ECONOMICS 1471
HOMEWORK #2: ANSWERS

1. Blacks in the post-Civil War agricultural South were in great demand as farm-workers because manpower was very scarce. Assume that a black farmworker X was willing to accept a minimum of $300 per year while planter Y was willing to pay a maximum of $1,200 (the value of his crops). During the off-season, X promises to work a whole year for Y in exchange for a wage of $600. But once harvest time arrives, the scarcity of farm labor causes planter Z to offer X a wage of $1,500 because the value of his crops is $2,500.

a. Assume that planter Y could take X to court for a breach of contract. Make up a numerical example showing how breach of contract can be efficient. Do damages and specific performance produce the same outcomes? Explain.
(1) Normal Situation
X: share of surplus = $300 = $600 - $300
Y: share of surplus = $600 = $1,200 - $600

(2) Fortunate Contingency: Assume Z offers $1500 to X
X: share of new surplus = $1,200
Z: share of new surplus = $1,000

(1) If Y took X to court for breach of contract and received damages he would be awarded $600 (his surplus). X would still be better off since he would now have a surplus of $600 (which is better than the $300 he would earn if the contract with Y was not breached). This would yield the following surplus calculations:

X: $1,500 - $600 - $300 = $600

Y: $600 (damages)

Z: $1,000

(2) If Y took X to court for breach of contract and received a judgment of specific performance the outcome would be the same. In essence, X would be willing to pay Y a maximum of $899 to take the job with Z (leaving X better off with a $1 gain over the non-breach case) and Y would not accept less than $601 in payment (leaving Y better off with a $1 gain over the non-breach case). Given the method adopted in previous chapters of splitting the surplus in half, X would pay Y $750. This would yield the following surplus calculations:

X: $1,500 - $750 - 300 = $450

Y: $750 (payment for breach)

Z: $1,000

Conclusion: It is efficient for the worker to breach the contract regardless of the remedy. Y prefers the remedy of specific performance and X prefers the payment of damages.

b. If planters collectively pressure the legislature to pass an anti-inducement law making it illegal to induce a breach of contract, explain the consequences of such a law.

Such a law prevents an efficient allocation of resources in the case of a fortunate contingency. In that sense, it prevents a reallocation of resources to higher valued uses and produces an inefficient result. This outcome was a desirable one for many planters because it kept the cost of labor down. Before this law was passed, planters had attempted to collude in holding down wages but such agreements were always broken. The only way to enforce such a collusive agreement was to use the power of government to enforce it. Hence the passage of the anti-inducement laws.

c. Suppose X and Y agree to the insert a clause in their contract specifying that X will pay Y $2,000 in damages if he does not complete his contract. Discuss the efficiency properties of this contract (see section on liquidated damages).

Y may include such a clause in the contract if he places a high subjective value on getting his crops harvested (perhaps he is entering them in some prestigious contest at a county fair). In this case, Z must offer a wage in excess of $2600 (so that $2600 - $2000 - $300 = $300) to entice him away. Since Z's crop are only worth $2500, this will discourage him from making such an offer. However, it is conceivable that X will demand a higher wage in return for the inclusion of such a clause (which acts as an insurance policy).

While courts have been reluctant to enforce contracts with liquidated damage clauses that appear to be punitive, there are good economic reasons for enforcing such clauses: such clauses represent either the purchase of insurance against breach (with the promisor being the low cost insurer) or the lowest cost method of conveying information on reliability in executing the contract by the promisor (since this method is a good substitute for an established reputation, such clauses facilitate entry into lines of business where reputation is important).

d. Assume that a drought occurs and planter Y's crops are worth only $400. Make up a numerical example showing how breach of contract can be efficient. Do damages and specific performance produce the same outcomes? Explain.

