Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 12

Economic Issues in the November Election Thursday, October 25th 3pm-5pm 6210 Social Science Please join the Department of Economics and the Economics Student Association as we host Douglas Holtz-Eakin and Jeffrey Liebman, discussing economic policy issues in the upcoming election. Holtz-Eakin, is former Director of the Congressional Budget Office and was a top economic adviser for McCain 2008. Liebman, is the former Deputy Director of the Office of Management and Budget and is an economic adviser for Obama 2012.  They will address economic issues such as the labor market, tax and budget policy, and the international economy:  issues that are at the heart of the November election. 

Logistics MT1 – to be returned today HW3 (contract law) – online, due Thursday November 8

Results of Monday’s experiment (trust)

The game we played Player A starts with $10 Chooses how much of it to give to player B That money is tripled Player B has $10, plus 3x whatever A gave him/her Chooses how much (if any) to give back to player A Tried it four ways: Anonymous On paper, but with names Face to face In “public”

What did we find With anonymity, trust was a problem Average A sent $5.15, got back $5.50 So about half of potential gains were realized On average, trust paid off, but just barely: of those who sent money, 44% got back less than they sent including 22% who got back zero on the other hand, 27% got back at least twice what they sent Names made a huge difference! Average A sent $7.91, got back $12.39, so 80% of gains realized Of those who sent something… 11% got back less than they sent (7% got nothing) 54% got back at least twice what they sent Face to face: every A sent $10, every B sent $20 (boring!)

What did we find Anonymous With Names A sent # Obs Avg back Avg gain % less % zero 10 14 10.79 +0.79 43% 21% 6-9 6 8.17 +0.67 50% 0% Anonymous 3-5 21 4.57 +0.43 38% 19% 1-2 4 0.25 –1.25 75% 75% 9 0.00 +0.00 100% > 0 Avg: 6.18 6.60 +0.42 44% 22% A sent # Obs Avg back Avg gain % less % zero 10 34 16.03 +6.03 9% 6% 6-9 9 11.00 +4.56 11% 11% With Names 3-5 11 5.45 +0.91 9% 9% 1-2 2 1.00 –0.50 50% 0% 1 0.00 +0.00 100% > 0 Avg: 8.05 12.60 +4.55 11% 7%

Reliance

Monday Breach of contract Reliance To get efficient breach, make promisor’s liability for breach = promisee’s benefit from performance (expectation damages) Reliance Any investment whose value depends on performance Or, any investment which increases value of performance If reliance increases damages owed, promisees will rely more than the efficient amount (overreliance) I promised you a continuous example of this Stick with example we’ve already used: I’m building you an airplane Price is $350,000, you value plane at $500,000 You need to decide how much to invest in building a hangar

Continuous reliance investments Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600Öx Continuous reliance investments Additional value of plane Designer hangar with Starbucks - $480,000 Functional heating - $240,000 Metal poles, rigid roof - $120,000 Plywood frame, canvas roof - $60,000 Tarp and rope - $6,000 benefit Investment in hangar $100 $10,000 $40,000 $160,000 $640,000

Three questions Let p be probability of breach Three questions Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600Öx Three questions Let p be probability of breach Three questions What is the efficient level of reliance? What will promisee do if expectation damages include anticipated benefit from reliance? What will promisee do if expectation damages exclude anticipated benefit from reliance?

Three questions Let p be probability of breach Three questions Price of plane = $350,000 Cost: either $250,000 or $1,000,000 Value of plane + $x hangar = $500,000 + 600Öx Three questions Let p be probability of breach Three questions What is the efficient level of reliance? x = $90,000 (1 – p)2 What will promisee do if expectation damages include anticipated benefit from reliance? x = $90,000 What will promisee do if expectation damages exclude anticipated benefit from reliance? Total social gain when costs stay low: 500,000 + 600 sqrt(x) – 250,000 – x Total social gain when costs go up: – x If probability costs rise is p, expected total social gain is (1-p) (250,000 + 600 sqrt(x) – x) + p (-x) 250,000 (1-p) + 600 (1-p) sqrt(x) – x Choose x to maximize this: derivative is 600 (1-p) /(2sqrt(x)) – 1 = 0 x = 90,000 (1 – p)2 x = 90,000 (1 – p)2 is the efficient level of reliance When expectation damages include anticipated benefit, private gain to promisee when costs stay low: 500,000 + 600 sqrt(x) – 350,000 – x = 150,000 + 600 sqrt(x) – x Private gain to promisee when costs go up: 150,000 + 600 sqrt(x) – x Expected private gain to promisee is 150,000 + 600 sqrt(x) – x Choose x to maximize this: derivative is 600/(2Öx) – 1 = 0 x = 90,000 So promisee would invest x = $90,000 in reliance When expectation damages exclude anticipated benefit, Private gain to promisee when costs stay low: 500,000 + 600 sqrt(x) – 350,000 – x = 150,000 + 600 sqrt(x) – x Private gain to promisee when costs go up: 150,000 – x Expected private gain to promisee is 150,000 + (1 – p) 600 sqrt(x) – x Choose x to maximize this: derivative is 600 (1 – p)/(2sqrt(x)) – 1 = 0 So promisee would invest x = $90,000 (1-p)2 in reliance

