Law, Economics and the Knowledge Problem

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Law, Economics and the Knowledge Problem

• Pierre Garello

pierregarello_at_hotmail.com
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Lecture 5

• Contract Law
• in a dynamic perspective

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Outline

• The neoclassical approach of contract
• See for instance Posner, Cooter and Ulen
• The Austrian approach
• See Wonnell, Epstein, Garello
• The first one advocates greater regulation of the
  contract process

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Link with what we have seen previously

• Cooter and Ulen
•  The economic rationale for regulating contracts
  resembles the economic rationale for regulating
  markets. The economic rationale for regulating
  markets begins with a description of a perfectly
  competitive market, which requires no regulation.
  Next, the theory describes the ways that actual
  markets depart from this ideal, or the forms of
  market failure. We will adapt this approach to
  contracts.  (186)
• Attention paid to the knowledge problem will
  again distinguish the two approaches

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Neoclassical starting point

• Contract Voluntary exchange Pareto
  improvement
• Therefore needs no regulation
• However, this is true only under certain
  conditions
• This is true according to the perception and
  situation of the parties (Are the parties
  rational? Are they well informed?)
• It is not true if you have superior knowledge
• In particular it might not be true ex-post

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The role of contract law more details

• 1. Facilitates cooperation (via damages or
  specific performance)
• 2. Expectation damages makes sure that only
  socially optimal breaches occur.
• 3. With perfect expectation damages parties will
  engage in specific investment only if socially
  optimal (overreliance and unforseeability)
• 4. Reduces transaction costs by providing the
  right default terms.
• 5. Corrects or invalidates imperfect contracts.
  (imperfection being due to lack of rationality or
  high transaction costs)

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Zoom on expectation damages

• Promisors view point
• If Cost of performance gt cost of breach then
  breach
• If Cost of performance lt cost of breach then
  perform
• Socials view point
• If Social cost of performance gt benefit to
  promisee (ie, social benefits) Then breach
• If Social cost of performance lt benefit to
  promisee (ie, social benefits) Then perform
• Expectation damages (cost of breach) benefit to
  promisee
• Dont we have a simpler justification for this
  rule?

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Other tasks for the judge (and for regulation)

• Fill up the gaps in the contract
• Mimic what the parties would have done had they
  contracted on that point (Pareto optimal
  solution)
• e.g. who would have born this risk?
• Impossibility (unforseeable events)
• Social cost of performing gt social benefit from
  performing
• Duty to disclose information
• Unconscionability
• The problem should be solved using other tools
  (e.g., competition law)

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What it takes to be a good (neoclassical) judge
or regulator

• Like contracts, the officials who regulate them
  are imperfect. The officials who regulate
  contracts need information and motivation to
  correct market failures. In reality courts have
  limited information and some judges lack
  motivation. Contract law should take the
  imperfection of officials into account by
  discouraging them from exceeding their own
  limitations in attempting to correct imperfect
  contracts.
• Cooter and Ulen (p.192).

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Complete v. incomplete contracts

• Definition of completeness
• Sources of incompleteness
• Transaction costs (rational gaps in the contract)
• Strategy (purposeful) (rational gaps in the
  contract)
• But also genuine uncertainty
• Incompleteness and efficiency
• But also incompleteness and entrepreneurial
  discovery

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Another approach of the contract

• J. Ghestin The contract is, as far as the
  individual is concerned, the best forecasting
  instrument generating legal security, and the
  favoured path to freedom and responsibility that
  is necessary for the flourishing of human beings
  in a society.
• (J. Ghestin, Lutile et le juste dans les
  contrats, 26 Archives de Philosophie du Droit,
  p.44)
• The contract is never perfect and almost always
  incomplete (see Epstein)

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Remember the role of the entrepreneur (Wonnell)

• She has by definition a divergent perception
  (often a sharper one)
• She helps the price system to be efficient (if
  she is allowed to act on the basis of better
  information)
• Consequently
• Asymmetry of information is not a market failure
• Duty to reveal knowledge can stop the discovery
  process
• If someone charges too high a price he creates
  profit opportunities

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This has consequences for

• Duty to disclose (waved only if costly search
  says the neoclassical theory, never says Wonnell)
• Impossibility to perform is not like very
  costly performance (Crapone case and Théorie de
  limprévision)
• Allocating risks (what if only one had perceived
  it?)
• the question becomes whether there are any
  circumstances in which gains from entrepreneurial
  perceptiveness should be confiscated by use of
  the doctrine of mistake or impossibility
  (Wonnell, 30)
• Unconscionability
• Make sure competition prevails
• Standard contract (contract of adhesion) not so
  dangerous
• Regulation of contract to reduce asymmetries of
  power (labor contracts)

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An illustration the market for lemons
peach
lemon
seller
buyer
1/3
2/3
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Contract as a discovery process

• Freedom to and from contract defined (as any
  freedom) by the respect of some negative rights.
  For example
• No fraud
• No (physical) constraint (duress, necessity)
• No contracting with insane or unstable
  (incompetency, incapacity)
• Autonomy of the will as engine for discovery
• Border line cases will always show up Helping
  parties to build safe expectations should be goal
  number one 

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Final word

• The movement of the progressive societies has
  hitherto been a movement from Status to
  Contract 
• (H. Maine)