1. Econ 522 Economics of Law
Dan Quint
Spring 2012
Lecture 11

2. Contract law: the story so far
Contract = legally binding promise
Allow for cooperation/trade when transactions aren’t instantaneous
First purpose of contract law: enable cooperation
What promises should be enforced?
Bargain theory: those given as part of a bargain
Requires consideration – promisee giving up something in exchange for the promise
Efficiency: any promise both promisor and promisee wanted to be enforceable
Think of Coase – allow all voluntary transactions to get to efficiency
Why do we need contracts?
…agency game: my inability to commit to a future action led to a breakdown in cooperation
…first purpose of contract law: enable cooperation, in settings where trade does not occur all at once

3. Contract law: the story so far
May become efficient/necessary to break a promise
When should a contract be breached? Breach is efficient when
cost to perform > benefit of performance to promisee
When will breach happen? Breach is in promisor’s interest when
cost to perform > promisor’s liability from breach
Expectation damages: liability from breach = benefit expected by promisee
Leads to breach exactly when it’s efficient
Also leads to efficient level of investment in performance
“Designing the law to internalize an externality”
What else can contract law accomplish?
Next, we introduced the idea that even after a promise was made in good faith, it might become efficient for it to be broken
And there are a couple of reasons why we may not want the punishment for doing so to be too severe
If the penalty for breach of contract is very severe and transaction costs to renegotiate are high, I might get stuck performing on a contract even when that’s inefficient
And even when the transaction costs are low, the penalty would effect my threat point; and if I would have to pay a lot to get out of a contract, I might be afraid to sign the contract in the first place
So now we’ve seen, contract law can…
- allow for non-simultaneous trade, which turns some settings with “bad” equilibria into settings with “good” equilibria
- encourage efficient disclosure of information
- create incentives for efficient breach of contract, and efficient investment in performance
What else can contract law accomplish?

4. Reliance

5. Reliance You expect an airplane to arrive in spring – you might…
Sign up for flying lessons
Build yourself a hangar
Buy a helmet and goggles
Reliance – investments which depend on performance
Reliance increases the value of performance to promisee
Reliance increases the social cost of breach
The fourth purpose of contract law is to secure optimal reliance
I’m an airplane builder
You come to me in the fall and order an airplane, which I will build over the winter and deliver in the spring
Now that you’re expecting an airplane in the spring, there are a bunch of things you might do
You might sign up for flying lessons
You might build yourself a hangar – a covered parking space for the plane – so that your plane doesn’t get rained on after I deliver it
You might buy an awesome leather helmet and aviator goggles, so you can look like this guy
Similarly, the farmer who has mailed in a check for $25 for a sure means to kill grasshoppers might plant more crops, since he’s no longer worried about the risk of grasshopper damage
Similarly, the nephew whose uncle promised him a trip around the world might go out and buy a backpack, or a linen suit to wear in the tropics
These are all examples of reliance – investments whose value depend on performance of the promise
(An airplane hangar is very valuable if you end up with an airplane, and worthless otherwise)
Or to put it another way, reliance is any investment which increases the value of performance to the promisee
(An airplane is more valuable if you already have a hangar)
Is reliance a good thing?
well, in some cases, it may be cheaper to make these investments ahead of time
if you wait to build a hangar until I deliver your airplane, the plane might get damaged in a hailstorm before the hangar is complete
if the nephew waits to buy a linen suit until his uncle sends him plane tickets, he might miss a big spring sale
On the other hand, we know that the promisor may not always perform (and that this may be OK)
So reliance investments are not a sure thing – if I fail to keep my promise, your investment in reliance is lost
Or, since reliance increases the value of performance, it also increases the social cost of breach – you’ve built a hangar for nothing, or you resell the helmet and goggles at a loss
And this brings us to:
The fourth purpose of contract law is to secure optimal reliance.

