Econ 522 – Lecture 15 (Oct 25 2007)
Tuesday, we looked more closely at the incentives created by various remedies for breach
of contract. Today, we wrap up contract theory by returning to the first question we
asked: what promises should the courts enforce?
When we began contract law, we introduced contracts as a way to secure cooperation in
instances where it required an ability to commit to future actions. Thus, we introduced
the principle that in general, courts should enforce promises when both parties wanted
them to be enforceable at the time they were made.
What types of contracts, then, should not be enforced? Contracts that were not signed by
people who could rationally act in their own best interests; contracts based on bad
information, especially deliberate bad information; contracts with negative spillovers
(like externalities) on other parties; and contracts where monopoly power left one side in
a position to be taken advantage of.
(Cooter and Ulen lump many of these types of problems together as “transaction costs”,
relating back to the principle we saw earlier with Coase: when there are no transaction
costs, we expect voluntary negotiations to lead to efficiency, and contracts should
therefore be enforced. Thus, situations where contracts should not be enforced can be
thought of as instances where efficiency was disrupted by transaction costs.)
Today, we’ll look at many of these situations where contracts are not enforced, and look
at the rationale for not enforcing them and the incentives that this creates.
(Before we do that… Generally, in trying to get out of a promise, a defendant can claim
one of two things:
 there is no contract
(that is, I may have told him I might perhaps give him a trip around the world, but the
legal requirements for considering this a contract were not met)
 I should be excused from performing
(that is, yes, there is a contract, but circumstances have arisen and I should be let off
the hook)
The first type of claim is a formation defense; the second is a performance excuse.)
The first doctrine is incompetence. Voluntary negotiations assume that people can
rationally do what is in their own best interest; people who cannot are considered legally
incompetent.
Because some people (children, the insane) cannot protect their own interests, contract
law protects them, by forcing others to protect their interests. Contract law generally
upholds contracts which are in the interests of someone considered incompetent, but does
not uphold contracts which are against their interests. This gives others (in particular,
competent partners they transact with) the incentive (or the responsibility) to protect their
interests.
(To put it another way, the law takes away the incentive to cheat the incompetent, by
invalidating contracts that hurt them.)
The next doctrine is duress. The law will not enforce contracts signed under threat of
harm – “give me $100 or I’ll shoot you.”
However, lots of negotiations involve threats of some sort – “give me a raise or I’ll quit
and work for your competitor,” “$3000 for my car is my final offer, take it or I walk.”
This kind of threat is fine – it’s often necessary to tease out both sides’ threat points and
figure out whether cooperation is efficient or not.
To distinguish between the two types of threats, note what happens in each case when
bargaining fails. In the second case, failure to reach a bargain results in a failure to create
more value. In the first case, failure to agree leads to destruction.
In addition, successful bargains tend to create value, while contracts created under duress
tend to just shift resources from one owner to another.
In general, the following rule applies to distinguish duress: a promise is enforceable if it
was extracted as the price of cooperating in creating value; a promise is
unenforceable if it was extracted by a threat to destroy value.
The book gives a nice example of this. The captain of a boat hires a crew in Seattle for a
fishing expedition to Alaska. Once they reach Alaska, the crew demands higher wages.
After they return to Seattle, the captain refuses to pay the higher wages, claiming he
agreed to them under duress.
While in Seattle, the crew that signed on faced competition from other fishermen. Once
in Alaska, they did not. The captain had relied on the promise – by investing in fuel and
supplies, and the time to sail to Alaska.
While in Seattle, the crew’s only threat was to not cooperate in creating value – in which
case the captain could have hired another crew. Once in Alaska, the crew’s threat was to
destroy value – by destroying the investment the captain had already made.
We also gave the principle earlier that contracts, including renegotiated contracts, should
be enforceable if both parties wanted them to be enforceable at the time of the agreement.
In this case, think what happens if the renegotiated contract will not be enforceable. The
crew is still better off fishing (and getting paid their original wages) than return to port
with no fish and not get paid. So while the crew may want the contract renegotiated
under duress to be enforceable, the captain does not; courts would tend not to enforce it.
On the other hand, suppose that half way into the voyage, circumstances change – the
weather gets worse, or a message arrives that makes the crew want to return home. Now
the captain offers them higher wages to get them to stay. In this case, both sides would
like the new promise to be enforceable, since without it the ship would have to return
home.
In general, when a contract is renegotiated under duress will not be enforced; but a
contract that is renegotiated under changed circumstances will.
The next doctrine is necessity. Last week, we gave an example of a tugboat that arrives
to tow my sinking sailboat back to shore. The book gives the examples of a driver
running out of gas on a remote road, and a passerby offering to sell him gas at an absurd
price.
