Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 12

1  Midterm and HW2 will be returned at the end of lecture  HW3 is online – due Fri Nov 5 Logistics

2  Player A starts with $10  Chooses how much of it to give to player B  That money is tripled  Player B has $10, plus 3x whatever A gave him/her  Chooses how much (if any) to give back to player A  We played the game three ways:  Anonymously – A and B don’t know who each other are  Face to face – A and B know who each other are, and can discuss the game before playing, but their actions remain private  In public – A and B play out loud in front of the whole class Monday: how big a problem is trust

3  Face to face: trust is not a problem  Every pair got maximum joint payoffs ($40), even split ($20 each)  In front of whole class: trust is not a problem  Every pair got maximum joint payoffs  In anonymous setting: trust is a bit of a problem  Player A sent $6.92 on average, so 69% of gains were realized  Player B got back $7.78 on average  Of those who sent money, 27% got back nothing, including 30% of those who sent $10  Of those who sent money, 34% got back less than they sent, including 37% of those who sent $10 Monday: how big a problem is trust?

4 In the anonymous treatment… Average money back from player B if player A sent x Average payoff for player A if he/she sent x

5 In the anonymous treatment… 34%27%11% All 37%30%10% %13%4% ,8,9 24% 26% ,5,6 50% -22% ,2,3 -67% % who got back less % who got back 0 Average ROI Avg payoff (player A) Average received Observ.

6  Reliance  Investments which depend on performance of contract  Or, investments which increase value of performance  If damages include expected benefit from reliance investments, we get overreliance  (But if they don’t, we get inefficient breach)  Courts tend to compensate for foreseeable reliance Monday: reliance and default rules

7 Incentives for reliance: example Investment in hangar Additional value of plane $100$10,000$40,000$160,000$640,000 Tarp and rope - $6,000 benefit Plywood frame, canvas roof - $60,000 Metal poles, rigid roof - $120,000 Functional heating - $240,000 Designer hangar with Starbucks - $480,000 Plane worth $500,000 to you, price $350,000 Cost: either $250,000 or $1,000,000 $x investment  600  x increase in value of performance

8  Let p be probability of breach  Three questions  What is the efficient level of reliance?  What will promisee do if expectation damages include anticipated benefit from reliance?  What will promisee do if expectation damages exclude anticipated benefit from reliance? Three questions Plane worth $500,000 to you, price $350,000 Cost: either $250,000 or $1,000,000 $x investment  600  x increase in value of performance

9  Let p be probability of breach  Three questions  What is the efficient level of reliance? x = $90,000 (1 – p) 2  What will promisee do if expectation damages include anticipated benefit from reliance? x = $90,000  What will promisee do if expectation damages exclude anticipated benefit from reliance? x = $90,000 (1 – p) 2 Three questions Plane worth $500,000 to you, price $350,000 Cost: either $250,000 or $1,000,000 $x investment  600  x increase in value of performance

10  Remedy for breach sets incentive for both promisor and promisee  Promisor: perform or breach  Promisee: how much to rely  Generally impossible to set both incentives efficiently at the same time Paradox of compensation

11  Default rules  Cooter and Ulen: supply rules which most parties would have wanted (efficient rules)  Ayres and Gertner: penalty defaults (penalize the parties for leaving a gap, or penalize better-informed party) Also Monday: default rules

12 Regulations

13  Default rules can be contracted around; some rules cannot  immutable rules, or mandatory rules, or regulations  Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations.  Coase: if individuals are rational and there are no transaction costs, private negotiations lead to efficiency  So additional regulations can only make things worse  But when people are not rational, or when there are transaction costs/market failures, regulations may help Default rules versus regulations

14  Derogate, verb. detract from; curtail application of (a law)  Contracts which derogate public policy – that is, undermine 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”

15  Derogate, verb. detract from; curtail application of (a law)  Contracts which derogate public policy – that is, undermine 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”

16  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

17  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?

18  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?

19  Which works better in this case:  Default rule allowing Garland to breach and pay diminution fee?  Default rule forcing Garland to perform restorative work?  Ayres and Gertner: default rule should “penalize” the better-informed party  Garland routinely signed contracts like these  Peevyhouses were doing this for the first time  Default rule allows Garland to pay diminution fee: they have no reason to bring it up, Peevyhouses don’t know  Default rule forces Garland to do cleanup: if that’s inefficient, they could bring it up during negotiations  In this case, specific performance would work as a penalty default We can also think about Peevyhouse in terms of penalty defaults

20 Ways to get out of a contract

21  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

22  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

23  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?

24  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?

25  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?

26  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?

27  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)  The Borat lawsuits What if you signed a contract while drunk?

28  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)  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 What if you signed a contract while drunk?

29 Another formation defense: dire constraints

30  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

31  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

32  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

33  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?

34  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/ $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/ $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?

