0. Econ 522 Economics of Law
Dan Quint
Fall 2011
Lecture 13

1. Logistics HW3 is online, due next Thursday (Nov 3)
Second midterm is Wednesday Nov 9
Cumulative – covers everything up to end of contract law
More weight on more recent material (contracts)

2. Last Wednesday… Regulations/immutable rules
Derogation of public policy
Formation defenses and performance excuses
Incompetence (but not drunkenness)
Duress and necessity
Impossibility, and determining the efficient bearer of a risk
Today: more ways to get out of a contract, and remedies for breach
Derogation – assume the law or policy itself is efficient; not enforcing this type of contract makes it harder to violate or circumvent the law, which is therefore efficient
Incompetence, duress, necessity – all situations where one party to the contract may not have been able to act rationally
Generally want to enforce voluntary trade where both parties are willing participants – which may not be the case here
Drunkenness – could make same argument; but costs of allowing this way out of a contract might be too high
Chance that performance will become impossible is just another type of risk; if it wasn’t explicitly allocated in the contract, allocate it to efficient bearer
Friedman gave us three ways to determine who that is:
Who was in best position to affect/influence outcome?
Who had best information/was in best position to predict outcome?
Who could spread risk over many transactions?

3. Derogation of public policy

4. Discussion question Old urban legend: Serious question:
A man bought a box of extremely rare and expensive cigars, and insured them against loss or damage.
After smoking them, he filed an insurance claim, saying they had been destroyed in 20 separate small fires.
The insurance company refused to pay, the man sued and won.
But as he was leaving the courtroom, he was arrested on 20 counts of arson.
Serious question:
If the intent of a contract is clear, but different from the literal meaning, which should be enforced?

5. Contracts based on bad information

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

7. 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 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
source:

8. What if you trick someone by withholding information?
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
Less so under the common law
Seller only has to share information about hidden dangers…
…not information that makes a product less valuable but not 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
A used car dealer does not have to tell you every flaw about a car he is selling you, although he cannot lie about these faults if you ask him.
(On the other hand, new products come with an “implied warranty of fitness”: the seller of a new car must return the purchase price if the car proves unfit to perform its basic function, transportation.)

9. 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)
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
A bit more on the duty to disclose
Sellers are legally required to inform buyers about any hidden safety risks associated with their product
The rationale is fairly obvious
Under the common law, sellers are generally not required to disclose other information to a buyer, only safety information
But there have been exceptions
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

10. 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)
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
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
Victims of fraud are generally entitled to damages in the amount of the harm caused by the fraud.
The reasoning here is clear
If parties know fraudulent contracts will not be enforced, they can rely on the truthfulness of the other party’s statements, rather than having to incur the costs of verifying everything for themselves
This lowers transaction costs of completing agreements, which is one of the goals of contract law.
We said that historically, the common law generally does not impose a duty to disclose
However, courts and legislatures have begun imposing a duty to disclose in certain 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
Whether doing so outweighs the cost of enforcing them is a separate question.

11. 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 Indianapolis for February 5, 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 became ill, and the coronation was postponed
The renters, then, 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
Frustration of purpose would also presumably void the agreement if you won an auction for an expensive painting, and then you and the seller both discovered it was a forgery
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

12. 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.

13. 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)
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 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

14. Mutual vs. 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.

15. 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.)

16. 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.

17. 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
redistributive information is information that can be used to redistribute wealth in favor of the informed party
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 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.

18. Other reasons a contract may not be enforced

19. Vague contract terms
Courts will generally not enforce contract terms that are overly vague
Can be thought of as a penalty default
But some exceptions
Parties may commit to renegotiating the contract “in good faith” under certain contingencies
Courts will generally not enforce terms of contracts that are overly vague.
For example, a promise to give one’s “best efforts” toward some goal are often not enforceable.
In some cases, the parties might want the court to enforce these terms
They may leave terms vague because they cannot foresee all contingencies, but hope the court will insert its judgment after the fact.
However, courts generally set aside vague promises
This can be thought of as a penalty default, as in Ayres and Gertner
it is difficult for the court to figure out the intent of vague terms, so they supply a default the parties would not want – refusing to enforce them – to force the parties to be more specific in the contract.
However, there are some situations where a court may at least partially enforce such terms
For example, a term requiring the parties to renegotiate the contract “in good faith” under certain contingencies might be held against a party who broke off negotiations without giving a good reason.

20. “Shrink-wrap” licenses
Back when software came on disks or CDs…
Box was wrapped in cellophane
Inside, “By unwrapping this box, you agree to the following terms…”
If party given no opportunity to review contract, not binding
“Due to the unscheduled trip to the autowrecking yard the school bus will be out of commission for two weeks. Note by reading this letter out loud you have waived any responsibility on our part in perpetuity throughout the known universe.”

