Analytical Methods
for Lawyers
v Idea of the Course
¯ Brief survey of lots of areas useful to lawyers
¯ Many of which could be a full course--my L&E
¯ Enough so that you won't be lost when they come up, and É
¯ Can learn enough to deal with them if it becomes necessary.
v Mechanics
¯ Reading is important
¯ Discussion in class
¯ Homework to be discussed but not graded--way of testing yourself
¤ Prefer handout hardcopy or on web page? URL on handout
¯ Midterm? First time.
v
Topics
¯
Decision Analysis
¯
Game Theory
¯
Contracting: Application of Ideas
¯
Accounting.
¯
Finance
¯
Microeconomics.
¯
Law and Economics.
¯
Statistics.
¯ Multivariate
Statistics: Untangling one out of many causes. Death penalty
v First Topic:
Decision Analysis
¯ Way of
formally setting up a problem to make it easier to decide
¯ Typically
¤ Make a
choice.
¤ Observe the
outcome, depends partly on chance
¤ Make another
choice.
¤ Continue
till the end, get some cost or benefit
¤ Want to know
how to make the choices to maximize benefit or minimize cost
¯ Simple
Example: Settlement negotiations
¤ Accept
settlement (known result) or go to trial
¤ If trial win with some probability and
get some amount, or lose and have costs
¤ Compare settlement offer to average
outcome at trial, including costs.
¯ Fancy example: Hazardous materials
disposal firm
¤ You suspect employees may have cut some
corners, violated disposal rules
¤ First choice: Investigate or don't.
á
If you
don't, probably nothing happened (didn't violate or don't get caught)
á
If you do,
some probability that you discover there is a problem. If so É
¤ Conceal or report to EPA
á
If you
conceal, risk of discovery--greater than at previous stage (whistleblowers)
á
If you
report, certain discovery but lower penalty
¯ In each case, how do you figure out what
to do? Two parts:
¤ If you knew all the probabilities and
payoffs, how would you decide (Decision Analysis)
¤ What are the probabilities and payoffs,
and how do you find them?
¯ Simple case again: Assuming numbers
¤ First pass
á
Settlement
offer is $70,000
á
Trial cost
is $20,000
á
Sure to win
á
Tree
diagram
á
Lop off
inferior branch--easy answer
¤ Second pass: As above, but 60% chance of
winning
á
Square for
decision, circle for chance node
á
On average,
trial gives you $40,000
á
Is that the
right measure?
á
If so,
inferior. Lop off that branch
á
Settle
¤ Risk aversion
á
If you are
making similar decisions many times, expected value.
á
If once,
depends on size of stakes.
¯ Where do the numbers come from?
¤ Alternatives: Think. Talk to client,
colleagues, É Think through
alternatives.
á
Partly your
professional expertise
á
Forces you
to think through carefully what the alternatives are.
¤ Probabilities
á
Might have
data--outcome of similar cases in the past. Audit rate.
á
Generate
it--mock trial. Hire an expert.
á
By
intuition, experience. Interrogate. What bets would I accept?
¤ Payoffs
á
Include
money--costs, profits, fines, É Past cases, experts, É .
á
Reputational
gains and losses
á
For an
individual, moral gains and losses? Other nonpecuniary?
¯ Sensitivity analysis
¯ (Land Purchase Problem?)
¯ Is ethics relevant?
¤ Criminal trial--does it matter if you
think your client is guilty?
¤ EPA--does it matter that concealing may
be illegal. Immoral?
á
What if not
looking for the problem isn't illegal, but É
á
Finding and
concealing is?
v
Query re Becca
v Mechanics
¯ Office Hours
handout
¯ Everyone
happy with doing stuff online?
v Review:
Points covered
¯ Basic
approach
¤ Set up a
problem as
á
Boxes for choices
á
Circles for chance outcomes
á
Lines joining them
á
Payoffs, + or -, and probabilities.
¤ Calculate
the expected return from each choice, starting with the last ones
á
Since the payoff from one choice
á
May depend on the previous choice or chance.
¤ If one
choice has a lower payoff than an alternative at the same point, lop that
branch
¤ Work right
to left until you are left with only one series of choices.
¯ Complications
¤ Expected
return only if risk neutral
¤ You have to
work out the structure, with help from the client and others
¤ Estimate the
probabilities, and É
¤ Payoffs, not
all of which are in money.
¯ Sensitivity
analysis to find out whether the answer changes if you change your estimates.
v Handout
problems
¯ Settle or go
to trial
¯ Which
contract to offer
¤ Easy answer
for the team
¤ Note that we
have implicitly solved the player's problem too.
á
Upper contract, if he has back pain, playing costs him $2 million,
gets him nothing, not playing neither costs nor gets, so don't play
á
Lower contract, if he has back pain, playing costs him $2 million,
gets him $10 million. Not playing gets and costs nothing. So he plays.
¤ Note also a
third option, that we didn't mention--no contract.
á
Better than the first
á
Could change the numbers to make it better than the second
á
Demonstrating that one has to figure out the structure of the
problem.
v Questions?
v More book
problems
¯ Land
purchase problem
v
v Game Theory
Intro: Show puzzling nature by examples
¯ Bilateral monopoly
¤ Economic case--buyer/seller, union/employer
¤ Parent/child case
¤ Commitment strategies
á
In economic
case
á
Aggressive
personality.
1/17/06
v Move to front of the room
v Strategic Behavior: The Idea
¯ A lot of what we do involves optimizing
against nature
¤ Should I take an umbrella?
¤ What crops should I plant?
¤ How do we treat this disease or injury?
¤ How do I fix this car?
¯ We sometimes imagine it as a game against
a malevolent opponents
¤ Finagle's Law: If Something Can Go Wrong,
It Will
¤ "The perversity of inanimate
objects"
¤ Yet we know it isn't
¯ But consider a two person zero sum game,
where what I win you lose.
¤ From my standpoint, your perversity is a
fact not an illusion
¤ Because you are acting to maximize your
winnings, hence minimize mine
¯ Consider a non-fixed sum game--such as
bilateral monopoly
¤ My apple is worth nothing to me (I'm
allergic), one dollar to you (the only customer)
¤ If I sell it to you, the sum of our gains
is É ?
¤ If bargaining breaks down and I don't
sell it, the sum of our gains is É
?
¤ So we have both cooperation--to get a
deal--and conflict over the terms.
¤ Giving us the paradox that
á
If I will
not accept less than $.90, you should pay that, but É
á
If you will
not offer more than $.10, I should accept that.
¤ Bringing in the possibility of bluffs,
commitment strategies, and the like.
