicago analysis of tying arrangements only holds under conditions of perfect information. Chicago theorists also exerted a clear influence upon American merger policy. The current 1992 Merger Guidelines are evidence that many concepts that started out as Chicago School concepts are now embraced by almost all of the US antitrust community. Throughout the Guidelines the analysis is focused on whether consumers or producers ‘likely would’ take certain actions, that is whether the action is in the actor’s economic interest. This reflects the concern to explain, rather than to merely describe, behaviour in (concentrated) markets, in order to be able to avoid inappropriate regulatory interventions. Intervention by the antitrust authorities is also geared to the goals of allocative efficiency: merger control should prevent that prices are raised above competitive levels for a significant period of time. Market power is defined accordingly. To create or enhance market power or facilitate its exercise, the merger must significantly increase concentration. The concentrated market must be properly defined and measured; the Guidelines pay considerable attention to the difficult problem of market definition. As a measure of market concentration the HHI index is used,
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instead of the CR4. If concentration increases significantly, the American antitrust agency will assess whether the merger raises concern about potential adverse competitive effects. It is stressed that market share and concentration data provide only the starting point for analyzing the competitive impact of a merger. Hasty conclusions from market structure of performance are thus overcome. A merger may diminish competition by enabling the firms selling in the relevant market more likely, more successfully or more completely to engage in coordinated interaction that harms consumers (tacit or express collusion). Mergers may also harm consumers if they create conditions conducive to reaching terms of coordination or conditions conducive to detecting and punishing deviations. If the merger raises significant competitive concerns, the antitrust agency will examine whether market entry may counteract the competitive effects of concern. At this point of the analysis the Chicago influence is obvious: Chicagoans stress that the possibility of market entry may prevent the post-merger firm from earning above-normal profits. Following this view, the Guidelines state that mergers in markets where entry is easy raise no antitrust concern. Entry is considered as ‘easy’ when it passes the tests of timeliness (entry must take place within a timely period), likelihood (entry must be profitable) and sufficiency (entry must be sufficient to return market prices to their pre-merger levels). The analysis of entry conditions will not yet complete the analysis. Efficiency gains of the merger will next be assessed. The Guidelines explicitly state that the primary benefit of mergers to the economy is their efficiency-enhancing potential, which can increase the competitiveness of firms and result in lower prices to consumers: ‘As a consequence, in the majority of cases, the Guidelines will allow firms to achieve available efficiencies through mergers’. Finally, it will be examined whether, but for the merger, either party to the transaction would be likely to fail, causing its assets to exit the market (failing company defense). The ultimate question whether the merger is likely to cause prices above competitive levels for a significant period of time will thus only be answered after an assessment of market concentration, potential adverse competitive effects, entry, efficiency and failure (US Department of Justice, 1992). 7.2 Europe Notwithstanding the fact that it is unlikely that the authors of the Treaty of Rome were aware of the concept of workable competition, many of the distinguishing features of European competition policy seem to fit into this theoretical framework. It is noteworthy that the European Court of Justice, in its leading Metro judgement, referred to the concept of workable competition as being the type of competition that was necessary to achieve the economic objectives of the EC Treaty (Metro v. SABA and Commission). The judgement was concerned with the lawfulness of selective distribution agreements. Once
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technical and luxury products are sold - for resale - only to recognised distributors, there can no longer be any question of a market which accords with the model of perfect competition. On the other hand, it is indeed possible to speak of workable competition. The European Court of Justice emphasised that price competition is not the only form of competition for wholesalers and retailers. It considered that it was in consumers’ interests for prices to be set at a certain level in order to be able to support a network of specialised dealers alongside a parallel system of dealers who themselves provide services and undertake other actions to keep distribution costs down. This choice is open to certain sectors in which high-quality, technically advanced and durable goods are produced and distributed. The manner in which the concept of workable competition acquired specific content can, by way of example, be further examined by studying present-day law in relation to selective distribution systems (for an overview, see Goyder, 1993). Provided the only criteria for selecting a distributor are objective, qualitative ones relating to his technical qualifications, his staff and his firm, and these criteria are determined uniformly for all distributors; and provided, furthermore, that they are applied in a non-discriminatory manner, the agreement is not regarded as restricting competition within the meaning of Article 85(1) EC Treaty. In order to establish the precise nature of such qualitative criteria for the selection of distributors, it is necessary to consider whether the characteristics of the product require a selective distribution system in order to maintain the quality and the proper use of the product. It is also necessary to examine to what extent these aims can already be accomplished by national regulations concerning access to the distributor’s profession or the conditions under which the products in question may be sold. Finally, one must answer the question of the extent to which the criteria thus determined are necessary in order to achieve the objective of improved quality. The European Commission has approved selective distribution systems for, for example, cars, television sets, watches and personal computers. It is evident that selective distribution agreements make resale to non-recognised dealers in other EC countries impossible, but the European Commission has nothing against this so long as exports within the selective distribution channels continue unhindered. By contrast, with the strict prohibition against absolute territorial protection in exclusive distribution agreements, increasing interbrand competition is balanced against the restraints inherent in intra-brand competition. Inter-brand competition guarantees consumers’ freedom of choice so long as access to the relevant market, or the competition within it, is not restricted to a significant extent by the cumulative effects of parallel networks or by similar agreements between competing producers or distributors. It is therefore necessary, when judging selective distribution systems, to take account of competition between competing systems of distribution. When selective distribution goes hand in hand with a quantitative restriction on
