Econ 522 – Lecture 11 (Feb 24 2009)

HW 1 will be returned on Thursdayo (if you didn’t get, I have extra copies of my solutions)

HW 2 is online, not due for a while Midterm is next Tuesday

o Chao and I are switching our office hours next week to Monday:o Me: Monday 1:30-3:30, Social Sciences 7428o Chao: Monday 10-12, Social Sciences 7231

Last Thursday, we examined efficient breach and efficient reliance. We found: It’s efficient to breach a contract whenever the cost of performance exceeds the

value of performance Expectation damages lead to breach only when it’s efficient Reliance is efficient if its expected benefit (its benefit times the probability of

performance) exceeds its cost Including the benefit from reliance in expectation damages may lead to

overreliance Adjusting expectation damages to include only efficient reliance creates the

correct incentive, but is difficult from a practical point of view The law tends to only reward foreseeable reliance, which is reliance that could

reasonably be expected given the situation

We also introduced the notion of default rules – rules that apply in contingencies that weren’t explicitly addressed in a contract. We saw two very different views of what default rules should be.

Cooter and Ulen supported efficient default rules – that is, the rules that most parties would have chosen if they had addressed a particular risk

o most parties can save transaction costs by not bothering to address those risks

Ayres and Gertner introduced the idea of penalty defaults – default rules that are not efficient, but which penalize one party, in order to encourage them to disclose information while negotiating the contract

We saw an example of this: Hadley v Baxendaleo The efficient rule would likely be for the shipper to bear the risk of lost

profits due to delay – since he has more control over how quickly the delivery happens

o But the ruling penalized Hadley for hiding the urgency of the shipment – giving an incentive to reveal information

Default rules can be overridden by specific terms of a contract, and are only used in contingencies the contract didn’t address.

At the end of the last lecture , we introduced the idea of immutable rules, or regulations, which are rules that always apply, that is, that can’t be overridden.

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Going back to Coase if individuals are rational and there are no transaction costs, private negotiations

(in this case, contracting) will lead to efficiency so any additional regulation (any rules they’re not allowed to contract around)

would be inefficient on the other hand, regulation could be efficient in situations where individuals are

not rational, or where there are transaction costs, externalities, or market failures.

One example of an immutable rule: a contract is not enforceable if its completion would require violating the law.

The legal doctrine is derogation of public policy Contracts which derogate public policy are not enforceable

Obvious examples of this would be a sales contract for a kilo of cocaine, or a contract to kill someone

However, there are also less obvious situations where a contract derogates public policy, and would therefore be unenforceable

In the U.S., labor unions have a statutory obligation to bargain with management “in good faith”

A contract between a labor union and a third party, which would violate this obligation, would therefore derogate public policy, and not be enforced

An example of this is a contract that “ties the union’s hands” in negotiations

Suppose that the union (B) and ownership (C) at a factory are bargaining over wages

The union wants its workers to earn $15 an hour, ownership is offering $10 an hour, and negotiations are ongoing.

Now the union goes to a competing factory owner (A) and signs the following contract:

“If I ever agree to work for C for less than $15 an hour, I promise to have all my members work for you for $1 an hour.”

The intent of the contract is not for it to actually happen, just to change the union’s bargaining position with C, by “burning its bridges,” that is, making it much more costly to back down from its demands.

Since this would violate the union’s obligation to bargain in good faith, this contract would not be enforced.

Other examples of contracts which would derogate public policy.

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A victim of a crime offering a policeman a reward for solving the crimeo The police’s job is to solve crimeso Allowing rewards might distort the focus toward crimes with rewards,

away from more important crimes without rewards A contract among competitors to act as a cartel, similar to a monopoly

o A contract that fixed prices, say, would derogate laws designed to foster competition, and would therefore be unenforceable.

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

However, there are still some instances where, even though performing would require laws to be broken, a contract is still enforced, that is, a remedy is still supplied for breach

Three examples from the textbook:

o “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.”

o “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.”

o “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.”

