Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 12

1  Midterm will be returned at end of lecture  HW2 is online, due in two weeks (Wed Mar 17)  Second midterm Wed Mar 24  Cumulative, through end of contract law Logistics

2  Default rules  Why are gaps left in contracts?  What rules should be applied to fill those gaps?  C&U: use terms most parties would have chosen (efficient terms)  Ayres and Gertner: under some conditions, use default rules which penalize one or both parties for concealing information  Regulations  Example: derogation of public policy  Ways to get out of a contract  Formation defenses (“no contract exists”)  Performance excuses (“circumstances have changed”)  One formation defense: incompetence (but not drunkenness) Last time…

3 Another formation defense: dire constraints

4  Necessity  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  Someone makes me an offer I can’t refuse Dire constraints

5  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: don’t enforce Pareto-improving trade, in order to avoid incentive for bad behavior Friedman on duress

6  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: don’t enforce Pareto-improving trade, in order to avoid incentive for bad behavior Friedman on duress

7  Same logic doesn’t work for necessity  You get caught in a storm on your $10,000,000 sailboat  Tugboat offers to tow you to shore for $9,000,000  (Otherwise he’ll save your life but let your boat sink)  Duress: if we enforce contract, incentive for more crimes  Here: if we enforce contract, incentive for more tugboats to be available for rescues – how is that bad?  Social benefit of rescue: value of boat, minus cost of tow  Say, $10,000,000 – $10,000 = $9,990,000  If tugboat gets entire value, his private gain = social gain  So tugboat captain would invest the efficient amount in being available to rescue you  So what’s the problem? What about necessity?

8  What about your decision: whether to sail that day  1 in 1000 chance of being caught in a storm  If so, 1 in 2 that a tugboat will rescue you  Private cost of sailing: 1 in 2000 you lose boat, 1 in 2000 you pay tugboat captain value of boat  $10,000,000/ $10,000,000/2000 = $10,000  So you’ll choose to sail if your value is above $10,000  Social cost: 1 in 2000 boat is lost, 1 in 2000 boat is rescued  $10,000,000/ $10,000/2000 = $5,005  Efficient to sail when your value is above $5,005  When your value from sailing is between $5,005 and $10,000, you undersail  If the price of being towed was just the marginal cost, you would sail the efficient amount What about necessity?

9  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’s point

10  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 Friedman’s point

11  Single price can create multiple incentives  Often impossible to set them all efficiently  Already saw this with remedy for breach  Expectation damages: efficient breach, but inefficient signing  Include gains from reliance: overreliance  Exclude gains from reliance: inefficient breach More general point

12  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 Real duress versus fake duress

13  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, refuses higher wages, claiming duress Example

14 A performance excuse: impossibility

15  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 Next doctrine for voiding a contract: impossibility

16  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” Next doctrine for voiding a contract: impossibility

17  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  Party that can take precautions to minimize the risk  Or can best spread the risk over many transactions Next doctrine for voiding a contract: impossibility

18  Who is the efficient bearer of a particular risk?  Also called low-cost avoider  Who is in best position to mitigate/reduce a risk, or hedge it, or endure it?  We already saw this question with efficient default rules  When a contract leaves a gap, an efficient contract would have allocated each risk to low-cost avoider  Construction company building a house, completion is delayed  Family might be efficient risk-bearer, because it’s cheaper for them to stay with friends than for construction company to pay for hotel  Cost of raw materials goes up, increasing cost of construction  Construction company might be efficient risk-bearer, because they can buy materials early or change design plans Important general concept

19 Contracts based on bad information

20  Four doctrines for invalidating a contract based on faulty information  Fraud  Failure to disclose  Frustration of purpose  Mutual mistake Misinformation

21  Fraud violates “negative duty” not to misinform  In some circumstances, positive duty to disclose certain information  Civil law: contract may be voided if you did not supply information you should have (“failure to disclose”)  Common law: seller is not forced to disclose everything he knows  Must warn about hidden dangers  Need not share information that makes product less valuable but not dangerous  But, new products come with “implied warranty of fitness” Fraud and Failure to Disclose

22  Both parties based a contract on the same bad information  contract may be voided due to frustration of purpose  Coronation Cases  Rooms rented out with view of new king’s coronation parade  Parade was postponed, owners still tried to collect rent  Courts ruled change in circumstance had frustrated the purpose of the original contracts, which were therefore void  “When a contingency makes performance pointless, assign liability to the party who can bear the risk at least cost” Frustration of Purpose