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recognised resellers the Commission will, as a rule, give full effect to the prohibition against cartels. The fact that the economic doctrine of the Chicago School has not influenced European competition law is clearly apparent from the decisions in AKZO and Tetra Pak II. The Court of Justice accepted a price-cost comparison as the yardstick by which to establish predatory pricing. Abuse of dominant position must be deemed to be present once prices fall below the level of average variable costs. According to the Court of Justice, a firm with a dominant position will always suffer losses if it charges such prices and it will have an interest in doing so only if it is aiming to exclude competitors in order to profit thereafter, by means of price increases, from the monopoly it has achieved. Furthermore, the Court of Justice considered that prices which are higher than average variable costs but lower than average total costs must be considered as unlawful to the extent that the fixing of prices at that level forms part of a strategy of excluding competitors. According to the Court of Justice, such prices can exclude from the market firms which, while just as efficient as the dominant firm, do not possess sufficient financial resources to enter such a price war. One can detect in this last argument the ‘deep pocket’ reasoning which has been discredited in the Chicago-oriented economic literature. In the event that the prices of the defendant firm are lower than average variable costs, there exists an irrefutable presumption of prohibited price-undercutting (predatory pricing). The European Court therefore adopts a stricter attitude towards price wars than the American judges do. Once prices are higher than average variable costs but lower than average total costs, supplementary evidence must be adduced in order to establish incontrovertibly the existence of a strategy aimed at the exclusion of competitors. From the Court’s further reasoning it seems that making threats, asking ‘unreasonably low prices’, maintaining artificially low prices over long periods and granting fidelity rebates can, together, provide the necessary supplementary evidence. In the AKZO case the Court relied heavily on the subjective evidence of intention on AKZO’s part (AKZO v. Commission). According to the Court, AKZO’s intention was clearly aimed at annihilating ECS (the target of the price war) because AKZO’s prices were not fixed in order to respond to competition from ECS but turned out in fact to be significantly lower. The weakest point both in the Commission’s reasoning and in that of the Court of Justice’s is that in neither of them was it adequately demonstrated that AKZO’s so-called predatory pricing could have succeeded. In the Chicago view an essential condition for considering predatory pricing as a rational competitive strategy is that the price-undercutter can recoup his losses after driving the target from the market. The longer the price-undercutting lasts, the larger the accumulated losses will be. Also, it will be very difficult or impossible to recoup the losses if potential new entrants to the market have to
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be borne in mind. Neither the Commission nor the Court of Justice gave sufficient consideration to these factors. In 1994, the European Court of First Instance had an opportunity to reconsider the position in Tetra Pak II, for the Commission’s finding that Tetra Pak had practised predatory pricing was specifically challenged by reference to the economic theory accepted in the most recent American case-law. Tetra Pak argued that, even if it had priced its products under cost, it could not have been indulging in predatory pricing because it had no reasonable hope of recouping its losses in the long term. The Court, however, upheld the Commission’s finding without any serious examination of this argument, holding that, where a producer charged AKZO-type loss-making prices, a breach of Article 86 EC Treaty was established ipso facto, without any need to consider specifically whether the company concerned had any reasonable prospect of recouping the losses which it had incurred (Tetra Pak International SA v. Commission). Finally, in the field of merger control the emphasis of the inquiry is on whether the concentration ‘creates or strengthens a dominant position’ (Reg. 4064/89). This clearly reflects the Harvard ideas that the structure of the market has an impact on the ultimate performance of the market. There is no explicit efficiency defence. Efficiencies are often seen as evidence of market power, rather than as benefits which may outweigh the anti-competitive consequences of mergers (see Neven, Nuttall and Seabright, 1993).
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Sleuwaegen, Leo and Van Cayseele, Patrick (1997), ‘Belgian Competition Policy, Some Facts and an Economic Analysis’, in Martin, S. (ed), Competition Policy in Europe, Amsterdam, North Holland, 185-204. Smets, Hilde and Van Cayseele, Patrick (1995), ‘Competing Merger Policies in a Common Agency Framework’, 15 International Review of Law and Economics, 425-441. Smith, Adam ([1776] 1937), An Enquiry into the Nature and Causes of the Wealth of Nations, New York, Modern Library Edition. Spence, A. Michael (1980), ‘Notes on Advertising, Economics of Scale, and Entry Barriers’, 95 Quarterly Journal of Economics, 493-507. Stigler, George J. (1942), ‘The Extent and Bases of Monopoly’, 32(2) American Economic Review, 1-22. Stigler, George J. (1968), The Organisation of Industry, Homewood, Ill., Irwin.. Stigler, George J. (1964), ‘A Theory of Oligopoly’, 72 Journal of Political Economy, 44-61. Stigler, George J. (1971), ‘The Theory of Economic Regulation’, 2 Bell Journal of Economics and Management Science, 3-21 Stigler, George J. (1976), ‘The Xistence of X-Efficiency’, 66 American Economic Review, 213-216. Sullivan, Thomas E. (1991), The Political Economy of the Sherman Act. The First One Hundred Years, New York and Oxford, Oxford University Press. Sullivan, Daniel (1985), ‘Testing Hypotheses about Firm Behaviour in the Cigarette Industry’, 93 Journal of Political Economy, 586-598. Sutton, John (1990), ‘Explaining Everything, Explaining Nothing? Game Theoretic Models in Industrial Economics’, 34 European Economic Review, 505-512. Sutton, John (1991), Sunk Costs and Market Structure, Cambridge, MA, MIT Press. Telser, Lester G. (1960), ‘Why Should Manufacturers Want Fair Trade?’, 3 Journal of Law and Economics, 86-103. Tirole, Jean (1988), The Theory of Industrial Organisation, Cambridge, MA, MIT Press. US Department of Justice (1968), Merger Guidelines, Trade Regulation Reports, CCH, 13, 101ff. US Department of Justice (1985), Vertical Restraints Guidelines, Washington. US Department of Justice (1992), Merger Guidelines, Washington. Utton, Michael A. (1995), Market Dominance and Antitrust Policy, Aldershot, Edward Elgar, 342 p. Van Cayseele, Patrick (1993), ‘Lemons, Peaches and Creampuffs, or the Economics of Second-hand Markets’, 38 Tijdschrift voor Economie en Management, 73-85. Van Cayseele, Patrick (1994), De Belgische Wet op de Mededinging in een Industrieel Economisch en Internationaal Juridisch Perspectief (The Belgian Law on Competition in a Industrial, Economic and International Legal Perspective), Antwerpen, Maklu, p. 152. Van Cayseele, Patrick (1996), ‘Industriële Economie, Toen en Nu (Industrial Economics, Then and Now)’, Maandschrift Economie, 5-24. Van Cayseele, Patrick (1998), ‘Market Structure and Innovation: A Survey of the Last Twenty Years’, De Economist, forthcoming. Van Cayseele, Patrick and Furth, Dave (1996a), ‘Bertrand-Edgeworth Duopoly with Buyouts or First Refusal Contracts’, 16 Games and Economic Behavior, 153-180. Van Cayseele, Patrick and Furth, Dave (1996b), ‘Von Stackelberg’s Equilibria for Bertrand-Edgeworth Duopoly with Buyouts’, 23 Journal of Economic Studies, 96-109.
