Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 12
Contract law so far
 What is a contract? Why do we need them?
 Which contracts should be enforced?
 Breach of contract. What should happen? Can we design
law to get efficient amount of breach?
 Reliance investments. Can we design law to get efficient
amount of reliance investments?
 Default rules. Two views of how to use default rules to
increase efficiency.
 This week: when should contracts not be enforced?
1
When should a contract
not be enforced?
2
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
3
Discussion question
 “For efficiency, enforce any contract which both the promisor and
the promisee wanted to be enforceable when it was signed”
4
Example of an unenforceable contract: a
contract which breaks the law
 Obvious: contract to buy a
kilo of cocaine is unenforceable
5
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
6
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
7
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
8
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.
9
Ways to get out
of a contract
10
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
11
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”
12
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
13
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.”
14
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.”
15
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
16
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
17
Another formation defense:
dire constraints
18
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
19
Duress
source: http://news.yahoo.com/man-sues-former-hostages-saysbroke-promise-190902970.html
20
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
21
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
22
What about necessity?
 Same logic doesn’t work for necessity



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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
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Here: if we enforce contract, incentive for more tugboats to be
available for rescues – why 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?
23
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, your private
cost = social cost and you would sail the efficient amount
24
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!
25
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
26
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
27
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
28
A performance excuse:
impossibility
29
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
30
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”
31
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?
32
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?
33
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.”
34
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
35
Hadley v Baxendale
 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
36
Contracts based on
bad information
(may not get to this)
37
Contracts based on faulty information
 Four doctrines for invalidating a contract

Fraud

Failure to disclose

Frustration of purpose

Mutual mistake
38
Fraud
 Fraud: one party was deliberately tricked
source: http://www.wyff4.com/r/29030818/detail.html
39
What if you trick someone by withholding
information?
 Under the civil law, there is a duty to disclose

If you fail to supply information you should have, contract will be
voided – failure to disclose
 Less so under the common law




Seller only has to share information about hidden dangers…
…not information that makes a product less valuable but not
dangerous
Exception: new products come with “implied warranty of fitness”
Another exception: Obde v Schlemeyer
40
Duty to disclose under common law
 Under common law, seller required to inform buyer about
hidden safety risks, generally not other information
 But…




Obde v Schlemeyer (1960, Sup Ct of WA)
Seller knew building was infested with termites, did not tell buyer
Termites should have been exterminated immediately to prevent
further damage
Court in Obde imposed duty to disclose (awarded damages)
41
Duty to disclose under common law
 Under common law, seller required to inform buyer about
hidden safety risks, generally not other information
 But…





Obde v Schlemeyer (1960, Sup Ct of WA)
Seller knew building was infested with termites, did not tell buyer
Termites should have been exterminated immediately to prevent
further damage
Court in Obde imposed duty to disclose (awarded damages)
Some states require used car dealers to reveal major repairs done,
sellers of homes to reveal certain types of defects…
42
What if both parties were misinformed?
Frustration of Purpose

Change in circumstance
made the original promise
pointless

Coronation Cases

“When a contingency
makes performance
pointless, assign liability to
party who can bear risk at
least cost”
43
What if both parties were misinformed?
Frustration of Purpose

Change in circumstance
made the original promise
pointless
Mutual Mistake

Mutual mistake about facts



Coronation Cases

“When a contingency
makes performance
pointless, assign liability to
party who can bear risk at
least cost”

Circumstances had already
changed, but we didn’t know
Logger buys land with timber
on it, but forest fire had
wiped out the timber the
week before
Mutual mistake about identity

Disagreement over what was
being sold
44
Another principle for allocating risks
efficiently: uniting knowledge and control
 Hadley v Baxendale (miller and shipper)



Hadley knew shipment was time-critical
But Baxendale was deciding how to ship crankshaft (boat or train)
Party that had information was not the party making decisions
 Efficiency generally requires uniting knowledge and
control


Contracts that unite knowledge and control are generally efficient,
should be upheld
Contracts that separate knowledge and control may be inefficient,
should more often be set aside
45
Mutual vs. Unilateral Mistake
 Mutual mistake: neither party had correct information

Contract neither united nor separated knowledge and control
 Unilateral mistake: one party has mistaken information


I know your car is a valuable antique, you think it’s worthless
You sell it to me at a low price
 Contracts based on unilateral mistake are generally
upheld
46
Unilateral mistake
 Mutual mistake: neither party had correct information

Contract neither united nor separated knowledge and control
 Unilateral mistake: one party has mistaken information


I know your car is a valuable antique, you think it’s worthless
You sell it to me at a low price
 Contracts based on unilateral mistake are generally
upheld


Contracts based on unilateral mistake generally unite knowledge
and control
And, enforcing them creates an incentive to gather information
47
Unilateral mistake: Laidlaw v Organ (U.S.
Supreme Court, 1815)
 War of 1812: British blockaded port of New Orleans

Price of tobacco fell, since it couldn’t be exported
 Organ (tobacco buyer) learned the war was over

Immediately negotiated with Laidlaw firm to buy a bunch of tobacco
at the depressed wartime price
 Next day, news broke the war had ended, price of tobacco
went up, Laidlaw sued

Supreme Court ruled that Organ was not required to communicate
his information
48
Unilateral mistake: productive versus
redistributive information
 Productive information: information that can be used to
produce more wealth
 Redistributive information: information that can be used to
redistribute wealth in favor of informed party
 Cooter and Ulen



Contracts based on one party’s knowledge of productive
information should be enforced…
…especially if that knowledge was the result of active investment
Contracts based on one party’s knowledge of purely redistributive
information, or fortuitously acquired information, should not be
enforced
49