1. Econ 522 Economics of Law
Dan Quint
Spring 2017
Lecture 10

2. Reminders Homework 2 due Thursday at midnight
Midterm 1 next Wednesday (Mar 1)
covers through the end of property law

3. Last time: Remedies Several limitations and exceptions to property law
Temporary versus permanent damages – when is each one preferable?
Several limitations and exceptions to property law
Adverse possession/squatter’s rights
Private necessity (emergencies)
Unbundling
Eminent domain/governmental “takings”
Today: regulation

4. Regulation 3 3

5. Recall the question: when should resources be privately owned?
Cost of private ownership: owners must take steps to make the resource excludable – boundary maintenance
Cost of public ownership: congestion and overuse
An economically rational society will privatize a resource when boundary maintenance costs are less than the waste from overuse of the resource.
The cost of privatization, of course, is that now owners must take steps to make the resource excludable, which may be costly
These costs are referred to as “boundary maintenance.”
In the case of pastureland, this may involve putting up fences to keep out other peoples’ cattle
The cost of continued public ownership, on the other hand, is congestion and overuse
Thus, An economically rational society will privatize a resource at the point in time where boundary maintenance costs less than the waste from overuse of the resource

6. Recall the question: when should resources be privately owned?
Cost of private ownership: owners must take steps to make the resource excludable – boundary maintenance
Cost of public ownership: congestion and overuse
An economically rational society will privatize a resource when boundary maintenance costs are less than the waste from overuse of the resource.
(either because congestion got worse…
or because boundary maintenance became cheaper)
This can happen either because congestion becomes a greater cost, or because technology makes boundary maintenance cheaper
In the Demsetz example of Native American land rights, the cost of congestion became higher as the fur trade led to overhunting
On the other hand, the invention of barbed wire lowered the cost of boundary maintenance, and would be expected to have encouraged privatization of land rights in the American West.
Similarly, Friedman’s observation that we owe civilization to the dogs

7. This leaves the question:
For resources that aren’t privatized, how should they be provided?

8. Multiple forms of public ownership
Open Access
Anyone free to use the resource
Leads to overutilization (Tragedy of the Commons)
Example: oyster beds
Unanimous Consent
Opposite of open access – multiple owners must all agree to any use of the resource
Leads to underutilization
Example: empty storefronts in post-Communist Moscow
“Anti-commons” caused by existing intellectual property
Political Control/Regulation
The tragedy of the commons problem we mentioned earlier applies to open access – when private goods are free to everyone, they will be overexploited
Oyster beds are a nice example of this
Early in their lives, oysters attach themselves to underwater rocks or other surfaces, which makes it possible to assign property rights to them
Along the Atlantic and Gulf Coast, some states treat oyster beds as common property with open access – anyone can farm the oysters
Other states treat oyster beds as private property – the state owns the rights to the oysters, and leases these rights to private companies
The textbook mentions a paper showing that when oyster beds are common property, they become depleted, as measured by a greatly reduced output of oysters per man-hour of fishing – the classic tragedy of the commons problem that we’ve already discussed.
Unanimous consent gives multiple owners veto power over any use of the resource.
While open access resources will tend to be overutilized, resources governed by unanimous consent will tend to be underutilized
The book gives the example of vacant shops in Moscow after the fall of Communism
Due to the overlapping property rights established under Communism, too many people had the power to veto anyone’s use of the space
And so no one was able to put the space to use.
Another example of this is areas with excessive existing intellectual property – where lots of existing patentholders essentially have veto power over new innovation
This problem is sometimes referred to as an “anti-commons” problem 7 7

9. Third form of public ownership: political control/regulation
Dividing the mountain pasture among individual owners would require fencing it, which is prohibitively expensive.
Instead, the highland pasture is held in common, with each village owning different pastures that are separated by natural features such as lakes and mountain peaks.
If each person in the village could place as many sheep as he or she wanted in the common pasture, the meadows might be destroyed and eroded by overuse.
The other option for public resources is political regulation. An example of this is pasture land in parts of Iceland, which is held in common, but regulated. Quoting from the textbook:
Dividing the mountain pasture among individual owners would require fencing it, which is prohibitively expensive. Instead, the highland pasture is held in common, with each village owning different pastures that are separated by natural features such as lakes and mountain peaks. If each person in the village could place as many sheep as he or she wanted in the common pasture, the meadows might be destroyed and eroded by overuse. 8 8