Like duress, a contract made under necessity is made with the threat of destruction.
Under duress, the threat was destruction via action. Under necessity, the threat is
destruction via inaction. (The tugboat captain isn’t threatening to sink your boat, just to
let it sink; the passerby with gas isn’t threatening to shoot you, just to drive off and let
you starve.) While contracts made under necessity are generally not enforced, rescuers
are generally entitled to some reward, to create an incentive to perform the rescue in the
first place.
The book distinguishes between three types of rescue.
Fortuitous rescue uses resources that were available by chance. This is a tugboat who
stumbles upon the sailboat randomly, or the passerby who has a full tank of gas and
offers to siphon some.
Anticipated rescue uses resources that were deliberately set aside in case they were
needed for rescue. This is a passerby who carries an extra five-gallon can of gas in case
he runs into stranded drivers.
Planned rescue is someone who deliberately goes out looking for people to rescue. This
is the tugboat roaming around looking for sailboats in trouble, or AAA getting your
phone call and sending someone out with gas.
The book makes the case that to create the right incentives, planned rescue requires a
greater reward than anticipated rescue, which requires a greater reward than fortuitous
rescue. Fortuitous rescue used resources that were already available – the rescuer need
only be compensated for the resources actually used, plus his time, to ensure that he
prefers to rescue the victim rather than drive off. Anticipated rescue required an
investment – setting aside some extra resources – and so it requires a larger reward, to
create the incentive to set those resources aside ahead of time. Planned rescue is the most
costly, since it requires searching for people in distress – it requires the largest reward, to
compensate for search.
The next doctrine for ruling a contract unenforceable is impossibility. A surgeon agrees
to perform an operation, then breaks his hand in a hideous golf cart accident the weekend
before. Clearly, he cannot perform the operation; the question remains as to whether he
is excused from performing, or owes damages.
Perfect contracts would specify who would bear that risk. Of course, due to transaction
costs, real contracts will generally not address risks that are very remote. In some cases,
the contract, while not addressing a risk explicitly, may give clues as to how the gap
should be filled. An example from the book: a drilling company agrees to drill a well for
a landowner, but the drill runs into impenetrable granite. Suppose that the driller was
competing with other companies for the offer, but the landowner agreed to a price much
higher than the competition. The court might feel that the driller was implicitly
guaranteeing performance, and should owe damages when performance became
impossible. Or industry custom might be for one side or the other to bear that risk.
In situations where neither the contract itself nor the custom of the industry assigns the
risk, the law has to. In most typical cases, the promisor is liable for breach, even when
the breach is not his fault. (Contract liability is strict.) So a construction company that
finishes a building late due because or unexpected complications is generally liable.
However, there are some instances where non-performance is excused by physical
impossibility. A famous artist agrees to paint someone’s portrait, and then dies; his estate
does not owe for the breach of the promise. A manufacturer whose factory burns down
might be excused from performance. Similarly, breach is typically excused if
performance became illegal. A shipping company commandeered to carry military cargo
during a war is excused from its civilian commitments.
One legal theory in these cases is that an unexpected contingency destroyed “a basic
assumption on which the contract was made”. The painter assumed he would be alive;
the manufacturer assumed its factory would not burn down. Under this theory, if a
contract is made in good faith and then events destroy one of its basic assumptions,
breach is excused.
The question then becomes, when is something a “basic assumption” and when is it not?
The book sidesteps this question, and instead moves to what efficiency would require:
Efficiency requires assigning liability to the party who can bear the risk at least cost.
That is, nonperformance due to impossibility is just another type of risk; so for efficiency,
it should be allocated to whichever party is the low-cost bearer of the risk.
In many cases, one party can take precautions to minimize the risk – the manufacturer
can install sprinklers in his factory, the painter can prioritize commissioned pieces over
other work, and so on. In those cases, that party is typically the low-cost avoider, and
efficiency suggests they should bear the risk.
When the risk cannot be reduced, the book claims that liability should lie with the party
who can best spread the risk, through insurance or diversification.
We already saw the general principle of gap-filling by allocating risk to the low-cost
avoider, that is, the person who can most cheaply mitigate or bear the risk. The rationale
is that this is what the original contract would have done, if it had bothered to consider
that risk.
The same principle applies in situations where contracts are based on faulty information.
Return to the doctrine of frustration of purpose, which we saw with the coronation
cases. A bunch of Londoners rented rooms with a view of the new king’s coronation
parade; the parade was postponed, so they no longer wanted the rooms. An unexpected
contingency made performance of the original contracts pointless.
