Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2017 Lecture 13

2. Logistics • Exam will be graded/returned later this week • Homework 3 (contract law) is up – due March 30 • Class will not meet next Wednesday (March 15) • (unless there’s a snow day before then or something)

3. Last week… • What default rules should fill in the gaps? • C&U: impute the terms the parties would have wanted – allocate each risk to efficient bearer of that risk • (Friedman: several ways to tell who that is) • Ayres & Gertner: use default rules to penalize one or both parties from withholding information • Reasons a contract might not be enforced • Derogation of public policy • Incompetence • but not drunkenness • Today: more reasons a contract might not be enforced • But first…

4. Another experiment:is trust a problem?

5. We motivated contracts with an agency (trust) game Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (0, 200) • Without binding contracts, might be no reason for me to return your money, so no reason for you to trust me

6. To see if trust is a problem, we’ll use a similar game as an experiment • Player A starts with $5 • Chooses how much of it to give to player B • That money is quadrupled • Player B has $5, plus 4x whatever A gave him/her • Chooses how much (if any) to give back to player A • So for example… • if player A decides to send $3… • then B has $5 + $12 = $17, and can send A any amount up to 17 and keep the rest… • …and A ends up with $2 plus whatever B sends

7. To see if trust is a problem, we’ll use a similar game as an experiment Player 1 Send 0 Send 5 x Player 2 Return 0 Return 5 + 4x y ((5 – x) + y, (5 + 4x) – y) • Player 1 gets whatever he kept, plus whatever 2 sends him • Player 2 gets 5, plus four times what 1 sends him, minus whatever he sends to player 1

8. We’ll try this game three different ways • Anonymously – A and B don’t know who each other are • we’ll use student ID numbers to identify players, and play on paper • Privately – A and B don’t interact, but will learn who each other are after the game • still on paper, but with names, so B sees A’s name • after class, I’ll email A and B with each others’ names • Publicly – A and B play out loud in front of the class

9. Back to work:formation defenses andperformance excuses

10. Two ways to try to get out of a contract • 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 without penalty • Last week, we saw incompetence, a formation defense • No meeting of the minds  no valid contract • But, being drunk isn’t a valid excuse!

11. Another formation defense: 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 belegally enforceable

12. Duress source: http://news.yahoo.com/man-sues-former-hostages-says-broke-promise-190902970.html

13. Friedman on duress • Example • Mugger threatens to kill you unless you give him $1000 • 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 $1000 • You did – you’d rather pay $1000 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

14. Friedman on duress • Example • Mugger threatens to kill you unless you give him $1000 • 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

15. What about necessity? • Same logic doesn’t work for necessity • You get caught in a storm on your $1,000,000 sailboat • Tugboat offers to tow you to shore for $900,000 • (Otherwise he’ll save your life but let your boat sink) • Duress: if we enforce contract, incentive for more crimes • Necessity: if we enforce contract, incentive for more tugboats to be available to rescue sailboats • Why is that bad?

16. What about necessity? “Should I motor around looking for sailboats to save?” • Social cost = private cost = value of my time • Social benefit = probability x (value of boat – cost of tow) • Private benefit = probability x (price I can charge – cost of tow) • If tugboat captain can charge the whole value of the boat, he spends efficient amount of time saving sailboats! • So maybe we should enforce this contract…

17. What about necessity? “Should I sail today?” • Suppose tugboat is there to rescue me if there’s a storm • Social benefit = private benefit = how much I enjoy sailing • Social cost = probability x cost of tow • Private cost = probability x price he can charge • If tugboat captain can only charge cost of tow, I sail efficient amount • If he can charge the whole value of the boat, I undersail!

18. 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!

19. 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

20. 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

21. 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

22. A performance excuse:impossibility

23. 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

24. 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”

25. 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 • We’ve seen several ways to determine who that is

26. 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

27. Contracts based onbad information

28. Contracts based on faulty information • Four doctrines for invalidating a contract • Fraud • Failure to disclose (sometimes) • Frustration of purpose • Mutual mistake

29. Fraud • Fraud: one party was deliberately tricked source: http://www.wyff4.com/r/29030818/detail.html

30. What if you trick someone by withholding information? • It depends • 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 • Under the common law, less so • 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

31. 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)

32. 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…

33. Failure to disclose? source: http://kdvr.com/2012/10/26/chinese-man-sues-wife-for-being-ugly-wins-120000/

34. 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”

35. 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” Mutual Mistake • Mutual mistake about facts • 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

36. 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

37. What About 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

38. What About 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

39. 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

40. 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

41. 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