10. Third form of public ownership: political control/regulation
In fact, the common pastures in the mountains of Iceland have not been overused and destroyed, because the villages have effective systems of governance.
They have adopted rules to protect and preserve the common pasture. The sheep are grazed in common pasture in the mountains during the summer and then returned to individual farms in the valleys during the winter.
The total number of sheep allowed in the mountain pasture during the summer is adjusted to its carrying capacity.
Each member of the village receives a share of the total in proportion to the amount of farmland where he or she raises hay to feed the sheep in the winter.
In fact, the common pastures in the mountains of Iceland have not been overused and destroyed because the villages have effective systems of governance. They have adopted rules to protect and preserve the common pasture. The sheep are grazed in common pasture in the mountains during the summer and then returned to individual farms in the valleys during the winter. The total number of sheep allowed in the mountain pasture during the summer is adjusted to its carrying capacity. Each member of the village receives a share of the total in proportion to the amount of farmland where he or she raises hay to feed the sheep in the winter.
The usual problem of overuse of public resources is that there is no (or very little) private cost to using them
That is, if all grazing land were public, there would be almost no private cost to having more sheep, so everyone would raise too many
Here, however, the system does impose a private cost – you can only graze more sheep in the common pasture if you have more farmland and more space for sheep in the winter
So overuse is less of a problem
(In addition, the system imposes an overall limit) 9 9

11. Similar to how Iceland maintains fishing stock
Open access would lead to overfishing, deplete fishing stock
Government of Iceland decides how much fish should be caught in total each year
People own permits which are right to catch a fixed fraction of each year’s total
Permits are property – can be bought, sold, etc.
In fact, this is similar to the way Iceland maintains its fishing stock. (See Michael Lewis article…)
Of course, there are administrative costs to this type of regulation – someone must enforce it
But in some instances, such regulation may be less costly than the transaction costs required for private ownership – in this case, building a lot of fences to separate different shepherds’ shares of the pastureland 10 10

12. Regulation
Regulation can be thought of as any limitations the government places on the use of private property
The government’s power to regulate is widespread
We mentioned earlier that one way to supply clean air (a public good) was to have air quality standards determined and enforced by the government
Similarly, most cities have zoning laws, which might prohibit industrial land use in residential areas, in order to avoid noise, pollution, and other nuisances.
Of course, a regulation is a limitation on what you can do with your property, so it may change the value you get from your property
A U.S. Supreme Court case decided in 1922 established that under certain circumstances, a regulation could diminish the value of your property so much that it would be considered a taking, and would therefore require compensation. 11 11

13. Regulation: Pennsylvania Coal v. Mahon
1800s: PA Coal purchased mineral and support estates, Mahon owned surface
1921: Kohler Act prohibited “mining of anthracite coal in such a way as to cause the subsidence of, among other things, any structure used as a human habitation.”
PA Coal sued government, claiming the regulation was same as seizing their land (without compensation)
“…While property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking.”
surface estate
support estate
mineral estate
The case was one that came up last week, when we discussed the unbundling of property rights: Pennsylvania Coal Company v Mahon.
Recall that land rights in Pennsylvania consisted of three separable pieces: surface, support, and mineral.
In the late 1800s, Pennsylvania Coal Company purchased both mineral and support rights to a piece of land, while Mahon owned surface rights.
Much later, in 1921, the Pennsylvania legislature passed the Kohler Act, which prohibited “the mining of anthracite coal in such way as to cause the subsidence of, among other things, any structure used as a human habitation.”
Pennsylvania Coal Company sued the government, claiming that the new regulation destroyed the value of its property by preventing the mining of the coal, and that the new law was therefore a taking and required compensation.
The lower court sided with the government, but the Supreme Court sided with Pennsylvania Coal. Oliver Wendall Holmes wrote the majority opinion:
What makes the right to mine coal valuable is that it can be exercised with profit.  To make it commercially impracticable to mine certain coal has very nearly the same effect for constitutional purposes as appropriating or destroying it.  This we think that we are warranted in assuming that the statute does.  … 
The general rule at least is, that while property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking. 12 12

