Econ 522
Economics of Law
Dan Quint
Spring 2011
Lecture 12
Last week
 Reliance
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Investments which depend on performance of contract
Or, investments which increase value of performance
 If damages include expected benefit from reliance
investments, we get overreliance

(But if they don’t, we get inefficient breach)
 Courts tend to compensate for foreseeable reliance
1
Last week
 Paradox of Compensation

Remedy for breach sets incentive for both promisor and promisee
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Promisor: perform or breach
Promisee: how much to rely
Generally impossible to set both incentives efficiently at the same
time
 Default Rules
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Cooter and Ulen: supply rules which most parties would have
wanted (efficient rules)
Ayres and Gertner: penalty defaults (penalize the parties for leaving
a gap, or penalize better-informed party)
2
Regulations
3
Default rules versus regulations
 Default rules can be contracted around; some rules cannot

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.
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Coase: if individuals are rational and there are no transaction costs,
private negotiations lead to efficiency
So additional regulations can only make things worse
But when people are not rational, or when there are transaction
costs/market failures, regulations may help
4
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,
undermine a law or regulation – are not enforceable

Contracts which could only be performed by breaking a law

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)
5
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,
undermine a law or regulation – are not enforceable

Contracts which could only be performed by breaking a law

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)
6
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”
7
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 cost $29,000
But “diminution in value” of farm
was only $300
Original jury awarded $5,000 in
damages, both parties appealed
OK Supreme Court reduced
damages to $300
8
Expectation damages: default rule or
immutable rule?
 At first, sounds like a perfect example 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”
9
We can think about Peevyhouse in terms of
penalty defaults
 Which works better in this case:


Default rule allowing Garland to breach and pay diminution fee?
Default rule forcing Garland to perform restorative work?
 Ayres and Gertner: default rule should “penalize” the
better-informed party

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Garland routinely signed contracts like these
Peevyhouses were doing this for the first time
Default rule allows Garland to pay diminution fee: they have no
reason to bring it up, Peevyhouses don’t know
Default rule forces Garland to do cleanup: if that’s inefficient, they
could bring it up during negotiations
In this case, specific performance would work as a penalty default
10
Ways to get out
of a contract
11
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
12
One formation defense: incompetence
 Courts will not enforce
contracts with people
who can’t be presumed
to be rational


Children
Legally insane
 Incompetence

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One party was “not
competent to enter into
the agreement”
No “meeting of the minds”
13
So…
 If courts won’t enforce a contract signed by someone who
wasn’t competent…
 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
(“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
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 $50,000.00, title
satisfactory to buyer.”
15
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 $50,000.00, title
satisfactory to buyer.”
16
Lucy v. Zehmer
 So, you can be pretty drunk and still be bound by the
contract you signed
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Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
17
Lucy v. Zehmer
 So, you can be pretty drunk and still be bound by the
contract you signed

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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
18
Another formation defense:
dire constraints
19
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
20
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
21
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”


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
22
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?
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, you would
sail the efficient amount
24
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!
25
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
26
More general point
 Single price creates 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
27
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
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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
28
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, refuses higher wages, claiming duress
29
A performance excuse:
impossibility
30
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
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Industry custom might be clear

But in some cases, court must fill gap
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”
32
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
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Party that can take precautions to minimize the risk
Or can best spread the risk over many transactions
33
Who is the efficient bearer of a particular risk?
 Friedman offers several bases for making this determination

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Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
34
Who is the efficient bearer of a particular risk?
 Friedman offers several bases for making this determination


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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.”
35
Hadley v Baxendale
 Suppose…
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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
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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
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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
37
Misinformation
 Four doctrines for invalidating a contract based on faulty
information
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Fraud
Failure to disclose
Frustration of purpose
Mutual mistake
38
Fraud and Failure to Disclose
 Fraud violates “negative duty” not to misinform
 In some circumstances, positive duty to disclose certain
information
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Civil law: contract may be voided if you did not supply information
you should have (“failure to disclose”)
Common law: seller is not forced to disclose everything he knows

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
Must warn about hidden dangers
Need not share information that makes product less valuable but not
dangerous
But, new products come with “implied warranty of fitness”
39
More on duty to disclose
 Sellers must inform buyers about hidden safety risks
 Common law does not generally require disclosure of other
types of information
 But…




Obde v Schlemeyer (1960)
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
40
More on duty to disclose
 Sellers must inform buyers about hidden safety risks
 Common law does not generally require disclosure of other
types of information
 But…




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Obde v Schlemeyer (1960)
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
Many states require used car dealers to reveal major repairs done,
sellers of homes to reveal certain types of defects…
41
Frustration of Purpose
 Both parties based a contract on the same bad
information  contract may be voided due to frustration of
purpose
 Coronation Cases
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Rooms rented out with view of new king’s coronation parade
Parade was postponed, owners still tried to collect rent
Courts ruled change in circumstance had frustrated the purpose
of the original contracts, which were therefore void
 “When a contingency makes performance pointless,
assign liability to the party who can bear the risk at least
cost”
42
Mutual Mistake
 Frustration of purpose: circumstances changed after the
contract was signed
 Mutual mistake: circumstances changed before the
contract was signed, but the parties didn’t know about it
 Enforcing the contract would be like forcing involuntary
exchange
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Coase: we expect voluntary exchange to be efficient
But involuntary exchange may not be
43
Another principle: knowledge and control
 Hadley v Baxendale (miller and shipper)

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Hadley knew shipment was time-critical
But Baxendale was deciding how to ship crankshaft (boat or train)
 A general principle about information: efficiency generally
requires uniting knowledge and control
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
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
44
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
45
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

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Contracts based on unilateral mistake generally unite knowledge
and control
And this creates an incentive to gather information
46
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
47
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


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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
48