WEB NOTES
Sixth Edition
The following are the web notes for the sixth edition of Law and Economics by Robert D.
Cooter and Thomas S. Ulen. Our intent in these notes is to extend the material in the text by describing some additional issues, articles, cases, and books. Because the fields of law, economics,
and law and economics are not standing still – because, that is, scholars are adding interesting
new material all the time, we may supplement, alter, and add to these notes from time to time.
Each note begins with a copy of the material from the text about the content of the web note
and the page on which that web note can be found. We will from time to time insert new material, update some of the entries, and add some additional material. You should be able to download pdf versions of each chapter’s web notes and of the entire set of web notes for all 13 chapters.
We have found that the very best students and their instructors from all over the world pay
close attention to these web notes. They often have good ideas about how to add to the entries
already here and suggestions about articles, cases, books, and topics that would be instructive to
add. We would be grateful for any comments or suggestions about any of the notes.
Chapter 8
Web Note 8.1 (p. 287)
Our website describes some recent literature on liability for precontractual bargaining
costs and the economics of gift promises.
Pre-Contractual Liability
Suppose that two parties begin to negotiate a contract. Suppose further that they get far
enough in the process that prospects for a successful completion to the negotiations and a fullblown contractual agreement are not unlikely. There are complexities and uncertainties about
whether the contemplated transaction will be mutually profitable. Suppose that one of the parties
believes that the expected value of a successful negotiation is high enough that it either incurs
some direct costs in anticipation of the contractual relationship’s being concluded (such as ordering equipment) or some indirect costs (such as breaking off negotiations with an alternative contractual partner). And, finally, suppose that the negotiations fail – the parties cannot complete
the contract.
In these circumstances, absent a contract, can one party claim reliance (or other) damages
against another with whom it negotiated but did not formalize a contract? That is, should there
be “precontractual liability?
A recent article by Professors Alan Schwartz and Robert Scott (“Precontratual Liability and
Preliminary Agreements,” 120 Harv. L. Rev. 661 (2007)) considers these matters from an economic point of view. We begin with the abstract of the article and then give some more extensive quotes from the article.
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Abstract: “For decades, there has been substantial uncertainty regarding when the law will impose precontractual liability. The confusion is partly due to scholars’ failure to recover the law
in action governing precontractual liability issues. In this Article, Professor Schwartz and Scott
show first that no liability attaches for representations made during preliminary negotiations.
Courts have divided, however, over the question of liability when parties make reliance investments following a ‘preliminary agreement.’ A number of modern courts impost a duty to bargain in good faith on the party wishing to exit such an agreement. Substantial uncertainty remains, however, regarding when this duty attaches and what the duty entails. Professors
Schwartz and Scott develop a model showing that parties create preliminary agreements rather
than complete contracts when their project can take a number of forms and the parties are unsure
which form will maximize profits. A preliminary agreement allocates investment tasks between
the parties, specifies investment timing, and commits the parties only to pursue a profitable project. Parties sink costs in the project because investment accelerates the realization of returns
and illuminates whether any of the possible project types would be profitable to pursue. A party
to a preliminary agreement ‘breaches’ when it delays its investment beyond the time the agreement specifies. Delay will save costs for this party if no project turns out to be profitable and
will improve this party’s bargaining power in any negotiation to a complete contract. Delay often disadvantages the promisee, and when parties anticipate such strategic behavior, they are less
likely to make preliminary agreements. This disincentive is unfortunate because a preliminary
agreement often is a necessary condition to the realization of a socially efficient opportunity.
Thus, contract law should encourage relation-specific investments in preliminary agreements by
awarding the promisee his verifiable reliance if the promisor has strategically delayed investment. Professors Schwartz and Scott study a large sample of appellate cases showing that: 91)
parties appear to make the preliminary agreements described in the model and breach for the reasons the model identifies, and (2) courts sometimes protect the promisee’s reliance interest when
they should, but the courts’ imperfect understanding of the parties’ behavior sometimes leads
them to err.”
