Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 12
Logistics
 Midterm will be returned at end of lecture
 HW2 is online, due in two weeks (Wed Mar 17)
 Second midterm Wed Mar 24
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Cumulative, through end of contract law
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Last time…
 Default rules
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Why are gaps left in contracts?
What rules should be applied to fill those gaps?
C&U: use terms most parties would have chosen (efficient terms)
Ayres and Gertner: under some conditions, use default rules which
penalize one or both parties for concealing information
 Regulations
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Example: derogation of public policy
 Ways to get out of a contract
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Formation defenses (“no contract exists”)
Performance excuses (“circumstances have changed”)
One formation defense: incompetence (but not drunkenness)
2
Another formation defense:
dire constraints
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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
4
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
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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
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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?
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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
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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!
9
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
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More general point
 Single price can create 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
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Real duress versus fake duress
 Court won’t enforce contracts signed under threat of harm
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“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
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Example
 Alaska Packers’ Association v Domenico (US Ct App 1902)
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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
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A performance excuse:
impossibility
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Next doctrine for voiding a contract:
impossibility
 When performance becomes impossible, should promisor
owe damages, or be excused from performing?
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A perfect contract would explicitly state who bears each risk
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Contract may give clues as to how gaps should be filled
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Industry custom might be clear
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But in some cases, court must fill gap
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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
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Change “destroyed a basic assumption on which the contract was
made”
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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
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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
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Important general concept
 Who is the efficient bearer of a particular risk?
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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
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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
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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
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Construction company might be efficient risk-bearer, because they can
buy materials early or change design plans
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Contracts based on
bad information
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Misinformation
 Four doctrines for invalidating a contract based on faulty
information
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Fraud
Failure to disclose
Frustration of purpose
Mutual mistake
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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”
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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”
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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
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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
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Unilateral mistake
 Mutual mistake: neither party had correct information
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Contract neither united nor separated knowledge and control
 Unilateral mistake: one party has mistaken information
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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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Unilateral mistake
 Mutual mistake: neither party had correct information
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Contract neither united nor separated knowledge and control
 Unilateral mistake: one party has mistaken information
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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
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Unilateral mistake: Laidlaw v Organ (U.S.
Supreme Court, 1815)
 War of 1812: British blockaded port of New Orleans
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Price of tobacco fell, since it couldn’t be exported
 Organ (tobacco buyer) learned the war was over
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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
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Supreme Court ruled that Organ was not required to communicate
his information
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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 – 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
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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
Sale did not unite knowledge and control
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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
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…
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Other reasons a contract
may not be enforced
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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
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Parties may commit to renegotiating the contract “in good faith”
under certain contingencies
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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
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Adhesion
Unconscionability
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Adhesion and unconscionability
 Adhesion: standardized “take-it-or-leave-it” contracts
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Friedman calls it “bogus duress”
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Adhesion and unconscionability
 Adhesion: standardized “take-it-or-leave-it” contracts
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Friedman calls it “bogus duress”
 Unconscionability
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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
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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.”
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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.”
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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”
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Think of Ploof v Putnam (sailboat in a storm)
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Midterms
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Midterm
 Overall pretty good
 Mean 82, median 84, std dev 14
 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-H
I-P
Q-Z
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