Law and Econ Exam 2 - CONTRACTS

Consideration

Consideration makes the promise enforceable We require consideration because there needs to be a mutually beneficial relationship Can't be nominal consideration Regardless of form, each bargain involves reciprocal inducement According to bargain theory, a court should enforce promises induced by consideration, regardless of whether the consideration was equivalent in value to the promise An alternative theory would limit courts to enforcing fair bargains

Reasons FOR enforcing penalty clauses

We presume if the contract has a penalty clause, they both have value from it being in there • Makes your commitment even more credible • Most penalties can be restated as bonuses- To increase the probability of enforcement by the court, the parties can reword the contract so that a bonus for performance replaces a penalty for breach in the language of the contract, but the two contracts have identical material outcomes

Unconscionability

When a contract seems so one-sided that its enforcement would violate the conscience of the court Same idea as ex ante / ex post stuff

Criticisms of bargain theory of contracts

1) Fails to enforce some promises both sides want enforced 2) If you have offer, acceptance, and consideration, you have a valid contract even if that contract is bad • Bargain theory calls for the routine enforceability of any bargain, just so long as it is a bargain and regardless of how outrageous the terms may be

2 fundamental Qs of contracts

1) What promises should be enforced? 2) What should be the remedy for a breach of contract?

Best damages under bargain theory

According to bargain theory, the promisee is entitled to the "benefit of the bargain" - the benefit he or she would have obtained from performance of the promise o So the bargain theory damages is Expectation damages o If this deal was going to leave me $10 ahead, and you breached, you owe me $10

Bargain Theory of Contracts

Answers fundamental question 1 An offer is legally enforceable if it's part of a bargain, which has: 1) Offer 2) Acceptance 3) Consideration

2 ways to solve problem of unverifiable acts

Anti-insurance Hypothetical expectation damages

The only time you see formation defenses and performance excuses is in litigation

B/c in litigation, transaction costs are high so parties can't figure it out on their own

Promissee

Beneficiary of the promise

Mandatory rules

Certain rules that apply to contract that you cannot contract around Ex: you can't make a contract to do illegal things Why do we have mandatory rules • You can have externalities • Book has 4 reasons: • Individual rationality • Spillovers • Asymmetric information • Monopoly

Contracts of Adhesion

Contracts with standard terms that are set and fixed • • Sometimes standard form contracts can dampen competition and promote monopoly (inefficient) by making cartels easier Cartel = monopoly with multiple members that agree to act together to act like a monopoly Standardization makes it easier for cartels to police their members • However, at the same time, standard form contract can promote competition Lower consumer search costs and that promotes competition Reduce transaction costs of bargaining, which is also pro-competition • Therefore, the fact you see a standard form contract alone doesn't tell you enough, you need more information

Interpreting contracts - 2 rules court can use

Default rules Mandatory rules

Monopoly contracts

Doesn't have to be actual monopoly, can just be when one side has much more power than the other Contracts of Adhesion Unconscionability

Duress v. necessity

Duress arises when the person you're contracting with (promisee) puts you in the situation Necessity arises when a third party / other situation puts you in a bad situation and the person you're contracting with takes advantage

Formation defenses v. performance excuses

Formation defense = we didn't sign a valid contract Performance excuse = yeah we signed a valid contract, but I should be excused from it

Issue with expectation damages

Get the agent's incentives right, but not the principal Perfect expectation damages cause the principal to overrely relative to the efficient reliance (buying too many lobsters example) • Principal is externalizing the risk of non-performance • Similar in torts to where strict liability with perfect compensation for accidents gives efficient incentives for injurer to take precaution, but the victim has no incentive to take precaution • This is the paradox of compensation again

Restitution

Have to repay you whatever you've given them NOTE: Doesn't have to be same thing as reliance • Ex: with the car, if you had gone and bought some cool things for your car in reliance of getting the car, you wouldn't get paid for that under restitution

Liquidated damages vs. penalty clause

If liquidated damages approximate actual damages, we'll keep calling them liquidated damages. But if liquidated damages are way higher than actual damages, courts stop calling it liquidated damages and call it penalty (and are thus much less likely to enforce it)

Disgorgement

If you breach a contract, you have to disgorge the profits you made from breach to me • If you have to give all this profit back, there's no incentive for you to breach anymore Perfect disgorgement makes the injurer indifferent between doing right, on one hand, or doing wrong and paying disgorgement damages, on the other hand • Thus, perfect disgorgement is identical to perfect compensation, with the roles of injurer and victim reversed

