Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 11
Grading
 HW 1: end of class today
 Midterm: hopefully Tuesday
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Contracts: the story so far…
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Why do we need contracts?
Which promises should be enforced?
First purpose: enable cooperation
Second purpose: efficient disclosure of information
Third purpose: optimal commitment to performance
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Cost < promisee’s benefit: efficient to perform
Cost < promisor’s liability: promisor will perform
 Fourth purpose: optimal reliance
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Reward any reliance  overreliance
Hadley v Baxendale, foreseeable reliance
 Fifth purpose: efficient default rules and regulations
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Gaps, efficient (majoritarian) defaults
Penalty defaults (Ayres and Gertner)
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Regulations
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Default Rules versus Regulations
 Default rules only apply in situations the contract doesn’t
address
 Regulations are mandatory – can’t be overruled in contract
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Coase: if individuals are rational and there are no transaction
costs, voluntary negotiations/contracting will lead to efficiency
So additional rules/prohibitions can only make things worse
But if individuals aren’t rational or there are transaction costs,
regulations may help
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One example of a regulation/immutable rule:
derogation of public policy
 Derogate, verb. detract from; curtail application of (a law)
 Contracts which derogate public policy – that is,
contradict a law or regulation – are not enforceable
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Contracts which could only be performed by breaking a law
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Contracts whose effect is to circumvent a law
A
(other factory)
“if I ever work for C for
less than $15/hr, I’ll work
for you for $1/hr”
B
(union)
C
(ownership)
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One example of a regulation/immutable rule:
derogation of public policy
 Derogate, verb. detract from; curtail application of (a law)
 Contracts which derogate public policy – that is,
contradict a law or regulation – are not enforceable
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Contracts which could only be performed by breaking a law
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Contracts whose effect is to circumvent a law
A
(other factory)
“if I ever work for C for
less than $15/hr, I’ll work
for you for $1/hr”
B
(union)
C
(ownership)
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Derogation of public policy
 In general: contracts which can only be performed by
breaking the law are not enforceable
 But…
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“A married man may be liable for inducing a woman to rely on his
promise of marriage, even though the law prohibits him from
marrying without first obtaining a divorce.”
“A company that fails to supply a good as promised may be liable
even though selling a good with the promised design violates a
government safety regulation.”
“A company that fails to supply a good as promised may be liable
even though producing the good is impossible without violating an
environmental regulation.”
 “A promisor should be liable for breach if he knew that the
promise was illegal”
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Expectation damages: default rule or
immutable rule?
 Peevyhouse v Garland Coal and Mining Co
(OK Supreme Court, 1962)
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Garland contracted to strip-mine coal on Peevyhouse’s farm
Contract specified Garland would restore property to original
condition; Garland did not
Restoration would have cost $29,000…
…but “diminution in value” of farm only $300
Original jury awarded $5,000 in damages, both parties appealed
Oklahoma Supreme Court reduced damages to $300
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Expectation damages: default rule or
immutable rule?
 Seems like classic case of efficient breach
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Performing last part of contract would cost $29,000
Benefit to Peevyhouses would be $300
Efficient to breach and pay expectation damages, which is what
happened
 But…
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Most coal mining contracts: standard per-acre diminution payment
Peevyhouses refused to sign contract unless it specifically
promised the restorative work
Dissent: Peevyhouses entitled to “specific performance”
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Ways to get out
of a contract
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Formation Defenses and Performance
Excuses
 Formation defense
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Claim that a valid contract does not exist
(Example: no consideration)
 Performance excuse
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Yes, a valid contract was created
But circumstances have changed and I should be allowed to not
perform
 Most doctrines for invalidating a contract can be explained
as either…
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Individuals agreeing to the contract were not rational, or
Transaction cost or market failure
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Incompetence
 Courts will not enforce contracts by irrational individuals
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Children
Legally insane
 Doctrine of incompetence
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One party was not competent to enter into contract
Invalidates contracts which are not in best interest of that party
 What if you signed a contract while drunk?
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You need to have been really, really, really drunk to get out of a
contract
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
 The Borat lawsuits
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
 The Borat lawsuits
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Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazakh
Journalist for Make Benefit Guileless Americans In Film”
 Moral of story: don’t get drunk with someone who might
ask you to sign a contract
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Dire constraints
 Necessity
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I’m about to starve, someone offers me a sandwich for $10,000
My boat’s about to sink, someone offers me a ride to shore for
$1,000,000
Contract would not be upheld: I signed it out of necessity
 Duress
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Other party is responsible for situation I’m in
Someone makes me an offer I can’t refuse
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Friedman on duress
 Example
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Mugger threatens to kill you unless you give him $100
You write him a check
Do you have to honor the agreement?
