Contract Law

1. Contract Law Here we begin our study of contract law from an economic perspective.

2. It is generally felt that any system of contract law must answer two fundamental questions: • What promises should be enforced?, and • What should be the remedy for breaking enforceable contracts? Bargaining theory has been a way to think about answering the fundamental questions. It has actually been used in practice to some extent at various times in history in various places. Here we look at some details of bargaining theory. The bargain principle: a promise is legally enforceable if it is given as part of a bargain.

3. It has been held that a bargain should include the following 1) offer, 2) acceptance, and 3) consideration – the promisee gives something to induce the promisor to give the promise. Here is a general illustration of a bargain: (promisor) I will give you…(offer) (promisee) I accept and as a sign of good acceptance I give to you… (consideration) The nature of the bargain is said to have reciprocal inducement. Example from the book: A magazine ad has written “A sure means to kill grasshoppers.” This is the promise The farmer accepts by mailing in the order form. The $25 payment by the farmer is the consideration.

4. Summary so far: Promises as part of a bargain should be enforced. Remedy for breach According to bargain theory the promisee is entitled to the ‘benefit’ of the bargain. This is the benefit that would have been received from the performance of the promise. In this context you hear the phrase expectation damages used. Example continued Farmer gets a package in the mail, opens it and see two blocks of wood labeled A and B. Directions say place grasshopper on block A and smash with block B. Expectation damages the farmer would collect equal the value of the crops destroyed by the grasshoppers.

5. Criticism of Bargaining Theory Let’s consider an example first: Mr. Bo Jangles promises to give to Gigantic State U funds to construct a new building. He wants construction to begin immediately, but it will take time to liquidate assets and give funds to GSU. GSU dare not begin construction without an enforceable promise. But, under bargain theory, without consideration by GSU the promise is unenforceable. Gift promises are not induced by the prospect of gain and so they always lack consideration. In the example, both parties to the promise want it to be enforceable, yet bargain theory withholds enforcement due to a lack of consideration.

6. In the example of GSU, Mr. Jangles felt he would be better off and GSU felt it would be better off, both measured by their own desires. Since bargain theory would not enforce a promise between two who want it enforced, bargain theory is said to be dogmatic and inefficient. In the example, enforceability is pareto efficient in that both are better off without making anyone worse off. Pareto efficient law is said to be responsive law. So, economic efficiency requires enforcing a promise if the promisor and the promisee both want enforceability at the time the promise was made.

7. Agency Game Here we begin to develop an economic theory of contracts by studying the game known as the agency game.

8. Here we develop the Agency Game We have two players involved in a game. The 1st player must decide whether or not to put a valuable asset under the control of the 2nd player. Examples of this include investing in a corporation, a consumer advancing funds for the purchase of goods, and a buyer of an insurance policy. If the first player puts assets into the 2nd player’s control, the 2nd player can cooperate and perform as promised, or appropriate, or breach promise and take and use the assets as his own. On the next screen we will consider a numerical example and by assumption a contract can not be enforceable.

9. 2nd player cooperate appropriate 1st or perform or breach p invest .5 1 l or contract .5 -1 a don’t 0 0 y invest 0 0 e r The details are the following: - the invest/cooperate cell is a payoff of .5 for each. The 1st player actually puts in $1 and gets the $1 back and $1 is made on the contact and the two players split the $1 evenly. - the invest/appropriate cell has the first player put in $1 and he loses it because the 2nd player takes it as his own. - if the first player does not invest neither gets any gain.

10. The first player looks at what the 2nd player might do, one at a time. If the 2nd player cooperates, the first player will invest. But, if the 2nd player appropriates, the first player will not invest. The 1st player does not have a dominant strategy. Let’s see about this for the 2nd player. The 2nd player thinks that if the 1st player invests then he (the 2nd player) can do better by appropriating. If the 1st player does not invest, then either option is irrelevant. So, the 2nd player has a dominant strategy of appropriating. Even though player 1 does not have a dominant strategy, he will see the 2nd player does. Thus the 1st player will not invest. The not invest solution is not pareto efficient. Both would be better off at invest/cooperate. But in the absence of an enforceable contract, the 1st player finds it better to not invest.

11. Now, let’s change the game to where they can have an enforceable contract and breach of contract would lead to expectations damages. 2nd player cooperate appropriate 1st or perform or breach p invest .5 -.5 l or contract .5 .5 a don’t 0 0 y invest 0 0 e r Here, if the 1st player invests and the 2nd player breaches, the 1st player gets back his original dollar and gets the .5 he would have gained if the 2nd player had performed. The 1st player has a dominant strategy - invest. The 2nd player has a dominant strategy - perform. So, we have invest/perform as the outcome.

12. The authors state a couple of ideas here about contracts that are enforceable. The first purpose of contract law is to enable people to cooperate by converting games of noncooperative solutions into games with cooperative solutions, or The first purpose of contract law is to enable people to cooperate by converting games of inefficient solutions into games with efficient solutions. Here, the investing/cooperate solution is productive, and both share in the gain. The don’t invest options produce nothing. The appropriate option merely redistributes money between the two players.