In all these examples, the liability rests with the party that knew, or should have known, that it was committing to something illegal

This is similar to the reasoning in Ayres and Gertner Putting the liability on the informed party gives them an incentive to be honest (or

in these cases, to not enter into this type of contract) Cooter and Ulen argue that the promisor should be liable for breach if he knew (or

should have known) that the promise was illegal but the promisee did not On the other hand, the promisor should not be liable if he did not know the

promise was illegal and the promisee did.

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Derogation of public policy is one example of an immutable rule, or a regulation – a rule that the parties to a contract cannot overrule

Most of what we’ve done up to now has been focused on default rules – rules which hold when the parties chose not to overrule them

For example, we said that expectation damages lead to efficient breach, and that they were therefore a good rule for contracts that did not specify damages

However, we never said that expectation damages should be a mandatory ruleo That is, we never said parties should not be able to specify a different

remedy for breach

However, there is a legal precedent for a court imposing expectation damages (or something like them) even when the contract seemed to call for a different remedy

The case is Peevyhouse v Garland Coal and Mining Company Decided by the Supreme Court of Oklahoma in 1962

Peevyhouse owned a farm in Oklahoma Garland contracted to strip-mine some coal on the property The contract specified that Garland would take certain steps to restore the

property to its previous condition after mining the coal After mining the coal, Garland made no attempt to take these restorative steps It was estimated at trial the restoration would cost $29,000 Peevyhouse sued for about that much ($25,000) The parties agreed during trial that everything else in the contract had been

performed The defendant introduced evidence that although the damage would cost $29,000

to repair, it lowered the value of the plaintiffs’ farm by only $300 (The “diminution in value” of the farm due to the damage was $300.)

The original jury awarded Peevyhouse $5000 in damages Both parties appealed to the Oklahoma Supreme Court

o Peevyhouse saying this was less than the service that had been promisedo Garland saying this was still more even than the total value of the farm

after repairs The OK Supreme Court reduced the damage award to $300.

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At first glance, this seems like a nice example of efficient breacho Performing the last part of the contract would cost $29,000o The benefit to the Peevyhouses would be $300o So it is efficient to breach and pay expectation damages, which is what

was awarded

However, the dissenting opinion noted that the coal company was well aware of what they were getting into when they signed the contract

Most coal mining contracts at that time contained a standard per-acre diminution payment, that the coal company would pay instead of repairing the property

The Peevyhouses specifically rejected that clause of the contract during initial negotiations, and would not sign the contract unless it specifically promised the restorative work

The dissent argued that the Peevyhouses were therefore entitled to “specific performance” of the contract, that is, to have the restorative work completed as promised.

Even though objectively, the damage to the property diminished its value by only $300, the Peevyhouses’ subjective value appears to have suffered much more

Expectation damages are meant to make the promisee as well off as they would have been under performance – here, this seems not to be the case.

At least one scholar has claimed that the judges who decided Peevyhouse were either incompetent or corrupt

o one was later impeached, and others resignedo although others have disagreed

Still, it appears that the ruling here attempted to turn an efficient default rule – expectation damages – into a mandatory rule, that is, a rule that would be enforced even when it was not what the parties intended at the time of the contract.

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Next, I want to discuss a number of ways to get out of a contract, that is, conditions under which a contract will not be enforced.

These are typically divided into two categories: formation defenses and performance excuses

A formation defense is a claim that a contract does not exist: that the requirements for a contract to be valid were not met

(Under the bargain theory, for example, a formation defense might be that consideration was not given.)

