Econ 522Economics of Law

Dan Quint

Fall 2009

Lecture 12

2

Midterm will be returned Thursday

HW2 is up – due Tuesday, November 3 (11 a.m. sharp)

Second midterm (on contract law) Thursday, November 5

Logistics

3

The game: Players A and B each start with $10 Player A gives x to player B, which gets tripled Player B gives y back to player A, keeps 10 + 3x – y

The treatments: Totally anonymous: done randomly, on paper, with SID (no names) In pairs, face to face, but with strategies written down In pairs, out loud, in front of whole class

In-class experiment from Thursday…

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In anonymous version, trust was a problem, but not a huge problem Average A transferred $7.21, got back $7.92 So over 70% of gains from cooperation realized But, of those Player A’s who sent anything, 19% got back nothing, and

30% got back less than they gave

Communication more important than public shaming “Out loud”: average A transferred $7.67, all got back more than they

gave “Face to face, in private”: full efficiency – all 7 A’s transferred $10, all 7

got back either $15 or $20

The results

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The results

40.021.418.618.610.0Face to Face

35.320.015.313.07.7Out Loud

34.423.710.77.97.2Anonymous

Average Combined

Average B Payoff

Average A Payoff

Average B Transfer

Average A Transfer

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The raw data

0

2

4

6

8

10

12

14

16

18

20

0 1 2 3 4 5 6 7 8 9 10

Player A Sent...

Pla

yer

B R

etu

rned

...

Anonymous (56)

Face to Face (7)

Public (3)

1x, 2x, 3x

7

Something I found funny (anonymous treatment)

97%42%42%29%2410

128%66%21%10%291 – 9

33%0%67%30

“Average return”

% that got more than they gave

% that got less than they gave

% that got nothing

back

Observa-tions

Player A gave

8

Something I found funny (anonymous treatment)

97%42%42%29%2410

113%50%21%14%147 – 9

151%87%13%0%84 – 6

132%71%28%14%71 – 3

33%0%67%30

“Average return”

% that got more than they gave

% that got less than they gave

% that got nothing

back

Observa-tions

Player A gave

9

Something I found funny (anonymous treatment)

-2

0

2

4

6

8

10

0 1 2 3 4 5 6 7 8 9 10

Player A's Transfer

average B transfer

average A payoff

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Back tocontract law

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Default rules versus regulations/immutable rules

Contracts that are not enforcable: derogation of public policy

Ways to get out of a contract: formation defenses and performance excuses Incompetence (But not drunkenness) Dire constraints: duress and necessity Today: more of these

Thursday...

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When performance becomes impossible, should promisor owe damages, or be excused from performing?

A perfect contract would explicitly state who bears each risk

Contract may give clues as to how gaps should be filled

Industry custom might be clear

But in some cases, court must fill gap

Next doctrine for voiding a contract: impossibility

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In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach

But there are exceptions Change “destroyed a basic assumption on which the contract was

made”

Next doctrine for voiding a contract: impossibility

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In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach

But there are exceptions Change “destroyed a basic assumption on which the contract was

made”

Efficiency requires assigning liability to the party that can bear the risk at least cost Party that can take precautions to minimize the risk Or can best spread the risk over many transactions

Next doctrine for voiding a contract: impossibility

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Who is the efficient bearer of a particular risk? Also called low-cost avoider Who is in best position to mitigate/reduce a risk, or hedge it, or endure

it?

