1 George Mason School of Law Contracts I B.Why Enforce Contracts F.H. Buckley

2 Last day  We wouldn’t want all contracts to be enforced Fraud and Duress Error Unconscionability? More controversially, a role for distributive justice?

3 A presumption of enforceability  But let’s start with the presumption that contracts should otherwise be enforceable  And that comes is best understood from the perspective of law-and- economics

4 Law and Economics: Understand the world through numbers  Can we count up pleasure and pain?

5 By numbers: Jeremy Bentham’s hedonic calculus  The principle of utility is the foundation of the present work: it will be proper therefore at the outset to give an explicit and determinate account of what is meant by it. By the principle of utility is meant that principle which approves or disapproves of every action whatsoever, according to the tendency which it appears to have to augment or diminish the happiness of the party whose interest is in question: or, what is the same thing in other words, to promote or to oppose that happiness. I say of every action whatsoever and therefore not only of every action of a private individual, but of every measure of government. Principles of Morals and Legislation (1789)

6 By numbers: Jeremy Bentham’s hedonic calculus  The principle of utility: Utilitarianism

7 Jeremy Bentham—really… The “auto-icon” Founder of University College, London

The Law and Economics movement as an application of utilitarianism 8 Henry ManneRichard Posner

Economic Analysis of Contract Law  Economics as an explanation for why we enforce contracts 9

Economic Analysis of Contract Law  Economics as an explanation for why we enforce contracts  Economics as an explanation for the contours of contract law Positive and normative 10

Economic Analysis of Contract Law  Economics as an explanation for contract enforcement  Economics as an explanation for the contours of contract law 11

Economics as an explanation for contract enforcement  Printing & Numerical v. Sampson 12 Sir George Jessel M.R

Printing & Numerical v. Sampson  When, per Jessel, should contracts not be enforced because they are against public policy?  Private vs. Public Law 13

Printing & Numerical v. Sampson  What was the promise here and what was the argument that it was against public policy? 14

Printing & Numerical v. Sampson  What was the promise here and what was the argument that it was against public policy? Sale of future inventions Fetters on improvements? 15

Printing & Numerical v. Sampson  Why per Jessel is public policy on the side of contract enforcement? 16

Printing & Numerical v. Sampson  If there is one thing which more than another public policy requires it is that men of full age and competent understanding shall have the utmost liberty of contracting, and that their contracts when entered into freely and voluntarily shall be held sacred and shall be enforced by Courts of justice. 17

Printing & Numerical v. Sampson  Who benefits in a case such as this from contract enforcement? 18

Printing & Numerical v. Sampson  Who benefits? A man who is a needy and struggling inventor may well agree either for a present payment in money down, or for an annual payment, to put his intellectual gifts at the service of a purchaser. 19

Promising and Efficiency  The benefit afforded by promissory institutions is a greater assurance of performance  So why is that important? 20

Promising and Efficiency  Let’s assume (for the moment) that contract enforceability has something to do with societal wealth 21

Promising and Efficiency  Let’s also assume (with Bentham) that happiness is a desirable goal 22

Promising and Efficiency  So is happiness correlated with societal wealth? 23

24

The Happiness Literature  Survey reports of subjective well-being “Would you say that you are very happy, pretty happy, or not too happy?” 25

The Happiness Literature: Frey & Stutzer  The Easterlin paradox: The Hedonic Treadmill  For countries and individuals, a regression to the mean over time  Adaption set-points?  Aspiration levels change?  Relative preferences and the rise of inequality? 26

The Happiness Literature  But the relationship holds for a snapshot at a single time, for nations and individuals both 27

28

The Happiness Literature  The omitted variable problem: What about happiness and freedom? 29

30

Heritage Economic Freedom Hong Kong90.1Free 2 Singapore89.4Free 3 Australia82.0Free 4 Switzerland81.6Free 5 New Zealand81.2Free 6 Canada80.2Free 7 Chile78.7Partly Free 8 Mauritius76.5Partly Free 9 Ireland76.2Partly Free 10 Denmark76.1Partly Free 11 Estonia75.9Partly Free 12 United States75.5Partly Free 31

The earth’s economic center of gravity 32 Weighing locations by GDP and projecting to the earth’s surface

Where does contract law come in?  Freedom makes people happy And contract enforcement promotes freedom per Jessel.  Wealth makes people happy And contract enforcement make people wealthy per Jessel 33

Where does contract law come in?  Exploiting bargaining gains through contract enforcement  And how we leave money on the table without contract enforcement 34

35 Contracting as a solution to the Prisoners’ Dilemma game  A simple game that has become the dominant paradigm for social scientists since it was invented about  How the game works – and why did not work for Dilbert

