Previous Section of the Notes

• O. Digression on simplified pictures.
  • A. In thinking through the logic of a problem, whether in physics, mathematics, or economics, we frequently use simplified pictures, designed to bring out the particular issue we are interested in.
  • B. For example, we worth out the logic of Newtonian motion by analyzing the trajectory of cannonballs in a vacuum--without worrying about the fact that in a vacuum, the cannoneers would die before they could fire their cannons.
  • C. Similarly, much of what we are doing in this course involves deliberately simplified pictures, intended to let us think through the logic of one problem or another.
  • D. After doing so, one is better equipped to deal with the much messier conditions of real life problems.

   

• I. Contract Law: General issues
  • A. Why have encforceable contracts?
    • 1. Why not do everything on the spot market?
    • 2. Because transactions occur over time: Building a house.
      • a. If I pay at the beginning and contracts are not enforceable, you take my money and don't build the house.
      • b. If I pay at the end, then when you are finished I decide to "renegotiate" the contract. After all, I am the only customer for a house built on my property; if you don't want to accept my (new) price you can't tear down the house instead.
    • 3. The Coase Theorem should prevent inefficient breaches, but ...
    • 4. Once the transaction has started, you are locked into a bilateral monopoly
    • 5. With significant bargaining costs.
    • 6. Some of which can be avoided by contract.
    • 7. Note that one function of the contract is simply to define the obligations--which may not always be clear otherwise. If the land floods while the house is being built, who is responsible for the additional building costs?
  • B. Does contract enforcement have to be by the government?
    • 1. In many cases, it can be by reputation, desire for repeat dealings, etc.
    • 2. In order for reputation with third parties to be relevant, third parties must have some way of knowing which party to the contract failed to live up to his agreements.
    • 3. Which can be done by direct investigation in small, closeknit societies.
    • 4. Otherwise by arbitration, either after the fact with an arbitrator who has a good reputation, or
    • 5. By the parties agreeing on the arbitrator when they sign the contract--and making the fact public then.
    • 6. And in some trust-intensive industries we observe dominance by close knit ethnic groups
      • a. A striking case is the old dominance of the diamond industry in NY by orthodox jews.
      • b. Who were forbidden by their religion from suing each other, but ...
      • c. Had good arbitration/reputation institutions.
    • 7. An alternative to reputation is posting a bond--with a bonding agency that has a good reputation.
    • 8. And there are less explicit bonding mechanisms--giving hostages.
      • a. William Marshall story. When Stephen threatened to execute Gilbert Marshall's son, given him as a hostage, Gilbert replied that he had three more sons--and the hammer and anvil to make more. Stephen didn't carry through on his threat, and William grew up to become the best knight in Europe and, before he died, regent of England (for John's minor son).
      • b. Big public announcement of a joint project. If it later falls through, both parties look bad.
      • c. More generally, making it possible for the other party to injure you--in a way which isn't profitable to him, since ...
      • d. We only want him to do it when you break the contract.
    • 9. But while such mechanisms cover many transactions, there are many more which they don't cover, hence a role for government contract enforcement.
  • C. Do we need contract law? Why not just enforce the contract as it is written:
    • 1. We need a definition of when a contract exists.
      • a. Does a unilateral contract count? If I post a reward offer for finding my lost pet, is that an enforceable contract? What if you never read it? If I announce that I will pay my nephew's college tuition--and later change my mind?
      • b. What about a contract signed under duress--your money or your life? What is the price for saving a sinking ship?
      • c. What if both parties agree to a contract--but there is some confusion in communication such that they have different ideas of what they agreed to?
      • d. What if, hidden in fine print on page three of your auto rental contract, was "I agree to give everything I own to Hertz?"
    • 2. There is never enough fine print to cover all contingencies, so we need some rules for filling in the blanks.
    • 3. Do we want to enforce all contracts as written?
      • a. Assassination contracts?
      • b. Marriage contracts with their own divorce rules? Polygamy?
      • c. Contracts the court believes are unwise? Should courts exercise paternalism?

