Econ 522 – Lecture 10 (Oct 9 2007)
Our next big topic: contract law
Fundamentally, contract law is the attempt to make certain types of promises legally
binding
Why do we want this? Suppose I have an opportunity to make a valuable investment, but
I don’t have any money. You have some money, but don’t have access to the investment
on your own. You could give me your money, I could invest it for you, and then we
could split the proceeds: if you lent me $100, I could invest it, double our money, and
promise to give you back $150 and keep $50 for myself.
But there’s no way for you to be sure, once I’ve doubled your money, that I’ll choose to
give you back your share. We can draw this as a simple game tree:
Keep all the money
(0, 200)
Me
Trust me
You
Share
(150, 50)
Don’t
(100, 0)
This is a classic example of an agency game – there’s some surplus we can achieve
together, but it requires you to trust me. But if we look at my incentives here once
you’ve given me the money, I have no reason to give you your money back. Since you
anticipate this problem, you refuse to trust me, so we miss out on this great opportunity.
The important thing to note here is: it’s not just that you’re worse off because you can’t
trust me; I’m worse off too, since my inability to commit to returning your money causes
us to miss out on the investment.
(One powerful way around this problem is to rely on reputation. That is, if this is a
situation we find ourselves in over and over, it becomes valuable to me to be looked at as
someone who is trustworthy; that way, you can keep investing your money with me, and
we both do better. So if the game is to be repeated many times, we may be able to
cooperate even when we could not in a one-shot game. The Friedman book gives the
example of the diamond industry in New York, where disputes are never settled in court.
There is a tight community of sellers (mostly orthodox Jews initially, now less so),
everyone knows everyone, and reputation as an honest seller is vital. This is part of the
success of eBay – realizing that making sellers’ reputations public would give a strong
incentive to behave well. However, many interactions are “one-shot” – this is the only
time I expect to deal with a person, and the incentives to maintain a good reputation may
be too small.)
What contract law does is give us one way to change this game into one that has a
cooperative solution. Suppose we can sign a contract, under which I am punished if I run
off with all the money. The punishment doesn’t have to be too severe – it just has to be
bad enough that I’d rather share the gains rather than face the punishment. Suppose that
the punishment is that a court steps in and forces me to give you back your $150, and
charges each of us an additional $25 fee for doing so. This changes the game to:
Keep all the money
(125, 25)
Me
Trust me
You
Share
(150, 50)
Don’t
(100, 0)
Now there is a way for us to cooperate. After the investment, I’m better off giving you
back your share of the money; so now you have a reason to trust me, and we get the
benefit of the investment.
So that’s the first purpose of contract law: to allow for efficient trade in situations where
this requires some sort of commitment ability, that is, some way to make a promise
credible.
Of course, this begs a number of different questions, first among them, exactly what
types of promises should be enforced by the law? The book motivates the question with
three examples:
1. “The rich uncle of a struggling college student learns at the graduation party that
his nephew graduated with honors. Swept away by good feeling, the uncle
promises the nephew a trip around the world. Later the uncle reneges on his
promise. The student sues his uncle, asking the court to compel the uncle to pay
for a trip around the world.”
2. “One neighbor offers to sell a used car to another for $1000. The buyer gives the
money to the seller, and the seller gives the car keys to the buyer. To her great
surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back
yard, not the shiny Cadillac in the driveway. The seller is equally surprised to
learn that the buyer expected the Cadillac. The buyer asks the court to order the
seller to turn over the Cadillac.”
3. “A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,”
mails $25 and receives in the mail two wooden blocks with the instructions,
“Place grasshopper on Block A and smash with Block B.” The buyer asks the
court to require the seller to return the $25 and to pay $500 in punitive damages.”
In a little while, we’ll start developing a theory of what contract law should look like for
efficiency. But first…
One of the early theories of contract law was developed in the late 1800s and early 1900s:
the bargain theory of contracts. The bargain theory determined what promises would
be held to be legally binding. The theory was:
A promise should be enforced if it was given in a bargain, otherwise it should not.
