Econ 522 – Lecture 11 (Feb 24 2009)
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HW 1 will be returned on Thursday
o (if you didn’t get, I have extra copies of my solutions)
HW 2 is online, not due for a while
Midterm is next Tuesday
o Chao and I are switching our office hours next week to Monday:
o Me: Monday 1:30-3:30, Social Sciences 7428
o Chao: Monday 10-12, Social Sciences 7231
Last Thursday, we examined efficient breach and efficient reliance. We found:
 It’s efficient to breach a contract whenever the cost of performance exceeds the
value of performance
 Expectation damages lead to breach only when it’s efficient
 Reliance is efficient if its expected benefit (its benefit times the probability of
performance) exceeds its cost
 Including the benefit from reliance in expectation damages may lead to
overreliance
 Adjusting expectation damages to include only efficient reliance creates the
correct incentive, but is difficult from a practical point of view
 The law tends to only reward foreseeable reliance, which is reliance that could
reasonably be expected given the situation
We also introduced the notion of default rules – rules that apply in contingencies that
weren’t explicitly addressed in a contract. We saw two very different views of what
default rules should be.
 Cooter and Ulen supported efficient default rules – that is, the rules that most
parties would have chosen if they had addressed a particular risk
o most parties can save transaction costs by not bothering to address those
risks
 Ayres and Gertner introduced the idea of penalty defaults – default rules that are
not efficient, but which penalize one party, in order to encourage them to disclose
information while negotiating the contract
 We saw an example of this: Hadley v Baxendale
o The efficient rule would likely be for the shipper to bear the risk of lost
profits due to delay – since he has more control over how quickly the
delivery happens
o But the ruling penalized Hadley for hiding the urgency of the shipment –
giving an incentive to reveal information
Default rules can be overridden by specific terms of a contract, and are only used in
contingencies the contract didn’t address.
At the end of the last lecture , we introduced the idea of immutable rules, or
regulations, which are rules that always apply, that is, that can’t be overridden.
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Going back to Coase
 if individuals are rational and there are no transaction costs, private negotiations
(in this case, contracting) will lead to efficiency
 so any additional regulation (any rules they’re not allowed to contract around)
would be inefficient
 on the other hand, regulation could be efficient in situations where individuals are
not rational, or where there are transaction costs, externalities, or market failures.
One example of an immutable rule: a contract is not enforceable if its completion would
require violating the law.
 The legal doctrine is derogation of public policy
 Contracts which derogate public policy are not enforceable
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Obvious examples of this would be a sales contract for a kilo of cocaine, or a
contract to kill someone
However, there are also less obvious situations where a contract derogates public
policy, and would therefore be unenforceable
In the U.S., labor unions have a statutory obligation to bargain with management
“in good faith”
A contract between a labor union and a third party, which would violate this
obligation, would therefore derogate public policy, and not be enforced
An example of this is a contract that “ties the union’s hands” in negotiations
Suppose that the union (B) and ownership (C) at a factory are bargaining over
wages
The union wants its workers to earn $15 an hour, ownership is offering $10 an
hour, and negotiations are ongoing.
Now the union goes to a competing factory owner (A) and signs the following
contract:
“If I ever agree to work for C for less than $15 an hour, I promise to have all my
members work for you for $1 an hour.”
The intent of the contract is not for it to actually happen, just to change the
union’s bargaining position with C, by “burning its bridges,” that is, making it
much more costly to back down from its demands.
Since this would violate the union’s obligation to bargain in good faith, this
contract would not be enforced.
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Other examples of contracts which would derogate public policy.
 A victim of a crime offering a policeman a reward for solving the crime
o The police’s job is to solve crimes
o Allowing rewards might distort the focus toward crimes with rewards,
away from more important crimes without rewards
 A contract among competitors to act as a cartel, similar to a monopoly
o A contract that fixed prices, say, would derogate laws designed to foster
competition, and would therefore be unenforceable.
