The Economics of Contracts"Never promise more than you can perform."

-Publius Syrus (42 B.C.)

"A verbal contract isn’t worth the paper it is written on."

-Samuel Goldwyn (1882–1974)

Groucho: "That's in every contract, that's what you call a sanity clause." 

Chico: "You can't a fool a me, there ain't no sanity clause"

-Groucho/Chico in A Night at the Opera (movie)

Fundamental Questions

What is a contract?What promises should be enforced?What should be the remedy for breaking enforceable promises?

A contract enforces a bargain

Components of a classic bargain Offer Acceptance Consideration

What the promisee gives the promisor to induce the promise.

A bargain should have reciprocal inducementA promise lacks reciprocal inducementA contract typically entails delayed performance

Consideration MoneyGoodsServicesA promise

Reasons for not having a valid contractA bargain requires cooperation. A contract may not exists because cooperation is lacking

Nothing given by one party - gift Confused promise Deception

The remedy may be criminal or tort actions When does withholding information constitute

deception?

Remedy for breach of a bargainA breach creates an incomplete bargain

Either or both parties can breachPromisee is entitled to the “benefit of the bargain”The economic measure of damages is expectation damages

Restores the victim to the where he or she would have been if the contract was completed

Not necessarily the same as what the victim expected at the beginning of the contract

Bargain theory may not enforce contracts that people want enforced, particularly if no consideration is given

Law that frustrates the desires of people is dogmatic

Law that satisfies desires is responsive

Economic Theory of ContractA theory of law based upon Pareto efficiency is responsive

Economic efficiency requires enforcement of a promise that both parties wanted when it was made

Enforces contracts that the parties want enforced (Courts may not enforce liquidated damages clauses. This is

dogmatic.) Liquidated damages – contractually specified dollar penalties for breach

A contract typically creates a deferred exchange Deferred exchanges create uncertainty and risk Unforeseen circumstances may change the benefits of the

bargain Fortuitous circumstances Unfortuitous circumstances

Unenforceable promises involve risk Enforcing the promises reduces the risk of the contract.

The Economic Purpose of Contract Law

To enable people to convert games with inefficient solutions to games with efficient solutions

Avoid prisoner’s dilemmaTo encourage the efficient disclosure of information within the contractual relationship.

Promotes efficient investment in informationTo secure optimal commitment to performing.

Encourages optimal reliance Require disclosure or allow non-disclosure

To minimize transaction costs of negotiating contracts by supplying efficient default terms and regulationsEncourage non-contractual cooperation

Agency Game without Contract

Cooperate Appropriate

Invest .5, .5 -1.0, 1.0Don’t Invest

0, 0 0,0

Investment of $1 could produce $2. The investor is promised $1.50

Payoff is difference in wealth before and after

Agency Game with Contract and Compensatory Damages

Cooperate Appropriate

Invest .5, .5 .5, -.5Don’t Invest

0, 0 0,0

Investment of $1 could produce $2. The investor is promised $1.50

Payoff is difference in wealth before and after

Perfect expectation damages

They restore the promisee to the position he would have been in had the promise been kept.

Does not necessarily coincide with initial expectations concerning the non-contractual environment

Unexpected circumstances may change the relative benefits from the contract and change perfect expectations damages

Perfect expectation damages provide incentives for efficient performance and breach

They cause the promisor to internalize the costs of breach Leave the victim indifferent between performance and

breach Create incentive for Pareto optimal decisions

Expectation damages create commitment

The opportunity to appropriate is foreclosed by the high cost of liability for breachA commitment is credible when the other party observes the foreclosing of an opportunity.

Optimal Performance

What is the appropriate remedy for breaking enforceable promises?Purpose is secure optimal commitment and provide for optimal breachesOptimal commitment exists when the joint profits from performance are greater than the joint profits from breachIt is optimal to breach when the joint profits from a breach are greater than the joint profits with commitment.

Optimal BreachIt is optimal to breach when the party breaching is better off because of the breach and the victim is no worse off given the breach.

If liability is the only concern, the promisor will perform if cost of

performance is less than liability

Promisor’s cost of performing > promisor’s liability for breaching, then breachPromisor’s cost of performing < promisor’s liability for breaching, then perform

Efficiency requires maximizing the sum of the payoffs to the promisor and the promisee

Promisor’s cost of performing > promisee’s benefit --- then it is efficient to breachPromisor’s cost of performing < promisee’s benefit --- then it is efficient to perform

There is an efficient incentive for breaching when liability is equal to promisee’s foregone benefit

Expectation damages

Optimal Breaching

PerformCooperating

cost 0

PerformCooperating

cost 1.5

Breach and pay

invest .5,.5 .5,-1.0 .5,-.5

Don’tinvest

0,0 0,0 0,0

If invested with no breach, a $1 investment returns $1

Alternative ExampleA promises B the future delivery of widgets for $10.B expects to earn $2 in profits if the widgets are deliveredIf the widgets are not delivered B will earn zero profitsA locates an alternate offer from C of $15 for the widgetsIs it efficient for A to breach?

What decision allocates the resource to its most highly valued use?

Perfect expectation damages

They restore the promisee to the position he would have been in had the promise been kept. (This is not necessarily the same position he expected when he entered into the contract.)Perfect expectation damages provide incentives for efficient performance and breachThey cause the promisor to internalize the costs of breachLeave the victim indifferent between performance and breach

Opportunity Cost Damages

Damages replace the value of a lost opportunityLeave victims indifferent between breach and performance given the best alternative contract

In perfectly competitive markets there is no difference between perfect expectation damages and opportunity cost damages

They place the victim in the position he would have been in had he taken the next best opportunity

Reliance damages

Places the victims in the position they would have been if they had never contracted with the other partyDo not take into account lost opportunities.The promisor may invest in performance.The promisee may invest in reliance on the promiseReliance increases the gain from performance and the loss from breach.

