1. Econ 522 Economics of Law
Dan Quint
Spring 2017
Lecture 13

2. Logistics Exam will be graded/returned later this week
Homework 3 (contract law) is up – due March 30
Class will not meet next Wednesday (March 15)
(unless there’s a snow day before then or something)

3. Last week… What default rules should fill in the gaps?
C&U: impute the terms the parties would have wanted – allocate each risk to efficient bearer of that risk
(Friedman: several ways to tell who that is)
Ayres & Gertner: use default rules to penalize one or both parties from withholding information
Reasons a contract might not be enforced
Derogation of public policy
Incompetence
but not drunkenness
Today: more reasons a contract might not be enforced
But first…

4. Another experiment: is trust a problem?

5. We motivated contracts with an agency (trust) game
Player 1 (you)
Trust me
Don’t
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(0, 200)
Without binding contracts, might be no reason for me to return your money, so no reason for you to trust me

6. To see if trust is a problem, we’ll use a similar game as an experiment
Player A starts with $5
Chooses how much of it to give to player B
That money is quadrupled
Player B has $5, plus 4x whatever A gave him/her
Chooses how much (if any) to give back to player A
So for example…
if player A decides to send $3…
then B has $5 + $12 = $17, and can send A any amount up to 17 and keep the rest…
…and A ends up with $2 plus whatever B sends

7. To see if trust is a problem, we’ll use a similar game as an experiment
Player 1
Send 0
Send 5 x
Player 2
Return 0
Return 5 + 4x y
((5 – x) + y, (5 + 4x) – y)
Player 1 gets whatever he kept, plus whatever 2 sends him
Player 2 gets 5, plus four times what 1 sends him, minus whatever he sends to player 1

8. We’ll try this game three different ways
Anonymously – A and B don’t know who each other are
we’ll use student ID numbers to identify players, and play on paper
Privately – A and B don’t interact, but will learn who each other are after the game
still on paper, but with names, so B sees A’s name
after class, I’ll A and B with each others’ names
Publicly – A and B play out loud in front of the class

9. Back to work: formation defenses and performance excuses

10. Two ways to try to get out of a contract
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 without penalty
Last week, we saw incompetence, a formation defense
No meeting of the minds  no valid contract
But, being drunk isn’t a valid excuse!
In the background of incompetence:
We want to enforce contracts because that facilitates voluntary trade
If trade is voluntary and everyone is looking out for their own interests, we expect trade to make both sides better off, and therefore, unless there are externalities, to be efficient
Incompetence covers one instance where we can’t expect both parties to look out for their own interests – therefore can’t assume the contract made both parties better off – therefore can’t assume the contract was efficient

11. Another formation defense: dire constraints
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
“I made him an offer he couldn’t refuse”
Contract signed at gunpoint would not be legally enforceable
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.
(Recall Ploof v Putnam, the sailboat case in property law.
If Ploof had found Putnam and Putnam offered to let him ride out the storm on his pier for $1,000,000, he might accept, but the contract would not be enforceable due to 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.)

12. Duress November 2011 story from Kansas
Guy broke into a house to hide from police, took the homeowners hostage
Offered them money in exchange for hiding him, they agreed
Instead, when he fell asleep, they called police
He’s suing them for breach of contract
"I, the defendant, asked the Rowleys to hide me because I feared for my life. I offered the Rowleys an unspecified amount of money which they agreed upon, therefore forging a legally binding oral contract," Dimmick said in his hand-written court documents. He wants $235,000, in part to pay for the hospital bills that resulted from him being shot by police when they arrested him.
source:

13. Friedman on duress Example
Mugger threatens to kill you unless you give him $1000
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 $1000
You did – you’d rather pay $1000 than be killed
So why not enforce it?
Makes muggings more profitable  leads to more muggings
Tradeoff: refuse to enforce a Pareto-improving trade, in order to avoid incentive for bad behavior
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
He begins with an example of duress
A mugger approaches you in an alley and threatens to kill you unless you give him $1000
You don’t have $1000 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?
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 $1000 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.

14. Friedman on duress Example
Mugger threatens to kill you unless you give him $1000
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: refuse to enforce a Pareto-improving trade, in order to avoid incentive for bad behavior
(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.)

