Econ 522 – Lecture 10 (February 19 2009)
On Tuesday, we asked the question of what promises the law should enforce, and
introduced contract law as the attempt to answer that question.
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We talked about one early attempt to answer the question, the bargain theory of
contracts, and some of the problems with it.
o Under the bargain theory, promises are legally enforceable if they were
given as part of a bargain; there are three elements that must be present,
offer, acceptance, and consideration
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We showed an example of an agency game, where my inability to commit to a
future action (in that case, returning your investment) led to a breakdown in
cooperation…
…we said that the first purpose of contract law is to enable cooperation, by
turning games with noncooperative solutions into games with cooperative
solutions…
…and we argued that efficiency generally requires a promise to be enforceable if
both the promisor and the promisee wanted it to be enforceable when it was
made
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We saw an example of how asymmetric information can inhibit trade…
(the example of you being unable to buy my used car, because I “know too much”
about its condition and have no incentive to tell you what’s wrong with it)
…and claimed that the second purpose of contract law is to encourage the
efficient disclosure of information
We discussed the fact that efficiency sometimes requires breaching a contract…
…and said that the third purpose of contract law is to secure optimal
commitment to performing…
…and argued that setting the promisor’s liability equal to the promisee’s benefit –
expectation damages – accomplishes this goal
We introduced the idea of reliance, that is, investments made by the promisee to
increase their benefit from the promise…
…and said that the fourth purpose of contract law is to secure the optimal level of
reliance…
…and then we ran out of time.
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Today, I want to
 give an example of efficient breach
 give an example of reliance
 then move on to default rules and mandatory rules
We begin with an example of efficient breach
Suppose that I build airplanes, and you contract to buy one from me
 You value the airplane at $500,000
 We agree on a price of $350,000
 It will simplify the example if we assume you paid me up front; so let’s assume
this contract was money-for-a-promise: you already paid up front and I promised
to deliver a plane
o (This doesn’t really matter much, it just makes all the numbers positive.)
The rule for efficient breach is:
If [ Promisor’s Cost ] > [ Promisee’s Benefit ]  Efficient to breach
If [ Promisor’s Cost ] < [ Promisee’s Benefit ]  Efficient to perform
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The promisee’s benefit is known to be $500,000
So it’s efficient to perform whenever the cost of building the airplane is below
$500,000, and efficient to breach whenever the cost is above $500,000.
Since the promisor only looks at his own private cost and benefit when deciding whether
to breach or perform,
If [ Promisor’s Cost ] > [ Liability ]  Promisor will breach
If [ Promisor’s Cost ] < [ Liability ]  Promisor will perform
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In the case of expectation damages, the promisor’s liability would be the amount
of benefit the promisee would have received, which is $500,000
This leads to the promisor performing whenever the cost of building the airplane
is less than $500,000, which is exactly what efficiency would require
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This is what we saw Tuesday – expectation damages, which set liability equal to the
promisee’s benefit, lead to breach exactly when it’s efficient.
It turns out that any other level of damages would lead to inefficiency
 Suppose liability were just $350,000 – I can just return your money and get out of
building you the plane
 Then if the cost of building you the plane goes up to $400,000, I would choose to
breach, even though performance is efficient – the plane is worth more than it
costs to build
 On the other hand, suppose the penalty for breach of contract was very large – if I
breach the contract, I have to pay you $1,000,000, almost triple your money back
 Then if the cost of building the plane goes up to $700,000, I would perform, even
though performance is inefficient – the plane costs more than it’s worth
So what, you might ask? Remember Coase? If transaction costs are low, we can just
negotiate again, right?
Go back to the first example – if I breach, I just owe you your money back
 We agreed on a price of $350,000
 The cost of building the plane goes up to $400,000
 I decide to breach
 We can just renegotiate and agree on a new price of $450,000
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But if I can get out of a promise just by returning your money, it might be
tempting for me to do this too often, just to try to raise the price
Suppose the cost doesn’t change at all
But I know you agreed to pay $350,000, so you must value the plane more highly
than that
So I go to you with a made-up story about one of my workers threatening to quit
unless he gets a raise, I tell you my costs went up, and you can only have the
plane if you’re willing to pay me $400,000
If it’s too easy to get out of a contract, agreements become meaningless
And if transaction costs are high – say, you’re mad because I breached the first
contract, and don’t want to deal with me anymore – then you don’t get your plane,
even though it would be efficient for me to build it.