Just like impossibility is a doctrine for assigning the risk that performance becomes
impossible, frustration of purpose is a doctrine for assigning the risk that performance
becomes pointless. The same economic principle, then, says,
When a contingency makes performance pointless, assign liability to the party who
can bear the risk at least cost.
In this case, the property owners could eliminate their losses by renting the rooms a
second time, for the rescheduled parade. Thus, there was hardly any cost to the owners
from bearing the risk; so efficiency would seem to allocate the risk to them, which is
what happened.
Frustration of purpose is what a contingency arises after the contract is signed that makes
performance pointless. Mutual mistake about facts can be thought of as a contingency
already having arisen before the parties signed the contract, but without their knowledge.
Suppose a buyer contracts to buy some land with timber on it. As it happens, the timber
was destroyed by forest fire the day before the contract was signed, but neither knew
about it.
The owner at the time of the accident is usually the low-cost avoider of the risk – that is,
the buyer is unlikely to be able to prevent forest fires on someone else’s land – so this
generally entails not enforcing the contract. Personally, I was perfectly comfortable with
the doctrine of just unwrapping contracts based on mutual mistake, but this gives some
economic relevance to it.
Another type of mutual mistake is mutual mistake about identity, as in the case of the
rusty Chevy and the new Cadillac from three weeks ago. When there is mutual mistake
about the object being sold, enforcing the contract would have the effect of making an
involuntary exchange. We assume that voluntary exchange is efficient; involuntary
exchange may not be. So efficiency agrees with the doctrine of setting aside contracts
based on mutual mistake of this type.
Our analysis of the doctrines of impossibility, frustration of purpose, and mutual mistake
has been in terms of allocating risk – choosing which party to a contract is the efficient
bearer of the risk that performance becomes impossible, or pointless, or was based on a
faulty premise.
The next doctrines have to do with information.
Public information (or common information) is information that both parties have.
Private information (or asymmetric information) is information that one party has and
the other party lacks.
We saw in Hadley v Baxendale that bad things happened because the party with
information – Hadley, who knew how time-critical his shipment was – was not the party
with control – Baxendale, who had to decide which way to ship it. This brings us to a
general principle about information:
Efficiency generally requires uniting knowledge and control.
If I value some land more than you, it may be because I have knowledge of a way to
derive more value from the land. (The land has coal underneath, and I know how to mine
it; or the land is good for growing tomatoes, and I know how to grow tomatoes.) In those
cases, selling the object to the party who values it more unites knowledge and control,
and therefore increases efficiency.
(Cooter and Ulen go a little further, and say, efficiency requires uniting knowledge and
control over resources at least cost, including the transaction costs of transmitting
information and selling goods.)
As a general principle, then, contracts that unite knowledge and control should generally
be upheld, and contracts that separate knowledge and control should more often be set
aside. This brings us to three doctrines related to information: mistake, failure to
disclose, and fraud.
When we looked at mutual mistake, neither party had correct information, so the contract
neither united nor separated knowledge and control. Thus, we did not discuss it in those
terms. However, there are situations where one party to a contract has mistaken
information and one does not. This is called unilateral mistake.
For example, suppose you have an old car and you think it’s just a worthless old car, but I
know it’s a classic and worth a lot of money. I agree to buy it from you at a low price,
and afterwards, you learn the truth. The contract was based on unilateral mistake – you
were wrong about the value of the car, but I knew the truth.
In these cases, the contract is generally enforced. While mutual mistake may be cause to
set aside a contract, unilateral mistake is generally not.
This makes sense for two reasons. First, if I know the car is more valuable and manage
to buy it from you, this unites knowledge and control. I probably know the car is
valuable because I’m more into classic cars, and will thus take better care of it. Much as
it’s disappointing to you to get screwed out of something valuable, this may well be
efficient.
And second, this creates an incentive to gather information. Sometimes gathering
information is costly; and often, having better information leads to efficiency. Rewarding
people for having better information (allowing them to profit from it) leads to an
incentive to gather information, which may be a good thing.
(Of course, if you sued to try to void our contract, it would put me in a funny position.
Since mutual mistake is a valid formation defense, you could claim neither of us knew
the true value of the car when you sold it to me; so now I have to get up in court and
claim, no, I wasn’t ignorant, I was trying to rip you off. And if I can convince the court I
was trying to rip you off, I get to keep the car. Weird.)
There was a famous case in 1815 that concerned unilateral mistake, Laidlaw v Organ.