Perfect expectation damages ≥Opportunity cost damages ≥Reliance damages

The Case of the Hairy HandHawkins v. McGee (N.H., 1929),

The plaintiff, George Hawkins, suffered a childhood accident that left a permanent scar on his hand. When Hawkins was 18 years old, his family physician, McGee, persuaded him to submit to an operation that the doctor asserted would restore the hand to perfection. In the operation, skin from the plaintiff’s chest was grafted onto his hand. The result was hideous. The formerly small scar was enlarged, covered with hair, and irreversibly worse. Hawkins prevailed against McGee in a suit alleging that the doctor had broken his contractual promise to make the hand perfect.

Damages for Mr. Hawkins?

Reliance damagesOpportunity cost damagesExpectation damages

The Court Decision“ We, therefore, conclude that the true measure of the plaintiff's damage in the present case is the difference between the value to him of a perfect hand or a good hand, such as the jury found the defendant promised him, and the value of his hand in its present condition, including any incidental consequences fairly within the contemplation of the parties when they made their contract.”

Expectation Damages

Tattooed Man and Artist Argue Over Misspelling

Aug 1999Seaside Heights--A tattoo artist who draws better than he spells is in trouble with a customer who got more than he bargained for. The customer, Joseph Beahm of Woodbridge, wanted a tattoo on his right shoulder showing a knife stabbing into a man's back, with the words "Why Not, Everyone Else Does" accompanying it. But the tattoo artist, James Kastel of Body Art World, misspelled "else," making the tattoo read: "Why Not, Everyone Elese Does.“

Mr. Beahm wants the tattoo parlor to pay $2,100 for laser surgery to remove the misspelled word. The parlor offered Mr. Beahm his $100 back or alterations that would cover it up, but Mr. Beahm said no. Mr. Kastel said Mr. Beahm should have caught the mistake earlier. He was shown a rendering of the tattoo--including the mistake--before it was applied Aug. 7, Mr. Kastel said. Mr. Beahm says he wants to sue for $20,000 in damages. He is trying to hire a lawyer, he said yesterday. "Everywhere I go, people are making fun of me," Mr. Beahm said.

http://www.cnn.com/US/9908/26/fringe/tattoo.update/

Damage ExerciseQuestion 7.1 p. 255

B pays $10,000 to D to deliver grain in London on October 1

B does not sign alternate contract for $10,500

D contracts with S to ship grain

B sells grain in forward market for $11,000 and pays $100 for non-refundable docking fee

Ship takes on water and returns. D sells spoiled grain

for $500

D informs B who purchases grain for delivery on October 1

for $12,000

DNew

Orleans Grain Dealer

BLondon Grain

Speculator

CalculateExpectation damagesOpportunity cost damagesReliance damages

No Breach - B’s Expectation

Revenues

$11,000

Expenses

Grain$10,0

00delivery 100

-10,10

0Expected profit $ 900

With Breach – B’s ProfitRevenues $11,000Expenses

Grain$10,00

0delivery 100Replacement Grain 12,000

-22,100

Loss-$

11,100

Expectation Damages

Loss-$

11,100Expectations Damages 12,000

Profits $ 900Return victim to same profits that would exist without breach

•Suppose the $100 docking fee had been refunded.•Suppose D did not sell grain in the forward market.

With Breach – B’s Profit (no futures contract)Revenues (value on Oct. 1) $12,000Expenses

Grain $10,000delivery 100

-10,100Loss -$ 11,100

Breach with opportunity cost damages

Revenues $11,000Expenses

Grain $10,500delivery 100

-10,600Profit $ 400

Opportunity Cost DamageLoss -$ 11,100Opportunity Cost Damages 11,500

Profits $ 400Return victim to profits that would have been earned on next best opportunity

Breach with reliance damagesReturn cost of grain $ 10,000 Return loss on delivery 100 Return loss on sale 1,000

$ 11,100

Loss -$ 11,100Reliance damages 11,100

Profits $ 0Return victim to profits that would have existed without contract

Summary of DamagesExpectation Damages $ 12,000

Opportunity Cost Damages

$ 11,500

Reliance Damages $ 11,100

Did B Over rely?Reliance Costs

Rented dock Sold grain in forward market

Should the New Orleans grain dealer be responsible for London’s speculative losses?

Should it matter whether he knew that B was a speculator?

Question 7.5Jan. 1

A contracts to deliver a widget to B on June 1 at a price of $2

April 1A breaches and informs B of breach.

B can purchase a widget for immediate delivery for $3,

or contract with C to deliver on June 1 at $3.25.

B does not do either

June 1B sues A and wins perfect expectation

damages. At this time B can buy a widget for $4

How should the damages be computed?

Question 7.5Price on June 1 $ 4.00 Promised delivered price on June 1 2.00 Damages $ 2.00

Breach on April 1Price on April 1 for immediate delivery $ 3.00 Promised delivered price on June 1 2.00 Damages $ 1.00 (Carrying costs not included)Price on April 1 for delivery on June 1 $ 3.25 Promised delivered price on June 1 2.00 Damages $ 1.25

Cooter & Ulen suggested answer

Think about the ease of finding substitute performance in each situation. Clearly, the law ought to encourage B to purchase the substitute widget after A repudiates at the lowest alternative price. (This is called “mitigating damages.”)

Note: This places the responsibility on B to remedy the uncertainty that A has created. A could just as well mitigate damages.

Alternate Question 7.5Price on June 1 $ 3.00 Promised delivered price on June 1 2.00 Damages $ 1.00

Breach on April 1Price on April 1 for immediate delivery $ 3.00 Promised delivered price on June 1 2.00 Damages $ 1.00

Price on April 1 for delivery on June 1 $ 3.25 Promised delivered price on June 1 2.00 Damages $ 1.25

If A wanted to accept the risk, he could have purchased product for delivery for June 1 on June 1

Airline Overbooking

How should damages be calculated?• A ticket refund• A ticket on an alternative flight• Are the expectation damages

foreseeable?

