LS 145 Disc_Week 10_Handout_Solved (1)

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LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 1 Default Rules Consider the following scenario: Andrea wants to buy Bethany’s used laptop, but there is a risk that it could be defective. A would like for B to issue a warranty. B is hesitant to bring the question of a warranty into the negotiation. • Negotiating a warranty will cost the parties $20 in transaction costs. • Should the laptop be defective, the dispute will cost $400 to fix. • The probability of a defect is 3% . 1. Does it pay for Andrea to ask Bethany for a warranty? No. The expected monetary loss ($12) is less than the transaction costs that would be required to negotiate the warranty ($20). We know that the expected monetary loss is $12 because: EML = p 1 O 1 (+ p 2 O 2 + p 3 O 3 + p 4 O 4 … ) EML = .03 * $400 EML = $12 2. If the transaction costs were only $10, would it pay off to deliberately leave a gap in the contract? No, now it no longer makes sense to leave a gap in the contract, because the transaction costs to negotiate the warranty are less than the expected monetary loss (EML is still $12). The parties should determine this term of the contract ex ante . Remember, when determining whether to leave a gap in the contract, refer to this rule: If allocating a risk > allocating a loss * its probability (EMV), then leave the contractual gap. If allocating a risk ≤ allocating a loss * its probability (EMV), then fill the contractual gap. 3. If the probability of a defect is 5%, as opposed to 3%, does it pay for A to ask for a warranty? Yes, Andrea should ask for a warranty. EML is now $20 (.05 * $400). As long as transaction costs are less than or equal to $20, it is worth filling this contractual gap and getting the warranty.

LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 2 Now, further assume that: • Andrea would be willing to pay up to $75 for Bethany’s warranty. • Bethany would sell the warranty to Andrea for at least $25. • The law has a default rule of caveat emptor, or “as is,” so, without the warranty, Bethany is not liable if there is a defect. 4. If transaction costs are still $20, does it pay to negotiate the allocation of the loss (i.e., to “contract around” the default “as is” rule through the use of a warranty)? Yes, even with $20 in transaction costs, the parties save $50 in risk bearing costs ($75-$25) through negotiating the allocation of the loss in advance. 5. What is the net surplus value generated by the warranty agreement between A and B? The parties save $50 in risk bearing costs (A’s risk premium – B’s risk premium = $75 – $25 = $50). Net surplus = Value generated – Transaction costs Net surplus = $50 – $20 Net surplus = $30 6. What if the default rule was latent defect, instead of “as is?” Would any surplus value be generated, and, if so, how much? Yes, surplus value would be generated. Because the default rule is latent defect, the liability now lies with the superior risk bearer, Bethany, instead of with the inferior risk bearer, Andrea. The parties no longer have to negotiate the allocation of the risk in advance, so they save the transaction costs required to do so ($20). Now, continue to assume a latent defect rule, but also assume that transaction costs are now zero. Per the latent defect rule, B will have to pay damages to A if the laptop contains a defect that could not have been discovered by a reasonably thorough inspection before the sale. 7. By how much would Bethany have to reduce the price of the laptop so that Andrea would sign a release to free Bethany from liability for defects? We learned above that A’s risk premium is $75, because that is how much that A was willing to pay for a warranty from B when the default rule was “as is.” This means that Andrea is indifferent between (1) losing $75 and not bearing the risk, and (2) having $75 and bearing the risk. Now that the default rule is the opposite (“latent defect” instead of “as is”), we can say that Andrea would require at least $75 to bear the risk associated with the laptop. Before, she was

LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 3 willing to pay up to $75 to get rid of the risk, so now she would need at least $75 to be incentivized to bear it. Bethany needs to reduce the price of the laptop by $75 to get Andrea to sign the release. 8. What is the maximum discount that Bethany is willing to give to incentivize Andrea to sign the release? We learned above that Bethany’s risk premium is $25. This means that she is indifferent between (1) receiving $25 and bearing the risk, and (2) not receiving $25 and not bearing the risk. When the default rule was “as is,” this meant that Bethany was willing to bear the risk for at least $25. Now that the default rule is the opposite, “latent defect,” Bethany will not offer anything more than $25 to incentivize Andrea to release her from liability. The maximum discount B will offer is $25. 9. Will the parties be able to negotiate a signing of the release? No. Andrea needs a discount of at least $75 to be incentivized to sign, but Bethany is only willing to offer a discount of up to $25.