Later, the authors write:
“Parties have made a ‘fully binding contract’ when they have agree on all material terms and
memorialized their agreement in a final written document. If the parties have not yet reached a
fully binding contract, their negotiations will fall into one of three categories. First, the parties
have engaged in ‘preliminary negotiations’ when they have discuss a deal but have no agree to
one. In this event, the disappointed party can recover nothing. Second, the parties have agreed
on all material terms and intend to memorialize this agreement in a formal document. In the interval between agreement and memorialization, the promisor has had a change of heart. Courts
treat this type of agreement as a fully binding contract when the evidence supports a finding that
the parties did not intend the formalization of their agreement to be essential as is usual with
binding contracts, courts protect the promisee’s expectation interest. Third, the parties have
made a preliminary agreement as defined above when they have agreed on certain terms but left
other terms open, so that the best inference from their negotiations is that they have made a binding preliminary commitment to pursue a profitable transaction. Here, the emerging legal rule
requires parties to such preliminary agreements to bargain in good faith over open terms. Should
the promisor – the party who prefers to exit – fail to bargain in good faith, she will be for the
promisee’s reliance expenditures.” 664-665.
And then, shifting to the perspective of the parties who are negotiating:: “There are three
open questions that must be answered. First, parties often write complete contracts – or contracts
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that are as complete as they can write – before they make relation-specific investments. Why do
parties in this context make preliminary agreements? Second. Although it sometimes is infeasible for parties to write a complete contract at the beginning of their relationship, it does not follow that they must sink costs in what may turn out to be an unprofitable venture. A common alternative is to delay contracting until the ex post state of the world becomes clear. Why do these
parties invest after making the preliminary agreement but before uncertainty is resolved? Third,
parties would not invest in this interval unless the expected value of investment were positive.
However, investments are sunk when uncertainty dissipates, so the fact of investment will not
cause the parties to pursue a deal that will lose money. If both parties realize that exit is best,
how, then, can one of them have a reasonable expectation that the other will reimburse his sunk
costs in the absence of a specific promise?
“Our article is the first to address these three questions as a set. Parties make a preliminary
agreement because they cannot write a complete contract at the outset: they function in a complex environment in which a profitable project can take a number of forms, and just which form
will work, if any, is unknown at the start. … Preliminary agreements thus commonly are exploratory; that is, the performance of a preliminary agreement sometimes is a necessary condition for parties to pursue an efficient project later.” 665-666.
…
“It is efficient for contract law to protect the promisee’s reliance interest if his promisor deviated from an agreed investment sequence. A reliance recovery will encourage parties to make
preliminary agreements and will deter some strategic behavior. Therefore, the new rule governing preliminary agreements – awarding the promisee reliance if the promisor fails to bargain in
good faith but not requiring the parties to agree – is a step in the right direction. The law cannot
protect the promisee’s expectation interest because, in the context that we study, there is no
complete contract to enforce.
“The new legal rule is deficient, however, because it is unnecessary to require parties to bargain in good faith. As we show, efficiency would be enhanced if the law were simply to protect
the promisee’s reliance interest.” 667.
The most common case that American law students study about precontractual liability is
Hoffman v. Red Owl Stores, Inc., 133 N.W.2d (Wis. 1965). Here are the facts: “Hoffman and
Red Owl engaged in extensive negotiations and preparations aimed at Hoffman’s opening a Red
Owl franchise. In the course of these negotiations, Red Owl officials recommended that Hoffman take numerous financial and nonfinancial actions. He followed these recommendations because the officials also assured him that $18,000 would be a sufficient capital investment. thereafter, Red Owl developed several financing proposals, the last of which require Hoffman to contribute $34,000 of debt and equity. In response, Hoffman broke off negotiations and sued Red
Owl to recover his sunk costs. The court held as a matter of law that the parties never reached
agreement on essential factors necessary to establish a contract. For example, they had not
agreed on any of the details concerning Red Owl’s investment, such as the size, cost, design, and
layout of the store, nor had the parties agreed on the terms of the lease, including rent, maintenance, renewal, and franchise purchase options. Indeed, the parties never agreed on just what
was meant by the statement that $18,000 of capital would be a sufficient investment to sustain a
franchise. Thus, the court held, there could be no basis-of-the-bargain liability, nevertheless, the
court permitted Hoffman to recover sunk costs based on the doctrine of promissory estoppel.”
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Schwartz and Scott do not like this outcome. “There is scant support in the law of contracts
for this legal analysis. … More importantly, [this case] is an outlier: the case has not been followed in its own or other jurisdictions.” 669-70.
The authors put together a data set of 105 cases litigated between 1999 and 2003 for recovery
for precontractual liability in order to see .