Anti-Insurance

If you breach, you have to pay. But the other side doesn't get the money • Contract would look something like "I'll finish the restaurant by x date, and if I don't I'll pay expectation damages to a charity you hate" • This moves you along the x axis, and not up the y axis In general, the efficient supply of unverifiable inputs requires each of the two parties to be liable for 100% of the output so that their total liability adds up to 200% • This three party solution is anti-insurance

Endgame Problem

If you know when the game ends you can get no cooperation at all So the contract itself is just telling you what to do in the end game to prevent appropriation in the end game Courts: • If the contract is about the last round only, it's fine that the parties may have deviated in earlier rounds from the contract but in the last round you need to make sure they stick to the contract • Enforce the plain language of the contract on the last round, even if the parties are arguing "our practice has been something else"

Incompetence excuse

If you sign a contract with someone the law deems incompetent, that contract is not enforceable Incompetent people have preferences that are not orderly and stable, and therefore we can't assume that when they sign a contract it makes them better off o Issue of transitive v. intransitive preferences o Apples > Ham, Ham > Mushrooms, then you have to like applies more than mushrooms

Cost of foreseeability requirement

If you're delivery company, and other side tells you they don't have a second shaft in order to make damages foreseeable, you'll raise the price • The cost to you of a breach has just gone way up because they've made more damages foreseeable • So foreseeability doctrine usually does not perfectly actuate the idea of hypothetical expectation damages, but maybe it's a move in the right direction

Economic advantage of foreseeability requirement

It's information-forcing doctrine • If you want to get paid for your harm you need to tell us about it. Making private info public lowers transaction costs of bargaining

Frustration of Purpose

It's not that you can't perform, there's just no point in performing on the contract o Ex: get hotel in room NOLA for Mardi Gras parade, but parade cancelled o Think about this exactly like impossibility • Once purpose has been frustrated, someone incurs a loss - who should we allocate the loss to? • Analysis is exactly the same Who's the least cost bearer ex post? • The hotel can probably sell the room to someone else. If you make me pay it'll cost me a lot of money Who's least cost avoider ex ante • Can't really take precautions against the parade being cancelled

How to operationalize hypothetical expectation damages

Liquidated Damages Foreseeability

Party-designed remedies

Liquidated damages and penalty clauses

Purpose of contract law

Need it for sequential exchanges (not simultaneous deals) o Contract law is lowering the transaction costs of bargaining • The first purpose of contract law is to enable people to cooperate by converting games with non-cooperative solutions into games with cooperative solutions

Do economists like consideration requirement?

No - Pareto efficiency o When at least one party is made better off and no party is made worse off o If both parties to a promise want the thing enforced, that implies it's a pareto improvement (assuming something like people not being coerced or irrational) o So economic theory of contract law says contracts should always be enforced when both sides want it enforced at the time it's made. So economists don't really get what consideration is doing in the equation

Promisor

One who makes the promise

Which damages > other damages

Perfect expectation damages > perfect opp cost damages > perfect reliance damages If we assume people sign the best contract for themselves, then expectation damages will be bigger than opp cost damages And reliance just puts you in place where you would've been pre-contract, so smaller than opp cost NOTE: key to this is PERFECT - if courts make mistake, won't always end up like this

Public v. Asymmetric info

Public information = info all parties to the contract share Private/asymmetric info = info only one side has • Sometimes subjective valuation motivates exchanges. • Other times, it's differences in information that motivates exchanges Ex: you know a car is worth a lot of money. You buy it from me for cheap because I don't know that In general, law enforces contracts based on asymmetric information • If you want to promote efficiency, you want to unite ownership of an asset with information on how to use it

Perfect Expectation Damages

Require breaching party to pay such that breached-against party is indifferent to performance or breach + damages

Default rules

Rules courts impute to fill a gap in the contract You left this issue unaddressed, situation arises, we just stick this into your contract as if you had written it Example in notes of why a party would ever leave a hole in a contract (it's more costly to fill it than to deal with it if it arises) IMPORTANT: • Judge should put themselves in the shoes of the parties and try to figure out, if the transaction costs were 0, what the parties would have said about this • This is what law and econ says the default rule should be • Filling gaps by a hypothetical bargain - impute the terms to the contract the parties would have agreed to if they had bargained over all the relevant risk

Paradox of Compensation in Contracts

The promisee has an incentive to rely more when liability for breach is higher

Reasons for NOT enforcing penalty clauses

They lower transaction costs of bargaining when contracts initially signed (make contracts more credible) BUT they make renegotiations much harder, even when renegotiations are efficient