21. What if a party chose not to review the contract?
Source:

22. What if a party chose not to review the contract?
British computer game retailer GameStation, on April Fool’s Day, added this to Terms & Conditions customers agreed to before buying online:
“By placing an order via this website… you agree to grant us a non-transferable option to claim, for now and for ever more, your immortal soul.
Should we wish to exercise this option, you agree to surrender your immortal soul, and any claim you may have on it, within 5 (five) working days of receiving written notification from gamestation.co.uk or one of its duly authorised minions.
…If you a) do not believe you have an immortal soul, b) have already given it to another party, or c) do not wish to grant us such a license, please click the link below to nullify this sub-clause and proceed with your transaction.”
Only about 10% of online shoppers clicked the box to opt out of the soul clause.
GameStation wasn’t actually trying to collect souls – they ed their customers to formally give up their immortal soul claims – and were just doing it to make the point: nobody reads the fine print
Shrink-wrap licenses are not considered binding, since it’s impossible to agree to something without having a chance to read it; but as long as customers are given an opportunity to read the terms before agreeing, a contract like this would generally be binding
However, in this particular case, if GameStation really did try to collect peoples’ souls, there would be another way out

23. Contracts of adhesion
Adhesion: standardized “take-it-or-leave-it” contracts where terms are not negotiable
“Bogus duress”
Not illegal per se, but might attract “closer scrutiny”
A few state courts have adopted a rule: if I put a clause in a contract that I think you would not agree to if you noticed it, then it doesn’t count
When you rent a car, you don’t stand at the counter negotiating each particular detail of the agreement
Instead, they hand you a standard contract, off a large pile of contracts
And you either sign it or you leave without a car
Standardized contracts, and in particular contracts offered as “take-it-or-leave-it” deals, are sometimes referred to as “contracts of adhesion”
Arguments are sometimes made that standardized contracts make it easier to stifle competition
If Avis, Hertz, and other rental car agencies all use standard contracts, they are more committed to not competing against each other
It’s not really that strong an argument – Friedman refers to adhesion as “bogus duress”
If a market is really competitive, competition still limits what the companies can get away with in their standard contracts, even if they are offered as being non-negotiable at the time
Once people learn that a particular car company is charging high prices, customers will start using other companies
Cooter and Ulen offer a couple of defenses of standardized contracts
First, by standardizing all the other terms of the agreement, they may make price competition fiercer, because companies can no longer obscure prices by varying other parts of the deal
And second, they may reduce transaction costs, again by fixing most parts of the deal and leaving fewer to bargain over
They suggest worrying about adhesion only in situations of genuine monopoly.
Standardized contracts are not illegal, but may attract “closer scrutiny”
A few state courts have adopted a rule proposed by the American Law Institute: “Where the other party has reason to believe that the party mainfesting such assent would not do so if he knew that the writing contained a particular term, the term is not part of the agreement”

24. What if you signed a contract that was dramatically unfair?
Under the bargain theory, courts should ask only whether a bargain occurred, not whether it was fair
Hamer v Sidway (drinking and smoking)
But both common and civil law have doctrines for not enforcing overly one-sided contracts
Unconscionability/Lesion
“Absence of meaningful choice on the part of one party due to one-sided contract provisions, together with terms which are so oppressive that no reasonable person would make them and no fair and honest person would accept them”
When “the sum total of its provisions drives too hard a bargain for a court of conscience to assist”
Terms which would “shock the conscience of the court”
That is unconscionability: the doctrine that an overly one-sided contract may be set aside (not enforced)
Traditionally, unconscionability was defined as terms “such as no man in his senses and not under delusion would make on the one hand, and as no honest and fair man would accept on the other.”
Later it was restated as when “the sum total of its provisions drives too hard a bargain for a court of conscience to assist.”
The current standard, I believe, is terms which would “shock the conscience of the court.”
The civil law tradition has a similar concept, called lesion.

25. Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)
“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”
One well-known case relating to this doctrine is Williams v Walker-Thomas Furniture (California District Court, 1965).
Over the course of several years, Williams bought durable goods on credit
Each time she bought more goods, the previous goods (some of which were already paid off) were used as “add-on” collateral, in place of a down payment
Eventually, Williams missed a bunch of payments on the newest goods, and the furniture company repossessed everything; she sued
The contract was deemed unconscionable
Quoting from the decision:
...we hold that where the element of unconscionability is present at the time a contract is made, the contract should not be enforced. ... Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. ... In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.

26. Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)
“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”
... The manner in which the contract was entered is also relevant to this consideration. Did each party to the contract, considering his obvious education or lack of it, have a reasonable opportunity to understand the terms of the contract, or were the important terms hidden in a maze of fine print and minimized by deceptive sales practices? Ordinarily, one who signs an agreement without full knowledge of its terms might be held to assume the risk that he has entered a one-sided bargain. But when a party of little bargaining power, and hence little real choice, signs a commercially unreasonable contract with little or no knowledge of its terms, it is hardly likely that his consent, or even an objective manifestation of his consent, was ever given to all the terms. In such a case the usual rule that the terms of the agreement are not to be questioned should be abandoned and the court should consider whether the terms of the contract are so unfair that enforcement should be withheld.
Cooter and Ulen make the case that add-on collateral may be reasonable in some situations
You want to buy furniture worth $1000 today, but once you get it home, if the furniture company had to repossess it, it would only be worth $800
If you have $200 on hand for a down payment, no problem
If not, and you had poor credit, they might refuse to sell you the furniture
So linking payments on one piece of furniture to other furniture may be reasonable, even desirable, in some instances
Cooter and Ulen argue that by invalidating the contract, the court served Williams, but harmed lots of other people in similar situations, since now they might not be given credit at all.

27. Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)
“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.
…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”
Not normal monopoly cases but “situational monopolies”
Think of Ploof v Putnam (sailboat in a storm), not Microsoft
Unconscionability tends to be invoked not in the usual circumstances of monopoly, but in “situational monopolies”
That is, in particular circumstances that limit one’s choice of trading partners
This was the example in Ploof v. Putnam
Recall, Ploof was sailing on a lake when a storm appeared
Putnam was the only person who could give him safe harbor
Thus, Putnam became a monopolist in this situation, even though he normally would not have been.

28. Remedies for breach of contract
That’s all for ways to invalidate a contract. Next, we’ll consider the remedies that are available when a contract is breached.

29. Three broad types of remedy for breach of contract
Party-designed remedies
Remedies specified in the contract
Court-imposed damages
Court may decide promisee entitled to some level of damages
Specific performance
Forces breaching party to live up to contract
There are three general types of remedies for breach of contract:
party-designed remedies
court-imposed damages
specific performance
Party-designed remedies are remedies specified in the contract for a particular scenario
for example, a construction contract might stipulate a particular daily fee if completion of the building is delayed
Court-imposed damages are what we’ve already been talking about
the court may rule that the promisee is entitled to some amount of money as compensation for the breach
The third alternative is for the court to require specific performance
This forces the breaching party to live up to the contract
(Not always possible, of course
But if I agreed to sell you my painting, and then tried to breach the contract to sell it to someone else, the court could simply rule that I have to sell it to you at the agreed price.)
When a court awards monetary damages, there are still several different ways these damages could be calculated

30. Expectation damages
Compensate promisee for the amount he expected to benefit from performance
You agreed to buy an airplane for $350,000
You expected $500,000 of benefit from it
Expectation damages: if I breach, I owe you that benefit
($500,000 if you already paid, $150,000 if you didn’t)
“Positive damages”
Make promisee indifferent between performance and breach
We’ve already seen one: expectation damages.
Expectation damages are meant to compensate the promisee for the amount he expected to benefit from performance of the promise
Recall the airplane example we did a while back
you contracted to buy an airplane from me for $350,000
you expected to derive $500,000 of benefit from it
under expectation damages, I would owe you that benefit
($500,000 if you had already paid me, or $500,000 - $350,000 = $150,000 if you had not.)
The civil law refers to these as positive damages, as they compensate you for the positive benefit you anticipated from the contract
When they are calculated correctly, expectation damages make the promisee indifferent about whether the promisor performs or breaches
Thus, under expectation damages, the promisor internalizes all the costs of breach, and therefore makes the efficient decision about breach.

31. Reliance damages
Reimburse promisee for cost of any reliance investments made, but not for additional surplus he expected to gain
Restore promisee to level of well-being before he signed the contract
You contracted to buy the plane and built a hangar
If I breach, I owe you what you spent on the hangar, nothing else
“Negative damages” – undo the negative (harm) that occurred
A second type of damages are reliance damages
These compensate the promisee for any investments he made in reliance on the promise, but not for the additional surplus he expected to gain
Reliance damages, therefore, restore the promisee to the level of well-being he would have had if he had not received the promise in the first place
In the airplane example, suppose I chose not to deliver the plane but you had built yourself a hangar
Reliance damages would require me to reimburse you the cost of the hangar, but not the surplus you expected to earn from owning the plane
In the rich uncle example – the rich uncle promises his nephew a trip around the world, then changes his mind – reliance damages would pay for whatever supplies the nephew had purchased in preparation for the trip, minus whatever price he could resell them for
Again, this puts the promisee back in the position he was in before the promise was made
The civil law tradition refers to these as negative damages, as they undo the negative (the harm) that actually occurred in response to the promise
If no investments were made in reliance on the promise, reliance damages would be 0 – sort of a “no harm, no foul” rule.