Reliance and breach Just showed: if damages include added benefit from reliance, promisee will invest more than efficient amount But if damages exclude added benefit… Then promisor’s liability < promisee’s benefit from performance Which means: promisor will breach more often than efficient And promisor will underinvest in performance “Paradox of compensation” Single “price” (damages owed) sets multiple incentives… …impossible to set them all efficiently! (When we get to tort law – that is, rules covering liability for accidents – we’ll see this same problem One price – how much I owe you if I hit you with my car – will create incentives for me (how fast to drive), and for you (how carefully to look when crossing the street) And it’s hard to set both incentives efficiently In tort law, we’ll see, there is a trick we can use)

So what do we do? Cooter and Ulen: include only efficient reliance Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount So promisee rewarded for efficient reliance, not for overreliance So how do we fix this? Cooter and Ulen adjust their definition of expectation damages in the following way: Perfect expectation damages restore the promisee to the level of well-being he would have had, had the promise been kept, and had he relied the optimal amount (This is why they attach the word “perfect” to expectation damages) Thus, the promisee is rewarded for efficient reliance this increases his payoff from performance of the promise, and also increases his payoff from breach, since it increases the amount of damages he receives But the promisee is not rewarded for excessive reliance – overreliance damages are limited to the benefit he would have received given the optimal level of reliance. It’s a nice idea, but it seems like it would be very hard in general for a court to determine after the fact what the optimal level of reliance was (It might also be hard for the promisee to know this, since he may not know the probability of breach.)

So what do we do? Cooter and Ulen: include only efficient reliance Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount So promisee rewarded for efficient reliance, not for overreliance Actual courts: include only foreseeable reliance That is, if promisor could reasonably expect promisee to rely that much What is actually done in practice? The usual rule is that liability is limited to the level of reliance that is foreseeable. Reliance is foreseeable if the promisor could reasonably expect the promisee to rely that much under the circumstances Reliance is unforeseeable if it would not be reasonably expected American and British law tend to define overreliance as unforeseeable, and therefore noncompensable. An example of unforeseeable reliance telegraph company fails to transmit a stockbroker’s message, resulting in millions of dollars in losses the telegraph company could not reasonably expect the stockbroker to rely that heavily on one message so the telegraph company would not be liable for the full extent of the losses Another example: the rich uncle’s nephew, when he was promised a trip around the world, goes out and buys “a white silk suit for the tropics and matching diamond belt buckle”. After the uncle refuses to pay for the trip, the nephew sells the suit and belt buckle at a loss, and sues his uncle for the difference The court might find the silk suit foreseeable reliance, but the diamond belt buckle unforeseeable, and only award him the loss on the suit. (The book points out that “in American law, gift promises are usually enforceable to the extent of reasonable reliance.”)

Foreseeable reliance: Hadley v Baxendale 1850s England Hadley ran flour mill, crankshaft broke Baxendale’s firm hired to transport broken shaft for repair Baxendale shipped by boat instead of train, making it a week late Hadley sued for the week’s lost profits “The shipper assumed that Hadley, like most millers, kept a spare shaft. …Hadley did not inform him of the special urgency in getting the shaft repaired.” Court listed several circumstances where broken shaft would not force mill to shut down Ruled lost profits not foreseeable  Baxendale didn’t have to pay Reliance is part of the issue in the famous case of Hadley v Baxendale, a precedent-setting English case decided in the 1850s I give a link to the actual court decision on the syllabus Hadley owned a gristmill – turned wheat into flour, using a mill powered by a steam engine the crankshaft of the mill broke, and he didn’t have a spare, so the mill shut down until the crankshaft could be repaired The shaft had to be sent back to the manufacturer for repair; Hadley hired a shipping firm where Baxendale worked to ship it Baxendale decided to ship it by boat instead of by train, and as a result, it took a week longer than it was supposed to Hadley sued for the profits he lost during that extra week in which the mill was shut down Quoting from the textbook: The shipper assumed that Hadley, like most millers, kept a spare shaft. The shipper contended that Hadley did not inform him of the special urgency in getting the shaft repaired. The shipper prevailed in court on the damages issue, and the case subsequently stands for the principle that recovery for breach of contract is limited to foreseeable damages. The ruling was that the lost profits were not foreseeable the court specifically listed several circumstances in which a broken crankshaft would not force a mill to shut down – and therefore why it was reasonable that Baxendale would not have imagined the harm from delay would be so high Baxendale was only held liable for damages he could reasonably have foreseen