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Van den Bergh, Roger (1996), ‘Modern Industrial Organisation versus Old-Fashioned European Competition Law’, 17 European Competition Law Review, 75-87. Van den Bergh, Roger (1997), Economische Analyse van het Mededingingsrecht. Een Terreinverkenning, 2nd edn, Arnhem, Gouda Quint. Verboven, Frank (1996), ‘International Price Discrimination in the European Car Market’, 27 Rand Journal of Economics, 240-268. Viscusi, W. Kip, Vernon, John M. and Harrington, Joseph E. (1995), Economics of Regulation and Antitrust, Cambridge, MA, MIT Press, 757 p. Weiss, Leonard W. (1963), ‘Average Concentration Ratios and Industry Performance’, 11 Journal of Industrial Economics, 237-254. Weiss, Leonard W. (1969), ‘Quantitative Studies of Industrial Organisation’, in Intriligator (ed), Frontiers of Quantitative Economics, Amsterdam, North-Holland. Weiss, Leonard W. (1989), Concentration and Price, Cambridge, MA, MIT Press. Williamson, Oliver (1975), Markets and Hierarchics: Analysis and Antitrust Implications, New York, The Free Press. Williamson, Oliver (1979),’ Assessing Vertical Market Restrictions: Antitrust Ramifications of the Transaction Cost Approach’, 127 University of Pennsylvania Law Review, 953-993. Williamson, Oliver (1985), The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting, New York, The Free Press. Williamson, Oliver (1986), Economic Organisation, Firms, Markets and Policy Control, New York, New York University Press. Worcester, Dean A. (1973), ‘New Estimates of the Welfare Loss to Monopoly in the United States 1956-1969', 40 Southern Economic Journal, 234-245. Young, H. Peyton and Foster, Dean (1991), ‘Cooperation in the Short and in the Long Run’, 3 Games and Economic Behavior, 145-156.
Cases US Eastman Kodak Co. v. Image Technical Services, Inc. et al., 112 S.Ct. 2072 (1992)) Matsushita Elec. Indus. Co. v. Zenith Radio Co.,475, pp. 597-598 (1968) State Oil v. Kahn, US 1997 WL 679424 (U.S. Nov. 4, 1997) United States v. Arnold, Schwinn & Co., 388 U.S. 365 (1967) White Motor Co. v. United States, 372 U.S. 253 (1963) EU AKZO v. Commission (1991), Case 62/86, ECR 3359 Metro v. SABA and Commission (1977) , Case 26/76, ECR 1875 Tetra Pak International SA v. Commission (1994), Case T-83/91, ECR II
5400 REGULATION OF NATURAL MONOPOLY Ben W.F. Depoorter Researcher Center for Advanced Studies in Law and Economics University of Ghent, Faculty of Law © Copyright 1999 Ben W.F. Depoorter
Abstract The concept of natural monopoly presents a challenging public policy dilemma. On the one hand a natural monopoly implies that efficiency in production would be better served if a single firm supplies the entire market. On the other hand, in the absence of any competition the monopoly holder will be tempted to exploit his natural monopoly power in order to maximize its profits. This chapter will take a closer look at the model of natural monopoly. It will address those areas where an unregulated natural monopoly is generally considered to be the cause of concern, before offering a brief overview of the regulatory process and some of its specific regulatory tools. It should be noted that this chapter mainly aims to provide an introduction to the vast literature on this topic, which has fascinated many economic and legal scholars over the years. JEL classification: K23, L90 Keywords: Cream Skimming, Price Regulation, Incentive Regulation, Contestable Markets, Public Ownership
1. The Natural Monopoly Model A natural monopoly exists in an industry where a single firm can produce output such as to supply the market at a lower per unit-cost than can two or more firms. The telephone industry, electricity and water supply are often cited as examples of natural monopolies. These industries face relatively high fixed cost structures. The costs necessary to produce even a small amount are high. In turn, once the initial investment has been made, the average costs decline with every unit produced. Competition in these industries is deemed socially undesirable because the existence of a large number of firms would result in needless duplication of capital equipment. The classic example might be that of two separate companies providing local water supplies, each constructing underground pipelines. 498
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In undergraduate textbooks one finds the natural monopoly condition linked to the issue of economies of scale. Traditionally, natural monopoly is often described as a situation where one firm may realize such economies of scale that it can produce the market’s desired output at an average cost which is lower than two firms could with smaller scale processes. The modern approach to defining natural monopoly was initiated by William J. Baumol (1977). In an industry where a single firm can produce output to supply the entire market at a lower per-unit cost than can two or more firms (subadditivity of the cost functions) or in an industry to which entrants are not ‘naturally’ attracted and are incapable of survival, even in the absence of predatory measures by the incumbent monopolist (sustainability of monopoly) the single firm is called a natural monopoly. The concept of subadditivity is a precise mathematical representation of the natural monopoly concept (Baumol, 1977) . If all potential active firms in the industry have access to the same technology, represented by a cost function c, then at an aggregate output x, the industry is a natural monopoly if c (x) < c (x1) + ... + for any set of outputs of x1, ..., xt such that
A cost function c is globally subadditive if for any non-negative output vectors x and y, c (x1 + y1, ..., xn + yn) < c (x1, ..., xn) + c (y1, ..., yn )
Given the production of a set N' 71, ..., n? of indivisible objects, the cost function is subadditive if c (S cT) < c (S) + c (T) for any disjoint subsets S and R (on the concept of subadditivity, see Baumol, 1977; Sharkey, 1982). There is a close relation between economies of scale and subadditivity. In a single-product firm economies of scale are a sufficient but not necessary condition for a natural monopoly. Production processes, although subadditive at output levels which exhibit economies of scale (decreasing average costs), may also be subadditive when exhibiting increasing average costs. In a multiproduct firm, for instance, economies of scope may create a natural monopoly although there are no economies of scale with regard to the production of the goods separately.
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Herein lies the difference between a strong and a weak natural monopoly (Gegax and Nowotny, 1993, p. 67). While strong natural monopolies exhibit decreasing average costs, the weak natural monopoly firm exhibits increasing average costs even though its costs are subadditive. The latter finds itself in a situation where it may not be able to prevent entry by other firms, for example when its monopoly position is non-sustainable. Since costs are subadditive, society might prefer a market consisting of only one firm rather than a multiplicity of firms producing the same output. Therefore, in the case of a weak natural monopoly it is often considered desirable that regulatory authorities bar entry into the market of the weak natural monopoly and in turn regulate prices. Graphically, a strong natural monopoly exists when the long-run average cost curve of a single firm is still declining at the point where it intersects the total market demand curve for the product. The D line on Figure 1 represents the demand curve, which is also the market-demand curve. A monopolist will supply the market with output at a price Po. The optimal scale of the firm is reached at point A in the figure. The market conditions, illustrated in Figure 1, allow for one firm to provide the entire market cheaper than could two or more firms. Suppose the market consists of four firms, each producing at an optimal level, where marginal revenue equals marginal costs. Thus, each firm produces a quantity of 1000. The total market demand curve determines price, which adds up to Px. At scale B, where the market is restructured into 4 firms, instead of one monopoly firm, each firm produces at a smaller scale. The total amount produced is unchanged but the average unit costs are higher at scale B. The market allows for one producer to generate total market demand at cheaper costs than can two or more equal producers. Figure 1
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A. Why Regulate Natural Monopoly? Many supposed natural monopolies are the subject of various types of regulation. As described above, under conditions of natural monopoly the market is best served when one firm supplies total market demand. Public interest theory claims to provide an explanation for government intervention in what may be considered a market imperfection. The need to avoid duplication of facilities, particularly fixed costs, would serve as a justification for traditional entry regulation. Consider in this respect the restructuring of the telecom industry in the United States that broke up the Bell system to AT&T, while forbidding Regional Bell Operating Systems to enter the lines of business assigned to AT&T in order to prevent destructive competition (Crandall, 1988). In Part A we will try to provide a brief insight into some other motives behind the regulation of natural monopolies. We refer to Chapter 5940 in this volume for a detailed review of the specifics of regulation of utilities and to Chapter 5000 for a general discussion of the various theories of regulation.