¯ Consider a many player game
¤ We now add to all the above a new element
¤ Coalitions
¤ Even if the game is fixed sum for all of
us put together
¤ It can be positive sum for a group of
players
¤ At the cost of those outside the group
v Ways of representing a game
¯ Like a decision theory problem
¤ A sequence of choices, except that now
some are made by player 1, some by player 2 (and perhaps 3, 4, É)
¤ May still be some random elements as well
¤ Can rapidly become unmanageably
complicated, but É
¤ Useful for one purpose: Subgame Perfect
Equilibrium
¤ Back to our basketball player--this time
a two person game
¤ But É Tantrum/No Tantrum game
¤ So Subgame Perfect works only if
commitment strategies are not available
¯ As a strategy matrix
¤ Works for all two player games
¤ A strategy is a complete description of
what the player will do under any circumstances
¤ Think of it as a computer program to play
the game
¤ Given two strategies, plug them both in,
players sit back and watch.
¤ There may still be random factors, but É
¤ One can define the value of the game to
each player as the average outcome for him.
¯ Dominant Solution: Prisoner's Dilemma as
a matrix
¤ There is a dominant pair of
strategies--confess/confess
á
Meaning
that whatever Player 1 does, Player 2 is better off confessing, and
á
Whatever Player
2, does Player 1 is better off confessing
á
Even though
both would be better off if neither confessed
|
|
Baxter |
||
|
Confess |
Deny |
||
|
Chester |
Confess |
10,0 |
0,15 |
|
Deny |
15,0 |
1,1 |
|
¤ How to get out of this?
á
Enforceable
contract
¬ I won't confess if you won't
¬ In that case, using nonlegal mechanisms
to enforce
á
Commitment
strategy--you peach on me and when I get out É
¯ Von Neumann Solution
¤ Von Neumann proved that for any 2 player
zero sum game
¤ There was a pair of strategies, one for
player A, one for B,
¤ And a payoff P for A (-P for B)
¤ Such that if A played his strategy, he
would (on average) get at least P whatever B did.
¤ And if B played his, A would get at most
P whatever he did
¯ Nash Equilibrium
¤ Called that because it was invented by
Cournot, in accordance with Stigler's Law
á
Which holds
that scientific laws are never named after their real inventors
á
Puzzle: Who
invented Stigler's Law?
¤ Consider a many player game.
á
Each player
chooses a strategy
á
Given the
choices of the other players, my strategy is best for me
á
And
similarly for everyone else
á
Nash
Equilibrium
¤ Driving on the right side of the road is
a Nash Equilibrium
á
If everyone
else drives on the right, I would be wise to do the same
á
Similarly
if everyone else drives on the left
á
Multiple
equilibria
¤ One problem: It assumes no coordinated
changes
á
A crowd of
prisoners are escaping from Death Row
á
Faced by a
guard with one bullet in his gun
á
Guard will
shoot the first one to charge him
á
Standing
still until they are captured is a Nash Equilibrium
¬ If everyone else does it, I had better do
it too.
¬ Are there any others?
á
But if I
and my buddy jointly charge him, we are both better off.
¤ Second problem: Definition of Strategy is
ambiguous. If you are really curious, see the game theory chapter
in my webbed Price Theory
v Solution Concepts
¯ Subgame Perfect equilibrium--if it exists
and no commitment is possible
¯ Strict dominance--"whatever he does
É" Prisoner's Dilemma
¯ Von Neumann solution to 2 player game
¯ Nash Equilibrium
¯ And there are more
1/19/06
v A simple game theory problem as a lawyer
might face it:
You represent the
plaintiff, Robert Williams, in a personal injury case. Liability is fairly
clear, but there
is a big dispute over damages. Your occupational expert puts the plaintiffÕs
expected future losses at $1,000,000, and the defendantÕs expert estimates the
loss at only $500,000. (Pursuant to a pretrial order, each side filed
preliminary expert reports last month and each party has taken the deposition
of the opposing partyÕs expert.) Your experience tells you that, in such a
situation, the jury is likely to split the difference, awarding some figure
near $750,000.
The deadline for
submitting any further expert reports and final witness lists is rapidly
approaching. You
contemplate hiring an additional expert, at a cost of $50,000. You suspect that
your additional expert will confirm your initial expertÕs conclusion. With two
experts supporting your higher figure and only one supporting theirs, the
juryÕs award will probably be much closer to $1,000,000 — say, it would
be $900,000.
You suspect,
however, that the defendantÕs lawyer is thinking along the same lines. (That
is, they could
find an additional expert, at a cost of about $50,000, who would confirm their
initial expertÕs figure. If they have two experts and you have only one, the
award will be much closer to $500,000 — say, it would be $600,000.)
If both sides hire
and present their additional experts, in all likelihood their testimony will
cancel out,
leaving you with a likely jury award of about $750,000. What should you advise
your client with regard to hiring an additional expert?
Any other ideas?
Set it up as a
payoff matrix
If neither hires
an additional expert, plaintiff receives $750,000 and defendant pays $750,000?
If plaintiff
hires an additional expert, plaintiff receives $850,000 and defendant pays
$900,000
If defendant
hires an additional expert, plaintiff receives $600,000 and defendant pays
$650,000?
If both hire
additional experts, plaintiff receives $700,000 and defendant pays $800,000?
|
|
Defendant: Doesn't hire |
Defendant: Hires |
|
Plaintiff: Doesn't Hire |
750, -750 |
600, -650 |
|
Plaintiff: Hires |
850, -900 |
700, -800 |
What does
Plaintiff do?
What does Defendant
do?
What is the
outcome?
Can it be
improved?
How?
v Game Theory: Summary
¯ The idea: Strategic behavior.
¤ Looks like decision theory, but
fundamentally different
¤ Because even with complete information,
it is unclear
á
What the
solution is or even
á
What a
solution means
¤ With decision theory, there is one person
seeking one objective, so we can figure out how he can best achieve it.
¤ With game theory, there are two or more
people
á
seeking
different objectives
á
Often in
conflict with each other
¤ A solution could be
á
A
description of how each person decides the best way to play for himself or
á
A
description of the outcome
¯ Solution concepts
¤ Subgame perfect equilibrium
á
assumes no
way of committing
á
No
coalition formation
¬ In the real world, A might pay B not to
take what would otherwise be his ideal choice--
¬ because that will change what C does in a
way that benefits A.
¬ One criminal bribing another to keep his
mouth shut, for instance
á
But it does
provide a simple way of extending the decision theory approach
¬ To give an unambiguous answer
¬ In at least some situations
¬ Consider our basketball player problem
¤ Dominant strategy--better against everything. Might not
exist in two senses
á
If I know
you are doing X, I do Y—and if you know I am doing Y, you do X. Nash
equilibrium. Driving on the right. The outcome may not be unique, but it is
stable.
á
If I know
you are doing X, I do Y—and if you know I am doing Y, you don't do X.
Unstable. Scissors/paper/stone.
¤ Nash equilibrium
á
By freezing
all the other players while you decide, we reduce it to decision theory for
each player--given what the rest are doing
á
We then
look for a collection of choices that are consistent with each other
¬ Meaning that each person is doing the
best he can for himself
¬ Given what everyone else is doing
á
This assumes
away all coalitions
¬ it doesn't allow for two ore more people
simultaneously shifting their strategy in a way that benefits both
¬ Like my two escaping prisoners
á
It also
ignores the problem of how to get to that solution
¬ One could imagine a real world situation
where
¯ A adjusts to B and C
¯ Which changes B's best strategy, so he
adjusts
¯ Which changes C and A's best strategies É
¯ Forever É
¬ A lot of economics is like this--find the
equilibrium, ignore the dynamics that get you there
¤ Von Neumann solution aka minimax aka saddlepoint aka É.?