 “Efficiency requires enforcing a contract if both parties
wanted it to be enforceable”
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He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?
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Makes muggings more profitable  leads to more muggings
Tradeoff: don’t enforce Pareto-improving trade, in order to avoid
incentive for bad behavior
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Friedman on duress
 Example
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Mugger threatens to kill you unless you give him $100
You write him a check
Do you have to honor the agreement?
 “Efficiency requires enforcing a contract if both parties
wanted it to be enforceable”
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He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?
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Makes muggings more profitable  leads to more muggings
Tradeoff: don’t enforce Pareto-improving trade, in order to avoid
incentive for bad behavior
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What about necessity?
 Same logic doesn’t work for necessity
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You get caught in a storm on your $10,000,000 sailboat
Tugboat offers to tow you to shore for $9,000,000
(Otherwise he’ll save your life but let your boat sink)
 Duress: if we enforce contract, incentive for more crimes
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Here: if we enforce contract, incentive for more tugboats to be
available for rescues – how is that bad?
Social benefit of rescue: value of boat, minus cost of tow
Say, $10,000,000 – $10,000 = $9,990,000
If tugboat gets entire value, his private gain = social gain
So tugboat captain would invest the efficient amount in being
available to rescue you
So what’s the problem?
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What about necessity?
 What about your decision: whether to sail that day
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1 in 1000 chance of being caught in a storm
If so, 1 in 2 that a tugboat will rescue you
Private cost of sailing: 1 in 2000 you lose boat, 1 in 2000 you pay
tugboat captain value of boat
$10,000,000/2000 + $10,000,000/2000 = $10,000
So you’ll choose to sail if your value is above $10,000
Social cost: 1 in 2000 boat is lost, 1 in 2000 boat is rescued
$10,000,000/2000 + $10,000/2000 = $5,005
Efficient to sail when your value is above $5,005
When your value from sailing is between $5,005 and $10,000, you
undersail
If the price of being towed was just the marginal cost, you would
sail the efficient amount
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Friedman’s point
 Same transaction sets incentives on both parties
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Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”
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Least inefficient price is somewhere in the middle
And probably not the price that would be negotiated in the middle of
a storm!
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Friedman’s point
 Same transaction sets incentives on both parties
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Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”
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Least inefficient price is somewhere in the middle
And probably not the price that would be negotiated in the middle of
a storm!
So makes sense for courts to overturn contracts signed under
necessity, replace them with ex-ante optimal terms
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More general point
 Single price can create multiple incentives
 Often impossible to set them all efficiently
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Already saw this with remedy for breach
Expectation damages: efficient breach, but inefficient signing
Include gains from reliance: overreliance
Exclude gains from reliance: inefficient breach
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Real duress versus fake duress
 Court won’t enforce contracts signed under threat of harm
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“Give me $100 or I’ll shoot you”
 But many negotiations contain threats
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“Give me a raise, or I’ll quit”
“$3,000 is my final offer for the car, take it or I walk”
 The difference?
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Threat of destruction of value versus failure to create value
A promise is enforceable if extracted as price of cooperating in
creating value; not if it was extracted by threat to destroy value
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Example
 Alaska Packers’ Association v Domenico (US Ct App 1902)
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Captain hires crew in Seattle for fishing expedition to Alaska
In Alaska, crew demands higher wages or they’ll quit
Captain agrees
Back in Seattle, refuses higher wages, claiming duress
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Example
 Alaska Packers’ Association v Domenico (US Ct App 1902)
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Captain hires crew in Seattle for fishing expedition to Alaska
In Alaska, crew demands higher wages or they’ll quit
Captain agrees
Back in Seattle, refuses higher wages, claiming duress
 Contracts should be enforced if both parties wanted
enforceability
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Same with renegotiated contracts
 Contracts renegotiated under duress will not be enforced;
contracts renegotiated under changed circumstances will
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Example
 Alaska Packers’ Association v Domenico (US Ct App 1902)
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Captain hires crew in Seattle for fishing expedition to Alaska
In Alaska, crew demands higher wages or they’ll quit
Captain agrees
Back in Seattle, refuses higher wages, claiming duress
 Contracts should be enforced if both parties wanted
enforceability
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Same with renegotiated contracts
 Contracts renegotiated under duress will not be enforced;
contracts renegotiated under changed circumstances will
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Next week: more doctrines for invalidating
contracts, and other stuff
 Have a good weekend
 Don’t get drunk and sign contracts!
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