A bargain was taken to have three elements – that is, at its core, there are three things that
must be present for a bargain to have occurred, and therefore for a promise to be
enforceable this theory:



offer
acceptance
consideration
“Offer” and “acceptance” are pretty clear. One of us approaches the other and offers
some deal – “I’ll give you $1000 for that old car.” The other decides to accept. This is
done differently in different situations. When you walk into a store and see price tags on
goods, each of those is an offer to sell you that good at a given price. In an art auction,
every time you raise your hand or nod to the auctioneer, you are making an offer to buy
the piece up for sale; at some point, when there are no other bidders, the auctioneer
accepts your offer. In most states, buying land requires a written contract, which
functions as both offer and acceptance.
On to consideration…
We refer to the “promisor” as the person who gives a promise, and the “promisee” the
person who receives it. In a bargain, both sides must be giving up something, so the
promisee must be giving something to the promisor to induce the promise. It could be
money – I give you $25 in exchange for the promise to give me a way to kill
grasshoppers. It could be goods or services – you give me a car, or paint my house, in
exchange for the promise of payment later. It could be another promise – a farmer
promises to deliver a certain amount of wheat on a certain date, and a wholesaler
promises to pay a certain amount at that time. “Money-for-a-promise”, “goods-for-apromise,” “service-for-a-promise”, “promise-for-a-promise” all refer to different types of
bargains we could reach.
The key is that both of us are giving up something. Bargains involve “reciprocal
inducement” – the promisee gives something to the promisor to induce the promise, and
the promisor gives the promise to induce the promisee to give up that thing.
“Consideration” is the legal term for the thing the promisee gives the promisor to induce
the promise.
So the payment of $25, given to induce the promise of a way to kill grasshoppers, is
consideration; giving up the car, or painting the house, is consideration for the promise of
payment; and the promise of crops is consideration for the promise of payment.
Under the bargaining theory of contracts, a promise becomes enforceable once
consideration is given, that is, once the promisee gives something to the promisor in
exchange for the promise.
Going back to the examples at the beginning. When the rich uncle promised his nephew
a trip around the world, no consideration was given – the nephew did not give him
anything to induce the promise. So under the bargaining theory, the promise is not
enforceable. Promises of gifts are generally not enforceable under the bargaining theory,
since the promisee is not giving anything as inducement and therefore the promise is not
part of a bargain.
In the example of the disputed car, although consideration was given, the conditions of
offer and acceptance were not met, since the seller was offering one thing and the buyer
was accepting another. In Cooter and Ulen’s words, “Without a meeting of the minds,
there is no offer and no acceptance, just a failure to communicate.”
In the third example, the seller offered a method for killing grasshoppers, the buyer
accepted the offer, and the payment of $25 acted as consideration; so under the bargain
theory, this was a valid promise, and therefore enforceable.
The bargain theory does not distinguish between fair and unfair bargains; that is, even a
bargain that is extremely one-sided is considered enforceable under the bargain theory. It
would be difficult, and costly, to enforce a theory that required the court to only enforce
fair bargains, since the court would have to calculate the value of the contract to each
party and determine what was “fair.” Thus, one way to make a gift promise enforceable
is, instead of promising to give away something for free, selling it for $1. This makes the
promise take the form of a bargain, and makes it enforceable under the bargain theory.
(Modern courts, however, do sometimes refuse to enforce bargains that are completely
one-sided. This is the doctrine of “unconscionability”, which we’ll come back to this.)
Having answered the question of which promises should be enforceable, the bargain
theory also answers the question of what the remedy should be when an enforceable
promise is broken. Since the promisor agreed to the bargain, he owes it to the promisee
to make him as well off as had the promise been fulfilled.
Since the promise was not kept, however, it is sometimes impossible to calculate exactly
what the benefits would be. Under the bargain theory, a promisor who breaches a
promise owes the promisee “expectation damages” – the amount of benefit that the
promisee could reasonably expect from the performance of the promise. This still leaves
a lot of ambiguity sometimes. With the rich uncle and the college student, the benefit of
the trip to the student would depend on the length of the trip, the route, and the quality of
accommodations, which were not specified in the contract. The value to the farmer of a
means of killing grasshoppers depends on the value of the crop that ended up being
destroyed by them.
There are also other problems with the bargain theory. First of all, it turns out not to be
an accurate description of how courts actually behave, that is, which promises they tend
to enforce. And second, it turns out not to be a good description of how courts should
behave. There are instances in which, at the time a promise is being made, both the
promisor and promisee want the promise to be enforceable. The bargain theory says that
such a promise is not enforceable unless it arises as part of a bargain. But such a promise
may represent a Pareto-improvement, and therefore, an efficient legal system may need to
enforce such promises.