“The cases in our sample fell into four patterns, each of which produced a different legal outcome. Thirty cases raised the issue of reliance in the absence of any agreement by the parties
regarding terms. … The courts did not find liability, whether based on promissory estoppel or
quantum meruit [Latin for “what one has earned”; both estoppel and quantum meruit are equitable concepts; quantum meruit is typically invoked to get compensation to someone who has provided services or goods to another in the absence of a completed contract], in 26, or approximately 87 percent, of the 30 preliminary negotiation cases. The case data thus show that, absent
misrepresentation or deceit, there generally is no liability for inducing reliance investments during the negotiation process. In 27 cases, the parties had agreed on some material terms, but the
court nonetheless denied recovery for breach of contract because the parties had also indicated,
either expressly or by implication, that they did not intend to be legally bound. Thirty-six cases
turned on whether preliminary agreements were sufficiently complete to be binding contracts,
even though they contemplated a further memorialization, because the evidence showed that the
formal writing may not have been essential. … Finally, and most interesting, 12 cases turned on
whether there was a preliminary agreement to negotiate further in good faith. In sum, the sample
shows that courts consistently have denied recovery for precontractual reliance unless the parties,
by agreeing on something significant, indicated their intention to be bound.” 672-73.
“Substantial confusion remains regarding just how complete a preliminary agreement must
be to justify enforcement and just what remedies for breach are appropriate.” 703.
“[Our model] shows that commercial parties sometimes maximize expected surplus by beginning projects that, while promising, are too complex to describe in formal contract. The parties nevertheless understand what their project will be, what the primary responsibilities of each
will be, and the rough order in which their contributions will be made.” 703.
“Courts encourage efficient investment by enforcing contracts, and they encourage the exploration of investment opportunities by not protecting the expectation interest of parties disappointed by the failure to reach agreement. We show here that courts have a further facilitative
rule: to encourage exploration of investment opportunities by protecting the promisee’s verifiable reliance when the promisor strategically delays investment and thus breaches an ex ante efficient agreement to pursue a potentially profitable deal. Anticipating the availability of a reliance
recovery can motivate parties to sink costs in the exploration of possibly profitable ventures and
thus will expand the set of efficient contracts that parties can create.” 703-04.
Schwartz and Scott give several reasons why their analysis should help courts. Of these, this
one struck us as the most important: “it shows what must be settled for there to be an actionable
preliminary agreement: the parties must agree on the type of project, such as a shopping center or
a financing; on an imprecise but workable division of authority for investment behavior; and on
the rough order in which their actions are to be taken.” 704.
See, also, E. Allan Farnsworth, “Precontractual Liability and Preliminary Agreements: Fair
Dealing and Failed Negotiations,” 87 Colum. L. Rev. 217 (1987); Lucian A. Bebchuck & Omri
Ben-Shahar, “Precontractual Reliance,” 50 J. Legal Stud. 423 (2001); Richard Craswell, “Offer,
Acceptance, and Efficient Reliance,” 48 Stan. L. Rev. 481 (1996); Jason Scott Johnston, “Com4
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munication and Courtship: Cheap Talk Economics and the Law of Contract Formation,” 85 Va.
L. Rev. 385 (1999); and Avery Katz, “Should an Offer Stick?: The Economics of Promissory Estoppel in Preliminary Negotiations,” 105 Yale L.J. 1249 (1996).
The Enforceability of Gift Promises
The economically informed literature on gift promises is extensive. Some of the leading early articles to consider are these: Richard A. Posner, “Gratuitous Promises in Economics and
Law,” 6 J. Legal Stud. 411 (1977); Charles J. Goetz & Robert E. Scott, “Enforcing Promises: An
Examination of the Basis of Contract,” 89 Yale L. J. 1261 (1980); and Steven Shavell, “An Economic Analysis of Altruism and Deferred Gifts,” 20 J. Legal Stud. 401 (1991). There are important, subtle differences among these articles, but the common thrust among them is that the
old, doctrinal bargain-promise theory’s presumption against the enforceability of gift or donative
promises does not withstand careful scrutiny. That does not mean that they all believe that gift
promises should be presumptively enforceable. Rather, they all recognize that gift promises
might be enforceable if the appropriate circumstances for distinguishing serious from nonserious can be identified.
Examples of two important, relatively recent articles in this area are those by Mel Eisenberg
and Andrew Kull. Here are some brief notes on those articles.
Melvin A. Eisenberg, “Donative Promises,” 47 U. Chi. L. Rev. 1 (1979).
Professor Eisenberg beings with the observation that “[t]hree propositions are of central importance to this article and should therefore be stated at the outset. First, the issue of consideration is often merely a screen for complex issues of damages. … Second, contract rules must reflect considerations of adminstrability, particularly information costs, as well as considerations
of substance. An otherwise preferable rule may therefore be rejected if its application turns on
facts that cannot be readily, reliably, and suitably determined in the relevant forum. Third, in
analyzing the enforceability of donative promises, the critical distinctions are whether or not the
promise is formal – that is, case in a form to which special significance is attached – and whether
or not the promisee has incurred a significant cost in reliance on the promise by changing his position or forgoing an opportunity.”
