econ 522 economics of law
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Econ 522 Economics of Law. Dan Quint Fall 2011 Lecture 12. Monday. Reliance Investments which increase value of performance If this increases liability for breach overreliance If it doesn’t inefficient breach Paradox of compensation – unable to set both incentives efficiently - PowerPoint PPT PresentationTRANSCRIPT
Econ 522Economics of Law
Dan Quint
Fall 2011
Lecture 12
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Reliance Investments which increase value of performance If this increases liability for breach overreliance If it doesn’t inefficient breach Paradox of compensation – unable to set both incentives efficiently Courts compensate only for foreseeable reliance
Default Rules Cooter and Ulen: supply rules which most parties would have wanted
(efficient rules) Ayres and Gertner: penalty defaults (penalize the parties for leaving a
gap, or penalize better-informed party)
Monday
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Regulations
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Default rules can be contracted around
Some rules cannot 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. Coase: if people are rational and there are no transaction costs, private
negotiations lead to efficiency So additional regulations/limitations can only make things worse But when people may not be rational, or when there are transaction
costs or market failures, then regulations may help
Default rules versus regulations
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Last week: “for efficiency, enforce any contract which both the promisor and the promisee wanted to be enforceable when it was signed”
Discussion question
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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
Example of a regulation/immutable rule: contracts which break the law
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Labor unions required by law to negotiate “in good faith”
Current NBA labor troubles Old CBA: 57% of “basketball-related income” went to player salaries Owners 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 – example
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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
Derogation of public policy
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Ways to get outof a contract
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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
Formation Defenses and Performance Excuses
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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”
One formation defense: incompetence
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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
So…
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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
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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
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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
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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
Lucy v. Zehmer
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Another formation defense:dire constraints
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Necessity 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
Dire constraints
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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
Friedman on duress
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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
Friedman on duress
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Same logic doesn’t work for necessity You get caught in a storm on your $10,000,000 sailboat Tugboat offers to tow you to shore for $9,000,000 (Otherwise he’ll save your life but let your boat sink)
Duress: if we enforce contract, incentive for more crimes Here: if we enforce contract, incentive for more tugboats to be available for
rescues – why is that bad? Social benefit of rescue: value of boat, minus cost of tow Say, $10,000,000 – $10,000 = $9,990,000 If tugboat gets entire value, his private gain = social gain So tugboat captain would invest the efficient amount in being available to
rescue you So what’s the problem?
What about necessity?
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What about your decision: whether to sail that day 1 in 1000 chance of being caught in a storm If so, 1 in 2 that a tugboat will rescue you Private cost of sailing: 1 in 2000 you lose boat, 1 in 2000 you pay tugboat
captain value of boat $10,000,000/2000 + $10,000,000/2000 = $10,000 So you’ll choose to sail if your value is above $10,000 Social cost: 1 in 2000 boat is lost, 1 in 2000 boat is rescued $10,000,000/2000 + $10,000/2000 = $5,005 Efficient to sail when your value is above $5,005 When your value from sailing is between $5,005 and $10,000, you
“undersail” If the price of being towed was just the marginal cost, your private cost =
social cost and you would sail the efficient amount
What about necessity?
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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’s point
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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
Friedman’s point
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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
Real duress versus fake duress
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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
Example: Alaska Packers’ Association v Domenico (US Ct App 1902)
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A performance excuse:impossibility
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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 How to determine who that is?
Next doctrine for voiding a contract: impossibility
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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?
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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.”
Who is the efficient bearer of a particular risk?
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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
Hadley v Baxendale
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First midterm
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Overall very good
Mean 82, median 85
Not assigning letter grades till end of semester, but… to give a rough idea of how you’re doing, based on distribution of scores on first midterm, 70-78 would probably be a BC, 78-88 would probably be a B
First Midterm
A-G N-ZH-M
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Contracts based onbad information
(probably won’t get to)
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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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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
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 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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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
should be enforced… …especially if that knowledge was the result of active investment 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