During the War of 1812, the British blockaded the port of New Orleans, which depressed
the price of tobacco, since nobody could make money exporting it. Organ was a tobacco
buyer; he received private information that a treaty had been signed, ending the war, and
negotiated with the Laidlaw firm, which did not know about the treaty, to buy some
tobacco at the depressed price. The next day, news broke that the war was over, the price
of tobacco soared, and Laidlaw sued.
Despite it being a unilateral mistake – Organ knew the war was over, Laidlaw did not –
the contract was set aside at trial. It was appealed to the Supreme Court, who ruled that
Organ was not bound to communicate his knowledge and ordered a retrial. Things get a
little fuzzy from there, and the doctrine does not seem to be rock-solid; but nonetheless,
unilateral error is generally taken as not being a valid reason to void a contract.
To understand the situation on economic grounds, Cooter and Ulen draw a distinction
between productive information – information that can be used to produce more wealth
– and redistributive information – information that can be used to redistribute wealth in
favor of the informed party. Productive information could be that farmland is resting
atop valuable underground minerals, or a water route between Europe and China.
Redistributive information could be that the state plans to build a highway through a
particular piece of land, changing property values nearby.
Since productive information increases total wealth, efficiency demands giving incentives
for people to discover productive information; since redistributive information does not
create additional wealth, efficiency does not require giving incentives to discover it.
Thus, letting people profit from productive information – by enforcing contracts signed
under unilateral error – is good; letting people profit from redistributive error is bad.
They also point out that to create incentives, information only needs to be rewarded when
it was acquired through effort or investment, not by chance. Thus, they come to the
principle:
Contracts based upon one party’s knowledge of productive information – especially
if that knowledge was the result of active investment – should be enforced, whereas
contracts based upon one party’s knowledge of purely redistributive information or
fortuitously acquired information should not be enforced.
Unfortunately, information is often a mixture between productive and redistributive.
Without much explanation, Cooter and Ulen suggest enforcing “most” contracts based on
mixed information.
We talked earlier about the duty to disclose – the fact that sellers must inform buyers
about any hidden safety risks associated with their product. The rationale is fairly
obvious.
So safety information is treated separately from productive and redistributive
information. The law does not generally require disclosure of either productive or
redistributive information to a buyer, but does require the disclosure of safety
information.
While common law sellers generally do not have a duty to disclose anything besides
safety information, there have been exceptions. In Obde v Schlemeyer (1960), a seller
knew his building was infested with termites and did not tell the buyer, who discovered
the termites after the fact and sued.
The termites should have been exterminated immediately to prevent further damage; the
court in Obde deviated from tradition and imposed a duty to disclose.
We talked earlier about uniting knowledge and control. In this case, the seller knew
about the termites and the buyer did not; so the sale separated knowledge from control.
So efficiency seems to support the ruling in Obde.
In Obde, the seller did not offer the fact that the building had termites, but also did not lie
about it – the buyer didn’t ask. If the buyer had asked, and the seller claimed there were
no termites, we would have been in the case of fraud. Victims of fraud are generally
entitled to damages in the amount of the harm caused by the fraud.
The reasoning here is clear: if parties know fraudulent contracts will not be enforced,
they can rely on the truthfulness of the other party’s statements, rather than having to
incur the costs of verifying everything for themselves. This lowers transaction costs of
completing agreements, which is one of the goals of contract law.
Courts and legislatures have begun imposing a duty to disclose in certain situations.
Lenders now must disclose the APR on all consumer loans. Many states require used car
dealers to reveal major repairs done on the car being sold. Many states require sellers of
homes to reveal certain types of defects. Such requirements are meant to improve
information exchange and lower transaction costs. Whether doing so outweighs the cost
of enforcing them is a separate question.
Courts will generally not enforce terms of contracts that are overly vague. For example,
a promise to give one’s “best efforts” toward some goal are often not enforceable.
In some cases, the parties might want the court to enforce these terms. That is, they may
leave terms vague because they cannot foresee all contingencies, but hope that the court
will insert its judgment after the fact.
However, courts generally set aside vague promises. This can be thought of as a penalty
default, as in Ayres and Gertner – it is difficult for the court to figure out the intent of
vague terms, so they supply a default the parties would not want – refusing to enforce
them – to force the parties to be more specific in the contract.
There are some situations where a court may at least partially enforce such terms. For
example, a term requiring the parties to renegotiate the contract “in good faith” under
certain contingencies might be held against a party who broke off negotiations without
giving a good reason.
Monopoly
We said earlier that under the bargain theory of contracts, courts generally do not ask
whether a contract is fair, just whether it was given as part of a bargain.