14. Regulation: Pennsylvania Coal v. Mahon
1800s: PA Coal purchased mineral and support estates, Mahon owned surface
1921: Kohler Act prohibited “mining of anthracite coal in such a way as to cause the subsidence of, among other things, any structure used as a human habitation.”
PA Coal sued government, claiming the regulation was same as seizing their land (without compensation)
“…While property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking.”
surface estate
support estate
mineral estate
Up until then, an action was only considered a taking if the government took physical possession of the property
Pennsylvania Coal was the first recognition of a regulatory taking
That is, a situation where the government removed the value of property through regulation, which would also require compensation under circumstances
Holmes wrote that regulation that “goes too far” constitutes a taking, but never defines what “goes too far” means
(SKIP THIS: And from the dissent, by Louis Brandeis: Every restriction upon the use of property imposed in the exercise of the police power deprives the owner of some right theretofore enjoyed, and is, in that sense, an abridgment by the States of rights in property without making compensa­tion.  But restriction imposed to protect the public health, safety or morals from dangers threatened is not a taking.  The restriction here in question is merely the prohibition of a noxious use.  The property so restricted remains in the possession of its owner.  The State does not appropriate it or make any use of it.  The State merely prevents the owner from making a use which interferes with paramount rights of the public.) 13 13

15. Regulation: Pennsylvania Coal v. Mahon
1800s: PA Coal purchased mineral and support estates, Mahon owned surface
1921: Kohler Act prohibited “mining of anthracite coal in such a way as to cause the subsidence of, among other things, any structure used as a human habitation.”
PA Coal sued government, claiming the regulation was same as seizing their land (without compensation)
“…While property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking.”
surface estate
support estate
mineral estate
There is an interesting backstory behind the Pennsylvania Coal case. Cooter and Ulen cite a book by William Fischel, Regulatory Takings: Law, Economics, and Politics.
Fischel investigated the circumstances leading up to the passage of the Pennsylvania regulation, and found that at that time, even when they owned both the mineral and support rights, coal companies in Pennsylvania tended to take care of the damage they caused. Quoting from the book:
The coal companies and the citizens of Scranton were neighbors; some were employers; many were employees; and social contacts among them were, and long had been, frequent.
Even if the companies had retained subsurface rights and landowners had waived their right to claims for subsidence damages, as was frequently the case, there was the strong likelihood of hard feelings among surface owners towards the coal companies, and those feelings would interfere with employment and other on-going social relationships.
Long before Pennsylvania Coal and the Kohler Act, the very practical necessity of maintaining good public relations led the coal companies to adopt a policy of routinely repairing surface damage caused by their subsurface mining, regardless of the contractual assignment of liability.
According to a retired executive of the Pennsylvania Coal Company to whom Fischel spoke, “[I]f the company caused subsidence to any surface structure, it sent a crew up to fix the damage, at company expense.  It did not matter to whom the right of support belonged, although it typically belonged to the company.” 14 14

16. Regulation: Pennsylvania Coal v. Mahon
1800s: PA Coal purchased mineral and support estates, Mahon owned surface
1921: Kohler Act prohibited “mining of anthracite coal in such a way as to cause the subsidence of, among other things, any structure used as a human habitation.”
PA Coal sued government, claiming the regulation was same as seizing their land (without compensation)
“…While property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking.”
surface estate
support estate
mineral estate
Fischel then wondered why the legislature bothered to pass the law, given that its goals were already being met
He found that there had been recent developments in mining technology, which the court apparently feared might disrupt the status quo
In addition, one local mining company had recently gone bankrupt and had therefore not repaired the damage it had done
The Kohler Act was coupled with another bill imposing a tax on coal companies, which would be used to repair the damage already done by the bankrupt firm
Part of Pennsylvania Coal’s objection, then, was not even to the regulation itself, but to being forced to pay for another company’s damage when they were already voluntarily paying for their own.
(Fischel’s thesis, BTW, is that regulatory takings should only be compensated when they stem from local government, not from state or federal regulations
He feels that compensation for regulatory takings should only be required to discourage excessive or inefficient regulation; which he argues is unlikely to occur at the federal or state level, but a legitimate risk at the local level.
He also argues that immovability of the property, or inelasticity of its supply, should also be necessary for compensation to be required, since with movable property, the owner could simply relocate to avoid the effect of the regulation.
There’s more in the textbook website, if you’re interested.) 15 15