2. Allocative Inefficiency Under perfect competition prices of goods equal marginal cost, as firms engage in a competitive bidding process. Under conditions of monopoly, the profitmaximizing behavior of the incumbent firm will lead to a higher price charged to consumers and a lower output. It enables the seller to capture much of the value that would otherwise be attained by consumers. Monopoly pricing thus results in a wealth transfer from consumers of a product to the seller. At the higher price, at which the monopolist tries to maximize profits, a group of potential consumers will be excluded as they will not be able to afford the product at the higher (artificially set) price. Thus, monopoly leads to the classic case of the occurrence of dead weight losses: the part of the consumer surplus that the monopolist cannot appropriate but consumers lose. Now as a result of the monopoly pricing scheme, these consumers may be forced to consume more costly substitutes or less useful products, although society’s resources would be better used producing more of the good provided by the monopoly firm. Furthermore, the argument goes that by limiting output the monopolist underutilizes productive resources. The argument of the negative consequences of monopoly on economic welfare has been the subject of heavy debate. This article will not venture into the broad discussion of welfare economics, monopoly and distributive justice (for an introduction, see Tullock, 1967; Rahl, 1967; for case studies on the consequences of monopoly pricing and welfare, Albon, 1988). We can,
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however, focus on a few of the arguments concerning the case of natural monopoly which challenge the relevance of the alleged allocative inefficiency. The classic opposition to monopoly rents as opposed to everyday rent-seeking by the common man is that monopoly rents are the result of an artificial scarcity rather than a natural scarcity (Schap, 1985). The question arises whether the same really can be said about an unregulated natural monopolist. Early on, Posner (1969) rightly noted that market power in the latter case stems from cost and demand characteristics of the market, not from unfair or restrictive practices.
3. X-Inefficiency The condition of natural monopoly raises the question whether internal efficiency, cost minimization by the firm, is achieved under natural monopoly. Does a monopoly firm put its resources to the best possible use within the existing state of technology? Modern antitrust economists have used the term ‘X-Inefficiency’ to indicate the internal wastes that occur when a firm acquires monopoly power and is no longer pressured by strong competitors to keep its costs at the competitive minimum. Often-cited legendary examples are US Steel, General Motors, Sears, IBM and American Airlines. These giant firms, which once dominated their industries, are accused of falling victim to their own inefficiencies (Mueller, 1996). Empirical data suggest that the amount to be gained by increasing X-efficiency is significant (for a review, see Leibenstein, 1966). Generally, in a competitive market firms have an incentive to reduce costs, in order to obtain higher profits by selling at the same price or a price between the old price and the new cost level. Although cost reduction might be shortlived in a competitive situation, as competitors reduce their production costs and adjust their prices to those of their direct competitors, the concern for survival provides a firm in such a market with a strong incentive to minimize costs (Dewey, 1959). If a firm fails to anticipate or match the cost reductions of its competitors, it might suddenly find itself in a market dominated by its competitors. Where there are no significant entry barriers the threat of potential competition will hold price down to cost. Otherwise other firms will enter the market at the same scale of production, sell at a slightly lower price and capture the whole market for as long as it is profitable (for more on contestability, see Section 8). Also, it could be argued a monopoly firm has an even stronger incentive to minimize costs in order to gain maximized profits. Since the threat of a counter
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reaction to its pricing schemes is absent, it does not face the risk that the consequential benefits will only be short-lived.
4. Technological Progress Technological developments have been the drive behind the transformation of certain natural monopoly markets to more competitive outcomes. Most notably, this is the case for the more recent changes in the telecommunications industry, where the enhancement and development of microwave and satellite technology has come to provide a strong substitute for the traditional cable networks. The value of technical development should not be underestimated. Technological progress often reduces production costs or creates new products and has been of enormous importance to economic welfare. The classic argument goes that monopoly firms lack an efficient incentive to promote technical change and invest in expensive R&D programs. Allegedly, a monopoly firm would discourage progress. By virtue of its protected position it would not fear that a rival will promote products and production methods and would therefore not be driven to pioneering himself. Real-life observations regarding the introduction of new technology in monopoly firms seem to validate this criticism - witness the long life of equipment in telephone industries. This is often the case, regardless of whether the monopoly firm is conducted as a public or private monopoly (Dewey, 1959). Some empirical data suggests that small, profit-seeking firms are responsible for most major innovations (Scherer, 1984). However, there are strong arguments that provide indications that contradict the traditional allegations concerning the case of under-innovation under monopoly. Even when assuming that a monopoly firm will not introduce new products unless the cost of the new product is less than the marginal cost of the old (as sunk costs are bygones), there is no reason the same could not be said about competitive firms (Fellner, 1951). Furthermore, an important point has to be made. The fact that an industry is a monopoly does not mean than only one firm is pursuing research and development in its technology. Through the presence of external forces it is likely that the incumbent monopoly firm will feel the pressure to spend time and money on innovation, in order to safeguard its position (Posner, 1969). Certainly in an unregulated market, with free entry, successful research in the field of production methods could seriously threaten the position of natural monopoly firms. Although a natural monopolist is less concerned about survival, the possible threat of the introduction of new technology in substitute
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markets should provide monopoly firms with a strong incentive to anticipate such developments through R&D expenditure (this relates to the theory of contestable markets, see Section 8). At the other end of the spectrum Schumpeter (1950) holds that there is a positive relation between innovation and market power. A monopoly firm would be a strong instead of a poor innovator. Superior access to capital, the ability to pool risks and economies of scale in the maintenance of R&D laboratories are likely to advance industrial technology.
