Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2017 Lecture 12

Reminder: midterm exam Wednesday • Covers through end of property law, no contract law • Closed book: no books/notes, no calculators • Also: HW2 solutions available after lecture • For now: back to contract law

So far in contract law… • What types of promises should be binding contracts? • Bargain theory: enforce promises that were part of a bargain • Efficiency: enforce if both sides wanted it enforceable when made • Breach of contract • Expectation damages  efficient breach… • …and also efficient investment in performance • Reliance • If investments make performance more valuable, should they increase liability for breach? • Paradox of compensation: no rule guarantees efficient reliance and also efficient breach

Discussion question • Old urban legend: 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?

Hadley v.Baxendale

Paradox of compensation • If we “reward” reliance investments with higher damages, we create incentive for over-reliance • Investments by promisee impose negative externality on promisor, so happen more than the efficient amount • But if damages don’t go up with these investments, then liability for breach is below value of performance • Which means more breach than is efficient, • And less investment in performance than is efficient

What to do about it? • Textbook: “perfect expectation damages” • If reliance was less than or equal to efficient level: damages for breach set to actual benefit from performance • If reliance was more than efficient level: damages are based on efficient level of reliance • Actual courts: include only foreseeable reliance • That is, if promisor could reasonably expect promisee to rely that much

Foreseeable reliance: Hadley v Baxendale • 1850s England • Hadley ran flour mill, crankshaft broke • Baxendale’s firm hired to transportbroken 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

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 contem-plated that the mill owner would suffer those idleness damagesas a result of late delivery.” • To award damages for lost sales, Hadley should have to prove that Baxendale could have predicted those losses

Foreseeable reliance: Hadley v Baxendale • Why didn’t Hadley and Baxendalejust specify in the original contractwhat happens in case of delay? • What rules should apply in circumstances that aren’t addressed in a contract?

DefaultRules

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

Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps • One example: who bears the cost when performance becomes impossible? • I break my hand and can’t build you the airplane • So clearly, I don’t • But, do I owe you damages? Or am I excused from performing?

So, how should we fill these gaps? • Why are gaps left? • Because it wasn’t worth the cost to fill them • Normative Coase: design law to minimize transaction costs • In this case: make it “safe” to leave gaps in contracts • How to do this? • When there’s a gap in a contract… • …impute the rule the parties would have wanted, if they had chosen to think about this issue • What would the parties have wanted? Whatever was efficient!

Efficient contracts • Example • A family hires a construction company to build a house • Risk a worker strike might cause a delay • 1 in 50 chance of a strike • If company is responsible, they’ll have to pay for a hotel for the family, cost of $3,000 • If not responsible, family can stay with friends, cost of $1,000 • Expected cost is $60 if company bears it, $20 if family does • Efficient contract would make company not responsible • (If family was paying X for the house and company was liable for delay, BOTH parties would prefer a price of X – 40 and the company not being liable!)

Efficient contracts • Efficient contracts generally allocate each risk to whoever can bear (or prevent, or hedge) that risk at least cost • Sometimes called “low-cost avoider” • So, textbook argues: default rule should be to allocate risks that way • If something happens that wasn’t specified in the contract… • …figure out what efficient rule would have been… • …and allocate the loss to whoever the efficient contract would have allocated the risk!

Complications • Don’t want ambiguity in the law • Don’t want similar cases to be decided differently, since this would make contract law unpredictable • So default rule can’t vary contract by contract • 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 • If risk was unforeseen, might make sense to compensate party for bearing the risk

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?

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.”

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?

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?

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 • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules • Do this by imputing the terms most parties would have chosen if they had addressed this contingency • But there’s also a different view…

PenaltyDefaults

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”

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 holds Baxendale liable… • Hadley has no need to tell him the shipment is urgent • Baxendale doesn’t know and bad outcome is reached • If default rule doesn’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!

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

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

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

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.”

When should a contractnot be enforced?

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… • In general: 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

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

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

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 NBAPAaccepts a CBA paying less than 55%of BRI in player salaries, then we alsoagree that all non-retired players will work for you as coal miners everyoffseason at federal minimum wage.” • Purpose is purely to “bind hands” innegotiations with ownership • Contract would not be enforced

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

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.

Ways to get outof a contract

Formation Defenses and Performance Excuses • Formation defense • Claim that a valid contract does not exist • (Example: no consideration) • Performance excuse • Yes, a valid contract was created • But circumstances have changed and I should be allowed to not perform 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

One formation defense: incompetence • Courts will not enforce contracts with peoplewho can’t be presumed to be rational • Children • Legally insane • Incompetence • One party was “not competent to enter intothe agreement” • No “meeting of the minds”

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

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.”

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

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 Kazakh 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

Econ 522 Economics of Law