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In general, contracts which can only be performed by breaking the law are not
enforceable
However, there are still some instances where, even though performing would
require laws to be broken, a contract is still enforced, that is, a remedy is still
supplied for breach
Three examples from the textbook:
o “A married man may be liable for inducing a woman to rely on his
promise of marriage, even though the law prohibits him from marrying
without first obtaining a divorce.”
o “A company that fails to supply a good as promised may be liable even
though selling a good with the promised design violates a government
safety regulation.”
o “A company that fails to supply a good as promised may be liable even
though producing the good is impossible without violating an
environmental regulation.”
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In all these examples, the liability rests with the party that knew, or should have
known, that it was committing to something illegal
This is similar to the reasoning in Ayres and Gertner
Putting the liability on the informed party gives them an incentive to be honest (or
in these cases, to not enter into this type of contract)
Cooter and Ulen argue that the promisor should be liable for breach if he knew (or
should have known) that the promise was illegal but the promisee did not
On the other hand, the promisor should not be liable if he did not know the
promise was illegal and the promisee did.
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Derogation of public policy is one example of an immutable rule, or a regulation – a
rule that the parties to a contract cannot overrule
 Most of what we’ve done up to now has been focused on default rules – rules
which hold when the parties chose not to overrule them
 For example, we said that expectation damages lead to efficient breach, and that
they were therefore a good rule for contracts that did not specify damages
 However, we never said that expectation damages should be a mandatory rule
o That is, we never said parties should not be able to specify a different
remedy for breach
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However, there is a legal precedent for a court imposing expectation damages (or
something like them) even when the contract seemed to call for a different
remedy
The case is Peevyhouse v Garland Coal and Mining Company
Decided by the Supreme Court of Oklahoma in 1962
Peevyhouse owned a farm in Oklahoma
Garland contracted to strip-mine some coal on the property
The contract specified that Garland would take certain steps to restore the
property to its previous condition after mining the coal
After mining the coal, Garland made no attempt to take these restorative steps
It was estimated at trial the restoration would cost $29,000
Peevyhouse sued for about that much ($25,000)
The parties agreed during trial that everything else in the contract had been
performed
The defendant introduced evidence that although the damage would cost $29,000
to repair, it lowered the value of the plaintiffs’ farm by only $300
(The “diminution in value” of the farm due to the damage was $300.)
The original jury awarded Peevyhouse $5000 in damages
Both parties appealed to the Oklahoma Supreme Court
o Peevyhouse saying this was less than the service that had been promised
o Garland saying this was still more even than the total value of the farm
after repairs
The OK Supreme Court reduced the damage award to $300.
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At first glance, this seems like a nice example of efficient breach
o Performing the last part of the contract would cost $29,000
o The benefit to the Peevyhouses would be $300
o So it is efficient to breach and pay expectation damages, which is what
was awarded
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However, the dissenting opinion noted that the coal company was well aware of
what they were getting into when they signed the contract
Most coal mining contracts at that time contained a standard per-acre diminution
payment, that the coal company would pay instead of repairing the property
The Peevyhouses specifically rejected that clause of the contract during initial
negotiations, and would not sign the contract unless it specifically promised the
restorative work
The dissent argued that the Peevyhouses were therefore entitled to “specific
performance” of the contract, that is, to have the restorative work completed as
promised.
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Even though objectively, the damage to the property diminished its value by only
$300, the Peevyhouses’ subjective value appears to have suffered much more
Expectation damages are meant to make the promisee as well off as they would
have been under performance – here, this seems not to be the case.
At least one scholar has claimed that the judges who decided Peevyhouse were
either incompetent or corrupt
o one was later impeached, and others resigned
o although others have disagreed
Still, it appears that the ruling here attempted to turn an efficient default rule –
expectation damages – into a mandatory rule, that is, a rule that would be
enforced even when it was not what the parties intended at the time of the
contract.
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Next, I want to discuss a number of ways to get out of a contract, that is, conditions under
which a contract will not be enforced.
These are typically divided into two categories: formation defenses and performance
excuses
 A formation defense is a claim that a contract does not exist: that the
requirements for a contract to be valid were not met
 (Under the bargain theory, for example, a formation defense might be that
consideration was not given.)