5. Cream-Skinning and Cross-Subsidization Because of social considerations, government may often feel the need to ensure the provision of certain products or services at a lower-than-cost price to some consumers. For instance, it is quite common that governments demand the provision of ‘universal services’ to consumers by telephone companies, the availability of minimum services at reasonable prices, even to small and distant communities where the small scale of operation may lead to very high costs, which often results in the occurrence of losses. The delivery of such services is often financed by obtaining higher profits on the sale of other products and services. This is termed cross-subsidization, referring to the practice where the difference between the price charged to the targeted consumers and the cost of supply might be funded by crosssubsidization from the prices paid by other consumers or, in a multiproduct firm by the purchases made for other products or services. When a firm, burdened with ‘universal service’ obligations of some sort, is not protected from price competition and free entry of competitors, it might not be able to maintain its position in the market as potential competitors will enter these market segments that are provided at prices well above cost. Creamskimming occurs when a supplier concentrates only on those areas of the market where the costs of supply are lowest, for instance because of geographical reasons (on cream-skimming in a natural monopoly market, see Zupan, 1990). Regulated firms on such a market, with universal services obligations, might find themselves in a possibly fatally detrimental situation, when competitors capture these low-cost/high-profit parts of the market which are crucial to recover losses made in the high cost market parts. Take the example of the US Postal Service. Without legislative protection, its uniform pricing scheme, according to which it charges the same price to deliver a letter anywhere in the United States regardless of distance and specific difficulties, would soon deprive it of its most profitable routes.
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Yet, the practice of cross-subsidization, when a company that supplies more than one product and uses the revenues from product A to recover a portion of the costs of product B, generates economic inefficiencies. Although benefits from economics of joint production might have to be sacrificed, in most cases the consumers of product A would be better off if the products were produced and priced separately, while the customers of good B are given incorrect price signals about the incremental costs of producing product B (Spulber, 1995). The cross-subsidization of loss-making services by taxing remunerative services has been demonstrated to lead to significant allocative inefficiencies (Brennan, 1991).
B. The Regulatory Process 6. Price Regulation Price control, although driven to the background in the years of deregulation, has been of increased importance in the recent trend of privatization in Europe. From a public interest perspective, price control should allow regulators to set prices at a level which induces allocative and productive efficiency. This part provides a brief, non-technical introduction to some of the tools governments have at their disposal to assure that firms meet consumer demand at efficient cost levels. For a more in-depth look at the different forms of price regulation and its analysis, reference is made to Chapter 5200, Price Regulation, which also deals with natural monopoly. Figure 2
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Marginal and Average Cost Pricing and Rate of Return Policy Without regulation, Qm in Figure 2 represents the profit-maximizing output of the monopolist and the demand, in turn, determines the market price Pm. The monopoly earns a positive economic profit represented by the area of the rectangle PmFGH. Welfare maximization to society as a whole is achieved at the quantity-price of P1 , Q1 . In other words, regulating authorities should set a price P1 (marginal cost pricing) in order to maximize economic welfare. However, at price P1 consumers will buy a quantity of Q1, whereas AC is NQ1, which is greater than the price P3. This will result in a total negative economic profit, shown by the area of the rectangle P1P2AM. In the long run, the monopoly firm will not stay in business. If the commodity or service provided is desirable, the only way to keep the monopoly firm in business is to provide a public subsidy to the amount of P1 P2 AM. The political problems associated with subsidization, its implementation and financing and the difficulties of calculating demand and MC have led to the application in the public utility field of average cost pricing. In Figure 2 such a price is P2, determined by the intersection of the demand and long-run AC curve. The output under average-cost pricing, Q2, is greater than the unregulated monopoly output of Qm. Also, part of the welfare costs arising from restricted output by an unregulated monopoly is eliminated. Expansion of output, from Qm to Q2 provides benefits to consumers that are greater than the additional costs. On the other hand, average cost pricing can hardly be deemed entirely satisfactory either. Under average cost pricing, when Q2 is produced, welfare losses are caused because at this point average costs (the AC curve) exceed marginal costs (MC). Graphically, the AMO triangle in Figure 2 represents this consequential welfare loss. When applying a rate-of-return policy, regulating agencies focus on the rate of return on invested capital (accounting profit) earned by a monopoly (fair rate of return) (Moorehouse, 1995). Allowing regulated firms to acquire a total sum that consist of annual expenditure plus a reasonable profit on capital investment, the so-called ‘fair’ rate of return, was constructed by American courts and the regulating bodies in order to meet constitutional demands of utilities to set prices on a ‘just and reasonable’ level. This can be formulated as E + ( r ·RB) where E represents the firms annual expenditure, r is the multiplier, representing the fair rate of return, and RB the rate (attributed value of the capital investment). If the realized rate of return is higher than what is considered to be a normal return, then the price must be above average cost. In a trial-and-error fashion regulators try to locate the price where profit is normal, for example, where price equals average cost.
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Allowing the regulated monopolist a fair rate of return creates various economic problems that have to be taken into account. Auditing costs involved in determining the firms capital base are considerable. Especially the determination of r, which should reflect a level of return that is satisfactory to attract investment, is problematic. Looking at other ‘comparable’ industries or applying the capital asset pricing model, where one looks at the returns obtained by investors from a portfolio of investments, as modified by the difference between the returns from shares in utilities and those from more general market shares, it is clear that these are imperfect methods for determining a rate of return that potential investors will demand from the regulated industry. Also, the perverse effects on incentives that occur when applying the standard rate of return policy are perhaps even more troublesome (Train, 1991). The regulated firm has an incentive to inflate its capital cost figures, since higher costs imply higher absolute returns (Baron and Taggart, 1977, on profitmaximizing behavior under rate of return regulation, see Hughes, 1990). If the regulator sets the fair rate of return above the cost of capital, the regulated firm is likely to utilize more capital than if it were unregulated. Thus, it might use inefficient high capital/labor ratios for its output. Also, average cost pricing diminishes the monopolist’s incentive to minimize costs. Figure 2 illustrates some of the consequences of this behavior. Inflation of costs shift the actual AC curve to AC'. At a price of P2 losses occur, therefore, regulators grant a price increase to cover the higher costs (point C). When implementing rate-of-return regulation the complexity accompanied with instituting and enforcing regulation schemes may often lead to delays in the regulatory response to changes in costs and other market conditions. When costs are fallingduring a certain period of time firms will benefit from these socalled regulatory lags, as they will be able to enjoy rates of return greater than those deemed ‘fair’ in the outcome of the regulatory proceedings. Several authors have argued in favor of regulatory lags:they would, at least temporarily, provide a way to allow regulated firms to profit from achieving lower costs (Baumol, 1967; Williamson, 1971; Bailey, 1973). However, if costs shift upwards, for instance due to factors external to the regulated firm, the opposite effect will occur and, the firm will incur costs that were not foreseen by the regulator. Also, because profit rates are restricted, the firm’s managers face the option of providing themselves with amenities in their salaries or the firm’s profits. Whether they do take advantage of this option in practice is largely dependent on whether they are externally controlled by reliable public officials, which in turn involves considerable monitoring costs.