A performance excuse is a claim that, even though a valid contract was created, circumstances have changed and you should be excused from performing

We said earlier that, under Coase, when individuals are rational and there are no transaction costs, voluntary negotiations should lead to efficiency

So refusing to enforce voluntary contracts would not make sense Thus, most of the doctrines for invalidating a contract can be explained as a

violation of one of these assumptionso either the individuals agreeing to the contract were not rationalo or there was some sort of transaction cost or market failure

The first exception is that courts will generally not enforce contracts made by irrational individuals. There are several ways that this can happen. For example:

children cannot sign binding contracts the legally insane cannot sign binding contracts

These both fall under the doctrine of incompetence: one party to the contract was not competent to enter into a binding agreement

In fact, the law does not automatically invalidate all contracts made with children or insane people

It only invalidates contracts which were not in their best interests (Basically, the law creates an incentive not to cheat people who can’t take care of

themselves.)

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My first time teaching this course, after I introduced the doctrine of incompetence, one of my students emailed me an excellent question: what if you signed a contract while drunk?

Can a drunk person sign a legally enforceable contract? or would the fact that he was drunk get him off the hook?

We mentioned that the bargain theory required a “meeting of the minds” to agree to a contract

It’s reasonable to question whether this could occur with someone who was drunk However, the general rule in the U.S. is this:

You have to be really, really, really drunk for the contract not to count.

OK, that’s not how it’s written in the case law The rule is, for a contract to be unenforceable, you need to have been “intoxicated

to the extent of being unable to comprehend the nature and consequences of the instrument he executed.”

Basically, not just drunk enough to have bad judgment, but drunk enough to have no idea of what you’re doing

There’s a classic case that upheld this standard, Lucy v Zehmer, decided by the Supreme Court of Virginia in 1954

It’s a little embarrassing when your drunken antics end up in front of a state supreme court

But the case makes for really fun reading

The Zehmers owned a farm The Lucys had been trying to buy it from them for a long time (They had made multiple offers, over the course of several years, beginning at

$20,000.) One night, Zehmer’s out drinking, and he runs into Lucy They continue to drink, and at some point, Lucy says something like, “I bet you’d

sell that farm for $50,000.” Zehmer says, “You don’t have $50,000.” Lucy says, “I can get it!” Zehmer says, “No you can’t!” They argue for a while about whether Lucy would be able to raise $50,000 And eventually Lucy says, “Write it down!”

So Zehmer grabs a discarded guest check (seriously), turns it over, and writes on the back, “I agree to sell such-and-such farm to this guy for $50,000.”

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It was revealed at trial that among other things, Zehmer had misspelled both the name of the farm and the word “satisfactory”

Lucy says, “Hold on a second, your wife owns it too!” So Zehmer crosses out the word “I”, replaces it with “We,” and walks to the other

end of the bar where his wife is sitting He tells her to sign it, she says, “What?” He whispers to her, don’t worry, it’s just a joke, we’re not selling the farm So she signs it They add a couple more legal terms to make it look like a contract

o giving the Lucys the right to check the validity of the title He brings it back, Lucy takes the contract and puts it in his pocket

Monday morning, Lucy goes to the registry of deeds to check the title, starts raising the money, and contacts Zehmer to carry out the contract

Zehmer claims he was drunk, and joking, and refuses to honor the contract Lucy sues for specific performance, that is, asks the court to force Zehmer to sell

him the farm at the agreed price

There was some dispute during trial about exactly how drunk Zehmer was But it was ruled that while he was clearly drunk, he was not so drunk as to be

“unable to comprehend the nature and consequences” of what he was doing (For one thing, a little while later, his wife asked him to drive her home.) Most of the opinion focuses on whether Lucy knew that Zehmer was joking when

he wrote what looked like a proper, if unusual, legal contract The court basically ruled that it wasn’t Lucy’s job to know Zehmer was joking

o That is, Zehmer may have thought he was joking, but it looked to Lucy like he was serious

o Zehmer behaved exactly as he would have behaved if he were drunk but actually wanted to sell the farm; which was good enough.

