Econ 522 Economics of Law Dan Quint Fall 2016 Lecture 13

Monday… What default rules should fill in the gaps? C&U: impute the terms the parties would have wanted – allocate each risk to efficient bearer of that risk (Friedman: several ways to tell who that is) Ayres & Gertner: use default rules to penalize one or both parties from withholding information Reasons a contract might not be enforced Derogation of public policy Formation defenses (incompetence, but not drunkenness) Performance excuses Today: more reasons a contract might not be enforced But first…

Another experiment: is trust a problem?

We motivated contracts with an agency (trust) game Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (0, 200) Without binding contracts, might be no reason for me to return your money, so no reason for you to trust me

To see if trust is a problem, we’ll use a similar game as an experiment Player A starts with $5 Chooses how much of it to give to player B That money is quadrupled Player B has $5, plus 4x whatever A gave him/her Chooses how much (if any) to give back to player A So for example… if player A decides to send $3… then B has $5 + $12 = $17, and can send A any amount up to 17 and keep the rest… …and A ends up with $2 plus whatever B sends

To see if trust is a problem, we’ll use a similar game as an experiment Player 1 Send 0 Send 5 x Player 2 Return 0 Return 5 + 4x y ((5 – x) + y, (5 + 4x) – y) Player 1 gets whatever he kept, plus whatever 2 sends him Player 2 gets 5, plus four times what 1 sends him, minus whatever he sends to player 1

We’ll try this game three different ways Anonymously – A and B don’t know who each other are we’ll use student ID numbers to identify players, and play on paper Privately – A and B don’t interact, but will learn who each other are after the game still on paper, but with names, so B sees A’s name after class, Nathan will email A with B’s name Publicly – A and B play out loud in front of the class

Back to work: dire constraints

Dire constraints Necessity Duress I’m about to starve, someone offers me a sandwich for $10,000 My boat’s about to sink, someone offers me a ride to shore for $1,000,000 Contract would not be upheld: I signed it out of necessity Duress Other party is responsible for situation I’m in “I made him an offer he couldn’t refuse” Contract signed at gunpoint would not be legally enforceable Back to contract law, and another situation in which we would not expect people to act rationally: courts will not enforce contracts signed under dire constraints, specifically, duress and necessity Necessity is when I’m at the point of starvation, and someone comes along and offers me a sandwich for $10,000 I don’t have it on me, so I sign a contract agreeing to pay him $10,000 and I eat the sandwich Or I’m on a boat that’s about to sink, and another boat offers me a ride back to shore for a million dollars In either case, the contract would not be upheld, since I signed it out of necessity. Duress is similar, but when the uncomfortable situation I’m in is being caused by the other party This is when someone kidnaps my child, and I agree to pay ransom to get her back The contract is not enforceable, because I agreed to it under duress This is exactly the idea of “making someone an offer he can’t refuse” from the Godfather; courts would not uphold a contract signed at gunpoint (Of course, whether you want to breach a contract with the Mafia, or sue the Mafia, is a separate question.) It’s not that hard to argue against holding people responsible for promises made under duress or necessity based on notions of fairness and morality The Friedman book (Law’s Order), however, tries to explain both of these in straight economic terms – I like his treatment a lot

Duress November 2011 story from Kansas Guy broke into a house to hide from police, took the homeowners hostage Offered them money in exchange for hiding him, they agreed Instead, when he fell asleep, they called police He’s suing them for breach of contract "I, the defendant, asked the Rowleys to hide me because I feared for my life. I offered the Rowleys an unspecified amount of money which they agreed upon, therefore forging a legally binding oral contract," Dimmick said in his hand-written court documents. He wants $235,000, in part to pay for the hospital bills that resulted from him being shot by police when they arrested him. source: http://news.yahoo.com/man-sues-former-hostages-says-broke-promise-190902970.html