23  Frustration of purpose: circumstances changed after the contract was signed  Mutual mistake: circumstances changed before the contract was signed, but the parties didn’t know about it  Enforcing the contract would be like forcing involuntary exchange  Coase: we expect voluntary exchange to be efficient  But involuntary exchange may not be Mutual Mistake

24  Hadley v Baxendale (miller and shipper)  Hadley knew shipment was time-critical  But Baxendale was deciding how to ship crankshaft (boat or train)  A general principle about information: efficiency generally requires uniting knowledge and control  Contracts that unite knowledge and control are generally efficient, should be upheld  Contracts that separate knowledge and control may be inefficient, should more often be set aside Another principle: knowledge and control

25  Mutual mistake: neither party had correct information  Contract neither united nor separated knowledge and control  Unilateral mistake: one party has mistaken information  I know your car is a valuable antique, you think it’s worthless  You sell it to me at a low price  Contracts based on unilateral mistake are generally upheld Unilateral mistake

26  Mutual mistake: neither party had correct information  Contract neither united nor separated knowledge and control  Unilateral mistake: one party has mistaken information  I know your car is a valuable antique, you think it’s worthless  You sell it to me at a low price  Contracts based on unilateral mistake are generally upheld  Contracts based on unilateral mistake generally unite knowledge and control  And this creates an incentive to gather information Unilateral mistake

27  War of 1812: British blockaded port of New Orleans  Price of tobacco fell, since it couldn’t be exported  Organ (tobacco buyer) learned the war was over  Immediately negotiated with Laidlaw firm to buy a bunch of tobacco at the depressed wartime price  Next day, news broke the war had ended, price of tobacco went up, Laidlaw sued  Supreme Court ruled that Organ was not required to communicate his information Unilateral mistake: Laidlaw v Organ (U.S. Supreme Court, 1815)

28  Productive information: information that can be used to produce more wealth  Redistributive information: information that can be used to redistribute wealth in favor of informed party  Cooter and Ulen  Contracts based on one party’s knowledge of productive information – especially if that knowledge was the result of active investment – should be enforced  Contracts based on one party’s knowledge of purely redistributive information or fortuitously acquired information should not be enforced Unilateral mistake: productive versus redistributive information

29  Sellers must inform buyers about hidden safety risks  Common law does not generally require disclosure of other types of information  But…  Obde v Schlemeyer (1960)  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  Sale did not unite knowledge and control More on duty to disclose

30  Sellers must inform buyers about hidden safety risks  Common law does not generally require disclosure of other types of information  But…  Obde v Schlemeyer (1960)  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  Sale did not unite knowledge and control  Many states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects… More on duty to disclose

31 Other reasons a contract may not be enforced

32  Courts will generally not enforce contract terms that are overly vague  Can be thought of as a penalty default  But some exceptions  Parties may commit to renegotiating the contract “in good faith” under certain contingencies Vague contract terms

33  Bargain theory: courts ask only whether a contract was part of a bargain, not whether that bargain was fair  Hamer v Sidway (drinking and smoking)  But two common law doctrines to get out of extremely one-sided contracts  Adhesion  Unconscionability Fairness

34  Adhesion: standardized “take-it-or-leave-it” contracts  Friedman calls it “bogus duress” Adhesion and unconscionability

35  Adhesion: standardized “take-it-or-leave-it” contracts  Friedman calls it “bogus duress”  Unconscionability  Overly one-sided contract may not be enforced  Terms “such that no man in his senses and not under delusion would make on the one hand, and as no honest and fair man would accept on the other”  When “the sum total of its provisions drives too hard a bargain for a court of conscience to assist”  Terms which would “shock the conscience of the court”  Similar concept in civil law: lesion Adhesion and unconscionability

36  “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.” Unconscionability: Williams v Walker- Thomas Furniture (CA Dist Ct, 1965)

37  “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.” Unconscionability: Williams v Walker- Thomas Furniture (CA Dist Ct, 1965)

38  “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”  Not normal monopoly cases but “situational monopolies”  Think of Ploof v Putnam (sailboat in a storm) Unconscionability: Williams v Walker- Thomas Furniture (CA Dist Ct, 1965)

39 Midterms

40  Overall pretty good  Mean 82, median 84, std dev 14  Not actually assigning letter grades till after final  But to have an approximate idea of where you stand… 90sroughly AB or A 80sroughly B 70sroughly BC high 50s/60sroughly C Midterm A-HQ-ZI-P