Econ 522
Economics of Law
Dan Quint
Fall 2010
Lecture 13
Last Wednesday…
 Example of reliance, and why we might get overreliance
 Regulations, derogation of public policy
 Formation defenses and performance excuses


Incompetence (but not drunkenness)
Duress and necessity
 Today: more ways to get out of a contract
1
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
2
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
3
A performance excuse:
impossibility
4
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
5
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”
6
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
7
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
8
Who is the efficient bearer of a particular risk?
 When performance becomes impossible, assign liability to
party who can bear risk at least cost
 How do we know who this is? Friedman offers several
bases for this decision…


Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
9
Who is the efficient bearer of a particular risk?
 When performance becomes impossible, assign liability to
party who can bear risk at least cost
 How do we know who this is? Friedman offers several
bases for this decision…




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
10
over that particular something.”
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
11
Contracts based on
bad information
12
Misinformation
 Four doctrines for invalidating a contract based on faulty
information




Fraud
Failure to disclose
Frustration of purpose
Mutual mistake
13
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”
14
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”
15
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
16
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
17
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
18
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
19
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
20
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
21
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
22
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…
23
Other reasons a contract
may not be enforced
24
Vague contract terms
 Courts will generally not enforce contract terms that are
overly vague
 Can be thought of as a penalty default
 But some exceptions

Parties may commit to renegotiating the contract “in good faith”
under certain contingencies
25
Fairness
 Bargain theory: courts ask only whether a contract was
part of a bargain, not whether that bargain was fair

Hamer v Sidway (drinking and smoking)
 But two common law doctrines to get out of extremely
one-sided contracts


Adhesion
Unconscionability
26
Contracts of adhesion
 Adhesion: standardized “take-it-or-leave-it” contracts

Friedman calls it “bogus duress”
 One extreme version: “shrink-wrap licenses”

“By opening the box, you have already agreed to…”
 More general problem: people never read the fine print…
27
Adhesion?
Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/
28
Adhesion?
 British computer game retailer GameStation, on April Fool’s
Day, added this to Terms & Conditions customers agreed to
before buying online:
“By placing an order via this website… you agree to grant us a non
transferable option to claim, for now and for ever more, your
immortal soul.
Should we wish to exercise this option, you agree to surrender your
immortal soul, and any claim you may have on it, within 5 (five)
working days of receiving written notification from
gamestation.co.uk or one of its duly authorised minions.
…If you a) do not believe you have an immortal soul, b) have
already given it to another party, or c) do not wish to grant us such a
license, please click the link below to nullify this sub-clause and
proceed with your transaction.”
29
Unconscionability
 Overly one-sided contract may not be enforced
 Terms “such that no man in his senses and not under
delusion would make on the one hand, and as no honest
and fair man would accept on the other”
 When “the sum total of its provisions drives too hard a
bargain for a court of conscience to assist”
 Terms which would “shock the conscience of the court”
 Similar concept in civil law: lesion
30
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “Unconscionability has generally been recognized to
include an absence of meaningful choice on the part of
one of the parties together with contract terms which are
unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is
negated by a gross inequality of bargaining power.”
31
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “Unconscionability has generally been recognized to
include an absence of meaningful choice on the part of
one of the parties together with contract terms which are
unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is
negated by a gross inequality of bargaining power.”
32
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “Unconscionability has generally been recognized to
include an absence of meaningful choice on the part of
one of the parties together with contract terms which are
unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is
negated by a gross inequality of bargaining power.”
 Not normal monopoly cases but “situational monopolies”

Think of Ploof v Putnam (sailboat in a storm), not Microsoft
33
Remedies for breach
of contract
34
Three broad types of remedy for breach of
contract
 Party-designed remedies

Remedies specified in the contract
 Court-imposed damages

Court may decide promisee entitled to some level of damages
 Specific performance

Forces breaching party to live up to contract
35
Expectation damages
 Compensate promisee for the amount he expected to
benefit from performance




