1. Econ 522 Economics of Law
Dan Quint
Fall 2015
Lecture 12

2. Announcements
Office hours cancelled this week, should be back to normal next week
HW2 scores online
MT2 scores should be online in the next day or two, I’ll send out an when they are
Bluebooks will be returned on Wednesday
OK, back to contract law…

3. So far in contract law…
What types of promises should be binding contracts?
Breach of contract
Reliance
How liability for breach creates incentive for both, paradox of compensation
Default rules
C&U: impute the rule the parties would have wanted and apply that
That’s whatever rule would have been efficient – allocating each risk to whoever can bear it most cheaply
Ayres/Gertner: use default rule to “penalize” one or both
Create incentive for one party to reveal information, or for both parties to address contingency in contract

4. Discussion question Old urban legend: Serious question:
A man bought a box of extremely rare and expensive cigars, and insured them against loss or damage.
After smoking them, he filed an insurance claim, saying they had been destroyed in 20 separate small fires.
The insurance company refused to pay, the man sued and won.
But as he was leaving the courtroom, he was arrested on 20 counts of arson.
Serious question:
If the intent of a contract is clear, but different from the literal meaning, which should be enforced?

5. Wrapping up “penalty defaults”

6. Penalty defaults
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

7. 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 Baxendale doesn’t know and bad outcome is reached
If default rule didn’t hold Baxendale liable for unforeseen damages, Hadley would have to tell him about urgency…
…leading to Baxendale making more efficient choices (trading off cost vs speed/reliability correctly)
Even though it’s efficient for Baxendale to bear risk, efficient default rule might instead “penalize” Hadley for withholding 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)

8. 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.

9. When should a contract not be enforced?

10. When should voluntary trade not be allowed?
Going back to property law…
Coase Theorem: to get efficient outcomes, we should let people trade whenever they want to
But also saw some exceptions – some trades that aren’t, and shouldn’t, be allowed
Selling enriched uranium to a terrorist
Similarly with contract law…
First day: to get efficient outcomes, enforce any contract both parties wanted enforced
But next, we’ll see exceptions – contracts which shouldn’t be enforced, due to externalities or market failures/transaction costs

11. Example of an unenforceable contract: a contract which breaks the law
Obvious: contract to buy a kilo of cocaine is unenforceable
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

12. 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

13. 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.
(Also note for efficiency, we should be skeptical of contracts that impose externalities on people who aren’t parties to the contract…)

14. 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

15. 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.

16. Ways to get out of a contract

17. Formation Defenses and Performance Excuses
Claim that a valid contract does not exist
(Example: no consideration)
Performance excuse
Yes, a valid contract was created
But circumstances have changed and I should be allowed to not perform without penalty
Most doctrines for invalidating a contract can be explained as either…
Individuals agreeing to the contract were not rational, or
Transaction cost or market failure
Next, I want to discuss a number of ways to get out of a contract, that is, conditions under which a contract will not be enforced.
These are typically divided into two categories: formation defenses and performance excuses
A formation defense is a claim that a contract does not exist: that the requirements for a contract to be valid were not met
(Under the bargain theory, for example, a formation defense might be that consideration was not given.)
A performance excuse is a claim that, even though a valid contract was created, circumstances have changed and you should be excused from performing
We said earlier that, under Coase, when individuals are rational and there are no transaction costs, voluntary negotiations should lead to efficiency
So refusing to enforce voluntary contracts would not make sense
Thus, most of the doctrines for invalidating a contract can be explained as a violation of one of these assumptions
either the individuals agreeing to the contract were not rational
or there was some sort of transaction cost or market failure

18. One formation defense: incompetence
Courts will not enforce contracts with people who can’t be presumed to be rational
Children
Legally insane
Incompetence
One party was “not competent to enter into the agreement”
No “meeting of the minds”
The first exception is that courts will generally not enforce contracts made by people who can’t be assumed to be rational. For example:
children cannot sign binding contracts
the legally insane cannot sign binding contracts
For example: this article (about a month old) is about 7-year-old who was messing around on eBay and hit the “buy it now” button for a decommissioned Harrier fighter jet selling for 70,000 pounds, or a bit over $100,000.
His father saw what he’d done and contacted the seller to apologize, and the seller, very reasonably, just re-listed the plane and sold it to another bidder
But if the seller had tried to hold the son to the deal, he would have failed
Contracts with children, and with the legally insane, can be invalidated under the doctrine of incompetence: one party to the contract was not competent to enter into a binding agreement
In fact, the law does not automatically invalidate all contracts made with children or insane people
It only invalidates contracts which were not in their best interests
(Basically, the law creates an incentive not to cheat people who can’t take care of themselves.)

