econ 522 economics of law dan quint spring 2010 lecture 11

Econ 522Economics of Law

Dan Quint

Spring 2010

Lecture 11

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HW 1: end of class today

Midterm: Wednesday

Grading

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Why do we need contracts?

Which promises should be enforced?

First purpose: enable cooperation

Second purpose: efficient disclosure of information

Contracts: the story so far…

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Breach of contract Breach is efficient when cost to perform > benefit Breach will happen when cost to perform > liability Expectation damages: liability for breach = anticipated benefit Leads to breach exactly when breach is efficient Third purpose: secure optimal commitment to performance

Reliance Reliance is efficient when expected benefit > cost Or (Probability of performance) X (Increase in value) > cost Reward any reliance overreliance Fourth purpose: secure optimal reliance Hadley v Baxendale, foreseeable reliance

Contracts: the story so far…

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Default Rules

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Gaps: risks or circumstances that aren’t specifically addressed in a contract

Default rules: rules applied by courts to fill gaps

Default rules

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Gaps: risks or circumstances that aren’t specifically addressed in a contract

Default rules: rules applied by courts to fill gaps

Writing something into a contract vs leaving a gap Allocating a loss (ex post) Versus allocating a risk (ex ante), before it becomes a loss

Default rules

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Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue

This will be whatever rule is efficient

What should default rules be?

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Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue

This will be whatever rule is efficient

Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules Do this by imputing the terms the parties would have chosen if they

had addressed this contingency

What should default rules be?

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Don’t want ambiguity in the law

So default rule can’t vary with every case

Majoritarian default rule: the terms that most parties would have agreed to In cases where this rule is not efficient, parties can still override it in the

contract

Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate

Default rules

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Example: probability ½, the cost of construction will increase by $2,000 Construction company can hedge this risk for $400 Family can’t do anything about it

Price goes up – who pays for it?

Default rules

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Price goes up – who pays for it? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction

company Should prices be adjusted to compensate?

Default rules

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Price goes up – who pays for it? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction

company Should prices be adjusted to compensate?

Default rules

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So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases

Most contracts can leave this gap, save on transaction costs

In cases where this rule is inefficient, parties can contract around it

Default rules

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Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules”

Sometimes better to make default rule something the parties would not have wanted To give incentive to address an issue rather than leave a gap Or to give one party incentive to disclose information “Penalty default”

Default rules: a different view

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Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk

If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent

So Hadley might hide this information, which is inefficient Ayres and Gertner: Ruling in Hadley was a good one, not because

it was efficient, but because it was inefficient… …but in a way that created incentive for disclosing information

Penalty defaults: Hadley v Baxendale

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Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to

bring it up if it’s efficient to change this

Penalty defaults: other examples

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Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to

bring it up if it’s efficient to change this

Courts will impute missing price of a good, but not quantity Forces parties to explicitly contract on quantity, rather than leave it

for court to decide

Penalty defaults: other examples

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Look at why the parties left a gap in contract Because of transaction costs use efficient rule For strategic reasons penalty default may be more efficient

Similar logic in a Supreme Court dissent by Justice Scalia Congress passed a RICO law without statute of limitations Majority decided on 4 years – what they thought legislature would have

chosen Scalia proposed no statute of limitations; “unmoved by the fear that this…

might prove repugnant to the genius of our law…” “Indeed, it might even prompt Congress to enact a limitations period that it

believes appropriate, a judgment far more within its competence than ours.”

When to use penalty defaults?

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Regulations

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Default rules can be contracted around

Some rules cannot – immutable rules, or mandatory rules, or regulations

Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations. Coase: if individuals are rational and there are no transaction costs,

private negotiations lead to efficiency So additional regulations can only make things worse But when people are not rational, or when there are transaction

costs/market failures, regulations may help

Default rules versus regulations

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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

One example of a regulation/immutable rule: derogation of public policy

B(union)

C(ownership)

A(other factory)

“if I ever work for C for less than $15/hr, I’ll work

for you for $1/hr”

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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

One example of a regulation/immutable rule: derogation of public policy

B(union)

C(ownership)

A(other factory)

“if I ever work for C for less than $15/hr, I’ll work

for you for $1/hr”

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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”

Derogation of public policy

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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?

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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”

Expectation damages: default rule or immutable rule?

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Which works better in this case: Default rule allowing Garland to breach and pay diminution fee? Default rule forcing Garland to perform restorative work?

Ayres and Gertner: default rule should “penalize” the better-informed party Garland routinely signed contracts like these Peevyhouses were doing this for the first time Default rule allows Garland to pay diminution fee: they have no reason

to bring it up, Peevyhouses don’t know Default rule forces Garland to do cleanup: if that’s inefficient, they

could bring it up during negotiations In this case, specific performance would work as a penalty default

We can also think about Peevyhouse in terms of penalty defaults

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Ways to get outof a contract

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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

Formation Defenses and Performance Excuses

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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

Incompetence

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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?

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The Borat lawsuits


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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


econ 522 economics of law dan quint spring 2010 lecture 11

Documents

cost of construction

default rule thats efficient

efficient default rulesdo

efficient bearer

rule parties

lawso default rule

casemajoritarian default

riskso efficient contract