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Price Discrimination Charging consumers different prices relative to what they are willing to pay, even though the costs of producing and supplying the goods or services are the same, has been demonstrated to enable allocative efficiency. With this technique, often referred to as Ramsey pricing, information on the priceelasticity of the different goods should allow for efficient price setting (the higher the price-elasticity, the closer the price needs to be set to marginal cost) (Ramsey, 1927). The objection often heard is that such a pricing scheme involves a wealth transfer from the consumer (consumer surplus) to the producer. Also, severe price discrimination, often termed predatory discrimination, is an effective method by which competition may be crushed out (see however for a detailed and comprehensive account McGee’s case study of the Oil of Indiana case, 1958). The classical analysis of price discrimination was set out by Pigou (1920). A distinction between three degrees of discrimination was made. The first degree involves a different price set for every unit purchased by every consumer, in such a way that virtually all the possible consumer surplus is obtained by the producer. Although this pricing mechanism can be efficient, as marginal decisions are made as marginal cost, it is often opposed on income distributional grounds: the transfer from consumer to producer. Second-degree price discrimination consists of pricing groups according to their willingness to pay, where all those with a demand price above a certain level are charged one price, while those with a lower demand price are charged a lower price. Third-degree price discrimination comes into effect when consumers are divided into separate groups, each group is charged a different monopoly price. This technique is of course strongly dependent on the possibility for the seller to identify groups in each specific case, which will vary according to market circumstances. In the telephone and electricity industries, for instance, the distinction is made between residential and commercial customers, who pay different prices (Hollas and Friedland, 1980; Primeaux and Nelson, 1980; Naughton, 1986; Eckel, 1987). Sometimes, sorting consumers by their willingness to pay can be achieved by requiring customers to tie (Cummings and Ruhter, 1979) or bundle (Adams and Yellen, 1976). In circumstances of uncertainty of demand, where prices must be established before demand is known, special distinctions, such as ‘saver-airfares’ requiring early bookings may be enforced on separate consumers (Leland and Meyer, 1976; Sherman and Visscher, 1982). Peak-Load Pricing When demand follows a periodic cycle, during which demand might be high at certain times and low at others, peak-load pricing might offer a way to achieve marginal cost pricing. As marginal cost generally rises with output,
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price variations will allow it to reflect the higher costs. This allows for the moderation of the demand cycle while establishing a more effective use of capacity (Crew, Fernando and Kleindorfer, 1995). Higher pricing during periods of peak demand might discourage use and save costly capacity, whilst lower prices when demand is low might encourage use of capacity that otherwise would have been left idle.
7. Incentive Regulation Many of the problems arising from the pricing models, such as the AverechJohnson model find their origin in the absence of incentives to operate at minimum cost levels. The motivation behind incentive regulation is to provide the firm with the motivation to behave more consistently with regard to the social optimum. Price-Cap Regulation or RPI-X Requiring the firm to increase its prices for each year within a given period by no more than the retail price index (RPI) minus a variable factor (X) which is the agency’s assessment of the firm’s cost-efficiency potential, price-cap regulation was found to be superior to the fair rate of return method both in terms of efficiency and administrative costs (Littlechild and Beesley, 1992). The system, as described above, would require less information from the firms to the regulating bodies, which would not only make this model less costly but also diminish the capture problems associated with rate of return regulation (for an overview, see Chapter 5200, Price Regulation).
C. Alternatives for Regulation The inefficiencies (Coase, 1959, Posner, 1969, 1975) and costs (Gerwig, 1962; Hahn and Hird, 1991) of the regulatory processes have been well documented over the years. Many scholars became dissatisfied with the public interest approach to regulation and looked for an alternative that would explain data that did not correspond with the normative approach to regulation. Capture theory, which holds that producers are the winners under most, began to shape (Jordan, 1972). A considerable body of literature, the economic theory of regulation, grew from this (Peltzman, 1976; Stigler, 1971, 1976; for an overview, see Viscusi, Vernon and Harrington, 1995).
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This in turn, has given rise to new, appealing theories where the approach is to have optimality induced without regulation, even in markets with one producer. Competition amongst numerous firms can be used to achieve optimality under natural monopoly conditions, where competition is held amongst firms that could produce. The argument goes that the pressure from potential producers will induce efficient pricing decisions by the natural monopolist.
8. Contestable Markets Building upon Demsetz’s ideas (1968) on the threat of potential competition as a disciplinary mechanism, the theory of contestable markets was further developed by Willig (1980) and Baumol, Panzar and Willig (1982) and applied to natural monopoly (Coursey, Issac and Smith, 1984). In a market where entry and exit are completely free and unconstrained, the threat of potential competition may hold price down to cost. When potential entrants exercise strong constraints on the behavior of the incumbent monopoly firm, the latter will be moved to pricing schemes closer to cost. Firms in a contestable market will not be able to gain pricing profits that exceed normal profits under competitive circumstances, as otherwise other firms will enter the market at the same scale of production, sell at a slightly lower price and capture the whole market for as long as it may be profitable, a practice often referred to as hitand-run entry and exit (Baumol, 1982). When entry is allowed, new firms will be able to enter the market of a Ramsey-pricing natural monopolist at a lower price (Faulhaber, 1975; Sharkey, 1982). Thus, when the nature of the market allows for only one firm to provide total demand, competition can assert itself by deciding which firm will obtain market domination. Contestability of a market would render regulation pure waste, as without regulation the monopoly would yield price efficiency. Instead, given this theory, when determining the proper form of regulation, governments should restrain from measures that obstruct potential entry and create an environment that promotes contestability. In other words, regulators should encourage rather than prevent entry into the natural monopoly market. However, in order for a market to be qualified as contestable various conditions, most notably the absence of any significant entry barriers, are demanded. Perfectly contestable markets are based on free entry - the firm does not have to incur any cost that is not also incurred by the incumbent natural monopolist - by entrepreneurs who do not face any disadvantages in relation to the incumbent monopolist. It assumes the possibility for the firms to freely exit, that is, potential recoupal of all costs incurred upon entering - minus
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depreciation. Also, the potential entrants must have access to equally efficient production technology as employed by the incumbent firm. Finally, the incumbent firm must not be able to adjust prices instantaneously when faced with the threat of entry. As a theoretical construction the theory of contestable market certainly has its merits. Indeed, a natural monopoly firm may not be immune to profitseeking hit and run entry (Faulhaber, 1975; Baumol, Bailey and Willig, 1977; Baumol, Panzar and Willig, 1982; Sharkey, 1982). However, it remains uncertain whether perfectly contestable markets do actually exist. The assumption which holds that an entrant can leave a market without costs when its presence is no longer profitable is rarely encountered in real-life economics (Waterson, 1988). Also, sunk costs, the difference between the ex ante opportunity cost of the funds and the value that could be recovered ex ante, have early on been demonstrated to deter entry (Eaton and Lipsey, 1978; Spence, 1977, 1980; Dixit, 1980). Cost curves reflecting large sunk fixed costs, already borne by the incumbent firm, place potential entrants in a disadvantaged situation. (Bailey and Panzar, 1981).