Foreseeable reliance: Hadley v Baxendale “Before you can award damages for wages paid and lost sales while the mill was idle, you must first find that at that time they entered into the contract to ship the crankshaft, the shipping company contemplated that the mill owner would suffer those idleness damages as a result of late delivery.” To award damages for lost sales, Hadley should have to prove that Baxendale could have predicted those losses (During the appeal, the shipping company argued that the jury should be given roughly the following instructions, and the appeals court agreed: before you can award damages for wages paid and lost sales while the mill was idle, you must first find that at the time they entered into the contract to ship the crankshaft, the shipping company contemplated that the mill owner would suffer those idleness damages as a result of late delivery.  That is, to award damages for lost sales, Hadley should have to prove that Baxendale could have predicted those losses However, this isn’t only a question of reliance Part of the issue is that Hadley knew about the urgency of getting the crankshaft fixed quickly, but did not tell Baxendale Last week, we said that one purpose of contract law is to encourage the efficient disclosure of information We’ll come back to this question of information shortly.

Foreseeable reliance: Hadley v Baxendale Why didn’t Hadley and Baxendale just specify in the original contract what happens in case of delay? What rules should apply in circumstances that aren’t addressed in a contract? \

Default Rules Of course, Hadley and Baxendale could have made things much easier for the court – if they had just writing into the contract what should happen in case of delay they could have signed a contract saying, Hadley agrees to pay X for shipping, and Baxendale will refund Y for each day of delay beyond the first or they could have been even more specific Baxendale agrees to ship by train But then what happens if he learns the train schedule has changed, and shipping by boat becomes more practical?

Default rules Gaps: risks or circumstances that aren’t specifically addressed in a contract Default rules: rules applied by courts to fill gaps In a world without any transaction costs, the two sides to a contract could spell out exactly what should occur in every possible contingency what happens if the cost of sheet metal rises what happens if another buyer appears who wants the plane I’m building you what happens if a shipment is delayed, and so on This would make contract law much simpler – courts could simply enforce the letter of the contract, since nothing was left unclear However, in reality, some circumstances are impossible to foresee And even if they weren’t, the cost and complexity of writing a contract to deal with every possibility would make perfect contracts unworkable Risks or circumstances that aren’t specifically addressed in a contract are called gaps Default rules are rules that the court applies to fill in these gaps. Gaps can be inadvertent or deliberate Our contract to sell you my painting might not have addressed my uncle wanting the painting because I didn’t know he was coming to visit, or because I never would have imagined he would be so excited about it On the other hand, we could have imagined that it was at least possible for the price of raw materials for building an airplane to go up significantly But we might have felt it was such a remote risk that it was not worth the time and effort to build it into the contract.

Default rules 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 risk (ex ante), before it becomes a loss Versus allocating a loss (ex post) Only have to deal with it if the loss occurs The decision to leave a gap or to fill it (specifically address a particular contingency) is the difference between allocating a loss after it has occurred (ex post) and allocating a risk before it becomes a loss (ex ante) At the time I agree to build you an airplane, there is some risk that the cost of raw materials will go up We can choose to worry now about who should bear that risk Or we can leave it out of the contract, and if that risk becomes a loss (that is, if the costs do go up), then we can worry about who should bear the loss In the first case, allocating the risk, the cost of adding it to the contract is definitely incurred But in the second case, allocating a loss that has occurred, the cost of allocating the loss is only incurred when the loss occurs Thus, it is often rational to leave gaps when the risk is very remote But this means that courts must decide what rules should fill the gaps that are left in imperfect contracts So… what should these default rules be? We will look at two different views of this

What should default rules be? 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 Cooter and Ulen answer this question by going back to the Normative Coase view: the law should be structured to minimize transaction costs Since filling a gap in a contract requires some cost, the default rule should be the rule that most parties would want if they chose to negotiate over the issue This way, most contracts will not have to address this particular rule – they can use the default rule – and therefore avoid additional transaction costs And the rule that most parties would want is whatever rule is efficient. They give an example A construction company has contracted to build a house for a family, and there is some risk of a worker strike at the company which would delay completion Suppose that the company can bear the risk of a strike at a cost of $60, and that the family can bear the risk at a cost of $20 (It might be cheaper for the family to bear the risk because they could stay with friends for a while if the house were delayed; if the company held the risk, it might have to pay for a hotel for the family.) (Also note that these numbers are low not because a strike would have low costs, but because a strike might be fairly unlikely, so the expected cost is fairly low.)