Duress

Threats in bargaining are impermissible, but demands are permissible • So we need a theory to distinguish when you're making threats and when you're making demands • No clear answer, but econ gives you perspectives to think about how to draw the line a. Without duress, parties to contract want it enforced because it leaves them better off. When signed under duress, one of the parties don't want it enforced at all. • Demand: contract > no contract/status quo • Threat: status quo > contract > no contract b. Failed bargaining with threats means the injurer acts on the threat and destroys something valuable to the victim. Failed bargaining with demands just doesn't create any value, but doesn't destroy any either. • In general, failed bargains do not create, whereas failed coercion can destroy c. If contracts that are executed under duress are enforceable, people will burn all kinds of resources to avoid putting themselves in a position to be threatened • That's individually rational, but it's inefficient

Problem of unverifiable acts

To solve paradox of compensation, why can't we just have everyone promise to act efficiently all the time? • To enforce a promise, courts must verify whether it was performed or broken. Many promises to act efficiently are unverifiable by courts Think about contract between restaurateur and builder (lobsters) • We want to include provisions to prevent the restaurateur to not over-rely (you can't put some clause that says don't over-rely) So it's hard to verify what "over-relying" means if you include it and want to sue over it

Necessity

We want rescuers to be incentivized to rescue • So we don't want to set aside all contracts based on necessity • On the other hand, we don't want to pay them too much because it would incentivize people to get people stranded in the desert (eager rescuers) • And if people are worried they'll be purposefully stranded in the desert they won't go to the desert and that destroys value

Time / Anticipatory Breach

We've been assuming that if someone breaches, they breach at the end of the contract. • Sometimes people breach early. Anticipatory breach o Anticipatory breach lowers your cost, so there's incentive to do it sometimes o If you breach early there's more time for the other time to respond and then your damages are less

How to get agent to take efficient precautions against breach?

We've been treating nature/luck as exogenous, but in the real world you can affect your own luck by taking precautions against breach -How can we get the agent to take efficient precautions against breach? • Restaurant builder example • The difference in payoffs for agent if you go from world of bad luck to good luck is 1 (go from -.5 to .5) • So you're willing to spend up to 1 to make sure you have good luck • So expectation damages also make you willing to take the exact level of precautions to get to the beneficial point Makes promisor take the exact amount of precautions against breach - nothing less and nothing more So perfect expectation damages have this advantage • When a contract only affects the parties to it, liability for perfect expectation damages gives the promisor efficient incentives to take precaution against breach • See notebook - willing to pay up to 1, and that's what society gains with good luck

Efficient Breach - 2 ways

When circumstances change, not performing a promise can be more efficient than performing In these circumstances, non-performance occurs in 2 ways • First, the promisor can breach the contract by breaking his promise • Second, the parties can renegotiate and modify the contract to allow nonperformance of the original obligation

Perfect Reliance Damages

Why do promisees rely? • Reliance when things go well increases the value of performance • The downside of reliance is that if performance doesn't happen, the cost is higher Perfect reliance damages put breached-against party in position they were in before the contract was signed

Reliance graph in notes

X axis = promisor's liability Y axis = promisee's entitlement to damages (extent promisor externalizes costs) • Moving left to right on x axis is good, but at the same time moving up the y axis is bad 1. In order for the injurer to internalize costs, he must fully compensate the victim 2. In order for the victim to internalize costs, she must receive no compensation for her injuries 3. In private law, compensation paid by the injurer equals compensation received by the victim 4. Therefore, private law cannot internalize costs for the injurer and the victim as required for efficiency • We want to be where the arrow is - at 100% right on the x axis

Why contracts for information are tricky

You can't inspect the information ahead of time like you could with a good or service

Specific Performance

You have to do what the contract say you're going to do o Makes a lot more sense when talking about unique goods than when talking about goods that are easily substituted o Always concern that if court is making you do something, though, you just won't do a good job o By adopting the remedy of specific performance for breach of promise to deliver unique goods, courts avoid the impossible task of determining the promisee's subjective valuation

Duty to Disclose

You hid the fact that there are termites in the house I just bought for you (you didn't lie, you just didn't say anything) o Contract law will usually reverse these contracts o Encourages you to share info when involved in negotiations • Lowers transactions cost - make private info public

TCs low, have bad luck - compare remedies

o If transaction costs are low and you can renegotiate, you'll get to the same place if the remedy is specific performance or perfect expectation damages • If specific performance, you'll just renegotiate the contract to get out of it • As long as the principal and agent can renegotiate successfully and very cheaply, both the legal and equitable remedies affect distribution but not efficiency