 A performance excuse is a claim that, even though a valid contract was created,
circumstances have changed and you should be excused from performing
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We said earlier that, under Coase, when individuals are rational and there are no
transaction costs, voluntary negotiations should lead to efficiency
So refusing to enforce voluntary contracts would not make sense
Thus, most of the doctrines for invalidating a contract can be explained as a
violation of one of these assumptions
o either the individuals agreeing to the contract were not rational
o or there was some sort of transaction cost or market failure
The first exception is that courts will generally not enforce contracts made by irrational
individuals. There are several ways that this can happen. For example:
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children cannot sign binding contracts
the legally insane cannot sign binding contracts
These both fall under the doctrine of incompetence: one party to the contract was not
competent to enter into a binding agreement
 In fact, the law does not automatically invalidate all contracts made with children
or insane people
 It only invalidates contracts which were not in their best interests
 (Basically, the law creates an incentive not to cheat people who can’t take care of
themselves.)
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My first time teaching this course, after I introduced the doctrine of incompetence, one of
my students emailed me an excellent question: what if you signed a contract while
drunk?
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Can a drunk person sign a legally enforceable contract?
or would the fact that he was drunk get him off the hook?
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We mentioned that the bargain theory required a “meeting of the minds” to agree
to a contract
It’s reasonable to question whether this could occur with someone who was drunk
However, the general rule in the U.S. is this:
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You have to be really, really, really drunk for the contract not to count.
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OK, that’s not how it’s written in the case law
The rule is, for a contract to be unenforceable, you need to have been “intoxicated
to the extent of being unable to comprehend the nature and consequences of the
instrument he executed.”
Basically, not just drunk enough to have bad judgment, but drunk enough to have
no idea of what you’re doing
There’s a classic case that upheld this standard, Lucy v Zehmer, decided by the
Supreme Court of Virginia in 1954
It’s a little embarrassing when your drunken antics end up in front of a state
supreme court
But the case makes for really fun reading
The Zehmers owned a farm
The Lucys had been trying to buy it from them for a long time
(They had made multiple offers, over the course of several years, beginning at
$20,000.)
One night, Zehmer’s out drinking, and he runs into Lucy
They continue to drink, and at some point, Lucy says something like, “I bet you’d
sell that farm for $50,000.”
Zehmer says, “You don’t have $50,000.”
Lucy says, “I can get it!”
Zehmer says, “No you can’t!”
They argue for a while about whether Lucy would be able to raise $50,000
And eventually Lucy says, “Write it down!”
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So Zehmer grabs a discarded guest check (seriously), turns it over, and writes on
the back, “I agree to sell such-and-such farm to this guy for $50,000.”
It was revealed at trial that among other things, Zehmer had misspelled both the
name of the farm and the word “satisfactory”
Lucy says, “Hold on a second, your wife owns it too!”
So Zehmer crosses out the word “I”, replaces it with “We,” and walks to the other
end of the bar where his wife is sitting
He tells her to sign it, she says, “What?”
He whispers to her, don’t worry, it’s just a joke, we’re not selling the farm
So she signs it
They add a couple more legal terms to make it look like a contract
o giving the Lucys the right to check the validity of the title
He brings it back, Lucy takes the contract and puts it in his pocket
Monday morning, Lucy goes to the registry of deeds to check the title, starts
raising the money, and contacts Zehmer to carry out the contract
Zehmer claims he was drunk, and joking, and refuses to honor the contract
Lucy sues for specific performance, that is, asks the court to force Zehmer to sell
him the farm at the agreed price
There was some dispute during trial about exactly how drunk Zehmer was
But it was ruled that while he was clearly drunk, he was not so drunk as to be
“unable to comprehend the nature and consequences” of what he was doing
(For one thing, a little while later, his wife asked him to drive her home.)
Most of the opinion focuses on whether Lucy knew that Zehmer was joking when
he wrote what looked like a proper, if unusual, legal contract
The court basically ruled that it wasn’t Lucy’s job to know Zehmer was joking
o That is, Zehmer may have thought he was joking, but it looked to Lucy
like he was serious
o Zehmer behaved exactly as he would have behaved if he were drunk but
actually wanted to sell the farm; which was good enough.