(1) Normal Situation
X: share of surplus = $300 = $600 - $300
Y: share of surplus = $600 = $1,200 - $600

(2) Unfortunate Contingency
X: share of surplus = $600 - $300 = $300
Y: share of surplus = $400 - $600 = -$200

In this situation, if Y breached the contract he would have to pay damages of $300. Since his losses are only $200, Y has an incentive to pay X the full $600 wage and avoid the larger loss.

If Y's output has a value of $250 (any value less than $300) then breach of contract will be efficient. Breach in this case allows Y to avoid the larger loss by paying $300 in damages. That is:

X: share of surplus = $600 - $300 = $300

Y: share of surplus = $250 - $600 = -$350

Specific performance yields a similar result. If Y is ordered by the court to carry out the contract, then he can bargain with X by offering him a payment of $325. Since this exceeds the surplus he could have earned from Y, X will take the $325, find a job paying $300, and be better off ($625 vs $600). Y is better off since he would have lost $350 in carrying out the contract while actually only losing $325.

In general, the text argues that specific performance should be ordered by the courts whenever transactions costs are low (because this allows bargaining between the two parties). Since the parties are already in a contractual relationship, the presumption of low transactions costs seems reasonable. This means that specific performance should normally be used for cases involving breach of contract. This result is efficient because the parties themselves would appear to be the low cost providers of the means of dispute resolution. In contrast, courts would have to do extensive research on the relevant market, what contractual terms were customary, and so on. In essence, the courts would incur very high costs to gather such information as is available to the contracting parties at much lower cost.

Thus specific performance is efficient because it recruits low cost means of resolving disputes over contracts. Some economists worry that specific performance may be inefficient because it requires higher transactions costs to reallocate the resources to their presumed highest valued use when unexpected contingencies arise. This inefficiency must be weighed against the inefficiencies that might arise when courts fail to assess damages correctly. Additionally, specific performance allows the parties to bargain around its requirements: the low cost option, be it executing the contract or reaching a satisfactory agreement over breaching the contract and dividing the surplus appropriately, would normally be carried out.

2. Consider the following questions in Chapter 7: Q.7.27 and 7.47. Do you see any parallel between the supplementary reading on George Michaels and these questions? What would you conclude about the ultimate effects of favoring Michaels in this case? Explain.

See answers in back of text to those questions. Those answers should give you a reasonable way to answer the question about Michaels.

3. R has rented L's premises for five years under the condition that he use the property as a saloon; furthermore, the contract forbids him to sublet the premises during the term of the lease. After two years, the county in which R has been operating his saloon suddenly and unexpectedly makes the sale of alcoholic beverages illegal. R breaches his contract with L and L sues for specific performance. Under that remedy, might it not be the case that R will be inefficiently bound to pay R the remaining three years rental? And would it not be more efficient if L had a duty to mitigate his losses by re-letting the premises if the routine award were money damages with a duty to mitigate? (Note: This question wonders whether an award of specific performance would be inefficient because L would not have to find another renter and would be able to force R to pay all the remaining rent owed under the contract.)

Several things must be considered here. First, suppose that R paid a lower market rent for L's property because of L's restrictions on use (must use as a saloon and no subletters). In the absence of these restrictions R would pay L $600 a month while with them he would pay $500 a month. Under specific performance L would be entitled to $500 a month for the next three years. Wouldn't this cause L not to mitigate his losses from R's breach (an inefficiency)? No, because R can make an offer to L to waive the clauses which do not allow subletting or require only a saloon on his property. If H would be willing to pay R $400 a month to use the property as a clothing store, R could offer L $600 a month for the remaining life of the contract ($100 a month extra to waive the restrictive clauses) with both L and R being better off: R pays only $200 a month from his own pocket instead of $500 and L gets $100 more a month. (H is better off too, assuming that he would have had to pay $600 a month for comparable property.) The only difference between these two scenarios lies in who bears the mitigation costs in negotiating with H: under specific performance, R must bear them while under expectation damages with a mitigation requirement, L must bear them.