• II. Why should we or shouldn't we enforce contracts?
  • A. Argument for--efficient rules because:
    • 1. Any change that produces net benefits can be combined with a price change to make it an improvement for both parties, so ...
    • 2. A sensible lawyer or other contract draughtsman will look for the efficient terms in order to maximize the gain, then try to get as much of the gain as possible for his side, rather than picking inefficient terms biased towards his side.
    • 3. What about a monopoly?
      • a. Can he charge any price he like, and combine it withthe most favorable possible terms to him?
      • b. No--monopolies don't sell their goods for an infinite price.
      • c. They are constrained by what customers will pay (more precisely, by how much they can sell at what price), so moving to a more efficient contract and compensating themselves in the price makes them better off, except ...
    • 4. That contract terms might be a device for discriminatory pricing.
      • a. I have two customers, one of whom will pay $10 and one $15; currently I charge $10 and sell two units--at $10 each, since I don't want to lose the first customer. Assume I can't charge them different prices, perhaps because I don't know which is which.
      • b. A change in contract terms will make the first customer worse off by $1, the second by $5, and benefit me by $4--so it is inefficient, with a net cost of $2.
      • c. I make it, cut my price to $9, losing $2 in sales revenue but gaining $4 in more favorable contract terms.
      • d. So in such situations, where inefficient contract terms are a device for price discrimination, we might get them.
      • e. For example tie-in sales.
      • f. But note that price discrimination has some benefits--it may make it possible to produce a product that could not otherwise cover its costs, or
      • g. Make the product available to people who would not buy it at the profit maximizing single price.
  • B. Obvious exception--third party effects.
    • 1. Assassination contracts are not enforceable
    • 2. Nor contracts agreeing to keep silent about illegal acts.
    • 3. Except for the marriage contract--which includes an enforceable obligation not to testify against your spouse.
  • C. Second exception--parties we believe incompetent. Children and the insane.
  • D. Shakier exception--parties we believe incompetent because we are sure those terms cannot be in their interest.
    • 1. Consumer repossession agreements--might be in the consumer's interest if he is a bad credit risk, and cannot otherwise buy consumer goods on credit.
    • 2. Penalty clause in a contract: An agreement that the breaching party must pay a large penalty to the other party, representing more than the actual cost of the breach.
      • a. Maybe it is the best solution to adverse selection--I know I won't default and you don't, so I "tell" you convincingly by agreeing to a penalty clause.
      • b. Maybe it compensates for the risk of judgement-proof breach--someone who breaches and then goes bankrupt.
      • c. Maybe it reflects distrust of the court's ability to correctly measure damages... in fact
      • d. It is simply the private version of a property rule (you can only breach with the other party's consent--or bad things happen to you) instead of a liability rule
      • e. Which we think reasonable in settings where transaction costs are low and/or courts are expensive or incompetent.