17. Blume and Rubinfeld, “Compensation for Takings: An Economic Analysis”
Support compensation for regulatory takings
Shifting burden of regulation from owners of affected property to all taxpayers
Equivalent to selling everyone insurance against harmful regulation
If such insurance were available, people would buy it
But it’s not available, for usual reasons insurance markets may fail
adverse selection
moral hazard
So government should provide it instead…
…by paying compensation for regulatory takings
The article by Blume and Rubinfeld, “Compensation for Takings: An Economic Analysis,” gives an argument in favor of requiring compensation for regulatory takings.
They point out that compensation is basically just shifting the burden of the regulation’s cost from a narrow base (the owners of the property) to a broader base (all taxpayers).
Ordinarily, these are simply zero-sum transfers, and so they wouldn’t matter from an efficiency point of view
But if we allow for the possibility that people are risk-averse, then requiring compensation after the fact is the same as providing an insurance policy against harmful regulation.
Blume and Rubinfeld argue that, if insurance against regulatory harm were made available at fair prices, people would probably buy it
However, privately-supplied insurance against regulatory harm does not exist; and Blume and Rubinfeld argue it cannot exist, for the usual reasons of market failure in insurance markets: adverse selection and moral hazard
If an insurance company offered such insurance, it would have to worry that it would only sell policies to people who had inside information about the likelihood of regulation
or that after buying insurance, owners would be less likely to lobby against regulation that would harm them
So such insurance, even though it would be beneficial, is not provided by the market. 16 16

18. Blume and Rubinfeld, “Compensation for Takings: An Economic Analysis”
Support compensation for regulatory takings
Shifting burden of regulation from owners of affected property to all taxpayers
Equivalent to selling everyone insurance against harmful regulation
If such insurance were available, people would buy it
But it’s not available, for usual reasons insurance markets may fail
adverse selection
moral hazard
So government should provide it instead…
…by paying compensation for regulatory takings
But requiring regulatory takings to be compensated is a way for the government to provide exactly this type of insurance.
By compensating owners after the fact when the harm actually occurs, the government would be spreading the cost of the regulation over everyone, rather than forcing it to be borne only by the person directly affected.
Looked at from an ex-ante point of view (before the harm occurs), this is identical to selling everyone fair insurance against regulatory harm
Of course, the compensation would have to be funded through taxes, and taxes are somewhat distortive; but broad-based taxes are less distortive and harmful than narrow ones, so spreading the cost over everyone causes less distortion (less inefficiency) than having it borne by few
Blume and Rubinfeld justify compensation for regulatory takings by focusing on risk aversion, but there is also another way for regulatory uncertainty to be harmful, which we mentioned earlier
The possibility of uncompensated regulation leads to uncertainty about the future value of property.
This uncertainty may hamper trade, that is, the uncertainty may make it harder to negotiate the sale of property to the owner who values it most, since the possibility of unfavorable regulation may make the two sides uncertain threat points during bargaining.
Again, by providing insurance against adverse regulation, the government would be reducing the uncertainty over the property’s value, which would encourage it to be traded to the owner who could put it to most valuable use. 17 17

19. Zoning Zoning laws Distinguish industrial areas from residential areas
We mentioned earlier another restriction on property rights – zoning laws
These are a specific type of regulation separating industrial property from residential property
You could imagine that a single plot of land might be worth more to a factory than to a homeowner, but that the nuisance this would create to the neighboring residences (dust, noise, whatever) would make locating the factory their socially inefficient
So a single homeowner selling his land to a factory would impose a negative externality on his neighbors
Zoning laws rule out this type of situation
Zoning laws also allow a legislature to deliberately plan or alter the way a town is organized
For example, as shipping by boat becomes less important to a town’s economy, they might choose to redevelop a large area of waterfront property away from industrial uses and into residences or public space.
These transitions might not occur without governmental encouragement, not because they are inefficient, but because nobody would want to be the first to move
That is, nobody wants to be the only resident in an industrial space, because it would have a terrible view until all the land was converted, and might be far from supermarkets and other residential amenities
By changing the zoning, the town ensures that people expect the area to become largely residential, and therefore people are willing to move in 18 18