TCs high, have bad luck - compare remedies

o If transaction costs high, then specific performance is not efficient • Just like in property how injunctions don't work with high transaction costs • With bad luck, it'll be efficient to breach the contract or renegotiate it. BUT here the remedy is to make you do the thing, which is inefficient

Indefiniteness / Vagueness of contract

o In general, courts can refuse to enforce indefinite terms in contracts, or courts can enforce the terms roughly or use vague terms to change presumptions and procedures o Courts should understand thoroughly the purpose of the contract if they want to enforce vague terms o Good idea to enforce vague terms - parties wanted the contract to be valid at the time of signing, so there's economic value to be had

Mutual Mistake of Fact

o Like frustration of purpose, but the thing happens before the contract is signed, not after, but no one knows it o Just like the last 2 circumstances, someone bears the cost o So run the analysis the exact same way • Think about least cost bearer • But then also need to think about least cost avoider

Mutual Mistake of Identity

o Occurs when the buyer and seller have different objects in mind so their minds don't meet o If reasonable parties disagreed about the identity of the performance offered and accepted, the contract is void o Raffles v. Wichelhaus example - Peerless case

Opportunity Cost Damages

o Often when you make one contract, you're foreclosing the option of making another one Perfect opportunity cost damages: • Leave victim of breach indifferent between breach and performance of best alternative contract • Have to put you in position you would've been in had you contracted with the best alternative to the one that was breached

Unilateral Mistake

o One party thinks an object has no value, other party knows better o In general, law does enforce contracts when there's unilateral mistake (above) • Contracts based upon one party's knowledge of productive information - especially if that knowledge was the result of active investment - should be enforced • Contracts based upon one party's knowledge of purely redistributive information, or fortuitously acquired information should not be enforced HOWEVER, Gilbert addition that if no one was ever gonna find this info, enforce it.

3 Categories of Remedies

o Party-designed remedies o Court-imposed damages o Specific performance

Why perfect expectation damages?

o Perfect expectation damages gets the agent's incentives correct o When a contract only affects the parties to it, liability for perfect expectation damages gives the promisor efficient incentives to perform or breach • Makes the agent internalize all the costs of the breach • NOTE: in this example we're assuming no externalities - contract only affects the parties to it

Fraud

o When you gave false info o Contract law will usually reverse these contracts o Encourages you to tell the truth when involved in negotiations • Lowers transactions cost - make private info public • If you enforce contracts with fraud, how can I trust anything you're saying?

Remedies as costs of calculating damages rises

• As the costs of calculating perfect expectation damages goes up, maybe just award specific performance (cheap to administer since don't need to calculate anything) and then just hope TCs are low enough and the house ends up with the party that values the house the highest (P.329 House Example)

Hypothetical Expectation Damages

• Breaching party pays the other side to put them in the position they would've been in had they relied efficiently • Ex: rational person would've ordered 10 lobsters, and you ordered 20 • Perfect expectation damages would pay you for the 20 lobsters, hypothetical would pay you for 10

When nonperformance is more efficient than performance, what determines whether the person will breach the contract or renegotiate it?

• Coase - parties will renegotiate whenever transaction costs are low • In renegotiating, parties will divide the surplus from substituting a more efficient contract for the original one • The terms of the renegotiated contract will depend on the bargaining power of the parties, which in turn depends on the legal remedy in the event that bargaining fails

Liquidated damages (in relation to hypothetical expectation damages)

• Contract can stipulate damages at the level required for hypothetical expectation damages • Parties specify the amount that must be paid in the event of breach • They often serve to check the reliance of the promisee • So builder would say if I'm late I'll only pay you X and no more • So this is extra reason for courts to enforce liquidated damages

Foreseeability (in relation to hypothetical expectation damages)

• Hadley v. Baxendale • Court says only foreseeable damages awarded Doctrine of foreseeability does not have to overlap completely with hypothetical expectation damages • Suppose the miller had said, by the way, we don't have a backup shaft. Now damages are completely foreseeable, but not efficient (you should have a second shaft on hand)

Impossibility

• The dire constraint arises after the contract is signed, not before • Some cases involve physical impossibility o This thing literally cannot happen • Some cases are better known as impracticability o The thing could happen, but it's now impractical because something happened • How do courts decide when to enforce them o Common law approach: if it affects a basic assumption of the contract, they don't have to perform o Issue: how do you decide what's a basic assumption o Economic approach - see notebook driller/owner example o When some contingency arises that causes impossibility/impracticability, it creates a cost for someone. o We ask, who can bear the cost the least at the lowest amount • Least cost bearer o We also ask who can avoid the cost at the lowest amount • Look ex ante and imagine before the contract was signed and see who can take precautions • Least cost avoider o These are not the same thing