Econ 522
Economics of Law
Dan Quint
Fall 2013
Lecture 14
Reminder
 Midterm 1 on Wednesday, regular class time, in
Education L196
 I’ll hold my usual office hours tomorrow, 2-4
(but can’t stay late)
1
Last week: reasons a contract might not be
enforced
 Derogation of Public Policy
 Incompetence

but not drunkenness
 Duress and Necessity
 Today: several others



performance became impossible
contract was premised on (certain types of) bad information
terms are overly vague or one-sided
2
One final point on duress
3
Real duress versus fake duress
 Court won’t enforce contracts signed under threat of harm

“Give me $100 or I’ll shoot you”
 But many negotiations contain threats


“Give me a raise, or I’ll quit”
“$3,000 is my final offer for the car, take it or I walk”
 The difference?


Threat of destruction of value versus failure to create value
A promise is enforceable if extracted as price of cooperating in
creating value; not if it was extracted by threat to destroy value
4
Example: Alaska Packers’ Association v
Domenico (US Ct App 1902)
 Captain hires crew in Seattle for fishing expedition to Alaska
 In Alaska, crew demands higher wages or they’ll quit,
captain agrees
 Back in Seattle, captain refuses to pay the higher wages,
claiming he agreed to them under duress
 Court ruled for captain

Since crew had already agreed to do the work, no new consideration
was given for promise of higher wage
5
A performance excuse:
impossibility
6
Next doctrine for voiding a contract:
impossibility
 When performance becomes impossible, should promisor
owe damages, or be excused from performing?

A perfect contract would explicitly state who bears each risk

Contract may give clues as to how gaps should be filled

Industry custom might be clear

But in some cases, court must fill gap
7
Next doctrine for voiding a contract:
impossibility
 In most situations, when neither contract nor industry norm
offers guidance, promisor is held liable for breach
 But there are exceptions

Change “destroyed a basic assumption on which the contract was
made”
8
Next doctrine for voiding a contract:
impossibility
 In most situations, when neither contract nor industry norm
offers guidance, promisor is held liable for breach
 But there are exceptions

Change “destroyed a basic assumption on which the contract was
made”
 Efficiency requires assigning liability to the party that can
bear the risk at least cost

How to determine who that is?
9
Who is the efficient bearer of a particular risk?
 Friedman offers several bases for making this determination


Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
10
Who is the efficient bearer of a particular risk?
 Friedman offers several bases for making this determination



Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Adverse selection: who is more aware of risk, even if he can’t do
anything about it?
 “…The party with control over some part of the production
process is in a better position both to prevent losses and to
predict them.
It follows that an efficient contract will usually assign the
loss associated with something going wrong to the party
with control over that particular something.”
11
That’s why Hadley v Baxendale was
“surprising”
 Baxendale (shipper) could influence speed of delivery,
Hadley could not
 So Baxendale was efficient bearer of the risk of delay
 Court ruled he didn’t owe damages for lost profits, forcing
Hadley to bear much of this risk


Only makes sense as a “penalty default”
Rule creates incentive for Hadley to reveal urgency of this shipment
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Contracts based on
bad information
13
Contracts based on faulty information
 Four doctrines for invalidating a contract

Fraud

Failure to disclose

Frustration of purpose

Mutual mistake
14
Fraud
 Fraud: one party was deliberately tricked
source: http://www.wyff4.com/r/29030818/detail.html
15
What if you trick someone by withholding
information?
 Under the civil law, there is a duty to disclose

If you fail to supply information you should have, contract will be
voided – failure to disclose
 Less so under the common law




Seller has to share information about hidden dangers…
…but generally not information that makes a product less valuable
without making it dangerous
Exception: new products come with “implied warranty of fitness”
Another exception: Obde v Schlemeyer
16
Duty to disclose under common law
 Under common law, seller required to inform buyer about
hidden safety risks, generally not other information
 But…




Obde v Schlemeyer (1960, Sup Ct of WA)
Seller knew building was infested with termites, did not tell buyer
Termites should have been exterminated immediately to prevent
further damage
Court in Obde imposed duty to disclose (awarded damages)
17
Duty to disclose under common law
 Under common law, seller required to inform buyer about
hidden safety risks, generally not other information
 But…





Obde v Schlemeyer (1960, Sup Ct of WA)
Seller knew building was infested with termites, did not tell buyer
Termites should have been exterminated immediately to prevent
further damage
Court in Obde imposed duty to disclose (awarded damages)
Some states require used car dealers to reveal major repairs done,
sellers of homes to reveal certain types of defects…
18
Failure to disclose?
source: http://kdvr.com/2012/10/26/chinese-man-sues-wife-for-being-ugly-wins-120000/
19
What if both parties were misinformed?
Frustration of Purpose

Change in circumstance
made the original promise
pointless

Coronation Cases

“When a contingency
makes performance
pointless, assign liability to
party who can bear risk at
least cost”
20
What if both parties were misinformed?
Frustration of Purpose

Change in circumstance
made the original promise
pointless
Mutual Mistake

Mutual mistake about facts



Coronation Cases

“When a contingency
makes performance
pointless, assign liability to
party who can bear risk at
least cost”

Circumstances had already
changed, but we didn’t know
Logger buys land with timber
on it, but forest fire had
wiped out the timber the
week before
Mutual mistake about identity

Disagreement over what was
being sold
21
Another principle for allocating risks
efficiently: uniting knowledge and control
 Hadley v Baxendale (miller and shipper)



