Econ 522
Economics of Law
Dan Quint
Fall 2015
Lecture 12
Announcements
 Office hours cancelled this week, should be back to normal
next week
 HW2 scores online
 MT2 scores should be online in the next day or two, I’ll
send out an email when they are
 Bluebooks will be returned on Wednesday
 OK, back to contract law…
1
So far in contract law…
 What types of promises should be binding contracts?
 Breach of contract
 Reliance
 How liability for breach creates incentive for both,
paradox of compensation
 Default rules

C&U: impute the rule the parties would have wanted and apply that


That’s whatever rule would have been efficient – allocating each risk to whoever
can bear it most cheaply
Ayres/Gertner: use default rule to “penalize” one or both

Create incentive for one party to reveal information, or for both parties to
address contingency in contract
2
Discussion question
 Old urban legend:
A man bought a box of extremely rare and expensive cigars, and
insured them against loss or damage.
After smoking them, he filed an insurance claim, saying they had
been destroyed in 20 separate small fires.
The insurance company refused to pay, the man sued and won.
But as he was leaving the courtroom, he was arrested on 20
counts of arson.
 Serious question:
If the intent of a contract is clear, but different from the literal
meaning, which should be enforced?
3
Wrapping up
“penalty defaults”
4
Penalty defaults
 Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete
Contracts: An Economic Theory of Default Rules”
 Sometimes better to make default rule something the
parties would not have wanted



To give incentive to address an issue rather than leave a gap
Or to give one party incentive to disclose information
“Penalty default”
5
Penalty defaults: Hadley v Baxendale
 Baxendale (shipper) is only one who can influence when
crankshaft is delivered; so he’s efficient bearer of risk
 If default rule held Baxendale liable, Hadley has no need to
tell him the shipment is urgent, so Baxendale doesn’t know
and bad outcome is reached
 If default rule didn’t hold Baxendale liable for unforeseen
damages, Hadley would have to tell him about urgency…
 …leading to Baxendale making more efficient choices
(trading off cost vs speed/reliability correctly)
 Even though it’s efficient for Baxendale to bear risk,
efficient default rule might instead “penalize” Hadley for
withholding information!
6
When to use penalty defaults?
 Look at why the parties left a gap in contract


Because of transaction costs  use efficient rule
For strategic reasons  penalty default may be more efficient
 Similar logic in a Supreme Court dissent by Justice Scalia




Congress passed a RICO law without statute of limitations
Majority decided on 4 years – what they thought legislature would
have chosen
Scalia proposed no statute of limitations; “unmoved by the fear that
this… might prove repugnant to the genius of our law…”
“Indeed, it might even prompt Congress to enact a limitations period
that it believes appropriate, a judgment far more within its
competence than ours.”
7
When should a contract
not be enforced?
8
When should voluntary trade not be
allowed?
 Going back to property law…



Coase Theorem: to get efficient outcomes, we should let people
trade whenever they want to
But also saw some exceptions – some trades that aren’t, and
shouldn’t, be allowed
Selling enriched uranium to a terrorist
 Similarly with contract law…


First day: to get efficient outcomes, enforce any contract both
parties wanted enforced
But next, we’ll see exceptions – contracts which shouldn’t be
enforced, due to externalities or market failures/transaction costs
9
Example of an unenforceable contract: a
contract which breaks the law
 Obvious: contract to buy a
kilo of cocaine is unenforceable
10
Example of an unenforceable contract: a
contract which breaks the law
 Obvious: contract to buy a
kilo of cocaine is unenforceable
 Less obvious: otherwise-legal contract whose real purpose
is to circumvent a law




Legal doctrine: derogation of public policy
Derogate, verb. detract from; curtail application of (a law)
Applies to contracts which could only be performed by breaking
law…
…but also to “innocent” contracts whose purpose is to get around a
law or regulation
11
Derogation of public policy – example
 Labor unions required by law to negotiate “in good faith”
 Recent NBA labor troubles



