Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 11

1  HW 1: end of class today  Midterm: Wednesday Grading

2  Why do we need contracts?  Which promises should be enforced?  First purpose: enable cooperation  Second purpose: efficient disclosure of information Contracts: the story so far…

3  Breach of contract  Breach is efficient when cost to perform > benefit  Breach will happen when cost to perform > liability  Expectation damages: liability for breach = anticipated benefit  Leads to breach exactly when breach is efficient  Third purpose: secure optimal commitment to performance  Reliance  Reliance is efficient when expected benefit > cost  Or (Probability of performance) X (Increase in value) > cost  Reward any reliance  overreliance  Fourth purpose: secure optimal reliance  Hadley v Baxendale, foreseeable reliance Contracts: the story so far…

4 Default Rules

5  Gaps: risks or circumstances that aren’t specifically addressed in a contract  Default rules: rules applied by courts to fill gaps Default rules

6  Gaps: risks or circumstances that aren’t specifically addressed in a contract  Default rules: rules applied by courts to fill gaps  Writing something into a contract vs leaving a gap  Allocating a loss (ex post)  Versus allocating a risk (ex ante), before it becomes a loss Default rules

7  Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue  This will be whatever rule is efficient What should default rules be?

8  Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue  This will be whatever rule is efficient  Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules  Do this by imputing the terms the parties would have chosen if they had addressed this contingency What should default rules be?

9  Don’t want ambiguity in the law  So default rule can’t vary with every case  Majoritarian default rule: the terms that most parties would have agreed to  In cases where this rule is not efficient, parties can still override it in the contract  Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate Default rules

10  Example: probability ½, the cost of construction will increase by $2,000  Construction company can hedge this risk for $400  Family can’t do anything about it  Price goes up – who pays for it? Default rules

11  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? Default rules

12  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? Default rules

13  So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases  Most contracts can leave this gap, save on transaction costs  In cases where this rule is inefficient, parties can contract around it Default rules

14  Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules”  Sometimes better to make default rule something the parties would not have wanted  To give incentive to address an issue rather than leave a gap  Or to give one party incentive to disclose information  “Penalty default” Default rules: a different view

15  Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk  If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent  So Hadley might hide this information, which is inefficient  Ayres and Gertner: Ruling in Hadley was a good one, not because it was efficient, but because it was inefficient…  …but in a way that created incentive for disclosing information Penalty defaults: Hadley v Baxendale

16  Real estate brokers and “earnest money”  Broker knows more about real estate law  Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this Penalty defaults: other examples

17  Real estate brokers and “earnest money”  Broker knows more about real estate law  Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this  Courts will impute missing price of a good, but not quantity  Forces parties to explicitly contract on quantity, rather than leave it for court to decide Penalty defaults: other examples

18  Look at why the parties left a gap in contract  Because of transaction costs  use efficient rule  For strategic reasons  penalty default may be more efficient  Similar logic in a Supreme Court dissent by Justice Scalia  Congress passed a RICO law without statute of limitations  Majority decided on 4 years – what they thought legislature would have chosen  Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…”  “Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.” When to use penalty defaults?

19 Regulations

20  Default rules can be contracted around  Some rules cannot – immutable rules, or mandatory rules, or regulations  Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations.  Coase: if individuals are rational and there are no transaction costs, private negotiations lead to efficiency  So additional regulations can only make things worse  But when people are not rational, or when there are transaction costs/market failures, regulations may help Default rules versus regulations

21  Derogate, verb. detract from; curtail application of (a law)  Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable  Contracts which could only be performed by breaking a law  Contracts whose effect is to circumvent a law One example of a regulation/immutable rule: derogation of public policy B (union) C (ownership) A (other factory) “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr”

22  Derogate, verb. detract from; curtail application of (a law)  Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable  Contracts which could only be performed by breaking a law  Contracts whose effect is to circumvent a law One example of a regulation/immutable rule: derogation of public policy B (union) C (ownership) A (other factory) “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr”

23  In general: contracts which can only be performed by breaking the law are not enforceable  But…  “A married man may be liable for inducing a woman to rely on his promise of marriage, even though the law prohibits him from marrying without first obtaining a divorce.”  “A company that fails to supply a good as promised may be liable even though selling a good with the promised design violates a government safety regulation.”  “A company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation.”  “A promisor should be liable for breach if he knew that the promise was illegal” Derogation of public policy

24  Peevyhouse v Garland Coal and Mining Co (OK Supreme Court, 1962)  Garland contracted to strip-mine coal on Peevyhouse’s farm  Contract specified Garland would restore property to original condition; Garland did not  Restoration would have cost $29,000…  …but “diminution in value” of farm only $300  Original jury awarded $5,000 in damages, both parties appealed  Oklahoma Supreme Court reduced damages to $300 Expectation damages: default rule or immutable rule?

25  Seems like classic case of efficient breach  Performing last part of contract would cost $29,000  Benefit to Peevyhouses would be $300  Efficient to breach and pay expectation damages, which is what happened  But…  Most coal mining contracts: standard per-acre diminution payment  Peevyhouses refused to sign contract unless it specifically promised the restorative work  Dissent: Peevyhouses entitled to “specific performance” Expectation damages: default rule or immutable rule?

26  Which works better in this case:  Default rule allowing Garland to breach and pay diminution fee?  Default rule forcing Garland to perform restorative work?  Ayres and Gertner: default rule should “penalize” the better-informed party  Garland routinely signed contracts like these  Peevyhouses were doing this for the first time  Default rule allows Garland to pay diminution fee: they have no reason to bring it up, Peevyhouses don’t know  Default rule forces Garland to do cleanup: if that’s inefficient, they could bring it up during negotiations  In this case, specific performance would work as a penalty default We can also think about Peevyhouse in terms of penalty defaults

27 Ways to get out of a contract

28  Formation defense  Claim that a valid contract does not exist  (Example: no consideration)  Performance excuse  Yes, a valid contract was created  But circumstances have changed and I should be allowed to not perform  Most doctrines for invalidating a contract can be explained as either…  Individuals agreeing to the contract were not rational, or  Transaction cost or market failure Formation Defenses and Performance Excuses

29  Courts will not enforce contracts by irrational individuals  Children  Legally insane  Doctrine of incompetence  One party was not competent to enter into contract  Invalidates contracts which are not in best interest of that party  What if you signed a contract while drunk?  You need to have been really, really, really drunk to get out of a contract Incompetence

30  Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]”  Lucy v Zehmer (VA Sup Ct, 1954) What if you signed a contract while drunk?

31  Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]”  Lucy v Zehmer (VA Sup Ct, 1954) What if you signed a contract while drunk?

32  Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]”  Lucy v Zehmer (VA Sup Ct, 1954) What if you signed a contract while drunk?

33  Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]”  Lucy v Zehmer (VA Sup Ct, 1954) What if you signed a contract while drunk?

34  Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]”  Lucy v Zehmer (VA Sup Ct, 1954)  The Borat lawsuits What if you signed a contract while drunk?

35  Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]”  Lucy v Zehmer (VA Sup Ct, 1954)  The Borat lawsuits  Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for Make Benefit Guileless Americans In Film”  Moral of story: don’t get drunk with someone who might ask you to sign a contract What if you signed a contract while drunk?