9. Entry Regulation and Auction Until 1968, the inevitability of regulation of natural monopoly was broadly accepted. It was Demsetz (1968) who argued that formal regulation, as described above, is uncalled-for where government can allow ‘rivalrous competitors’ to bid for the exclusive right to supply a good or service over the given ‘franchise period’. Monopoly pricing is prevented, as competition has asserted itself at the bidding stage. In other words, competition at the franchise stage will be sufficient to reduce the price below that of the monopoly profit maximizer. Therefore, a monopoly structure does not necessarily lead to monopoly behavior. Along the same lines we may situate Chadwick’s (see Crain and Eklund, 1976) historical reasoning in his investigation of water supply in London in the 1850s, where he advocates competition for the market rather than the costly and that time prevalent competition within the market. Successful and competitive bidding, in terms of prices and services offered, could initially eliminate the need for a principal-agent relationship (Chadwick, 1859). In certain cases, government might find it appropriate, most notably in the case of a natural monopoly, to limit the number of firms operating in a certain market. Bidding refers to a free and open right to supply the market, where the regulator announces that it will accept bids from all firms that are willing to provide the goods. Each bid could consist of the price that the firm would agree to charge consumers when awarded the franchise. In such a bidding process,
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price will eventually be bid down to a price at which the winning firm earns zero-profits. This will be the result of a repeated process where firms given the choice between zero profits from not winning the auction, and earning a small but positive profit by bidding below the lowest bid, will choose the latter. Even in the case where the bidding would be held at once, each firm would realize it could only win if it bids at a price that provides zero economic profit with least-cost production. (Coursey, Isaac and Smith, 1984; for a survey on the bidding process in the electricity industry, see Rozek, 1989; in cable television franchise allocation, see Zupan, 1989). This form of bidding, often referred to as Chadwick bidding, should be distinguished from auctions where the state is acting as a monopolist attempting to attain high prices, for instance when auctioning oil exploitation rights, instead of acting as a consumer agent (Posner, 1972; Waterson, 1988). At this point, reference should be made to recent proposals to have the auctions centered around an incentive contract, where the winner is consequentially bound to a desirable incentive arrangement (McAffee and McMillan, 1987; also Riordan and Sappington, 1987). However, the effective pursuit of economic welfare through the competitive awarding of monopoly franchises has its difficulties. Auction theory suggest that the quality of the winning bid only increases as the number of bidders increases (for a different view, see Bishop and Bishop, 1996). As has been demonstrated early on (see Williamson, 1976) in the cable television industry, the winner of a monopoly franchising procedure does not always fulfill the service contract as promised. Here, monitoring costs and the principle-agent problems should be taken into account. Government contracts are often won by bidding in terms that cannot be met (Sherman, 1989), the main reason being that the services are complicated and all eventualities cannot be anticipated fully when contracts are drawn up (see also the debate on the winner’s curse, Thaler, 1992). Also, once a firm has obtained the franchise for a certain period of time with exclusive information on costs, production processes and control over resources, future franchise biddings will be among unequals. Furthermore, it should be noted that costs and demand change over time in such a way that the price fixed in the franchise contract might not be optimal at a later point of time (Williamson, 1976). Contingency clauses, anticipating future events might offer a remedy, but are merely second best solutions, as they are bound to bring about considerable imperfections. Contractual stipulations, which specify the price movement in the event of price changes, demand information from a government which it simply does not have. Another type of contingency clause, the implementation of procedures by which to revise prices periodically, faces the same problem of asymmetry of information, as it provides the regulated firm with incentives to report smaller than real cost changes, for instance from
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technological progress (Train, 1991, p. 301). Reference can be made to the suggestion (Posner, 1992) to have repeated auctions held with short-term contracts for the winning firm. These short-time contracts will allow a better reflection of changes in cost and demand. However, it should be reminded that these auctions will only result in efficient price offerings if the incumbent firm has no other advantages with respect to the other firms involved in the franchise bid. Loeb and Magat (1979) propose an institutional arrangement consisting of a mixing of regulation and franchising, while supposedly eliminating the problems associated with both. As an alternative to rate-of-return regulation, they set forth a decentralized system of regulation in which the utility chooses its own price and where the regulatory agency subsidizes the utility on a per unit basis equal to the consumer surplus at the selected price. The classic opposition to subsidies, that revenues to provide a subsidy have to be collected elsewhere and that any subsidy policy as such brings along allocative inefficiencies, are countered by the introduction of a sale of the franchise which should reduce the net subsidy or, alternatively, the imposition on the utility of a lump-sum tax by the regulatory agency in order to recover part of the subsidy. Sharkey (1979), commenting on the Loeb-Magat (L-M) scheme, argues that such a policy might hold if conditions exist that the net subsidy paid to the utility is sufficiently small. Aside from imperfections of the regulatory bodies and the costs resulting from political manipulation, the L-M scheme is less convincing where one attaches more importance to the quality of service as opposed to the price. Nevertheless, as an alternative to rate of return regulation the L-M model has the advantage that the regulatory body does not need to obtain or verify information about the cost function of the utility and as such it has considerable merit (Sharkey, 1979). Moreover, experimental research on the behavioral robustness of the contestable market hypothesis has shown it to be promising (Coursey, et al., 1984; Harrison and McKee, 1985) especially in environments where the Bertrand-Nash assumption is satisfied (Harrison, 1987).