19. So…
If courts won’t enforce a contract signed by someone who wasn’t competent…
What if you signed a contract while drunk?
You need to have been really, really, really drunk to get out of a contract
(“Intoxicated to the extent of being unable to comprehend the nature and consequences of the instrument he executed”)
Lucy v. Zehmer, Virginia Sup Ct 1954
The first time I taught this course, after I introduced the doctrine of incompetence, one of my students ed me an excellent question: what if you signed a contract while drunk?
Can a drunk person sign a legally enforceable contract?
or would the fact that he was drunk get him off the hook?
We mentioned that the bargain theory required a “meeting of the minds” to agree to a contract
It’s reasonable to question whether this could occur with someone who was drunk
However, the general rule in the U.S. is this:
You have to be really, really, really drunk for the contract not to count.
OK, that’s not how it’s written in the case law
The rule is, for a contract to be unenforceable, you need to have been “intoxicated to the extent of being unable to comprehend the nature and consequences of the instrument he executed.”
Basically, not just drunk enough to have bad judgment, but drunk enough to have no idea of what you’re doing
There’s a classic case that upheld this standard, Lucy v Zehmer, decided by the Supreme Court of Virginia in 1954
It’s a little embarrassing when your drunken antics end up in front of a state supreme court
But the case makes for really fun reading

20. Lucy v. Zehmer
Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time
While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”
“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”
The Zehmers owned a farm
Lucy had been trying to buy it from them for a long time
(They had made multiple offers, over several years, beginning at $20,000.)
One night, Zehmer’s out drinking, and he runs into Lucy
They continue to drink, and at some point, Lucy says something like, “I bet you’d sell that farm for $50,000.”
Zehmer says, “You don’t have $50,000.” Lucy says, “I can get it!”
Zehmer says, “No you can’t!”
They argue for a while about whether Lucy would be able to raise $50,000
And eventually Lucy says, “Write it down!”
Zehmer grabs a discarded guest check (seriously), turns it over, writes on the back, “We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,000, title satisfactory to buyer”
(It appears from the trial proceedings that there were two drafts. In the first, the name of the farm and the word “satisfactory” were both misspelled. Also, the first draft originally said “I agree,” to which Lucy pointed out that Zehmer’s wife co-owned the farm; Zehmer crossed off the “I” and wrote “We”)
So, Zehmer writes this contract and signs it; then he walks to the other end of the bar where his wife is sitting
He tells her to sign it, she says, “What?”
He whispers to her, don’t worry, it’s just a joke, we’re not selling the farm
So she signs it
He brings it back, Lucy takes the contract and puts it in his pocket

21. Lucy v. Zehmer
Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time
While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”
“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”
That was Saturday. Sunday, Lucy calls his brother and gets him to put up half the money. Monday, Lucy goes to the registry of deeds to check the title, and then contacts Zehmer to carry out the contract
Zehmer claims he was drunk, and joking, and refuses to honor the contract
Lucy sues for specific performance, that is, asks the court to force Zehmer to sell him the farm at the agreed price
There was some dispute during trial about exactly how drunk Zehmer was
But it was ruled that while he was clearly drunk, he was not so drunk as to be “unable to comprehend the nature and consequences” of what he was doing
(For one thing, a little while later, his wife asked him to drive her home.)
Most of the opinion focuses on whether Lucy knew that Zehmer was joking when he wrote what looked like a proper, if unusual, legal contract
Zehmer claimed the whole thing was “a bunch of two doggoned drunks bluffing to see who could talk the biggest and say the most”
The court basically ruled that it wasn’t Lucy’s job to know Zehmer was joking
That is, Zehmer may have thought he was joking, but it looked to Lucy like he was serious
Zehmer behaved exactly as he would have behaved if he were drunk but actually wanted to sell the farm; which was good enough.