What should default rules be? 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 If the risk were not addressed by the contract, the default rule would apply. If the default rule were for the construction company to bear the risk, this would be inefficient in this case The parties could create an additional $40 of surplus by overruling the default rule (addressing the risk) So as long as the transaction cost of allocating the risk were not too large, they would choose to do so, but incur this transaction cost. On the other hand, if the default rule were for the family to bear the risk, they would not need to address the risk in the contract, and would not incur the transaction cost. This brings Cooter and Ulen to their fifth pronouncement: The fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules. They also offer a simple rule for doing this: Impute the terms to the contract that the parties would have agreed to if they had bargained over the relevant risk. That is, figure out what terms the parties would have chosen if they had chosen to address a risk, and let those be the default rule.

Default rules 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 Of course, you don’t want a lot of ambiguity in the law So you don’t want the default rule to vary constantly with the particular circumstances of a given case So what’s more practical to do is to set the default rule to the terms that most parties would have agreed to This is called a majoritarian default rule In circumstances where this is not the efficient rule, the parties are still free to contract around it, that is, to put terms in the contract that override the default rule If the parties had chosen to address a particular risk, it’s safe to assume that they would have allocated it efficiently That is, as long as the parties were choosing to consider a risk, they would allocate it in the way that led to the highest total surplus, and then compensate the party who bears the risk for bearing it Thus, this is what the court would need to do to figure out the efficient default rule: it should figure out the efficient allocation of risks, and then adjust prices in a reasonable way

Default rules 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? The book gives an example of this: a family is having a house built The family and the construction company are negotiating a contract The construction company knows that with probability ½ , the price of copper pipe will go up in such a way as to increase the cost of construction by $2,000 So in expectation, the cost of construction will be $1,000 higher due to this risk The company can hedge against this risk (by buying copper pipe in advance and then paying to store it somewhere) at a cost of $400 Assume that the family has no reason to know anything about the cost of copper pipes, and therefore does not anticipate the risk or have any way to mitigate it. The company chooses not to hedge this risk; the price of copper pipes does go up The company builds the house and bills the family $2,000 more than they had expected The family refuses to pay, and the case goes to court The original contract does not say anything about the risk of rising copper prices. So how would the court address this?

Default rules 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? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction company Should prices be adjusted to compensate? First, the court must decide to whom the contract would have allocated this risk, if it had addressed it. Then it must adjust prices to reflect this. In this case, the cost of bearing the risk would be $1,000 to the family (since they have no way to mitigate it), but $400 to the company (since hedging the risk is cheaper than bearing it) So the company is the efficient bearer of the risk That is, an efficient contract would have allocated this risk to the construction company Next, the court must consider whether the price should be adjusted In this case, the court might rule that the risk of a spike in copper prices was foreseeable The construction company foresaw, or should have foreseen, that this risk was present So the court could assume that the price the parties negotiated already included compensation for bearing this risk

Default rules 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? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction company Should prices be adjusted to compensate? On the other hand, there are some risks that are unforeseeable Suppose that the leader of the copper miners’ union in Peru died, and there was a battle to succeed him, and that his replacement called a strike to flex his muscles, and that this strike was what led to the increase in copper prices Here, it’s reasonable that neither party would have foreseen the risk. In this case, the construction company might still be the efficient bearer of this risk – since they might be able to make changes to the construction plan to use less copper and more of other materials But since the risk was unforeseen, it was not included in the negotiated price So the court might adjust the price paid to the construction company, to compensate them for the risk; but then still hold the construction company responsible for the extra $2,000 in costs Thus, the ruling might be that the family should pay some smaller amount – say, $700 – which is what the company would have needed to receive as compensation for bearing this risk – but that the company was then responsible for the rest of the $2,000. (The book then continues this story to give another example of overreliance and breach – check it out if you’re still confused about these points.)

Default rules 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 So the rule in Cooter and Ulen is fairly straightforward: Courts should set default rules that are efficient in the majority cases, so that… most parties can leave that risk unaddressed and save on transaction costs while parties can contract around this rule in circumstances where it is not efficient.

Default rules: a different view 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” There’s also a very different take on default rules, in the article on the syllabus, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules” by Ian Ayres and Robert Gertner They argue that in some instances, it is better to make the default rule something the parties would not have wanted Either to give the parties an incentive to specifically address an issue rather than leaving a gap Or to give one of the parties an incentive to disclose information They refer to this type of intentionally-inefficient default rule as a penalty default Ayres and Gertner argue that in some cases, gaps are left not because the of the transaction costs of filling them, but for strategic reasons One party might know that the default rule is inefficient; but negotiating around the default rule would require him to give up some valuable information, so he might be tempted not to A penalty default would force him to disclose it Which would likely be efficient

