Tutorial 4 – Economic Rationale of Contract Law
General information
Contents of this tutorial:
Game Theory (continued):
o Cooperation and Commitment
o Optimal Performance
o Optimal Reliance
Default Rules and Transaction Costs
Perfect Contracts and Market Failures
Assignment 7.1: Game Theory and Contract Law
Suppose that we have a single shot game with two players: an old widow lady (W) and an investment
consultant (IC). The widow wants to invest €100,000 in stocks and shares for one year, but has no idea
how to do so, until an investment consultant shows up. He claims that in that one year he can produce
a return on that investment of 5%, so € 5,000. The two parties agree that these € 5,000 in profits will
be split evenly, i.e. € 2,500 each. Using game theory, show that we need contract law (including some
system of remedies) to make sure that the widow lends out the money to the investment consultant,
and to make sure that the investment consultant does not ‘appropriate’, i.e. take the money and
disappear. Compare the games without and with contract law, and point out any efficiency effects
(Pareto, Kaldor Hicks). For the game with contract law, show also what type of remedies are
necessary to make sure that the money is invested.
Please note that this example is slightly different from the one provided in the book, as here it is
assumed that co-operation is not required to make a profit with the investment. In other words: the
investment consultant can make a € 5,000 profit even if he ‘appropriates’ the money or breaches the
contract.
Why game tree?
This shows the order in which the decisions are made. Not in last weeks example, because the
farmers made decisions at the same time (symmetric). In all other situations, the game tree is
advised; especially when one party decides before the other one (asymmetrical).
Which party makes the first decision?
The widow, she decides that she wants to invest.
Not invest (the game already ends); 0,0 (net pay-off)
Cooperate; 2.500, 2.500
W Invest
Investment consultant Appropriate; -100.000, 105.000 = dominant
If there is cooperation, the parties will decide to split evenly the profit: 5000:2 = 2,500 per
party;
How do we solve the game?
o The widower is first to choose. She can decide between investing or not-investing.
But in order to know which one she will pick, she will want to know what the other
person is about to do. So we look at what the investment consultant will do. He of
course cannot decide for the widower, but he can control what he himself will do. He
, will always choose the dominant strategy and choose the highest pay-off: meaning if
the widow decides to invest, he will always appropriate.
NB: with game trees it’s best to start at the end and work towards the beginning.
Is this an efficient outcome?
o We would like to end up at cooperation, this is most efficient;
o Is this Pareto-efficient? Yes, neither party is better or worse off;
o Is this Kaldor-Hicks efficient? Yes. Kaldor-Hicks efficient means there can be losers
and gainers at the same time, but it has to produce more benefits than costs.
NB: Pareto is the strictest efficiency, meaning if something is Pareto efficient it will
naturally also be Kaldor-Hicks efficient.
The other outcome, appropriate, is not Pareto-efficient because there is an obvious
loser (-100.000). But there is a Kaldor-Hicks improvement: the total gains outweigh
the losses.
The game with contract law
Do not invest (the game already ends); 0,0 (net pay-off)
Perform; 2.500, 2.500
W Invest
Investment consultant
Breach; Expectation damages:
W: 2500 (expected to gain this out of the contract)
IC: 2500 Get this number down with at least 1
euro, that will be enough to make sure that the IC
chooses perform rather than breach (fine, costs of
court proceedings)
Reliance damages:
0,5000 (W (hurt party) has no net pay-off; no
losses and no gains)
Both branches are Pareto-efficient; we do have a preference for perform. At the breach-branch we
have to make additional costs: trace the guy, have the court order him to pay back. To make sure we
end up at the perform branch in a situation like the underlying one, there has to be done more than
expectation damages. Ordering specific performance for example, or a fine or cost of court
proceedings.
