30
Foundations of Contract Law
§ 1.3 Distributional Concerns
Passi ng on the Costs of Leg al Ru les
RICHARD CRASWELL
Many legal rules in many legal fields define the relations between sellers of
goods or services and their customers . For example, contract law defines the
respects in which a seller warrants the quality of its products , as well as the
Richard Craswell , Passing on the Costs of Legal Rules: Efficiency and Distribution in BuyerSeller Relationships , 43 Stanford Law R eview 361 , 361 , 365-77 , 385 , 391-97 (1991) . Copyright ©
1991 by the Board of Trustees of the Lel and Stanford Junior University. Reprinted by permission .
Normative Underpinnings
31
damages due if it breaks the .cont.met. Products lia?ility law determines a
lier's responsibility for physical m1ury caused by its products. Landlordnant law defines the landlords' liability for unsafe or inadequate housing; it
~so limits the landlords' powers vis-a-vis tenants who damage the premises or
:re delinquent in paying the rent. Debtor-creditor law limits the analogous
powers exercised by creditors outside the rental housing market.
The debate surrounding these rules often pits those who are concerned
about a rule's efficiency against those who are concerned about its distributional effects. The law-and-economics literature , for example , usually aims
only at economic efficiency: maximizing the joint welfare of buyers and sellers
without distinguishing between benefits to sellers and benefits to buyers ....
To some, however, the identity of those who gain or lose is at least as
important as the size of the total gains or losses . Especially where consumer
transactions are concerned , people often attach more weight to the welfare of
consumers than to the welfare of sellers. For expositional purposes, I will
define the "pro-consumer" position (in somewhat extreme fashion) as the
belief that a rule should be adopted if, and only if, it benefits consumers more
than it costs them .
This pro-consumer position could of course be criticized directly, by asking
why consumers ought to be favored over sellers . For example, some sellers
are publicly-held corporations whose shareholders include insurance companies and pension funds , and there is no obvious reason why the beneficiaries
of these funds deserve less concern than consumers. Some of the sellers' costs
may also be borne by their employees if the increased costs lead to reduced
sales and , hence , to reduced employment in the industry.
My concern here, however, is a very different criticism which is based on
the argument that the pro-consumer analysis will usually lead to the same
result as an efficiency analysis once the effect of a rule on the seller's price is
taken into account. According to this argument, a rule that benefits consumers by $10 while increasing sellers' costs by $50 will not benefit consumers for
very long, because sellers will eventually pas on their higher costs to consumers in the form of higher prices . Thus, consumers will end up as net winners
(according to this argument) only if their direct benefits exceed the direct
costs of the rule to sellers , for only in such a case will they still be better off
even after they have paid the higher prices ... .
:e
The Standard Analysis of Cost Pass-Ons
The princip al objection to this passing-on argument is that it assumes that all
of the sellers' costs or benefits will be passed on in the form of higher or lower
prices. If all $50 of the sellers' costs are passed on as higher prices , then buyers
will indeed by worse off unless they receive direct benefits of $50 or more
from the rul e , so the distributional and efficiency goals will indeed coincide.
But if only $40 of sellers ' costs can be passed on, buyers might end up better
off even if they on ly received $45 worth of direct benefits. A pro-consumer
32
Foundation• of Contract uw
advocate would approve of such a rule, in spite of the fact that it fails a
Kaldor-Hicks efficiency test because the $50 cost to sellers exceeds the $45
gain to consumers.
Thus, the asserted identity between the pro-consumer and overall efficiency positions seems to depend critically on the assumption that sellers can
pass on all of their costs and benefits. However, the conventional economic
wisdom is that sellers usually will not be able to pass on the entire amount of
an exogenous cost increase .... Figure 1.1 illustrates the conventional economic analysis of the effect of an increase in the seller's costs of the sort that
might be brought about by an increase in raw material prices or the imposition
of a tax on sellers. Before the cost increase, the market price should have
stabilized at the level at which the amount suppliers were willing to sell
(shown by the line marked Sl) just equalled the amount buyers demanded
(shown by the line marked D). These will be equal only at the point where the
two lines cross, which corresponds to a market-clearing price of Pl.