Damages for Airline Overbooking

There is no compensation if alternative transportation gets the passenger to the destination within one hour of the original scheduled arrival.The equivalent of the passenger's one way fare up to a maximum of $400 for substitute domestic flights that arrive between one and two hours after the original scheduled arrival time or for substitute international flights that arrive between one and four hours after the original scheduled arrival time.If the substitute transportation is scheduled to get you to your destination more than two hours later (four hours internationally), or if the airline does not make any substitute travel arrangements for you, the compensation doubles to a maximum of $800.

Optimal RelianceA promise is made, then time elapses

During this time

- promisor might incur costs associated with performing (investing in performing)

- promisee might incur costs associated with the anticipation of the promise being fulfilled (invest in reliance)

Reliance costs - costs incurred by the promisee in order to increase the utility, profits, etc. resulting from the fulfilment of the contract

The investments in performance and reliance might take the form of time, effort, money or foregone alternatives

RelianceReliance increases the benefits of the bargainReliance increases expectation damagesShould all reliance costs be reimbursed?Can there be overreliance?

Question?How much reliance should a promisee place on the fulfilment of the contract? What is optimal reliance?

For the want of a nail~Anonymous proverb

For want of a nail the shoe was lost.For want of a shoe the horse was lost.For want of a horse the rider was lost.For want of a rider the battle was lost.For want of a battle the kingdom was lost.And all for the want of a horseshoe nail

Should the blacksmith be liable for the loss of the kingdom?

Modern versionBecause the stationary wasn’t deliveredThe envelope was not mailedTherefore the payment for raw materials was not receivedTherefore the raw materials were not deliveredTherefore the factory shut down

Should the delivery boy be liable? If not, why not?

Hadley v. Baxendale (1854)

Operations at the plaintiff’s mill were halted because of a broken crank shaft. The plaintiff ordered delivery of a new crank shaft from the defendant. The plaintiff’s employee told the clerk that a new shaft had to be delivered immediately. The clerk promised delivery by the next day. Because of neglect the shaft was not delivered for several days. As a consequence, the mill remained stopped and the plaintiff experienced substantial lost profits.

The mill owner sued for breach of contract requesting the lost profits from shutting down the factory.

Should the delivery company be responsible for the mill’s lost profits?

Should it matter whether the losses were foreseeable? Why?

Hadley v. Baxendale (1854)

''There are certain established rules according to which the jury ought to find and here there is a clear rule, that the amount which would have been received if the contract had been kept, is the measure of damages if the contract is broken.Now we think the proper rule in such a case as the present is this:—Where two parties have made a contract which one of them has broken, the damages which the other party ought to receive in respect of such breach of contract should be such as may fairly and reasonably be considered either arising naturally, i.e., according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it. Now, if the special circumstances under which the contract was actually made were communicated by the plaintiffs to the defendants, and thus known to both parties, the damages resulting from the breach of such a contract, which they would reasonably contemplate, would be the amount of injury which would ordinarily follow from a breach of contract under these special circumstances so known and communicated. But, on the other hand, if these special circumstances were wholly unknown to the party breaking the contract, he, at the most, could only be supposed to have had in his contemplation the amount of injury which would arise generally, and in the great multitude of cases not affected by any special circumstances, from such a breach of contract.

Hadley v. Baxendale (1854)

“All the plaintiffs told the defendants at the time the contract was made, were, that the article to be carried was the broken shaft of a mill, and that the plaintiffs were the millers of that mill.”Other possible reasons for the delivery

A back up shaft was ordered Other parts of the machinery were also defective

“The Judge ought, therefore, to have told the jury, that upon the facts then before them they ought not to take the loss of profits into consideration at all in estimating the damages.”

Legal Incentives for RelianceSimple expectation damages provide an incentive for overreliance.A sophisticated measure takes optimal reliance as a baseline for damages.How should optimal reliance be determined?

Optimal Reliance

The expected gain from additional reliance (increase in value of performance x the probability of performance.)

Expected savings from not having backup given the probability the part will be delivered on time

The expected loss from additional reliance (the increase in the loss from the breach x the probability of breach)

Expected loss of profits from plant shut down given the probability the part may not be delivered on time

Optimal where marginal gain equal to marginal lossIn Hadley the expected savings from not having a backup were less than the expected loss from a plant shut down.

Optimal Reliance

Optimal reliance is high when performance is certain.Optimal reliance is low when performance is uncertain

An example: Boy Scout Apple Day

During the Summer, the Boy Scouts contract with Farmer Jones to buy 100 bushels of apples for their fall Apple Day promotion

– they pay $500 for 100 bushels which they expect to sell for $1,000 ($500 profit)

The Boy Scouts realize that the probability that Farmer Jones will not be able to supply the apples is 0.25 (25% due to hail, drought, etc.)

The Boy Scouts also know that their Apple Day will generate an additional $400 in revenue if they spend $150 in promotion (signs, TV ads, soliciting corporate sponsors, etc.). Net gain from reliance is $250 ($400 - $150)

Should the Boy Scouts undertake the promotion? Is it an ‘optimizing’ investment? [in addition, is it an ‘efficient’ investment?]

We know:- increase in value of performance from reliance is

$250 = $400 -$150- probability of performance is 0.75 (1 - 0.25)- increase in cost of breach from reliance is $150- probability of breach is 0.25

Expected gain to promisee from reliance: ($250) x (0.75) =

$187.50

Expected loss to promisee from breach: ($150) x (0.25) =

$37.50Yes, the Boy Scouts should undertake this investment

in reliance since their expected gain from reliance is greater than their expected loss from reliance

Calculating damages The Boy Scouts expect to gain $650 from Apple Day.