An example of this: suppose again I’m looking to buy a car, and I test-drive one, like it,
but decide to look at a couple others as well. In order to get me to seriously consider the
car, the seller might offer it to me at a particular price, and give me a week to decide –
allowing me to test-drive a couple other cars, but keeping his in mind as an option. I’d
like for this offer to be enforceable – I don’t want to come back a week later and find that
he’s changed his mind. And he wants this offer to be enforceable – he knows that I’ll
only take the offer seriously if I think it’s enforceable, and he wants me to take it
seriously. So this is an instance where both sides want the promise to be binding, but the
bargain theory would not enforce it.
Another example: a rich alumnus promises a large donation to his university, to finance a
new building; but it will take him time to liquidate some assets to actually deliver the
donation. The university would like to begin construction immediately; and the alumnus,
who wants the university to use the money optimally, also wants the university to begin
to put the money to use immediately. But since the promise is not enforceable, the
university can’t begin construction until the donation arrives. Again, both sides want the
promise to be enforceable; but because a gift lacks consideration, the bargain theory
would not enforce it.
There are other problems with the bargain theory – it is not an accurate description of
what courts actually do, and it also enforces certain promises that on many grounds
should not be enforced. So we’ll put it aside and consider what efficiency would require
of contract law.
(Changing definition of “consideration”. Originally, something the promisee gives the
promisor to induce the promise; which, under the bargain theory, makes the promise
enforceable. But as time passed, exceptions began to arise. Eventually, rather than
abandoning the bargain theory, the courts redefined “consideration” to be “the thing that
makes a promise enforceable.” Thus, if a promise is not held to be enforceable, by
definition consideration was lacking, which validates the decision that it should not be
enforceable. Kind of useless…)
In the examples we just gave – the rich uncle, and the alumnus – both sides wanted the
contract to be enforceable. This suggests that both sides think the contract being
enforceable makes them better off. Neither of these contracts seem to impose any
externalities on anyone else. So the enforceability of these contracts would appear to be a
Pareto-improvement, that is, make the two sides better off without making anyone worse
off. And therefore, efficiency suggests they should be enforceable.
This brings us to the general principle:
In general, economic efficiency requires enforcing a promise if the promisor and the
promisee both wanted enforceability when it was made.
Go back to the example we did at the beginning, you trusting me to make an investment
with your money. Suppose I promise to share the gains of the investment with you. You
want the contract to be enforceable: it’s the only way you’ll get your money back. And I
want the contract to be enforceable: it’s the only way I can get you to trust me with your
money, which is good for both of us. So we both want my promise to be enforceable;
efficiency then suggests that it should be.
There are lots of situations that are variations on this agency game. I gave the example of
an investment opportunity. It could have simply been a Pareto-improving trade: I have a
good you want, but we’re far apart, and so you have to trust me with your money before I
ship you the good. It could be an insurance policy: I choose to buy insurance, trusting
that if my house burns down, the insurance company will pay for it. I could simply be
putting my money in the bank, trusting I can get it out later. In all these cases, a lack of
enforceable contracts might lead us to forego a profitable exchange of some sort.
This brings us to Cooter and Ulen’s first proclamation about the purpose of contract law:
The first purpose of contract law is to enable people to cooperate by converting
games with noncooperative solutions into games with cooperative solutions.
Clearly, in the example we did, cooperation is more efficient than no cooperation, since
the combined payoffs are higher; thus, in this case, cooperation is efficient. (If
cooperation were not efficient, we would not have tried.) Thus, we could rephrase this by
saying that contract law enables people to convert games with inefficient solutions into
games with efficient solutions.
Also note that without enforceable contracts, it is my ability to run off with your money
that causes cooperation to break down. In usual choice theory, more options always
make you better off. When a restaurant adds items to its menu, you should be at least as
well off – if you don’t like the new items, you don’t order them. But in a dynamic
setting, more options can make you worse off, since they change what other people
expect you to do. Enforceable contracts give me a way to limit my options – in this case,
to take away my ability to run off with your money. In this case, limiting my options
gives you a reason to trust me, and therefore makes me better off as well.