H sellers' costs then increase by some amount c, sellers will no longer be
willing to sell as much at any given price. This should cause the supply curve to
shift upward by the amount of the cost increase, to become the new line
marked S2. This, in turn, will cause the market price to rise until it reaches the
new price P2, where supply and demand again become equal. Because demand is somewhat elastic, however, the increase in price from Pl to P2 is less
than the increase in seller's costs from Sl to S2 (c). Thus, less than lOOpercent
of the cost increase has been passed on ....
Given this analysis, it seems easy to imagine a rule that produces total
benefits equal to, say, only 80 percent of its total costs, but that nonetheless
leaves buyers better off because buyers receive all of the rule's benefits while
less than 80 percent of the costs are passed on. The problem, however, is
that the graphs given [above] are incomplete. They show the seller's costs
rising without any simultaneous increase in consumers' willingness to pay for
the product. This is a perfectly reasonable assumption to make when analyzing an increase in raw material prices or the imposition of a tax on the
seller, for such changes would increase the seller's costs without making the
product any more attractive to consumers. An implied warranty, however,
would normally make the product more attractive to consumers, thereby
causing consumer demand (as well as sellers' costs) to increase. Tu determine the effects of rules such as implied warranties, we need a more complex analysis. . . .
A Simple Model with Homogeneous Consumers
In this section of the article, I make ... [some] important assumptions to
prevent the model from becoming too complex. First, I assume that each
consumer would pay exactly the same amount for the addition of a warranty.
In other words, consumers may differ in their tastes regarding the product
itself, but they have identical preferences concerning the presence or absence
33
Normative Underpinning•
S2
SI
Q2 QI
quantity
Figure 1.1. Effects of a cost increase
of a warranty. While this assumption is something of an oversimplification, it
aids the initial exposition considerably. . . .
Second, and more controversially, I further assume that the increase in the
maximum consumers are willing to pay is an appropriate measure of the
benefits consumers receive from the warranty. That is, I adopt the consumer
sovereignty position that consumer welfare is to be judged solely by reference
to consumers' own tastes and preferences. I also assume that those tastes and
preferences can be meaningfully translated into a dollar amount and that the
appropriate amount is whatever each consumer is willing to pay to satisfy
those preferences. Tu make this assumption more plausible, I also assume
consumers have perfect information about the presence or absence of the
warranty and about its value to them. . . .
As noted earlier, a legal rule such as an implied warranty should raise both
the demand and the supply curves, although not necessarily by the same
amount. The demand curve will shift upward by an amount equal to the
consumers' increased willingness to pay for the product/warranty combination, reflecting the benefits consumers derive from the warranty. The supply
cmve will rise by the expected costs of the warranty to sellers. Under the
above assumptions about consumers' valuation of the warranty, the warranty's efficiency can be assessed simply by comparing the upward shift of the
demand and supply curves. If the value of the warranty to consumers exceeds
118 cost to sellers, the demand curve will rise by more than the supply curve; if
not, then demand will rise by less than supply.
Under these assumptions, consumers cannot gain if the warranty is inefficient. That is, if the value of the warranty to consumers is less than its cost to
sellers, consumers will end up worse off as a result of the warranty, even if
sellers cannot pass on all of their costs. Figure 1.2 illustrates this by depicting a
eblft in the demand curve that is less than the shift in the supply curve. The
Increase from Pl to P2 is clearly less than the total cost increase c, showing
that only a portion of the cost increase is passed on to consumers. The price
increase is small because significant numbers of consumers are no longer
34
Foundations of Contract Ln
S2
SI
02
DI
Q2 QI
quantity
Figure 1.2. An inefficient warranty
willing to purchase the product/warranty package at the higher price, so the
total quantity produced has declined from 01 to 02. The marginal consumers, who before the addition of the warranty were just willing to purchase the
product alone, are now unwilling to pay a higher price for the product plus the
warranty. These consumers must have valued the warranty at an amount less
than the resulting price increase, so they have been made worse off by the
introduction of the warranty.
Less obviously, consumers who continue to buy the product are also made
worse off by the introduction of the warranty. I assumed earlier that all
consumers placed the same value on the warranty; thus, if the marginal consumers value the warranty less than the price increase, so too must all the
other consumers. The other consumers are still willing to purchase the
product/warranty package because the value they place on the product alone
is sufficiently greater than its price that the purchase is still worthwhile, even
after the addition of a relatively unattractive warranty and price increase. But
since they value the addition of the warranty by less than they value the price
increase, even these consumers must end up with less satisfaction than if they
were buying the product at the old price without the warranty. This can be
verified by visual inspection of Figure 1.2: The amount by which consumers'
valuation of the package has increased (shown by the increase from Dl to 02)
is less than the amount by which the price has increased (shown by the increase from Pl to P2).