Penalty defaults: Hadley v Baxendale 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 Consider again the case of Hadley v Baxendale, the miller with the broken crankshaft While the crankshaft is en route, Hadley’s mill is not operating, so he’s losing money Baxendale, the shipper, is the only one who can influence when the crankshaft is delivered; so he is likely the efficient bearer of this risk (It was his choice to ship the crankshaft by boat, rather than by rail, that led to the delay; if Baxendale bears the risk of delay, he internalizes the cost of his decision) If the default rule were for Baxendale to be responsible for any lost profits, however, Hadley has no incentive to tell him how urgent the shipment is In fact, he is likely to not want to mention it; if he made it clear how important the crankshaft was, Baxendale might try to charge him a higher price for delivery! So a default rule holding Baxendale responsible for lost profits due to delay would lead Hadley not to disclose the urgency of his shipment And this would be inefficient, since it could lead to Baxendale making a bad decision about what method of shipment to use (which is exactly what happened) On the other hand, a default rule that Baxendale is not responsible for lost profits seems to be inefficient we just argued that Baxendale is the efficient bearer of this risk This gives Hadley an incentive to try to negotiate different terms in the actual contract Over the course of the negotiations, the urgency would become apparent Baxendale would agree to take on the risk But he would also know the costs of delay, and could plan around them better. So Ayres and Gertner argue that the ruling in Hadley was a good one Not because the default rule was efficient But because it was inefficient in a way that created good incentives In this case, the incentive for the better-informed party to disclose information (In this sense, the default rule is a “penalty default:” it penalizes the better-informed party, giving an incentive to contract around the default.)

Penalty defaults: example Suppose… 80% of millers are low-damage – suffer $100 in losses from delay 20% of millers are high-damage – suffer $200 in losses from delay Shipper liable for actual damages Average miller would suffer $120 in losses Shipper makes efficient investment for average type But not efficient for either type Shipper liable for foreseeable damages Shipper makes efficient investment for low-damage millers High-damage millers have strong incentive to negotiate around default rule The book Game Theory and the Law (by Baird, Gertner, and Picker) has a nice analysis of the problem “Let us assume that there are two types of millers. One type of miller is low-damage. In the event that the carrier fails to deliver the crankshaft on time, the low-damage miller suffers damages of $100. The other type of miller is high-damage and suffers $200 in damages when the carrier fails to deliver the crankshaft on time. The carrier knows that 20% of millers are high-damage and 80% are low-damage, but the carrier has no way of telling one type from the other.” If miller was making the decision, high-damage millers would spend more to ensure prompt delivery Consider rule where shipper is liable for actual damages. If there’s no way for shipper to figure out what type of miller he’s dealing with, the shipper knows that when there’s a delay, on average, he’ll owe $120. So the shipper will choose efficient investment level for average case – that is, $120 in expected damages. So he spends inefficiently little for high-damage millers, inefficiently much for low-damage millers. If the shipper is liable only for foreseeable damages, this would be $100; so he would spend efficient investment level for low-damage case. This means the high-damage millers do badly – there’s an inefficiently high risk of delay, and they don’t get fully compensated if it happens. But now high-damage millers have strong incentive to negotiate around the rule – basically, to buy insurance from shipper against delay. This would lead shipper to know who he’s dealing with, leading to efficient contracts for both types.

Penalty defaults: other examples 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 Consider a real estate broker who is handling the sale of a house by a private seller to a private buyer When a buyer’s offer is accepted, he puts down a deposit, called “earnest money,” to show that he is serious If he then backs out of the deal, he doesn’t get this earnest money back The question remains, though, how should the earnest money be divided between the seller and the broker? Both the broker and the seller are inconvenienced by the breach; it’s not really clear who is the efficient bearer of this risk However, what is clear is that the broker probably knows more about real estate law than the seller The broker is a professional, who does this type of transaction for a living The seller might be selling a house for the first time. If the default rule allowed the broker to keep the earnest money, the broker has no reason to bring this up when negotiating a contract with the seller But the seller might not know to bring this up; the seller might have no idea about earnest money, and not realize that this was another point that could be negotiated with the broker. On the other hand, if the default rule gave the earnest money to the seller, the broker would have a clear incentive to raise this with the seller And so they could negotiate whatever was the efficient allocation of the earnest money. Thus, whether or not it’s efficient, a default rule favoring the less-informed party once again gives an incentive to disclose information, which may be desireable.

Penalty defaults: other examples 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 Ayres and Gertner give another nice example of penalty defaults used for a different purpose When a contract does not specify a price for a good, courts will tend to impute whatever the market price was at the time of the transaction That is, they will enforce the contract, and just impose the market price However, when a contract does not specify a quantity, courts will refuse to enforce the contract This means the default rule for price is the market price, but the default rule for quantity is 0 A quantity of 0 cannot possibly be what the parties would have wanted Nobody would go through the hassle of signing a contract in order to transact no goods So what is the reason for this default rule? Ayres and Gertner argue it is a penalty default, to force the parties to decide on a quantity Why should the parties be forced to decide on a quantity and not a price? Because it’s easier (cheaper) for the court to fill in the price than the quantity The rule for figuring out the price the parties would have agreed to is easy – the court can usually ascertain the market price of a given good on a given date However, if the court had to impute the quantity the parties would have wanted, this is much more difficult The court would have to figure out the marginal value of an incremental unit of the good to each side to figure out the efficient amount to transact Thus, shifting the burden of calculating the right quantity from the parties in the contract to the courts is inefficient So the default rule forces the parties to decide on the quantity themselves.