You agreed to buy an airplane for $350,000
You expected $500,000 of benefit from it
Expectation damages: if I breach, I owe you that benefit
($500,000 if you already paid, $150,000 if you didn’t)
 “Positive damages”
 Make promisee indifferent between performance and breach
36
Reliance damages
 Reimburse promisee for cost of any reliance investments
made, but not for additional surplus he expected to gain
 Restore promisee to level of well-being before he signed
the contract


You contracted to buy the plane and built a hangar
If I breach, I owe you what you spent on the hangar, nothing else
 “Negative damages” – undo the negative (harm) that
occurred
37
Opportunity cost damages
 Give promisee benefit he would have gotten from his
next-best option






Make promisee indifferent between breach of the contract that
was signed, and performance of best alternative contract
You value plane at $500,000
You contract to buy plane from me for $350,000
Someone else was selling similar plane for $400,000
By the time I breach, that plane is no longer available
I owe you $100,000 – the benefit you would have gotten from
buying the other seller’s plane
38
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Michigan football
game for $50



Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of face paint and giant foam
finger
39
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Michigan football
game for $50






Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of face paint and giant foam
finger
When you agreed to sell me ticket, other tickets available for $70
Opportunity cost damages: $80
(I paid a scalper $150 to get in; I would have been $80 better off if
I’d ignored your offer and paid someone else $70)
40
Ranking damages
Contract
I Sign

Best
Alternative

Do Nothing
=
=
=
Breach +
Expectation
Damages

Breach +
Opportunity Cost
Damages

Breach +
Reliance
Damages

Opportunity Cost
Damages

Reliance
Damages
Expectation
Damages
$100
$80
$0-20
41
Hawkins v McGee (“hairy hand case”)
 Hawkins had a scar on his hand
 McGee promised surgery to “make the hand a hundred
percent perfect”
 Surgery was a disaster, left scar bigger and covered with
hair
42
Hawkins v McGee (“hairy hand case”)
+ Opp Cost
Damages
+ Reliance
Damages
Initial Wealth
Opp Cost Damages
Reliance Damages
+ Expectation
Damages
Expectation Damages
$
Hand
Hairy Scarred
Next
best
doctor
100%
Perfect
43
Recapping different types of damages
 Expectation damages

Give promisee benefit he would have had from performance
 Opportunity cost damages

Give promisee benefit he would have had from next-best contract
 Reliance damages

Give promisee benefit he would have had from doing nothing
 Expectation Dam  Opp Cost Dam  Reliance Dam

But order can be reversed when calculated incorrectly
44
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
45
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
 Specific Performance




Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
46
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
 Specific Performance




Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
47
Party-designed remedies
 Remedy for breach could be written directly into contract
 But common law courts don’t always enforce remedy terms




Liquidated damages – party-specified damages that reasonably
approximate actual harm done by breach
Penalty damages – damages greater than actual harm done
Civil law courts are generally willing to enforce penalty damages
But common law courts often do not
48
Penalty Damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
 Peevyhouse v Garland Coal







Peevyhouses only wanted farm strip-mined if it would be restored to
original condition after
Suppose coal extracted worth $70,000
Garland paid $25,000 for rights to mine it
Restoration work would cost $30,000
Diminution of value was $300
So liquidated damages would be $300
Suppose Peevyhouses got $40,000 of disutility from land being left
in poor condition
49
Liquidated damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay damages
(-14,700, 44,700)
 If damages limited to liquidated damages…



Peevyhouses have no reason to believe restorative work will get done
So Peevyhouses better off refusing to sign
Even though mining and restoring Pareto-dominates
50
Penalty damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay penalty
(25,000, 5,000)
 If penalty clauses in contracts enforceable…



Write contract with $40,000 penalty for leaving land unrestored
Now restoration work would get done, so Peevyhouses willing to sign
But if courts won’t enforce penalty damages, this won’t work
51
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus




I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
52
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus





I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
Similarly, Peevyhouse example



Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is
not restored
Equivalently, get $65,000 for mining rights, pay $40,000 bonus if
restoration is completed
But, if intent of contract is too transparent, still might not be enforced
53