Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 11

1  HW 1: end of class today  Midterm: hopefully Tuesday Grading

2  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…

3 Regulations

4  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

5  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”

6  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”

7  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

8  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?

9  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?

10 Ways to get out of a contract

11  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

12  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

13  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?

14  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?

15  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?

16  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?

17  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?

18  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?

19  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

20  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

21  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

22  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?

23  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?

24  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

25  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

26  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

27  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

28  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

29  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  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

30  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  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

31  Have a good weekend  Don’t get drunk and sign contracts! Next week: more doctrines for invalidating contracts, and other stuff