Old CBA: 57% of “basketball-related income” went to player salaries
Owners were offering less than 50%, players demanding 53%...
Imagine the following contract:



“For the next 50 years, if the NBAPA
accepts a CBA paying less than 55%
of BRI in player salaries, then we also
agree that all non-retired players will
work for you as coal miners every
offseason at federal minimum wage.”
Purpose is purely to “bind hands” in
negotiations with ownership
Contract would not be enforced
12
Derogation of public policy
 In general: a contract is not enforceable if it cannot be
performed without breaking the law
 Exception: if promisor knew (and promisee didn’t)




I’m married, my girlfriend in California doesn’t know; I promise her
I’ll marry her, she quits her job and moves to Madison
My company agrees to supply a product that we can’t produce
without violating a safety or environmental regulation
Keeping either promise would require breaking the law…
…but I’d still be liable for damages for breach
 Like in Ayres and Gertner: default rule penalizes betterinformed party for withholding information
13
Default rules versus regulations
 Talked earlier about default rules


Default rules apply if no other rule is specified…
…but can be contracted around
 Rules like “derogation of public policy” cannot be
contracted around


Parties to a contract can’t say, “even though this type of contract
would normally not be valid, this one is”
Rules which always apply: immutable rules, or mandatory rules,
or regulations
 Fifth purpose of contract law is to minimize transaction
costs of negotiating contracts by supplying efficient default
rules and regulations.
14
Ways to get out
of a contract
15
Formation Defenses and Performance
Excuses
 Formation defense


Claim that a valid contract does not exist
(Example: no consideration)
 Performance excuse


Yes, a valid contract was created
But circumstances have changed and I should be allowed to not
perform without penalty
 Most doctrines for invalidating a contract can be explained
as either…


Individuals agreeing to the contract were not rational, or
Transaction cost or market failure
16
One formation defense: incompetence
 Courts will not enforce
contracts with people
who can’t be presumed
to be rational


Children
Legally insane
 Incompetence


One party was “not
competent to enter into
the agreement”
No “meeting of the minds”
17
So…
 If courts won’t enforce a contract signed by someone who
wasn’t competent…
 What if you signed a contract while drunk?



You need to have been really, really, really drunk to get out of a
contract
(“Intoxicated to the extent of being unable to comprehend the
nature and consequences of the instrument he executed”)
Lucy v. Zehmer, Virginia Sup Ct 1954
18
Lucy v. Zehmer
 Zehmer and his wife owned a farm (“the Ferguson farm”),
Lucy had been trying to buy it for some time
 While out drinking, Lucy offers $50,000, Zehmer responds,
“You don’t have $50,000”
 “We hereby agree to sell to
W.O. Lucy the Ferguson Farm
complete for $50,00000, title
satisfactory to buyer.”
19
Lucy v. Zehmer
 Zehmer and his wife owned a farm (“the Ferguson farm”),
Lucy had been trying to buy it for some time
 While out drinking, Lucy offers $50,000, Zehmer responds,
“You don’t have $50,000”
 “We hereby agree to sell to
W.O. Lucy the Ferguson Farm
complete for $50,00000, title
satisfactory to buyer.”
20
Lucy v. Zehmer
 So, you can be pretty drunk and still be bound by the
contract you signed


Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
21
Lucy v. Zehmer
 So, you can be pretty drunk and still be bound by the
contract you signed


Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
 Borat lawsuits

Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk
Journalist for Make Benefit Guileless Americans In Film”
 Moral of the story: don’t get drunk with people who might
ask you to sign a contract
22
Another formation defense:
dire constraints
23
Dire constraints
 Necessity



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



Other party is responsible for situation I’m in
“I made him an offer he couldn’t refuse”
Contract signed at gunpoint would not be
legally enforceable
24
Duress
source: http://news.yahoo.com/man-sues-former-hostages-saysbroke-promise-190902970.html
25
Friedman on duress
 Example



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”


He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?