6. When is reliance efficient?
When social benefit of reliance > social cost of reliance
Social benefit: increased benefit to promisee
(Value of airplane + hangar) – (Value of airplane without hangar)
Value is only realized if the promise is performed
Social cost: direct cost borne by promisee
Cost occurs whether or not promise is performed
Reliance is efficient whenever
(True of both discrete choices – whether or not to build a hangar – and also on the margin, for continuous choices)
Increase in value of performance
Probability of performance
Cost of investment X
>

7. How should reliance figure into damages?
Expectation damages = expected benefit from performance
If your reliance investment increases your anticipated benefit…
should it increase the damages I owe you if I breach?
Can we design damages to get efficient reliance, in addition to efficient breach?

8. Reliance and damages: example
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
Reliance and damages: example
You’re buying an airplane from me
Price is $350,000, to be paid on delivery
Airplane alone gives you benefit of $500,000
Building a hangar costs $75,000
Airplane with hangar gives you benefit of $600,000
Without hangar, expectation damages = $150,000
If you build a hangar and I fail to deliver plane, do I owe…
$150,000? (Value of original promise)
$250,000? (Value of performance after your investment)
$225,000? (Value of original promise, plus reimburse you for investment you made)
Some other amount?

9. To get efficient breach…
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
To get efficient breach…
The only way to guarantee efficient breach is if damages included the added benefit from reliance
Once you’ve made investment, you anticipate benefit of $250,000 from performance
If damages are anything less than that, I’ll breach too often
(If damages exclude the added benefit, then I’m back to imposing an externality when I choose to breach the contract)
So what happens to the incentive for reliance investments if damages will increase to include this added benefit?

10. If exp damages include benefit from reliance…
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
If exp damages include benefit from reliance…
If you don’t build hangar, your payoff will be…
$150,000 if I deliver the plane ($500,000 – $350,000)
$150,000 if I breach and pay expectation damages
If you build hangar, your payoff will be…
$175,000 if I deliver the plane ($600,000 – $350,000 – $75,000)
$175,000 if I breach and pay (higher) expectation damages
So if expectation damages include the increased value of performance due to reliance investments…
You’ll invest whenever (increase in benefit) > (cost)
In this case, you’ll invest (because $100,000 > $75,000)

11. If exp damages include benefit from reliance…
Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000
If exp damages include benefit from reliance…
If expectation damages include increased value of performance, you’ll invest for sure
Is this efficient?
Reliance is efficient if
(increase in benefit) X (probability of performance) > (cost)
$100,000 X (probability of performance) > $75,000
Only efficient if probability of performance > ¾
If probability of performance < ¾, reliance is inefficient, but happens anyway
Overreliance!

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

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

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

15. X + X > X > Overreliance
If reliance investments increase the damages you’ll receive in the event of breach, you’ll over-rely
You’ll rely if
Efficient to rely if
So if damages increase when you make reliance investments, we’re sure to get overreliance!
(Your investment imposes an externality on me)
Increase in benefit X
Prob. of perform. +
Increase in damages X
Prob. of breach
>
Cost of investment
Increase in benefit X
Prob. of perform.
>
Cost of investment

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

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

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

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

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

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

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

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

24. Default rules
Gaps: risks or circumstances that aren’t specifically addressed in a contract
Default rules: rules applied by courts to fill gaps
Writing something into a contract vs leaving a gap
Allocating a risk (ex ante), before it becomes a loss
Versus allocating a loss (ex post)
Only have to deal with it if the loss occurs
The decision to leave a gap or to fill it (specifically address a particular contingency) is the difference between allocating a loss after it has occurred (ex post) and allocating a risk before it becomes a loss (ex ante)
At the time I agree to build you an airplane, there is some risk that the cost of raw materials will go up
We can choose to worry now about who should bear that risk
Or we can leave it out of the contract, and if that risk becomes a loss (that is, if the costs do go up), then we can worry about who should bear the loss
In the first case, allocating the risk, the cost of adding it to the contract is definitely incurred
But in the second case, allocating a loss that has occurred, the cost of allocating the loss is only incurred when the loss occurs
Thus, it is often rational to leave gaps when the risk is very remote
But this means that courts must decide what rules should fill the gaps that are left in imperfect contracts
So… what should these default rules be?
We will look at two different views of this