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Now go back to the second example – if I breach, I owe you $1,000,000
 Now my costs actually go up, and it would cost me $700,000 to build the plane
 I go to you and say, “look, I know I promised you a plane, but it would cost me
$700,000 to build, can we just agree to undo the deal?”
 And you say, “Sure, just give me the $700,000.”
 And I say, “Why? You were only going to get $500,000 of benefit out of the
plane.”
 And you say, “Yeah, so what? If you don’t give me a plane, you owe me a lot
more than that. So give me $700,000, or else.”
What’s the problem with that?
 In a static world, nothing
 Me being forced to pay you $700,000 to get out of my promise is annoying to me,
but it’s not inefficient
 But now go back to when we were originally agreeing to the contract
 If I know there’s a small chance my costs will go way up, and if contracts are
strong enough that you could do this to me, then maybe I don’t want to take the
risk of making the promise in the first place
 So now even though it might be efficient for me to agree to build you a plane, I’d
be afraid to make that promise.
On the other hand, if the cost to me of breaching the contract – my liability – is exactly
equal to your benefit, there is no problem
 I’ll still build the plane exactly when it’s efficient for me to build the plane –
whether or not transaction costs are low enough that we could renegotiate
 We’ll see later that expectation damages don’t perfectly solve the problem of
efficient signing – being willing to sign the right contract in the first place – but at
least it doesn’t make this problem too severe.
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So that’s efficient breach. Next, reliance
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You’ll recall that reliance is any investment the promisee makes that increases the
value of performance
So you contract to buy my painting, and go buy a frame for it
Or you contract to buy an airplane from me, and you start building a hangar
Since reliance increases the value of the promise to you, it increases my liability
for breach under the concept of expectation damages as we’ve defined them
(That is, if I break my promise, I’m responsible for making you as well off as you
would have been if I had kept my word; so if you’ve built a hangar, now I have to
reimburse you for the value of the plane with a hangar, rather than the value of a
plane without a hangar.)
So reliance increases my losses under breach
But you don’t take that into account when deciding how much to invest in
reliance
So there is no guarantee that the level of reliance will be efficient.
We’ll use the same example – you contract to buy a plane from me
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This time, it will be simpler if the bargain was promise-for-a-promise – you agree
to pay on delivery
And assume the penalty for breach of contract is expectation damages
You value the plane at $500,000, and agree to pay $350,000 for it
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Now you have the option of building yourself a hangar
Suppose that building a hangar costs $75,000, and increases the value of owning a
plane from $500,000 to $600,000.
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Suppose that it’s most likely that building the plane will cost me $250,000; but
that there’s some probability p that it will instead cost $700,000
Clearly, if it costs $700,000, I won’t build it; I’ll just breach the contract and pay
you whatever damages I owe
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Let’s look at what happens under each outcome
First, suppose the cost of the plane is $250,000, so I build it. Our payoffs (in thousands):
If you relied (built the hangar):
you get 600 – 75 – 350 = 175
I get 350 – 250 = 100
If you didn’t rely (build)
you get 500 – 350 = 150
I get the same 350 – 250 = 100
Now look at the case where the cost of sheet metal went through the roof and I choose to
breach. I owe expectation damages as we’ve defined them – that is, enough to make you
as well off as if I’d performed.
If you relied (built the hangar):
Your surplus would have been 600 – 350 = 250
from the plane, so I owe you 250 in damages
And you paid 75 to build the hangar
So you end up with payoff of 175
I get –250 (since I have to pay you 250 in damages)
If you didn’t rely (build)
Your surplus would have been 500 – 350 = 150, so
I owe you 150 in damages, which is your payoff
I get –150 after paying you damages
So whether or not I perform, you get 175 if you relied, 150 if you didn’t. So clearly,
reliance makes you better off.
But then the question is, is reliance efficient? That depends on how likely I am to breach.
Let p be the probability that costs go up, that is, the probability of breach
If you rely, our combined expected payoffs are
(1–p) (175 + 100) + p (175 – 250) = 275 (1–p) – 75 p = 275 – 350 p
If you didn’t rely, our combined expected payoffs are
(1-p) (150 + 100) + p (150 – 150) = 250 – 250 p
So the total social gain from you building the hangar is
(275 – 350 p) – (250 – 250 p) = 25 – 100 p
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So it turns out that when p < ¼, reliance is efficient – it increases our combined payoffs.
When p > ¼, reliance is inefficient – it decreases our combined payoffs.
This is indicative of a more general idea: when the probability of breach is low, more
reliance tends to be efficient; when the probability of breach is high, less reliance
tends to be efficient.