• III. Does a contract exist?
  • A. Economics of a one sided reward offer.
    • 1. If such offers are known to be enforceable, more lost goods will be returned at a given reward.
      • a. Posner doesn't think so, but that is because he hasn't followed through the analysis.
      • b. If, in equilibrium, fewer were being returned, then the professional lookers would have more incentive to look, not less.
      • c. This is equivalent to the question of whether adding a low cost producer can raise market price.
      • d. Or whether a new freeway can slow traffic.
    • 2. The cost of offering a given reward will be higher, however, since you have to pay even if the finder didn't know about the reward.
    • 3. So people will be less willing to post rewards.
      • a. So the net effect might be fewer lost goods returned.
      • b. Or more, depending on which effect is stronger.
    • 4. Not making the contract enforceable results in a form of price discrimination--but since the offerer cannot control the terms, it may or may not benefit him.
  • B. Economics of offer without consideration:
    • 1. My rich uncle says he will pay my college tuition. I quit my job. He changes his mind.
    • 2. He is liable under the doctrine of detrimental reliance.
    • 3. Not clear if this is really a contract, or an odd sort of tort.
  • C. Zero-sided contracts--emergency medical treatment.
    • 1. A doctor finds someone injured and unconscious, treats him, bills him.
    • 2. And collects.
    • 3. What if the injured person doesn't want the treatment--he is a Christian Scientist or an attempted suicide?
    • 4. From the supply side, it is irrelevant--it costs just as much to treat him--but
    • 5. It isn't worth as much--from the demand side, the value of the treatment is zero.
    • 6. The right rule would seem to be no payment if the treatment is unwanted, and a payment if the treatment is wanted scaled up a little to compensate the doctor for the risk that his patient will turn out to be a Christian Scientist, but ...
    • 7. That rule would be an invitation to fraud--by people who converted to Christian Science after receiving the Doctor's bill.
  • D. Mistake: General rule is that the party in the best position to avoid it is responsible.
    • 1. If there was a problem in transmission, the party that chose the communication medium.
    • 2. If ambiguity in the agreement, it is interpreted according to trade practice.
  • E. Making sense of the idea of duress:
    • 1. Real duress--when you demand my money or my life and I offer a check instead, should I be free to stop payment?
      • a. If I am, either you don't take the check or you take it and then kill me so I can't stop payment.
      • b. But if I am not free to stop the check , that increases your incentive to find me alone, point a gun at me, and say "your money or your life." Most people have more money in their checking account than in their wallet.
      • c. So whether such agreements should be enforced depends on the elasticity of supply of such situations (if such contracts are enforced, how much does that increase their frequency) and how much they ameliorate situations that would have occurred anyway.
      • d. For example, we may want to enforce parole/ransom rules during wartime--getting paid ransom isn't why you were captured, but it may be a good reason not to kill you.
    • 2. Semi-real duress: The sinking ship or the starving traveller in a snowstorm.
      • a. It isn't duress in the previous sense, because the tug isn't the reason your ship is sinking.
      • b. Do we want to let the tug bargain for the full value of the sinking ship?
      • c. Yes if we want the right incentive for tugs to steam around looking for ships in trouble.
      • d. No if we want the right incentive for ships to stay out of trouble.
      • e. This is our old problem of dual causation in a new form.
      • f. There is much to be said for some prearranged rule, whatever it is, since bargaining costs may be excessive if the water is rising past your ankles while you bargain.
      • g. And admiralty law provides for a "reasonable" salvage fee.
      • h. Analogous case in the snowstorm.
      • i. Posner gets this wrong--worries about "excessive" efforts when the efforts to rescue due to getting the full value are efficient.
      • j. This is not like the patent race or the sunk treasure case, because if another rescuer or salver is expected in ten minutes, the first one isn't going to be able to get a very high price.
    • 3. Bogus duress: "Contracts of adhesion" (take it or leave it form contracts); the argument for efficiency does not depend on bargaining.
      • a. Consider the sort of contract that a consumer faces when he rents a car or an apartment, buys a computer program, ... .
        • i. It is drawn up by the other party in a standard form, applied to many transactions, and ...
        • ii. Although he may have a choice as to some optional terms, the consumer's basic choice is to sign or not to sign.
        • iii. Does this count as a sort of "duress," since one party cannot bargain about the terms?
        • iv. And does that imply that the arguments for freedom of contract do not apply to such contracts?
    • 4. Innocent explanation: Form contracts reduce drafting costs, eliminate the problem of the firm having to control the employee who negotiates the individual contracts.
    • 5. The argument for freedom of contract still applies, since the firm, in drafting the contract, will take account of benefits and losses to its customers. Anything that makes the terms of the deal more attractive to the customer will also increase the amount he is willing to pay.
    • 6. The freedom of contract argument even applies to a monopoly. The more unfavorable the contract is to the consumer, the lower the price the monopolist will be able to charge and still sell his goods. Although a monopolist has no competitor, his customers still have the alternative of not buying the good at all--which is why monopolists to not charge an infinite price.
    • 7. Although the argument does not always hold in the case of a monopolist, since (inefficient) contract terms might be a device for profitable discriminatory pricing--charging a higher (pecuniary plus nonpecuniary) price to those consumers who will still buy at a higher price.
    • 8. Courts sometimes refuse to enforce the terms of form contracts on the grounds that they represent a sort of duress. These arguments suggest the courts are wrong.
    • 9. Although we have not considered the separate issue of contracts sufficiently complicated so that the consumer does not really know what he is signing.

