Econ 522 Economics of Law

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Econ 522Economics of Law
Dan Quint Spring 2010 Lecture 12
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Logistics

• Midterm will be returned at end of lecture
• HW2 is online, due in two weeks (Wed Mar 17)
• Second midterm Wed Mar 24
• Cumulative, through end of contract law

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Last time

• Default rules
• Why are gaps left in contracts?
• What rules should be applied to fill those gaps?
• CU use terms most parties would have chosen
  (efficient terms)
• Ayres and Gertner under some conditions, use
  default rules which penalize one or both parties
  for concealing information
• Regulations
• Example derogation of public policy
• Ways to get out of a contract
• Formation defenses (no contract exists)
• Performance excuses (circumstances have
  changed)
• One formation defense incompetence (but not
  drunkenness)

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Another formation defensedire constraints
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Dire constraints

• Necessity
• Im about to starve, someone offers me a sandwich
  for 10,000
• My boats 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 Im in
• Someone makes me an offer I cant refuse

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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 youd rather pay 100 than be killed
• So why not enforce it?
• Makes muggings more profitable ? leads to more
  muggings
• Tradeoff dont enforce Pareto-improving trade,
  in order to avoid incentive for bad behavior

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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 youd rather pay 100 than be killed
• So why not enforce it?
• Makes muggings more profitable ? leads to more
  muggings
• Tradeoff dont enforce Pareto-improving trade,
  in order to avoid incentive for bad behavior

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What about necessity?

• Same logic doesnt 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 hell 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 whats the problem?

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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 youll 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

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Friedmans 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!

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Friedmans 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

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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

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Real duress versus fake duress

• Court wont enforce contracts signed under threat
  of harm
• Give me 100 or Ill shoot you
• But many negotiations contain threats
• Give me a raise, or Ill 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

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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 theyll
  quit
• Captain agrees
• Back in Seattle, refuses higher wages, claiming
  duress

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A performance excuseimpossibility
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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

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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

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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

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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
  its 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

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Contracts based onbad information
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Misinformation

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

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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

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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 kings
  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

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Mutual Mistake

• Frustration of purpose circumstances changed
  after the contract was signed
• Mutual mistake circumstances changed before the
  contract was signed, but the parties didnt 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

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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

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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
  its worthless
• You sell it to me at a low price
• Contracts based on unilateral mistake are
  generally upheld

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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
  its 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

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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 couldnt 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

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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 partys knowledge of
  productive information especially if that
  knowledge was the result of active investment
  should be enforced
• Contracts based on one partys knowledge of
  purely redistributive information or fortuitously
  acquired information should not be enforced

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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

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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

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Other reasons a contract may not be enforced
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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

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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

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Adhesion and unconscionability

• Adhesion standardized take-it-or-leave-it
  contracts
• Friedman calls it bogus duress

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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

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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.

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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.

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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)

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Midterms
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Midterm

• Overall pretty good
• Mean 82, median 84, std dev 14
• Not actually assigning letter grades till after
  final
• But to have an approximate idea of where you
  stand
• 90s roughly AB or A
• 80s roughly B
• 70s roughly BC
• high 50s/60s roughly C

A-H
Q-Z
I-P