contracts october 3, 2006. bilateral agency contracts contracts

CONTRACTSOctober 3, 2006

BILATERAL AGENCYCONTRACTS

Contracts

BILATERAL AGENCYCONTRACTS

. Bilateral Agency

Property RightsPrimarily “imposed rules” with some scope for contracting within the imposed frameworkHorizontal –joint or group rightsVertical – many landlord

and tenant cases

- subordinate possession

ContractsPrimarily “voluntary rules” with some scope for contracting hierarchiesHorizontal – equal partnersVertical – creating subordinate agents – most common form of contract

PRINCIPAL – AGENCYCONTRACTS

Principal

promisepayment

“SUPER”Principal Its “problem” is to maximize social

surplus

• This “Principal-Agency ” exchange model is the principal model featured in Cooter's treatment of contract law

Formation Of Contracts

Principal Makes

An Offer To An Agent

Agent Accepts The Offer

Performance Of The Contract

FORMATION OF CONTRACTS

CAPACITY

• Competent Parties: • Both parties must have the capacity to

understand the terms of the contract they are entering into, and the consequences of the promises they make.

• For example, animals, minor children, and mentally disabled individuals do not have the capacity to form every contract

• Any contracts with them will be considered void or voidable.

• Corporations are considered persons under the law, and thus competent to engage in contracts.

SUBJECT-MATTER

• Proper Subject Matter:

• The contract must have a lawful purpose.

• A contract to commit murder in exchange for money will not be enforced by the courts.

FORMALITIES

• Need for a written contract?• A spoken contract is often called an "

oral contract", not a "verbal contract". • A verbal contract is simply a contract that

uses words. Most oral contracts and written contracts are verbal contracts.

• Need for a written contract?• An informal exchange of promises may be

binding and legally as valid as a oral or a written contract.

• Statutory Regulation of Contracts• The Statute of Frauds requires that contracts

pertaining to land be in writing. • The Statute of Frauds attempts to prevent false

allegations of the existence of contracts that were never made.

• Offer

• Acceptance

• Exchange

• Offer

• Principal writes the document, but the document does not become a contract until the agent signs it

• Offer

• In presenting the written document to the agent as the first step for its review the parties are following a form of the Prisoner’s dilemna that is sequential and not simultaneous

• Offer

• The classical “bargaining theory of contract law assigns the legal word “offer” to the document

• Note – What judges say and due involves language. What one observes them do and why is the domain of

economic analysis

• Offer

• Another way of characterizing “the first step”, taken by the principal is to describe the principal as the “first mover”

• (Cooter and Ulen, Law and Economics, 4th edn, Addison-Wesley, Longman, 2004, at p. 196)

• Offer

• Principal writes the document, with a view to selecting several potential agents

• Offer• In an “economic” sense, this step follows the Stackelberg process of a Principal that maximizes the profit or utility of the “agent” as part of its profit or utility maximizing step

• Offer• Cooter assumes that the Principal-

Agency game is played as a Stackleberg game

• Before making the “first move”, the Principal considers the “second move” that would be made by the Agent

• A boss designing a contract for a worker (which, usually but not always, must satisfy a “participation constraint” that the worker be willing to accept it instead of quitting the job)

• Offer

• The Agent’s “incentive compatibility constraint” is binding

A(CA(a) – 1) = 0

• Offer

• The offer generates an agency cost

• This agency cost depends upon the amount of effort provided by the agent

• This cost enters the “contract problem” through the incentive constraint.

• Offer• This agency cost is usually described

as a disutility of effort or a benefit from shirking or foregone pleasurable activities.

• This agency cost is the marginal cost of effort and may vary with effort.

• Offer• If the Agent “would co-operate”, the

“first move” occurs by the Principal• If the Agent “would not cooperate”,

then no “first move”• No Offer• No Contract

• (Cooter, Figure 6.1, 4th p. 197)

• Offer (Advertising)

• How, where, when and what?

• Carlill v. Carbolic Smoke Ball Company [1893] 1 QB 256; Court of Appeal, 1892 Dec. 6,7, LINDLEY, BOWEN and A. L. SMITH, L.JJ.

ACCEPTANCE

• Acceptance

• If there is only one Agent, he or she has the choice of accepting or rejecting the offer

• Acceptance

• If the Agent or group of Agents reject the offer, the contract game is over

• Acceptance

• The classical “bargaining theory of contract law assigns the legal word “acceptance” to the document if the Agent or one of the Agents accepts the offer

• Acceptance

• Another way of characterizing “the second step”, taken by the agent is to describe the agent as the “second mover”

•Acceptance

•The “participation constraint” of the Agent is binding

A (TA + C(a) - a) = 0

• Acceptance • Acceptance of the offer generates a

“second” agency cost.• The second agency cost is the opportunity

cost of the agent participating in the contract.