Friedman on duress Example Mugger threatens to kill you unless you give him $100 You write him a check Do you have to honor the agreement? “Efficiency requires enforcing a contract if both parties wanted it to be enforceable” He did – he wants your $100 You did – you’d rather pay $100 than be killed So why not enforce it? Makes muggings more profitable  leads to more muggings Tradeoff: refuse to enforce a Pareto-improving trade, in order to avoid incentive for bad behavior He begins with an example of duress A mugger approaches you in an alley and threatens to kill you unless you give him $100 You don’t have $100 on you, but he says he’ll accept a check When you get home, can you stop payment on the check? Or do you have to honor the agreement you made? Recall our principle from before: Efficiency requires enforcing a contract if both parties wanted it to be enforceable Clearly, the mugger wants the agreement to be enforceable; he’d rather have $100 than kill you And if you believe he’ll kill you if you don’t give him the money, then you clearly want it to be enforceable as well So making the contract enforceable seems to be a Pareto-improvement So what’s the problem? The problem, of course, is that even if such a contract is a Pareto-improvement once you’re in the situation, making such contracts enforceable encourages more muggings, since it increases the gains So refusing to enforce contracts signed under duress seems to trade off a short-term “loss” – the efficiency lost by ruling out some mutually beneficial trades – against creating less incentive for the bad behavior that put you in that situation in the first place.

Friedman on duress Example Mugger threatens to kill you unless you give him $100 You write him a check Do you have to honor the agreement? “Efficiency requires enforcing a contract if both parties wanted it to be enforceable” He did – he wants your $100 You did – you’d rather pay $100 than be killed So why not enforce it? Makes muggings more profitable  leads to more muggings Tradeoff: refuse to enforce a Pareto-improving trade, in order to avoid incentive for bad behavior (The fact that there is a tradeoff here suggests that it may not be optimal to rule out enforceability under every instance of duress For example, peace treaties can be thought of as contracts signed under duress – the losing side is facing the threat of continuing to battle a superior force Most people agree that peace treaties being enforceable is a good thing Peace treaties are clearly a good thing “ex post” – they make war less costly, by ending it more quickly It’s possible that by making war less costly, they encourage more wars – but it seems unlikely that this has much effect It’s probably efficient for peace treaties to be enforceable, but for promises made to a mugger to be unenforceable.)

What about necessity? Same logic doesn’t work for necessity You get caught in a storm on your $1,000,000 sailboat Tugboat offers to tow you to shore for $900,000 (Otherwise he’ll save your life but let your boat sink) Duress: if we enforce contract, incentive for more crimes Necessity: if we enforce contract, incentive for more tugboats to be available to rescue sailboats Why is that bad? However, the logic that tells us that contracts with muggers shouldn’t be enforced doesn’t work for contracts signed under necessity. You’re out sailing on your $10 million boat and get caught in a storm The boat starts taking on water and slowly begins to sink A tugboat comes by and offers to tow you back to shore, if you pay him $9 million If not, he won’t leave you to die – he’ll give you and your crew a ride back to shore, but your boat will be lost. With duress, we argued that making the contract enforceable would encourage muggers to commit more crimes, which is bad But here, making the contract enforceable would encourage tugboats to make themselves available to rescue more boats – so how is that a bad thing? In fact, Friedman points out that if we consider the tugboat captain’s decision beforehand – how much to invest in being in the right place at the right time – the higher the price, the better The total gain (to all parties) from the tugboat being there is the value of your boat, minus the cost of rescuing it – say, $10,000,000 - $10,000 = $9,990,000 Allowing the tugboat to recover the entire value of the boat would make his private gain from rescuing you exactly match the social gain This would cause the tugboat captain to invest the socially optimal amount in being available to rescue you!

What about necessity? “Should I motor around looking for sailboats to save?” Social cost = private cost = value of my time Social benefit = probability x (value of boat – cost of tow) Private benefit = probability x (price I can charge – cost of tow) If tugboat captain can charge the whole value of the boat, he spends efficient amount of time saving sailboats! So maybe we should enforce this contract…

What about necessity? “Should I sail today?” Suppose tugboat is there to rescue me if there’s a storm Social benefit = private benefit = how much I enjoy sailing Social cost = probability x cost of tow Private cost = probability x price he can charge If tugboat captain can only charge cost of tow, I sail efficient amount If he can charge the whole value of the boat, I undersail! But on the other hand, consider your decision about whether to take your boat out on a day when a storm is a possibility Suppose there’s a 1-in-1000 chance of being caught in a storm And if you are caught in a storm, there’s a one-in-two chance a tugboat will be there to rescue you. If the tugboat captain can charge you the full value of your boat, then when weighing the costs and benefits of going sailing that day, you consider a 1-in-1000 chance of losing the full value of the boat That is, in your analysis of whether it’s worth sailing, you’ll include the 1/2000 possibility the boat sinks, and the 1/2000 possibility you pay its full value to an opportunistic tugboat captain – a total expected cost of $10,000 So you’ll only go sailing on days where your benefit is greater than $10,000 But when you go sailing and start to sink, half the time, your loss is the tugboat captain’s gain The social cost of you sailing includes a 1-in-2000 chance the boat is lost, plus a 1-in-2000 chance it has to be towed to shore So the total expected cost is $10,000,000 / 2000 + $10,000 / 2000 = $5,005 So efficiency says you should go out sailing whenever the benefit to you is greater than $5,005. So if the tugboat captain is able to charge you the full value of the boat, you will “undersail” That is, in cases where your private gain from sailing is between $5,005 and $10,000, efficiency would suggest you should sail But since the private cost outweighs the benefit, you choose not to. On the other hand, suppose the tugboat could only charge you the cost of the tow Then the social cost of sailing would match the private cost to you - $5,005 This would lead you to go sailing exactly the efficient amount.