20. Zoning
Zoning laws
Distinguish industrial areas from residential areas
Nollan v California Coastal Commission (US Sup Ct, 1987)
Nollans owned coastal property
Asked for permit to expand building, which would diminish view
Commission: donate a public walking path, and you get permit
Supreme Court: such a deal only legal if there is clear connection – a nexus – between the harm being done and the remedy
Finally, I’ll mention a 1987 Supreme Court ruling, Nollan v. California Coastal Commission.
The California Coastal Commission is tasked with keeping the California coast looking nice and not allowing it to be spoiled by overdevelopment
The Nollans owned some property along the coast, and had a small beachfront bungalow
They asked the Commission for a permit to expand the building
This would diminish the view of the coast from the road, which the Commission wanted to preserve, so they could have simply said no
Instead, however, the Commission made the following offer: donate a public walking path along the beach, and you can have your permit
It’s not uncommon for developers to donate land for public use in exchange for permits. However, the Nollans instead chose to sue the Commission.
The court, by a vote of 5 to 4, ruled for Nollan.
Basically, they said that such a deal was only legal if there was a clear connection – a nexus – between the harm being done (the reduction in the view) and the remedy (the beach path)
If the Commission had asked Nollan for something specifically intended to mitigate the harm – a walking path to a point clear of the house to see the original view, for instance – this would have been fine
But without such a connection, the walking path was an illegal taking. 19 19

21. Zoning
Zoning laws
Distinguish industrial areas from residential areas
Nollan v California Coastal Commission (US Sup Ct, 1987)
Nollans owned coastal property
Asked for permit to expand building, which would diminish view
Commission: donate a public walking path, and you get permit
Supreme Court: such a deal only legal if there is clear connection – a nexus – between the harm being done and the remedy
The logic here is interesting.
It was within the Commission’s power to deny the permit; so all they were doing was offering an outcome that Pareto-dominated that – you get your house, we get our walking path
However, allowing this sort of trading – allowing arbitrary “offsets” to counter regulation – would give the Commission an incentive to enact lots of regulations, just to force property owners to give something up to be exempted from the regulation.
Of course, there’s nothing wrong with allowing an owner to mitigate the harm he was doing, and thus to satisfy the regulation that way; but the court required a clear connection (again, a nexus) between the harm and the remedy, in order to discourage the abuse of regulatory power.
(Cooter and Ulen make the case that by forbidding a Pareto-improving exchange, the court went too far, and could have discouraged abuse in other ways. They suggest the Court could have given the Nollans the choice between remedying the harm (doing something to improve the view) or creating this unrelated benefit to offset the harm; this would still discourage abuse of regulatory power, but leave both sides better off.) 20 20

22. Property law: the big-picture question
What are benefits and costs of…
having property rights at all?
expanding property rights to cover more things?
introducing an exception/limitation to property rights?
When will benefits outweigh the costs?
To sum up our approach to property law, nearly all the analysis we’ve done has boiled down to two related questions
What are the benefits, and what are the costs, of…
Having a system of property rights in place at all?
Expanding those rights to cover more goods, or more rights?
And introducing an exception or a limitation to these rights?
And in each case, under what conditions are the benefits likely to outweigh the costs?
And with that, I’ll draw a big horizontal line through the page, and say…
End of material on first midterm
Up next: contract law 21 21

23. Contract Law

24. Looking back The question we’ve posed:
Suppose we set up the rules, and then everyone does what’s best for them under those rules.
What rules do we set up, if we want efficient outcomes?
A couple of the ideas we’ve seen so far
Coase: initial rules don’t matter if no transaction costs (if all rights are well-defined and tradeable)
“More complicated” rules (such as more extensive property rights) lead to more efficient use of a resource, but also higher costs
Injunctive relief when transaction costs low, damages when high

25. So far, we haven’t worried about the details of trade
When two parties want to reallocate rights…
I want to buy your used car
Or you want to “buy” my permission to have a noisy party
Or neighbors want to pay a factory to pollute less
…we’ve assumed they can do so…
…subject (possibly) to there being some transaction costs

26. Timing of transactions
Some transactions happen all at once
I hand you a check for $3500, you hand me the keys to your car
There might be search costs and bargaining costs…
…but no enforcement costs
But some don’t
Neighbors pay the factory to pollute less going forward
Need to make sure factory sticks to the agreement
What if technology changes and factory wants to start polluting more again?
In particular, we haven’t worried at all about the timing of transactions

