Cadillac Contracts and Up-Front Payments: Efficient Investment Under Expectation Damages

This paper shows that up-front payments can play a crucial role in providing efficient investment incentives when contracts are incomplete. They can eliminate the overinvestment effect identified by Rogerson [1984] and Shavell [1980] when courts use an expectation damage remedy. This method extends to complex contracting situations if parties combine up-front payments with what we call 'Cadillac' contracts (contracts for a very high quality or quantity). This combination provides efficient investment incentives in complex contracting problems when an expectation damage remedy is accompanied by a broad duty to mitigate damages. This indicates that an expectation remedy is well-suited to multidimensional, but one-sided, investment problems, in contrast to specific performance, which Edlin and Reichelstein [1993] showed is well-suited to two-sided, but unidimensional, investment problems.

Clearings and Thickets

Intellectual property law, which includes patents and copyright law, establishes the ownership of innovations by people. It conveys a bundle of rights to creators as determined by rules. Applied to intellectual property law, the normative question of growth economics is, “Which ownership rules maximize innovation?” In order to increase the pace of innovation, ownership rules should increase venture profits. So the question of this essay is, “Which ownership rules maximize venture profits?".Institutions; property rights; intellectual property rights; law and economics

The American Airlines Case: A Chance to Clarify Predation Policy

Predation occurs when a firm offers consumers favorable deals, usually in the short run, that get rid of competition and thereby harm consumers in the long run. Modern economic theory has shown how commitment or collective-action problems among consumers can lead to such paradoxical effects. But the paradox does signal danger. Too hawkish a policy might ban favorable deals that are not predatory. It would be ironic indeed if the standards for predatory pricing liability were so low that antitrust suits themselves became a tool for keeping prices high. Predation policy must therefore diagnose the unusual cases where favorable deals harm competition. To this end, courts and commentators have largely defined predation as sacrifice followed, at least plausibly, by recoupment at consumers' expense. The American Airlines case raises difficult questions about this approach.

Optimal Penalties in Contracts

Contract law's liquidated damage rules prevent enforcement of contractual damage measures that require the promisor, if it breaches, to transfer to the promisee a sum that exceeds the net gain the promisee expected to make from performance; but these rules permit the promisor to transfer less than the promisee's expectation. We define a contractual damage multiplier as any number between zero and infinity by which the promisee's expected gain -- its expectation interest -- is multiplied. Multipliers of one or less thus comply with the liquidated damage rules while multipliers that exceed one do not; the high multipliers are unenforceable penalties. This paper shows that multipliers of any size can be efficient or inefficient, depending on the parties' purposes in creating them. For example, a multiplier that exceeds one will decrease welfare if used by a seller with market power to deter entry; but will increase welfare if used by parties to induce efficient relation specific investment. As a consequence, a court should inquire, not into the size of the multiplier, but into the purpose the multiplier serves for the parties.

Voting as a Rational Choice: Why and How People Vote to Improve the Well-Being of Others

For voters with "social" preferences, the expected utility of voting is approximately independent of the size of the electorate, suggesting that rational voter turnouts can be substantial even in large elections. Less important elections are predicted to have lower turnout, but a feedback mechanism keeps turnout at a reasonable level under a wide range of conditions. The main contributions of this paper are: (1) to show how, for an individual with both selfish and social preferences, the social preferences will dominate and make it rational for a typical person to vote even in large elections;(2) to show that rational socially-motivated voting has a feedback mechanism that stabilizes turnout at reasonable levels (e.g., 50% of the electorate); (3) to link the rational social-utility model of voter turnout with survey findings on socially-motivated vote choice.

The Accident Externality from Driving

We estimate auto accident externalities (more specifically insurance externalities) using panel data on state-average insurance premiums and loss costs. Externalities appear to be substantial in traffic dense states: in California, for example, we find that a typical additional driver increases the total of other people's insurance costs by $2231 per year. In such states, an increase in traffic density dramatically increases aggregate insurance premiums and loss costs. In contrast, the accident externality per driver in low traffic states appears quite small. On balance, accident externalities are so large that a correcting Pigouvian tax could raise$45 billion annually in California alone, and over $140 billion nationally. The extent to which this externality results from increases in accident rates, accident severity or both remains unclear. It is also not clear whether the same externality pertains to underinsured accident costs like fatality risk.

Contract Renegotiation in Agency Problems

This paper studies the ability of an agent and a principal to achieve the first-best outcome when the agent invests in an asset that has greater value if owned by the principal than by the agent. When contracts can be renegotiated, a well-known danger is that the principal can hold up the agent, undermining the agent's investment incentives. We begin by identifying a countervailing effect: Investment by the agent can increase his value for the asset, thus improving his bargaining position in renegotiation. We show that option contracts will achieve the first best whenever this threat-point effect dominates the holdup effect. Otherwise, achieving the first best is difficult and, in many cases, impossible. In such cases, we show that if parties have an appropriate signal available, then the first best is still attainable for a wide class of bargaining procedures. A noisy signal, however, means that the optimal contract will involve terms that courts might view as punitive and so refuse to enforce.

Per-Mile Premiums for Auto Insurance

Most insurance premiums are only weakly linked to mileage, and have largely lump-sum characteristics. The probable result is too many accidents and too much driving from the standpoint of economic efficiency. This paper develops a model of the relationship between driving and accidents that formalizes Vickrey's [1968] central insights about the accident externalities of driving. We use it to estimate the driving, accident, and congestion reductions that could be expected from switching to other insurance pricing systems. Under a competitive system of per-mile premiums, in which insurance companies quote risk-classified per-mile rates, we estimate that the reduction in insured accident costs net of lost driving benefits would be $9.8 -$12.7 billion in the U.S., or $58-$75 per insured vehicle. When congestion reductions are considered, the net benefits rise to $15-$18 billion, exclusive of monitoring costs. The total benefits of per-mile premiums with a Pigouvian tax to account for accident externalities would be $19-$25 billion, or $111-$146 per insured vehicle, exclusive of monitoring costs. Accident externalities may go a long way toward explaining why most insurance companies have not switched to per-mile premiums despite these large potential social benefits.