Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 11
Contract law: the story so far
 Contract = legally binding promise


Allow for cooperation/trade when transactions aren’t instantaneous
First purpose of contract law: enable cooperation
 What promises should be enforced?

Bargain theory: those given as part of a bargain


Requires consideration – promisee giving up something in exchange
for the promise
Efficiency: any promise both promisor and promisee wanted to be
enforceable

Think of Coase – allow all voluntary transactions to get to efficiency
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Contract law: the story so far
 May become efficient/necessary to break a promise


When should a contract be breached? Breach is efficient when
cost to perform > benefit of performance to promisee
When will breach happen? Breach is in promisor’s interest when
cost to perform > promisor’s liability from breach
 Expectation damages: liability from breach = benefit
expected by promisee


Leads to breach exactly when it’s efficient
Also leads to efficient level of investment in performance

“Designing the law to internalize an externality”
 What else can contract law accomplish?
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Reliance
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Reliance
 You expect an airplane to arrive
in spring – you might…



Sign up for flying lessons
Build yourself a hangar
Buy a helmet and goggles
 Reliance – investments which depend on performance
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Reliance increases the value of performance to promisee
Reliance increases the social cost of breach
 The fourth purpose of contract law is to secure optimal
reliance
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When is reliance efficient?
 When social benefit of reliance > social cost of reliance
 Social benefit: increased benefit to promisee


(Value of airplane + hangar) – (Value of airplane without hangar)
Value is only realized if the promise is performed
 Social cost: direct cost borne by promisee

Cost occurs whether or not promise is performed
 Reliance is efficient whenever
Increase in
value of
performance
X
Probability of
performance
>
Cost of
investment
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How should reliance figure into damages?
 Expectation damages = expected benefit from performance

If your reliance investment increases your anticipated benefit…

should it increase the damages I owe you if I breach?

Can we design damages to get efficient reliance, in addition to
efficient breach?
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Reliance and damages:
example
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 You’re buying an airplane from me




Price is $350,000, to be paid on delivery
Airplane alone gives you benefit of $500,000
Building a hangar costs $75,000
Airplane with hangar gives you benefit of $600,000
 Without hangar, expectation damages = $150,000
 If you build a hangar and I fail to deliver plane, do I owe…




$150,000? (Value of original promise)
$250,000? (Value of performance after your investment)
$225,000? (Value of original promise, plus reimburse you for
investment you made)
Some other amount?
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To get efficient breach…
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 The only way to guarantee efficient breach is if damages
included the added benefit from reliance



Once you’ve made investment, you anticipate benefit of $250,000
from performance
If damages are anything less than that, I’ll breach too often
(If damages exclude the added benefit, then I’m back to imposing
an externality when I choose to breach the contract)
 So what happens to the incentive for reliance investments
if damages will increase to include this added benefit?
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If exp damages include
benefit from reliance…
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 If you don’t build hangar, your payoff will be…


$150,000 if I deliver the plane ($500,000 – $350,000)
$150,000 if I breach and pay expectation damages
 If you build hangar, your payoff will be…


$175,000 if I deliver the plane ($600,000 – $350,000 – $75,000)
$175,000 if I breach and pay (higher) expectation damages
 So if expectation damages include the increased value of
performance due to reliance investments…


You’ll invest whenever (increase in benefit) > (cost)
In this case, you’ll invest (because $100,000 > $75,000)
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If exp damages include
benefit from reliance…
Price of plane = $350,000
Value of plane = $500,000
Cost of hangar = $75,000
Value of plane + hangar = $600,000
 If expectation damages include increased value of
performance, you’ll invest for sure
 Is this efficient?



Reliance is efficient if
(increase in benefit) X (probability of performance) > (cost)
$100,000 X (probability of performance) > $75,000
Only efficient if probability of performance > ¾
If probability of performance < ¾, reliance is inefficient, but happens
anyway
 Overreliance!
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Better example:
continuous investment
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500,000 + 600x
Additional
value of
plane
y  600 x
Designer hangar with Starbucks - $480,000
Functional heating - $240,000
Metal poles, rigid roof - $120,000
Plywood frame, canvas roof - $60,000
Tarp and rope - $6,000 benefit
Investment in hangar
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Three questions
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500,000 + 600x
 Let p be probability of breach
 Three questions

What is the efficient level of reliance?

What will promisee do if expectation damages include anticipated
benefit from reliance?

What will promisee do if expectation damages exclude anticipated
benefit from reliance?
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Three questions
Price of plane = $350,000
Cost: either $250,000 or $1,000,000
Value of plane + $x hangar =
$500,000 + 600x
 Let p be probability of breach
 Three questions

What is the efficient level of reliance?
x = $90,000 (1 – p)2

What will promisee do if expectation damages include anticipated
benefit from reliance?
x = $90,000

What will promisee do if expectation damages exclude anticipated
benefit from reliance?
x = $90,000 (1 – p)2
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Overreliance
 If reliance investments increase the damages you’ll receive
in the event of breach, you’ll over-rely

You’ll rely if
Increase
in benefit


+
Increase
in damages
X
Prob. of
breach
>
Cost of
investment
>
Cost of
investment
Efficient to rely if
Increase
in benefit

X
Prob. of
perform.
X
Prob. of
perform.
So if damages increase when you make reliance investments, we’re
sure to get overreliance!
(Your investment imposes an externality on me)
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Reliance and breach
 Just showed: if damages include added benefit from
reliance, promisee will invest more than efficient amount
 But if damages exclude added benefit…