27. Lots of transactions don’t take place all at once
I’m flying to Florida for Spring Break
I hire someone to paint my house…
…or fix my car
I ask you not to have a party on a particular night
I’m flying to Florida for Spring Break
If I were going to literally exchange money for a flight to Daytona Beach, I’d show up for the flight with a pile of $20 bills
And hand them to the gate agent as I boarded the plane? How would I know it was going to take off?
Hand them over as I was getting off the plane? How would the airline trust that I had the money?
Maybe the stewardess could come around in the middle of the flight and collect everyone’s money?
In fact, of course, I pay for the flight weeks in advance
Which means i’m not literally buying a flight
At the time, I was buying a promise of a flight
That is, I give someone (Expedia) money
and in return, they promise to fly me to Florida
now… what happens if they don’t?
Or, I hire someone to paint my house
If I wait till the end to pay him, how will he know I’ll pay?
If I pay him at the beginning, how will I know he’ll show up?
I could pay him each day for that day’s work
But if a half-painted house is worthless to me, he could threaten to quit in the middle, and I might have to agree to pay him more

28. This is what contracts are for
A contract is a promise…
…which is legally binding
Point of contracts: to enable trade when transactions aren’t concluded immediately
Fundamentally, contracts are simply promises
And they solve the problem of how to achieve cooperation or trade when transactions don’t occur all at one time
by giving a way to make a promise legally enforceable
That is, I can promise the painter I’ll pay him once the house is done, and he’ll know this promise is good
Then he can paint my house, knowing he’ll get paid in the end
There are lots of settings where this is what we do
So contracts are legally binding promises, which allow for trade in situations where transactions don’t take place all at once

29. Example: the 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)
A simple example of a situation where legally binding promises are valuable: the agency, or trust, game
Suppose I have an opportunity to make a valuable investment, but I don’t have any money
You have some money, but don’t have access to the investment on your own
You could give me your money, I could invest it for you, and then we could split the proceeds
if you lent me $100, I could invest it, double our money, and promise to give you back $150 and keep $50 for myself.
But without contract law, there’s no way for you to be sure, once I’ve doubled your money, that I’ll choose to give you back your share
We can draw this as a simple game tree:
This is a classic example of an agency game
There’s some surplus we can achieve together, but it requires you to trust me
But if we look at my incentives here once you’ve given me the money, I have no reason to give you your money back
Since you anticipate this problem, you refuse to trust me, so we miss out on this great opportunity.
The important thing to note here:
It’s not just that you’re worse off because you can’t trust me; I’m worse off too
My inability to commit to returning your money causes me to miss out on the investment as well.
So we’d both be better off if there was some way I could commit to returning your money
Subgame perfect equilibrium: I’ll keep all the money; so you don’t trust me
Inefficient outcome (100 < 200)
And we’re both worse off

30. (One solution: reputation)
(One powerful way around this problem is to rely on reputation
If this is a situation we find ourselves in over and over, it becomes valuable to me to be looked at as someone who is trustworthy; that way, you can keep investing your money with me, and we both do better
So if the game is to be repeated many times, we may be able to cooperate even when we could not in a one-shot game
This is part of the success of eBay – realizing that making sellers’ reputations public would give people a strong incentive to behave well
However, many interactions are fundamentally “one-shot” – this is the only time I expect to deal with a person, and the incentives to maintain a good reputation may be too small.)

31. Another solution: legally binding promises
Player 1 (you)
Trust me
Don’t
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(125, 25)
What contract law does is give us a way to make a promise legally binding,
which allows us to change this game into one that has a cooperative solution
Suppose we can sign a contract, under which I am punished if I run off with all the money
The punishment doesn’t have to be too severe – it just has to be bad enough that I’d rather share the gains rather than face the punishment
Suppose that the punishment is that a court steps in and forces me to give you back your $150, and charges each of us an additional $25 fee for doing so
This changes the payoffs, so the game looks like…
Now there is a way for us to cooperate
After the investment, I’m better off giving you back your share of the money
So now you have a reason to trust me, and we get the benefit of the investment.
Like before (with intellectual property), we’ve changed the game so that now, instead of a “bad” equilibrium where we don’t cooperate, it has a “good” equilibrium where we do
So that’s the first purpose of contract law
To allow for efficient trade in situations where this requires some sort of commitment ability, that is, some way to make a promise credible
Now we get cooperation (and efficiency)
Purpose of contract law: to allow trade in situations where this requires credible promises

32. Contract: a legally binding promise
Point of contracts: to enable trade when transactions aren’t concluded immediately
Obvious question: which promises should be legally binding, and which should not?