15. What about necessity? Same logic doesn’t work for necessity
You get caught in a storm on your $1,000,000 sailboat
Tugboat offers to tow you to shore for $900,000
(Otherwise he’ll save your life but let your boat sink)
Duress: if we enforce contract, incentive for more crimes
Necessity: if we enforce contract, incentive for more tugboats to be available to rescue sailboats
Why is that bad?
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!

16. What about necessity?
“Should I motor around looking for sailboats to save?”
Social cost = private cost = value of my time
Social benefit = probability x (value of boat – cost of tow)
Private benefit = probability x (price I can charge – cost of tow)
If tugboat captain can charge the whole value of the boat, he spends efficient amount of time saving sailboats!
So maybe we should enforce this contract…

17. What about necessity? “Should I sail today?”
Suppose tugboat is there to rescue me if there’s a storm
Social benefit = private benefit = how much I enjoy sailing
Social cost = probability x cost of tow
Private cost = probability x price he can charge
If tugboat captain can only charge cost of tow, I sail efficient amount
If he can charge the whole value of the boat, I undersail!
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-1000 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-1000 chance of losing the full value of the boat
That is, in your analysis of whether it’s worth sailing, you’ll include the 1/2000 possibility the boat sinks, and the 1/2000 possibility you pay its full value to an opportunistic tugboat captain – a total expected cost of $10,000
So you’ll only go sailing on days where your benefit is greater than $10,000
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-2000 chance the boat is lost, plus a 1-in-2000 chance it has to be towed to shore
So the total expected cost is $10,000,000 / $10,000 / = $5,005
So efficiency says you should go out sailing whenever the benefit to you is greater than $5,005.
So if the tugboat captain is able to charge you the full value of the boat, you will “undersail”
That is, in cases where your private gain from sailing is between $5,005 and $10,000, efficiency would suggest you should sail
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 - $5,005
This would lead you to go sailing exactly the efficient amount.

18. Friedman’s point 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, 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
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:
the least inefficient price is somewhere in the middle
and there’s no reason for it to be the price that would be negotiated during the storm

19. Friedman’s point 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
More general point
Single price creates multiple incentives
May be impossible to get efficient behavior in all dimensions
That is, once you’re caught in a storm, all the relevant decisions have already been made
you’ve decided whether to sail
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.

20. Real duress versus fake duress
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
One more thing about duress
We 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 sort
“give me a raise or I’ll quit and work for your competitor”
“$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

21. Example: 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, captain refuses to pay the higher wages, claiming he agreed to them under duress
Court ruled for captain
Since crew had already agreed to do the work, no new consideration was given for promise of higher wage
There’s a nice example of this in the textbook
(They don’t cite the actual case, which is Alaska Packers’ Association v. Domenico, US Court of Appeals, 1902)
A fishing boat captain hires a crew in Seattle for a fishing expedition to Alaska, agrees to pay them $50 each plus $0.02 per fish they catch
Once they reach Alaska, the crew demands higher wages ($100), or else they won’t work
Having little choice – they’re already there, and the fishing season is short – 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 their promise to work – by investing in fuel and supplies, and the time to sail to Alaska.
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
The court ruled the captain only had to pay the original wage – the renegotiated contract was not enforced

22. A performance excuse: impossibility
Incompetence, duress, necessity are all formation defenses – reasons why a valid contract never existed
Next, we turn to performance excuses – claims that even though a contract was signed in good faith, one of the parties should be allowed to break it without penalty

23. Next doctrine for voiding a contract: impossibility
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
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:
a drilling company agrees to drill a well for a landowner, but the drill runs into impenetrable granite
Suppose that the driller was competing with other companies for the offer, but the landowner agreed to a price much higher than the competition
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

24. Next doctrine for voiding a contract: impossibility
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”
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.
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
A shipping company takes a bunch of orders, but then its ships are commandeered to carry military cargo during a war; the company 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”
The painter assumed he would be alive
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:

25. Next doctrine for voiding a contract: impossibility
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
We’ve seen several ways to determine who that is
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 risk
the manufacturer can install sprinklers in his factory
the painter can prioritize commissioned pieces over other work
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.)