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You may think, being drunk, Zehmer lacked the necessary intent to enter into a
contract
Still, it probably makes sense not to make it too easy to invalidate a contract on
the grounds that one of the parties was drunk, or joking
o If the ruling went the other way, it seems there would an awful lot of
litigation over exactly how drunk someone was when a contract was
signed
o Not to mention a lot more contracts being signed in bars, to give the
parties an easy way out
o Or maybe a lot of lawyers carrying breathalyzers to make sure their
contracts would be enforceable
Basically, a more nuanced rule would be extremely difficult and costly to enforce
So we seem to accept the cost of an occasional person making a bad decision
while drunk, in order to keep the system working well the rest of the time.
However, that’s not quite the final word on drunkenness
If you were visibly drunk – that is, the other party clearly knew you were drunk –
the court might be more willing to finding the contract unenforceable on other
grounds (which we’ll get to shortly)
o such as fraud (you were tricked into signing)
o or unconscionability (the contract is too one-sided)
I suspect that if Zehmer had agreed to sell the farm for $10, the contract would
not have been upheld
But that since the terms seemed reasonable, it was
There’s also a more recent example of the doctrine that being drunk does not get
you out of a contract: the Borat lawsuits
Two of the frat boys who ended up looking like racist a-holes in the movie Borat
sued
They claimed they were tricked into signing the releases agreeing to be in the
movie
It seems the movie’s producers got them drunk and then asked them to sign the
releases
And may have lied to them a lot – telling them the movie was only going to be
released in Europe, they wouldn’t release the frat boys’ names, or college, or frat
Part of the problem for them is that the releases contained what are called “merger
clauses”
Merger clauses basically say, it doesn’t matter what else we already told you, all
we’re agreeing to is what’s in this contract
(Basically, any prior verbal agreement is “merged into” this contract, which is the
only thing we’re agreeing to.)
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It’s kind of sneaky, but it does seem to legally absolve the producers of anything
they told the frat boys to get them to sign but that wasn’t in the contract
Again, just being drunk doesn’t get you out of a contract
One of the fratboys seemed to find it relevant that he was under the drinking age;
but that, if anything, would make the producers liable in criminal court (for
supplying alcohol to a minor), but not invalidate the releases
(It’s also been established that the frat boys were all already heavy drinkers,
unsurprisingly.)
As far as I know, the lawsuits have all been dismissed, and the frat boys got
nothing.
(Since they’re not in the textbook; for the opinion in the Lucy v Zehmer case, which
really does make great reading, see
http://www.finance.pamplin.vt.edu/faculty/sds/Lucy.pdf
For an overview of the legal issues in the Borat lawsuits, see a piece by Julie Hilden, with
the brilliant title “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for
Make Benefit Guileless Americans in Film” at
http://writ.corporate.findlaw.com/hilden/20061129.html
)
So the moral of the story, I suppose, is don’t get drunk with people who might ask you to
sign contracts.
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Back to contract law, and another situation in which we would not expect people to act
rationally:
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courts will not enforce contracts signed under dire constraints, specifically,
duress and necessity
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Necessity is when I’m at the point of starvation, and someone comes along and
offers me a sandwich for $10,000
I don’t have it on me, so I sign a contract agreeing to pay him $10,000 and I eat
the sandwich
Or I’m on a boat that’s about to sink, and another boat offers me a ride back to
shore for a million dollars
In either case, the contract would not be upheld, since I signed it out of necessity.
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Duress is similar, but when the uncomfortable situation I’m in is being caused by
the other party
This is when someone kidnaps my child, and I agree to pay ransom to get her
back
The contract is not enforceable, because I agreed to it under duress
This is exactly the idea of “making someone an offer he can’t refuse” from the
Godfather; courts would not uphold a contract signed at gunpoint
(Of course, whether you want to breach a contract with the Mafia, or sue the
Mafia, is a separate question.)
It’s not that hard to argue against holding people responsible for promises made
under duress or necessity based on notions of fairness and morality
The Friedman book (Law’s Order), however, tries to explain both of these in
straight economic terms – I like his treatment a lot
Duress
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He begins with an example of duress
A mugger approaches you in an alley and threatens to kill you unless you give
him $100
You don’t have $100 on you, but he says he’ll accept a check
When you get home, can you stop payment on the check?