When to use penalty defaults? 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.” Ayres and Gertner do not argue penalty defaults should always be used, only that they are appropriate in certain circumstances They argue that we need to look at why the parties left a particular gap When gaps are left due to transaction costs of filling them, efficient defaults make sense But when gaps are left strategically – by a well-informed party who chooses not to contract around an inefficient default in order to get “a bigger share of a smaller pie” – penalty defaults may be more efficient. In the conclusion to their paper, Ayres and Gertner cite a similar point from a dissent by Supreme Court Justice Scalia The legislature had passed a RICO (racketeering/corruption) statute and had not specified a statute of limitations The Court was therefore being asked to decide on the statute of limitations The majority set the statute of limitations at 4 years, figuring that’s what the legislature most likely would have chosen had they remembered to specify it Scalia proposed no statute of limitations He was “unmoved by the fear that this… might prove repugnant to the genius of our law” Instead, he pointed out, “indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.” So his view: rather than do what Congress would have wanted, do something they would not have wanted, to force them to do it themselves next time Exactly the same idea as a penalty default for a contract It’s a pretty cool article – take a look if you’re interested.

When should a contract not be enforced?

When should voluntary trade not be allowed? Going back to property law… Coase Theorem: to get efficient outcomes, we should let people trade whenever they want to But also saw some exceptions – some trades that aren’t, and shouldn’t, be allowed Selling enriched uranium to a terrorist Similarly with contract law… First day: to get efficient outcomes, enforce any contract both parties wanted enforced But next, we’ll see exceptions – contracts which shouldn’t be enforced, due to externalities or market failures/transaction costs

Example of an unenforceable contract: a contract which breaks the law Obvious: contract to buy a kilo of cocaine is unenforceable One example of an immutable rule: a contract to do something illegal is not enforceable In some cases, this seems really obvious. I give you $25,000 in exchange for a promise to give me a kilo of cocaine. You take my money, give me nothing; I have no recourse through contract law. But there are also less obvious situations, where a contract to do something perfectly legal on its face, is not enforceable, because the actual purpose of the contract was to circumvent the law The legal doctrine here is derogation of public policy

Example of an unenforceable contract: a contract which breaks the law Obvious: contract to buy a kilo of cocaine is unenforceable Less obvious: otherwise-legal contract whose real purpose is to circumvent a law Legal doctrine: derogation of public policy Derogate, verb. detract from; curtail application of (a law) Applies to contracts which could only be performed by breaking law… …but also to “innocent” contracts whose purpose is to get around a law or regulation One example of an immutable rule: a contract to do something illegal is not enforceable In some cases, this seems really obvious. I give you $25,000 in exchange for a promise to give me a kilo of cocaine. You take my money, give me nothing; I have no recourse through contract law. But there are also less obvious situations, where a contract to do something perfectly legal on its face, is not enforceable, because the actual purpose of the contract was to circumvent the law The legal doctrine here is derogation of public policy

Derogation of public policy – example Labor unions required by law to negotiate “in good faith” Recent NBA labor troubles Old CBA: 57% of “basketball-related income” went to player salaries Owners were offering less than 50%, players demanding 53%... Imagine the following contract: “For the next 50 years, if the NBAPA accepts a CBA paying less than 55% of BRI in player salaries, then we also agree that all non-retired players will work for you as coal miners every offseason at federal minimum wage.” Purpose is purely to “bind hands” in negotiations with ownership Contract would not be enforced Collective bargaining agreement between players and team owners expired; owners have locked out the players (like an owner-initiated strike) until new agreement is reached Negotiations are happening at the league offices in New York Imagine during one of the off-days from negotiations, Derek Fisher, the president of the players union, drives down to Philadelphia, visits the owner of a coal mining company, and signs the following contract There’s nothing illegal about a bunch of NBA players working as coal miners during the offseason However, the purpose of this contract isn’t to actually do that – it’s purely to change the union’s bargaining position in its negotiations with the league Once this contract is signed, Fisher can go back to the NBA offices in New York and say, “I don’t care what you say, there’s no way I can accept less than 55%” But this would violate the union’s obligation to bargain in good faith, and so this type of contract would not be enforced.

