Economics 1450 Law and Economics Professor Daniel Berkowitz Spring

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1 Economics 1450 Law and Economics Professor Daniel Berkowitz Spring March 1, 2005 Problem Set 4 The problems are taken from Chapter 4&5. We will discuss these problems in class in class on March 15 th and I will collect these problem sets at the end of class on March 17 th. The midterm is scheduled for March 22 nd. Because the discussion of private disclosure of information in Chapter 4 contains rather difficult material, I am attaching some notes. Below, I expand upon the example presented in Micelli, pp Let V inf = $100 = value of infertile cow; V fer = $1000 = value of a fertile cow; 1-Pr = 0.90 = probability of obtaining an infertile cow; Pr = 0.10 = probability of obtaining a fertile cow. Consider the case when information is purely distributive. The seller believes the cow is infertile. However, the market prices out the cow before the information about the whether or not the cow is fertile is revealed. Suppose that courts always enforce contracts. Thus, even when the cow turns out to be fertile, the court would not back the seller when she breaches the contract on the basis of the contract doctrine of mistake. In this case, the market price for the cow is (0.10*1000$) + (0.90*100$) = 190$, and the results in Table 4.1 in Micelli can be easily derived. Note that in this case overall social value is $190 and the buyer reaps a major windfall in the case in which a fertile cow is sold. Suppose that the court does not enforce contracts. This means that the seller can breach the contract if she finds out that the cow is fertile. Thus, cows are only sold when they are infertile. The market anticipates this outcome and price cows at $100 and the results in Table 4.2 in Micelli again are straightforward to derive. Once again, social value is $190; however, now the seller reaps the windfall when a fertile cow is available.

2 Tables 4.1 and 4.2 illustrate a situation in which just whether or not courts enforce contracts or allow breach on the basis of the doctrine of mistaken information does not matter for social value; the only impact is on the distribution of gains to the buyer and seller. So, at a first pass, there is no compelling argument for or against either court rule. Suppose, however, the buyer can spend $50 to obtain training at the cow society in Scranton where she will learn to determine the cow s type with certainty. The buyer takes the training course prior to contracting with the seller and the seller is unaware that the buyer in fact has taken this course. In this situation, the buyer has private information. If the court enforces contracts in which there is this private information, then, effectively, the court does not require disclosure of private information. In this case, the market once again prices the cow at (0.10*$1000) + (0.90*$100) = $190, and the results in Table 4.1 in Micelli can be used to derive pay-offs when it is possible for the buyer to have this information advantage over the seller. Table 4.1 Adapted to include purely distributive information State of the world Buyer s profit Seller s profit Social Value Fertile Cow ($1000-$190 - $50) 190$ $760 + $190 = $950 = $760 Infertile Cow - $50 $100-50$ + $100 = $50 Expected Value (0.10)*($760) + (0.90)*(-50$) = $31 (0.10*$190) + (0.90$*$100) = $109 (0.10*$950) + (0.90*50$) = $31 + $109 = $140 Note that in this Table 4.1 (Adapted to include purely distributive information) there are several major changes from Table 4.1 in Micelli. First, the buyer increases his expected value from $0 (when he obtains no information) to $31. So, he obtains a private gain that (as we will see when we get to point 4) is socially inefficient. Second, when the buyer knows that the cow is infertile, he does not buy it (if he did, then he would knowingly buy the cow for $190, even though its worth is only $100; so his overall losses would be -$90 - $50 = -$140). Third, the seller s expected profits are now (0.10*$190) + (0.90*$100) = $109. Thus, the seller obtains $190 for a cow sold under contract, and when the seller can sell the cow, she knows that it is infertile and worth just $100. Fourth, total social value drops to $140, so even though the buyer gains by investing in this private information, acquiring this information in fact destroys social value. So, taking the view that courts are advocates primarily of social value, the idea then is that this destruction of social value should be eliminated. The court can do this by requiring that the buyer disclose his private information to the seller. If the buyer does not do this, then the court will enable the seller to breach her contract and keep the fertile cow. This eliminates the buyer s incentive to invest the $50 investment in the information gathering. The general point then is that when information is purely redistributive, the courts should require complete disclosure which means that they would allow the seller