Then promisor’s liability < promisee’s benefit from performance
Which means: promisor will breach more often than efficient
And promisor will underinvest in performance
 “Paradox of compensation”


Single “price” (damages owed) sets multiple incentives…
…impossible to set them all efficiently!
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So what do we do?
 Cooter and Ulen: include only efficient reliance


Perfect expectation damages: restore promisee to level of wellbeing he would have gotten from performance if he had relied the
efficient amount
So promisee rewarded for efficient reliance, not for overreliance
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So what do we do?
 Cooter and Ulen: include only efficient reliance


Perfect expectation damages: restore promisee to level of wellbeing he would have gotten from performance if he had relied the
efficient amount
So promisee rewarded for efficient reliance, not for overreliance
 Actual courts: include only foreseeable reliance

That is, if promisor could reasonably expect promisee to rely that
much
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Foreseeable reliance: Hadley v Baxendale
 1850s England
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Hadley ran flour mill, crankshaft broke
Baxendale’s firm hired to transport
broken shaft for repair
Baxendale shipped by boat instead of
train, making it a week late
Hadley sued for the week’s lost profits
 “The shipper assumed that Hadley, like most millers, kept a
spare shaft. …Hadley did not inform him of the special
urgency in getting the shaft repaired.”


Court listed several circumstances where broken shaft would not
force mill to shut down
Ruled lost profits not foreseeable  Baxendale didn’t have to pay18
Foreseeable reliance: Hadley v Baxendale
 “Before you can award damages
for wages paid and lost sales while
the mill was idle, you must first find
that at that time they entered into
the contract to ship the crankshaft,
the shipping company contemplated
that the mill owner would suffer
those idleness damages as a result
of late delivery.”
 To award damages for lost sales, Hadley should have to
prove that Baxendale could have predicted those losses
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Foreseeable reliance: Hadley v Baxendale
 Why didn’t Hadley and Baxendale
just specify in the original contract
what happens in case of delay?
 What rules should apply in circumstances that aren’t
addressed in a contract?
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Default Rules
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Default rules
 Gaps: risks or circumstances that aren’t specifically
addressed in a contract
 Default rules: rules applied by courts to fill gaps
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Default rules
 Gaps: risks or circumstances that aren’t specifically
addressed in a contract
 Default rules: rules applied by courts to fill gaps
 Writing something into a contract vs leaving a gap


Allocating a risk (ex ante), before it becomes a loss
Versus allocating a loss (ex post)

Only have to deal with it if the loss occurs
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What should default rules be?
 Cooter and Ulen: use the rule parties would have wanted,
if they had chosen to negotiate over this issue
 This will be whatever rule is efficient
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What should default rules be?
 Cooter and Ulen: use the rule parties would have wanted,
if they had chosen to negotiate over this issue
 This will be whatever rule is efficient
 Fifth purpose of contract law is to minimize transaction
costs of negotiating contracts by supplying efficient
default rules

Do this by imputing the terms the parties would have chosen if they
had addressed this contingency
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Default rules
 Don’t want ambiguity in the law
 So default rule can’t vary with every case
 Majoritarian default rule: the terms that most parties would
have agreed to

In cases where this rule is not efficient, parties can still override it in
the contract
 Court: figure out efficient allocation of risks, then
(possibly) adjust prices to compensate
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?



Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?



Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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Default rules
 So, Cooter and Ulen say: set the default rule that’s efficient
in the majority of cases

Most contracts can leave this gap, save on transaction costs

In cases where this rule is inefficient, parties can contract around it
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Default rules: a different view
 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”
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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 Hadley might hide this information, which is inefficient


Ayres and Gertner: Ruling in Hadley was a good one, not because
it was efficient, but because it was inefficient…
…but in a way that created incentive for disclosing information
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Penalty defaults: example
 Suppose…


80% of millers are low-damage – suffer $100 in losses from delay
20% of millers are high-damage – suffer $200 in losses from delay
 Shipper liable for actual damages



Average miller would suffer $120 in losses
Shipper makes efficient investment for average type
But not efficient for either type
 Shipper liable for foreseeable damages


Shipper makes efficient investment for low-damage millers
High-damage millers have strong incentive to negotiate around
default rule
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Penalty defaults: other examples
 Real estate brokers and “earnest money”


Broker knows more about real estate law
Default rule that seller keeps earnest money encourages broker to
bring it up if it’s efficient to change this
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Penalty defaults: other examples
 Real estate brokers and “earnest money”


Broker knows more about real estate law
Default rule that seller keeps earnest money encourages broker to
bring it up if it’s efficient to change this
 Courts will impute missing price of a good, but not quantity

Forces parties to explicitly contract on quantity, rather than leave it
for court to decide
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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



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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
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competence than ours.”
When should a contract
not be enforced?
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When should a contract not be enforced?
 We said earlier: in general, efficiency requires enforcing
contract whenever both sides wanted it to be enforced


Coase: if people are rational and there are no transaction costs,
private negotiations should lead to efficiency…
…so any additional regulations/limitations on trade can only make
things worse
 But: if a contract imposes externalities, or there are
transaction costs or market failures, maybe not
 Next: settings where a contract may not be enforced
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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
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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
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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
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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.
 Next week: other reasons a contract might not be enforced
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