Or do you have to honor the agreement you made?
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Recall our principle from before:
Efficiency requires enforcing a contract if both parties wanted it to be enforceable
Clearly, the mugger wants the agreement to be enforceable; he’d rather have $100
than kill you
And if you believe he’ll kill you if you don’t give him the money, then you
clearly want it to be enforceable as well
So making the contract enforceable seems to be a Pareto-improvement
So what’s the problem?
The problem, of course, is that even if such a contract is a Pareto-improvement
once you’re in the situation, making such contracts enforceable encourages more
muggings, since it increases the gains
So refusing to enforce contracts signed under duress seems to trade off a shortterm “loss” – the efficiency lost by ruling out some mutually beneficial trades –
against creating less incentive for the bad behavior that put you in that situation in
the first place.
(The fact that there is a tradeoff here suggests that it may not be optimal to rule
out enforceability under every instance of duress
For example, peace treaties can be thought of as contracts signed under duress –
the losing side is facing the threat of continuing to battle a superior force
Most people agree that peace treaties being enforceable is a good thing
Peace treaties are clearly a good thing “ex post” – they make war less costly, by
ending it more quickly
It’s possible that by making war less costly, they encourage more wars – but it
seems unlikely that this has much effect
It’s probably efficient for peace treaties to be enforceable, but for promises made
to a mugger to be unenforceable.)
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Necessity
However, the logic that tells us that contracts with muggers shouldn’t be enforced doesn’t
work for contracts signed under necessity.
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You’re out sailing on your $10 million boat and get caught in a storm
The boat starts taking on water and slowly begins to sink
A tugboat comes by and offers to tow you back to shore, if you pay him $9
million
If not, he won’t leave you to die – he’ll give you and your crew a ride back to
shore, but your boat will be lost.
With duress, we argued that making the contract enforceable would encourage
muggers to commit more crimes, which is bad
But here, making the contract enforceable would encourage tugboats to make
themselves available to rescue more boats – so how is that a bad thing?
In fact, Friedman points out that if we consider the tugboat captain’s decision
beforehand – how much to invest in being in the right place at the right time – the
higher the price, the better
The total gain (to all parties) from the tugboat being there is the value of your
boat, minus the cost of rescuing it – say, $10,000,000 - $10,000 = $9,990,000
Allowing the tugboat to recover the entire value of the boat would make his
private gain from rescuing you exactly match the social gain
This would cause the tugboat captain to invest the socially optimal amount in
being available to rescue you!
But on the other hand, consider your decision about whether to take your boat out
on a day when a storm is a possibility
Suppose there’s a 1-in-100 chance of being caught in a storm
And if you are caught in a storm, there’s a one-in-two chance a tugboat will be
there to rescue you.
If the tugboat captain can charge you the full value of your boat, then when
weighing the costs and benefits of going sailing that day, you consider a 1-in-100
chance of losing the full value of the boat
That is, in your analysis of whether it’s worth sailing, you’ll include the 1/200
possibility the boat sinks, and the 1/200 possibility you pay its full value to an
opportunistic tugboat captain – a total expected cost of $100,000
So you’ll only go sailing on days where your benefit is greater than $100,000
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But when you go sailing and start to sink, half the time, your loss is the tugboat
captain’s gain
The social cost of you sailing includes a 1-in-200 chance the boat is lost, plus a 1in-200 chance it has to be towed to shore
So the total expected cost is $10,000,000 / 200 + $10,000 / 200 = $50,050
So efficiency says you should go out sailing whenever the benefit to you is greater
than $50,050.
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So if the tugboat captain is able to charge you the full value of the boat, you will
“undersail”
o That is, in cases where your private gain from sailing is between $50,050
and $100,000, efficiency would suggest you should sail
o But since the private cost outweighs the benefit, you choose not to.
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On the other hand, suppose the tugboat could only charge you the cost of the tow
Then the social cost of sailing would match the private cost to you - $50,050
This would lead you to go sailing exactly the efficient amount.
Friedman, then, makes the following point
 The same transaction sets ex-ante incentives on both parties
 And the price that would lead to an efficient decision by one of them, would lead
to an inefficient decision by the other.