(Slightly off topic, but as an example of how “foreclosing (ruling out) an opportunity”
can be beneficial, the book quotes Sun Tzu’s The Art of War: “When your army has
crossed the border [into hostile territory], you should burn your boats and bridges, in
order to make it clear to everybody that you have no hankering after home.” By taking
away your option of retreating, you make it clear that you’re serious about fighting.)
This gives us a nice first pass at which promises should be enforceable: those which both
the promisor and the promisee want to be enforceable when the promise is made. And it
suggests one purpose of contract law: to enable cooperation by changing a game to have
a cooperative solution. However, there are a number of other considerations.
One is information. We mentioned earlier in the course that asymmetric, or private,
information can get in the way of beneficial trade. Consider the example of one of you
wanting to buy my car. You really need a car, so you figure that whatever my car is
worth to me, it’s worth 50% more than that to you. So whatever the car is worth, there
are clearly gains from trade.
However, I know exactly what the car is worth, and you don’t; all you know is that it’s
worth somewhere between $5000 and $0, and any value within that range is equally
likely. Even worse, there are no mechanics available and you know nothing about cars,
so there’s no way for you to figure out its true value.
So how are you going to buy this car from me? Well, you know that on average, the car
is worth $2500 to me, and you value it at 50% more than me; so suppose you decide to
offer me $3000. What happens?
Well, if you offer me $3000 for my car, I’ll sell it to you when it’s worth less than $3000
to me, and when it’s worth more than $3000 to me, I’ll say no. So you can expect to only
get the car when it’s worth less than $3000, so the times that I sell it to you, it will be
worth, on average, $1500 to me, and therefore $2250 to you. So you’re losing money.
But the less money you offer me, the less the car will be worth in the event that I choose
to sell it to you. In this case, unless there is some way for us to verify the value of the
car, there is no price you’re willing to offer me for the car. So even though the car is
worth more to you then me, due to asymmetric information, we are unable to transact.
(This example comes from a famous paper by George Akerloff, “The Market for
Lemons.” It’s also exactly the same problem as adverse selection in insurance markets.)
This is another way that contract law can facilitate efficient trade. Contract law could
impose on me an obligation to truthfully tell you anything I know about the condition of
the car. That is, once we’ve signed a contract for you to buy my car, contract law could
make me liable for any mechanical problems with the car that I didn’t warn you about. In
this case, requiring me to share information is efficient, since it reduces your uncertainty
about the value of the car, and therefore gives us a way to trade. Which brings us to…
The second purpose of contract law is to encourage the efficient disclosure of
information within the contractual relationship.
(We’ll come back to this when we come to applications of contract law.)
We will need to address the question of what should be the remedy for breaking a legally
enforceable promise? In the first example we gave – the investment opportunity – it
doesn’t really matter; all that matters is that the remedy be severe enough that I don’t run
off with your money. However, there are situations in which, after a contract is signed, it
becomes efficient for it to be broken. This is the idea of efficient breach. And in those
cases, the remedy becomes very important.
Consider a situation where I am working on a painting. It’s still a couple of weeks away
from completion, but you’ve seen my work before, and you like my theme, and you know
that when I’m done, you’ll value my painting at $1000. There are other buyers out there
who might value it similarly, so you don’t want to wait until it’s done to buy it; but I’m
happy to sell it to you, and we agree on a price of $600.
But now, as I’m finishing the painting, my crazy cousin comes to visit, and sees my
painting, and loves it, and thinks the colors would go perfectly in his beach house, and
offers me $5000 for it. Clearly, he values the painting much more highly than you do.
Efficiency would require that he get it. But I’ve already committed to sell the painting to
you.
(In some instances, you could just resell the painting to him. But in some cases, that
won’t work – he’s crazy, and only wants to buy it from me, or he’s leaving town
tomorrow and you’re not around.)
The efficient thing, then, is for me to breach my contract with you, because the cost of
performing – in this case, the opportunity cost of selling the painting to you instead of my
cousin – is higher than the benefit you will get from the painting.
(Of course, if we foresaw the possibility of my cousin wanting the painting, we could
have written that into the contract. However, it’s often impossible, or at least unrealistic,
to foresee and contract for every possible contingency. Much of contract law is figuring
out what to do in situations the parties to the contract didn’t consider.)