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

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

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

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

29. Default rules
Example: probability ½, the cost of construction will increase by $2,000
Construction company can hedge this risk for $400
Family can’t do anything about it
Price goes up – who pays for it?
Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction company
Should prices be adjusted to compensate?
First, the court must decide to whom the contract would have allocated this risk, if it had addressed it.
Then it must adjust prices to reflect this.
In this case, the cost of bearing the risk would be $1,000 to the family (since they have no way to mitigate it), but $400 to the company (since hedging the risk is cheaper than bearing it)
So the company is the efficient bearer of the risk
That is, an efficient contract would have allocated this risk to the construction company
Next, the court must consider whether the price should be adjusted
In this case, the court might rule that the risk of a spike in copper prices was foreseeable
The construction company foresaw, or should have foreseen, that this risk was present
So the court could assume that the price the parties negotiated already included compensation for bearing this risk

30. Default rules
Example: probability ½, the cost of construction will increase by $2,000
Construction company can hedge this risk for $400
Family can’t do anything about it
Price goes up – who pays for it?
Construction company is efficient bearer of this risk
So efficient contract would allocate this risk to construction company
Should prices be adjusted to compensate?
On the other hand, there are some risks that are unforeseeable
Suppose that the leader of the copper miners’ union in Peru died, and there was a battle to succeed him, and that his replacement called a strike to flex his muscles, and that this strike was what led to the increase in copper prices
Here, it’s reasonable that neither party would have foreseen the risk.
In this case, the construction company might still be the efficient bearer of this risk – since they might be able to make changes to the construction plan to use less copper and more of other materials
But since the risk was unforeseen, it was not included in the negotiated price
So the court might adjust the price paid to the construction company, to compensate them for the risk; but then still hold the construction company responsible for the extra $2,000 in costs
Thus, the ruling might be that the family should pay some smaller amount – say, $700 – which is what the company would have needed to receive as compensation for bearing this risk – but that the company was then responsible for the rest of the $2,000.
(The book then continues this story to give another example of overreliance and breach – check it out if you’re still confused about these points.)

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

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

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

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

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

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

37. When to use penalty defaults?
Look at why the parties left a gap in contract
Because of transaction costs  use efficient rule
For strategic reasons  penalty default may be more efficient
Similar logic in a Supreme Court dissent by Justice Scalia
Congress passed a RICO law without statute of limitations
Majority decided on 4 years – what they thought legislature would have chosen
Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…”
“Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.”
Ayres and Gertner do not argue penalty defaults should always be used, only that they are appropriate in certain circumstances
They argue that we need to look at why the parties left a particular gap
When gaps are left due to transaction costs of filling them, efficient defaults make sense
But when gaps are left strategically – by a well-informed party who chooses not to contract around an inefficient default in order to get “a bigger share of a smaller pie” – penalty defaults may be more efficient.
In the conclusion to their paper, Ayres and Gertner cite a similar point from a dissent by Supreme Court Justice Scalia
The legislature had passed a RICO (racketeering/corruption) statute and had not specified a statute of limitations
The Court was therefore being asked to decide on the statute of limitations
The majority set the statute of limitations at 4 years, figuring that’s what the legislature most likely would have chosen had they remembered to specify it
Scalia proposed no statute of limitations
He was “unmoved by the fear that this… might prove repugnant to the genius of our law”
Instead, he pointed out, “indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.”
So his view: rather than do what Congress would have wanted, do something they would not have wanted, to force them to do it themselves next time
Exactly the same idea as a penalty default for a contract
It’s a pretty cool article – take a look if you’re interested.

38. When should a contract not be enforced?

39. When should a contract not be enforced?
We said earlier: in general, efficiency requires enforcing contract whenever both sides wanted it to be enforced
Coase: if people are rational and there are no transaction costs, private negotiations should lead to efficiency…
…so any additional regulations/limitations on trade can only make things worse
But: if a contract imposes externalities, or there are transaction costs or market failures, maybe not
Next: settings where a contract may not be enforced

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

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

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

43. Default rules versus regulations
Talked earlier about default rules
Default rules apply if no other rule is specified…
…but can be contracted around
Rules like “derogation of public policy” cannot be contracted around
Parties to a contract can’t say, “even though this type of contract would normally not be valid, this one is”
Rules which always apply: immutable rules, or mandatory rules, or regulations
Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations.
Next week: other reasons a contract might not be enforced