Econ 522 – Lecture 9 (February 17 2009)
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Last week, we wrapped up property law
Homework due Thursday (1 p.m. sharp)
Our next big topic: contract law
Today:
 Why contracts?
 An old theory of contract law, and some of the problems with it
 Begin our economic analysis of contract law, with an eye toward efficiency
Fundamentally, contract law is the attempt to make certain types of promises legally
binding
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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
o 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:
YOU
Don’t
Trust me
ME
Share
(150, 50)
Keep all the money
(100, 0)
(0, 200)
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.
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The important thing to note here:
It’s not just that you’re worse off because you can’t trust me; I’m worse off too
o My inability to commit to returning your money causes me to miss out on
the investment as well.
So we’d both be better off if there was some way I could commit to returning
your money
(One powerful way around this problem is to rely on reputation
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 historically, now less
so), everyone knows everyone, and reputation as an honest seller is vital
This is also part of the success of eBay – realizing that making sellers’ reputations
public would give people 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:
YOU
Don’t
Trust me
ME
Share
(150, 50)
Keep all the money
(125, 25)
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(100, 0)
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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.
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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 under this theory:
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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
 Of course, 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 person who gives a promise as the promisor, and the person who
receives it as the promisee
 In a bargain, both sides must be giving up something
 So the promisee must be giving something to the promisor to induce the promise
o It could be money – I give you $25 in exchange for the promise to give me
a way to kill grasshoppers
o It could be goods or services – you give me a car, or paint my house, in
exchange for the promise of payment later
o 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
o “Money-for-a-promise”, “goods-for-a-promise,” “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
o the promisee gives something to the promisor to induce the promise
o 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.
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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
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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 bargain theory, the promise is not enforceable
Promises of gifts are generally not enforceable under the bargain 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.”
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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.
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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.
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One example of a court’s refusal to examine whether a bargain was “fair,” and focus only
on whether consideration was given
 An 1891 case, Hamer v Sidway (New York Court of Appeals)
 An uncle promised his nephew $5,000 to give up drinking and smoking until his
21st birthday
 When the nephew turned 21, he refused to pay
 The court wrote:
The promisee [the nephew] used tobacco, occasionally drank liquor, and he had a
legal right to do so. That right he abandoned for a period of years upon the
strength of the promise of the [uncle] that for such forbearance he would give him
$5,000. We need not speculate on the effort which may have been required to
give up the use of these stimulants. It is sufficient that he restricted his lawful
freedom of action within certain prescribed limits upon the faith of his uncle’s
agreement, and now, having fully performed the conditions imposed, it is of no
moment whether such performance actually proved a benefit to the
promisor, and the court will not inquire into it.
(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 addresses the question of what the remedy should be when an enforceable
promise is broken
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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.
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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 efficiency-minded
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 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, or that, knowing I’m ready to buy, he’s
raising his price
 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
because consideration was not given, the bargain theory would not enforce it.
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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.
Other problems with the bargain theory
 it is not all that accurate a description of what courts actually do
 and it demands enforcement of certain promises that on many other grounds
should not be enforced
 So next, we’ll put aside the bargain theory and consider what efficiency would
require of contract law.
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In the two examples we just saw – buying a used car, and the rich 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.
And this illustrates a more 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
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(Note the important distinction here between wanting the contract to be
enforceable and wanting it to actually be enforced.
At the time I make the promise, I want it to be enforceable – I want us both to live
in a place and time whose laws would hold me to my promise
Because if not, you won’t trust me, and won’t give me the money
Once you’ve given me the money, though, I’d rather the contract not actually be
enforced – I’d still be better off if I could keep all the money
Hence, the wording of the principle above: efficiency requires enforcing a
promise if both sides wanted it to be enforceable when it was made.)
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There are lots of other 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 (of many) proclamations about the purposes 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.
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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 (equilibria) 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
o 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 strategic 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 own 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.)
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So now we have an initial idea of which promises should be enforceable
o Those which both the promisor and the promisee want to be enforceable
when the promise is made
And we know one purpose of contract law: to enable cooperation by changing a
game to have a cooperative solution
However, there are a number of other purposes that contract law can serve.
One has to do with information
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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
Suppose 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 $0 and $5000, 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.
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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 on average, you value it at $3750
So suppose you decide to offer me $3000
What happens?
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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, on average, it will be worth $2250 to you
So on average, you’re overpaying for the car
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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.)
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This suggests another way that contract law can facilitate efficient trade
Contract law could give me a way to offer a legally binding warranty
Or contract law could impose on me a legal obligation to truthfully tell you
anything I know about the condition of the car
o 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 also need to address the question of enforcement, that is, 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 these cases, the remedy becomes very important.
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Suppose I’m an artist, and I’m 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 $1,000
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
He sees my painting, and loves it, and thinks the colors would go perfectly in his
beach house, and offers me $5,000 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.
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(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.)
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The efficient thing, then, would be for me to breach my contract with you and
sell it to him
Breach is efficient here 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.
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(If we had foreseen 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 now 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 – it will
cost me $1,000,000 to fulfill my promise, but the benefit to you will only be
$500,000
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!
And if I anticipate ahead of time that there’s a chance this could happen, it might
discourage me from ever 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).
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And this is where the choice remedy becomes important
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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 expectation damages
My liability is exactly equal to the benefit the promisee would have received had I
performed
So under 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.
Expectation damages lead to breach of contract only when it is efficient.
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reliance
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And now let’s complicate things one step further
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
That is, you may make investments that will enhance the value of me holding up
my end of the contract
o 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
o 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
o And 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
o if you wait to build a hangar until I deliver your airplane, it might get
damaged in a snowstorm before the hangar is complete
o 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 OK)
But this 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
And this brings us to:
The fourth purpose of contract law is to secure optimal reliance.
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When is reliance efficient?
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Obviously: when its expected benefit outweighs its cost
Your investment in reliance will only pay off if the promisor performs
So the expected gain from reliance is the increase in the value of performance,
times the probability that the promisor performs
But you’ll pay the cost no matter what
So efficiency suggests that reliance should increase as long as
(probability of performance) X (increase in value) > (incremental cost)
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We said before that expectation damages make the promisee as well off as if the
promisor had performed
Now we have to specify whether or not this includes the additional gains from
reliance
o Once you’ve made this investment in reliance, your benefit from
performance is higher
o So expectation damages would presumably be higher, to recognize this
added benefit
If that’s the case, then the promisee knows that no matter what, he’ll get the
benefit from his reliance investment
o If the promisor performs, performance is more valuable
o If the promisor breaches, expectation damages are increased by the added
benefit he expected to get
So 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
o the promisee would make inefficient investments in increasing the value
of performance, since he is insulated from the risk of breach
On Thursday, I’ll give examples of both efficient breach and efficient reliance, and
discuss how the law can be designed to achieve it.
We’ll also discuss default rules, including the paper by Ayres and Gertner
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