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You may think, being drunk, Zehmer lacked the necessary intent to enter into a contract

Still, it probably makes sense not to make it too easy to invalidate a contract on the grounds that one of the parties was drunk, or joking

o If the ruling went the other way, it seems there would an awful lot of litigation over exactly how drunk someone was when a contract was signed

o Not to mention a lot more contracts being signed in bars, to give the parties an easy way out

o Or maybe a lot of lawyers carrying breathalyzers to make sure their contracts would be enforceable

Basically, a more nuanced rule would be extremely difficult and costly to enforce So we seem to accept the cost of an occasional person making a bad decision

while drunk, in order to keep the system working well the rest of the time.

However, that’s not quite the final word on drunkenness If you were visibly drunk – that is, the other party clearly knew you were drunk –

the court might be more willing to finding the contract unenforceable on other grounds (which we’ll get to shortly)

o such as fraud (you were tricked into signing)o or unconscionability (the contract is too one-sided)

I suspect that if Zehmer had agreed to sell the farm for $10, the contract would not have been upheld

But that since the terms seemed reasonable, it was

There’s also a more recent example of the doctrine that being drunk does not get you out of a contract: the Borat lawsuits

Two of the frat boys who ended up looking like racist a-holes in the movie Borat sued

They claimed they were tricked into signing the releases agreeing to be in the movie

It seems the movie’s producers got them drunk and then asked them to sign the releases

And may have lied to them a lot – telling them the movie was only going to be released in Europe, they wouldn’t release the frat boys’ names, or college, or frat

Part of the problem for them is that the releases contained what are called “merger clauses”

Merger clauses basically say, it doesn’t matter what else we already told you, all we’re agreeing to is what’s in this contract

(Basically, any prior verbal agreement is “merged into” this contract, which is the only thing we’re agreeing to.)

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It’s kind of sneaky, but it does seem to legally absolve the producers of anything they told the frat boys to get them to sign but that wasn’t in the contract

Again, just being drunk doesn’t get you out of a contract One of the fratboys seemed to find it relevant that he was under the drinking age;

but that, if anything, would make the producers liable in criminal court (for supplying alcohol to a minor), but not invalidate the releases

(It’s also been established that the frat boys were all already heavy drinkers, unsurprisingly.)

As far as I know, the lawsuits have all been dismissed, and the frat boys got nothing.

(Since they’re not in the textbook; for the opinion in the Lucy v Zehmer case, which really does make great reading, seehttp://www.finance.pamplin.vt.edu/faculty/sds/Lucy.pdfFor an overview of the legal issues in the Borat lawsuits, see a piece by Julie Hilden, with the brilliant title “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for Make Benefit Guileless Americans in Film” athttp://writ.corporate.findlaw.com/hilden/20061129.html)

So the moral of the story, I suppose, is don’t get drunk with people who might ask you to sign contracts.

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Back to contract law, and another situation in which we would not expect people to act rationally:

courts will not enforce contracts signed under dire constraints, specifically, duress and necessity

Necessity is when I’m at the point of starvation, and someone comes along and offers me a sandwich for $10,000

I don’t have it on me, so I sign a contract agreeing to pay him $10,000 and I eat the sandwich

Or I’m on a boat that’s about to sink, and another boat offers me a ride back to shore for a million dollars

In either case, the contract would not be upheld, since I signed it out of necessity.

Duress is similar, but when the uncomfortable situation I’m in is being caused by the other party

This is when someone kidnaps my child, and I agree to pay ransom to get her back

The contract is not enforceable, because I agreed to it under duress This is exactly the idea of “making someone an offer he can’t refuse” from the

Godfather; courts would not uphold a contract signed at gunpoint (Of course, whether you want to breach a contract with the Mafia, or sue the

Mafia, is a separate question.)

It’s not that hard to argue against holding people responsible for promises made under duress or necessity based on notions of fairness and morality

The Friedman book (Law’s Order), however, tries to explain both of these in straight economic terms – I like his treatment a lot

Duress

He begins with an example of duress A mugger approaches you in an alley and threatens to kill you unless you give

him $100 You don’t have $100 on you, but he says he’ll accept a check When you get home, can you stop payment on the check? Or do you have to honor the agreement you made?