.
By contrast, Figure 1.3 illustrates a case in which consumers value the
warranty by an amount that exceeds the cost c of providing the warranty. In
this case, the total quantity sold has increased (from 01 to 02), as consumers
who were unwilling to pay for the product alone are now willing to pay for the
product plus the warranty. Sellers have had to increase their production of the
product to meet this new demand, thereby raising their production costs (as
indicated by the move upwards and to the right along the S2 line) over and
above the extra costs added by the warranty itself. The result is that the price
increase from Pl to P2 actually exceeds the cost of the warranty c; more than
35
Normative Underpinnings
pnce
S2
SI
02
DI
QI Q2
quantity
Figure 1.3. An efficient warranty
100 percent of the cost increase has been passed on. However, because the
increase in consumers' valuation of the product (shown by the increase from
Dl to 02) is greater than the price increase from Pl to P2, consumers still
benefit from the introduction of this warranty. Indeed, the price increase
exceeds the cost of the warranty in this case precisely because consumers find
the product with the warranty so much more attractive, thereby requiring an
increase in total production. . . .
Tu summarize, this section has shown that when consumers have identical
preferences regarding a warranty or other legal rule, consumers will benefit
from the rule if, and only if, the rule is efficient under a Kaldor-Hicks test.
Moreover, the significance of sellers' ability to pass along their costs in such a
market is exactly the opposite of what most people suppose. Under the model
used in this section, if less than 100 percent of the costs are passed on, the rule
has made the product/warranty package less attractive to consumers, which
implies that the rule is not very good for consumers. Conversely, if more than
100 percent of the costs are passed on, the rule has made the product/warranty
package more attractive to consumers, thereby increasing overall demand.
Paradoxical as it may seem, the rules whose costs are most heavily passed on
are also the rules that will benefit consumers the most.
Heterogeneous Consumers
... In this section . . . I assume that sellers are dealing with consumers who
differ in their willingness to pay for a warranty. I also assume that sellers must
charge all customers the same price for the product/warranty package-that
is, I assume that it is impossible for the seller to engage in price discrimination. Under these assumptions, it is possible for some consumers to be made
better off by the warranty while other consumers are made worse off. Moreover, it is also possible for consumers as a class to benefit from an inefficient
warranty, or to lose from an efficient one-although the question of what it
36
Foundations of Contract Lew
means for consumers "as a class" to benefit becomes more problematic when
consumers differ in their willingness to pay. . ..
In markets where different consumers attach different values to a warranty, the size of the accompanying price increase will be determined largely
by the valuations held by those consumers who are on the margin between
buying and not buying the product/ warranty package. These consumers, the
marginal consumers, will stop buying the package if its price rises; consequently, the willingness to pay of marginal consumers will determine how high
the price of the combined package will rise.
If these consumers (on average) value the addition of a warranty by more
than the warranty increases the sellers' costs, then overall demand for the
combined package will increase, and the price will go up by more than 100
percent of the warranty cost. However, marginal consumers will still end up
better off for the reasons discussed in [the preceding section]. While the price
will increase by more than the sellers' costs, it will increase by less than the
value the marginal consumers place on the warranty, so marginal consumers
will still come out ahead.
Alternatively, if the marginal consumers value the warranty by less than
the increase in sellers' costs, they will end up worse off as a result of the
introduction of the warranty. The price increase will be less than the cost of
the warranty to sellers because the reduction in demand will prevent sellers
from passing along all of the costs of the warranty. However, the marginal
consumers will still end up worse off since the reduction in demand means that
some marginal consumers have dropped out of the market. In short, the
marginal consumers will gain or lose depending on whether the value they
place on the warranty is greater or less than the seller's costs-just as in the
simple model presented in [the preceding section].
