Prof. Dr. Friedrich Schneider
Institut für Volkswirtschaftslehre
http://www.econ.jku.at/schneider
Recht und Ökonomie(Law and Economics)
LVA-Nr.: 239.203
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(6) Contract Law (Vertragsrecht)
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1. Contract
Contract: agreement that regulates an exchange that ismutually beneficial.
–Contracts to give or to make.
–Replicable goods or ‘specific’ goods.
General problems:
–breach of contract;
–information may be asymmetric (one party knowsmore);
–correct incentives to fulfil the contract.
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2. Incompleteness of Contracts
Complete contingent contract (hypothetical)
Incompleteness: Costs of specification:
–ex ante, e. g. lawyers fees.
–ex post, conflict resolution.
Minimise cost by comparing:
–ex ante cost (usually certain) to
–ex post cost, usually with presumed probability
•assumption: many contracts concluded.
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3. Breach or Re-Negotiation
Suppose seller (S) and buyer (B) contract for 100washing machines per month for € 35.000.
‘Daily’ cost of equipment (sunk cost) € 15.000.
•sunk costs = incurred costs that cannot be recovered.
Opportunity cost € 25.000 (value of best alternative useof the equipment).
Buyer could re-negotiate contract for a new price ofless than € 35.000 (but more than € 25.000).
Post-contractual opportunistic negotiations.
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4. Incompleteness and Contract Law
Reliance on contract law (C. L.) to resolve unexpected(unlikely) occurrences.
Only major or contract specific terms have to becontained in the contract.
Plus some clause: “ … contract is to be governed bythe laws of…”
Contract law thus:
–serves as ‘default option’;
–reduces transaction costs through provision of(efficient) enforcement mechanisms.
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5. Inefficient Contract Laws
Breach of contract reduces profits (welfare).
Possible solution: penalty
–e.g.: “ … delay of delivery (finishing construction, …) leads to apenalty of € … per day (week, …)”;
–recovers profits foregone by buyer.
Seller can choose to deliver on time or with delay to maximise hisprofits optimal solution for both.
Poor enforcement mechanisms (may) lead to reduced economicactivities, reducing welfare.
Uncertain debt recovery (or payment) will lead to request forsecurities, increases cost.
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6. Efficient Contract Laws
Reduce transaction costs.
Economise on information costs.
–Imperfect versus asymmetric information.
Lead to only efficient contract breaches.
–Penalty.
Imply efficient reliance.
–Avoid opportunistic re-negotiation.
Involve risk minimisation:
–precautions to avoid risk;
–cost-minimising risk bearing.
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7. Asymmetric Information
Problem: one party in a transaction has more or betterinformation compared to other party can takeadvantage of other party’s lack of knowledge marketfailure (?)
Causes general problems:
Adverse selection.
Moral hazard.
Principal-Agent-Problem
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7. Asymmetric Information (cont.)
Example: consider used car market.
With 100 cars: 50 ‚plums‘ and 50 ‚lemons‘.
Sellers know the quality of car, buyers do not( asymmetric information).
‚Plums‘ would be offered for € 6.000, ‚lemons‘ for€ 3.000.
Willingness-to-pay (WTP): € 7.200 and € 3.600,respectively.
WTP with no information on quality: € 5.400.
Result: only ‚lemons‘ would be offered no contract.
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8. Adverse Selection
Example 1: Bicycle Insurance.
Assume regional differences in theft rates.
Insurance company offers insurance based on averagetheft rate.
Only people in areas with high theft rates will take outinsurance adverse selection (A. S.).
Result: company will go out of business due toadverse selection (and not due to unbiased selection).
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8. Adverse Selection (cont.)
Example 2: Health Insurance.
Insurance company bases rates on averageoccurrence of health problems.
Individuals know their health status (better), insurancecompanies do not (or know it less than individuals).
Result: Only high risk people will take out insurance.
Solutions to avoid A. S.:
–mandatory insurance (e. g. Europe);
–‘health plan’ by firms (e. g. US, also Europe).
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9. Moral Hazard
Example: Bicycle Insurance.
Assume probability of theft (also) depends on action, that is caretaken by owners (e.g. type of locks).
If no insurance is available: maximum care
–Marginal Costs (MC) of taking care = Marginal Benefit (MB) oftaking care.
With insurance: level of care is reduced (change of behaviour) moral hazard (M. H.).
–Holds also for health insurance, fire insurance, ...
Solutions:
–deductibles: no full coverage;
–try to observe level of care:
•rates differ for smokers, houses with sprinkler systems, …
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9.1. Adverse Selection and Moral Hazard
Adverse Selection is due to ‘hidden information’:
–one side of the market cannot observe quality.
Moral Hazard is due to ‘hidden action’:
–one side of the market cannot observe care.
Lack of information causes inefficiency.
Government action may alleviate the problem only incase of hidden information.
–Compulsory insurance.
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10. Signalling
Car example: seller knows more ( signal to buyer):
warranty on used cars;
reputation of seller.
Quality of workers: employee knows more ( signal to employer):
–years of school attended;
–diploma (‘sheepskin effect’);
–additional qualifications;
–voluntary work;
–…
Objective: reduce the asymmetry in information (at low cost!).
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11. Incentives and Asymmetric Information
Which contract ensures that someone does what Iwant her/him to do for me?
Also known as ‘Principal–Agent–Problem’: a principalhires one (or more) agent(s), to pursue principal'sinterests.
Problem: performance of agent(s) not perfectlyobservable information asymmetry incentivescheme / contract?
Examples: employer and employee; owner andmanager of company.
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11. Incentives and Asymmetric Information (cont.)
Consider four types of contracts:
(1)Rent;
(2)wage labour;
(3)take-it-or-leave-it;
(4)Sharecropping.
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11.1. Rent
Agent (hirer) pays fixed amount to principal(landowner).
Agent gets all the surplus beyond rent.
Maximum output produced efficient.
–Utility maximizing for agent.
But: agent also bears all the risk.
If agent is more risk averse than the owner the resultwill be inefficient.
Agent would be willing to give up some income for areduction in risk.
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11.2. Wage Labour
Principal (employer) pays to agent (worker) a constantamount per unit of effort.
Utility maximizing agent chooses his effort such thatmarginal product of effort equals marginal cost ofeffort efficient.
With asymmetric information: effort cannot beobserved by principal (only hours can be observed).
•Unless: piece work.
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11.3. Take-it-or-leave-it
Agent (worker) is paid the full amount if he/shechooses the optimum effort level – and zero otherwise.
Outcome: agent chooses this optimal level efficient.
With asymmetric information:
–agent bears all the risk (if payment is based onoutput); or
–effort cannot be observed (payment based on input).
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11.4. Sharecropping
Principal (landowner) and agent each get some fixedproportion of total output.
Since agent gets only a fraction of output he/she willequalize this fraction of marginal product (MP) to themarginal cost (MC).
Leads to an inefficient level of effort (output).
Introducing risk aversion of actors leads to optimumoutput since both (principal and agent) bear risk.
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12. Conclusions
Results of ‘simple’ economic models may change ifone adds:
–asymmetry of information;
–risk (uncertainty) considerations (risk neutral, riskaverse, or risk loving);
–behavioural insights (how are decisions actuallymade?).
If one wants to arrive at recommendations for theconcrete design of contracts (more) advancedeconomic analysis may be required.
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