Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 11.

Econ 522Economics of Law

Dan Quint

Fall 2009

Lecture 11

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HW 1: end of class today

Midterm: hopefully Tuesday

Grading

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Why do we need contracts? Which promises should be enforced? First purpose: enable cooperation Second purpose: efficient disclosure of information Third purpose: optimal commitment to performance

Cost < promisee’s benefit: efficient to perform Cost < promisor’s liability: promisor will perform

Fourth purpose: optimal reliance Reward any reliance overreliance Hadley v Baxendale, foreseeable reliance

Fifth purpose: efficient default rules and regulations Gaps, efficient (majoritarian) defaults Penalty defaults (Ayres and Gertner)

Contracts: the story so far…

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Regulations

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Default rules only apply in situations the contract doesn’t address

Regulations are mandatory – can’t be overruled in contract Coase: if individuals are rational and there are no transaction

costs, voluntary negotiations/contracting will lead to efficiency So additional rules/prohibitions can only make things worse But if individuals aren’t rational or there are transaction costs,

regulations may help

Default Rules versus Regulations

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Derogate, verb. detract from; curtail application of (a law)

Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable

Contracts which could only be performed by breaking a law

Contracts whose effect is to circumvent a law

One example of a regulation/immutable rule: derogation of public policy

B(union)

C(ownership)

A(other factory)

“if I ever work for C for less than $15/hr, I’ll work

for you for $1/hr”

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Derogate, verb. detract from; curtail application of (a law)

Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable

Contracts which could only be performed by breaking a law

Contracts whose effect is to circumvent a law

One example of a regulation/immutable rule: derogation of public policy

B(union)

C(ownership)

A(other factory)

“if I ever work for C for less than $15/hr, I’ll work

for you for $1/hr”

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In general: contracts which can only be performed by breaking the law are not enforceable

But… “A married man may be liable for inducing a woman to rely on his promise

of marriage, even though the law prohibits him from marrying without first obtaining a divorce.”

“A company that fails to supply a good as promised may be liable even though selling a good with the promised design violates a government safety regulation.”

“A company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation.”

“A promisor should be liable for breach if he knew that the promise was illegal”

Derogation of public policy

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Peevyhouse v Garland Coal and Mining Co(OK Supreme Court, 1962) Garland contracted to strip-mine coal on Peevyhouse’s farm Contract specified Garland would restore property to original

condition; Garland did not Restoration would have cost $29,000… …but “diminution in value” of farm only $300 Original jury awarded $5,000 in damages, both parties appealed Oklahoma Supreme Court reduced damages to $300

Expectation damages: default rule or immutable rule?

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Seems like classic case of efficient breach Performing last part of contract would cost $29,000 Benefit to Peevyhouses would be $300 Efficient to breach and pay expectation damages, which is what

happened

But… Most coal mining contracts: standard per-acre diminution payment Peevyhouses refused to sign contract unless it specifically

promised the restorative work Dissent: Peevyhouses entitled to “specific performance”

Expectation damages: default rule or immutable rule?

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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

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 by irrational individuals Children Legally insane

Doctrine of incompetence One party was not competent to enter into contract Invalidates contracts which are not in best interest of that party

What if you signed a contract while drunk? You need to have been really, really, really drunk to get out of a

contract

Incompetence

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Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]”

Lucy v Zehmer (VA Sup Ct, 1954)

What if you signed a contract while drunk?

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The Borat lawsuits


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The Borat lawsuits Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazakh

Journalist for Make Benefit Guileless Americans In Film”

Moral of story: don’t get drunk with someone who might ask you to sign a contract


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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 Someone makes me an offer I can’t refuse

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: don’t enforce 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: don’t enforce 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 – how 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, 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

Friedman’s point

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Single price can create multiple incentives

Often impossible to set them all efficiently Already saw this with remedy for breach Expectation damages: efficient breach, but inefficient signing Include gains from reliance: overreliance Exclude gains from reliance: inefficient breach

More general 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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Alaska Packers’ Association v Domenico (US Ct App 1902) 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, refuses higher wages, claiming duress

Example

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Contracts should be enforced if both parties wanted enforceability Same with renegotiated contracts

Contracts renegotiated under duress will not be enforced; contracts renegotiated under changed circumstances will

Example

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Contracts should be enforced if both parties wanted enforceability Same with renegotiated contracts

Contracts renegotiated under duress will not be enforced; contracts renegotiated under changed circumstances will

Example

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Have a good weekend

Don’t get drunk and sign contracts!

Next week: more doctrines for invalidating contracts, and other stuff

Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 11.

Documents

Transcript of Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 11.