   

• IV. What should contract law be like? Filling in the blanks
  • A. Parties have an incentive to negotiate to an efficient contract, since any change in terms that increases the size of the pie provide gains for the parties to divide among themselves.
  • B. So if the court wants to fill in the blanks as the parties would have, it can try to figure out the efficient terms.
    • 1. This is a good idea if the court favors efficiency. Or favors giving the parties what they would have agreed to.
    • 2. And maybe even if it doesn't, since if courts don't write in the terms the parties would have agreed to, parties will write longer contracts, which is costly.
    • 3. But one can still imagine courts accepting that cost either because they don't favor efficiency, or ...
    • 4. Don't believe in rationality.
    • 5. Which raises the same issues as the question of freedom of contract.
  • C. Who should bear risks? We've been here before
    • 1. The party who can best risk spread.
    • 2. The party who can best control the risk: moral hazard.
      • a. Himalayan photographer. If he doesn't tell the photo labs that his six rolls of film cost thirty thousand dollars to get, they don't owe him thirty thousand when they lose the film.
      • b. Risk of strike, factory burning down, is best controlled by the producer--who owns the factory and negotiates with the workers, but ...
      • c. Risk of buyer deciding he doesn't need the product is best controlled by the buyer.
    • 3. The party who best knows the risk--adverse selection.
    • 4. Note that this is relevant both to negotiating the contract and to filling in the details.
  • D. What happens if someone breaches the contract?
    • 1. Objective. Efficiency:
      • a. Efficient breach--breach if and only if it makes the parties on net better off.
      • b. Efficient contracting--adverse selection.
      • c. Efficient reliance. Explain.
      • d. Note that the breach/reliance issue is an example of the Coaseian joint causation problem.
    • 2. Nothing: no enforceable contract. Inefficient breach? Not if Coase Theorem applies.
    • 3. Breach forbidden--specific performance. Inefficient performance. Not if ... .
    • 4. Expectation damages:
      • a. Give the right incentive to breach.
      • b. The wrong incentive to rely.
      • c. the wrong incentive to sign if there is asymmetric information
    • 5. Reliance damages:
      • a. Wrong incentive to breach.
      • b. Wrong incentive to rely.
      • c. Right incentive to sign if breaching party has the asymmetric information.
    • 6. Liquidated damages--agree in advance on what the damages will be if a breach occurs.
      • a. Right incentive to rely--because damages don't depend on reliance expenditures.
      • b. Right incentive to breach if and only if the amount agreed on is what expectation damages would be.
      • c. Right incentive to sign if and only if the amount agreed on is what reliance damages would be.
      • d. Note that the disadvantage here is that there is less information available when the contract is signed than when breach is contemplated.
      • e. On the other hand, the negotiation is happening in a competitive framework before the contract is signed, and in a bilateral monopoly when breach is contemplated.
      • f. Penalty clause--liquidated damage equivalent of specific performance.
    • 7. Property/liability issue:
      • a. Specific performance or penalty clause is like a property rule--you need the other party's permission to breach the contract.
      • b. Expectation or reliance damages are like a liability rule
      • c. Liquidated damages amount to Coasian bargaining aimed at producing a liability rule rather than a property rule.

• V. Consumer fraud, liability, etc.
  • A. Distinguish the argument for default rules
    • 1. Who can more cheaply control
    • 2. And has better information: The Himalayan photographer doesn't get his thirty thousand dollars back when Walmart loses his film.
    • 3. And can more easily bear the risk
  • B. From the argument for non-waivable rules.
    • 1. If the consumer knows he is ignorant, he can insist on a guarantee, etc.
    • 2. If consumers do not know that they need a guarantee, how do we get the laws imposing a non-waivable--given that the consumers are also the voters?
  • C. Does having the court decide (non-waivable or default) case by case make more sense than a broad rule?
    • 1. Better tailored to the facts, but ...
    • 2. Less predictable.
    • 3. Did you buy the lawnmower under a rule of caveat emptor or caveat venditor? Only the Supreme Court knows.