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Recall our principle from before: Efficiency requires enforcing a contract if both parties wanted it to be enforceable Clearly, the mugger wants the agreement to be enforceable; he’d rather have $100

than kill you And if you believe he’ll kill you if you don’t give him the money, then you

clearly want it to be enforceable as well So making the contract enforceable seems to be a Pareto-improvement So what’s the problem?

The problem, of course, is that even if such a contract is a Pareto-improvement once you’re in the situation, making such contracts enforceable encourages more muggings, since it increases the gains

So refusing to enforce contracts signed under duress seems to trade off a short-term “loss” – the efficiency lost by ruling out some mutually beneficial trades – against creating less incentive for the bad behavior that put you in that situation in the first place.

(The fact that there is a tradeoff here suggests that it may not be optimal to rule out enforceability under every instance of duress

For example, peace treaties can be thought of as contracts signed under duress – the losing side is facing the threat of continuing to battle a superior force

Most people agree that peace treaties being enforceable is a good thing Peace treaties are clearly a good thing “ex post” – they make war less costly, by

ending it more quickly It’s possible that by making war less costly, they encourage more wars – but it

seems unlikely that this has much effect It’s probably efficient for peace treaties to be enforceable, but for promises made

to a mugger to be unenforceable.)

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Necessity

However, the logic that tells us that contracts with muggers shouldn’t be enforced doesn’t work for contracts signed under necessity.

You’re out sailing on your $10 million boat and get caught in a storm The boat starts taking on water and slowly begins to sink A tugboat comes by and offers to tow you back to shore, if you pay him $9

million If not, he won’t leave you to die – he’ll give you and your crew a ride back to

shore, but your boat will be lost.

With duress, we argued that making the contract enforceable would encourage muggers to commit more crimes, which is bad

But here, making the contract enforceable would encourage tugboats to make themselves available to rescue more boats – so how is that a bad thing?

In fact, Friedman points out that if we consider the tugboat captain’s decision beforehand – how much to invest in being in the right place at the right time – the higher the price, the better

The total gain (to all parties) from the tugboat being there is the value of your boat, minus the cost of rescuing it – say, $10,000,000 - $10,000 = $9,990,000

Allowing the tugboat to recover the entire value of the boat would make his private gain from rescuing you exactly match the social gain

This would cause the tugboat captain to invest the socially optimal amount in being available to rescue you!

But on the other hand, consider your decision about whether to take your boat out on a day when a storm is a possibility

Suppose there’s a 1-in-100 chance of being caught in a storm And if you are caught in a storm, there’s a one-in-two chance a tugboat will be

there to rescue you.

If the tugboat captain can charge you the full value of your boat, then when weighing the costs and benefits of going sailing that day, you consider a 1-in-100 chance of losing the full value of the boat

That is, in your analysis of whether it’s worth sailing, you’ll include the 1/200 possibility the boat sinks, and the 1/200 possibility you pay its full value to an opportunistic tugboat captain – a total expected cost of $100,000

So you’ll only go sailing on days where your benefit is greater than $100,000

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But when you go sailing and start to sink, half the time, your loss is the tugboat captain’s gain

The social cost of you sailing includes a 1-in-200 chance the boat is lost, plus a 1-in-200 chance it has to be towed to shore

So the total expected cost is $10,000,000 / 200 + $10,000 / 200 = $50,050 So efficiency says you should go out sailing whenever the benefit to you is greater

than $50,050.

So if the tugboat captain is able to charge you the full value of the boat, you will “undersail”

o That is, in cases where your private gain from sailing is between $50,050 and $100,000, efficiency would suggest you should sail

o But since the private cost outweighs the benefit, you choose not to.

On the other hand, suppose the tugboat could only charge you the cost of the tow Then the social cost of sailing would match the private cost to you - $50,050 This would lead you to go sailing exactly the efficient amount.

Friedman, then, makes the following point The same transaction sets ex-ante incentives on both parties And the price that would lead to an efficient decision by one of them, would lead

to an inefficient decision by the other.