á
It tells
each player how to figure out what to do, and É
á
Describes
the outcome if each follows those instructions
á
But it
applies only to two person fixed sum games.
¤ Von Neumann solution to multi-player
game (new)
á
Outcome--how
much each player ends up with
á
Dominance:
Outcome A dominates B if there is some group of players, all of whom do better
under A (end up with more) and who, by working together, can get A for
themselves
á
A solution
is a set of outcomes none of which dominates another, such that every outcome
not in the solution is dominated by one in the solution
á
Consider,
to get some flavor of this, É
¤ Three player majority vote
á
A dollar is
to be divided among Ann, Bill and Charles by majority vote.
¬ Ann and Bill propose (.5,.5,0)--they
split the dollar, leaving Charles with nothing
¬ Charles proposes (.6,0,.4). Ann and
Charles both prefer it, to it beats the first proposal, but É
¬ Bill proposes (0, .5, .5), which beats
that É
¬ And so around we go.
á
One Von
Neumann solution is the set: (.5,.5,0), (0, .5, .5), (.5,0,.5) (check)
á
There are
others--lots of others.
¤ Other approaches to many player games
have been suggested, but this is enough to show two different elements of the
problem
á
Coalition
formation, and É
á
Indeterminacy,
since one outcome can dominate other which dominates another which É .
¤ Almost enough to make you appreciate Nash
equilibrium, where nobody can talk to anybody so there is no coalition
formation.
v Applied Schelling Points
¯ In a bargaining situation, people may end
up with a solution because it is perceived as unique, hence better than
continued (costly) bargaining
¤ We can go on forever as to whether I am
entitled to 61% of the loot or 62%
¤ Whether to split 50/50 or keep bargaining
is a simpler decision.
¯ But what solution is unique is a function
of how people think about the problem
¤ The bank robbery was done by your family
(you and your son) and mine (me and my wife and daughter)
¤ Is the Schelling point 50/50 between the
families, or 20% to each person?
¤ Obviously the latter (obvious to me--not
to you).
¯ It was only a two person job--but I was
the one who bribed a clerk to get inside information
¤ Should we split the loot 50/50 or
¤ The profit 50/50--after paying me back
for the bribe?
¯ In bargaining with a union, when everyone
gets tired, the obvious suggestion is to "split the difference."
¤ But what the difference is depends on
each party's previous offers
¤ Which gives each an incentive to make
offers unrealistically favorable to itself.
¯ What is the strategic implication?
¤ If you are in a situation where the
outcome is likely to be agreement on a Schelling point
¤ How might you improve the outcome for
your side?
v Odds and Ends
¯ Prisoner's dilemma examples?
¤ Athletes taking steroids. Is it a PD?
¤ Countries engaging in an arms race
¤ Students studying in order to get better
grades?
¯ Is repeated prisoner's dilemma a
prisoner's dilemma?
¤ Suppose we are going to play the same
game ten times in succession
¤ If you betray me in round 1, I can punish
you by betraying in round 2
¤ It seems as though that provides a way of
getting us to our jointly preferred outcome—neither confesses.
¤ But É
¯ Experimental games
¤ Computers work cheap
¤ So Axelrod set up a tournament
á
Humans
submit programs defining a strategy for many times repeated prisoner's dilemma
á
Programs
are randomly paired with each other to play (say) 100 times
á
When it is
over, which program wins?
¤ In the first experiment, the winner was
"tit for tat"
á
Cooperate
in the first round
á
If the
other player betrays on any round, betray him the next round (punish), but cooperate
thereafter if he does (forgive)
¤ In fancier versions, you have evolution
á
Strategies
that are more successful have more copies of themselves in the next round
á
Which
matters, since whether a strategy works depends in part on what everyone else
is doing.
á
Some more
complicated strategies have succeeded in later versions of the tournament,
á
but tit for
tat does quite well
¤ His book is The Evolution of
Cooperation
v Threats, bluffs, commitment strategies:
¯ A nuisance suit.
¤ Plaintiff's cost is $100,000, as is
defendant's cost
¤ 1% chance that plaintiff wins and is
awarded $5,000,000
¤ What happens?
¤ How might each side try to improve the
outcome
¯ Airline hijacking, with hostages
¤ The hijackers want to be flown to Cuba
(say)
¤ Clearly that costs less than any serious
risk of having the plane wrecked and/or passengers killed
¤ Should the airline give in?
¯ When is a commitment strategy believable?
¤ Suppose a criminal tries to commit to
never plea bargaining?
¤ On the theory that that makes convicting
him more costly than convicting other criminals
¤ So he will be let go, or not arrested
v Moral Hazard
¯ This is really economics, not game
theory, but it's in the chapter
¯ I have a ten million dollar factory and
am worried about fire
¤ If I can take ten thousand dollar
precaution that reduces the risk by 1% this year, I
will—(.01x$10,000,000=$100,000>$10,000)
¤ But if the precaution costs a million, I
won't.
¯ insure my factory for $9,000,000
¤ It is still worth taking a precaution
that reduces the chance of fire by %1
¤ But only if it costs less than É?
¯ Of course, the price of the insurance
will take account of the fact that I can be expected to take fewer precautions:
¤ Before I was insured, the chance of the
factory burning down was 5%
¤ So insurance should have cost me about
$450,000/year, but É
¤ Insurance company knows that if insured I
will be less careful
¤ Raising the probability to (say) 10%, and
the price to $900,000
¯ There is a net loss
here—precautions worth taking that are not getting taken, because I pay
for them but the gain goes mostly to the insurance company.
¯ Possible solutions?
¤ Require precautions (signs in car repair
shops—no customers allowed in, mandated sprinkler systems)
á
The
insurance company gives you a lower rate if you take the precautions
á
Only works
for observable precautions
¤ Make insurance only cover fires not due
to your failure to take precautions (again, if observable)
¤ Coinsurance.
¤
¯ Is moral hazard a bug or a feature?
¤ Big company, many factories, they insure
á
Why? They
shouldn't be risk averse
á
Since they
can spread the loss across their factories.
¤ Consider the employee running one factory
without insurance
á
He can
spend nothing, have 3% chance of a fire
á
Or spend $100,000, have 1%--and make
$100,000 less/year for the company
á
Which is it
in his interest to do?
v Adverse Selection—also not really
game theory
¯ The problem: The market for lemons
¤ Assumptions
á
Used car in
good condition worth $10,000 to buyer, $8000 to seller
á
Lemon worth
$5,000, $4,000
á
Half the
cars are creampuffs, half lemons
¤ First try:
á
Buyers
figure average used car is worth $7,500 to them, $6,000 to seller, so offer
something in between
á
What
happens?