26. That’s why Hadley v Baxendale was “surprising”
Baxendale (shipper) could influence speed of delivery, Hadley could not
So Baxendale was efficient bearer of the risk of delay
Court ruled he didn’t owe damages for lost profits, forcing Hadley to bear much of this risk
Only makes sense as a “penalty default”
Rule creates incentive for Hadley to reveal urgency of this shipment

27. Contracts based on bad information

28. Contracts based on faulty information
Four doctrines for invalidating a contract
Fraud
Failure to disclose (sometimes)
Frustration of purpose
Mutual mistake

29. Fraud Fraud: one party was deliberately tricked
This is a piece of wood, painted to look a little bit like an iPad
This is a 2011 story of a woman in South Carolina who was approached in a McDonald’s parking lot and paid $180 for an iPad
Fraud covers situations where one party was deliberately tricked
The guy with the escort was similarly claiming fraud – saying he was originally promised one price, and then a different price was demanded later
In the example from the textbook – the farmer pays $25 for a sure method of killing grasshoppers – the contract would be overturned due to fraud (the farmer was tricked), and he would get his money back
If you are selling me a used car, and specifically lie to me about the condition that it’s in – you tell me you just replaced the clutch when in fact you did not – I could later get the contract overturned (force you to buy back the car) based on fraud
Similarly, if I ask you a specific question about the car, you have to answer me honestly
The economic rationale is obvious. The point of contracts is to allow us to transact. The point of transacting is to allocate rights and resources efficiently. If people are allowed to “trick” other people into buying things they don’t really value, this doesn’t increase efficiency – and makes it more costly to achieve valuable trades, since people have to be more careful.
source:

30. What if you trick someone by withholding information?
It depends
Under the civil law, there is a duty to disclose
If you fail to supply information you should have, contract will be voided – failure to disclose
Under the common law, less so
Seller has to share information about hidden dangers…
…but generally not information that makes a product less valuable without making it dangerous
Exception: new products come with “implied warranty of fitness”
Another exception: Obde v Schlemeyer
In the civil law tradition, a contract may be void because you did not supply the information that you should have
The doctrine here is failure to disclose
Under the common law, however, a seller is not forced to tell a buyer everything he knows about what he’s selling
He is forced to warn the buyer about any hidden dangers – such as the side effects of a drug, or failing brakes on a car
But under the common law, there is not a general duty to disclose information that makes a product less valuable without making it dangerous
(If you’re selling me a used car, you have to tell me if the brakes don’t work; you don’t have to mention that the stereo doesn’t work.)
But there are a couple of exceptions:
If you’re selling a new product, it’s assumed that it can perform the basic function it’s intended for – new products come with an “implied warranty of fitness”
Another exception was introduced by the Washington Supreme Court in 1960

31. Duty to disclose under common law
Under common law, seller required to inform buyer about hidden safety risks, generally not other information
But…
Obde v Schlemeyer (1960, Sup Ct of WA)
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 (awarded damages)
Obde v Schlemeyer (1960): a seller knew his building was infested with termites and did not tell the buyer
The buyer discovered the termites after the sale was completed, and sued
The termites should have been exterminated immediately to prevent further damage
The court in Obde deviated from tradition and imposed a duty to disclose

32. Duty to disclose under common law
Under common law, seller required to inform buyer about hidden safety risks, generally not other information
But…
Obde v Schlemeyer (1960, Sup Ct of WA)
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 (awarded damages)
Some states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects…
In Obde, the seller did not offer the fact that the building had termites, but also did not lie about it – the buyer didn’t ask
If the buyer had asked, and the seller claimed there were no termites, we would have been in the case of fraud
Other common-law courts and legislatures have also begun imposing a duty to disclose in particular situations
Lenders now must disclose the APR on all consumer loans
Many states require used car dealers to reveal major repairs done on the car being sold
Many states require sellers of homes to reveal certain types of defects
Such requirements are meant to improve information exchange and lower transaction costs

