Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 12
Logistics
 Midterm will be returned Thursday
 HW2 is up – due Tuesday, November 3 (11 a.m. sharp)
 Second midterm (on contract law) Thursday, November 5
1
In-class experiment from Thursday…
 The game:



Players A and B each start with $10
Player A gives x to player B, which gets tripled
Player B gives y back to player A, keeps 10 + 3x – y
 The treatments:



Totally anonymous: done randomly, on paper, with SID (no names)
In pairs, face to face, but with strategies written down
In pairs, out loud, in front of whole class
2
The results
 In anonymous version, trust was a problem, but not a huge
problem



Average A transferred $7.21, got back $7.92
So over 70% of gains from cooperation realized
But, of those Player A’s who sent anything, 19% got back nothing,
and 30% got back less than they gave
 Communication more important than public shaming


“Out loud”: average A transferred $7.67, all got back more than they
gave
“Face to face, in private”: full efficiency – all 7 A’s transferred $10,
all 7 got back either $15 or $20
3
The results
Average A
Transfer
Average B
Transfer
Average
A Payoff
Average
B Payoff
Average
Combined
Anonymous
7.2
7.9
10.7
23.7
34.4
Out Loud
7.7
13.0
15.3
20.0
35.3
10.0
18.6
18.6
21.4
40.0
Face to Face
4
The raw data
20
Anonymous (56)
Face to Face (7)
Public (3)
1x, 2x, 3x
18
Player B Returned...
16
14
12
10
8
6
4
2
0
0
1
2
3
4
5
6
Player A Sent...
7
8
9
10
5
Something I found funny (anonymous
treatment)
Player A
gave
Observations
% that got
nothing
back
% that got
less than
they gave
% that got
more than
they gave
0
3
67%
0%
33%
1–9
29
10%
21%
66%
128%
10
24
29%
42%
42%
97%
“Average
return”
6
Something I found funny (anonymous
treatment)
Player A
gave
Observations
% that got
nothing
back
% that got
less than
they gave
% that got
more than
they gave
0
3
67%
0%
33%
1–3
7
14%
28%
71%
132%
4–6
8
0%
13%
87%
151%
7–9
14
14%
21%
50%
113%
10
24
29%
42%
42%
97%
“Average
return”
7
Something I found funny (anonymous
treatment)
10
average B transfer
average A payoff
8
6
4
2
0
0
-2
1
2
3
4
5
6
7
8
9
10
Player A's Transfer
8
Back to
contract law
9
Thursday...
 Default rules versus regulations/immutable rules
 Contracts that are not enforcable: derogation of public
policy
 Ways to get out of a contract: formation defenses and
performance excuses




Incompetence
(But not drunkenness)
Dire constraints: duress and necessity
Today: more of these
10
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
11
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”
12
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
13
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
14
Misinformation
 Four doctrines for invalidating a contract based on faulty
information




Fraud
Failure to disclose
Frustration of purpose
Mutual mistake
15
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”
16
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”
17
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
18
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
19
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
20
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
21
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
22
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
23
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
24
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…
25
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
26
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
27
Adhesion and unconscionability
 Adhesion: standardized “take-it-or-leave-it” contracts

Friedman calls it “bogus duress”
28
Adhesion and unconscionability
 Adhesion: standardized “take-it-or-leave-it” contracts

Friedman calls it “bogus duress”
 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
29
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.”
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.”
 Not normal monopoly cases but “situational monopolies”

Think of Ploof v Putnam (sailboat in a storm)
32
Remedies for breach
of contract
33
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
34
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
35
Reliance damages
 Reimburse promisee for 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
36
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
37
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
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
When you agreed to sell me ticket, other tickets available for $75
Opportunity cost damages: $75
(I paid a scalper $150 to get in; I would have been $75 better off if
I’d ignored your offer and paid someone else $75)
39
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
$75
$0-20
40
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
41
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
Perfect
42