We already saw this question with efficient default rules When a contract leaves a gap, an efficient contract would have

allocated each risk to low-cost avoider Construction company building a house, completion is delayed

Family might be efficient risk-bearer, because it’s cheaper for them to stay with friends than for construction company to pay for hotel

Cost of raw materials goes up, increasing cost of construction Construction company might be efficient risk-bearer, because they can buy

materials early or change design plans

Important general concept

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

Misinformation

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Fraud violates “negative duty” not to misinform

In some circumstances, positive duty to disclose certain information Civil law: contract may be voided if you did not supply information

you should have (“failure to disclose”) Common law: seller is not forced to disclose everything he knows

Must warn about hidden dangers Need not share information that makes product less valuable but not

dangerous But, new products come with “implied warranty of fitness”

Fraud and Failure to Disclose

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Both parties based a contract on the same bad information contract may be voided due to frustration of purpose

Coronation Cases Rooms rented out with view of new king’s coronation parade Parade was postponed, owners still tried to collect rent Courts ruled change in circumstance had frustrated the purpose of

the original contracts, which were therefore void

“When a contingency makes performance pointless, assign liability to the party who can bear the risk at least cost”

Frustration of Purpose

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Frustration of purpose: circumstances changed after the contract was signed

Mutual mistake: circumstances changed before the contract was signed, but the parties didn’t know about it

Enforcing the contract would be like forcing involuntary exchange Coase: we expect voluntary exchange to be efficient But involuntary exchange may not be

Mutual Mistake

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Hadley v Baxendale (miller and shipper) Hadley knew shipment was time-critical But Baxendale was deciding how to ship crankshaft (boat or train)

A general principle about information: efficiency generally requires uniting knowledge and control Contracts that unite knowledge and control are generally efficient,

should be upheld Contracts that separate knowledge and control may be inefficient,

should more often be set aside

Another principle: knowledge and control

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Mutual mistake: neither party had correct information Contract neither united nor separated knowledge and control

Unilateral mistake: one party has mistaken information I know your car is a valuable antique, you think it’s worthless You sell it to me at a low price

Contracts based on unilateral mistake are generally upheld

Unilateral mistake

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Mutual mistake: neither party had correct information Contract neither united nor separated knowledge and control

Unilateral mistake: one party has mistaken information I know your car is a valuable antique, you think it’s worthless You sell it to me at a low price

Contracts based on unilateral mistake are generally upheld Contracts based on unilateral mistake generally unite knowledge and

control And this creates an incentive to gather information

Unilateral mistake

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War of 1812: British blockaded port of New Orleans Price of tobacco fell, since it couldn’t be exported

Organ (tobacco buyer) learned the war was over Immediately negotiated with Laidlaw firm to buy a bunch of tobacco

at the depressed wartime price

Next day, news broke the war had ended, price of tobacco went up, Laidlaw sued Supreme Court ruled that Organ was not required to communicate

his information

Unilateral mistake: Laidlaw v Organ (U.S. Supreme Court, 1815)

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Productive information: information that can be used to produce more wealth

Redistributive information: information that can be used to redistribute wealth in favor of informed party

Cooter and Ulen Contracts based on one party’s knowledge of productive information –

especially if that knowledge was the result of active investment – should be enforced

Contracts based on one party’s knowledge of purely redistributive information or fortuitously acquired information should not be enforced

Unilateral mistake: productive versus redistributive information

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Sellers must inform buyers about hidden safety risks

Common law does not generally require disclosure of other types of information

But… Obde v Schlemeyer (1960) Seller knew building was infested with termites, did not tell buyer Termites should have been exterminated immediately to prevent

further damage Court in Obde imposed duty to disclose Sale did not unite knowledge and control

More on duty to disclose

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Sellers must inform buyers about hidden safety risks

Common law does not generally require disclosure of other types of information

But… Obde v Schlemeyer (1960) Seller knew building was infested with termites, did not tell buyer Termites should have been exterminated immediately to prevent further

damage Court in Obde imposed duty to disclose Sale did not unite knowledge and control Many states require used car dealers to reveal major repairs done,

sellers of homes to reveal certain types of defects…

More on duty to disclose

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Courts will generally not enforce contract terms that are overly vague

Can be thought of as a penalty default

But some exceptions Parties may commit to renegotiating the contract “in good faith”

under certain contingencies

Vague contract terms

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Bargain theory: courts ask only whether a contract was part of a bargain, not whether that bargain was fair Hamer v Sidway (drinking and smoking)