36 The paradox of the PD game  While cooperation is collectively rational, defection is individually rational.

37 Hollywood gets in the act Russell Crowe as John Nash in “A Beautiful Mind”

38 The need for poetic license

39 Modeling PD games  Game theoretic problems: payoffs for each player depend on actions of both

40 Modeling PD games  Game theoretic problems: payoffs for each player depend on actions of both  Two possible strategies: A party cooperates when he performs value- increasing promises, and defects when he breaches

41 Cooperate Player 1 Modeling Two-party choice

42 Defect Player 1 Modeling Two-party choice

43 Cooperate Player 2 Modeling Two-party choice: Player 2

44 Defect Player 2 Modeling Two-party choice Player 2

45 CooperateDefect Cooperate Both cooperate Defect Player 2 Player 1 Modeling Two-party Choice Both Cooperate

46 CooperateDefect Cooperate Defect Both defect Player 2 Player 1 Modeling Two-party Choice Both Defect

47 CooperateDefect Cooperate Player 1 cooperates, Player 2 defects Defect Player 2 Player 1 Modeling Two-party Choice Sucker’s payoff for Player 1

48 CooperateDefect Cooperate Defect Player 1 defects, Player 2 cooperates Player 2 Player 1 Modeling Two-party Choice Player 1’s temptation to defect

49 CooperateDefect Cooperate Joint cooperation Player 1: sucker’s payoff Defect Player 2: Sucker’s payoff Joint defection Player 2 Player 1 Bargains as a Prisoner Dilemma game Cooperation: Promise and Perform Defect: Promise and Breach

50 CooperateDefect Cooperate3, 3-1, 4 Defect4, -10, 0 Player 2 Player 1 Plugging in payoffs First number is payoff for Player 1, Second number is payoff for Player 2

51 Cooperate 3 Defect4 Player 1 What should Player 1 do if he knows Player 2 will cooperate? Player 2

52 Cooperate 3 Defect4 Player 1 What should Player 1 do if he knows Player 2 will cooperate? Player 2 Player 1 gets 3 if he cooperates and 4 if he defects So he defects…

53 Cooperate 3 Defect4 Player 1 What should Player 1 do if he knows Player 2 will cooperate? 

54 Defect Cooperate Defect0 Player 1 What should Player 1 do if he knows Player 2 will defect?

55 Defect Cooperate Defect0 Player 1 What should Player 1 do if he knows Player 2 will defect? 

56 CooperateDefect Cooperate3 Defect40 Player 1 Defection dominates for Player 1 

57 CooperateDefect Cooperate34 Defect Player 2 What should Player 2 do if he knows Player 1 will cooperate?

58 CooperateDefect Cooperate34 Defect Player 2 What should Player 2 do if he knows Player 1 will cooperate? 

59 CooperateDefect Cooperate Defect0 Player 2 What should Player 2 do if he knows Player 1 will defect?

60 CooperateDefect Cooperate Defect0 Player 2 What should Player 2 do if he knows Player 1 will defect? 

61 CooperateDefect Cooperate34 Defect0 Player 2 Defection dominates for Player 2  

62 CooperateDefect Cooperate Defect 0 Player 2 Defection dominates for both Players

63 The paradox of the PD game  While cooperation is collectively rational, defection is individually rational.

64 The paradox of the PD game  While cooperation is collectively rational, defection is individually rational.  The undersupply of cooperation is “the tragedy of the commons.” Garrett Hardin, The Tragedy of the Commons (1968).

65 The Tragedy of the Commons and the Law of the Sea )

66 The Tragedy of the Commons: Ranchers (open land) vs farmers (private property) ) The Man Who Shot Liberty Valance (1962)

67 CooperateDefect Cooperate Joint cooperation: Both perform Player 1 performs, Player 2 breaches Defect Player 1 breaches, Player 2 performs Both defect: Neither performs Player 2 Player 1 Two-party Choice in Contracting

68 Joint Cooperation Everyone promises and performs I’m worried about Tessio… The food is better at the Tattaglias…

69 CooperateDefect Cooperate Joint cooperation: Both perform Player 1 performs, Player 2 breaches Defect Player 1 breaches, Player 2 performs Both defect: Neither performs Player 2 Player 1 Joint Defection

70 Joint defection Can these gentlemen be acting efficiently? In what sense is this joint defection?

71 CooperateDefect Cooperate Joint cooperation: Both perform Player 1 performs, Player 2 breaches Defect Player 1 breaches, Player 2 performs Both defect: Neither performs Player 2 Player 1 The Sucker’s Payoff

72 The Sucker’s payoff Sucker performs, other party defects GONERIL Hear me, my lord; What need you five and twenty, ten, or five, To follow in a house where twice so many Have a command to tend you? REGAN What need one? KING LEAR O, reason not the need…

73 CooperateDefect Cooperate Joint cooperation: Both perform Player 1 performs, Player 2 breaches Defect Player 1 breaches, Player 2 performs Both defect: Neither performs Player 2 Player 1 The Defector’s Payoff

74 The Defector’s Payoff Defector breaches, sucker performs Gov. Earl K. Long "Don't write anything you can phone. Don't phone anything you can talk. Don't talk anything you can whisper. Don't whisper anything you can smile. Don't smile anything you can nod. Don't nod anything you can wink." "I can make them voting machines sing Home Sweet Home."