Revenue = $1,000 plus $400 (from reliance) $1,400

LESS:Costs Apples $500

Investment in reliance $150

Total costs $ 650

Profit $ 750

What if the Boy Scouts make the above contract and farmer Jones breaches the contract? What are optimal damages?

Calculating damages

What would perfect expectation damages be?

Original investment (payment to Farmer) $ 500

Investment in reliance $ 150

Expected gain after ‘optimal reliance’ $ 750

Perfect expectation damages$1,400

Forseeability Reliance by the promisee is foreseeable by the promisor if it equals the amount the promisor could reasonably expect. Should the promisor be held liable for unforeseeable losses?

Unforeseen events do not affect behavior Unforeseen events do not influence economic

incentives

ForseeabilityForseeability helps defines overrelianceOverreliance is unforeseeable and hence not compensableWhich party could have avoided the loss at the least cost?

The Paradox of Compensation

Reliance increases the profitability of performance, but also increases the liability from breachIf all reliance costs are compensated there is an incentive for overreliance

Expectation DamagesSimple expectationSophisticated expectationPerfect expectation

Simple ExpectationDamages are equal to expectations regardless whether reliance is high or low.Probability of breach is ignored.Heavy reliance regardless of probability of breach.Over reliance causes excessive harm from breach.

Sophisticated Expectation Damages

Damages that would have occurred had I undertaken optimal reliance. I am not fully reimbursed for my losses if my reliance was based upon an unrealistic probability of performance.

Perfect Expectation Damages

Perfect expectation damages should equal sophisticated expectation damagesDamages needed to restore the promisee who relied optimally to the position he would have enjoyed if the promise had been kept The law discourages overreliance by limiting damages

B pays $10,000 to D to deliver grain in London on October 1

B does not sign alternate contract for $10,500

D contracts with S to ship grain

B sells grain in forward market for $11,000 and pays $100 for docking fee

Ship takes on water and returns. D sells spoiled grain

for $500

D informs B who purchases grain for delivery on October 1

for $12,000

DNew

Orleans Grain Dealer

BLondon Grain

Speculator

Discussion – Question 7.1

Did the London grain dealer over rely?Who could have avoided the loss at the least possible cost?

D or B could have purchased insurance on the shipment to reimburse at market value

B could purchase option to buy in forward marketWas B’s loss foreseeable to D?

What is custom in the industry? Is grain to arrive typically sold in the forward market?

Other measures of Damages

RestitutionDisgorgementLiquidated damagesSpecific Performance

RestitutionReturn what was givenReturn of down paymentMinimal damagesLess than or equal to reliance damages

“money back guarantee”

DisgorgementBreaching party pays the injured part an amount equal to the promisor’s gain from the breachDamages paid to eliminate the injurer’s profit from the wrongdoingInjurer is indifferent between doing right and appropriatingEliminates incentive for efficient breach

Emphasizes trust which may be necessary for efficiently functioning financial markets

Eliminates incentive for misuse of funds Embezzlement

DisgorgementMay not eliminate incentive for misappropriation of funds ifthe profit from breach >

(the probability of being caught in breach of trust) x (the profit from breach of trust)

Punitive action may be needed to deter misappropriation

What rate should late payments be compounded at?

Opportunity cost to breaching party Disgorgement

Opportunity cost to victim Expectation damages

Other possibilities The higher of the two Average market rate A rate stipulated by statute

Liquidated damagesAlso called “stipulated damages”The contract stipulates a sum that will be paid upon breachNot enforced when it is out of line with the damages caused by the breach.

Reasons Courts Should Award Liquidated Damages

Punitive element may be considered payment on an insurance contractLiquidated damages convey information about promisor’s reliabilityPenalties may be restated as bonusesPerformance bonds are another alternative

a sum of money, deposited with a third party, to be paid to the injured party in the case of breach

Specific Performance A court order which requires a party to perform a specific act (an equitable remedy)Requires promisor to do what was promised.Promisor may be released from the promise by the injured partyMay be useful when it is difficult to place a value on the breach (review injunction in property law)

Often used as a remedy in breaches of transferred assets

Specific Performance or Monetary Damages?

I contract to purchase an old home in a part of town undergoing gentrification. Between the contract and the closing on the home, the house burns down.

I do not feel that other homes are perfect substitutes for this house. The market value and the contracted value on the home was $100,000.

However, to rebuild the same home today would cost $250,000.

I want the home rebuilt and request specific performance from the courts. The home is unique and I do not view any other existing home as a perfect substitute.

Monetary Damages or Specific Performance?

Monetary Damages or Specific Performance?

Should the seller be ordered to rebuild the home, or pay me $150,000, the difference between my subjective value and market value, so that I can replace the home I did not buy?

Damage options $0 $150,000 = $250,000 - $100,000 (estimated value) Specific performance

If the court awards specific performance and it is not really worth an extra $150,000 to me is there an opportunity for a Coasian bargain?Is it efficient to build a home at cost of $250,000 that only has a market value of $100,000?

Property InsuranceActual Cash Value (Market Value) or Replacement

Cost?Specified in insurance contract

Car (ACV = RC)Roof (ACV < RC)

Old home (ACV < RC)

Fortunate Contingency and Specific Performance

A owns the house and values living in the house at $90,000

B values living in the house at $110,000 and offers A $100,000

A accepts

C values living in the house at $126,000 and offers A $118,000

What should A do? This will depend on the potential remedy

Fortunate Contingency Example

B offers $100,000 C offers $118,000

With zero transactions costs asset will find its way to the most valued user.

Fortunate Contingency Example• Remedy favors promisor when remedy is damages• Remedy favors promisee when remedy is specific

performance• Efficiency only matters when transactions costs are

positive. Specific performance involves two transactions

• With specific performance the court avoids the problem of valuation.

