Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Fall 2009 Lecture 12

2. Logistics • Midterm will be returned Thursday • HW2 is up – due Tuesday, November 3 (11 a.m. sharp) • Second midterm (on contract law) Thursday, November 5

3. In-class experiment from Thursday… • The game: • Players A and B each start with $10 • Player A gives x to player B, which gets tripled • Player B gives y back to player A, keeps 10 + 3x – y • The treatments: • Totally anonymous: done randomly, on paper, with SID (no names) • In pairs, face to face, but with strategies written down • In pairs, out loud, in front of whole class

4. The results • In anonymous version, trust was a problem, but not a huge problem • Average A transferred $7.21, got back $7.92 • So over 70% of gains from cooperation realized • But, of those Player A’s who sent anything, 19% got back nothing, and 30% got back less than they gave • Communication more important than public shaming • “Out loud”: average A transferred $7.67, all got back more than they gave • “Face to face, in private”: full efficiency – all 7 A’s transferred $10, all 7 got back either $15 or $20

5. The results Average A Transfer Average B Transfer Average A Payoff Average B Payoff Average Combined Anonymous 7.2 7.9 10.7 23.7 34.4 Out Loud 7.7 13.0 15.3 20.0 35.3 Face to Face 10.0 18.6 18.6 21.4 40.0

6. The raw data

7. Something I found funny (anonymous treatment) Player A gave Observa-tions % that got nothing back % that got less than they gave % that got more than they gave “Average return” 0 3 67% 0% 33% 1 – 9 29 10% 21% 66% 128% 10 24 29% 42% 42% 97%

8. Something I found funny (anonymous treatment) Player A gave Observa-tions % that got nothing back % that got less than they gave % that got more than they gave “Average return” 0 3 67% 0% 33% 1 – 3 7 14% 28% 71% 132% 4 – 6 8 0% 13% 87% 151% 7 – 9 14 14% 21% 50% 113% 10 24 29% 42% 42% 97%

9. Something I found funny (anonymous treatment)

10. Back tocontract law

11. Thursday... • Default rules versus regulations/immutable rules • Contracts that are not enforcable: derogation of public policy • Ways to get out of a contract: formation defenses and performance excuses • Incompetence • (But not drunkenness) • Dire constraints: duress and necessity • Today: more of these

12. 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

13. 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”

14. 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

15. Important general concept • Who is the efficient bearer of a particular risk? • Also called low-cost avoider • Who is in best position to mitigate/reduce a risk, or hedge it, or endure it? • We already saw this question with efficient default rules • When a contract leaves a gap, an efficient contract would have allocated each risk to low-cost avoider • Construction company building a house, completion is delayed • Family might be efficient risk-bearer, because it’s cheaper for them to stay with friends than for construction company to pay for hotel • Cost of raw materials goes up, increasing cost of construction • Construction company might be efficient risk-bearer, because they can buy materials early or change design plans

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

17. 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”

18. 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”

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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 – especially if that knowledge was the result of active investment – should be enforced • Contracts based on one party’s knowledge of purely redistributive information or fortuitously acquired information should not be enforced

25. 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 • Sale did not unite knowledge and control

26. 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 • Sale did not unite knowledge and control • Many states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects…

27. Vague contract terms • Courts will generally not enforce contract terms that are overly vague • Can be thought of as a penalty default • But some exceptions • Parties may commit to renegotiating the contract “in good faith” under certain contingencies

28. Fairness • Bargain theory: courts ask only whether a contract was part of a bargain, not whether that bargain was fair • Hamer v Sidway (drinking and smoking) • But two common law doctrines to get out of extremely one-sided contracts • Adhesion • Unconscionability

29. Adhesion and unconscionability • Adhesion: standardized “take-it-or-leave-it” contracts • Friedman calls it “bogus duress”

30. Adhesion and unconscionability • Adhesion: standardized “take-it-or-leave-it” contracts • Friedman calls it “bogus duress” • Unconscionability • Overly one-sided contract may not be enforced • Terms “such that no man in his senses and not under delusion would make on the one hand, and as no honest and fair man would accept on the other” • When “the sum total of its provisions drives too hard a bargain for a court of conscience to assist” • Terms which would “shock the conscience of the court” • Similar concept in civil law: lesion

31. Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965) • “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

32. Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965) • “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

33. Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965) • “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.” • Not normal monopoly cases but “situational monopolies” • Think of Ploof v Putnam (sailboat in a storm)

34. Remedies for breachof contract

35. Three broad types of remedy for breach of contract • Party-designed remedies • Remedies specified in the contract • Court-imposed damages • Court may decide promisee entitled to some level of damages • Specific performance • Forces breaching party to live up to contract

36. Expectation damages • Compensate promisee for the amount he expected to benefit from performance • You agreed to buy an airplane for $350,000 • You expected $500,000 of benefit from it • Expectation damages: if I breach, I owe you that benefit • ($500,000 if you already paid, $150,000 if you didn’t) • “Positive damages” • Make promisee indifferent between performance and breach

37. Reliance damages • Reimburse promisee for any reliance investments made, but not for additional surplus he expected to gain • Restore promisee to level of well-being before he signed the contract • You contracted to buy the plane and built a hangar • If I breach, I owe you what you spent on the hangar, nothing else • “Negative damages” – undo the negative (harm) that occurred

38. Opportunity cost damages • Give promisee benefit he would have gotten from his next-best option • Make promisee indifferent between breach of the contract that was signed, and performance of best alternative contract • You value plane at $500,000 • You contract to buy plane from me for $350,000 • Someone else was selling similar plane for $400,000 • By the time I breach, that plane is no longer available • I owe you $100,000 – the benefit you would have gotten from buying the other seller’s plane

39. Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Michigan football game for $50 • Expectation damages: you owe me value of game minus $50 • If I pay scalper $150, then expectation damages = $100 • Reliance damages: maybe 0, or cost of face paint and giant foam finger

40. Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Michigan football game for $50 • Expectation damages: you owe me value of game minus $50 • If I pay scalper $150, then expectation damages = $100 • Reliance damages: maybe 0, or cost of face paint and giant foam finger • When you agreed to sell me ticket, other tickets available for $75 • Opportunity cost damages: $75 • (I paid a scalper $150 to get in; I would have been $75 better off if I’d ignored your offer and paid someone else $75)

41. Ranking damages ContractI Sign BestAlternative Do Nothing ³ ³ = = = Breach +ExpectationDamages Breach +Opportunity Cost Damages Breach +RelianceDamages ³ ³ ExpectationDamages Opportunity CostDamages RelianceDamages ³ ³ $100 $75 $0-20

42. Hawkins v McGee (“hairy hand case”) • Hawkins had a scar on his hand • McGee promised surgery to “make the hand a hundred percent perfect” • Surgery was a disaster, left scar bigger and covered with hair

43. Hawkins v McGee (“hairy hand case”) $ + Expectation Damages + Opp Cost Damages Expectation Damages Reliance Damages Opp Cost Damages + Reliance Damages Initial Wealth Hand Hairy Scarred Nextbestdoctor Perfect