He concludes that unrelied-upon, informal donative should not be enforceable” and reliedupon formal donative promised should be enforced to the extent of the reliance.” “Unreliedupon formal donative promises present a borderline case for enforceability.” He suggests that
there be this simple rule for resolving these borderline cases: “A promise that is reasonably relied
upon is enforceable to the extent of the reliance.”
Melvin A. Eisenberg, “The World of Promise and the World of Gift,” 85 Cal. L. Rev. 821
(1997).
Abstract: Under the donative-promise principle, a simple, unrelied-upon donative promise is
unenforceable. In the past, this principle has been explained largely on the ground that a rule under which such promises were enforceable would involve significant process problems. In this
Article, Professor Eisenberg develops two substantive bases for the donative-promise principle:
(1) The world of gift would be impoverished if simple donative promises that are based on affective considerations, such as love or friendship, were folded into the hard-headed world of contract. (2) Where a donative promise is based on affective considerations, in the absence of reli5
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ance a donative promisee is morally obliged to release a repenting promisor. In the course of the
Article, Professor Eisenberg shows why the principles that govern donative promises play a key
role in both contract doctrine and the social significance of contract doctrine. For example, developments in the area of donative promises have been instrumental in leading to a new principle
of contract remedies, under which the extent to which a promise is enforceable depends on the
reason why the promise is enforceable. Professor Eisenberg also considers the major theses that
have been put forward in recent commentary on donative promises, including claims that under
present law all seriously made promises are enforceable by expectation damages.
Andrew Kull, “Reconsidering Gratuitous Promises,” 21 J. Legal Stud. 39 (1992).
Professor Kull “offers three suggestions for reexamining the received wisdom on the subject
of gratuitous promises[, which is that those promises ought to be presumptively unenforceable,
even though courts seem to be willing to enforce them]. First, if the case law is scrutinized for
outcomes rather than for judicial statement, an unequivocal promises of a gift, seriously intended, should probably be seen as presumptively enforceable rather than the contrary. Second, the
standard modern justification of the nonenforceability of such promises was derived by attributing to them characteristics opposite to those attributed by [older commentators such as Lon]
Fuller and others to bargain promises[, such as consideration]. The resulting description of gratuitous promises (though widely repeated) is inaccurate and will not justify the refusal to enforce
them. Third, the affirmative reason for enforcing gratuitous promises can be found by considering the benefits of enforceability to the promisor at the time the promise is made and not (as has
been customary) by weighing the dubious merits of the promisee against the presumptive hardship of the promisor in the context of litigation ex post.”
In his conclusion, Kull says, “If people who make gratuitous promises are presumed to be as
rational as those who make bargain promises and no more in need of special protection, then
their promises have no less claim on the social resources devoted to enforcement. All gratuitous
promises are presumptively beneficial to the promisor at the time the promise is made; relatively
few cause subsequent regret. The fundamental misconception of the older, paternalistic reasoning about gratuitous promises lay in treating the set of litigated promises (both real and hypothetical) as if it constituted the whole universe of such promises. The result was inevitable to see the
enforcement of gratuitous promises as a detriment to those who make them; when, on the contrary, a rule of nonenforceability penalties gratuitous promisors by restricting the terms on which
they may arrange their affairs.”
Web Note 8.2 (p. 296)
Much research has been done recently on deviations from individual rationality. See our
website for a discussion of some of that literature as it applies to the theory of contracts.
One of the themes that we have sought to stress in this edition of Law and Economics is the
importance of behavioral studies for the economic analysis of law. You will find in the text
some reference to some behavioral studies of contractual issues, such as Tess Wilkinson-Ryan’s
experiments on the effects of inserting liquidated damages clauses. And in some of the Web
Notes for Chapter 9, we discuss some behavior literature.
The three articles that we summarize here are excellent introductions to some of the issues.
At the end of the note, we list some additional articles that you might wish to read.
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Melvin Aron Eisenberg, “The Limits of Cognition and The Limits of Contract,” 47 Stan. L. Rev.
211 (1995).