Determining whether the non-marginal (or "infra-marginal") consumers
gain or lose from the introduction of a warranty is more difficult. The easiest
case to analyze is one in which the marginal consumers value the warranty by
an amount equal to the cost of the warranty to sellers. In that case, the price
of the product/warranty package will rise by exactly the marginal consumers'
valuation of the warranty. Consequently, any consumers of the product who
value the warranty more highly than the marginal consumers will derive benefits which exceed the price increase and will be net winners from the introduction of the warranty. On the other hand, consumers who value the warranty
less than the marginal consumers will derive benefits which are less than the
price increase and will be net losers.
Some numerical examples may help illustrate this point. Suppose that the
product without the warranty sold for $20, the warranty costs the seller $8 to
administer, and the combined product/warranty package now sells for $28. Of
the consumers who continue to buy the product after introduction of the
warranty, those who value the warranty by more than $8 will have gained from
its introduction. This clearly includes any consumer who valued the product at
$18 and who also valued the warranty at $10 or more, for these consumers
would not have been willing to buy the product at its old price of $20 without a
Normative Underpinnings
37
warranty. It also includes other consumers who were previously willing to buy
the product without the warranty and are now even happier to buy it with the
warranty. For example, some consumers might have been willing to pay $24
for the product alone but are willing to pay $34 for the product/warranty
package. These consumers derived a net surplus of $4 from the product without the warranty but a net surplus of $6 after the addition of the warranty.
Thus, these consumers end up $2 better off as a result of the warranty. In
effect, they are getting a warranty they value at $10 in exchange for a price
increase of only $8.
At the same time, consumers of the product who value the warranty by
less than $8 will be made worse off by the warranty's introduction. Some of
these consumers will no longer buy the product-for example, those who
valued the product alone at $22 but who are only willing to pay an extra $4 (or
a total of $26) for the addition of the warranty. These consumers will not buy
the product/warranty package at a combined price of $28 and, therefore, will
lose the $2 surplus they received from buying the product alone. Other consumers may continue to buy the product, but they will nonetheless suffer a
reduction in their net surplus. For example, consider a consumer who was
willing to pay $27 for the product alone but will pay only $7 extra (or a total of
$34) for the product/warranty combination. This consumer derived a net surplus of $7 ($27 minus $20) without the warranty but now receives a surplus of
only $6 ($34 minus $28) after the introduction of the warranty. In general,
consumers of the product who value the warranty by less than $8 will end up
worse off as a result of the warranty, while those who value the warranty by
more than $8 will end up better off. . . .
When consumers have identical preferences concerning the warranty, a
warranty that benefits any one consumer must benefit all other consumers as
well. When consumers differ in their willingness to pay for a warranty, however, this section has shown that the warranty can benefit some consumers
while hurting others. In such a case, an unambiguous pro-consumer position is
harder to define .
. . . Admittedly, in some cases, those who gain and those who lose from a
warranty may be distributed randomly with respect to any social policy regarding redistribution. For example, consumers who are risk-neutral or riskprcferring place a relatively low value on protection against risks and are,
therefore, likely to be among those who lose from the introduction of a
warranty. If risk-aversion is distributed randomly throughout the population,
a warranty that benefits the risk-averse while hurting risk-preferring or riskneutral consumers would neither advance nor retard any current social policies concerning the proper direction of redistribution.
In other cases, however, the identity of the winners and losers may be
correlated with wealth in a way that makes the resulting redistribution regressive. For example, critics of modern products liability law, ranging from Richard Abel on the left to George Priest on the right, have pointed out that
wealthy people generally have more to lose from product-related accidents
that result in lost earnings or in conseouential damaee to orooertv. As R rP.s11h
38
Found&Uons of Contract Lai
rich people will usually benefit much more than poor people from any form o
seller liability that protects them from such losses. Indeed, even if the prop
erty at risk is the same for both rich and poor consumers, the rich may bt
willing to pay more for protection against that risk simply because they have
more money with which to pay. In economic terms, the marginal value o.
money to the rich may be lower, even if the property at risk is the same. Thi!
difference does not guarantee that the rich will be willing to pay more fOJ
protection since rich consumers may also be less risk-averse than poor consum·
ers. The higher risk-aversion of the poor could make them willing to pay more
for a warranty, not less. However, if the difference runs the other way-as is
almost certain to be true of extremely poor consumers, who could barely
afford to pay any more money-the inter-consumer distributional effects
might favor the rich at the expense of the poor. . . .