So, what should we do? As Friedman puts it, “put the incentive where it will do the most good.” Somewhere in between the cost of the tow and $10 million is the “least bad” price

o That is, the price that minimizes the losses due to inefficient choices by both sides

If the tugboat captain is more sensitive to incentives than you are, the best price is likely closer to the value of the boat

If you respond more to incentives than he does, the best price may be closer to the cost of the tow

But regardless of the details, two things will generally be true:o the least inefficient price is somewhere in the middleo and there’s no reason for it to be the price that would be negotiated during

the storm

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That is, once you’re caught in a storm, all the relevant decisions have already been made

o you’ve decided whether to sailo the tugboat captain has decided whether to be out there looking for sinking

sailboats Those are like sunk costs – they don’t affect your bargaining position now So there’s no reason that, if you bargained over saving your boat during the storm,

you’d end up anywhere near that efficient price On the other hand, there’s always the risk that bargaining breaks down and you

refuse the tugboat captain’s offer, incurring a large social cost (the value of the boat minus the tow is lost)

So from an efficiency point of view, it makes sense for courts to step in, overturn contracts that were signed under necessity, and replace them with what would have been ex-ante optimal terms

This takes away the need to bargain hard during the storm, ensuring that the boat is saved; and it creates the “least bad” combination of incentives.

So that’s Friedman’s take on duress and necessity.

There’s an important point here that is more general: that a single price creates multiple incentives and they cannot all be set efficiently at the same time we already saw this with remedies for breach

o expectation damages set the incentive to breach the contract efficiently – that is, lead to efficient breach

o but they set a different incentive incorrectly – the incentive to sign the contract in the first place

o If you will owe expectation damages under circumstances that favor breach, the private cost of those circumstances is higher to you than the social cost

o so you may forego some contracts that would be overall value-creatingo later on, we’ll come to a different type of damages which would lead to

efficient signing decisions, but inefficient breacho we also saw that it’s difficult to set a general rule that accomplishes both

efficient breach and efficient relianceo you basically have to “cheat” and count on courts to decide what level of

reliance would have been efficiento Again, it’s often difficult, or impossible, to set all the incentives correctly

at the same time.

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Going back to duress

We just said that the law will not enforce contracts signed under threat of harm – “give me $100 or I’ll shoot you.”

However, lots of negotiations involve threats of some sorto “give me a raise or I’ll quit and work for your competitor”o “$3000 for my car is my final offer, take it or I walk.”

This kind of threat is fine – it’s often necessary to tease out both sides’ threat points and figure out whether cooperation is efficient or not

To distinguish between the two types of threats, note what happens in each case when bargaining fails

In the second case, failure to reach a bargain results in a failure to create more value

In the first case, failure to agree leads to destruction.

In addition, successful bargains tend to create value, while contracts created under duress tend to just shift resources from one owner to another.

In general, the following rule applies to distinguish duress:

A promise is enforceable if it was extracted as the price of cooperating in creating value; a promise is unenforceable if it was extracted by a threat to destroy value

There’s a nice example of this in the textbook

(I believe taken from a real case: Alaska Packers’ Association v. Domenico, US Court of Appeals, 1902)

The captain of a boat hires a crew in Seattle for a fishing expedition to Alaska Once they reach Alaska, the crew demands higher wages, or else they’ll quit

working Having little choice, the captain agrees After they return to Seattle, the captain refuses to pay the higher wages, claiming

he agreed to them under duress.

While in Seattle, the crew that signed on faced competition from other fishermen Once in Alaska, they did not The captain had relied on the promise – by investing in fuel and supplies, and the

time to sail to Alaska.