A basic principle of contract law is that bargains are enforced according to their terms, this
principle is called “bargain principle”. A complex of social propositions supports the bargain
principle. Parties are normally the best judges of their own utility, and normally reveal their determinations of utility in their promises. Bargain promises are normally made in a deliberate
manner for personal gain, and so these promises should be kept. Also, bargains create value, enable the parties to plain their future conduct reliably, allocate commodities to their highestvalued uses, and best distribute the factors of production, and the enforcement of bargain promises promotes these desirable ends. In addition, these propositions, and therefore the bargain
principle itself, rest on the empirical premise that in making a bargain a contracting party will act
with full cognition to rationally maximize his subjective expected utility.
However, contract law recognizes a number of exceptions to the rule that courts should fully
enforce bargains between capable actors. Eisenberg argues that we can justify a number of these
doctrines by reference to the limits of human cognition. He shows that a recent empirical research on the cognitive limits and the theoretical framework for the empirical evidence has established a formal scientific foundation for the limits of the cognition. Then, he also shows how
these discoveries shed light on six areas of contract: liquidated damages, express conditions,
form contracts, contracts to waive fiduciary obligations, and prenuptial agreements. While the
limits of cognition do not explain all of contract law, Eisenberg argues, and understanding of the
psychological constraints on decisionmaking should play a central role in the development of
contract doctrine.
Robert E. Scott, “The Limits of Behavioral Theories of Law and Social Norms,” 86 Va. L. Rev.
1603 (2000).
Scott argues that the law influences the behavior of its citizens in various ways. There is no
doubt about the direct effects of legal rules, By imposing sanctions or granting subsidies, the law
either expands or contracts the horizon of opportunities within individuals can satisfy their preferences. So, society can give incentives for desirable behavior. The tools of economics have been
shown to be well suited to analyzing variables- such as legal rules- that stimulate changes in the
costs of certain behaviors.
Scott also argues that recently, the social norms literature has shown that law can also have
indirect effects on incentives. He analyzes recent efforts to enrich rational theory through the incorporation of endogenous preferences derived from social norms. He suggests that the best approach to understand the indirect effects is to deploy rational choice analysis on its own terms,
but retain (as part of the analyst’s frame of judgment) the situation sense of context-specific
knowledge as an antidote to inapposite analogies and generalizations.
In addition, Scott argues that law, as applied behavioral theory, strives to generalize form real-world observations in order to implement socially desirable changes in real-world behaviors.
This requires the legal analyst to generalize from the particular observations of the behavioral
sciences and to particularize the abstractions of economics.
Clayton P. Gillette, “Commercial Rationality and the Duty to Adjust Long-Term Contracts,” 69
Minn. L. Rev. 521 (1985).
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Gillette argues that the Uniform Commercial Code (UCC) purports to set forth circumstances
under which a disruptive event would excuse the disadvantaged party. For example: two parties
voluntarily enter into a long-term agreement for the sale of goods, and each party presumes the
agreement serves its particular interests. Then, an event occurs that is not expressed provided for
in the agreement, rendering the agreement far more beneficial to one party and far less beneficial
to the other than either anticipated. The disadvantaged party seeks to avoid performance by invoking any of the several contract law doctrines that address this situation: frustration of purpose, mistake, impossibility, or impracticability.
In section 2-615, the UCC conditions excuse on the parties’ failure to allocate the risk that
the disruptive event might materialize, their assumption that the event would not occur, and the
impracticability of performance after materialization of the event. This section provides the
courts more flexibility to excuse performance, and mandates appropriate relief for the party aggrieved by the unforeseen or unanticipated event. The UCC also provides greater liberalization
of remedies in case of such an event. The main idea is that the law ought to require the advantaged party to adjust to original agreement.
However courts have demonstrated singular resistance to the arguments for adjustment. Gillette shares with the courts the reluctance to embrace the theories of adjustment. He argues that
even if commercial actors cannot foretell the occurrence of events, they can plan rationally with
the inevitable uncertainty of the future in mind to estimate and control the consequences of those
events. If a commercial actor is able to bargain with uncertainty in mind, he suggests that the law
ought to consider such bargain the product of a cognitive and analytical process for which the
actor can be held accountable, notwithstanding the intervention of specific events that the actor
did not predict. The failure of the law to respect decisions made under these circumstances is unjustifiably paternalistic towards individual actors and frustrates individual effort that would otherwise generate greater personal and social welfare. Gillette rejects the idea that contract is a
necessarily communitarian exercise and instead adopt a conception of a contract as a mechanism
for individual expression by commercial actors capable of considering and bearing the consequences of reasoned choice. He argues that moral notion such as desert do not justify an obligation to adjust, in conclusion we must respect bargains struck through individual negotiation. According to Gillette, the issue is not whether individuals will suffer harsh results from such a legal
rule; on occasion, they will. The issue is whether we can do better by acting through the law rather than a sense of moral obligation by those who act within the structure created by the legal
rules.