10. Public Ownership Another possible alternative to regulation is government ownership of enterprises that provide services under conditions of natural monopoly. Although one could argue that regulation occurs in its most severe and complete form under public ownership, its unique characteristics distinguish it from the broad range of traditional regulatory processes (Ogus, 1994). Instead of having a privately owned monopoly with profit-seeking shareholders one could institute a publicly owned enterprise with less concern about profits. This
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lack of profit-maximizing incentives in a public enterprise is sometimes thought to be beneficial, as it allows publicly responsible attention to nonfinancial goals and/or distributional goals (on the various possible reasons for state ownership, Ahoroni, 1986). The institutional framework of public ownership would provide a way to impose public interest prices and standards. This would allow the equation of prices to marginal cost, to have monopoly profits avoided, and so on. Half a century ago, government ownership of firms was thought of as the key solution to market imperfections, such as monopoly. Due to the failures of competition, the regulation during the Great Depression, the apparent success of Soviet industrialization and a misunderstanding of the consequences of political control over firms, the state took control of significant parts of production in the economy of many countries. In the last 29 years, a renewed faith in the market process induced governments in market economies throughout the world to privatize most of their sectors, including strategic ones such as steel, energy and telecommunications. The absence of a profit incentive under the institutional framework of public ownership had proven to be a high price to pay. In a public enterprise which lacks a group of residual profit-claiming shareholders, who emphasize fiscal goals and enforce efficient performance through management, economic efficiency is no longer guaranteed (Spann, 1977; Williamson, 1987; for a survey of economic performance under public ownership in the British fuel and power industry see Shepard, 1965). When assets are publicly owned, the public manager has relatively weak incentives to reduce costs or to improve quality or innovate, because he only gets a fraction of the return as a non-owner (Hart, Shleifer and Vishny, 1997; more on public managers, De Alessi, 1974, 1980). In private corporations, the shareholders’ ability to sell their vote or to vote out management creates incentives for management to serve the interests of the owner. The diffuse, non-transferable shareholding that characterizes government ownership reduces these incentives. Those in control of the enterprise pay less attention to the taxpaying shareholders and are more likely to succumb to more concentrated interest groups, such as suppliers, consumers, employees, and so on (Zeckhauser and Horer, 1989). The statutory monopoly will become the primary source of information about industry possibilities. The monopoly will not suffer as a competitive firm would when it is wrong, because regulators either cannot appreciate its errors completely or will forgive them. Regulatory agencies, distanced from the industry, might have a hard time to reflect the complexity of the industry. As regulators cannot evaluate all decisions, inefficient technologies may be chosen for years (Sherman, 1989).
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Also, the question remains what goals replace the profit incentive? Imposition of vague goals often results in diminished accountability which imposes the risk of inefficient results. Moreover, it should be noted that the absence of a profit incentive does not guarantee the absence of monopoly prices; these remain a possibility, for instance to make the life of managers easier, and so on. A public enterprise is often constrained by its budget. As it is required only to have a certain difference between total revenue and total costs, it may, especially when no stronger restrictions have been set out, seek to maximize its total expenditures or its revenue. In order to do this it may well follow a monopoly pricing rule. The US Postal Service can serve as an example of a public enterprise (since its 1970 charter) exhibiting such behavior, empirical evidence shows it has behaved as a cost or revenue maximizer for many years (Sherman, 1989, pp. 265-268). A publicly-owned firm with limited restrictions such as budget constraint has considerable managerial discretion, which often leads to the pursuit of various goals such as budget maximization (Niskanen, 1971; Crew and Kleindorfer, 1979), revenue maximization (Baumol, 1976) and the maximization of total output. The importance of innovation in market economies should not be disregarded. Voices as early as Marshall (1907), have argued that government is generally a poor innovator. The development and adoption of new technologies in telecommunications, that occurred shortly after the privatization of phone companies in the US, may serve as an example of the benefits of private ownership (Winston, 1998). In industries where innovation is crucial, the case for government provision is strained (Shleifer, 1998). Technology changes often have enormous impact on cost structures and may cause a natural monopoly market to move to a more competitive setting.
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the Electricity Sector Regulation)’, 3-4 Ekonomist, 197-204. Armstrong, Christopher and Nellis, Henry Vivian (1986),Monopoly’s Moment: The Organization and Regulation, Toronto, University of Toronto Press, 393 p. Atkinson, Scott E. and Halvorsen, Robert (1990), ‘Tests of Allocative Efficiency in Regulated Multi-product Firms’, 12(1) Resources and Energy, 65-77. Atkinson, Scott E. and Kerkvliet, Joe (1989), ‘Dual Measures of Monopoly and Monopsony Power: An Application to Regulated Electric Utilities’, 71 Review of Economics and Statistics, 250-257. Babilot, George, Frantz, Roger and Green, Louis (1987), ‘Natural Monopolies and Rent: A Georgist Remedy for X Inefficiency among Publicly Regulated Firms’, 46 American Journal of Economics and Sociology, 205-217. Baca, Alvin (1987), ‘FERC $50 ERA: Issues in Natural Gas Regulation’, 27 Natural Resources Journal, 815-822. Bailey, Elisabeth E. (1973),Economic Theory of Regulatory Constraint, Lexington, MA, D.C. Health. Bailey, Elisabeth E. and Panzar John C. (1981), ‘The Contestabilty of Airline Markets, during the Transition to Deregulation’, 44 Law and Contemporary Problems, 125 ff. Baish, Richard O. (1987), ‘The Role of the California Public Utilities Commission in Western Gas’, 27 Natural Resources Journal, 805-810. Baldwin, John R. (1989), Regulatory Failure and Renewal: The Evolution of the Natural Monopoly Contract , Ottawa, Supply and Services Canada, 122 p. Barnes, David W. and Stout, Lynn A. (1992), Economic Foundations of Regulation and Antitrust Law, St Paul, MN, West Publishing. Baron, David P. and Besanko, David A. (1984a), ‘Regulation and Information in a Continuing Relationship’, 1(3) Information Economics and Policy, 267-302. Baron, David P. and Besanko, David A. (1984b), ‘Regulation, Asymmetric Information, and Auditing’, 15 Rand Journal of Economics, 447-470. Baumol, William J. (1967), ‘Reasonable Rules for Rate Regulation: Plausible Policies for an Imperfect World’, in Phillips A. and Williamsen O.E. (eds), Prices: Issues in Theory, Practice, and Public Policy, Philadelphia, University of Pennysylvania Press. Baumol, William J. (1976), Business Behaviour, Value and Growth, NY, Harcourt, Brace and World. Baumol, William J. (1977), ‘On the Proper Cost Tests for Natural Monopoly in a Multiproduct Industry’, 809 American Economic Review. Baumol, William J. (1982),’Contestable Markets: An Uprising in the Theory of Industry Structure’, 72 American Economic Review, 1982, 1-15. Baumol, W.J., Bailey, Elisabeth E. and Willig, R.D. (1977), ‘Weak Invisable Hand Theorems on Pricing and Entry in a Multiproduct Natural Monopoly’, 67 American Economic Review, 350365. Baumol, William J., Panzar, J. and Willig Robert (1982), Contestable Markets and the Theory of Industry Structure, New York, Harcourt Brace. Beesley, Michael E. (1997), Privatization, Regulation and Deregulation, London, New York, Routledge. Beesley, Michael E. and Littlechild, Stephen C. (1989), ‘The Regulation of Privatized Monopolies in the United Kingdom’, 20 Rand Journal of Economics, 454-472.
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5500 LABOR LAW AND EMPLOYMENT REGULATION: GENERAL © Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
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