33. What types of promises should be enforced by the law?
“The rich uncle of a struggling college student learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world.”
“One neighbor offers to sell a used car to another for $ The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back yard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac.”
“A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,” mails $25 and receives in the mail two wooden blocks with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and pay $500 in punitive damages.”
this raises a number of different questions, first among them, exactly what types of promises should be enforced by the law? The textbook motivates the question with three examples
In a little while, we’ll start developing a theory of what contract law should look like for efficiency. But first…

34. The Bargain Theory of Contracts
Before we start talking about what an efficient contract law system would look like,
we’ll discuss an early legal theory of contract law: the Bargain Theory

35. The bargain theory of contracts
Developed in the late 1800s/early 1900s
A promise should be enforced if it was given as part of a bargain, otherwise it should not
Bargains were taken to have three elements
Offer
Acceptance
Consideration
One of the early theories of contract law was developed in the late 1800s and early 1900s: the bargain theory of contracts. The bargain theory determined what promises would be held to be legally binding. The theory was:
A promise should be enforced if it was given in a bargain, otherwise it should not.
A bargain was taken to have three elements – that is, at its core, there are three things that must be present for a bargain to have occurred, and therefore for a promise to be enforceable under this theory:
offer; acceptance; consideration
“Offer” and “acceptance” are pretty clear
One of us approaches the other and offers a deal – “I’ll give you $1000 for that old car.”
The other decides to accept
Of course, this is done differently in different situations
When you walk into a store and see price tags on goods, each of those is an offer to sell you that good at a given price
In an art auction, every time you raise your hand or nod to the auctioneer, you are making an offer to buy the piece up for sale; at some point, when there are no other bidders, the auctioneer accepts your offer
In most states, buying land requires a written contract, which functions as both offer and acceptance.

36. What is consideration? Promisor: person who gives a promise
Promisee: person who receives it
In a bargain, both sides must give up something
reciprocal inducement
Consideration is what the promisee gives to the promisor, in exchange for the promise
Under the bargain theory, a contract becomes enforceable once consideration is given
We refer to the person who gives a promise as the promisor, and the person who receives it as the promisee
In a bargain, both sides must be giving up something
So the promisee must be giving something to the promisor to induce the promise
It could be money – I give you $25 in exchange for the promise to give me a way to kill grasshoppers
It could be goods or services – you give me a car, or paint my house, in exchange for the promise of payment later
It could be another promise – a farmer promises to deliver a certain amount of wheat on a certain date, and a wholesaler promises to pay a certain amount at that time
“Money-for-a-promise”, “goods-for-a-promise,” “service-for-a-promise”, “promise-for-a-promise” all refer to different types of bargains we could reach.
The key is that both of us are giving up something
Bargains involve reciprocal inducement
the promisee gives something to the promisor to induce the promise
and the promisor gives the promise to induce the promisee to give up that thing
Consideration is the legal term for the thing the promisee gives the promisor to induce the promise.
So the payment of $25, given to induce the promise of a way to kill grasshoppers, is consideration
Giving up the car, or painting the house, is consideration for the promise of payment
And the promise of crops is consideration for the promise of payment.
Under the bargain theory of contracts, a promise becomes enforceable once consideration is given, that is, once the promisee gives something to the promisor in exchange for the promise.

37. What is consideration? Promisor: person who gives a promise
Promisee: person who receives it
In a bargain, both sides must give up something
reciprocal inducement
Consideration is what the promisee gives to the promisor, in exchange for the promise
Under the bargain theory, a contract becomes enforceable once consideration is given
Going back to the examples at the beginning
When the rich uncle promised his nephew a trip around the world, no consideration was given – the nephew did not give him anything to induce the promise
So under the bargain theory, the promise is not enforceable
Promises of gifts are generally not enforceable under the bargain theory, since the promisee is not giving anything as inducement, and therefore the promise is not part of a bargain
In the example of the disputed car, although consideration was given, the conditions of offer and acceptance were not met, since the seller was offering one thing and the buyer was accepting another
In Cooter and Ulen’s words, “Without a meeting of the minds, there is no offer and no acceptance, just a failure to communicate.”
In the third example, the seller offered a method for killing grasshoppers, the buyer accepted the offer, and the payment of $25 acted as consideration; so under the bargain theory, this was a valid promise, and therefore enforceable.