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LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 4 Remedies – Seller’s Breach Remember the following three kinds of damages: Expectation damages Leaves injured party indifferent between performance and breach Actual loss + expected profit Reliance damages Leaves injured party indifferent between no contract and breach Actual loss Opportunity costs damages Leave injured party indifferent between breach and performance of the best alternative contract Actual loss + expected profit under the second-best alternative contract Consider the following scenario: • Jane promises to sell a table to Stacy for $25, to be paid upon delivery. • In anticipation of having Jane’s table, Stacy contracts to refurbish the table and then sell it to Derek for $30. • Jane breaches. • To avoid defaulting on the contract with Derek, Stacy buys a different table for $35 to refurbish. • Stacy sues Jane. 1. What are Stacy’s expected profits? $30 - $25 = $5 in expected profit 2. What are Stacy’s actual losses? $35 for different table - $30 for refurbished table = $5 3. What are Stacy’s expectation damages? Expectation damages = Actual loss + Expected profit Expectation damages = $5 + $5 Expectation damages = $10 4. What are Stacy’s reliance damages? Reliance damages = Actual loss = $5

LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 5 5. Suppose Stacy could have bought the table from Jake for $27. What were Stacy’s expected profits under this second-best alternative? $30 - $27 = $3 in expected profit under the alternative contract 6. What are Stacy’s opportunity cost damages? Opportunity cost damages = Actual loss + Expected profit under the second-best alternative contract Opportunity cost damages = $5 + $3 Opportunity cost damages = $8 7. Suppose Stacy paid Jane $12.50 upfront, with the other $12.50 to be paid upon delivery of the table. Now what are Stacy’s actual losses? Actual losses = $12.50 + ($35 for different table - $30 for refurbished table) Actual losses = $12.50 + $5 Actual losses = $17.50 8. Now what are Stacy’s expectation damages? Expectation damages = Actual loss + Expected profit Expectation damages = $17.50 + $5 Expectation damages = $22.50 9. Now what are Stacy’s opportunity cost damages? Opportunity cost damages = Actual loss + Expected profit under the second-best alternative contract Opportunity cost damages = $17.50 + $3 Opportunity cost damages = $20.50

LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 6 Remedies – Buyer’s Breach Dave hires Dawn to paint his apartment and promises to pay $500. Dawn buys the paint for $200, but then Dave cancels. Dawn can only resell the paint, which is a very specific color that Dave liked, for $100. 1. What were Dawn’s expected profits? Expected profits = $500 - $200 in paint costs Expected profits = $300 2. What are Dawn’s actual losses? Actual losses = $200 for paint - $100 resale Actual losses = $100 3. What are Dawn’s expectation damages? Expectation damages = Actual loss + Expected profit Expectation damages = $100 + $300 Expectation damages = $400 4. What are Dawn’s reliance damages? Reliance damages = Actual loss = $100 If Dawn had not accepted Dave’s paint job, she would have gotten a job with Ellen. Ellen would have paid Dawn $450, and Dawn’s profits would have been $250. 5. What are Dawn’s opportunity cost damages? Opportunity cost damages = Actual loss + Expected profit under the second-best alternative contract Opportunity cost damages = $100 + $250 Opportunity cost damages = $350

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LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 7 Reliance and Expectation Remedies with Different Subjective Valuation Carrie has a dress that she values at $100. Samantha values the same dress at $150. Carrie and Samantha agree to exchange the dress for $125. Carrie brings the dress to Samantha, but Samantha never pays her for it. Carrie sues. 1. What are Carrie’s expectation damages? Expectation damages = Actual loss (what Carrie values the dress as) + Expected profit Expectation damages = $100 + $25 Expectation damages = $125 2. What are Carrie’s reliance damages? Reliance damages = Actual loss = $100

LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 8 Damages and Efficient Breach Consider the following scenario: • Jenny hires Steve to photograph her and promises to pay Steve $500. Jenny does not pay Steve upfront. • Jenny could have also hired Stuart to photograph her at a cost of $650. • Relying on Steve’s promise, Jenny buys an outfit to wear for the photoshoot that costs $150 (all non-refundable). • Jenny hopes to use the photos for marketing materials to use for a big convention next week, where she wants to advertise her business. If she can market her business properly, there is a 15% chance that she will receive a $10,000 investment. • Steve later realizes that doing the photoshoot will cost him $700. • If Steve fails to perform, Jenny will not be able to find another photographer in time for the convention, meaning that she will not be able to secure the investment, and she will not be able to return the outfit. 1. What are Jenny’s expected profits? Expected profits = .15 * 10,000 – 500 – 150 Expected profits = 1500 – 500 – 150 Expected profits = $850 2. If Steve fails to perform, what are Jenny’s reliance damages? Reliance damages = Actual loss = $150 3. If Steve fails to perform, what are Jenny’s expectation damages? Expectation damages = Actual loss + Expected profit Expectation damages = $150 + $850 Expectation damages = $1000 4. If Steve fails to perform, what are Jenny’s opportunity cost damages? Opportunity cost damages = Actual loss + Expected profit under the second-best alternative contract Opportunity cost damages = $150 + (.15 * 10,000 – 650 – 150) Opportunity cost damages = $150 + 700 Opportunity cost damages = $850

LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 9 5. Does a rule of expectation damages result in the socially efficient outcome? Yes, it does. Steve would rather perform and lose $200 (the difference between how much Jenny is paying him and how much it costs him to do the photoshoot), than not perform and have to pay expectation damages of $1000. Him performing at a loss is also the most socially efficient outcome—a net result of $700 is better from a Kaldor Hicks perspective (social efficiency) than a net outcome of -$150. Jenny’s expected payoff Steve’s payoff Net result Steve performs $850 -$200 $700 Steve does not perform, pays expectation damages $850 -$1000 -$150 6. Does a rule of reliance damages result in the socially efficient outcome? No, it does not. Reliance damages do not incentivize Steve to perform at a loss, because he would rather pay damages of $150 than perform and lose $200. But combined gains and losses are more when Steve performs. Reliance damages do not result in the socially efficient outcome. Jenny’s expected payoff Steve’s payoff Net result Steve performs $850 -$200 $650 Steve does not perform, pays reliance damages $0 -$150 -$150 Now, assume that Jenny paid Steve upfront. 7. If Steve fails to perform, what are Jenny’s reliance damages? Reliance damages = Actual loss = $150 + $500 = $650 8. Does a rule of reliance damages result in the socially efficient outcome? No. Reliance damages still do not incentivize Steve to perform, which is the socially efficient outcome. It would be cheaper for him to pay damages than to perform at a loss. In the table below, see how the payoffs are the same as in the above scenario. Even though reliance damages are greater than before, the overall payoff is the same because Steve has to give back Jenny’s $500 deposit.

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LS 145 Discussion Section, Fall 2023, Week 10 Quizzes 12, 13 Review GSI: Cristina Violante 10 Jenny’s expected payoff Steve’s payoff Net result Steve performs $850 -$200 $650 Steve does not perform, pays reliance damages $0 -$150 -$150 9. Does a rule of expectation damages result in the socially efficient outcome? Yes, expectation damages incentivize Steve to perform, and result in the most efficient outcome. Now expectation damages are $1500 ($650 in actual loss + $850 in expected profit). Steve would of course prefer to perform and lose $200 than to have a net loss of $1000 (remember that when paying expectation damages, Steve returns the $500 deposit, so his net loss is expected profit plus the actual loss from the outfit, or $1000). Jenny’s expected payoff Steve’s payoff Net result Steve performs $850 -$200 $650 Steve does not perform, pays expectation damages $850 -$1000 -$150 10. Now suppose that Steve has a last-minute emergency that makes performance very expensive for him. It now costs him $1600 to perform. Do expectation damages result in the socially efficient outcome? Yes. Expectation damages still result in the socially efficient outcome. Now, Steve would rather breach and pay expectation damages (net $1000) than perform at a loss of $1100, and this is also the socially efficient outcome (combined losses of $250 as opposed to $150). Jenny’s expected payoff Steve’s payoff Net result Steve performs $850 -$1100 -$250 Steve does not perform, pays expectation damages $850 -$1000 -$150 Þ When Steve’s payoff exceeds the amount he would pay in expectation damages, performance is no longer socially efficient, and he will be disincentivized from performing. Þ With perfect expectation damages, only efficient breaches happen.

LS 145 Disc_Week 10_Handout_Solved (1)

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