3 to breach following the action of Walker in Sherwood v. Walker (66 Mic. 568, 33 N.W> 919, Mich. 1887). Now consider the case in which information is socially valuable. The idea used in Micelli is that in the absence of a $50 investment in information made by the buyer, both the seller and buyer will never know with certainty just what kind of cow is being traded. In particular, the 90% probability that the cow is infertile is taken to be a sufficiently good approximation of reality and the cow simply is slaughtered. Thus, there is a social loss because fertile cows (worth 1000$) are slaughtered 10% of the time. The loss, as one of the students from this class noted, equals (0.10)*(1000$ - 100$) = probability of slaughtering a fertile cow * the difference in value between a fertile and infertile cow = 90$ (congrats to the student on a fine back of the envelope calculation!!). To add to the students calculation, then a $50 investment by the buyer should yield a gain in social surplus of $90 - $50 = 40$; so that even if this information benefits the buyer, this investment should be encouraged because it expands social surplus. To see this, note that in the absence of information all cows that are sold or not sold go to slaughter since everybody expects that they are infertile. Thus, the market prices cows at $100. The buyer buys at $100 and makes $100 off of slaughtering the cow and makes $0 profit. The seller makes $100 on the sale, and overall social value is $100. Note that in this case the buyer and seller behave in this fashion when the cow is infertile and fertile (when the cow is fertile, they act as if it were infertile). Now, suppose that the buyer invests in information and does not disclose it to the seller. Table 4.3 shows buyer s profit, seller s profit and social value when the contract is enforced and information is socially valuable. There are several points that are notable: first, the buyer can take advantage of his additional information and reap a major windfall when the cow is fertile, and increase his expected profits from $0 to $40; second, the seller s profits remain fixed at $100; third, the seller is uninformed as he sells the cow still expecting that it is infertile; fourth, as previously noted, overall social surplus increases by $40 from $100 to $140. To repeat, this gain represents the expected benefit of not slaughtering the fertile cow (90$) net of the cost of acquiring information ($50). So, the courts in the common law tradition favor this outcome that does not require disclosure of private information when such information is socially productive. Solve the following problems. 1. Suppose that the probability that a cow is fertile is only 5%. Rework the example from the Micelli, pp Do the same conclusions still apply? 2. Micelli, Exercise Micelli, p.126, problems 1, 2, 3 and Explain the role that consideration plays in contract law in making a contract enforceable. 5. Explain why the application of the contract doctrine of mistakes is problematic in the famous Sherwood v. Walker case (66 Mich. 568, 33 N.W. 919, Mich. 1887).

4 6. The economic theory underlying contract law says that the role of courts is to provide the missing terms of incomplete contracts so that the economic gains from trade will be realized. Explain how several of the assumptions of a perfectly competitive market including 1) rationality, 2) absence of monopoly and 3) perfect information can be used so as to enforce or breach a contract. Selected Answers to Problem Set IV. Rework example in Micelli, pp , for the case when Pr = In the case of purely distributive information, if the court enforces contracts, the market price for the cow is (0.05*1000$) + (0.95*100$) = 145$. Now, when the cow is fertile, the buyer s profit is $ $145 = $855m and $100-$145 = -$45 when the cow is interfile; the seller s profit is always $145; social value is $1000 when the cow is fertile, and $100 when the cow is infertile; and expected social value is (0.05)*1000$ + (0.95)*(100$) = 145$. You can compute this simply by putting in the new price into table 4.1. Now, if contracts are not enforced, then, again, you can plug in the market price (now, 100$ since cows are only sold when they are good for slaughter if the seller can know before selling whether or not the cow is infertile). Buyer s profit and seller s profit in the different states are the same, buyer s expected value of 0 is unchanged; but, now seller s expected profit is $145, and social value is also %=$145. Now, suppose that the buyer can go off to Scranton and at a cost of 50$ can learn to identify the cow s type. If the court does not require disclosure of this private information, the market will again price the cow at 145$, and now Table 4.1 Adapted to include purely distributive information, and Pr = 0.05 State of the world Buyer s profit Seller s profit Social Value Fertile Cow ($1000-$145 - $50) 145$ $805 + $145 = $950 = $805 Infertile Cow - $50 $100-50$ + $100 = $50 Expected Value (0.05)*($805) + (0.95)*(-50$) = -$7.25 (0.05*$145) + (0.95$*$100) = $ $95 Because the buyer earns a negative expected profit, he/she will not go to Scranton to obtain the private information. In this situation, the socially efficient outcome is achieved because the expected benefits of obtaining information are not sufficiently high.

