Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2010 Lecture 11

Grading • HW 1: end of class today • Midterm: Wednesday

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

Contracts: the story so far… • Breach of contract • 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 • 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

Default Rules

Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps

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 • Allocating a loss (ex post) • Versus allocating a risk (ex ante), before it becomes a loss

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

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

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

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?

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? • Construction company is efficient bearer of this risk • So efficient contract would allocate this risk to construction company • Should prices be adjusted to compensate?

Default rules • So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases • Most contracts can leave this gap, save on transaction costs • In cases where this rule is inefficient, parties can contract around it

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 • To give incentive to address an issue rather than leave a gap • Or to give one party incentive to disclose information • “Penalty default”

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 • 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

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

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

When to use penalty defaults? • Look at why the parties left a gap in contract • 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 • 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 competence than ours.”

Regulations

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. • 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

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 “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr” A(other factory) B(union) C(ownership)

Derogation of public policy • In general: contracts which can only be performed by breaking the law are not enforceable • But… • “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”

Expectation damages: default rule or immutable rule? • Peevyhouse v Garland Coal and Mining Co(OK Supreme Court, 1962) • 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

Expectation damages: default rule or immutable rule? • Seems like classic case of efficient breach • 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… • 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”

We can also think about Peevyhouse in terms of penalty defaults • Which works better in this case: • 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 • 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

Ways to get outof a contract

Formation Defenses and Performance Excuses • Formation defense • Claim that a valid contract does not exist • (Example: no consideration) • Performance excuse • 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… • Individuals agreeing to the contract were not rational, or • Transaction cost or market failure

Incompetence • Courts will not enforce contracts by irrational individuals • Children • Legally insane • Doctrine of incompetence • 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

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)

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

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

Econ 522 Economics of Law