Friedman’s point Same transaction sets incentives on both parties Price that would be efficient for one decision, is inefficient for other “Put the incentive where it would do the most good” Least inefficient price is somewhere in the middle And probably not the price that would be negotiated in the middle of a storm! Friedman, then, makes the following point The same transaction sets ex-ante incentives on both parties And the price that would lead to an efficient decision by one of them, would lead to an inefficient decision by the other. So, what should we do? As Friedman puts it, “put the incentive where it will do the most good.” Somewhere in between the cost of the tow and $10 million is the “least bad” price That is, the price that minimizes the losses due to inefficient choices by both sides If the tugboat captain is more sensitive to incentives than you are, the best price is likely closer to the value of the boat If you respond more to incentives than he does, the best price may be closer to the cost of the tow But regardless of the details, two things will generally be true: the least inefficient price is somewhere in the middle and there’s no reason for it to be the price that would be negotiated during the storm

Friedman’s point Same transaction sets incentives on both parties Price that would be efficient for one decision, is inefficient for other “Put the incentive where it would do the most good” Least inefficient price is somewhere in the middle And probably not the price that would be negotiated in the middle of a storm! So makes sense for courts to overturn contracts signed under necessity, replace them with ex-ante optimal terms More general point Single price creates multiple incentives May be impossible to get efficient behavior in all dimensions That is, once you’re caught in a storm, all the relevant decisions have already been made you’ve decided whether to sail the tugboat captain has decided whether to be out there looking for sinking sailboats Those are like sunk costs – they don’t affect your bargaining position now So there’s no reason that, if you bargained over saving your boat during the storm, you’d end up anywhere near that efficient price On the other hand, there’s always the risk that bargaining breaks down and you refuse the tugboat captain’s offer, incurring a large social cost (the value of the boat minus the tow is lost) So from an efficiency point of view, it makes sense for courts to step in, overturn contracts that were signed under necessity, and replace them with what would have been ex-ante optimal terms This takes away the need to bargain hard during the storm, ensuring that the boat is saved; and it creates the “least bad” combination of incentives. So that’s Friedman’s take on duress and necessity.

Real duress versus fake duress Court won’t enforce contracts signed under threat of harm “Give me $100 or I’ll shoot you” But many negotiations contain threats “Give me a raise, or I’ll quit” “$3,000 is my final offer for the car, take it or I walk” The difference? Threat of destruction of value versus failure to create value A promise is enforceable if extracted as price of cooperating in creating value; not if it was extracted by threat to destroy value One more thing about duress We said that the law will not enforce contracts signed under threat of harm – “give me $100 or I’ll shoot you.” However, lots of negotiations involve threats of some sort “give me a raise or I’ll quit and work for your competitor” “$3000 for my car is my final offer, take it or I walk.” This kind of threat is fine – it’s often necessary to tease out both sides’ threat points and figure out whether cooperation is efficient or not To distinguish between the two types of threats, note what happens in each case when bargaining fails In the second case, failure to reach a bargain results in a failure to create more value In the first case, failure to agree leads to destruction. In addition, successful bargains tend to create value, while contracts created under duress tend to just shift resources from one owner to another. In general, the following rule applies to distinguish duress: A promise is enforceable if it was extracted as the price of cooperating in creating value; a promise is unenforceable if it was extracted by a threat to destroy value