Derogation of public policy In general: a contract is not enforceable if it cannot be performed without breaking the law Exception: if promisor knew (and promisee didn’t) I’m married, my girlfriend in California doesn’t know; I promise her I’ll marry her, she quits her job and moves to Madison My company agrees to supply a product that we can’t produce without violating a safety or environmental regulation Keeping either promise would require breaking the law… …but I’d still be liable for damages for breach Like in Ayres and Gertner: default rule penalizes better-informed party for withholding information

Default rules versus regulations Talked earlier about default rules Default rules apply if no other rule is specified… …but can be contracted around Rules like “derogation of public policy” cannot be contracted around Parties to a contract can’t say, “even though this type of contract would normally not be valid, this one is” Rules which always apply: 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.

Ways to get out of a contract

Formation Defenses and Performance Excuses 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 without penalty 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 Next, I want to discuss a number of ways to get out of a contract, that is, conditions under which a contract will not be enforced. These are typically divided into two categories: formation defenses and performance excuses A formation defense is a claim that a contract does not exist: that the requirements for a contract to be valid were not met (Under the bargain theory, for example, a formation defense might be that consideration was not given.) A performance excuse is a claim that, even though a valid contract was created, circumstances have changed and you should be excused from performing We said earlier that, under Coase, when individuals are rational and there are no transaction costs, voluntary negotiations should lead to efficiency So refusing to enforce voluntary contracts would not make sense Thus, most of the doctrines for invalidating a contract can be explained as a violation of one of these assumptions either the individuals agreeing to the contract were not rational or there was some sort of transaction cost or market failure

One formation defense: incompetence Courts will not enforce contracts with people who can’t be presumed to be rational Children Legally insane Incompetence One party was “not competent to enter into the agreement” No “meeting of the minds” The first exception is that courts will generally not enforce contracts made by people who can’t be assumed to be rational. For example: children cannot sign binding contracts the legally insane cannot sign binding contracts For example: this article (about a month old) is about 7-year-old who was messing around on eBay and hit the “buy it now” button for a decommissioned Harrier fighter jet selling for 70,000 pounds, or a bit over $100,000. His father saw what he’d done and contacted the seller to apologize, and the seller, very reasonably, just re-listed the plane and sold it to another bidder But if the seller had tried to hold the son to the deal, he would have failed Contracts with children, and with the legally insane, can be invalidated under the doctrine of incompetence: one party to the contract was not competent to enter into a binding agreement In fact, the law does not automatically invalidate all contracts made with children or insane people It only invalidates contracts which were not in their best interests (Basically, the law creates an incentive not to cheat people who can’t take care of themselves.)

So… If courts won’t enforce a contract signed by someone who wasn’t competent… What if you signed a contract while drunk? You need to have been really, really, really drunk to get out of a contract (“Intoxicated to the extent of being unable to comprehend the nature and consequences of the instrument he executed”) Lucy v. Zehmer, Virginia Sup Ct 1954 The first time I taught this course, after I introduced the doctrine of incompetence, one of my students emailed me an excellent question: what if you signed a contract while drunk? Can a drunk person sign a legally enforceable contract? or would the fact that he was drunk get him off the hook? We mentioned that the bargain theory required a “meeting of the minds” to agree to a contract It’s reasonable to question whether this could occur with someone who was drunk However, the general rule in the U.S. is this: You have to be really, really, really drunk for the contract not to count. OK, that’s not how it’s written in the case law The rule is, for a contract to be unenforceable, you need to have been “intoxicated to the extent of being unable to comprehend the nature and consequences of the instrument he executed.” Basically, not just drunk enough to have bad judgment, but drunk enough to have no idea of what you’re doing There’s a classic case that upheld this standard, Lucy v Zehmer, decided by the Supreme Court of Virginia in 1954 It’s a little embarrassing when your drunken antics end up in front of a state supreme court But the case makes for really fun reading

Lucy v. Zehmer Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000” “We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.” The Zehmers owned a farm Lucy had been trying to buy it from them for a long time (They had made multiple offers, over several years, beginning at $20,000.) One night, Zehmer’s out drinking, and he runs into Lucy They continue to drink, and at some point, Lucy says something like, “I bet you’d sell that farm for $50,000.” Zehmer says, “You don’t have $50,000.” Lucy says, “I can get it!” Zehmer says, “No you can’t!” They argue for a while about whether Lucy would be able to raise $50,000 And eventually Lucy says, “Write it down!” So Zehmer grabs a discarded guest check (seriously), turns it over, and writes on the back, “We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,000, title satisfactory to buyer” (It appears from the trial proceedings that there were two drafts. In the first, the name of the farm and the word “satisfactory” were both misspelled. Also, the first draft originally said “I agree,” to which Lucy pointed out that Zehmer’s wife co-owned the farm; Zehmer crossed off the “I” and wrote “We”) So, Zehmer writes this contract and signs it; then he walks to the other end of the bar where his wife is sitting He tells her to sign it, she says, “What?” He whispers to her, don’t worry, it’s just a joke, we’re not selling the farm So she signs it He brings it back, Lucy takes the contract and puts it in his pocket