¤ What is the final result?
¯ How might you avoid this
problem—due to asymmetric information
¤ Make the information
symmetric—inspect the car. Or É
¤ Transfer the risk to the party with the
information—seller insures the car
¯ What problems does the latter solution
raise?
v To think about:
¯ Genetic testing is making it increasingly
possible to identify people at risk of various medical problems
¯ If you are probably going to get cancer,
or have a heart attack, and the insurance company knows it, insurance will be
very expensive, so É
¯ Some people propose that it be illegal
for insurance companies to require testing.
¯ What problems would that proposal raise?
1/24/06
v Genetic Testing:
¯ A. No Testing
¯ B. Customers can test; insurance
companies cannot condition rates on results
¯ Customers can test, insurance companies
can condition rates
¯ What happens?
v Contracts
¯ Why they matter
¤ A large part of what lawyers do is
drawing up and negotiating contracts
¤ In many different areas of the law
á
Employment
á
Partnerships
á
Sales
contracts
á
Contracts
between firms
á
Prenuptial
agreements and Divorce settlements É
¯ Why make a contract?
¤ Why deal with other people at all?
á
Because
there are gains to trade
á
The same
property may be worth more to buyer than seller
á
Different
people have different abilities
á
Specialization
and division of labor
á
Complementary
abilities
á
Risk
sharing
¬ An insurance contract not only transfers
risk
¬ It reduces it--via the law of large
numbers
á
Does a bet
due to different opinions count as gains from trade?
¤ A spot sale isn't much of a contract--why
anything else?
á
Because
performance often takes place over time
á
And the
dimensions of performance are more complicated than "seventeen bushels of
wheat."
á
Even a spot
contract might include details of quality--not immediately observable--and
recourse.
¯ Two Objectives in negotiating a contract
¤ Maximize the size of the pie
¤ Get as much of it as possible for your
client
¯ The second was covered in the previous
chapter
¤ If there is some surplus from the
exchange
á
Meaning
that you can both be better off with a contract
á
Than
without one
¤ Then you are in a bilateral monopoly
bargaining game
á
You are
both better off if you agree to a contract
á
But the
terms will determine how much of the gain each of you gets
¤ Where commitment strategies or control of
information might help
á
But at the
risk of causing bargaining breakdown
¬ Each of us is committed to getting at
least 60% of the gain, or É
¬ I have persuaded you that what you are
selling is only worth $10 to me, and it is worth $11 to you.
á
And the pie
goes into the trash
¯ This chapter is about the first--maximize
the size of the pie
¤ Any time you see a way of increasing the
size
¤ You can propose it, combined with a
change in other terms--such as price
¤ That makes both parties better off
¤ This point is central to the
chapter—if you are not convinced, we should discuss it now.
v Why incentives matter
¯ People often talk as if "more
incentive" was unambiguously good
¤ Gordon Tullock's auto safety device
¤ There is such a thing as too much
incentive
¤ What is the right incentive--for
anything?
¯ Consider a fixed price contract to build
a house
¤ Instead of spending $10,000 on roofing
material that lasts 20 years
¤ The builder spends $5,000 on material
that lasts 5 years
¤ After which the material must be replaced
at a cost of $12,000
¯ What is the sense in which this is a bad
thing?
¤ Compare to the case where the $5,000
material lasts 19 years.
¤ You want to set up the contract so he
won't use the cheap material in the first case, but É
¤ What about the second?
¯ How about the incentive not to breach a
contract?
¤ Should contracts ever be breached?
¤ When?
¤ How do you get that outcome?
¯ Enforceability and observeability
¤ Consider the marriage contract
á
Al-Tanukhi
story
á
Lots of
dimensions of performance are unobservable by an outside party
á
So a wife
who wants a divorce É .
á
You might
want to think about the general problem of marriage contracts
¬ Traditional: Divorce hard, gender roles
largely specified by custom
¬ Current: Divorce on demand, terms freely
negotiable day by day, mostly not enforceable
¬ Alternatives?
¬ What are the problems in designing a
marriage contract?
¬ We will return to that question
¤ Ideally, the contract specifies terms
that are observable
¤ Not always a sharp distinction
á
Sometimes performance
can be imperfectly observed--how well is this house built?
á
And one
might specify how to observe it--name the expert body whose standards you are
agreeing to.
¤ A second enforceability problem--what if
a party breaches and can't pay the damages?
¯ Reputation
¤ In today's discussion, we implicitly
assume that the only constraint on both parties is the contract itself
¤ In many cases that's not realistic. One
or both parties is a repeat player, and wants not only to stay out of court but
to keep customers and get more.
¤ We will return to that question later,
since it is relevant to how to structure contracts.
v Production Contracts—building a
house.
¯ One party pays the cost, gets the house,
the other builds it.
¯ Cost-plus or flat fee: Advantages and
disadvantages
¤ Why is there a "plus" in cost
plus?
á
If one
contractor will do the job for cost+$10,000, why won't another do it for
cost+$9,000?
á
Isn't the
"plus" something for nothing? $9,000 is better than zero.
¤ Is it "plus" or "plus
10%?"
¤ Why?
¯ Incentive to get inputs at the lowest
possible cost
¤ Flat fee: any savings goes to the contractor
á
So he wants
to minimize cost--including both price and his time and trouble
á
Which is
what you want him to do
á
Why do you
care about his time and trouble?
á
What would
happen if you set up the contract to force him to buy the input at the lowest
possible price (holding quality fixed--same brand of windows, say)? Imagine he
had to pay you a five thousand dollar penalty if you could show that,
somewhere, it was possible to buy an input for less than he paid?
¤ Cost plus: savings on price goes to you
á
But any
increase in time and trouble needed to get the lower price he pays
á
So he won't
try very hard to find a lower price
á
Even if it
would save you more than it costs him to do so
¤ Cost plus 10%?
á
Friedman's
rule for finding the men's room
á
And why it
sometimes doesn't work
¤ If you are using cost plus, how might you
control the problem?
¤ What are the problems you will face?
¯ Incentive to get inputs of the right
quality
¤ Do we always want the highest quality
inputs?
á
Do you only
eat at gourmet restaurants?
á
And buy the
highest quality car you can afford?
¤ Flat fee contract: Incentive of the
builder is É
á
To use the
least expensive inputs, whatever their quality
á
Because a
dollar saved is a dollar earned--for him
¤ Cost plus contract, he doesn't
care--extra quality comes out of your pocket
¤ Cost plus 10%?
¤ With a flat fee contract, how might you
try to control the problem?
¤ What problems arise in doing so?
¯ Uncertainty:
¤ Renegotiating the contract
á
Your client
forgot something important--try to prevent that in advance
á
Something
important changed.
á
You are
stuck in a bilateral monopoly with the builder
¬ The bargaining range is bounded on one
side by the terms of the initial contract--if he fulfills it he is in the clear
¬ And on the other side by the most you are
willing to pay for the change
¬ Which might be expensive
á
You could
include terms for changes in the contract
¬ Will that be easier with flat fee, cost
plus, cost plus 10%?
