Econ 522
Economics of Law
Dan Quint
Fall 2010
Lecture 12
Logistics
 Midterm and HW2 will be returned at the end of lecture
 HW3 is online – due Fri Nov 5
1
Monday: how big a problem is trust
 Player A starts with $10


Chooses how much of it to give to player B
That money is tripled
 Player B has $10, plus 3x whatever A gave him/her

Chooses how much (if any) to give back to player A
 We played the game three ways:



Anonymously – A and B don’t know who each other are
Face to face – A and B know who each other are, and can discuss
the game before playing, but their actions remain private
In public – A and B play out loud in front of the whole class
2
Monday: how big a problem is trust?
 Face to face: trust is not a problem

Every pair got maximum joint payoffs ($40), even split ($20 each)
 In front of whole class: trust is not a problem

Every pair got maximum joint payoffs
 In anonymous setting: trust is a bit of a problem




Player A sent $6.92 on average, so 69% of gains were realized
Player B got back $7.78 on average
Of those who sent money, 27% got back nothing, including 30% of
those who sent $10
Of those who sent money, 34% got back less than they sent,
including 37% of those who sent $10
3
In the anonymous treatment…
Average payoff for
player A if he/she sent x
14
12
10
8
6
Average money back from
player B if player A sent x
4
2
0
0
1
2
3
4
5
6
7
8
9
10
4
In the anonymous treatment…
Observ.
Average
received
Avg payoff
(player A)
Average
ROI
% who got
back 0
% who got
back less
0
3
0.33
10.33
-
67%
-
1,2,3
6
2.00
9.67
-22%
50%
50%
4,5,6
21
6.43
11.33
26%
24%
24%
7,8,9
8
7.75
10.38
4%
13%
38%
10
27
10.96
10.96
10%
30%
37%
All
65
7.78
10.86
11%
27%
34%
5
Monday: reliance and default rules
 Reliance

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
6
Plane worth $500,000 to you, price $350,000
Incentives for reliance:
example
Cost: either $250,000 or $1,000,000
$x investment  600x increase in value of
performance
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
7
Plane worth $500,000 to you, price $350,000
Three questions
Cost: either $250,000 or $1,000,000
$x investment  600x increase in value of
performance
 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?
8
Plane worth $500,000 to you, price $350,000
Three questions
Cost: either $250,000 or $1,000,000
$x investment  600x increase in value of
performance
 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
9
Paradox of compensation
 Remedy for breach sets incentive for both promisor and
promisee


Promisor: perform or breach
Promisee: how much to rely
 Generally impossible to set both incentives efficiently at the
same time
10
Also Monday: default rules
 Default rules

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)
11
Regulations
12
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.



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
13
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)
14
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)
15
Derogation of public policy
 In general: contracts which can only be performed by
breaking the law are not enforceable
 But…



“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”
16
Expectation damages: default rule or
immutable rule?
 Peevyhouse v Garland Coal and Mining Co
(OK Supreme Court, 1962)






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
17
Expectation damages: default rule or
immutable rule?
 Seems like classic case of efficient breach



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…



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”
18
We can also 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





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
19
Ways to get out
of a contract
20
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
 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
21
Incompetence
 Courts will not enforce contracts by irrational individuals


Children
Legally insane
 Doctrine of incompetence


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?

You need to have been really, really, really drunk to get out of a
contract
22
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)
23
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)
24
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)
25
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)
26
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
27
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

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
28
Another formation defense:
dire constraints
29
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
Someone makes me an offer I can’t refuse
30
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: don’t enforce Pareto-improving trade, in order to avoid
incentive for bad behavior
31
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: don’t enforce Pareto-improving trade, in order to avoid
incentive for bad behavior
32
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






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?
33
What about necessity?
 What about your decision: whether to sail that day










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
34
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!
35
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
36
More general point
 Single price can create multiple incentives
 Often impossible to set them all efficiently




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
37
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
38
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
39
A performance excuse:
impossibility
40
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
41
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”
42
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


Party that can take precautions to minimize the risk
Or can best spread the risk over many transactions
43
Important general concept
 Who is the efficient bearer of a particular risk?


Also called low-cost avoider
Who is in best position to mitigate/reduce a risk, or hedge it, or
endure it?
 We already saw this question with efficient default rules


When a contract leaves a gap, an efficient contract would have
allocated each risk to low-cost avoider
Construction company building a house, completion is delayed


Family might be efficient risk-bearer, because it’s cheaper for them to
stay with friends than for construction company to pay for hotel
Cost of raw materials goes up, increasing cost of construction

Construction company might be efficient risk-bearer, because they can
buy materials early or change design plans
44
Contracts based on
bad information
45
Misinformation
 Four doctrines for invalidating a contract based on faulty
information




Fraud
Failure to disclose
Frustration of purpose
Mutual mistake
46
Fraud and Failure to Disclose
 Fraud violates “negative duty” not to misinform
 In some circumstances, positive duty to disclose certain
information


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



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”
47
Frustration of Purpose
 Both parties based a contract on the same bad
information  contract may be voided due to frustration of
purpose
 Coronation Cases



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”
48
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


Coase: we expect voluntary exchange to be efficient
But involuntary exchange may not be
49
Another principle: 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)
 A general principle about information: 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
50
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
51
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 this creates an incentive to gather information
52
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
53
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 – especially if that knowledge was the result of active
investment – should be enforced
Contracts based on one party’s knowledge of purely redistributive
information or fortuitously acquired information should not be
enforced
54
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
Sale did not unite knowledge and control
55
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
Sale did not unite knowledge and control
Many states require used car dealers to reveal major repairs done,
sellers of homes to reveal certain types of defects…
56
Midterms
57
Midterm
 Overall pretty good
 Mean 81, median 84, std dev 10
 Not actually assigning letter grades till after final
 But to have an approximate idea of where you stand…
90s
roughly AB or A
80s
roughly B
70s
roughly BC
high 50s/60s
roughly C
A-G
H-N
O-Z
58