Very often legal sanctions are focused on disgorgement of ill-gotten gains. In other words, a wrongdoer “bears a sanction equal to his gains.” It does discourage undesirable behavior, but only to a limited extent as compared to a rule that sets the penalty to the level of harm caused. It can, for example, still leave an incentive to act harmfully.
Shavell says, “Suppose, for example, that an act creates a gain of $1,000 and harm of $1,000,000. If the gain is estimated to be $950, a party would have an incentive to engage in it, because the sanction would be $950 so that he would profit by $50.”
I must admit that this is not 100% clear to me. Does Shavell mean to bring in the idea that the court may underestimate the gain, thus making it potentially profitable to engage in the activity?
Steven Shavell, Foundations of Economic Analysis of Law, pp. 476-78 (2004).
After all, if the contract is truly complete, then there is no chance of onerous performance because that eventuality would have been deal with by contract. So performance is always guaranteed and there is no reason to breach.
When contracts are incomplete, too-high damages may lead to undesirable performance. Moderate damages are better, since that will lead to breach when performance becomes too difficult or excessive. Thus, in certain circumstances, parties will simply receive expectation damages when it makes sense.
Thus, moderate damages allow for breach when performance would be expensive, and induce performance when it would not be expensive. This leads to performance closest to those under mutually beneficial completely specified contracts. In other words, moderate damage measures serve as substitutes for more complete contracts.
There is a qualification that comes in when contractual duties are purely financial, as damage measures cannot completely substitute for more completely specified contracts.
Steven Shavell, Foundations of Economic Analysis of Law, pp. 305-309 (2004).
Why do parties want their contracts to be enforced by courts? Without such enforcement, why would parties break their contracts and why would that be bad for the parties?
- Without enforcement, a party could appropriate funds that had been paid before contract performance (i.e., borrowers would be able to refuse to repay loans, insurers could keep premiums, etc.), rending the entire system unworkable.
- A party might not deliver a promised good or perform a promised service.If there is failure to perform even though performance would be best because its value exceeds its true cost, then the value of the contractual arrangement is diminished for the parties. This is avoided if contracts are enforced.
- Price cannot be fixed in advance, and parties can bargain opportunistically, changing prices later. This is price holdup and will result in underinvestment in the contractual enterprise.
Steven Shavell, Foundations of Economic Analysis of Law, pp. 297-299 (2004).
- Future provision of goods, especially for custom or specialized goods or services where a well-organized and routine market does not exist.
- Mutually beneficial reallocation or sharing of risks, including insurance contracts or partnerships for sharing of profits.
- Differences of opinion regarding future events. Thus each side “bets” on their outcome. Found especially in deals around securities and durable assets.
- Timing of consumption, i.e., borrowing or lending, which allows shifting the time a purchase is made.
Steven Shavell, Foundations of Economic Analysis of Law, pp. 296-97 (2004).
A contract is mutually beneficial or Pareto efficient:
- If it cannot be modified so as to raise the well-being (or “expected utility”) of each of the parties to it.
We expect contracts to tend toward this state, since we think that if a contract can be altered that would raise the expected utility of both parties, then that would be done.
From Steven Shavell, Foundations of Economic Analysis of Law, p. 293 (2004).
To deal with this, we can (1) grant property rights (patents, trade secrets, copyright) or (2) create a system of state rewards for creators.
Steven Shavell, Foundations of Economic Analysis of Law, p. 138 (2004).
Steven Shavell, Foundations of Economic Analysis of Law, pp. 293 (2004).
- Thus, they can reduce premiums to reflect risk reduction that care engenders.
- Insureds will thus purchase full coverage to cover risk and
- Insureds will take care to avoid risk in order to keep premiums as low as possible.
- Insureds will purchase incomplete care because full coverage would be too expensive (since there is no way to account for different levels of risk, everyone has to pay to cover risky behavior).
- This results in lessened risk that induces less than optimal precautions.