Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 11
Grading
 HW 1: end of class today
 Midterm: Wednesday
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Contracts: the story so far…
 Why do we need contracts?
 Which promises should be enforced?
 First purpose: enable cooperation
 Second purpose: efficient disclosure of information
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Contracts: the story so far…
 Breach of contract
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Breach is efficient when cost to perform > benefit
Breach will happen when cost to perform > liability
Expectation damages: liability for breach = anticipated benefit
Leads to breach exactly when breach is efficient
Third purpose: secure optimal commitment to performance
 Reliance
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Reliance is efficient when expected benefit > cost
Or (Probability of performance) X (Increase in value) > cost
Reward any reliance  overreliance
Fourth purpose: secure optimal reliance
Hadley v Baxendale, foreseeable reliance
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Default Rules
4
Default rules
 Gaps: risks or circumstances that aren’t specifically
addressed in a contract
 Default rules: rules applied by courts to fill gaps
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Default rules
 Gaps: risks or circumstances that aren’t specifically
addressed in a contract
 Default rules: rules applied by courts to fill gaps
 Writing something into a contract vs leaving a gap
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Allocating a loss (ex post)
Versus allocating a risk (ex ante), before it becomes a loss
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What should default rules be?
 Cooter and Ulen: use the rule parties would have wanted,
if they had chosen to negotiate over this issue
 This will be whatever rule is efficient
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What should default rules be?
 Cooter and Ulen: use the rule parties would have wanted,
if they had chosen to negotiate over this issue
 This will be whatever rule is efficient
 Fifth purpose of contract law is to minimize transaction
costs of negotiating contracts by supplying efficient
default rules

Do this by imputing the terms the parties would have chosen if they
had addressed this contingency
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Default rules
 Don’t want ambiguity in the law
 So default rule can’t vary with every case
 Majoritarian default rule: the terms that most parties would
have agreed to

In cases where this rule is not efficient, parties can still override it in
the contract
 Court: figure out efficient allocation of risks, then
(possibly) adjust prices to compensate
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000

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Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?
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Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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Default rules
 Example: probability ½, the cost of construction will
increase by $2,000


Construction company can hedge this risk for $400
Family can’t do anything about it
 Price goes up – who pays for it?

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
Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction
company
Should prices be adjusted to compensate?
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Default rules
 So, Cooter and Ulen say: set the default rule that’s efficient
in the majority of cases
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Most contracts can leave this gap, save on transaction costs
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In cases where this rule is inefficient, parties can contract around it
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Default rules: a different view
 Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete
Contracts: An Economic Theory of Default Rules”
 Sometimes better to make default rule something the
parties would not have wanted
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To give incentive to address an issue rather than leave a gap
Or to give one party incentive to disclose information
“Penalty default”
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Penalty defaults: Hadley v Baxendale
 Baxendale (shipper) is only one who can influence when
crankshaft is delivered; so he’s efficient bearer of risk
 If default rule held Baxendale liable, Hadley has no need to
tell him the shipment is urgent
 So Hadley might hide this information, which is inefficient

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Ayres and Gertner: Ruling in Hadley was a good one, not because
it was efficient, but because it was inefficient…
…but in a way that created incentive for disclosing information
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Penalty defaults: other examples
 Real estate brokers and “earnest money”
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Broker knows more about real estate law
Default rule that seller keeps earnest money encourages broker to
bring it up if it’s efficient to change this
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Penalty defaults: other examples
 Real estate brokers and “earnest money”


Broker knows more about real estate law
Default rule that seller keeps earnest money encourages broker to
bring it up if it’s efficient to change this
 Courts will impute missing price of a good, but not quantity