• VI. Information and Incentives: Laidlaw v Organ
  • A: Organ, with advance news of the treaty of Ghent which ended the war of 1812, ordered lots of tobacco from Laidlaw, at a low price reflecting the effect of the war on tobacco prices.
    • 1. When the news of the end of the war--and the end of the blockage of New Orleans--became public, Laidlaw tried to cancel the contract.
    • 2. The Supreme Court didn't let him.
    • 3. Did Organ, by not telling Laidlaw why he was buying the tobacco, commit fraud? Should the contract have been enforced?
  • B. The argument for the court's position is that producing information is a useful activity, and you can't make money doing it if, once the information is produced, you have to give it away.
  • C. Consider the more general case of speculation.
    • 1. Speculation produces a social benefit by reallocating resources from times when they are plentiful to times when (an expert can predict that) they will be scarce--the successful speculator buys low and sells high.
    • 2. By buying grain before other people anticipate the coming shortage he drives up the price early, giving other people an incentive to use less grain (slaughter hogs early, for example, to save their feed for human consumption), produce more food of other sorts, etc.
    • 3. So when the shortage hits and the speculator puts the grain he bought back on the market, the famine is less severe and the price does not go up as high as if he had not intervened.
  • D. This only works if the speculator has secure property rights.
    • 1. If, when the famine happens, a mob seizes his barn full of grain, or the government confiscates it, speculation won't pay and won't happen.
    • 2. And when there are bad harvests, people will starve
    • 3. Which suggests that the belief that speculators cause famine may be one of the most lethal errors in human history.
    • 4. It is a result of applying a useful rule of thumb in an inappropriate context.
      • a. The rule is "cui bono"--to find out who is responsible for something happening, first figure out who benefits by it.
      • b. It doesn't work in the case of production, since producers benefit by high prices but the act of producing increases supply and so makes prices lower than they would otherwise have been.
  • E. The successful speculator produces a benefit and gets a reward, but the latter is not equal, or even closely related to, the former. The relation between the private value of his activity and the social value of his activity is correct qualitatively (if he makes money he is also doing good) but not quantitatively (he might do a little good and make a lot of money, or vice versa).
    • 1. Even in a case where elasticities are low, so that the speculator produces only a small reallocation and a small benefit, he might still get a large profit--since his speculation means that resources belong to him instead of to someone else at the instant when their price goes up.
    • 2. So we might get inefficient speculation--spending $1000 dollars to get information whose private value is $1100 but whose social value is only $100.
    • 3. aka rent seeking.

• VII. Contracts, a summary.
  • A. It is useful to be able to commit yourself to binding agreements.
    • 1. Legally enforceable contracts are one way of doing so
    • 2. Reputational enforcement is an alternative in many contexts.
      • a. In some contexts it does not work
      • b. It is dependent on reliable information about who was in the wrong
      • c. But has the advantage of providing market incentives to judge correctly.
  • B. Figuring out what is the efficient contract arises in three different contexts.
    • 1. Drafting contracts. Efficiency improvements increase the size of the pie, giving a gain to be divided between the parties.
    • 2. Filling in blanks in contracts, by court or arbitrator.
      • a. Argument B1 above implies that the efficient rule is what they would have agreed to
      • b. And it is also the rule that makes the world a better place.
    • 3. Modifying contracts contrary to their language
      • a. On the grounds that the modified version is more efficient, which makes the world a better place
      • b. The problem being that B1 above implies that the parties have already agreed to the efficient rules, and since they probably know more about what rules are efficient than you do, you are likely to be making the world a worse place
      • c. Unless you have good reason to think that the argument for efficiency does not apply in this case--fraud, for example, or mistake.
  • C. Two important (and closely related) issues in designing the efficient contract are who should bear the risk if something goes wrong and what happens if one party breaches the contract.
  • D. Another important issue is whether the contract was formed in a fashion that leads to a valid (and presumptively efficient) contract--i.e. the issue of duress.

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