• It is also referred to as a reservation utility (0) and enters into the “contract problem” through the participation constraint.

Performance

FORMATION OF CONTRACTSPerformance

Principal Makes

Agent Sends A

Signal to the

Principal

.AGENT(Chosen)

PRINCIPAL

Promise To PerformPayment For Performance

• Parties enter into a “principal-agency” contract:

0 = input of Principal

a = input of Agent

y = C(0,a) = output of the contract

• Performance

• The parties perform the contract in accordance with an agreed upon exchange

•The “principal” makes an exchange of a “payment” to an “agent”

•The “agent” performs or executes a “promise” for the “principal”

• Performance

• If the principal is operating in a perfectly competitive market outside of its relationship with the agent, its longrun profit function = 0

F=Output

There is a “third” constraint” in the Principal – Agency Problem

The “Budget Constraint” of the Principal

• Performance

• This agency has the following profit function:

(0,a) = C(0,a) - a

(a) = C(a) - a

Principal

PAYMENT

PROMISED PERFORMANCE

PARTICIPATIONCONSTRAINT

INCENTIVE COMPATIBILITYCONSTRAINT

LEGAL ANALYSIS

PROMISED

ECONOMIC ANALYSIS

F=Output

A “perfectly competitive” risk neutral Principal contracts a “complete” contract with the “risk averse” agent

Contract Equilibrium Point

The parties are paid in “output” shares

• Performance

• One of the primary conclusions of the Principal-Agency contract model is that, because

• (1) the agent receives only a partial share of the profits generated from the agent’s effort,

• (2) the agent’s effort is not perfectly observed by the principal, and

• (3) the agent bears the entire cost of that effort,

the optimal incentive contract between the principal and agent cannot achieve a Pareto optimal outcome.

• Performance

• Even with risk neutrality on the part of both parties, moral hazard and inefficiency remain as long as there is a cost of effort born only by the agent and the agent receives only a share of the benefits generated by that effort

• Performance

• The principal is unable to costlessly observe (or verify) the agent’s actions

• The sub-optimal contract results in moral hazard and inefficiency.

• The principal’s value and the total value of the agent’s effort are not maximized.

• Performance = “Solution” to the “contract problem”

(a) = C(a) - a

A(CA(a) – 1) = 0 A > 0

A (TA + C(a) - a) = 0 A > 0

L(a) = C – a + A(CA – 1)+ A (TA + C - a)

dL/da = 0 impliesCAA + ACAA + A(CA - 1) = 0dL/d = 0 implies 1 = ACA/C + A

Solving

CAA + ACAA + A(CA - 1) = 01 = ACA/C + A

proves

(a*) = C(a*) - a* and C(a*) – a* are are optimal if because the principal applies no effort

PERFORMANCE OF CONTRACTSExample

Principal – Buyer - Contract

• A seller owns a house she values at $300,000.00

• A buyer has $500,000.00 but values the house at $400,000.00

F=Output

A Principal (buyer) contracts a “complete” contract with the “risk averse” Agent (seller)

Contract Equilibrium Point

The parties are paid in “output” shares

PERFORMANCE OF CONTRACTS Example

• If the parties fail to agree on a price, P, social surplus between the parties is sub-optimal at $800,000.00

• SS = SSA + SSB

= $300,000.00 + $500,000.00 = $800,000.00

Principal – Buyer - Contract

P(Vs, VB) = P(300,000, 400,000)

maximizes

SSB = (500,000 - P) + 400,000

subject to

SSs = P

• Principal Buyer Contract• Sequential Solution

If the parties successfully agree on a price, P, social surplus between the parties is optimize at $900,000.00

• SS = SSA + SSB

= P + [($500,000.00 – P) + $400,000.00]

= $900,000.00

F=Output

350,000.00Nash Equilibrium

CompetingAgents

FORMATION OF CONTRACTSAdverse Selection

.AGENT 1 AGENT 2

PRINCIPAL ASYMMETRIC INFORMATION

In the “adverse selection” game the agents have some information the principal does not know.

(See http://graphicsdept.com/melfarr7/)

• The question arises?

• What if the principal cannot discern the type of agent or the law says that they cannot use this information?

FORMATION OF CONTRACTSAdverse Selection – Example

• Privacy laws prevent employers from accessing student university marks without the student's written consent.

• So if all students agree to keep their marks private no prospective employer can get anyone's marks.

• So everybody's job search is on a level playing field.

• An application is submitted by student A. No transcript is provided. Employer assumes A was probably an “average student” (68 or GPA 2.5?)