Example: Alaska Packers’ Association v Domenico (US Ct App 1902) Captain hires crew in Seattle for fishing expedition to Alaska In Alaska, crew demands higher wages or they’ll quit, captain agrees Back in Seattle, captain refuses to pay the higher wages, claiming he agreed to them under duress Court ruled for captain Since crew had already agreed to do the work, no new consideration was given for promise of higher wage There’s a nice example of this in the textbook (They don’t cite the actual case, which is Alaska Packers’ Association v. Domenico, US Court of Appeals, 1902) A fishing boat captain hires a crew in Seattle for a fishing expedition to Alaska, agrees to pay them $50 each plus $0.02 per fish they catch Once they reach Alaska, the crew demands higher wages ($100), or else they won’t work Having little choice – they’re already there, and the fishing season is short – the captain agrees After they return to Seattle, the captain refuses to pay the higher wages, claiming he agreed to them under duress. While in Seattle, the crew that signed on faced competition from other fishermen Once in Alaska, they did not The captain had relied on their promise to work – by investing in fuel and supplies, and the time to sail to Alaska. While in Seattle, the crew’s only threat was to not cooperate in creating value – in which case the captain could have hired another crew Once in Alaska, the crew’s threat was to destroy value – by destroying the investment the captain had already made The court ruled the captain only had to pay the original wage – the renegotiated contract was not enforced

A performance excuse: impossibility Incompetence, duress, necessity are all formation defenses – reasons why a valid contract never existed Next, we turn to performance excuses – claims that even though a contract was signed in good faith, one of the parties should be allowed to break it without penalty

Next doctrine for voiding a contract: impossibility When performance becomes impossible, should promisor owe damages, or be excused from performing? A perfect contract would explicitly state who bears each risk Contract may give clues as to how gaps should be filled Industry custom might be clear But in some cases, court must fill gap A surgeon agrees to perform an operation, then breaks his hand in a hideous golf cart accident the weekend before Clearly, he cannot perform the operation The question remains as to whether he is excused from performing, or whether he owes his would-be patient damages As we mentioned last week, a perfect contract would specify explicitly who would bear that risk But due to transaction costs, real contracts will generally not address risks that are very remote In some cases, even if it does not address the risk explicitly, the contract itself may give clues as to how the gap should be filled An example of this from the textbook: a drilling company agrees to drill a well for a landowner, but the drill runs into impenetrable granite Suppose that the driller was competing with other companies for the offer, but the landowner agreed to a price much higher than the competition The court might feel that the driller was implicitly guaranteeing performance, and should owe damages when performance became impossible Or industry custom might be for one side or the other to bear that risk. In situations where neither the contract itself nor the custom of the industry assigns the risk, the law has to

Next doctrine for voiding a contract: impossibility In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach But there are exceptions Change “destroyed a basic assumption on which the contract was made” In most typical cases, the promisor is liable for breach, even when the breach is not his fault (To put it another way, contract liability is strict.) So a construction company that finishes a building late due because or unexpected complications is generally liable. However, there are some instances where non-performance is excused by physical impossibility A famous artist agrees to paint someone’s portrait, and then dies; his estate does not owe for the breach of the promise A manufacturer whose factory burns down might be excused from performance Similarly, breach is typically excused if performance became illegal A shipping company takes a bunch of orders, but then its ships are commandeered to carry military cargo during a war; the company is excused from its civilian commitments. One legal theory in these cases is that an unexpected contingency destroyed “a basic assumption on which the contract was made” The painter assumed he would be alive the manufacturer assumed his factory would be useable Under this theory, if a contract is made in good faith and then events destroy one of its basic assumptions, breach is excused. Of course, the question then becomes, when is something a “basic assumption” and when is it not? The book sidesteps this question, and instead moves to what efficiency would require:

Next doctrine for voiding a contract: impossibility In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach But there are exceptions Change “destroyed a basic assumption on which the contract was made” Efficiency requires assigning liability to the party that can bear the risk at least cost We’ve seen several ways to determine who that is Efficiency requires assigning liability to the party who can bear the risk at least cost. That is, nonperformance due to impossibility is just another type of risk; so for efficiency, it should be allocated to whichever party is the low-cost bearer of the risk. In many cases, one party can take precautions to minimize the risk the manufacturer can install sprinklers in his factory the painter can prioritize commissioned pieces over other work and so on In those cases, that party is typically the low-cost avoider, and efficiency suggests they should bear the risk. When the risk cannot be reduced, the book claims that liability should lie with the party who can best spread the risk, through insurance or diversification. (We already saw the general principle of gap-filling by allocating risk to the low-cost avoider, that is, the person who can most cheaply mitigate or bear the risk The rationale is that this is what the original contract would have done, if it had bothered to consider that risk.)

