Economic theory of contract law Contract law facilitates cooperation Ensures optimal commitment to perform Ensures optimal reliance

Minimizes transaction costs by setting up default terms Correct market failures by regulating contracts Facilitates long term relationships which facilitate cooperation without contracts Compensatory damages :- the sum of money the principal would have received had the agent performed the promise Expectation damages:- this is equal to the initial investment plus what the principal expected to earn on the investment

Reliance costs - costs incurred by the promisee in order to increase the utility, profits, etc. resulting from the fulfilment of the contract Rule for optimal reliance - the expected gain from reliance must equal the expected loss from reliance Perfect expectation damages are intended to restore the promisee to the position which they would have been in had the promise been kept - which can be expanded to include the amount of optimal reliance Rational gaps: these are cost minimizing gaps, some parties may deliberately leave gaps in contracts, this enables parties to allocate a loss if it materializes. Ex ante risks are the risks of future losses faced by the parties when they negotiate a contract. Ex post losses are the losses that actually materialize after making the contract.

w is the marginal social costs of precaution - the cost of one more, or one less, unit of precaution (x) -p(x*)A is the marginal social benefit associated with one more, or one less, unit of precaution evaluated at x* The marginal social benefit being the decrease in the expected costs of harm resulting from the last unit of precaution purchased The social cost of the last unit of precaution (the marginal social cost) should just equal the increase in social benefit (marginal social benefit) that it produces. Why? If social cost of the last unit of precaution < social benefit it produces, then it has a net benefit to society. If social cost of the last unit of precaution > social benefit it produces, then it is a waste.