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But if my damages cover your benefit whether or not it’s efficient, then you don’t
care about the risk of breach – you end up just as well off whether or not I breach
So you’ll clearly choose the higher level of reliance, whether it’s efficient or not
This will sometimes lead to overreliance – more reliance than is efficient.
So how do we fix this? Cooter and Ulen adjust their definition of expectation damages in
the following way:
Perfect expectation damages restore the promisee to the level of well-being he would
have had, had the promise been kept, and had he relied the optimal amount
(This is why they attach the word “perfect” to expectation damages)
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Thus, the promisee is rewarded for efficient reliance
o this increases his payoff from performance of the promise, and also
increases his payoff from breach, since it increases the amount of damages
he receives
But the promisee is not rewarded for excessive reliance – overreliance
o damages are limited to the benefit he would have received given the
optimal level of reliance.
It’s a nice idea, but it seems like it would be very hard in general for a court to
determine after the fact what the optimal level of reliance was
(It might also be hard for the promisee to know this, since he may not know the
probability of breach.)
What is actually done in practice?
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The usual rule is that liability is limited to the level of reliance that is foreseeable.
Reliance is foreseeable if the promisor could reasonably expect the promisee to
rely that much under the circumstances
Reliance is unforeseeable if it would not be reasonably expected
American and British law tend to define overreliance as unforeseeable, and
therefore noncompensable.
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An example of unforeseeable reliance
 telegraph company fails to transmit a stockbroker’s message, resulting in millions
of dollars in losses
 the telegraph company could not reasonably expect the stockbroker to rely that
heavily on one message
 so the telegraph company would not be liable for the full extent of the losses
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Another example: the rich uncle’s nephew, when he was promised a trip around
the world, goes out and buys “a white silk suit for the tropics and matching
diamond belt buckle”.
After the uncle refuses to pay for the trip, the nephew sells the suit and belt buckle
at a loss, and sues his uncle for the difference
The court might find the silk suit foreseeable reliance, but the diamond belt
buckle unforeseeable, and only award him the loss on the suit.
(The book points out that “in American law, gift promises are usually enforceable
to the extent of reasonable reliance.”)
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Reliance is part of the issue in the famous case of Hadley v Baxendale, a precedentsetting English case decided in the 1850s
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I give a link to the actual court decision on the syllabus
Here is Cooter and Ulen’s summary of the case:
Hadley owned a gristmill; the main shaft of the mill broke; and Hadley hired a
shipping firm where Baxendale worked to transport the shaft for repair. The
damaged shaft was the only one in Hadley’s mill, which remained closed awaiting
return of the repaired shaft.
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The shaft was supposed to be delivered in one day
Baxendale decided to ship it by boat instead of by train, and as a result, it arrived
a week late
Hadley sued for the profits he lost during that extra week in which the mill was
shut down
Quoting again:
The shipper assumed that Hadley, like most millers, kept a spare shaft. The
shipper contended that Hadley did not inform him of the special urgency in
getting the shaft repaired. The shipper prevailed in court on the damages issue,
and the case subsequently stands for the principle that recovery for breach of
contract is limited to foreseeable damages.
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The ruling was that the lost profits were not foreseeable
o the court specifically listed several circumstances in which a broken
crankshaft would not force a mill to shut down
Baxendale was only held liable for damages he could reasonably have foreseen
However, this isn’t only a question of reliance
Part of the issue is that Hadley knew about the urgency of getting the crankshaft
fixed quickly, but did not tell Baxendale
Recall on Tuesday, we said that the second purpose of contract law is to
encourage the efficient disclosure of information
We’ll come back to this question of information shortly.
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default rules
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In a world without any transaction costs, the two sides to a contract could spell
out exactly what should occur in every possible contingency
o what happens if the cost of sheet metal rises
o what happens if my uncle wants my painting
o what happens if a shipment is delayed, and so on
This would make contract law much simpler – courts could simply enforce the
letter of the contract, since nothing was left unclear
However, in reality, some circumstances are impossible to foresee
And even if they weren’t, the cost and complexity of writing a contract to deal
with every possibility would make perfect contracts unworkable
Risks or circumstances that aren’t specifically addressed in a contract are called
gaps; default rules are rules that the court applies to fill in these gaps.
