Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2011 Lecture 12

Last week • Reliance • Investments which depend on performance of contract • Or, investments which increase value of performance • If damages include expected benefit from reliance investments, we get overreliance • (But if they don’t, we get inefficient breach) • Courts tend to compensate for foreseeable reliance

Last week • Paradox of Compensation • Remedy for breach sets incentive for both promisor and promisee • Promisor: perform or breach • Promisee: how much to rely • Generally impossible to set both incentives efficiently at the same time • Default Rules • Cooter and Ulen: supply rules which most parties would have wanted (efficient rules) • Ayres and Gertner: penalty defaults (penalize the parties for leaving a gap, or penalize better-informed party)

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, undermine 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-minecoal on Peevyhouse’s farm • Contract specified Garlandwould restore property to originalcondition; Garland did not • Restoration would cost $29,000 • But “diminution in value” of farmwas only $300 • Original jury awarded $5,000 indamages, both parties appealed • OK Supreme Court reduceddamages to $300

Expectation damages: default rule or immutable rule? • At first, sounds like a perfect example 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 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

One formation defense: incompetence • Courts will not enforce contracts with peoplewho can’t be presumed to be rational • Children • Legally insane • Incompetence • One party was “not competent to enter intothe agreement” • No “meeting of the minds”

So… • If courts won’t enforce a contract signed by someone who wasn’t competent… • What if you signed a contract while drunk? • You need to have been really, really, really drunk to get out of a contract • (“Intoxicated to the extent of being unable to comprehend the nature and consequences of the instrument he executed”) • Lucy v. Zehmer, Virginia Sup Ct 1954

Lucy v. Zehmer • Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time • While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000” • “We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,000.00, title satisfactory to buyer.”

Lucy v. Zehmer • So, you can be pretty drunk and still be bound by the contract you signed • Might think “meeting of the minds” would be impossible • But imagine what would happen if the rule went the other way

Lucy v. Zehmer • So, you can be pretty drunk and still be bound by the contract you signed • Might think “meeting of the minds” would be impossible • But imagine what would happen if the rule went the other way • Borat lawsuits • Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk Journalist for Make Benefit Guileless Americans In Film” • Moral of the story: don’t get drunk with people who might ask you to sign a contract

Another formation defense:dire constraints

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 • Someone makes me an offer I can’t refuse

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: don’t enforce Pareto-improving trade, in order to avoid incentive for bad behavior

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 – how 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?

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, you would sail the efficient amount

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!

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 • Often impossible to set them all efficiently • Already saw this with remedy for breach • Expectation damages: efficient breach, but inefficient signing • Include gains from reliance: overreliance • Exclude gains from reliance: inefficient breach

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

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, refuses higher wages, claiming duress

A performance excuse:impossibility

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

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”

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 • Party that can take precautions to minimize the risk • Or can best spread the risk over many transactions

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?

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.”

Hadley v Baxendale • Suppose… • 80% of millers are low-damage – suffer $100 in losses from delay • 20% of millers are high-damage – suffer $200 in losses from delay • Shipper liable for actual damages • Average miller would suffer $120 in losses • Shipper makes efficient investment for average type • But not efficient for either type • Shipper liable for foreseeable damages • Shipper makes efficient investment for low-damage millers • High-damage millers have strong incentive to negotiate around default rule

Contracts based onbad information

Misinformation • Four doctrines for invalidating a contract based on faulty information • Fraud • Failure to disclose • Frustration of purpose • Mutual mistake

Fraud and Failure to Disclose • Fraud violates “negative duty” not to misinform • In some circumstances, positive duty to disclose certain information • Civil law: contract may be voided if you did not supply information you should have (“failure to disclose”) • Common law: seller is not forced to disclose everything he knows • Must warn about hidden dangers • Need not share information that makes product less valuable but not dangerous • But, new products come with “implied warranty of fitness”

More on duty to disclose • Sellers must inform buyers about hidden safety risks • Common law does not generally require disclosure of other types of information • But… • Obde v Schlemeyer (1960) • 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

More on duty to disclose • Sellers must inform buyers about hidden safety risks • Common law does not generally require disclosure of other types of information • But… • Obde v Schlemeyer (1960) • 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 • Many states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects…

Frustration of Purpose • Both parties based a contract on the same bad information  contract may be voided due to frustration of purpose • Coronation Cases • Rooms rented out with view of new king’s coronation parade • Parade was postponed, owners still tried to collect rent • Courts ruled change in circumstance had frustrated the purpose of the original contracts, which were therefore void • “When a contingency makes performance pointless, assign liability to the party who can bear the risk at least cost”

Mutual Mistake • Frustration of purpose: circumstances changed after the contract was signed • Mutual mistake: circumstances changed before the contract was signed, but the parties didn’t know about it • Enforcing the contract would be like forcing involuntary exchange • Coase: we expect voluntary exchange to be efficient • But involuntary exchange may not be

Another principle: 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) • A general principle about information: 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

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

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 this creates an incentive to gather information

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

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

Econ 522 Economics of Law