38. The bargain theory does not distinguish between fair and unfair bargains
Hamer v Sidway (NY Appeals Ct, 1891)
Uncle offered nephew $5,000 to give up drinking and smoking until his 21st birthday, then refused to pay
“The promisee [previously] used tobacco, occasionally drank liquor, and he had a legal right to do so. That right he abandoned for a period of years upon the strength of the promise… We need not speculate on the effort which may have been required to give up the use of these stimulants. It is sufficient that he restricted his lawful freedom of action within certain prescribed limits upon the faith of his uncle’s agreement, and now, having fully performed the conditions imposed, it is of no moment whether such performance actually proved a benefit to the promisor, and the court will not inquire into it.”
The bargain theory does not distinguish between fair and unfair bargains
That is, even a bargain that is extremely one-sided is considered enforceable under the bargain theory
One example of a court’s refusal to examine whether a bargain was “fair,” and focus only on whether consideration was given
An 1891 case, Hamer v Sidway (New York Court of Appeals)
An uncle promised his nephew $5,000 to give up drinking and smoking until his 21st birthday
When the nephew turned 21, he refused to pay; the nephew sued. The court wrote:
So under the bargain theory, the court should not take a stand on whether a bargain was fair, just whether a bargain occurred.
Which makes sense – it would be difficult, and costly, to enforce a theory that required the court to only enforce fair bargains, since the court would have to calculate the value of the contract to each party and determine what was “fair.”
Modern courts, however, do sometimes refuse to enforce bargains that are completely one-sided. This is the doctrine of “unconscionability”, which we’ll come back to later.

39. Under the bargain theory, what is the remedy?
Expectation damages
the amount of benefit the promisee could reasonably expect from performance of the promise
meant to make the promisee as well of as he would have been, if the promise had been fulfilled
Having answered the question of which promises should be enforceable, the bargain theory also addresses the question of what the remedy should be when an enforceable promise is broken
Since the promisor agreed to the bargain, he owes it to the promisee to make him as well off as had the promise been fulfilled
Since the promise was not kept, however, it is sometimes impossible to calculate exactly what the benefits would be
Under the bargain theory, a promisor who breaches a promise owes the promisee expectation damages – the amount of benefit that the promisee could reasonably expect from the performance of the promise
This still leaves a lot of ambiguity sometimes
With the rich uncle and the college student, the benefit of the trip to the student would depend on the length of the trip, the route, and the quality of accommodations, which were not specified in the contract
The value to the farmer of a means of killing grasshoppers depends on the value of the crop that ended up being destroyed by them.

40. So that’s one early theory
Not that accurate a description of what modern courts actually do
Not always efficient
Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable
The bargain theory, while fairly straightforward, turns out not to be a totally accurate description of how courts actually decide cases
It also turns out not to be a good description of how efficiency-minded courts should behave
There are instances in which, at the time a promise is being made, both the promisor and promisee want the promise to be enforceable
The bargain theory says that the promise is not enforceable unless it arises as part of a bargain
But such a promise may still represent a Pareto-improvement, and therefore, it might be efficient for the legal system to enforce such promises.
An example of this
I’m looking to buy a car, and I test-drive one, like it, but decide to look at a couple others as well
In order to get me to seriously consider the car, the seller might offer it to me at a particular price, and give me a week to decide – allowing me to test-drive a couple other cars, but keeping his in mind as an option
I’d like for this offer to be enforceable – I don’t want to come back a week later and find that he’s changed his mind, or that, knowing I’m ready to buy, he’s raising his price
And he wants this offer to be enforceable – he knows that I’ll only take the offer seriously if I think it’s enforceable, and he wants me to take it seriously
So this is an instance where both sides want the promise to be binding; but because consideration was not given, the bargain theory would not enforce it.

41. So that’s one early theory
Not that accurate a description of what modern courts actually do
Not always efficient
Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable
Does enforce certain promises that maybe should not be enforced
Another example: a rich alumnus promises a large donation to his university, to finance a new building
But it will take him time to liquidate some assets to actually deliver the donation
The university would like to begin construction immediately
And the alumnus, who wants the university to use the money optimally, also wants the university to begin to put the money to use immediately
But since the promise is not enforceable, the university can’t begin construction until the donation arrives
Again, both sides want the promise to be enforceable; but because a gift lacks consideration, the bargain theory would not enforce it.
The bargain theory also demands enforcement of certain promises that on many other grounds should not be enforced
So next, we’ll put aside the bargain theory and consider what efficiency would require of contract law.

42. For efficiency, what promises should be enforced?
And that’s where we’ll begin on Wednesday