5 Now, suppose that information is socially valuable. The social loss is that fertile cows are slaughtered 5% of the time, and this equals (0.05)*( ) = 45$. However, it is now the case that this 45$ gain is less than 50$ cost of obtaining this information, and so the effort allocated to obtaining it imposes at 5$ loss on social surplus. The question is just whether or not this inefficiency can occur in the market place. Again, if the information is not collected, and everybody believes that a cow is infertile, then the market price = 100$ and overall social value is 100$. Suppose that the buyer invests the 50$ in information tech. Check Table 4.3, and you will see that his/her expected profits are now (0.05*850$) + (0.95*(-50$)) = -2.50, and so the seller will not make this investment! Micelli, Exercise 4.1 (a) the information is socially valuable since the market price of 10,000$ does not take into account the probability that the land contains a mineral deposit. The value of this information is that it increases land value from 10,000$to 500,000$! (b) Information was discovered casually, as the buyer did this by accident when preparing the land for development. (c) The idea is that when information is acquired casually, then invalidating the contract and thereby forcing the buyer to disclose information will have not much impact on the subsequent rate of discovery. This, however, is debatable, as if the price does not include the possibility of finding a deposit, then the rate of development might. (d) Now this socially productive information has been obtained deliberately. Thus, if the court invalidates the contract because private information has not been disclosed, this will provide the wrong incentives to potential developers in the future. Micelli: chapter 4, problem 1. (a) In Recker v. Gustafson and in Blaskeslee et al v. Board of Water Commissioners both promisors agreed to these price increases. (b) In Receker v. Gustafson, this is coercion as the Gustafson is exerting monopoly power and threatening Recker. In the second case, the price increase is socially efficient because it reflects a genuine change in economic conditions not fully spelled in the initial (incomplete) contract and this increase allows the defendant to stay in business. Micelli: chapter 4, problem 2. This tells us that the probability that the highway would be approved was already priced into the land. In fact, you can compute this probability (Pr = market perception of the probability that the highway will be approved). Since land value with no highway = 5,000$ and land value with a highway is $100,000, and the sale of price of $15,000 = Pr*($100,000) + (1-Pr)*($5,000), then Pr = (10,000)/(95,000) = 10.5% (approximately). S s claim that the mistake was mutual does not hold, as the price was fully informative.

6 Micelli: chapter 4, problem 3. The information obtained by the buyer is socially valuable if the market price for the land does not reflect the expected value of mineral rights with and without this valuable deposit. If there is no indication that this land market is inefficient (i.e.., has uninformative prices), the information is distributive. Since the buyer obtains the information deliberately, this information should have been disclosed. However, if market prices are uninformative in that they do not reflect the probability of a valuable discovery, then the information is socially valuable and the buyer should not have to disclose and the contract then is enforced. Micelli: chapter 4, problem 4. Suppose that the price is fully informative and takes into the account the expected value from ending the war. The buyer s early knowledge that the treaty ending the war of 1812 is purely distributive because it enables him to get the rents associated with the higher price. If this was obtained deliberately, then the buyer should be required to disclose. However, if it was obtained casually, then the disclosure rule is irrelevant for efficiency and the judge can pursue distributional objectives. However, suppose that the price does not account for the probability that the war will end soon. Then, in this case information is socially valuable. If the information has acquired deliberately, the seller should not have to disclose; if it was acquire casually, then the particular disclosure rule becomes irrelevant. 4. Explain the role that consideration plays in contract law in making a contract enforceable. See Micelli, pp Explain why the application of the contract doctrine of mistakes is problematic in the famous Sherwood v. Walker case (66 Mich. 568, 33 N.W. 919, Mich. 1887). See class notes and discussion in Micelli on pp The economic theory underlying contract law says that the role of courts is to provide the missing terms of incomplete contracts so that the economic gains from trade will be realized. Explain how several of the assumptions of a perfectly competitive market including 1) rationality, 2) absence of monopoly and 3) perfect information can be used so as to enforce or breach a contract. See Micelli, pp and