Reasons for Voiding a Contract

Why Damages Should Not Be Awarded?Claims by Defendants in Contract Disputes

Formation defenses (no contract exists) Incapacity/Incompetence Coercion or Duress Mutual Mistake Fraud Unconsionability Only a promise

Performance excuses (contract exists, but performance should be excused)

Impossibility Frustration of Purpose

IncompetenceTemporary incompetence (Transactional incapacity)

High pressure sales tactics Cooling off period

Incompetence due to age, education or medical conditionCompetent contractual partners can usually protect the interests of incompetent contractual partners at less cost than anyone else

Dire Constraints and Remote RisksDuressNecessityImpossibilityFrustration of purposeMutual mistake about factsMutual mistake about information

DuressMust distinguish between forbidden threats and permitted demandsDuress involves extracting a promise by a threat (not Pareto optimal)Enforcement of contract redistributes wealth from one person to another and does not create a cooperative surplusFailed bargains do not create; whereas failed coercion can destroyCoercion causes investment in defense

By providing protection against threats the state channels resources from defense to production

Make him an offer he can’t refuse

Alaska Packers' Ass'n V. Domenico et al (1902)

Domenico hired workers in San Francisco to work the fishing season at a cannery in Alaska for a contracted wage.

When the workers got to Alaska they refused to work unless the received a new contract at a higher wage. Domenico had substantial funds invested in the cannery and had no way of replacing the striking workers. Consequently, it agreed to their demands.

However, after the workers return to San Francisco the company refused to pay them the higher amount owed under the renegotiated contract.

Should the contract be enforced?Nothing to be gained by the agreement that was not already promisedEnforcement discourages optimal performance

Alaska Packers' Ass'n V. Domenico et al (1902)

“… To permit plaintiff to recover under such circumstances would be to offer a premium upon bad faith, and invite men to violate their most sacred contracts that they may profit by their own wrong. That a promise to pay a man for doing that which he is already under contract to do is without consideration is conceded by respondents. The rule has been so long imbedded in the common law and decisions of the highest courts of the various states that nothing but the most cogent reasons ought to shake it. …. “

Baseball Player Problem

A baseball star signs a five-year contract for $1 million per year. In the third year the player hits more home runs than anyone else in the league. Now he demands to renegotiate his salary. Can the team owner sign a new contract for $2 million and then later claim duress? Does efficiency require the law to enforce the original contract or set it aside?

Possible Rules?A promise extracted as the price to cooperate in creating value is enforceable, and a promise extracted by a threat to destroy is unenforceable

A destructive threat to breach a contract after reliance constitutes coercion in renegotiating the price.

NecessityA dire constraint imposed on the promisor by someone (something) other than the promisee

With duress dire constraint imposed by the promisorPromisor threatens to destroy by not rescuingWhat is an efficient incentive for rescue when there is not a general duty to rescue?

Exceptions: emergency workers, parents, common carriers, employers

Marcus Licineus Crassus

“In 70 BC, an ambitious minor politician and extremely wealthy man, Marcus Licineus Crassus, wanted to rule Rome. Just to give you an idea of what sort of man Crassus really was, he is credited with invention of the fire brigade. But in Crassus' version, his fire-fighting slaves would race to the scene of a burning building whereupon Crassus would offer to buy it on the spot for a tiny fraction of it's worth. If the owner sold, Crassus' slaves would put out the fire. If the owner refused to sell, Crassus allowed the building to burn to the ground. By means of this device, Crassus eventually came to be the largest single private land holder in Rome, and used some of his wealth to help back Julius Caesar against Cicero.”http://www.atrium-media.com/rogueclassicism/2003/12/28.html

Should the contract be set aside because it had been signed under duress?

Should the law be dogmatic or responsive?

NecessityHow much wealth may a promisor extract from a promisee in dire circumstances?Might the efficient answer depend on the marginal cost of the rescue?

CrassusWhat is the cooperative surplus?With competition could Crassus extract the same amount?What is the efficient price for this service?What is the difference between this and fire insurance?Modern version of a Crassus Auction

Rescue Me Now, Bill Me LaterWho's Accountable for Madison County

Balloon Accident Rescue CostHikers rescued from cliff: Who should

cover the cost?*

Efficient remedy for rescue may depend on marginal cost

Fortuitous rescue Low cost accidental rescue

Anticipated rescue Minimal resources allocated for possible rescue

Planned rescue Substantial resources specifically used for rescue

Post v Jones (1857)The Richmond ran upon some rock while returning from a whaling voyage. The whaling ships Frith and Panama came upon the Richmond while she was floundering. They saved the crew and took on her cargo of whaling oil and whalebone after a forced auction. The price paid was considerably below the competitive market price. The captain of the Richmond claims that the auction was forced on him under duress and necessity. Therefore, this does not represent a valid sale.

Should the auction be set aside on efficiency grounds? Is this similar to what Crassus did?

We want an incentive to rescue, assuming there is no duty to rescue the cargo.We want individuals to seek rescue.

Post v Jones (1857)With their hulls full the Firth and the Panama terminated the rest of their whaling voyageThey were not required to save the cargoIf the auction is invalid, how should the court determine appropriate compensation?

Post v Jones (1857)Decision

Richmond should receive an amount for its oil based on the market price, after allocating a fraction of the oil to the salvors and giving them credit for freight.

The Panama and the Firth may have been deterred from taking on a full cargo from their whaling voyage, but this was uncertain. They could deposit their cargo at the first port of safety and continue their voyage. The salvage only delayed their voyage.

Comment The court may impose a hypothetical contract that would have

been entered into without necessity or duress If rescues are efficient, why are they not required by law?

Admiralty law requires rescue of lives without promise of reward, but not cargo.

Dire Constraints and Remote RisksDuressNecessityImpossibilityFrustration of purposeMutual mistake about factsMutual mistake about information

ImpossibilityDire constraint follows the promise and prevents performanceA contingency destroyed a basic assumption on which the contract was madeImpossibility may leave a gap in the contract. Default rules applied by the court will remedy the gap.