Gaps can be inadvertent or deliberate
Our contract to sell you my painting might not have addressed my uncle wanting
the painting because I didn’t know he was coming to visit, or because I never
would have imagined he would be so excited about it
On the other hand, we could have imagined that it was at least possible for the
price of raw materials for building an airplane to go up significantly
But we might have felt it was such a remote risk that it was not worth the time and
effort to build it into the contract.
The decision to leave a gap or to fill it (specifically address a particular
contingency) is the difference between allocating a loss after it has occurred (ex
post) and allocating a risk before it becomes a loss (ex ante)
At the time I agree to build you an airplane, there is some risk that the cost of raw
materials will go up
We can choose to worry now about who should bear that risk
Or we can leave it out of the contract, and if that risk becomes a loss (that is, if the
costs do go up), then we can worry about who should bear the loss
In the first case, allocating the risk, the cost of adding it to the contract is
definitely incurred
But in the second case, allocating a loss that has occurred, the cost of allocating
the loss is only incurred when the loss occurs
Thus, it is often rational to leave gaps when the risk is very remote
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But this means that courts must decide what “default rules” should apply to
circumstances that are not addressed in a contract
That is, what rules should fill the gaps that are left in imperfect contracts
The next obvious question is: what should these default rules be?
We will look at two different views of this
Cooter and Ulen answer this question by going back to the Normative Coase
view: the law should be structured to minimize transaction costs
Since filling a gap in a contract requires some cost, the default rule should be the
rule that most parties would want if they chose to negotiate over the issue
This way, most contracts will not have to address this particular rule – they can
use the default rule – and therefore avoid additional transaction costs
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And the rule that most parties would want is whatever rule is efficient.
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They give an example
A construction company has contracted to build a house for a family, and there is
some risk of a worker strike at the company which would delay completion
Suppose that the company can bear the risk of a strike at a cost of $60, and that
the family can bear the risk at a cost of $20
(It might be cheaper for the family to bear the risk because they could stay with
friends for a while if the house were delayed; if the company held the risk, it
might have to pay for a hotel for the family.)
(Also note that these numbers are low not because a strike would have low costs,
but because a strike might be fairly unlikely, so the expected cost is fairly low.)
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If the risk were not addressed by the contract, the default rule would apply.
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If the default rule were for the construction company to bear the risk, this would
be inefficient in this case
The parties could create an additional $40 of surplus by overruling the default rule
(addressing the risk)
So as long as the transaction cost of allocating the risk were not too large, they
would choose to do so, but incur this transaction cost.
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On the other hand, if the default rule were for the family to bear the risk, they
would not need to address the risk in the contract, and would not incur the
transaction cost.
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This brings Cooter and Ulen to their fifth pronouncement:
The fifth purpose of contract law is to minimize transaction costs of negotiating
contracts by supplying efficient default rules.
(leave space)
They also offer a simple rule for doing this:
Impute the terms to the contract that the parties would have agreed to if they had
bargained over the relevant risk.
That is, figure out what terms the parties would have chosen if they had chosen to address
a risk, and let those be the default rule.
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Of course, you don’t want a lot of ambiguity in the law
So you don’t want the default rule to vary constantly with the particular
circumstances of a given case
So what’s more practical to do is to set the default rule to the terms that most
parties would have agreed to
This is called a majoritarian default rule
In circumstances where this is not the efficient rule, the parties are still free to
contract around it, that is, to put terms in the contract that override the default rule
If the parties had chosen to address a particular risk, it’s safe to assume that they
would have allocated it efficiently
That is, as long as the parties were choosing to consider a risk, they would
allocate it in the way that led to the highest total surplus, and then compensate the
party who bears the risk for bearing it
Thus, this is what the court would need to do to figure out the efficient default
rule: it should figure out the efficient allocation of risks, and then adjust prices in
a reasonable way
The book gives an example of this
Again, suppose a family is having a house built
The family and the construction company are negotiating a contract
The construction company knows that with probability ½ , the price of copper
pipe will go up in such a way as to increase the cost of construction by $2,000
So in expectation, the cost of construction will be $1,000 higher due to this risk
The company can hedge against this risk (by buying copper pipe in advance and
then paying to store it somewhere) at a cost of $400
Assume that the family has no reason to know anything about the cost of copper
pipes, and therefore does not anticipate the risk or have any way to mitigate it.
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The company chooses not to hedge this risk
The price of copper pipes does go up
The company builds the house and bills the family $2,000 more than they had
expected
The family refuses to pay, and the case goes to court
The original contract does not say anything about the risk of rising copper prices.
So how would the court address this?
First, the court must decide to whom the contract would have allocated this risk, if
it had addressed it.