35  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

36  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

37  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

38  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

39  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: Alaska Packers’ Association v Domenico (US Ct App 1902)

40 A performance excuse: impossibility

41  When performance becomes impossible, should promisor owe damages, or be excused from performing?  A perfect contract would explicitly state who bears each risk  Contract may give clues as to how gaps should be filled  Industry custom might be clear  But in some cases, court must fill gap Next doctrine for voiding a contract: impossibility

42  In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach  But there are exceptions  Change “destroyed a basic assumption on which the contract was made” Next doctrine for voiding a contract: impossibility

43  In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach  But there are exceptions  Change “destroyed a basic assumption on which the contract was made”  Efficiency requires assigning liability to the party that can bear the risk at least cost  Party that can take precautions to minimize the risk  Or can best spread the risk over many transactions Next doctrine for voiding a contract: impossibility

44  Who is the efficient bearer of a particular risk?  Also called low-cost avoider  Who is in best position to mitigate/reduce a risk, or hedge it, or endure it?  We already saw this question with efficient default rules  When a contract leaves a gap, an efficient contract would have allocated each risk to low-cost avoider  Construction company building a house, completion is delayed  Family might be efficient risk-bearer, because it’s cheaper for them to stay with friends than for construction company to pay for hotel  Cost of raw materials goes up, increasing cost of construction  Construction company might be efficient risk-bearer, because they can buy materials early or change design plans Important general concept

45 Contracts based on bad information

46  Four doctrines for invalidating a contract based on faulty information  Fraud  Failure to disclose  Frustration of purpose  Mutual mistake Misinformation

47  Fraud violates “negative duty” not to misinform  In some circumstances, positive duty to disclose certain information  Civil law: contract may be voided if you did not supply information you should have (“failure to disclose”)  Common law: seller is not forced to disclose everything he knows  Must warn about hidden dangers  Need not share information that makes product less valuable but not dangerous  But, new products come with “implied warranty of fitness” Fraud and Failure to Disclose

48  Both parties based a contract on the same bad information  contract may be voided due to frustration of purpose  Coronation Cases  Rooms rented out with view of new king’s coronation parade  Parade was postponed, owners still tried to collect rent  Courts ruled change in circumstance had frustrated the purpose of the original contracts, which were therefore void  “When a contingency makes performance pointless, assign liability to the party who can bear the risk at least cost” Frustration of Purpose

49  Frustration of purpose: circumstances changed after the contract was signed  Mutual mistake: circumstances changed before the contract was signed, but the parties didn’t know about it  Enforcing the contract would be like forcing involuntary exchange  Coase: we expect voluntary exchange to be efficient  But involuntary exchange may not be Mutual Mistake

50  Hadley v Baxendale (miller and shipper)  Hadley knew shipment was time-critical  But Baxendale was deciding how to ship crankshaft (boat or train)  A general principle about information: efficiency generally requires uniting knowledge and control  Contracts that unite knowledge and control are generally efficient, should be upheld  Contracts that separate knowledge and control may be inefficient, should more often be set aside Another principle: knowledge and control

51  Mutual mistake: neither party had correct information  Contract neither united nor separated knowledge and control  Unilateral mistake: one party has mistaken information  I know your car is a valuable antique, you think it’s worthless  You sell it to me at a low price  Contracts based on unilateral mistake are generally upheld Unilateral mistake

52  Mutual mistake: neither party had correct information  Contract neither united nor separated knowledge and control  Unilateral mistake: one party has mistaken information  I know your car is a valuable antique, you think it’s worthless  You sell it to me at a low price  Contracts based on unilateral mistake are generally upheld  Contracts based on unilateral mistake generally unite knowledge and control  And this creates an incentive to gather information Unilateral mistake

53  War of 1812: British blockaded port of New Orleans  Price of tobacco fell, since it couldn’t be exported  Organ (tobacco buyer) learned the war was over  Immediately negotiated with Laidlaw firm to buy a bunch of tobacco at the depressed wartime price  Next day, news broke the war had ended, price of tobacco went up, Laidlaw sued  Supreme Court ruled that Organ was not required to communicate his information Unilateral mistake: Laidlaw v Organ (U.S. Supreme Court, 1815)

54  Productive information: information that can be used to produce more wealth  Redistributive information: information that can be used to redistribute wealth in favor of informed party  Cooter and Ulen  Contracts based on one party’s knowledge of productive information – especially if that knowledge was the result of active investment – should be enforced  Contracts based on one party’s knowledge of purely redistributive information or fortuitously acquired information should not be enforced Unilateral mistake: productive versus redistributive information

55  Sellers must inform buyers about hidden safety risks  Common law does not generally require disclosure of other types of information  But…  Obde v Schlemeyer (1960)  Seller knew building was infested with termites, did not tell buyer  Termites should have been exterminated immediately to prevent further damage  Court in Obde imposed duty to disclose  Sale did not unite knowledge and control More on duty to disclose

56  Sellers must inform buyers about hidden safety risks  Common law does not generally require disclosure of other types of information  But…  Obde v Schlemeyer (1960)  Seller knew building was infested with termites, did not tell buyer  Termites should have been exterminated immediately to prevent further damage  Court in Obde imposed duty to disclose  Sale did not unite knowledge and control  Many states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects… More on duty to disclose

57 Midterms

58  Overall pretty good  Mean 81, median 84, std dev 10  Not actually assigning letter grades till after final  But to have an approximate idea of where you stand… 90sroughly AB or A 80sroughly B 70sroughly BC high 50s/60sroughly C Midterm A-GO-ZH-N