33. Failure to disclose?
source:

34. What if both parties were misinformed?
Frustration of Purpose
Change in circumstance made the original promise pointless
Coronation Cases
“When a contingency makes performance pointless, assign liability to party who can bear risk at least cost”
Fraud and failure to disclose are situations where one party is misinformed
The other two doctrines cover situations in which both parties to the contract are misinformed
When a change in circumstance makes performance of a promise pointless, the contract will often not be enforced based on the doctrine of frustration of purpose
I buy tickets to the Super Bowl, and prepay a separate vendor $100 for game-day parking close to the stadium
For some reason, the game is delayed a week, so I no longer want an expensive parking space in San Francisco for February 7, but the vendor wants to keep my money
This is basically what happened in the Coronation Cases, which established the rule
In the early 1900s, rooms in buildings along certain streets in London were rented in advance for the day of the new king’s coronation parade
The new king got sick, and the coronation was postponed
The renters did not want the rooms, but some of the owners tried to collect the rent anyway
The courts ruled that a change in circumstance had “frustrated the purpose” of the original contracts, and refused to enforce them
Impossibility was a doctrine for assigning the risk that performance becomes impossible
Frustration of purpose is a doctrine for assigning the risk that performance becomes pointless
The same economic principle applies:
When a contingency makes performance pointless, assign liability to the party who can bear the risk at least cost.
In this case, the property owners could eliminate their losses by renting the rooms a second time, for the rescheduled parade
Thus, there was hardly any cost to the owners from bearing the risk
So efficiency would seem to allocate the risk to them
Which is exactly what happened

35. What if both parties were misinformed?
Frustration of Purpose
Change in circumstance made the original promise pointless
Coronation Cases
“When a contingency makes performance pointless, assign liability to party who can bear risk at least cost”
Mutual Mistake
Mutual mistake about facts
Circumstances had already changed, but we didn’t know
Logger buys land with timber on it, but forest fire had wiped out the timber the week before
Mutual mistake about identity
Disagreement over what was being sold
The other doctrine for misinformation is mutual mistake – there are different types
There could be a mutual mistake about facts
This can be thought of as a contingency already having arisen before the parties signed the contract, but without their knowledge.
A logger contracts to buy some land with timber on it
As it happens, the timber was destroyed by forest fire the week before the contract was signed, but neither party knew about it
The owner at the time of the accident is usually the low-cost avoider of the risk – that is, the buyer is unlikely to be able to prevent forest fires on someone else’s land
Having the owner bear this risk means not enforcing the contract
I buy a painting at an auction, and the gallery and I learn later the painting was a forgery
Another type of mutual mistake is mutual mistake about identity
One of our early examples featured a beat-up Chevy and a shiny new Cadillac
The seller believed he was negotiating the sale of the Chevy
The buyer thought she was negotiating the purchase of the Cadillac
In this case, the court would typically invalidate the contract based on mutual mistake, and simply return the buyer’s money and the seller’s keys.
When there is mutual mistake about the object being sold, enforcing the contract would have the effect of making an involuntary exchange
We assume that voluntary exchange is efficient; involuntary exchange may not be
So efficiency agrees with the doctrine of setting aside contracts based on mutual mistake of this type.

36. Another principle for allocating risks efficiently: uniting knowledge and control
Hadley v Baxendale (miller and shipper)
Hadley knew shipment was time-critical
But Baxendale was deciding how to ship crankshaft (boat or train)
Party that had information was not the party making decisions
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
We’ve seen a few principles for determining the efficient bearer of a particular risk
Another principle for allocating risks was illustrated in Hadley v Baxendale, the miller with the broken crankshaft
In that case, heavy losses were incurred because the party with information was not the one making decisions
That is, Hadley, knew how time-critical his shipment was
But it was Baxendale who chose to ship the crankshaft by boat instead of train
This brings us to a general principle about information:
Efficiency generally requires uniting knowledge and control.
If I value some land more than you, it may be because I have knowledge of a way to derive more value from the land
The land has coal underneath, and I know how to mine it
Or the land is good for growing tomatoes, and I know how to grow tomatoes.
In those cases, selling the object to the party who values it more unites knowledge and control, and therefore increases efficiency.
As a general principle, then, contracts that unite knowledge and control should generally be upheld, and contracts that separate knowledge and control should more often be set aside
This gives us another way to look at the doctrines related to information

37. What About Unilateral Mistake?
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
When we looked at mutual mistake, neither party had correct information
So the contract neither united nor separated knowledge and control
So we did not discuss it in those terms
However, there are situations where one party to a contract has mistaken information and one does not
This is called unilateral mistake.
Suppose you have an old car and you think it’s just a worthless old car
But I know it’s a classic and worth a lot of money
I agree to buy it from you at a low price, and afterwards, you learn the truth
The contract was based on unilateral mistake – you were wrong about the value of the car, but I knew the truth.
In these cases, the contract is generally enforced
While contracts based on mutual mistake will generally be set aside, contracts based on unilateral mistake are generally enforced.