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While in Seattle, the crew’s only threat was to not cooperate in creating value – in which case the captain could have hired another crew

Once in Alaska, the crew’s threat was to destroy value – by destroying the investment the captain had already made

We also gave the principle earlier that contracts should be enforceable if both parties wanted them to be enforceable at the time of the agreement

This principle also extends to renegotiated contracts In this case, think what happens if the renegotiated contract will not be

enforceable The crew is still better off fishing (and getting paid their original wages) than

return to port with no fish and not get paid So while the crew may want the contract renegotiated under duress to be

enforceable, the captain does not So courts would tend not to enforce it.

On the other hand, suppose that half way into the voyage, circumstances change The weather gets worse, or a message arrives that makes the crew want to return

home Now the captain offers them higher wages to get them to stay In this case, both sides would like the new promise to be enforceable, since

without it the ship would have to return home

In general, when a contract is renegotiated under duress it will not be enforced; but a contract that is renegotiated under changed circumstances will.

Like duress, a contract made under necessity is made with the threat of destruction Under duress, the threat was destruction via action Under necessity, the threat is destruction via inaction (The tugboat captain isn’t threatening to sink your boat, just to let it sink If you run out of gas on a remote road and a passing driver offers you gas for

$100 a gallon, he isn’t threatening to shoot you, just to drive off and let you starve.)

While contracts made under necessity are generally not enforced, rescuers are generally entitled to some reward, to create an incentive to perform the rescue in the first place.

o textbook has more detail on this

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Impossibility

Another doctrine that will make some contracts unenforceable is impossibility

A surgeon agrees to perform an operation, then breaks his hand in a hideous golf cart accident the weekend before

Clearly, he cannot perform the operation The question remains as to whether he is excused from performing, or whether he

owes his would-be patient damages

As we mentioned last week, a perfect contract would specify explicitly who would bear that risk

But due to transaction costs, real contracts will generally not address risks that are very remote

In some cases, even if it does not address the risk explicitly, the contract itself may give clues as to how the gap should be filled

An example of this from the textbook:o a drilling company agrees to drill a well for a landowner, but the drill runs

into impenetrable graniteo Suppose that the driller was competing with other companies for the offer,

but the landowner agreed to a price much higher than the competitiono The court might feel that the driller was implicitly guaranteeing

performance, and should owe damages when performance became impossible

Or industry custom might be for one side or the other to bear that risk.

In situations where neither the contract itself nor the custom of the industry assigns the risk, the law has to

In most typical cases, the promisor is liable for breach, even when the breach is not his fault

(To put it another way, contract liability is strict.) So a construction company that finishes a building late due because or unexpected

complications is generally liable.

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However, there are some instances where non-performance is excused by physical impossibility

A famous artist agrees to paint someone’s portrait, and then dies; his estate does not owe for the breach of the promise

A manufacturer whose factory burns down might be excused from performance Similarly, breach is typically excused if performance became illegal

o A shipping company commandeered to carry military cargo during a war is excused from its civilian commitments.

One legal theory in these cases is that an unexpected contingency destroyed “a basic assumption on which the contract was made”

o The painter assumed he would be aliveo the manufacturer assumed his factory would be useable

Under this theory, if a contract is made in good faith and then events destroy one of its basic assumptions, breach is excused.

Of course, the question then becomes, when is something a “basic assumption” and when is it not?

The book sidesteps this question, and instead moves to what efficiency would require:

Efficiency requires assigning liability to the party who can bear the risk at least cost.

That is, nonperformance due to impossibility is just another type of risk; so for efficiency, it should be allocated to whichever party is the low-cost bearer of the risk.

In many cases, one party can take precautions to minimize the risko the manufacturer can install sprinklers in his factoryo the painter can prioritize commissioned pieces over other worko and so on

In those cases, that party is typically the low-cost avoider, and efficiency suggests they should bear the risk.

When the risk cannot be reduced, the book claims that liability should lie with the party who can best spread the risk, through insurance or diversification.

(We already saw the general principle of gap-filling by allocating risk to the low-cost avoider, that is, the person who can most cheaply mitigate or bear the risk

The rationale is that this is what the original contract would have done, if it had bothered to consider that risk.)

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