¬ Think about it from the builder's
standpoint.
¤ Risk bearing
á
What if
something changes that greatly increases the cost?
¬ Under flat fee, the builder swallows the
loss
¬ Under cost plus, you do
á
What if
something changes that greatly lowers the value to you?
¬ You contract to have land cleared and a
new factory built
¬ In 1929
¬ Risk allocation depends on the
contractual terms for breach
¬ Or on negotiation--again, with a
potential holdout problem
á
Why does
risk bearing affect the size of the pie?
¬ Because different parties have different
abilities to bear risk
¬ Because poor contract terms or bargaining
breakdown might lead to a smaller pie--the land gets cleared, the factory
built, and it sits empty until 1942.
Electronic Equipment Service Contract
Global
Consolidated Industries (GCI) has for years had an in-house electronic
equipment maintenance department. It has been responsible for providing
maintenance (such as periodic cleaning and lubrication of moving parts) and
repair (fixing machines when they break down) on thousands of printers,
photocopy machines, FAX machines, scanners, and so forth. The experience, in a
word, has been a disaster. On most days, secretaries can be seen running from
floor to floor and pushing in line to use other machines when theirs are
inoperative. Even the CEO is often heard screaming about memos being late,
meetings having to be rescheduled, and other headaches caused by out-of-order
equipment.
GCI has
decided that it is time to contract out for these services. As a member of
GCIÕs general counselÕs office, you have been called in to participate in the
contract negotiations with the outside service provider, Reliable Response
Repair (RRR).
RRR has
offered two contracts for your consideration. Under one contract, RRR receives
a flat rate per machine each contract year. (For example, there is a $200 per
year charge for a standard, mid-size photocopy machine.) Under this
arrangement, RRR is obligated to provide all necessary maintenance and to
repair broken-down machines promptly.
Under the
second contact, RRR is paid $75 per hour (plus parts) for all maintenance and
repair services. Under this arrangement as well, RRR is obligated to provide
all necessary maintenance and to repair broken-down machines promptly.
Explain the
pros and cons of each of the two contracts. Which seems best? Can you think of
additional terms that would improve it?
v
What is RRR's
incentive to do a good job of maintaining and fixing the machines under either
contract?
v
To do it
promptly?
v
What are GCI's
incentives under each contract? Why might RRR care about that?
v
Flat rate:
¯ RRR incentives
¤
Incentive to
maintain if it is cheaper than fixing
¤
Incentive to do
a good job of fixing, since if not they have to come back
¤
Promptness?
Only to the extent you can enforce that term
á
So you may want
to define it more precisely
á
Must show up
within 2 hours, fix within 4, or É
á
Penalty based
on how many hours machines are down each year, or É
á
Bonus for less
than 6 hours down time per machine
¤
Risk?
á
Very little
risk to GCI—they know how much they will pay
á
All of the risk
is on RRR—what if a machine has problems and keeps giving trouble?
á
But GCI is big
enough so that such effects should average out
¯ GCI incentives:
¤
Why do you
worry about those?
¤
GCI has little
incentive to take good care of machines, train people well, control whatever
inputs they provide that affect the chance of breakdown
¤
Little
incentive to hold down RRR's cost by, say, not using machines heavily at two in
the morning, or only asking for a technician to be sent when the problem is
serious
¤
GCI has reduced
incentive to buy good quality machines
á
So the contract
might specify machines presently on site, which RRR can inspect in advance
á
Or specify what
brands and models of new purchases are covered
v
Per hour:
¯ RRR incentives
¤
If per hour is
more than their real cost, a serious problem
á
Why maintain
when you get paid to fix?
á
Why fix well
when you get paid to come back?
¤
If per hour is
at their real cost, still have to monitor to make sure they are really working
that many hours
¤
Promptness
still a problem as above.
¯ GCI Incentives
¤
GCI now has an
incentive to buy good machines
¤
To take good
care of the machines
¤
Only to call a
tech when really needed
¤
And RRR might
charge more at 2 A.M. (modification of terms)
¯ Question: Does GCI have to use RRR under this
contract?
¤
If not, they
can use competition or the threat of it to control some of these problems, but
É
¤
A problem if
RRR is hiring extra maintenance personnel specifically to deal with GCI
repairs.
v
What if quality
of repair affects machine lifetime?
¯ Either way, RRR has little incentive to do a
good job in that dimension
¯ Perhaps GCI should lease the machines from
RRR, with repairs and maintenance included in the terms.
v
Perhaps what we
want is some of the cost on each party
¯ Per hour payment low enough to give RRR an
incentive to maintain machines, fix
them right, but É
¯ High enough to give GCI an incentive to do
what it easily can to avoid breakdowns.
¯ The same principle as coinsurance.
¤
Neither party
bears the full cost, so neither has as much incentive to prevent the problem as
we would like, but É
¤
Each bears
enough of the cost to make it in its interest to take most of the precautions
that ought to be taken.
Musician and Nightclub
Booking Arrangement
Your client, Jerry the Jazz musician, is becoming increasingly
well-known in the region. He has recently been offered a booking arrangement by
the Nightowl nightclub, the ritziest jazz bar in the city, for Tuesday nights.
They propose paying him $500 per appearance plus 10% of house profits. Because
they want to have the opportunity to use other musicians for variety, taking
advantage of out-of-town players who pass through, they are only willing to
guarantee Jerry 26 Tuesday night appearances over the course of the year. They
would give him one weekÕs notice with regard to each Tuesday, and he would be
obligated to appear when called.
Jerry tells you that he finds this offer attractive because it
would give him some stability in his income, something he has never had before.
On the other hand, he does not like the idea that the arrangement would
preclude his doing any other gigs on a Tuesday night (or out-of town gigs on
Mondays or Wednesdays); given his increasing reputation, he occasionally gets
great one-shot offers.
How do you advise Jerry regarding his contract negotiations with
Nightowl?
v
Gains
from trade
¯
Jerry
and Nightowl both reduce uncertainty
¯
Appearing
regularly at Nightowl probably benefits both
v
Problems
that might be fixable:
¯
Jerry
wants flexibility for out of town gigs
¯
How
to reduce the cost of that to Nightowl?
¤
If
he gives them a month advance notice, might be able to fill in
á
They
only plan to use him half the Tuesdays
á
Still
some cost--there might not be anybody good in town
á
But
perhaps less than the benefit to Jerry
¤
What
if he can get off if he finds a substitute?
á
How
do we define an adequate substitute?
á
Someone
they have hired before?
á
Someone
from a pre-agreed list?
¤
What
if he agrees to play a different day when he isn't there Tuesday?
¤
What
if he can take off a fixed number of Tuesdays by one month advance notice?
