Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2009 Lecture 11

Grading • HW 1: end of class today • Midterm: hopefully Tuesday

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 • Third purpose: optimal commitment to performance • Cost < promisee’s benefit: efficient to perform • Cost < promisor’s liability: promisor will perform • Fourth purpose: optimal reliance • Reward any reliance  overreliance • Hadley v Baxendale, foreseeable reliance • Fifth purpose: efficient default rules and regulations • Gaps, efficient (majoritarian) defaults • Penalty defaults (Ayres and Gertner)

Regulations

Default Rules versus Regulations • Default rules only apply in situations the contract doesn’t address • Regulations are mandatory – can’t be overruled in contract • Coase: if individuals are rational and there are no transaction costs, voluntary negotiations/contracting will lead to efficiency • So additional rules/prohibitions can only make things worse • But if individuals aren’t rational or there are transaction costs, 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”

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

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 can create 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

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 • Contracts should be enforced if both parties wanted enforceability • Same with renegotiated contracts • Contracts renegotiated under duress will not be enforced; contracts renegotiated under changed circumstances will

Next week: more doctrines for invalidating contracts, and other stuff • Have a good weekend • Don’t get drunk and sign contracts!

Econ 522 Economics of Law