But two common law doctrines to get out of extremely one-sided contracts Adhesion Unconscionability

Fairness

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Adhesion: standardized “take-it-or-leave-it” contracts Friedman calls it “bogus duress”

Adhesion and unconscionability

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Adhesion: standardized “take-it-or-leave-it” contracts Friedman calls it “bogus duress”

Unconscionability Overly one-sided contract may not be enforced Terms “such that no man in his senses and not under delusion would

make on the one hand, and as no honest and fair man would accept on the other”

When “the sum total of its provisions drives too hard a bargain for a court of conscience to assist”

Terms which would “shock the conscience of the court” Similar concept in civil law: lesion

Adhesion and unconscionability

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“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.

…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)

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“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.

…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)

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“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.

…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

Not normal monopoly cases but “situational monopolies” Think of Ploof v Putnam (sailboat in a storm)

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)

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Remedies for breachof contract

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Party-designed remedies Remedies specified in the contract

Court-imposed damages Court may decide promisee entitled to some level of damages

Specific performance Forces breaching party to live up to contract

Three broad types of remedy for breach of contract

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Compensate promisee for the amount he expected to benefit from performance You agreed to buy an airplane for $350,000 You expected $500,000 of benefit from it Expectation damages: if I breach, I owe you that benefit ($500,000 if you already paid, $150,000 if you didn’t)

“Positive damages”

Make promisee indifferent between performance and breach

Expectation damages

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Reimburse promisee for any reliance investments made, but not for additional surplus he expected to gain

Restore promisee to level of well-being before he signed the contract You contracted to buy the plane and built a hangar If I breach, I owe you what you spent on the hangar, nothing else

“Negative damages” – undo the negative (harm) that occurred

Reliance damages

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Give promisee benefit he would have gotten from his next-best option Make promisee indifferent between breach of the contract that

was signed, and performance of best alternative contract You value plane at $500,000 You contract to buy plane from me for $350,000 Someone else was selling similar plane for $400,000 By the time I breach, that plane is no longer available I owe you $100,000 – the benefit you would have gotten from

buying the other seller’s plane

Opportunity cost damages

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You agree to sell me ticket to Wisconsin-Michigan football game for $50 Expectation damages: you owe me value of game minus $50 If I pay scalper $150, then expectation damages = $100 Reliance damages: maybe 0, or cost of face paint and giant foam

finger

Example: expectation, reliance, and opportunity cost damages

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You agree to sell me ticket to Wisconsin-Michigan football game for $50 Expectation damages: you owe me value of game minus $50 If I pay scalper $150, then expectation damages = $100 Reliance damages: maybe 0, or cost of face paint and giant foam

finger When you agreed to sell me ticket, other tickets available for $75 Opportunity cost damages: $75 (I paid a scalper $150 to get in; I would have been $75 better off if

I’d ignored your offer and paid someone else $75)

Example: expectation, reliance, and opportunity cost damages

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Ranking damages

ExpectationDamages

Opportunity CostDamages

RelianceDamages

ContractI Sign

BestAlternative

Do Nothing

Breach +ExpectationDamages

Breach +Opportunity Cost

Damages

Breach +RelianceDamages

$100 $75 $0-20

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Hawkins had a scar on his hand

McGee promised surgery to “make the hand a hundred percent perfect”

Surgery was a disaster, left scar bigger and covered with hair

Hawkins v McGee (“hairy hand case”)

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Hawkins v McGee (“hairy hand case”)

Hairy Scarred Nextbest

doctor

Perfect

$

Hand

Initial Wealth

+ Reliance Damages

+ Opp Cost Damages

+ Expectation Damages

Rel

ianc

e D

amag

es

Opp

Cos

t Dam

ages

Exp

ecta

tion

Dam

ages