That’s why Hadley v Baxendale was “surprising” Baxendale (shipper) could influence speed of delivery, Hadley could not So Baxendale was efficient bearer of the risk of delay Court ruled he didn’t owe damages for lost profits, forcing Hadley to bear much of this risk Only makes sense as a “penalty default” Rule creates incentive for Hadley to reveal urgency of this shipment

Contracts based on bad information

Contracts based on faulty information Four doctrines for invalidating a contract Fraud Failure to disclose (sometimes) Frustration of purpose Mutual mistake

Fraud Fraud: one party was deliberately tricked This is a piece of wood, painted to look a little bit like an iPad This is a 2011 story of a woman in South Carolina who was approached in a McDonald’s parking lot and paid $180 for an iPad Fraud covers situations where one party was deliberately tricked The guy with the escort was similarly claiming fraud – saying he was originally promised one price, and then a different price was demanded later In the example from the textbook – the farmer pays $25 for a sure method of killing grasshoppers – the contract would be overturned due to fraud (the farmer was tricked), and he would get his money back If you are selling me a used car, and specifically lie to me about the condition that it’s in – you tell me you just replaced the clutch when in fact you did not – I could later get the contract overturned (force you to buy back the car) based on fraud Similarly, if I ask you a specific question about the car, you have to answer me honestly The economic rationale is obvious. The point of contracts is to allow us to transact. The point of transacting is to allocate rights and resources efficiently. If people are allowed to “trick” other people into buying things they don’t really value, this doesn’t increase efficiency – and makes it more costly to achieve valuable trades, since people have to be more careful. source: http://www.wyff4.com/r/29030818/detail.html

What if you trick someone by withholding information? It depends Under the civil law, there is a duty to disclose If you fail to supply information you should have, contract will be voided – failure to disclose Under the common law, less so Seller has to share information about hidden dangers… …but generally not information that makes a product less valuable without making it dangerous Exception: new products come with “implied warranty of fitness” Another exception: Obde v Schlemeyer In the civil law tradition, a contract may be void because you did not supply the information that you should have The doctrine here is failure to disclose Under the common law, however, a seller is not forced to tell a buyer everything he knows about what he’s selling He is forced to warn the buyer about any hidden dangers – such as the side effects of a drug, or failing brakes on a car But under the common law, there is not a general duty to disclose information that makes a product less valuable without making it dangerous (If you’re selling me a used car, you have to tell me if the brakes don’t work; you don’t have to mention that the stereo doesn’t work.) But there are a couple of exceptions: If you’re selling a new product, it’s assumed that it can perform the basic function it’s intended for – new products come with an “implied warranty of fitness” Another exception was introduced by the Washington Supreme Court in 1960

Duty to disclose under common law Under common law, seller required to inform buyer about hidden safety risks, generally not other information But… Obde v Schlemeyer (1960, Sup Ct of WA) Seller knew building was infested with termites, did not tell buyer Termites should have been exterminated immediately to prevent further damage Court in Obde imposed duty to disclose (awarded damages) Obde v Schlemeyer (1960): a seller knew his building was infested with termites and did not tell the buyer The buyer discovered the termites after the sale was completed, and sued The termites should have been exterminated immediately to prevent further damage The court in Obde deviated from tradition and imposed a duty to disclose

Duty to disclose under common law Under common law, seller required to inform buyer about hidden safety risks, generally not other information But… Obde v Schlemeyer (1960, Sup Ct of WA) Seller knew building was infested with termites, did not tell buyer Termites should have been exterminated immediately to prevent further damage Court in Obde imposed duty to disclose (awarded damages) Some states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects… In Obde, the seller did not offer the fact that the building had termites, but also did not lie about it – the buyer didn’t ask If the buyer had asked, and the seller claimed there were no termites, we would have been in the case of fraud Other common-law courts and legislatures have also begun imposing a duty to disclose in particular situations Lenders now must disclose the APR on all consumer loans Many states require used car dealers to reveal major repairs done on the car being sold Many states require sellers of homes to reveal certain types of defects Such requirements are meant to improve information exchange and lower transaction costs

Failure to disclose? source: http://kdvr.com/2012/10/26/chinese-man-sues-wife-for-being-ugly-wins-120000/