Hadley knew shipment was time-critical
But Baxendale was deciding how to ship crankshaft (boat or train)
Party that had information was not the party making decisions
 Efficiency generally requires uniting knowledge and
control


Contracts that unite knowledge and control are generally efficient,
should be upheld
Contracts that separate knowledge and control may be inefficient,
should more often be set aside
22
What About Unilateral Mistake?
 Mutual mistake: neither party had correct information

Contract neither united nor separated knowledge and control
 Unilateral mistake: one party has mistaken information


I know your car is a valuable antique, you think it’s worthless
You sell it to me at a low price
 Contracts based on unilateral mistake are generally
upheld
23
What About Unilateral Mistake?
 Mutual mistake: neither party had correct information

Contract neither united nor separated knowledge and control
 Unilateral mistake: one party has mistaken information


I know your car is a valuable antique, you think it’s worthless
You sell it to me at a low price
 Contracts based on unilateral mistake are generally
upheld


Contracts based on unilateral mistake generally unite knowledge
and control
And, enforcing them creates an incentive to gather information
24
Unilateral mistake: Laidlaw v Organ (U.S.
Supreme Court, 1815)
 War of 1812: British blockaded port of New Orleans

Price of tobacco fell, since it couldn’t be exported
 Organ (tobacco buyer) learned the war was over

Immediately negotiated with Laidlaw firm to buy a bunch of tobacco
at the depressed wartime price
 Next day, news broke the war had ended, price of tobacco
went up, Laidlaw sued

Supreme Court ruled that Organ was not required to communicate
his information
25
Uniting knowledge and control
 Laidlaw v. Organ established: contracts based on unilateral
mistake are generally valid

Agrees with efficiency: these contracts typically unite knowledge
and control
 What about Obde v. Schlemeyer?



The termites case was based on unilateral mistake
Court still upheld contract, but punished seller for hiding information
In that case, contract separated knowledge from control
26
Unilateral mistake: productive versus
redistributive information
 Productive information: information that can be used to
produce more wealth
 Redistributive information: information that can be used to
redistribute wealth in favor of informed party
 Cooter and Ulen



Contracts based on one party’s knowledge of productive
information should be enforced…
…especially if that knowledge was the result of active investment
Contracts based on one party’s knowledge of purely redistributive
information, or fortuitously acquired information, should not be
enforced
27
Other reasons a contract
may not be enforced
28
Vague contract terms
 Courts will generally not enforce contract terms that are
overly vague
 Can be thought of as a penalty default


“Punish” the parties by refusing to enforce contract…
…so people will be more clear when they write contracts
 But some exceptions

Parties may commit to renegotiating the contract “in good faith”
under certain contingencies
29
Adhesion (I): “Shrink-wrap” licenses
 Back when software came on disks or CDs…


Box was wrapped in cellophane
Inside, “By unwrapping this box, you agree to the following terms…”
“Due to the unscheduled trip to the
autowrecking yard the school bus
will be out of commission for two
weeks. Note by reading this letter
out loud you have waived any
responsibility on our part in
perpetuity throughout the known
universe.”
 Contract is not binding if one party had no opportunity to
review it before agreeing
30
Adhesion (II): What if a party chose not to
review the contract?
Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/
31
Adhesion (II): What if a party chose not to
review the contract?
 British computer game retailer GameStation, on April Fool’s
Day, added this to Terms & Conditions customers agreed to
before buying online:
“By placing an order via this website… you agree to grant us a
non-transferable option to claim, for now and for ever more, your
immortal soul.
Should we wish to exercise this option, you agree to surrender your
immortal soul, and any claim you may have on it, within 5 (five)
working days of receiving written notification from
gamestation.co.uk or one of its duly authorised minions.
…If you a) do not believe you have an immortal soul, b) have
already given it to another party, or c) do not wish to grant us such a
license, please click the link below to nullify this sub-clause and
proceed with your transaction.”
32
Adhesion
 Contract of Adhesion: standardized “take-it-or-leave-it”
contract where terms are not negotiable

“Bogus duress”
 Not illegal per se, but might attract “closer scrutiny”

A few state courts have adopted a rule: if I have “reason to believe
that the other party would not agree if he knew the contract
contained a particular term, the term is not part of the agreement”
33
What if you signed a contract that was
dramatically unfair?
 Under bargain theory, courts should ask only whether a
bargain occurred, not whether it was fair

Hamer v Sidway (drinking and smoking)
 But both common and civil law have doctrines for not
enforcing overly one-sided contracts




Unconscionability/Lesion
“Absence of meaningful choice on the part of one party due to
one-sided contract provisions, together with terms which are so
oppressive that no reasonable person would make them and no
fair and honest person would accept them”
When “the sum total of its provisions drives too hard a bargain for
a court of conscience to assist”
Terms which would “shock the conscience of the court”
34
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “Unconscionability has generally been recognized to
include an absence of meaningful choice on the part of
one of the parties together with contract terms which are
unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is
negated by a gross inequality of bargaining power.”
35
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “Unconscionability has generally been recognized to
include an absence of meaningful choice on the part of
one of the parties together with contract terms which are
unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is
negated by a gross inequality of bargaining power.”
36
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “Unconscionability has generally been recognized to
include an absence of meaningful choice on the part of
one of the parties together with contract terms which are
unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is
negated by a gross inequality of bargaining power.”
 Not normal monopoly cases but “situational monopolies”

Think of Ploof v Putnam (sailboat in a storm), not Microsoft
37