á
Hypothetical
numbers
á
Jerry
wants the right to block out 5 Tuesdays, a month in advance
á
Nightowl
thinks it costs them $400/Tuesday
¬
Hassle
of finding a replacement
¬
Risk
of lower quality
¬
Disappointment
of Tuesday customers who are fans of Jerry's.
á
Jerry
offers to accept $400 instead of 500 per appearance in exchange
á
Saves
Nightowl $100x26 Tuesdays=$2600, so they are better off
á
Jerry can
make $1000 more for out of town gigs, so gains $5000, loses $2600, so he is
better off too
v
Other
issues
¯
If Jerry
has the option, he might choose big nights--New Year's Eve--since he is getting
the same fee for every night from Nightowl, could get more elsewhere.
¤
How might
we solve that?
¤
Pay him
more for specified big nights?
¤
Or
specified big nights he doesn't have the option of taking off?
¤
Or, when he
notifies them, they bargain with him?
¯
Breach:
Under the initial contract, what if he accepts a Tuesday gig and then Nightowl
wants him that Tuesday?
¤
Liquidated
Damages? What does the contract say?
¤
What if he
is sick and can't play?
¤
Can Nightowl
tell the difference? Depends how far away the gig is?
¤
Breach
terms another way of getting flexibility
á
Liquidated
damages of $300 if be backs out with a month notice
á
$500 a
week's nnotice
á
$2000 if he
just doesn't show up
á
How should
we set the damages?
á
How about
calling in sick?
¤
Negotiation
another way of getting flexibility
á
Gets an
invitation for an out of town gig
á
Asks
Nightowl if they need him that night
á
If they do,
starts bargaining
á
Assymetric
information? How is it in Nightowl's interest to act?
á
Can Jerry
tell?
v
Incentive
issues
¯
For Jerry:
What are his incentives
¤
To do a
good job?
¤
To come
when he says he will?
¯
What are
Nightowl's incentives?
¤
To
advertise Jerry
¤
To run a
good club (why does he care?)
¤
To use him
often?
á
Should
there be different terms for other nights?
á
He isn't
committed--but doesn't get paid as much?
á
His time is
probably worth much less than $500 if he doesn't have a gig
v
Verifiability:
¯
Jerry gets
10% of profits--how measured?
¤
You are an
unscrupulous Nightowl owner--how do you hold down what you pay Jerry?
¤
Can he
tell?
¯
Are there
other ways of rewarding him related to how good a job he does?
¤
More easily
observed? Revenue--but also a bit tricky
¤
More
closely targetted on his contribution?
v
General
issues here are:
¯
Enlarging
the pie
¯
Via incentives
¯
Risk
bearing?
¯
Verifiability
of terms
State AG Litigation Contract
You are a lawyer
in the consumer protection division of the state attorney generalÕs office.
Preliminary investigations as well as some undercover stories in the press
reveal the possibility of a major billing scandal involving the health care
industry. Following the growing number of states who have recently pursued such
claims and the recent huge success in tobacco litigation, it is proposed to
bring suit against a number of firms. The total damages claim is for hundreds
of millions of dollars, possibly more than a billion.
Your office, however, has only four
attorneys, many of whom are quite busy on other matters. Therefore, it is
agreed to hire an outside firm that specializes in large-scale litigation,
probably one of those super-successful plaintiffsÕ boutique firms. Many of them
have already expressed interest and some have been interviewed.
Two further notes.
First, although this novel litigation strategy has the potential to be
extremely lucrative, it will also be expensive, requiring that millions of
dollars worth of lawyersÕ and expertsÕ time be invested up front. Second, the
office is worried about the possible political fallout of making fee payments
to outside lawyers that prove embarrassingly large.
Advise your
department head on the compensation scheme that should be used in the contract
with the outside firm. Focus on the form of the compensation scheme and any
closely related matters. In preparing your advice, be sure that you do each of
the following:
Describe different
ways that the firm could be compensated.
Identify the major
pros and cons of each approach.
Discuss how, if at
all, any negatives of a given approach may be mitigated.
|
Compensation
Scheme |
Incentives |
Risk |
Political, Other |
|
Flat Fee |
|
|
|
|
Hourly |
|
|
|
|
Contingent Fee |
|
|
|
v
Flat Fee
¯
Incentives
¤
No
financial incentive for lawyers to win
¤
Possible
reputational incentive
¤
How well
can a small AG's office monitor the lawyers?
¤
Can you
control how hard they try by contract?
¯
Risk
¤
None on
payment for law firm
¤
But they
bear all the risk of costs
¤
Who is more
risk averse?
¯
Political
¤
No risk of
stories on huge fee payment, but É
¤
If the case
fails, agency looks bad--money for nothing
v
Cost-Plus
(hourly)
¯
Incentives
¤
To spend
too much time if rate is higher than real cost of time to firm
á
Too little
if rate is lower, but É
á
Less of a
problem than the previous case, where hourly rate is zero.
¤
Can you
verify
á
Hours
actually worked
á
Quality of
work. Who do they assign, how hard does he try?
¤
Can you
control by contract?
¯
Risk
¤
All of the
revenue risk is born by the state
¤
And most of
the cost risk
¯
Political
¤
No risk of
huge payments for now work, but É
¤
Risk of
huge payments for no return
v
Contingent
Fee
¯
Incentives
¤
Firm wants
to win.
¤
How large a
fractional payout?
á
Higher
percentage, better incentives, but É
á
Less left
for the state
á
What about
100% and negative fixed fee?
¤
At anything
less than 100%, incentive still imperfect. Assume 50%.
á
If it costs
the firm $1000 to increase expected return by $1500, they won't do it.
á
So still
want some oversight
á
And hope
reputation helps.
¤
No
incentive for the firm to get relief other than a damage payment
¯
Risk
¤
Is being
shared between firm and state
¯
Political
¤
No risk of
large payment for no result
¤
But very large
amounts to lawyers if the suit is successful might be embarrassing
v
What is the
maximand?
¯
Suppose the
defendant is actually innocent
¯
The law
firm still wants to win
¯
Does the
state?
v
School
Gymnasium: Applying what we have learned.
¯
Flat fee or
Cost plus?
¤
The school
probably doesn't know enough to monitor a cost-plus contract
¤
And is
probably in a poor position to bear risk
¤
So flat fee
is probably better, but É
¯
Problems
with flat fee
¤
Maintaining
quality
á
Have to
specify a lot of details
á
School
doesn't have the expertise to do that, but É
á
Their
architect might.
á
Hire some
sort of expert to write the specs
¤
Making
changes
á
Question
your client carefully to keep later changes from being necessary
á
Perhaps
include in the contract that changes can be made on a cost plus basis
á
Or plan on
negotiating changes.
v
Arguments
in litigation
¯
The book
sketches the law and econ argument for enforcing the quality terms in a flat
fee contract
¤
Because
otherwise the builder has an incentive to degrade quality
¤
Even when
doing so costs you more than it saves him.
¯
Do you
think a judge would find that more or less convincing
¯
Than the
"good faith" sort of argument?
v
Principle/Agent
Contracts
¯
Lots of
varieties, including
¤
Construction
contracts we have been discussing
¤
Employment
contracts
¤
Lawyer/client
contracts--you are the agent.