75 PD games help to explain why we do dumb things  Over-fish lakes and oceans  Pollute  Arms race

76 PD games help to explain why we do dumb things  Over-fish lakes and oceans  Pollute  Arms race  Fail to exploit bargaining gains

77 What if contracts are prohibited?

78 What if contracts are prohibited? Rembrandt, The Jewish Bride 1666 Marriage is more than a contract; it’s a covenant…

79 What if contracts are prohibited? Rembrandt, The Jewish Bride 1666 But it’s less than a contract if the parties have unilateral exit rights under no-fault divorce laws

80 Marriage, Divorce, Natality  What did no-fault divorce do to the cost of matrimonial fault?

81 Marriage, Divorce, Natality  What did no-fault divorce do to the cost of matrimonial fault? Under fault, the straying party pays if he wants a divorce—or if his spouse seeks one So fault is costly in a fault regime

82 Marriage, Divorce, Natality  What did no-fault divorce do to the cost of matrimonial fault?  So how do you think no-fault divorce laws affected divorce levels? Bring and Buckley, 18 Int. Rev. Law & Econ. 325 (1998) Subsidize something (or reduce costs) and you get more of it

83 Marriage, Divorce, Natality  How would you expect the parties to react to the increased probability of divorce?

84 Marriage, Divorce, Natality  How would you expect the parties to react to the increased probability of divorce? Fewer marriages

85 Marriage, Divorce, Natality  How would you expect the parties to react to the increased probability of divorce? Fewer marriages Increased female participation in the labor force

86 Marriage, Divorce, Natality  How would you expect the parties to react to the increased probability of divorce? Fewer marriages Increased female participation in the labor force And what about kids?

87 Children as marriage-specific assets Divorce rate ——— Natality rate for married couples ———

88 Contractarianism  Might other branches of the law, apart from contract, be amenable to bargaining?

89 Contractarianism  Might other branches of the law, apart from contract, be amenable to bargaining? Family Law Corporate Law Bankruptcy Secured Lending

90 Contractarianism  Might other branches of the law, apart from contract, be amenable to bargaining?  What might constrain the parties from entering into a bargain?

91 Contractarianism  What might constrain the parties from entering into a bargain? Illegal Contracts  Article 9 barriers to security interests in consumer goods  Waivers of divorce rights

92 Contractarianism  What might constrain the parties from entering into a bargain? Illegal Contracts  Article 9 barriers to security interests in consumer goods  Waivers of divorce rights  Recall Jessel in Printing & Numerical v. Sampson

93 Contractarianism  What might constrain the parties from entering into a bargain? Transaction Costs

94 Contractarianism  The Coase Theorem: Parties will enter a binding contract to exploit all bargaining games unless prevented from doing so by transaction costs Ronald Coase

So what are transaction costs? 95  Give examples of things that get in the way of bargaining

So what are transaction costs? 96  Too many parties. Eg, pollution

So what are transaction costs? 97  Emergencies: No time to bargain

So what are transaction costs? 98  Information processing problems

99 War as a Coasian Problem: Why no peace treaty? Uccello, Battle of San Romano

100 War as a Bargaining Problem The Absence of a Bargaining Space President Bashar al-Assad (and family?) in Vogue

101 War as a Bargaining Problem Too many parties?

102 War as a Bargaining Problem Informational Problems So you’re telling me there’s something wrong with attacking uphill and across a river? Ambrose Burnside December 1862

103 War as a Bargaining Problem Agent Misbehavior What was Sir Charles Napier’s explanation for his capture of Sindh in 1843?

104 War as a Bargaining Problem Agent Misbehavior Peccavi.

105 All we are saying is … Give Contracts a Chance Iranians employing the defect strategy

Is there no cooperation without binding contracts? 106

Cooperation without Law?  Voting as an economic puzzle 107

Cooperation without Law?  Voting  No littering 108

Cooperation without Law?  It’s There are two plans for an online dictionary. One is Encarta, promoted by Microsoft, which hires editors. The other relies on individuals to submit entries for free… 109

Wikiconomics  It’s There are two plans for an online dictionary. One is Encarta, promoted by Microsoft, which hires editors. The other relies on individuals to submit entries for free… 110

Open Source Software 111 Linux Mascot

Crowdsourcing 112

Bloggers vs. Mainstream Media 113