You should also see the following articles: Russell B. Korobkin, “The Status Quo Bias and
Contract Default Rules,” 83 Cornell L. Rev. 608 (1998); Korobkin, “Inertia and Preference in
Contract Negotiation: The Psychological Power of Default Rules and Form Terms,” 51 Vand. L.
Rev. 1583 (1998); and Korobkin, “Bounded Rationality, Standard Form Contracts, and Unconscionability,” 70 U. Chi. L. Rev. 1203 (2003).
Web Note 8.3 (p. 304)
For more on relational contracts, see our website.
The idea that there might be something significantly different between how real people structure their contractual relations and the law imagines or urges that they do so was most notably
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raised in the early 1960s by a famous article by Professor Stewart Macaulay of the University of
Wisconsin School of Law: “Non-Contractual Relations in Business,” 28 Am. Soc. Rev. 55
(1963). The abstract of that article, which surveyed many business people to find out how they
view contract law reads as follows:
Preliminary findings indicate that businessmen often fail to plan exchange relationships completely and seldom use legal sanctions to adjust these relationships or to settle disputes. Planning
and legal sanctions are often unnecessary and may have undesirable consequences. Transactions
are planned and legal sanctions are used when the gains are thought to outweigh the costs. The
power to decide whether the gains from using contract outweigh the costs will be held by individuals having different occupational roles. The occupational role influences the decision that is
made.
This marvelous insight gave rise to a strain of contract scholarship that ran alongside (but
never quite touched) the doctrinal scholarship of the 1970s and 1980s. One of the principal
scholars in this literature, which came to be known as dealing with “relational contracts,” was
the late Ian Macneil, John Henry Wigmore Professor at the Northwestern University School of
Law.
One might perceive two different (but related) central contentions of the relational contracts
literature. The first stems from Professor Macaulay’s work and holds that contracting and contract law are two related but distinct areas. Many people structure their business relationships in
a manner that relies on the formalities of contract law very little – if at all, as Professors Robert
Ellickson and Lisa Bernstein have independently pointed out, the reliance on formalities is triggered only in an end-game situation in which the contractual relationship has come to an end.
The second (related) strain is that the mechanisms of relational contracts are custom, renegotiation, and other informalities that the formal doctrines of contract law do not capture. There is
a significant game-theoretic aspect to relational contracts, just as there may be to other relations,
such as marriage. The implication is that to understand contract (and not necessarily contract
law, a distinction that Professor Robert Scott and Alan Schwartz always ask us to bear in mind),
we need to look beyond formalities, to gather empirical evidence, and to try to observe regularities in these relationships.
In 1995 The Northwestern University Law Review published a symposium issue in honor of
Macneil (“Relational Contract Theory: Unanswered Questions,” v. 94, n. 3). The first three
summaries are from contributions to that symposium.
Stewart Macaulay, “Relational Contracts Floating on a Sea of Custom?: Thoughts about the Ideas of Ian Macneil and Lisa Bernstein,” 94 Nw. U. L. Rev. 775 (2000).
Macneil argues that contract law assumes that parties’ contract records in detail their plan for
all foreseeable contingencies in a written record. Performance is guided by this plan, and any
disputes that cannot be avoided by reference to it can be resolved by interpreting it. However,
this story better fits situations where trust is limited and lawyers who do the drafting behave as if
they are being paid by the word. Most of the time, people agree in some terms, but not in everything, and just start performing: “The exercise of the free choice (about contract content) is … an
incremental process in which parties gather increasing information and gradually agree to more
and more as they proceed.” Rather than guide performance, contract documents are filed away
and ignored. In a relational contract often it is hard to say when the contract is formed. It is not
likely to be formed once and for all. Rather than a scene frozen in a still photograph, a relational
contract is more like an ongoing motion picture.
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Professor Bernstein affirms that many customs are vague and riddled with exceptions, but
these vague customs will affect how those in a long-term continuing relationship interpret the
situation.
Steward Macaulay argues that is easy to overstate the importance of the law of contracts. Relational sanctions and private governments do most of the work of protecting expectations and
reliance. Contract law in practice is a flawed product that costs too much in most situations.
Nonetheless, law can matter. The chance that a court might upset outrageous behavior by a
transactor makes some contribution to the trust necessary to make any economic system work.