Thus, contracts that are unequal because one party had more bargaining power are
generally upheld.
Monopoly, while often views as unfair, is not generally ruled out by the common law,
and contracts signed with monopolists are generally binding. However, specific laws –
antitrust statutes – have been passed which rule forbidding monopoly and cartels in many
instances.
Nonetheless, there are two doctrines in the common law giving performance excuses to
get out of monopoly contracts: adhesion and unconsciability.
When you rent a car, you don’t stand at the counter negotiating each particular detail of
the agreement; they hand you a standard contract, off a large pile of contracts, and you
sign it or you leave.
Standardized contracts, and in particular contracts offered as “take-it-or-leave-it” deals,
are sometimes referred to as “contracts of adhesion”. Arguments are sometimes made
that standardized contracts make it easier to stifle competition – if Avis, Hertz, and other
rental car agencies all use standard contracts, they are more committed to not competing
against each other. It’s not really that strong an argument – Friedman refers to adhesion
as “bogus duress”. If a market is really competitive, competition still limits what the
companies can get away with in their standard contracts, even if they are offered as being
non-negotiable at the time.
Cooter and Ulen offer a couple of defenses of standardized contracts. First, by
standardizing all the other terms of the agreement, they may make price competition
fiercer, because companies can no longer obscure prices by varying other parts of the
deal. And second, they may reduce transaction costs, again by fixing most parts of the
deal and leaving fwer to bargain over. They suggest worrying about adhesion only in
situations of genuine monopoly.
In genuine monopoly situations, however, a monopolist may use a standardized contract
to strengthen their monopoly position (say, by forbidding resale of their product, or by
requiring it to be purchased with other products).
Contracts of adhesion can also be used to take advantage of a buyer’s ignorance, by
specifying terms he would not know to challenge, or counting on him not to read the fine
print. Again, Cooter and Ulen argue that as long as the market itself is competitive, the
“problem” is not the absence of bargaining, but the buyer’s ignorance, and argue the
contract should be enforced.
Finally, we come to unconscionability, the doctrine that an overly one-sided contract
may be set aside if its terms “shock the conscience of the court”.
One well-known case is Williams v Walker-Thomas Furniture. Williams bought durable
goods on credit. Each time she bought more goods, the previous goods (some of which
were already paid off) were used as “add-on” collateral, in place of a down payment.
Eventually, Williams missed a bunch of payments on the newest goods, and the furniture
company repossessed everything; she sued. The contract was deemed unconscionable.
Cooter and Ulen make the case that add-on collateral may be reasonable in some
situations. You want to buy furniture worth $1000 today, but once you get it home, if the
furniture company had to repossess it, it would only be worth $800. If you have $200 on
hand for a down payment, no problem. If not, and you had poor credit, they might refuse
to sell you the furniture. So linking payments on one piece of furniture to other furniture
may be reasonable, even desirable, in some instances. Cooter and Ulen argue that by
invalidating the contract, the court served Williams, but harmed lots of other people in
similar situations, since now they might not be given credit at all.
To recap what we’ve done with contract law…
We began by motivating contracts (enforceable promises) by a way to secure efficient
cooperation, and introduced the notion that a promise should be enforceable if both
parties wanted it to be when it was made
We discussed the bargain theory of contracts, which states that promises made as part of
a bargain are enforceable and others are not, and discussed some of the problems with it
We discussed contract law, in particular remedies for breach, as one way to create an
incentive for information disclosure
We talked about efficient breach, and investment in reliance
We talked about several different remedies for breach, and the incentives that each one
creates: for the decision to breach or perform, for reliance, and for investment in
performance. We showed that when the transaction costs of renegotiating a contract are
small, any remedy should lead to efficiency, but different ones lead to different divisions
of the surplus; when transaction costs are high, the remedy matters for efficiency as well.
And we showed that it is difficult to set damages which will lead both to efficient breach
and efficient reliance (or efficient reliance and efficient investment in performance)
We talked about default rules, which are rules the court assumes hold in contingencies
that weren’t mentioned in the contract; and that efficient default rules generally allocate a
risk to whichever party can mitigate it, or bear it, at the lowest cost
(We talked about Ayres and Gertners’ discussion of penalty defaults – the deliberate use
of inefficient default rules, to encourage the parties to reveal information to each other or
to the court.)
We talked about regulations, or immutable rules, and why restricting voluntary contracts
sometimes makes sense
We talked about repeated interaction leading to more cooperation than one-shot
interaction, and ways in which contract law can encourage enduring business
relationships
That does it for contract law. Tuesday in class is the midterm, and next Thursday we’ll
begin tort law.