Makes muggings more profitable  leads to more muggings
Tradeoff: refuse to enforce a Pareto-improving trade, in order to
avoid incentive for bad behavior
26
Friedman on duress
 Example



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”


He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?


Makes muggings more profitable  leads to more muggings
Tradeoff: refuse to enforce a Pareto-improving trade, in order to
avoid incentive for bad behavior
27
What about necessity?
 Same logic doesn’t work for necessity



You get caught in a storm on your $1,000,000 sailboat
Tugboat offers to tow you to shore for $900,000
(Otherwise he’ll save your life but let your boat sink)
 Duress: if we enforce contract, incentive for more crimes
 Necessity: if we enforce contract, incentive for more
tugboats to be available to rescue sailboats

Why is that bad?
28
What about necessity?
“Should I motor around looking for sailboats to save?”





Social cost = private cost = value of my time
Social benefit = probability x (value of boat – cost of tow)
Private benefit = probability x (price I can charge – cost of tow)
If tugboat captain can charge the whole value of the boat,
he spends efficient amount of time saving sailboats!
So maybe we should enforce this contract…
29
What about necessity?
“Should I sail today?”






Suppose tugboat is there to rescue me if there’s a storm
Social benefit = private benefit = how much I enjoy sailing
Social cost = probability x cost of tow
Private cost = probability x price he can charge
If tugboat captain can only charge cost of tow, I sail efficient amount
If he can charge the whole value of the boat, I undersail!
30
Friedman’s point
 Same transaction sets incentives on both parties

Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”


Least inefficient price is somewhere in the middle
And probably not the price that would be negotiated in the middle of
a storm!
31
Friedman’s point
 Same transaction sets incentives on both parties

Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”



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
 More general point


Single price creates multiple incentives
May be impossible to get efficient behavior in all dimensions
32
Real duress versus fake duress
 Court won’t enforce contracts signed under threat of harm

“Give me $100 or I’ll shoot you”
 But many negotiations contain threats


“Give me a raise, or I’ll quit”
“$3,000 is my final offer for the car, take it or I walk”
 The difference?


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
33
Example: Alaska Packers’ Association v
Domenico (US Ct App 1902)
 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, captain refuses to pay the higher wages,
claiming he agreed to them under duress
 Court ruled for captain

Since crew had already agreed to do the work, no new consideration
was given for promise of higher wage
34
A performance excuse:
impossibility
35
Next doctrine for voiding a contract:
impossibility
 When performance becomes impossible, should promisor
owe damages, or be excused from performing?

A perfect contract would explicitly state who bears each risk

Contract may give clues as to how gaps should be filled

Industry custom might be clear

But in some cases, court must fill gap
36
Next doctrine for voiding a contract:
impossibility
 In most situations, when neither contract nor industry norm
offers guidance, promisor is held liable for breach
 But there are exceptions

Change “destroyed a basic assumption on which the contract was
made”
37
Next doctrine for voiding a contract:
impossibility
 In most situations, when neither contract nor industry norm
offers guidance, promisor is held liable for breach
 But there are exceptions

Change “destroyed a basic assumption on which the contract was
made”
 Efficiency requires assigning liability to the party that can
bear the risk at least cost

How to determine who that is?
38
Who is the efficient bearer of a particular risk?
 Friedman offers several bases for making this determination


Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
39
Who is the efficient bearer of a particular risk?
 Friedman offers several bases for making this determination



Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Adverse selection: who is more aware of risk, even if he can’t do
anything about it?
 “…The party with control over some part of the production
process is in a better position both to prevent losses and to
predict them.
It follows that an efficient contract will usually assign the
loss associated with something going wrong to the party
with control over that particular something.”
40
That’s why Hadley v Baxendale was
“surprising”
 Baxendale (shipper) could influence speed of delivery,
Hadley could not
 So Baxendale was efficient bearer of the risk of delay
 Court ruled he didn’t owe damages for lost profits, forcing
Hadley to bear much of this risk


Only makes sense as a “penalty default”
Rule creates incentive for Hadley to reveal urgency of this shipment
41