Melvin A. Eisenberg, “Why There Is No Law of Relational Contracts,” 94 Nw. U. L. Rev. 805
(2000)
The main objective of the article is to discuss why the relational contract has not led to a
body of relational contract law.
Relational contract theory has brought many important contributions for modern contract
law. First, relational contract law has helped to bring home two of the fundamental weaknesses
of classical contract law – its static character, and the flawed nature of its implicit empirical
premise that most contracts are discrete. Second, relational contract theory has greatly illuminated the economics and sociology of contracting. Finally, relational contract theory has excelled in
its treatment of specific types of contracts, like franchise agreements, and specific types of express or implied terms, like best-efforts provisions.
However, relational contract theory has not created a law of relational contracts because there
is no significant difference between contracts as a class and relational contracts. Then, relational
contracts must be governed by the general principles of contract law, whatever those should be.
Relational contracts are not special category of contract, because all or virtually all contracts are
relational.
Robert E. Scott, “The Case of Formalism in Relational Contract,” 94 Nw. U. L. Rev. 847 (2000)
Scott argues that the central task in developing a plausible normative theory of contract law
is to specify the appropriate role of the state in regulating incomplete or relational contracts.
Formalist modes of interpretation are justified because, and only because, they offer the best
prospect for maximizing the value of contractual relationships, given the empirical conditions
that seem to prevail.
The next four summaries are about articles from the economics literature about relational
contracts.
George Baker, Robert Gibbons and Kevin Murphy, “Relational Contracts and The Theory of the
Firm,” 117 Q. J. Econ. 39 (2002).
In this article, the authors show that relational contracts agreements sustained by the value of
future relationships are prevalent within and between firms. According to Baker, Gibbons and
Murphy, firms are riddled with relational contracts: informal agreements and unwritten codes of
conduct that powerfully affect the behavior of individuals within firms, such as informal quid pro
quos between co-workers, unwritten understandings between bosses and subordinates about taskassignment, promotion, and termination decisions. Also, business dealings are riddled with relational contracts.
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Relational contracts within and between firms help circumvent difficulties in formal contracting (i.e., contracting enforced by a third party, such as a court). For example, a formal contract
must be specified ex ante in terms that can be verified ex post by the third party, whereas a relational contract can be based on outcomes that are observed by only the contracting parties ex
post, and also on outcomes that are prohibitively costly to specify ex ante. The relational contracts allows the parties to utilize their detailed knowledge of their specific situation and adapt to
new information as it becomes available. However, for the same reasons, relational cannot be
enforced by a third party and so must be self-enforcing: the value of the future relationship must
be sufficiently large that neither party wishes to renege.
Also, the authors develop repeated-game models and analyze why and how relational contracts within firms and between firms are different. They show that integration affects the parties’ temptations to renege on a given relational contract. Thus, in a given environment, a desirable relational contract might be feasible under integration but not under non-integration (or the
reverse). So, integration can be an instrument in the service of the parties’ relationship.
In addition, relational contracts can encourage useful actions: the downstream party can
promise to pay the upstream party a bonus if she produces a good of high value. Because this
promise is based on non-contractible outcomes, it provides incentives to the upstream party only
if it is self-enforcing.
The key question in the analysis is whether choosing appropriate asset ownership (integration
or non-integration) can make a given promise self-enforcing. The recourse and bargaining position produce the main proposition: integration affects the parties’ temptations to renege on a relational contract, and hence affects the best relational contract the parties can sustain.
This proposition leads to a corollary: in their model, it is impossible for a firm to mimic the
spot-market outcome after it brings a transaction inside the firm, because the reneging temptation
is then too great.
Baker, Gibbons, and Murphy establish the main proposition and its corollary, and then explore the implications of the main proposition by deriving five results.
The first result is that the vertical integration is an efficient response to widely varying supply prices (even when all parties are risk-neutral), because integration reduces reneging temptations in such settings.
The second result is that high-powered incentives create bigger reneging temptations under
integration than under non-integration, with the consequence that performance payments in relational incentive contracts will be smaller under integration than under (otherwise equivalent)
non-integration. In their repeated-game model, the downstream party promises the upstream party a bonus for delivering high quality. In the integrated case, the upstream employee has no recourse if the downstream firm refuses to pay the promised bonus, in the non-integrated case,
however, if the upstream independent contractor is not paid a promised bonus, she can still extract some payment for the good through bargaining.