Then it must adjust prices to reflect this.
In this case, the cost of bearing the risk would be $1,000 to the family (since they
have no way to mitigate it), but $400 to the company (since hedging the risk is
cheaper than bearing it)
So the company is the efficient bearer of the risk
That is, an efficient contract would have allocated this risk to the construction
company
Next, the court must consider whether the price should be adjusted
In this case, the court might rule that the risk of a spike in copper prices was
foreseeable
The construction company was the efficient bearer of risk, and foresaw, or should
have foreseen, that this risk was present
So the court could assume that the price the parties negotiated already included
compensation for bearing this risk
On the other hand, there are some risks that are unforeseeable
Suppose that the leader of the copper miners’ union in Peru died, and there was a
battle to succeed him, and that his replacement called a strike to flex his muscles,
and that this strike was what led to the increase in copper prices
Here, it’s reasonable that neither party would have foreseen the risk.
In this case, the construction company might still be the efficient bearer of this
risk – since they might be able to make changes to the construction plan to use
less copper and more of other materials
But since the risk was unforeseen, it was not included in the negotiated price
So the court might adjust the price paid to the construction company, to
compensate them for the risk; but then still hold the construction company
responsible for the extra $2,000 in costs
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Thus, the ruling might be that the family should pay some smaller amount – say,
$700 – which is what the company would have needed to receive as compensation
for bearing this risk – but that the company was then responsible for the rest of the
$2,000.
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(The book then continues this story to give another example of overreliance and
breach – check it out if you’re still confused about these points.)
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So the rule in Cooter and Ulen is fairly straightforward:
Courts should set default rules that are efficient in the majority cases, so that…
o most parties can leave that risk unaddressed and save on transaction costs
o while parties can contract around this rule in circumstances where it is not
efficient.
Ian Ayres and Robert Gertner offer a very different take on default rules, in the article
on the syllabus, “Filling Gaps in Incomplete Contracts: An Economic Theory of
Default Rules.”
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They argue that in some instances, it is better to make the default rule something
the parties would not have wanted
Either to give the parties an incentive to specifically address an issue rather than
leaving a gap
Or to give one of the parties an incentive to disclose information
They refer to this type of intentionally-inefficient default rule as a penalty default
Ayres and Gertner argue that in some cases, gaps are left not because the of the
transaction costs of filling them, but for strategic reasons
One party might know that the default rule is inefficient; but negotiating around
the default rule would require him to give up some valuable information, so he
might be tempted not to
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Consider again the case of Hadley v Baxendale, the miller with the broken
crankshaft
While the crankshaft is en route, Hadley’s mill is not operating, so he’s losing
money
Baxendale, the shipper, is the only one who can influence when the crankshaft is
delivered; so he is likely the efficient bearer of this risk
(It was his choice to ship the crankshaft by boat, rather than by rail, that led to the
delay.)
If the default rule were for Baxendale to be responsible for any lost profits,
however, Hadley has no incentive to tell him how urgent the shipment is
In fact, he is likely to not want to mention it; if he made it clear how important the
crankshaft was, Baxendale might try to charge him a higher price for delivery!
So a default rule holding Baxendale responsible for lost profits due to delay
would lead Hadley not to disclose the urgency of his shipment
And this would be inefficient, since it could lead to Baxendale making a bad
decision about what method of shipment to use (this is what happened)
On the other hand, a default rule that Baxendale is not responsible for lost profits
seems to be inefficient
o we just argued that Baxendale is the efficient bearer of this risk
This gives Hadley an incentive to try to negotiate different terms in the actual
contract
Over the course of the negotiations, the urgency would become apparent
Baxendale would agree to take on the risk
But he would also know the costs of delay, and could plan around them better.
So Ayres and Gertner argue that the ruling in Hadley was a good one
Not because the default rule was efficient
But because it was inefficient in a way that created good incentives
In this case, the incentive for the better-informed party to disclose information
(In this sense, the default rule is a “penalty default:” it penalizes the betterinformed party, giving an incentive to contract around the default.)
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Ayres and Gertner offer other examples where penalty defaults are used in the same way
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Consider a real estate broker who is handling the sale of a house by a private
seller to a private buyer
When a buyer’s offer is accepted, he puts down a deposit, called “earnest money,”
to show that he is serious
If he then backs out of the deal, he doesn’t get this earnest money back
The question remains, though, how should the earnest money be divided between
the seller and the broker?