¤
Is the
President the voters' agent?
¤
É
¯
Possible
forms
¤
Pay by
performance--did you sell a car? Win a case?
¤
Pay for
inputs--how many billable hours?
¤
Fixed-fee
¤
Combinations.
á
Employees
frequently get a fixed salary, plus É
á
Bonus for
specified accomplishments, by them or their unit or the firm, or É
á
Optional
bonus--Google example.
á
Your raise
next year is to some extent a "by performance" for this year
¯
Incentives:
How to make it in the interest of the agent to do what the principal wants
¤
What does
the principal want?
á
"To
win her lawsuit?"
á
At any
cost?
¤
Performance
based contracts give the agent an incentive
á
To achieve
the objective
á
If the
reward for doing so is greater than the cost of doing so
á
Suppose the
reward is 10% of the value of success
á
Will the
agent act as the principal would like?
á
What about
200%?
á
If all we
are concerned about is the right incentive, the reward should be É?
á
What are
the problems with this solution?
¬
It might
pay the agent too much.
¬
Consider a
store whose profit depends on ten different employees.
¬
How would
we solve that problem?
¬
The
solution might impose too much risk on the agents.
á
So there
are costs to the rule that gives the right incentive.
á
A further
problem is measuring output
¬
Consider
the President of a publicly traded company
¬
Perhaps
profits are low this year because of high research costs which will bear fruit
in five or ten years
¬
Or because
of problems facing the industry for which he is not responsible.
¬
Consider a
secretary or janitor or É . How do
you measure output?
á
One reason
to decentralize firms is to make this problem a little easier to solve
¬
We can
judge the output of the Buick division of GM better if it is run like a
separate company
¬
Of one
partner in a law firm if we can keep track of his accounts
¯
Input based
contract
¤
For
instance, paying an hourly wage
¤
Or billable
hours
¤
Gives the
agent an incentive on the measurable dimension of input
¤
But not on
other dimensions--how hard he works, for instance.
¯
Fixed fee
contract
¤
No
automatic incentive to do anything
¤
Make the
fixed fee for some measurable result (show up in court, etc.)
¤
Or have
some way of defining what inputs the fixed fee is buying, and monitoring them.
¤
May rely
heavily on reputation.
v
Risk
bearing
¯
Performance
based, risk born largely by the agent
¯
Input
based, principal bears risk of outcome, risk of wanting more inputs.
¯
Fixed fee,
principal bears risk of outcome, agent risk of costs.
v
Coffee
house manager employment contract
¯
Performance
based
¤
Do we have
to base it on the profits of the whole firm?
¤
Or is there
a better solution?
¤
What about
compromises to reduce the risk the manager bears?
¯
Input based
¤
Performance
depends on manager's inputs, but É
¤
Much of it
is qualitative, hard to measure, harder to prove to a court in case of dispute
¤
And the
quantitative--hours put it in--requires someone monitoring the manager
á
Which means
someone working in his coffee house
á
And so
partly dependant on him for promotion etc.
¯
Fixed
fee--flat salary
¤
Requires
monitoring of inputs and performance
¤
If unsatisfactory,
replace the manager
v
Joint
undertakings
¯
Include
¤
Partnership--such
as a law firm
¤
Joint
project by two firms--Apple and IBM, say
á
IBM
develops a new chip (G5, 60 nm)
¬
Apple makes
plans and promises based on it
¬
And Steve
Jobs eats crow when he still doesn't have his 3 Ghz desktop.
á
How might a
contract deal with this (don't know if it did)
¬
IBM
controls how hard they try
¬
And has
more information on what they can do, risks (not enough information, as it
turned out—everyone had more trouble with 60 nm than expected)
¬
So should
IBM be liable for Apple's losses?
¬
But Apple
is the one deciding what promises Steve makes, other decisions affecting amount
of loss.
¤
É
¯
Incentives
¤
Horizontal
division—between partners, allocating income by business brought in,
billable hours, É
¤
Functional
division—Apple and Motorola above.
¯
Risk
sharing
¤
May modify
"reward by output" within firm
¤
Partly
output, partly input, partly fixed
¯
What is
observable?
¤
Did IBM
make best efforts to develop?
¤
Could Intel
be used as benchmark?
¤
Did Apple act
to minimize loss due to failure of IBM to deliver?
v
Sale or
lease of property
¯
Quality
dimension
¤
Of property
as delivered
¤
And as
returned
¤
Inspect?
¤
Contractual
restrictions on use, subletting, É
¤
Security
deposit
á
Saves court
costs if property damaged,
á
Solves
judgement proof problem, but É
á
How do you
keep landlord from confiscating it if not damaged?
á
Raises the
general issue of structuring a contract wrt what happens if nobody goes to
court. Will return to that Thursday
¤
Damage in
delivery
á
Make the
party who has possession liable? Can best control
á
Or the
party who chooses third party to deliver
¯
Information
¤
What are
you obliged to tell?
¤
Treaty of
Paris, war of 1812, case.
¤
Poltergeist
case
¯
Who bears
the risk of the rented building burning down?
¤
Incentive—tenant
¤
Risk
spreading? Probably landlord.
v
Loan
¯
Risk of
bankruptcy,
¤
deliberate
or otherwise.
¤
"deliberate"
might include taking risks—heads I win, tails you lose.
¤
Control by
á
Security
interest in property—borrower can't sell it
á
Controls on
what borrower can do.
v
Resolving
disputes
¯
Some can be
avoided by anticipation, but É.
¤
There isn't
enough small print in the world to cover everything
¤
And events
may occur that you hadn't thought of.
¯
Damages for
breach
¤
Expectation
damages lead to efficient breach, inefficient reliance
¤
Liquidated
damages solve the problem—if damages can be estimated in advance.
v
Negotiating
the contract
¯
Try to
maximize the pie
¤
By offering
to buy improvements that help your side at a cost to the other
¤
To sell
improvements that help them at a cost to you
¤
To trade
¯
Try to
maximize your share—typically in the price
¤
While
remembering that if you ask for too much
¤
You risk
bargaining breakthrough
¤
And getting
nothing
v
China to
Cyberspace: Contracts without court enforcement
¯
An issue
for
¤
You—because
part of an attorney's job is staying out of court
á
Which you
do in part by designing contracts
á
Which it
isn't in either party's interest to try to get out of
á
Look at how
many contracts amount to the consumer signing away as many of his potential
claims as possible
¬
One explanation
is that it is that way to benefit the seller at the buyer's expense
¬
That seems
inconsistent with our analysis—any expense to the buyer will reduce what
he is willing to pay for the product
¬
Why might
this arrangement be in the interest of both? (stay tuned)
¤
Imperial
China—because legal system was almost entirely penal
á
You could
complain you had been swindled, ask the district magistrate to act
á
But you
couldn't actually sue and control the case
á
And the
legal system said almost nothing about contract law
¤
Cyberspace,
because
á
Hard to use
the legal system when dealings routinely cross jurisdictions
á
The
technology makes it possible to combine anonymity and reputation
¬
Public key
encryption as a way of maintaining anonymity
¬
And digital
signatures as a way of proving identity
¯
Either your
realspace identity, or É
¯
Your
cyberspace identity
¯
I.e. that
you are the online persona with a particular reputation.