Custom may determine the default rule Efficiency allocates risk to party who can bear it at the least

cost. Had the contingency been included in the contract, which party would have

assumed the liability? (We might assume that custom is based on efficiency.)

Gaps in a ContractShould a contingency be included in the contract or should there be a gap in the contract?Leave Gap

Cost of allocating a risk (contracting cost) > cost of allocating a loss (litigation cost) x probability of a loss

Fill Gap Cost of allocating a risk (contracting cost)< cost of

allocating a loss (litigation cost) x probability of a loss

Gap Filling by Hypothetical Bargains

Impute the terms to the contract that the parties would have agreed to if they bargained over the relative riskThe court should respond to gaps by allocating risk efficiently and adjusting the price reasonablyWhich party can bear the risk more efficiently (at the lower cost)

TAYLOR v. CALDWELL (1863)Taylor rented the music hall for a concert. Between entering into the contract and the date of the performance the building was destroyed by fire. Since the performance was no longer possible, Taylor requested damages for the expenses he had incurred in advertising the concert and preparing for the concert. Should the owner be liable for Taylor’s losses? What is the efficient rule?

TAYLOR v. CALDWELL (1863)“… The principle seems to us to be that, in contracts in which the performance depends on the continued existence of a given person or thing, a condition is implied that the impossibility of performance arising from the perishing of the person or thing shall excuse the performance.”That performance would not be required was an implied condition of the contract.[Does this assume optimal precautions by the theater owner?]

The Restatement (Second) of Contracts § 261 states:

Where, after a contract is made, a party’s performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary.

Dire Constraints and Remote RisksDuressNecessityImpossibilityFrustration of purposeMutual mistake about factsMutual mistake about information

Frustration of PurposeContingency destroys the purpose of the contractPointless performance does not serve the purpose that induced the parties to make the contractAssign liability to party who can bear risk at least cost.

Frustration of PurposeAn individual reserves a hall for a wedding. In the event that the wedding is called off, the value of the agreement would be destroyed. Even though the promisee could still literally perform the obligation by reserving and providing the hall for the wedding, the purpose for which the contract was entered into was defeated. Apart from a nonrefundable deposit fee, the promisor is ordinarily discharged from any contractual duty to rent the hall.

The Restatement of Contracts, Second § 265 defines frustration of purpose:

“Where, after a contract is made, a party's principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his remaining duties to render performance are discharged, unless the language or circumstances [of the contract] indicate the contrary.

Frustration of PurposeYou enter into a purchase contract to obtain land for a business.The city government rezones the land as residentialDoes enforcement of the contract enhance efficiency?

Krell v Henry [1903]Henry agreed by contract to rent a flat for the purpose of watching the coronation procession of Edward VIIThe King fell ill and the coronation was cancelled.The coronation was an implied condition when the contract was made.The cancellation could not have been reasonably expected by either party.

Dire Constraints and Remote RisksDuressNecessityImpossibilityFrustration of purposeMutual mistake about factsMutual mistake about information

Mutual Mistake about the Facts or Identity

Different from unilateral mistakeNo true exchange because the expected cooperative surplus was based on a false premise.

Sherwood v. Walker, (Mich. 1887)

Walker, the seller, represented that his cow, Rose 2d of Aberlone, was infertile. When Sherwood, the buyer, came to pick up the cow, Walker refused to deliver her on the ground that she was pregnant. Walker claimed that both he and Sherwood were mistaken about the cow’s fertility, and so the contract should be void. Sherwood contended that this was an instance of unilateral mistake. What role should price play in this analysis?

Sherwood v. Walker, (Mich. 1887)

If the cow was a breeder, she was worth at least $750; if barren, she was worth not over $80. The parties would not have made the contract of sale except upon the understanding and belief that she was incapable of breeding, and of no use as a cow. It is true she is now the identical animal that they thought her to be when the contract was made; there is no mistake as to the identity of the creature. Yet the mistake was not of the mere quality of the animal, but went to the very nature of the thing…If the mutual mistake had simply related to the fact whether she was with calf or not for one season, then it might have been a good sale, but the mistake affected the character of the animal for all time, and for its present and ultimate use. She was not in fact the animal, or the kind of animal, the defendants intended to sell or the plaintiff to buy.

Information Disclosure in Contracting

Contracts should lead to the efficient disclosure and transmission of informationProblems

The value of information can only be fully determined after it is disclosed

Asymmetrical information can produce unfair bargains (Get rich quick schemes)

Information is a quasi public good

Related Concerns When Information is Not Disclosed

Unilateral mistakeDuty to discloseFraud and misrepresentation

Unilateral mistakeMutual mistakes are usually not enforced

Mutual mistakes destroy valueUnilateral mistake promotes efficiency

Courts usually enforce bargains based upon unilateral mistake

Rewards discovery

Laidlaw v. Organ (1817)

Immediately preceding the purchase, Organ had been informed that the Americans and the British had signed the Treaty of Ghent. This would have a positive impact on the price of tobacco. Not knowing the treaty had been signed; Laidlaw sold the tobacco at the lower pre-treaty price. Was this fraud? Given the unilateral information is there a valid contract? Did the plaintiff have the duty to inform the defendant of the recent news?

Laidlaw v. Organ (1817)

A duty to inform would reduce the return to discoveryThe other party is a free riderHow would we determine sufficient disclosure?Does the failure to disclose destroy value or only redistribute value?

Unilateral MistakeWhat about insider trading?

Productive information promotes efficiency Redistributive information does not

Was the information the result of investment? Most have mixed redistributive and productive results

Information disclosure can be required by the contracting parties

Health insurance policies typically require disclosure of preexisting conditions

Information DisclosureAcquired

through active investment

Acquired casually or

inadvertently

Productive information

Efficient not to disclose

Not efficient to protect

Redistributive information

Inefficient to protect(Insider trading:

costs resources and produces no net

benefit for society)

No particular efficiency effect

Restatement of Contracts, Second, s205

“Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” This may impose a duty to disclose

information when failure to disclose increases the cost of performance.