38. What About Unilateral Mistake?
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, enforcing them creates an incentive to gather information
This makes sense for two reasons
First, if I know the car is more valuable and manage to buy it from you, this unites knowledge and control
I probably know the car is valuable because I’m more into classic cars, and will thus take better care of it
Much as it’s disappointing to you to get screwed out of something valuable, this may well be efficient.
And second, this creates an incentive to gather information
Sometimes gathering information is costly
And often, having better information leads to efficiency
Rewarding people for having better information (allowing them to profit from it) leads to an incentive to gather information, which may be a good thing
(Of course, if you sued to try to void our contract, it would put me in a funny position
Mutual mistake is a valid formation defense
So you could claim neither of us knew the value of the car when you sold it to me.
So now I have to get up in court and claim, no, I wasn’t ignorant, I was just trying to rip you off
And if I can convince the court I was trying to rip you off, I get to keep the car.)

39. Unilateral mistake: Laidlaw v Organ (U.S. Supreme Court, 1815)
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
There was a famous case in 1815 that concerned unilateral mistake, Laidlaw v Organ
During the War of 1812, the British blockaded the port of New Orleans
This depressed the price of tobacco, since nobody could make money exporting it
Organ was a tobacco buyer; he received private information that a treaty had been signed, ending the war
That same day, he negotiated with the Laidlaw firm, which did not know about the treaty, to buy some tobacco at the depressed price
The next day, news broke that the war was over, the price of tobacco soared, and Laidlaw sued
Despite it being a unilateral mistake – Organ knew the war was over, Laidlaw did not – the contract was set aside at the original trial
It was appealed to the Supreme Court, who ruled that Organ was not required to communicate his knowledge and ordered a retrial
Things get a bit fuzzy from there, and the doctrine does not seem to be rock-solid
But nonetheless, unilateral error is generally not considered a valid reason to void a contract.

40. Uniting knowledge and control
Laidlaw v. Organ established: contracts based on unilateral mistake are generally valid
Agrees with efficiency: these contracts typically unite knowledge and control
What about Obde v. Schlemeyer?
The termites case was based on unilateral mistake
Court still upheld contract, but punished seller for hiding information
In that case, contract separated knowledge from control

41. Unilateral mistake: productive versus redistributive information
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 should be enforced…
…especially if that knowledge was the result of active investment
Contracts based on one party’s knowledge of purely redistributive information, or fortuitously acquired information, should not be enforced
We said that one of the reasons for enforcing contracts based on unilateral mistake is to create an incentive to gather information
Cooter and Ulen go further, by drawing a distinction between productive information and redistributive information
productive information is information that can be used to produce more wealth
productive information could be that farmland is resting atop valuable underground minerals, or the existence of a water route between Europe and China
redistributive information is information that can be used to redistribute wealth in favor of the informed party
redistributive information could be that the state plans to build a highway through a particular piece of land, changing property values nearby
Productive information increases total wealth
So efficiency requires giving people incentives to it
Thus, letting people profit from productive information is good
so enforcing contracts signed under unilateral error is good when the private information is productive
Redistributive information does not create additional wealth
So efficiency does not require giving incentives to discover it
Letting people profit from redistributive information is inefficient – leads to too much investment in this type of information
Cooter and Ulen also point out that to create incentives, information only needs to be rewarded when it was acquired through effort or investment, not by chance
Thus, they come to the principle:
Contracts based upon one party’s knowledge of productive information – especially if that knowledge was the result of active investment – should be enforced
Whereas contracts based upon one party’s knowledge of purely redistributive information or fortuitously acquired information should not be enforced.