So, what should we do?
 As Friedman puts it, “put the incentive where it will do the most good.”
 Somewhere in between the cost of the tow and $10 million is the “least bad” price
o That is, the price that minimizes the losses due to inefficient choices by
both sides
 If the tugboat captain is more sensitive to incentives than you are, the best price is
likely closer to the value of the boat
 If you respond more to incentives than he does, the best price may be closer to the
cost of the tow
 But regardless of the details, two things will generally be true:
o the least inefficient price is somewhere in the middle
o and there’s no reason for it to be the price that would be negotiated during
the storm
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That is, once you’re caught in a storm, all the relevant decisions have already
been made
o you’ve decided whether to sail
o the tugboat captain has decided whether to be out there looking for sinking
sailboats
Those are like sunk costs – they don’t affect your bargaining position now
So there’s no reason that, if you bargained over saving your boat during the storm,
you’d end up anywhere near that efficient price
On the other hand, there’s always the risk that bargaining breaks down and you
refuse the tugboat captain’s offer, incurring a large social cost (the value of the
boat minus the tow is lost)
So from an efficiency point of view, it makes sense for courts to step in, overturn
contracts that were signed under necessity, and replace them with what would
have been ex-ante optimal terms
This takes away the need to bargain hard during the storm, ensuring that the boat
is saved; and it creates the “least bad” combination of incentives.
So that’s Friedman’s take on duress and necessity.
There’s an important point here that is more general:
 that a single price creates multiple incentives
 and they cannot all be set efficiently at the same time
 we already saw this with remedies for breach
o expectation damages set the incentive to breach the contract efficiently –
that is, lead to efficient breach
o but they set a different incentive incorrectly – the incentive to sign the
contract in the first place
o If you will owe expectation damages under circumstances that favor
breach, the private cost of those circumstances is higher to you than the
social cost
o so you may forego some contracts that would be overall value-creating
o later on, we’ll come to a different type of damages which would lead to
efficient signing decisions, but inefficient breach
o we also saw that it’s difficult to set a general rule that accomplishes both
efficient breach and efficient reliance
o you basically have to “cheat” and count on courts to decide what level of
reliance would have been efficient
o Again, it’s often difficult, or impossible, to set all the incentives correctly
at the same time.
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Going back to duress
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We just said that 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
o “give me a raise or I’ll quit and work for your competitor”
o “$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
There’s a nice example of this in the textbook
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(I believe taken from a real case: Alaska Packers’ Association v. Domenico, US
Court of Appeals, 1902)
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, or else they’ll quit
working
Having little choice, the captain agrees
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.
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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 should be enforceable if both
parties wanted them to be enforceable at the time of the agreement
This principle also extends to renegotiated contracts
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
So 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 it will not be enforced; but a
contract that is renegotiated under changed circumstances will.
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
 If you run out of gas on a remote road and a passing driver offers you gas for
$100 a gallon, he 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.
o textbook has more detail on this
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Impossibility
Another doctrine that will make some contracts unenforceable is impossibility
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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 whether he
owes his would-be patient damages
As we mentioned last week, a perfect contract would specify explicitly who
would bear that risk
But due to transaction costs, real contracts will generally not address risks that are
very remote
In some cases, even if it does not address the risk explicitly, the contract itself
may give clues as to how the gap should be filled
An example of this from the textbook:
o a drilling company agrees to drill a well for a landowner, but the drill runs
into impenetrable granite
o Suppose that the driller was competing with other companies for the offer,
but the landowner agreed to a price much higher than the competition
o 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
(To put it another way, contract liability is strict.)
So a construction company that finishes a building late due because or unexpected
complications is generally liable.
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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
o 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”
o The painter assumed he would be alive
o the manufacturer assumed his factory would be useable
Under this theory, if a contract is made in good faith and then events destroy one
of its basic assumptions, breach is excused.
Of course, 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.
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In many cases, one party can take precautions to minimize the risk
o the manufacturer can install sprinklers in his factory
o the painter can prioritize commissioned pieces over other work
o 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 lowcost 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.)
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