EC476 Contracts and Organizations, Part III: Lecture 1 Leonardo Felli 32L.G.06 12 January 2015
Course Outline Law and Economics ◮ Lecture 1: Contracts what are they? The Coase Theorem. ◮ Lecture 2: Principal Agent: Hidden Information and Hidden Action. ◮ Lecture 3: Failures of the Coase Theorem: Asymmetric Information and Transaction Costs. ◮ Lecture 4: The Role of Courts and the Legal System. ◮ Lecture 5: Power and Enforcement. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 2 / 52
Admin ◮ My coordinates: 32L.4.02, x7525, lfelli@econ.lse.ac.uk ◮ PA: Katharine Buckle, 32L.1.03, k.buckle@lse.ac.uk. ◮ Office Hours: ◮ Monday 11:30-12:30 a.m. ◮ or by appointment (e-mail lfelli@econ.lse.ac.uk). ◮ Course Material: available at: http://econ.lse.ac.uk/staff/lfelli/teaching Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 3 / 52
References: ◮ Robert Gibbons, A Primer in Game Theory , London: Harvester-Wheatsheaf, 1992. ◮ Bernard Salani´ e, The Economics of Contracts: A Primer , Cambridge: The MIT Press, 2nd Edition, 2005. ◮ Jean-Jacques Laffont and David Martimort, The Theory of Inncentives: The Principal-Agent Model , Princeton and Oxford: Princeton University Press, 2002. ◮ Patrick Bolton and Mathias Dewatripont, Contract Theory , Cambridge: M.I.T. Press, 2004. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 4 / 52
The Contract The first natural question that needs to be answered is: What is a contract? Definition A contract is the ruling of an economic transaction: the description of the performance that the contracting parties agree to complete at a (possibly future) date. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 5 / 52
Example ◮ A contract for the purchase of a specific item, say a meal. It specifies: ◮ the restaurant’s performance (number of courses, quality of food, cooking details, etc. . . ), ◮ the customer’s performance (payment in full upon completion). ◮ Contracts involve not only the contracting parties, but also outsiders (enforcing authority: Court or Enforcer). Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 6 / 52
Implicit Contracts ◮ We distinguish between implicit and explicit contracts. ◮ A contract is implicit or self-enforcing whenever the environment in which the contracting parties operate corresponds to the extensive form of a game whose (unique) Subgame Perfect Nash equilibrium exactly corresponds to the outcome the parties would like to implement. ◮ If you believe in SPE then there is no need for explicit communication. The two rational individuals will behave in the way required. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 7 / 52
Explicit Contracts ◮ If the outcome the parties would like to implement is not the subgame perfect Nash equilibrium of the environment in which they operate the parties might want to modify the environment. ◮ This is accomplished through an explicit contract. ◮ An explicit contract is a commitment device requiring: ◮ an explicit agreement between the parties, ◮ the intervention of a third party: the enforcer . Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 8 / 52
Contracts as Commitment ◮ The role of the enforcer is to force the parties to behave in a way that differs from the one that would arise in the absence of any agreement. ◮ An explicit contract therefore specifies a new extensive form corresponding to a new game for the parties. ◮ The usual way for the enforcer to guarantee that the parties operate in this new environment is by modifying the parties’ payoffs , when necessary. ◮ By agreeing to bring in an enforcer in the game the parties commit to play a game that differs from the initial one they were in. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 9 / 52
A Model of Trade ◮ To see how the presence of an enforcer may work consider the following example: (Kreps, 1984) ◮ A buyer B and a seller S wish to trade an indivisible item at date 1. ◮ The buyer’s valuation: v , ◮ The seller’s delivery cost: c . ◮ Let v > c In other words, trade is socially efficient . Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 10 / 52
A Model of Trade (2) ◮ Let p be a reasonable price level (we abstract for the moment from bargaining) such that: v > p > c . ◮ B ’s and S ’s situation may be described by the following normal form: B \ S deliver not deliver pay p v − p > 0 , p − c > 0 − p , p not pay p v , − c 0 , 0 Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 11 / 52
No Trade Result ◮ The unique Nash equilibrium (dominant solvable) is: ( B does not pay , S does not deliver) . ◮ This is clearly an inefficient outcome: no trade. ◮ The situation does not change if any of the following two extensive forms are played. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 12 / 52
No Trade Result (2) The unique SPE of the following game is: { B does not pay , S does not deliver at both nodes } B ❜ � ❅ � ❅ pay p not pay p � ❅ � ❅ � ❅ S S � ❅ q q ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ not not deliver deliver ☞ ▲ ☞ ▲ deliver deliver ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ q q q q ( v − p , p − c ) ( − p , p ) ( v , − c ) (0 , 0) Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 13 / 52
No Trade Result (3) The unique SPE of the following game is: { S does not deliver , B does not pay at both nodes } S ❜ � ❅ � ❅ deliver not deliver � ❅ � ❅ � ❅ B B � ❅ q q ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ pay p pay p not not ☞ ▲ ☞ ▲ pay p pay p ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ ☞ ▲ q q q q ( p − c , v − p ) ( − c , v ) ( p , − p ) (0 , 0) Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 14 / 52
Trade by Contract ◮ Solution: to this inefficiency is an explicit contract enforced by a third party (enforcer). ◮ It specifies: ◮ the payment p that B is supposed to make contingent on S delivering the item, ◮ the punishment F B > p (implicit in the legal system) imposed by the enforcer on B in the event that S delivers and B does not pay, ◮ the punishment F S > c (implicit in the legal system) imposed by the enforcer on S in the event that B pays but S does not deliver. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 15 / 52
Trade by Contract (2) ◮ In this case the normal form describing the contracting parties problem once the contract is in place is: B \ S deliver not deliver pay p v − p , p − c F S − p , p − F S not pay p v − F B , F B − c 0 , 0 ◮ The unique Nash equilibrium is now: ( B pays p , S delivers) . ◮ This contract is budget balanced off-the-equilibrium-path (renegotiation proof) . ◮ The latter property does not always hold. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 16 / 52
Imperfect Enforcement ◮ Consider now an environment in which when a party goes to the enforcer (goes to court) detection is costly ( κ ) and is successful only with probability π . ◮ The payoffs associated with (not pay p , deliver) (British rule) are: v − π ( F B + κ ) , π F B − (1 − π ) κ − c ◮ The payoffs associated with (pay p , not deliver) (British rule) are: π F S − (1 − π ) κ − p , p − π ( F S + κ ) Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 17 / 52
Imperfect Enforcement (2) ◮ Let π F B > p , π F S > c . Notice that as deterrence goes: π and the size of the punishment, F B and F S , are substitutes (Becker 1968). ◮ The game assumes the British rule: the enforcer’s costs κ are paid by the loosing party B \ S deliver not deliver π F S − (1 − π ) κ − p , pay p v − p , p − c p − π ( F S + κ ) v − π ( F B + κ ) , not pay p 0 , 0 π F B − (1 − π ) κ − c ◮ If court’s costs κ are too high the game has multiple Nash equilibria: (pay p , deliver) and (not pay p , not deliver). Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 18 / 52
Enforcement Mechanism ◮ This example clearly shows the need for an enforcement mechanism . ◮ This mechanism may be due to: ◮ the parties being involved in a repeated relationship relationship/implicit contracting, (multiplicity might be a problem). ◮ the presence of a legal system that enforces the parties agreement (explicit contracting) . ◮ Notice that according to this interpretation the enforcer is essentially a commitment device available to the parties that can be used when the parties agree to call it in. Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 12 January 2015 19 / 52
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