Lucy v. Zehmer Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000” “We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.” That was Saturday. Sunday, Lucy calls his brother and gets him to put up half the money. Monday, Lucy goes to the registry of deeds to check the title, and then contacts Zehmer to carry out the contract Zehmer claims he was drunk, and joking, and refuses to honor the contract Lucy sues for specific performance, that is, asks the court to force Zehmer to sell him the farm at the agreed price There was some dispute during trial about exactly how drunk Zehmer was But it was ruled that while he was clearly drunk, he was not so drunk as to be “unable to comprehend the nature and consequences” of what he was doing (For one thing, a little while later, his wife asked him to drive her home.) Most of the opinion focuses on whether Lucy knew that Zehmer was joking when he wrote what looked like a proper, if unusual, legal contract Zehmer claimed the whole thing was “a bunch of two doggoned drunks bluffing to see who could talk the biggest and say the most” The court basically ruled that it wasn’t Lucy’s job to know Zehmer was joking That is, Zehmer may have thought he was joking, but it looked to Lucy like he was serious Zehmer behaved exactly as he would have behaved if he were drunk but actually wanted to sell the farm; which was good enough.

Lucy v. Zehmer So, you can be pretty drunk and still be bound by the contract you signed Might think “meeting of the minds” would be impossible But imagine what would happen if the rule went the other way You may think, being drunk, Zehmer lacked the necessary intent to enter into a contract Still, it probably makes sense not to make it too easy to invalidate a contract on the grounds that one of the parties was drunk, or joking If the ruling went the other way, it seems there would an awful lot of litigation over exactly how drunk someone was when a contract was signed Not to mention a lot more contracts being signed in bars, to give the parties an easy way out Or maybe a lot of lawyers carrying breathalyzers to make sure their contracts would be enforceable Basically, a more nuanced rule would be extremely difficult and costly to enforce So we seem to accept the cost of an occasional person making a bad decision while drunk, in order to keep the system working well the rest of the time. However, that’s not quite the final word on drunkenness If you were visibly drunk – that is, the other party clearly knew you were drunk – the court might be more willing to finding the contract unenforceable on other grounds (which we’ll get to shortly) such as fraud (you were tricked into signing) or unconscionability (the contract is too one-sided) If Zehmer had agreed to sell the farm for $10, the contract probably would not have been upheld But since the terms seemed reasonable, it was

Lucy v. Zehmer So, you can be pretty drunk and still be bound by the contract you signed Might think “meeting of the minds” would be impossible But imagine what would happen if the rule went the other way Borat lawsuits Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk Journalist for Make Benefit Guileless Americans In Film” Moral of the story: don’t get drunk with people who might ask you to sign a contract There’s also a more recent example of the doctrine that being drunk does not get you out of a contract: the Borat lawsuits After the movie Borat came out a few years ago, two of the frat boys who ended up looking like racist a-holes sued They claimed they were tricked into signing the releases agreeing to be in the movie It seems the movie’s producers got them drunk and then asked them to sign the releases And also lied to them a lot – saying the movie was only going to be released in Europe, they wouldn’t use the frat boys’ names, or college, or frat Part of the problem for them is that the releases contained what are called “merger clauses” Merger clauses basically say, it doesn’t matter what else we already told you, all we’re agreeing to is what’s in this contract (Basically, any prior verbal agreement is “merged into” this contract, which is all we’re agreeing to.) It’s kind of sneaky, but it does seem to legally absolve the producers of anything they told the frat boys to get them to sign but that wasn’t in the contract Again, just being drunk doesn’t get you out of a contract One of the fratboys seemed to find it relevant that he was under the drinking age; but that, if anything, would make the producers liable in criminal court (for supplying alcohol to a minor), but not invalidate the releases (It’s also been established that the frat boys were all already heavy drinkers, unsurprisingly.) Last I heard, the lawsuits have all been dismissed, and the frat boys got nothing. (Since they’re not in the textbook; for the opinion in the Lucy v Zehmer case, which really does make great reading, see http://www.finance.pamplin.vt.edu/faculty/sds/Lucy.pdf For an overview of the legal issues in the Borat lawsuits, see a piece by Julie Hilden, with the brilliant title “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for Make Benefit Guileless Americans in Film” at http://writ.corporate.findlaw.com/hilden/20061129.html Moral of the story: don’t get drunk with people who might ask you to sign contracts.

First Midterm Overall: pretty good Average and median both 81, std dev 11 Not assigning letter grades till end of semester, but… to give a rough idea of how you’re doing, based on distribution of scores on first midterm, 77-87 roughly a B, 65-72 roughly a C A-H I-O P-Z