22. Lucy v. Zehmer
So, you can be pretty drunk and still be bound by the contract you signed
Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
You may think, being drunk, Zehmer lacked the necessary intent to enter into a contract
Still, it probably makes sense not to make it too easy to invalidate a contract on the grounds that one of the parties was drunk, or joking
If the ruling went the other way, it seems there would an awful lot of litigation over exactly how drunk someone was when a contract was signed
Not to mention a lot more contracts being signed in bars, to give the parties an easy way out
Or maybe a lot of lawyers carrying breathalyzers to make sure their contracts would be enforceable
Basically, a more nuanced rule would be extremely difficult and costly to enforce
So we seem to accept the cost of an occasional person making a bad decision while drunk, in order to keep the system working well the rest of the time.
However, that’s not quite the final word on drunkenness
If you were visibly drunk – that is, the other party clearly knew you were drunk – the court might be more willing to finding the contract unenforceable on other grounds (which we’ll get to shortly)
such as fraud (you were tricked into signing)
or unconscionability (the contract is too one-sided)
If Zehmer had agreed to sell the farm for $10, the contract probably would not have been upheld
But since the terms seemed reasonable, it was

23. Lucy v. Zehmer
So, you can be pretty drunk and still be bound by the contract you signed
Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
Borat lawsuits
Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk Journalist for Make Benefit Guileless Americans In Film”
Moral of the story: don’t get drunk with people who might ask you to sign a contract
There’s also a more recent example of the doctrine that being drunk does not get you out of a contract: the Borat lawsuits
After the movie Borat came out a few years ago, two of the frat boys who ended up looking like racist a-holes sued
They claimed they were tricked into signing the releases agreeing to be in the movie
It seems the movie’s producers got them drunk and then asked them to sign the releases
And also lied to them a lot – saying the movie was only going to be released in Europe, they wouldn’t use the frat boys’ names, or college, or frat
Part of the problem for them is that the releases contained what are called “merger clauses”
Merger clauses basically say, it doesn’t matter what else we already told you, all we’re agreeing to is what’s in this contract
(Basically, any prior verbal agreement is “merged into” this contract, which is all we’re agreeing to.)
It’s kind of sneaky, but it does seem to legally absolve the producers of anything they told the frat boys to get them to sign but that wasn’t in the contract
Again, just being drunk doesn’t get you out of a contract
One of the fratboys seemed to find it relevant that he was under the drinking age; but that, if anything, would make the producers liable in criminal court (for supplying alcohol to a minor), but not invalidate the releases
(It’s also been established that the frat boys were all already heavy drinkers, unsurprisingly.)
Last I heard, the lawsuits have all been dismissed, and the frat boys got nothing.
(Since they’re not in the textbook; for the opinion in the Lucy v Zehmer case, which really does make great reading, see
For an overview of the legal issues in the Borat lawsuits, see a piece by Julie Hilden, with the brilliant title “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for Make Benefit Guileless Americans in Film” at
Moral of the story: don’t get drunk with people who might ask you to sign contracts.

24. Another formation defense: dire constraints

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

40. Who is the efficient bearer of a particular risk?
Friedman offers several bases for making this determination
Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Friedman offers several ways to figure out who this is
First: spreading losses
“Suppose I am having a house built by a large firm that builds many houses each year.
There is some risk that the house might burn down while it is being built.
We could allocate that risk either to me, by specifying that I will have to pay for the additional construction costs in such a case, or to the builder.
Since the builder is building many houses in different places, he can spread the risk; I cannot.
From that standpoint at least, our contract should specify a fixed price, whether or not something goes wrong.
If the contract does not specify who bears the risk, risk spreading provides an argument for assigning it to the builder.”
Second: who is in a better position to influence the outcome?
“In the case of a firm that builds houses the two arguments go in the same direction.
The builder is not only in a better position than I am to spread the risk, he is also in a better position than I am to keep the house from burning down while he is building it.”
(This is the argument that Baxendale should have borne the risk of a shipping delay – he’s the one who decided how to ship the broken crankshaft, so his actions influenced the outcome.)

41. Who is the efficient bearer of a particular risk?
Friedman offers several bases for making this determination
Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Adverse selection: who is more aware of risk, even if he can’t do anything about it?
“…The party with control over some part of the production process is in a better position both to prevent losses and to predict them.
It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”
For the third rule, Friedman gives the following question.
I promise to sell you 10,000 widgets; a drunk driver crashes into my factory, destroying half of them. I deliver them late, costing you money. Do I owe you damages?
“A third factor in allocating risk is adverse selection.
…I did not know that that particular drunk driver was going to crash through that particular wall.
But I probably do know a good deal more than you do about the chance that something – accident, strike, or bad planning – will prevent me from delivering the widgets to you on schedule.
If our contract makes me liable for the resulting loss, you don’t have to worry about that risk in deciding whom to buy your widgets from. You know what price I am charging, and you know that I am insuring you against the risk of nondelivery.
If the contract specified that you had to bear the risk, you would need to know the reliability of alternative sellers as well as their price in order to decide which one is offering the best deal.
“As this example suggests, moral hazard and adverse selection tend to cut in the same direction.
As a general rule the party with control over some part of the production process is in a better position both to prevent losses and to predict them.
It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”

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