Forces parties to explicitly contract on quantity, rather than leave it
for court to decide
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When to use penalty defaults?
 Look at why the parties left a gap in contract
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Because of transaction costs  use efficient rule
For strategic reasons  penalty default may be more efficient
 Similar logic in a Supreme Court dissent by Justice Scalia
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Congress passed a RICO law without statute of limitations
Majority decided on 4 years – what they thought legislature would
have chosen
Scalia proposed no statute of limitations; “unmoved by the fear that
this… might prove repugnant to the genius of our law…”
“Indeed, it might even prompt Congress to enact a limitations period
that it believes appropriate, a judgment far more within its
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competence than ours.”
Regulations
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Default rules versus regulations
 Default rules can be contracted around
 Some rules cannot – immutable rules, or mandatory
rules, or regulations
 Fifth purpose of contract law is to minimize transaction
costs of negotiating contracts by supplying efficient default
rules and regulations.
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Coase: if individuals are rational and there are no transaction costs,
private negotiations lead to efficiency
So additional regulations can only make things worse
But when people are not rational, or when there are transaction
costs/market failures, regulations may help
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One example of a regulation/immutable rule:
derogation of public policy
 Derogate, verb. detract from; curtail application of (a law)
 Contracts which derogate public policy – that is,
contradict a law or regulation – are not enforceable
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Contracts which could only be performed by breaking a law
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Contracts whose effect is to circumvent a law
A
(other factory)
“if I ever work for C for
less than $15/hr, I’ll work
for you for $1/hr”
B
(union)
C
(ownership)
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One example of a regulation/immutable rule:
derogation of public policy
 Derogate, verb. detract from; curtail application of (a law)
 Contracts which derogate public policy – that is,
contradict a law or regulation – are not enforceable

Contracts which could only be performed by breaking a law

Contracts whose effect is to circumvent a law
A
(other factory)
“if I ever work for C for
less than $15/hr, I’ll work
for you for $1/hr”
B
(union)
C
(ownership)
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Derogation of public policy
 In general: contracts which can only be performed by
breaking the law are not enforceable
 But…
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“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.”
“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.”
“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.”
 “A promisor should be liable for breach if he knew that the
promise was illegal”
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Expectation damages: default rule or
immutable rule?
 Peevyhouse v Garland Coal and Mining Co
(OK Supreme Court, 1962)
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Garland contracted to strip-mine coal on Peevyhouse’s farm
Contract specified Garland would restore property to original
condition; Garland did not
Restoration would have cost $29,000…
…but “diminution in value” of farm only $300
Original jury awarded $5,000 in damages, both parties appealed
Oklahoma Supreme Court reduced damages to $300
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Expectation damages: default rule or
immutable rule?
 Seems like classic case of efficient breach
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Performing last part of contract would cost $29,000
Benefit to Peevyhouses would be $300
Efficient to breach and pay expectation damages, which is what
happened
 But…
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Most coal mining contracts: standard per-acre diminution payment
Peevyhouses refused to sign contract unless it specifically
promised the restorative work
Dissent: Peevyhouses entitled to “specific performance”
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We can also think about Peevyhouse in
terms of penalty defaults
 Which works better in this case:

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Default rule allowing Garland to breach and pay diminution fee?
Default rule forcing Garland to perform restorative work?
 Ayres and Gertner: default rule should “penalize” the
better-informed party
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Garland routinely signed contracts like these
Peevyhouses were doing this for the first time
Default rule allows Garland to pay diminution fee: they have no
reason to bring it up, Peevyhouses don’t know
Default rule forces Garland to do cleanup: if that’s inefficient, they
could bring it up during negotiations
In this case, specific performance would work as a penalty default
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Ways to get out
of a contract
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Formation Defenses and Performance
Excuses
 Formation defense
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Claim that a valid contract does not exist
(Example: no consideration)
 Performance excuse
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Yes, a valid contract was created
But circumstances have changed and I should be allowed to not
perform
 Most doctrines for invalidating a contract can be explained
as either…
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Individuals agreeing to the contract were not rational, or
Transaction cost or market failure
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Incompetence
 Courts will not enforce contracts by irrational individuals
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Children
Legally insane
 Doctrine of incompetence
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One party was not competent to enter into contract
Invalidates contracts which are not in best interest of that party
 What if you signed a contract while drunk?

You need to have been really, really, really drunk to get out of a
contract
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
 The Borat lawsuits
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What if you signed a contract while drunk?
 Only unenforceable if you were “intoxicated to the extent of
being unable to comprehend the nature and
consequences of the [contract]”
 Lucy v Zehmer (VA Sup Ct, 1954)
 The Borat lawsuits

Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazakh
Journalist for Make Benefit Guileless Americans In Film”
 Moral of story: don’t get drunk with someone who might
ask you to sign a contract
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