Both the broker and the seller are inconvenienced by the breach; it’s not really
clear who is the efficient bearer of this risk
However, what is clear is that the broker probably knows more about real estate
law than the seller
o The broker is a professional, who does this type of transaction for a living
o The seller might be selling a house for the first time.
If the default rule allowed the broker to keep the earnest money, the broker has no
reason to bring this up when negotiating a contract with the seller
But the seller might not know to bring this up; the seller might have no idea about
earnest money, and not realize that this was another point that could be negotiated
with the broker.
On the other hand, if the default rule gave the earnest money to the seller, the
broker would have a clear incentive to raise this with the seller
And so they could negotiate whatever was the efficient allocation of the earnest
money.
Thus, whether or not it’s efficient, a default rule favoring the less-informed party
once again gives an incentive to disclose information, which may be desireable.
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Ayres and Gertner give another nice example of penalty defaults used for a different
purpose
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When a contract does not specify a price for a good, courts will tend to impute
whatever the market price was at the time of the transaction
That is, they will enforce the contract, and just impose the market price
However, when a contract does not specify a quantity, courts will refuse to
enforce the contract
This means the default rule for price is the market price, but the default rule for
quantity is 0
A quantity of 0 cannot possibly be what the parties would have wanted
Nobody would go through the hassle of signing a contract in order to transact no
goods
So what is the reason for this default rule?
Ayres and Gertner argue it is a penalty default, to force the parties to decide on a
quantity
Why should the parties be forced to decide on a quantity and not a price?
Because it’s easier (cheaper) for the court to fill in the price than the quantity
The rule for figuring out the price the parties would have agreed to is easy – the
court can usually ascertain the market price of a given good on a given date
However, if the court had to impute the quantity the parties would have wanted,
this is much more difficult
The court would have to figure out the marginal value of an incremental unit of
the good to each side to figure out the efficient amount to transact
Thus, shifting the burden of calculating the right quantity from the parties in the
contract to the courts is inefficient
So the default rule forces the parties to decide on the quantity themselves.
Ayres and Gertner do not argue penalty defaults should always be used, only that they are
appropriate in certain circumstances
 They basically argue that we need to look at why parties to a contract leave a
particular type of gap
 When gaps are left due to transaction costs of filling them, efficient defaults make
sense
 However, when gaps are left strategically – by a well-informed party who
chooses not to contract around an inefficient default in order to get “a bigger share
of a smaller pie” – penalty defaults may be more efficient.
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In the conclusion to their paper, Ayres and Gertner cite a similar point from a dissent by
Supreme Court Justice Scalia
 The legislature had passed a RICO (racketeering/corruption) statute and had not
specified a statute of limitations
 The Court was therefore being asked to decide on the statute of limitations
 The majority set the statute of limitations at 4 years, figuring that’s what the
legislature most likely would have chosen had they remembered to specify it
 Scalia proposed no statute of limitations
 He was “unmoved by the fear that this… might prove repugnant to the genius of
our law”
 Instead, he pointed out, “indeed, it might even prompt Congress to enact a
limitations period that it believes appropriate, a judgment far more within its
competence than ours.”
 So his view: rather than do what Congress would have wanted, do something they
would not have wanted, to force them to do it themselves next time
 Exactly the same idea as a penalty default for a contract
It’s a pretty cool article – take a look if you’re interested.
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Default rules are rules which hold when a contract leaves gaps, but which parties to a
contract are free to contract around
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That is, by specifying what should happen in a particular situation, the parties can
override the default rule
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If the default rule did not hold shippers liable for unforeseen losses, Hadley and
Baxendale could still choose negotiate a contract under which the shipper was
liable for all losses
However, there are some rules that cannot be contracted around
 Ayres and Gertner refer to these as immutable rules
 Cooter and Ulen refer to them as mandatory rules, or as regulations
Their Fifth Purpose of Contract Law, which we mentioned earlier, is actually,
The fifth purpose of contract law is to minimize transaction costs of negotiating
contracts by supplying efficient default rules AND REGULATIONS.
What are the circumstances where regulations, or mandatory rules, or immutable rules,
make sense?
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That is, in what circumstances should a rule be made that individuals are not able
to voluntarily contract around?
Think back to Coase
If individuals are rational and there are no transaction costs, private negotiations
(in this case, contracting) will lead to efficiency
So if individuals are rational and there are no transaction costs, any additional
regulation would just get in the way
On the other hand, when individuals are not rational, or when there are transaction
costs or market failures, regulation/immutable rules might be efficient
Next week, we will look at a bunch of these cases.
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