Los Angeles Unified School District v. Great American Insurance Company (July 12, 2010)

The California Supreme Court affirmed the ruling of the Court of Appeal, holding that a contractor on a public works project may be entitled to relief for a public entity’s nondisclosure in the following limited circumstances:

(1) the contractor submitted its bid or undertook to perform without material information that affected performance costs;

(2) the public entity was in possession of the information and was aware the contractor had no knowledge of, nor any reason to obtain, such information;

(3) any contract specifications or other information furnished by the public entity to the contractor misled the contractor or did not put it on notice to inquire; and

(4) the public entity failed to provide the relevant information.Note that this information was not acquired by active investment. Lack of information may not only be redistributive, but also waste resources.

Duty to DiscloseShould the law compel information revelation? Or should the law protect the incentive to develop information by not compelling revelation? The prevailing rule is to require disclosure of latent defects.

Safety information helps people to avoid harm Example: selling a car with defective brakes without telling

buyer. Failure to disclose diminishes welfare

Obde v. Schlemeyer, Wash.(1960)

Seller of home knew of termite infestation, but failed to discloseThe seller gave the termites the opportunity to cause further destruction.Failure to disclose caused further harm.

Fraud and MisrepresentationFraud requires a lie

A deceptive act or statement deliberately made by one person in an attempt to gain an unfair advantage over another. It can be based on an action; failure to act; and concealment or silence.

Penalizing fraud reduces the cost of contracting Saves verification costs

Puffery is not fraud Expression of an opinion

UnconscionabilityDefense against the enforcement of a contract because the conditions were

unfair to one party

UnconscionabilityIt offends the conscience of the courtThe terms appear grossly unfair to one of the partiesOne party would not voluntarily have accepted the terms. Therefore, they must either be incompetent or a victim of distress (duress or necessity).

Infers distress from the terms of the contract.Lesion – a contract which is too unequal to enforce

Procedural UnconscionabilityProcedural

Focuses on unfairness at the formation of the contract Inequality in bargaining power

Monopoly power Unfair surprise

Terms highly favorable to one party Lack of mutuality

Examples of Procedural Unconscionability

Use of incomprehensible or legalistic fine-print standard form contract provisions; Inequality between parties due to factors like age or illiteracySwitching contract documents at the last moment to include non-negotiated, one-sided terms; Pressuring signature on a contract before client can read it, or rushing the signing at a time when the consumer is vulnerable; Purposefully selecting impoverished consumers to target for sales.

Substantive UnconscionabilitySubstantive

Procedural unconscionability often results in substantive unconscionability.

Unreasonably favorable to one party Disproportionate price (price above opportunity cost?) Economic analysis might determine whether the bargain

was one sided by determining whether there was a legitimate business justification for the contract terms. Is it efficiency enhancing?

Examples of Substantive Unconscionability

Limitations or waiver of remedy clauses;Disclaimer of warranties or limitation of damages liquidated damages clauses; Arbitration clausesNotice requirements; Blanket security interests; Excessive price terms where there is a gross disparity between price and value; Clauses authorizing venue or jurisdiction in distant forums; waiver of right to jury trial.

Uniform Commercial Code§ 2-302. Unconscionable contract or Clause.

(1) If the court as a matter of law finds the contract or any clause of the contract to have been unconscionable at the time it was made the court may refuse to enforce the contract, or it may enforce the remainder of the contract without the unconscionable clause, or it may so limit the application of any unconscionable clause as to avoid any unconscionable result.

(2) When it is claimed or appears to the court that the contract or any clause thereof may be unconscionable the parties shall be afforded a reasonable opportunity to present evidence as to its commercial setting, purpose and effect to aid the court in making the determination.

Contracts of AdhesionDrawn up by one party and presented to the other on a take it or leave it basisParty presented with the contract has little powerStandard form contracts can increase the efficiency of exchangeThe term “contract of adhesion” should not be applied to all standard form contracts

Analysis of Unconscionability

Analysis begins with an inquiry into whether the contract is one of adhesionTwo judicially imposed limitations on adhesion contracts (See Jaramillo)

A contract or provision which does not fall within the reasonable expectations of the weaker or "adhering" party will not be enforced against him.

A contract or provision, even if consistent with the reasonable expectations of the parties, will be denied enforcement if, considered in its context, it is unduly oppressive or "unconscionable."

Cooter and Ulen..Lawyers frequently distinguish between substantive and procedural unconscionability. Substantive unconscionability usually refers to a price that is utterly disproportionate to market value. In contrast, procedural unconscionability consists of circumstances and procedures in the bargain that violate widely-accepted norms of fairness. Thus, substantive unconscionability refers to the terms or results of the contract whereas procedural unconscionability refers to the circumstances and procedures under which the contract was formed. Substantive and procedural unconscionability are often combined in actual cases because an unfair procedure frequently results in an unfair price. Instead of thinking of substantive and procedural unconscionability as types of cases, it is better to think of them as different aspects of the same case.

Add-on Clause A clause in a loan contracts that determines the default conditions on the loanThe amount borrowed on the most recent purchase is added to the amount borrowed from previous purchasesIf the borrower defaults on the loan, all of the goods for which credit was extended may be repossessed to pay for the remaining balance on the loan.