The third result is that, holding all other parameters constant, the optimal integration decision
can depend on the discount rate. At sufficiently low discount rates, ownership is irrelevant because the first-best can be achieved under either relational outsourcing or relational employment.
So increase the discount rates can change the optimal ownership structure. When discount rates
are high, relational contracts are not feasible, so either spot outsourcing or spot employment is
efficient.
The fourth result is that, holding all marginal incentives constant, the optimal integration decision can depend on the payoff levels. So if you increase the payoff level but holding marginal
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incentives constant and suppose that these constant marginal incentives make spot outsourcing
more efficient than spot employment. This increase in payoff level increases the maximum total
reneging temptation in relational outsourcing but not in relational employment. As a result, relational employment may be feasible when relational outsourcing is not, reversing the conclusion
of the static model.
The fifth result is that, a firm will be unable to mimic the spot-market outcome after it brings
a transaction inside the firm. A firm may be unable to improve upon the spot-market outcome
because the availability of the spot-market outcome as a fallback after reneging may ruin any
relational-employment contract that could improve on the spot market outcome. A small change
in parameters can force companies to abandon more efficient employment relationships in favor
of less efficient outsourcing.
In addition, the Baker, Gibbons and Murphy (2001) describe how their approach relates to
the extensive sociological literature and formal and informal aspects of organizational structure,
and suggest how their approach might be applied to understanding organizational forms other
than firms, such as joint ventures and business groups. Also they explore the implications of their
analysis for internal organizational processes such as transfer pricing, capital allocation, compensation, and corporate governance. Finally, Baker, Gibbons and Murphy argue that their focus on
relational contracts suggests a natural role for managers in the economic theory of the firm: managers formulate, communicate, implement, and change relational contracts.
Jonathan Levin, “Relational Incentive Contracts,” 93 Am. Econ. Rev. 835 (2003).
Levin argues that good faith is an essential ingredient to many contracting relationships. He
suggests that even in a complex environment where parties may not be able to precisely observe
each other’s costs or efforts, it may be possible to construct good faith agreements that parties
will live up to. These contracts are limited relative to what could be achieved if an infallible
court system could monitor and enforce all agreements. However, this limitation can be characterized succinctly in the form of bounds on promised compensation. As a result, optimal relational incentive schemes can be characterized and compared with predictions from standard incentive theory. For instance, the optimal contracts will forgo screening for private cost information unless parties are sufficiently patient, and even then will involve systematic distortions
from efficiency.
Levin also considered the difference between objective and subjective nonverifiable
measures of performance.
Benjamin Klein, “Fisher-General Motors and The Nature of the Firm,” 43 J. Law & Econ. 105
(2000).
Transactors choose the imperfect contract terms that govern their relationship based on the
expected effectiveness of the terms in supporting self-enforcement of the underlying contractual
understanding. It is only when market conditions develop unexpectedly as they did in the FisherGM case, that the relationship moves outside the “self-enforcing range” defined by these imperfect contract terms and the transactors’ reputational capital. When this occurs, one transactor will
find it profitable to use the court to take advantage of the imperfect, legally enforceable contract
terms in order to violate the intent of the contractual understanding.
After working well for more than 5 years, the Fisher Body-General Motors (GM) contract for
the supply of automobile bodies broke down when GM’s demand for Fisher’s bodies unexpectedly increased dramatically. This pushed the imperfect contractual arrangement between the par12
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ties outside the self-enforcing range and led Fisher to take advantage to the fact that GM was
contractually obligated to purchase bodies on a cost-plus basis. Fisher increased its short-term
profit by failing to make the investments required by GM. Vertical integration, with an associated side payment from GM to Fisher, was the way in which this contractual hold-up problem was
solved. This examination of the Fisher-GM case illustrates the role of vertical integration in
avoiding the rigidity costs of long-term contracts.
Klein affirms that this analysis does not imply that vertical integration will always be used
when large specific investments are present, because transactors always prefer a contractual arrangement that keeps transactors independent if performance can be assured without too much
rigidity. If sufficient reputational capital exists or if the performance can be measured ex ante
reasonably accurately, transactors will be able to solve the hold-up problem with a flexible contractual arrangement or sometimes with essentially no contract at all.
According to Klein, the theory illustrated by Fisher-GM case implies that the greater the relationship-specific investments, the greater the likelihood vertical integration will be used to minimize the expected hold-up costs. He also argues that generally, the key to understanding variations in contractual arrangements, including the incidence of vertical integration, lies in analyzing how particular arrangements may efficiently facilitate self-enforcement.
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