• Student A got 84 and G.P.A. 3.7. What do you predict A will do?

• Eventually all the above average students give permission to release their marks.

• (Posner, 6th ed., c. 1, p. 20)

• Now what happens? • The employer assumes the students

who did not submit their transcripts are “below average”.

• Their marks are somewhere between 68 and 0.

• The student closest 68 will release his marks and so on until only the student that got the lowest mark is left.

• Strategic behaviour prevented students from pursuing differentiated behaviour.

• Instead they strategically pursued a form of “common behaviour”

• Economists and game theorists describe as a “pooling equilibrium” (Posner, 6th ed., c. 1, p. 21)

• Cooter explains adverse selection –

(4th ed., 2004, c. 2., X, p. 54)

• Alternatively, the law might forbid the principal from acting on information that the principal does have on the agents

Example: laws against discrimination

BILATERAL AGENCY - EXPLICIT Vertical Contract – (Principal – Agency)

F=Output

A “perfectly competitive” risk neutral Principal contracts a “complete” contract with the agents

In this case two “different” agents – “two” different contracts

H – high risk agentL- low risk agent

The objective of the Principal is that the two (2) types of agents reveal themselves through the choice of written contracts the Principal writes and the agents accept

Can agents with different risk preferences or other characteristics be determined or sorted out through their choice of contract?

• In a “perfectly competitive” market, the principal will want to offer the “more profitable high risk contract” to BOTH agents

•This will “adversely select” against the “low risk agent” who will opt for “no contract” or a “sub-optimal” contract•The “exchange point” of the adversely selected group lies in the area indicated by the red arrow

•In this equilibrium, adverse selection occurs against the low risk agents. •So some “low risk agents” leave the market

The high risk budget constraint acts as an incentive compatibility constraint on the low risk agents who either drop out of the market entirely or agree to a suboptimal exchange In other words, high-risk agents impose a negative “risk” externality on low-risk agents

CONTRACTS - OFFERS

Principal Makes

BILATERAL AGENCY - EXPLICIT

SEPARATING EQUILIBRIA

CONTRACTS - OFFERSSeparating Equilibria

The separating equilibrium in this market entails a welfare loss – a reduction in social surplus.

Under the Rothschild-Stiglitz hypothesis, the principals and agents act non-strategically.

Neither principals nor agents anticipate the others’ possible reactions when deciding their strategy.

Area where Principal lose money

In the separating equilibrium the two types of risk averse agents “sort” the exchanges out among themselves so that: (i) the low-risk group gets

incomplete bargain EL (ii) the high-risk group gets

complete bargain EH

Area where principals lose money

The separating equilibrium “sorts” the contracts so that: (i) the low-risk agents gravitate

towards the less than optimal equilibrium EL

(ii) the high-risk agents gravitate

towards the optimal equilibrium EH

POOLING EQUILIBRIA

CONTRACTS - OFFERSPooling Equilibria

In 1976, C. Wilson removed the Rothschild-Stiglitz hypothesis. He altered the perfect competitive characterization of principals' supply to one of oligopoly. This permits principals to act strategically.

More specifically, oligopoly on the supply side also requires principals behave non-competitively.

The principals make “some” profit instead of negative profits at the pooling equilibrium point.

So under Wilson’s revision, the pooling equilibrium preferred by the low-risk agents becomes stable provided there are suitably few high-risk agents in the market

Pooling constraint

When the percentage of high-risk agents is small enough, low-riskagents prefer to cross-subsidize exchanges for high-risk agents in the pooling equilibrium rather than accept a lower level of coverage in the separating equilibrium.

SCREENING

CONTRACTS - OFFERS

Screening

A screening game is an adverse selection game where the uninformed party (principal) is the first mover.

Example: A principal offers a selection of contracts that “sort” out the agents

CONTRACTS - OFFERS

Screening

• Screening is an action taken by the uninformed principal to determine information possessed by informed agents

CONTRACTS - OFFERS

Screening

Examples: (1) Buyer test driving different used cars(2) Insurance company setting premiums based on age, marital status

SIGNALING

CONTRACTS - NEGOTIATION

Signalling

Principal Makes

Agent Sends A

Signal to the

Principal

Signalling

A signaling game is an adverse selection game where the informed party (agent) is the first mover.

Example: An agent “advertises”

(1) posts a resume

(2) offers a warranty

Signalling

• Action taken by an informed person to send information to a less-informed person

Signalling

Also for signals to be effective the cost of sending the signal should vary with type otherwise everybody would send the same signal and the signal would be of no use.

contracts october 3, 2006. bilateral agency contracts contracts

written contracts

oral contracts

verbal contracts

existence of contracts

simultaneous slide

spoken contract

acceptance exchange

social surplus slide

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