7 Selected Answers to Problem Set IV. Rework example in Micelli, pp , for the case when Pr = In the case of purely distributive information, if the court enforces contracts, the market price for the cow is (0.05*1000$) + (0.95*100$) = 145$. Now, when the cow is fertile, the buyer s profit is $ $145 = $855m and $100-$145 = -$45 when the cow is interfile; the seller s profit is always $145; social value is $1000 when the cow is fertile, and $100 when the cow is infertile; and expected social value is (0.05)*1000$ + (0.95)*(100$) = 145$. You can compute this simply by putting in the new price into table 4.1. Now, if contracts are not enforced, then, again, you can plug in the market price (now, 100$ since cows are only sold when they are good for slaughter if the seller can know before selling whether or not the cow is infertile). Buyer s profit and seller s profit in the different states are the same, buyer s expected value of 0 is unchanged; but, now seller s expected profit is $145, and social value is also %=$145. Now, suppose that the buyer can go off to Scranton and at a cost of 50$ can learn to identify the cow s type. If the court does not require disclosure of this private information, the market will again price the cow at 145$, and now Table 4.1 Adapted to include purely distributive information, and Pr = 0.05 State of the world Buyer s profit Seller s profit Social Value Fertile Cow ($1000-$145 - $50) 145$ $805 + $145 = $950 = $805 Infertile Cow - $50 $100-50$ + $100 = $50 Expected Value (0.05)*($805) + (0.95)*(-50$) = -$7.25 (0.05*$145) + (0.95$*$100) = $ $95 Because the buyer earns a negative expected profit, he/she will not go to Scranton to obtain the private information. In this situation, the socially efficient outcome is achieved because the expected benefits of obtaining information are not sufficiently high. Now, suppose that information is socially valuable. The social loss is that fertile cows are slaughtered 5% of the time, and this equals (0.05)*( ) = 45$. However, it is now the case that this 45$ gain is less than 50$ cost of obtaining this information, and so the effort allocated to obtaining it imposes at 5$ loss on social surplus. The question is just whether or not this inefficiency can occur in the market place. Again, if the information is not collected, and everybody believes that a cow is infertile, then the market price = 100$ and overall social value is 100$. Suppose that the buyer invests the 50$ in information tech. Check Table 4.3, and you will see that his/her

8 expected profits are now (0.05*850$) + (0.95*(-50$)) = -2.50, and so the seller will not make this investment! Micelli, Exercise 4.1 (e) the information is socially valuable since the market price of 10,000$ does not take into account the probability that the land contains a mineral deposit. The value of this information is that it increases land value from 10,000$to 500,000$! (f) Information was discovered casually, as the buyer did this by accident when preparing the land for development. (g) The idea is that when information is acquired casually, then invalidating the contract and thereby forcing the buyer to disclose information will have not much impact on the subsequent rate of discovery. This, however, is debatable, as if the price does not include the possibility of finding a deposit, then the rate of development might. (h) Now this socially productive information has been obtained deliberately. Thus, if the court invalidates the contract because private information has not been disclosed, this will provide the wrong incentives to potential developers in the future. Micelli: chapter 4, problem 1. (c) In Recker v. Gustafson and in Blaskeslee et al v. Board of Water Commissioners both promisors agreed to these price increases. (d) In Receker v. Gustafson, this is coercion as the Gustafson is exerting monopoly power and threatening Recker. In the second case, the price increase is socially efficient because it reflects a genuine change in economic conditions not fully spelled in the initial (incomplete) contract and this increase allows the defendant to stay in business. Micelli: chapter 4, problem 2. This tells us that the probability that the highway would be approved was already priced into the land. In fact, you can compute this probability (Pr = market perception of the probability that the highway will be approved). Since land value with no highway = 5,000$ and land value with a highway is $100,000, and the sale of price of $15,000 = Pr*($100,000) + (1-Pr)*($5,000), then Pr = (10,000)/(95,000) = 10.5% (approximately). S s claim that the mistake was mutual does not hold, as the price was fully informative. Micelli: chapter 4, problem 3. The information obtained by the buyer is socially valuable if the market price for the land does not reflect the expected value of mineral rights with and without this valuable deposit. If there is no indication that this land market is inefficient (i.e.., has uninformative prices), the information is distributive. Since the buyer obtains the information deliberately, this information should have been disclosed. However, if market prices are uninformative in that they do not reflect the probability of a valuable discovery, then the information is socially valuable and the buyer should not have to disclose and the contract then is enforced.

9 Micelli: chapter 4, problem 4. Suppose that the price is fully informative and takes into the account the expected value from ending the war. The buyer s early knowledge that the treaty ending the war of 1812 is purely distributive because it enables him to get the rents associated with the higher price. If this was obtained deliberately, then the buyer should be required to disclose. However, if it was obtained casually, then the disclosure rule is irrelevant for efficiency and the judge can pursue distributional objectives. However, suppose that the price does not account for the probability that the war will end soon. Then, in this case information is socially valuable. If the information has acquired deliberately, the seller should not have to disclose; if it was acquire casually, then the particular disclosure rule becomes irrelevant. Explain the role that consideration plays in contract law in making a contract enforceable. See Micelli, pp