There are many instances where breaching a contract might be efficient. Suppose I build
airplanes, and you contract to buy one from me. You value the plane at $500,000, and
we agree to a price of $350,000. Now before I begin construction, the price of sheet
metal goes through the roof, and building the plane would cost me $1,000,000. Clearly,
it’s inefficient for me to have to live up to my end of the contract. If we’re on good
terms, it’s possible we could renegotiate – you agree to let me off the hook in exchange
for some payment. But if we can’t agree, I’m facing a loss of $650,000; so I’m in a
pretty bad bargaining position, and you can demand pretty large compensation to let me
off the hook, even more than the contract was originally worth to me! This might
discourage me from agreeing to the contract in the first place.
In general, if the promisor’s cost of performing is higher than the promisee’s benefit from
performance of the contract, it is efficient to breach the contract. If the promisor’s cost of
performing is lower, it’s efficient to perform (to live up to the promise).
And this is where the choice remedy becomes important. If the punishment for breach of
contract is too severe, the promisor will have to perform, even when it would be efficient
to breach. If the punishment is too light, of course, the promisor will breach when
efficiency would require performance. (Suppose, for example, that after you contract to
buy something from me, something happens that makes the product more expensive for
me to produce but also more valuable to you, such that it is still efficient for me to
produce it, even though I may no longer be so excited about the price we agreed on.)
Self-interest suggests that I will choose to breach whenever the cost of performing is
higher than my liability from breaching. And efficiency suggests that I should breach
whenever the cost of performing is higher than the promisee’s benefit from my
performing. This means that self-interest will lead to efficiency if my liability from
breaching is exactly the promisee’s benefit if I had performed. This is what happens
under perfect expectation damages – my liability is exactly equal to the benefit the
promisee would have received had I performed. So under perfect expectation damages,
my liability causes me to exactly internalize the cost of breach, and leads me to make
efficient decisions about performing.
Which brings us to…
The third purpose of contract law is to secure optimal commitment to performing.
Perfect expectation damages lead to breach of contract only when it is efficient.
reliance
But now things get a little bit more complicated. Suppose that you’ve contracted to buy
my painting. Anticipating it, you might go out and buy a frame for it, or install track
lighting, or buy furniture that will go well with the colors – you make investments that
will enhance the value of me holding up my end of the contract. Similarly, if you’ve
contracted to buy an airplane from me, you might start building a hangar, so that the
plane doesn’t get rained on once it’s delivered.
Similarly, the farmer who has mailed in a check for $25 for a sure means to kill
grasshoppers might decide he can now plant more crops, since the risk of grasshopper
damage has been mitigated; the nephew who’s been promised a trip around the world
might go out and buy a backpack, or a linen suit to wear in the tropics.
All of these are examples of reliance – investments that increase the value of
performance to the promisee. In many cases, making these investments early is efficient
– if you wait to build a hangar until I deliver your airplane, it might get damaged in a
snowstorm before the hangar is complete; if the nephew waits to buy a linen suit until his
uncle sends him plane tickets, he might miss a big spring sale.
On the other hand, we’ve introduced the notion of efficient breach, and the idea that the
promisor may not always perform (and that this may be efficient); which means that
reliance is not a sure thing. Reliance will generally increase the losses due to breach –
you’ve built a hangar for nothing, or you resell your backpack and linen suit at a loss.
Which brings us to:
The fourth purpose of contract law is to secure optimal reliance.
The expected gain from reliance is the probability that the promisor performs, times the
increase in the value of performance; efficiency suggests that reliance should increase as
long as
(probability of performance) X (increase in value) > (incremental cost)
However, suppose that the promisor, upon breach, has to reimburse the promisee for the
value of performance after the increased reliance. (Simple perfect expectation damages
force the promisor to make the promisee as well off as if he had performed; so once the
promisee has made these additional investments, this is a higher level.) Then after
damages, the promisee will get the value of performance (with reliance), even when the
contract is breached. If the promisor’s liability includes the benefits of reliance, then the
promisee has an incentive to increase reliance as long as
Increase in value > incremental cost
This means that such a rule would lead to overreliance – the promisee would make
inefficient investments in increasing the value of performance, since he is insulated from
the risk of breach.
(ended here – example of optimal reliance to come on thursday)