What types of remedies?
o Restitution
o Specific performance: can be used in situations where damages are not fit. When
relying on a specific act or performance: wedding example. Substitute at the other
party’s expense.
o Damages (C&U seem to focus on damages)
Expectation damages: what you would have gotten if the contract followed
through (‘positief contractsbelang’)
General information
Contents of this tutorial:
Game Theory (continued):
o Cooperation and Commitment
o Optimal Performance
o Optimal Reliance
Default Rules and Transaction Costs
Perfect Contracts and Market Failures
Assignment 7.1: Game Theory and Contract Law
Suppose that we have a single shot game with two players: an old widow lady (W) and an investment
consultant (IC). The widow wants to invest €100,000 in stocks and shares for one year, but has no idea
how to do so, until an investment consultant shows up. He claims that in that one year he can produce
a return on that investment of 5%, so € 5,000. The two parties agree that these € 5,000 in profits will
be split evenly, i.e. € 2,500 each. Using game theory, show that we need contract law (including some
system of remedies) to make sure that the widow lends out the money to the investment consultant,
and to make sure that the investment consultant does not ‘appropriate’, i.e. take the money and
disappear. Compare the games without and with contract law, and point out any efficiency effects
(Pareto, Kaldor Hicks). For the game with contract law, show also what type of remedies are
necessary to make sure that the money is invested.
Please note that this example is slightly different from the one provided in the book, as here it is
assumed that co-operation is not required to make a profit with the investment. In other words: the
investment consultant can make a € 5,000 profit even if he ‘appropriates’ the money or breaches the
contract.
Why game tree?
This shows the order in which the decisions are made. Not in last weeks example, because the
farmers made decisions at the same time (symmetric). In all other situations, the game tree is
advised; especially when one party decides before the other one (asymmetrical).
Which party makes the first decision?
The widow, she decides that she wants to invest.
Not invest (the game already ends); 0,0 (net pay-off)
Cooperate; 2.500, 2.500
W Invest
Investment consultant Appropriate; -100.000, 105.000 = dominant
If there is cooperation, the parties will decide to split evenly the profit: 5000:2 = 2,500 per
party;
How do we solve the game?
o The widower is first to choose. She can decide between investing or not-investing.
But in order to know which one she will pick, she will want to know what the other
person is about to do. So we look at what the investment consultant will do. He of
course cannot decide for the widower, but he can control what he himself will do. He
, will always choose the dominant strategy and choose the highest pay-off: meaning if
the widow decides to invest, he will always appropriate.
NB: with game trees it’s best to start at the end and work towards the beginning.
Is this an efficient outcome?
o We would like to end up at cooperation, this is most efficient;
o Is this Pareto-efficient? Yes, neither party is better or worse off;
o Is this Kaldor-Hicks efficient? Yes. Kaldor-Hicks efficient means there can be losers
and gainers at the same time, but it has to produce more benefits than costs.
NB: Pareto is the strictest efficiency, meaning if something is Pareto efficient it will
naturally also be Kaldor-Hicks efficient.
The other outcome, appropriate, is not Pareto-efficient because there is an obvious
loser (-100.000). But there is a Kaldor-Hicks improvement: the total gains outweigh
the losses.
The game with contract law
Do not invest (the game already ends); 0,0 (net pay-off)
Perform; 2.500, 2.500
W Invest
Investment consultant
Breach; Expectation damages:
W: 2500 (expected to gain this out of the contract)
IC: 2500 Get this number down with at least 1
euro, that will be enough to make sure that the IC
chooses perform rather than breach (fine, costs of
court proceedings)
Reliance damages:
0,5000 (W (hurt party) has no net pay-off; no
losses and no gains)
Both branches are Pareto-efficient; we do have a preference for perform. At the breach-branch we
have to make additional costs: trace the guy, have the court order him to pay back. To make sure we
end up at the perform branch in a situation like the underlying one, there has to be done more than
expectation damages. Ordering specific performance for example, or a fine or cost of court
proceedings.
What types of remedies?
o Restitution
o Specific performance: can be used in situations where damages are not fit. When
relying on a specific act or performance: wedding example. Substitute at the other
party’s expense.
o Damages (C&U seem to focus on damages)
Expectation damages: what you would have gotten if the contract followed
through (‘positief contractsbelang’)