Willliams v. Walker-Thomas Furniture“On April 17, 1962, appellant Williams bought a stereo set of stated value of $514.95. She too defaulted shortly thereafter, and appellee sought to replevy all the items purchased since December, 1957. …The record reveals that prior to the last purchase appellant had reduced the balance in her account to $164. The last purchase, a stereo set, raised the balance due to $678. Significantly, at the time of this and the preceding purchases, appellee was aware of appellant's financial position. The reverse side of the stereo contract listed the name of appellant's social worker and her $218 monthly stipend from the government. Nevertheless, with full knowledge that appellant had to feed, clothe and support both herself and seven children on this amount, appellee sold her a $514 stereo set.…We cannot condemn too strongly appellee's conduct. It raises serious questions of sharp practice and irresponsible business dealings. “

Weblink

Williams Postscript Case brought by Georgetown Law Students. Furniture store closed because it no longer could afford to extend

credit to residents. Add-on clause created the necessary collateral to secure the

loans Were the residents served well by this decision? Is it ever possible for an add-on clause to be conscionable?

If a Harvard lawyer signed this contract would it still be unconscionable? Is this unilateral mistake? Does this mean that Williams is exempt

from reading the fine print?

Add-on clause may be a response to market failure

Goods depreciate when purchasedDown payment can cover the initial depreciationAdd-on clause can serve as substitute for down paymentAn excess in value of reclaimed items over the remaining debt must be returned.Even with an add-on clause the dealer may not claim more than the remaining debt.Cooter suggests that not enforcing an add-on clause hurts poor consumers.

MonopolyCommon law contains weak protections against monopolyStatutes provide protection against price gougingExceptions

Contracts of adhesion Unconscionability

Factors that may be present in an unfair contract

Monopoly Price gouging

Contracts of Adhesion

Contracts of AdhesionDrawn up by one party and presented to the other on a take it or leave it basisParty presented with the contract has little powerStandard form contracts can increase the efficiency of exchangeThe term “contract of adhesion” should not be applied to all standard form contracts

Judicially imposed limitations on adhesion contracts

A contract or provision which does not fall within the reasonable expectations of the weaker or "adhering" party will not be enforced against him.A contract or provision, even if consistent with the reasonable expectations of the parties, will be denied enforcement if, considered in its context, it is unduly oppressive or "unconscionable."

Price GougingState legislation – no federal prohibitionAt least 28 states have price gouging lawsUsually limited to period of emergencyPrices are capped at levels charged in the immediately preceding period

Hourly value in cleanup

Value of Groceries

Real cost of $1 ice with 4-

hour wait

Smith $10 $50 $41Buys Ice 

Jones $75 $300 $301Doesn't buy

ice

LaBand on Price Gouging

Posner on Price Gouging

Statutory law is a “Profound mistake”Admiralty and common law may find certain prices unconscionableMay not enforce contracts because of threat to withhold performance

Necessity (Post v Jones) Duress (Alaska Packers)

Posner on Price Gouging

He argues that these cases are different from price gougingPost v Jones

The salvage ships did not create the distress They were not engaging in price rationing The two ships formed a cartel There was no one else competing for the rescue

Alaska Packers There was no shortage of labor. The workers created the shortage

Windfall profits are unavoidable

Becker on Price Gouging

Keeping an inventory of items that will be demanded only in emergencies is extremely costly, and may be cost justifiable only if the merchant knows that should there be an emergency the items can be sold at a higher than normal price. This is an objection to a general windfall-profits tax.

Are price ceilings an uncompensated taking?

Is the controlled price just compensation?

Reasons for price gouging lawsThose without cash (the poor) will sufferCrisis redistributionHigh price may not stimulate additional supplies in the immediate periodDoes reputation keep stores from price gouging?

Why don’t stores mark up the price of umbrellas when it rains?

Price GougingPrice increase not due to a rise in costsHow should cost be measured?

Historical cost Market cost Replacement cost Opportunity cost

Florida v MedinaMedina traveled from Miami-Dade County to the town of Matthews, North Carolina, where he purchased generators at a Costco store. (Map)Medina offered to consumers the Nikato generators for $600 that he had purchased for $279.99 each, and the Coleman generators for $900 that he had purchased for $529.99 each. Charged with violating Florida’s price gouging statute

Statutory LimitationsIllegal contracts

Antitrust lawsPredatory lendingPrice gouging

Cost of Performance vs. Diminution in Value

Cost of Performance The cost of doing what was promised

Diminution in Value The reduction in value accompanying non-performance

Which is the appropriate remedy for a breach?In Peevyhouse the rule was the lesser of the cost of performance or the diminution in market value

Does this lead to efficient breaches?

Diminution in ValueObjective value

Assumes replacement at market value Perfect substitutes are available

May undercompensate victim May not perfectly compensate victim when

alternatives are not perfect substitutes Not compensated for subjective value

Reimbursement at cost of performance when it is greater than enhanced market value assumes:

Subjective value at least equal to cost of performance

Uncertain subjective costs increase the risk of contracting by increasing potential damages

Specific performance Forces victim to reveal whether subjective value

exceeds cost of performance There may be a compromise solution Negotiations may be costly

Cost of PerformanceMay impose costs on injurer that exceed harm to victimMay lead to inefficient performancePromisee may benefit from potentially inefficient performance

What are the damages?

P [the performing party] contracts to construct a monumental fountain in N's [the nonbreaching party] yard for $5000, but abandons the work after the foundation has been laid and $2800 has been paid by N.The contemplated fountain is so ugly that it would decrease the number of possible buyers of the place. The cost of completing the fountain would be $4000. Should N get a judgment for $1800, the cost of completion ($4,000) less the part of price unpaid $2,200 = ($5,000 - $2,800)?What is the main purpose of the contract?

Peevyhouse – Assumed values

Peevyhouse waived up front payment of $3,000 for use of landUp front royalty payment for coal

$2,000Additional royalties from mining coal

$500Garland’s profits from mining coal

$25,000 to $ 34,500Market value of the undisturbed land

$3,000Market value of unreclaimed mined land

-$0Cost of reclamation

-$25,000 to $29,000Market value after restoration

$300

Parol Evidence RuleThe parol evidence rule is a common law rule in contract cases that prevents a party to a written contract from presenting evidence that contradicts or adds to the written terms of the contract that appears to be whole.Is the parol evidence rule efficient?