¯
My legal
eagle business plan
á
For quite a
lot of people, anonymity might be a plus
¬
Lets you
opt out of the state legal system—which contracts often try to do.
¬
Protects
you in places where security of property is low
¯
Do you want
to be a programmer known to be making $50,000/year
¯
In China,
or Burma, or Indonesia, or É
¯
You might
be worried about either private seizures—kidnapping your kids, say
¯
Or public
ones.
¬
Might let
you evade taxes or regulations at home.
¯
One way of
enforcing contracts without the courts is reputation
¤
Reputational
enforcement depends on your being a repeat player, so your reputation matters
to you.
¤
It also
depends on interested third parties knowing whether you cheated someone
á
Since your
"punishment" isn't designed to punish you
á
But to keep
other people from letting you cheat them
¤
If it is
hard to know which party to a dispute is telling the truth
á
Interested
third parties will distrust both—either might be lying
á
So it isn't
in your interest, when cheated, to complain
á
So
reputational enforcement doesn't work
¤
Arbitration
is a way of lowering the information cost to third parties
á
If we went
to a respected arbitrator, or one we agreed on advance
á
And he
ruled in my favor, and you didn't go along
á
You are
probably the bad guy
¯
Another way
is structuring the contract so that it is never in either party's interest to
breach
¤
I hire you
to build a house on my property
á
If I pay
you at the beginning, it is in your interest to take the money and run, if you
can get away with it.
á
If I pay
you at the end, it is in my interest to keep the house and not pay
á
So I pay
you in installments during the construction
á
Arranged so
there is no point at which either of us gets a large benefit from breach
á
Sometimes
doing this requires costly changes in the pattern of performance
¬
Lloyd
Cohen's explanation of the consequences of no fault divorce
¯
In the
traditional marriage, women performed early, men late
¯
Many men
find younger women more attractive, so É
¯
Incentive
for a husband at forty, with the kids in school and his wife finally getting a
chance to rest
¯
To dump her
for a younger replacement
¬
How did
women change their behavior to control the problem?
¯
Postpone
childbearing in order to bring performance more nearly in sync
¯
Shift
household production to the market and get a job
¤
Which both
gets performance in sync, and
¤
Reduces the
degree to which the wife is specialized to being the wife of that man
¤
And so at
risk if he breaches.
¤
Since there
are gains from completing the contract, in a world of certainty we ought to be
able to structure payment and performance to achieve this, but É
á
In an
uncertain world, where costs and benefits may change, it's hard
á
We can
always reduce my incentive to breach by my giving you a deposit at the
beginning, which you hold and will keep if things break down
á
But that
increases my incentive to breach
¤
One
solution is to use a hostage instead of a deposit
á
I give you
something—my son, my trade secret—that
¬
it costs me
a lot to lose
¬
but
benefits you only a little to keep
¬
so pushes
down my benefit from breach a lot, yours up a little
¤
Another
solution is to structure payments so that the incentive to breach is on the
party who has reputational reasons not to
á
You are
going to do some work for me online—write a program, say
á
If you are
a repeat player with reputation, I pay in advance
á
If I am, I
pay for the program when it is delivered
á
Arguably,
these explains the feature of real contracts discussed above
¬
It is in
the interest of both parties to avoid expensive litigation
¬
The seller
is a repeat player with a reputation, the buyer is not
¬
So
substitute reputational enforcement for court enforcement
¬
Which would
you prefer
¯
To buy a
product with a long warranty from Apple or Kitchen Aid—in a world where
the warranty wasn't enforceable
¯
Or from a
no-name seller, in a world where you could sue the seller for not carrying out
the warranty?
v
Other ways
of staying out of the court
¯
So far as
possible, arrange the contract so that the result you want is the one that
happens with no court intervention
¯
Caveat
emptor is an example
v
General
observations
¯
a bunch of
simplifications
¤
cost rather
than current value
¤
Assets:
á
must be
linked to some past transaction or event
á
yield
probable future benefits
á
be obtained
or controlled by the entity
¤
assets
donÕt include good will, corporate culture, É
¤
all
probabilities are one or zero
¤
why?
¯
Compare to
tort law
¤
All
probabilities are one or zero
á
Someone
sues you for ten million dollars
á
If
probability of guilt is .4, you owe nothing
á
If .6, you
owe ten million
¤
Damages
tend to be limited to
á
pecuniary,
medical costs, lost earnings
á
less
willing to include pain and suffering and the llike
¯
in both
cases, we have to make decisions with a very crude process
¤
making
legal outcomes depend on things in complicated ways is likely to raise
litigation costs, legal uncertainty. Easier to prove a doctorÕs bill than a
pain.
¤
Accounting
aims at sufficiently clear cut decision rules
á
So that
firms canÕt easily manipulate the outcome
á
To make
them look good
á
Or reduce
their taxes.
á
At a
considerable cost in accuracy
v
Understanding
accounting
¯
First
rule—ignore Òdebit/creditÓ or reverse their meaning
¤
Most of the
time, a debit makes a firm richer
¤
A credit
poorer
¤
One
explanation: "Debit" is from Italian Debitare—what others owe
you
¤
And what
about credit?
¯
Second
rule—()= -
¯
making
sense of a balance sheet
¤
photograph
of the firm at an instant—compare two dates
¤
show a list
of assets, most liquid at the top, at two periods
á
group into
current assets, total
á
and long
term ("property, plant and equipment") and total
á
total the
two totals for total assets
¤
similar
list of liability and owner's equity
á
liability a
negative asset
¬
probable
sacrifice of economic benefit É
á
why do you
put equity with liabilities?
á
How much
wealth does the firm itself (as opposed to stockholders and others) have?
á
the
fundamental equation
¯
making
sense of an income statement
¤
designed to
show the changes over a period of time
¤
money coming
in: Sales revenue (or equivalent for other sorts of firms)
¤
costs
á
cost of
goods sold—raw material, labor, etc.
á
operating
expenses: Costs not attributable to particular output
á
interest
expense
á
income tax
expense
¤
at each
stage, you have a net to that point
¤
and end up
with net income
¯
making
sense of a cash flow statement
¤
the one in
the book
á
money comes
in as net income, but É
á
if part of
the "income" is accrued but not received É
¬
it goes
into accounts receivable, not cash,
¬
so less
cash
¬
reverse if
some accounts from last year are paid, increasing cash
¬
so subtract
from income the increase in accounts receivable
á
accounts
payable the same thing in the other direction
¬
we
subtracted out expenses in calculating income, but É
¬
if some
expenses were accrued but not paid É
¬
we still
have the cash
á