Econ 522
Economics of Law
Dan Quint
Fall 2012
Lecture 13
Logistics
 HW3 is online, due next Thursday (Nov 8)
 Next Monday: guest speaker to begin tort law
 Second midterm November 19


Cumulative, through end of contract law
More weight on more recent material
1
Last week…
 Default rules
 Contracts which won’t be enforced

Derogation of public policy
 Formation defenses and performance excuses


Incompetence
But not drunkenness – why?
 Today: more ways to get out of a contract
2
Discussion question
 Old urban legend:
A man bought a box of extremely rare and expensive cigars, and
insured them against loss or damage.
After smoking them, he filed an insurance claim, saying they had
been destroyed in 20 separate small fires.
The insurance company refused to pay, the man sued and won.
But as he was leaving the courtroom, he was arrested on 20
counts of arson.
 Serious question:
If the intent of a contract is clear, but different from the literal
meaning, which should be enforced?
3
Another formation defense:
dire constraints
4
Dire constraints
 Necessity



I’m about to starve, someone offers me a sandwich for $10,000
My boat’s about to sink, someone offers me a ride to shore for
$1,000,000
Contract would not be upheld: I signed it out of necessity
 Duress



Other party is responsible for situation I’m in
“I made him an offer he couldn’t refuse”
Contract signed at gunpoint would not be
legally enforceable
5
Duress
source: http://news.yahoo.com/man-sues-former-hostages-saysbroke-promise-190902970.html
6
Friedman on duress
 Example



Mugger threatens to kill you unless you give him $100
You write him a check
Do you have to honor the agreement?
 “Efficiency requires enforcing a contract if both parties
wanted it to be enforceable”


He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?


Makes muggings more profitable  leads to more muggings
Tradeoff: refuse to enforce a Pareto-improving trade, in order to
avoid incentive for bad behavior
7
Friedman on duress
 Example



Mugger threatens to kill you unless you give him $100
You write him a check
Do you have to honor the agreement?
 “Efficiency requires enforcing a contract if both parties
wanted it to be enforceable”


He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?


Makes muggings more profitable  leads to more muggings
Tradeoff: refuse to enforce a Pareto-improving trade, in order to
avoid incentive for bad behavior
8
What about necessity?
 Same logic doesn’t work for necessity



You get caught in a storm on your $10,000,000 sailboat
Tugboat offers to tow you to shore for $9,000,000
(Otherwise he’ll save your life but let your boat sink)
 Duress: if we enforce contract, incentive for more crimes






Here: if we enforce contract, incentive for more tugboats to be
available for rescues – why is that bad?
Social benefit of rescue: value of boat, minus cost of tow
Say, $10,000,000 – $10,000 = $9,990,000
If tugboat gets entire value, his private gain = social gain
So tugboat captain would invest the efficient amount in being
available to rescue you
So what’s the problem?
9
What about necessity?
 What about your decision: whether to sail that day










1 in 1000 chance of being caught in a storm
If so, 1 in 2 that a tugboat will rescue you
Private cost of sailing: 1 in 2000 you lose boat, 1 in 2000 you pay
tugboat captain value of boat
$10,000,000/2000 + $10,000,000/2000 = $10,000
So you’ll choose to sail if your value is above $10,000
Social cost: 1 in 2000 boat is lost, 1 in 2000 boat is rescued
$10,000,000/2000 + $10,000/2000 = $5,005
Efficient to sail when your value is above $5,005
When your value from sailing is between $5,005 and $10,000, you
“undersail”
If the price of being towed was just the marginal cost, your private
cost = social cost and you would sail the efficient amount
10
Friedman’s point
 Same transaction sets incentives on both parties

Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”


Least inefficient price is somewhere in the middle
And probably not the price that would be negotiated in the middle of
a storm!
11
Friedman’s point
 Same transaction sets incentives on both parties

Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”



Least inefficient price is somewhere in the middle
And probably not the price that would be negotiated in the middle of
a storm!
So makes sense for courts to overturn contracts signed under
necessity, replace them with ex-ante optimal terms
 More general point


Single price creates multiple incentives
May be impossible to get efficient behavior in all dimensions
12
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
13
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
14
A performance excuse:
impossibility
15
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
16
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”
17
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?
18
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?
19
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.”
20
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
21
Contracts based on
bad information
22
Contracts based on faulty information
 Four doctrines for invalidating a contract

Fraud

Failure to disclose

Frustration of purpose

Mutual mistake
23
Fraud
 Fraud: one party was deliberately tricked
source: http://www.wyff4.com/r/29030818/detail.html
24
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
25
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)
26
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…
27
Failure to disclose?
source: http://kdvr.com/2012/10/26/chinese-man-sues-wife-for-being-ugly-wins-120000/
28
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”
29
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
30
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
31
Mutual vs. 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
32
Mutual vs. 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
33
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
34
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
35
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
36
Other reasons a contract
may not be enforced
37
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
38
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
39
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/
40
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.”
41
Adhesion (general)
 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”
42
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”
43
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.”
44
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.”
45
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
46
Remedies for breach
of contract
(won’t get to this)
47
Three broad types of remedy for breach of
contract
 Party-designed remedies

Remedies specified in the contract
 Court-imposed damages

Court may decide promisee entitled to some level of damages
 Specific performance

Forces breaching party to live up to contract
48
Expectation damages
 Compensate promisee for the amount he expected to
benefit from performance




You agreed to buy an airplane for $350,000
You expected $500,000 of benefit from it
Expectation damages: if I breach, I owe you that benefit
($500,000 if you already paid, $150,000 if you didn’t)
 “Positive damages”
 Make promisee indifferent between performance and breach
49
Reliance damages
 Reimburse promisee for cost of any reliance investments
made, but not for additional surplus he expected to gain
 Restore promisee to level of well-being before he signed
the contract


You contracted to buy the plane and built a hangar
If I breach, I owe you what you spent on the hangar, nothing else
 “Negative damages” – undo the negative (harm) that
occurred
50
Opportunity cost damages
 Give promisee benefit he would have gotten from his
next-best option






Make promisee indifferent between breach of the contract that
was signed, and performance of best alternative contract
You value plane at $500,000
You contract to buy plane from me for $350,000
Someone else was selling similar plane for $400,000
By the time I breach, that plane is no longer available
I owe you $100,000 – the benefit you would have gotten from
buying the other seller’s plane
51
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Ohio State game
for $50



Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of
whatever pre-game investments I made
52
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Ohio State game
for $50






Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of
whatever pre-game investments I made
When you agreed to sell me ticket, other
tickets available for $70
Opportunity cost damages: $80
(I paid a scalper $150 to get in; I would
have been $80 better off if I’d ignored
your offer and paid someone else $70)
53
Ranking damages
Contract
I Sign

Best
Alternative

Do Nothing
=
=
=
Breach +
Expectation
Damages

Breach +
Opportunity Cost
Damages

Breach +
Reliance
Damages

Opportunity Cost
Damages

Reliance
Damages
Expectation
Damages
$100
$80
$15
54
Hawkins v McGee (“hairy hand case”)
 Hawkins had a scar on his hand
 McGee promised surgery to “make the hand a hundred
percent perfect”
 Surgery was a disaster, left scar bigger and covered with
hair
55
Hawkins v McGee (“hairy hand case”)
+ Opp Cost
Damages
+ Reliance
Damages
Initial Wealth
Opp Cost Damages
Reliance Damages
+ Expectation
Damages
Expectation Damages
$
Hand
Hairy Scarred
Next
best
doctor
100%
Perfect
56
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
57
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
 Specific Performance




Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
58