32. Opportunity cost damages
Give promisee benefit he would have gotten from his next-best option
Make promisee indifferent between breach of the contract that was signed, and performance of best alternative contract
You value plane at $500,000
You contract to buy plane from me for $350,000
Someone else was selling similar plane for $400,000
By the time I breach, that plane is no longer available
I owe you $100,000 – the benefit you would have gotten from buying the other seller’s plane
A third type of damages are opportunity cost damages
If you agree to buy a plane from me, you may pass up another chance to buy a plane from someone else
But if I breach our contract, that other option may no longer be available
Opportunity cost damages are set to restore the promisee to the level of well-being he would have had if he had not contracted with this promisor, and instead had gone with his “next-best option”
Opportunity cost damages can be seen as an extension of reliance damages, where now turning down another opportunity is seen as a form of reliance, that is, as an investment you make in reliance on the promise that was made
Thus, opportunity cost damages leave the promisee indifferent between breach of the contract that was signed and fulfillment of the best alternative contract
In the airplane example, you contracted to buy a plane worth $500,000 for $350,000
Suppose someone else had an equally attractive airplane for sale at $400,000
If I breach our contract, opportunity cost damages would be $100,000, since this is the surplus you would have realized by foregoing the contract with me and instead buying the other plane

33. Example: expectation, reliance, and opportunity cost damages
You agree to sell me ticket to Wisconsin-Purdue football game for $50
Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of whatever pre-game investments I made
An example
Wisconsin plays Purdue in football in two weeks, I decide I want to go
One of you has a roommate with an extra ticket, and so you agree to sell it to me for $50
At the last minute, your roommate decides to go to the game, and you break your promise to me
Expectation damages are supposed to make me as well-off as if you had indeed sold me the ticket for $50
It may be hard to measure exactly how well-off the football game would have made me
But once you tell me my ticket is gone, I could show up at the stadium before the game and buy a ticket from a scalper
Say this costs $150
This gives us an easy way to compute expectation damages
If you had lived up to your promise, I’d have paid $50 to get into the game; since you broke your promise, I paid $150
So I’d be $100 better off if you’d kept your promise; so expectations damages are $100
Next, consider reliance damages for the same contract
Going to a football game doesn’t involve a lot of substantial investments
It’s possible reliance damages would be 0
If I had already gone out and bought red-and-white face paint and a big foam finger, reliance damages might reimburse me for these purchases
But reliance damages would not compensate me for the benefit I expected to get.

34. Example: expectation, reliance, and opportunity cost damages
You agree to sell me ticket to Wisconsin-Purdue football game for $50
Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of whatever pre-game investments I made
When you agreed to sell me ticket, other tickets available for $70
Opportunity cost damages: $80
(I paid a scalper $150 to get in; I would have been $80 better off if I’d ignored your offer and paid someone else $70)
Finally, suppose when we made the deal, there were lots of people offering tickets on Craigslist for $70
By the time you breach, these tickets were gone, so all I could do was pay a scalper $150 for a ticket
The actual payoff I got was G – 150, where G is the value of attending the game
If I had signed the best alternative contract, my payoff would have been G – 70
So while the contract we signed would have made me $100 better off, the best alternative would have made me $80 better off
Opportunity cost damages, then, would be set at $80, to compensate me for having passed on that opportunity.
Also note that these are all remedies for seller breach
We could calculate what I would owe you if I changed my mind and decided not to go to the game – that is, the remedy for buyer breach – in the analogous way.
In this example, a ticket to a football game is a good with many substitutes
That is, there are lots of tickets to the game, and they’re all worth about the same amount
So it made sense to calculate damages based on the market price of a replacement ticket
When a contract is for a unique good, this doesn’t always work; but conceptually, the analysis is almost the same.

35. ³ ³ = = = ³ ³ ³ ³ Ranking damages $100 $80 $15 Contract I Sign
Best Alternative
Do Nothing = = =
Breach + Expectation Damages
Breach + Opportunity Cost Damages
Breach + Reliance Damages
In this example,
Expectation Damages >= Opportunity Cost Damages >= Reliance Damages
It turns out, as long as all three are computed correctly, this should always be true
The reason is simple.
If I am rational and choose to sign a particular contract, it must be because that contract is at least as good for me as my best alternative
Of course, doing nothing is always an option, so it stands to reason that both the contract I sign, and the next best alternative, are at least as good as doing nothing
So from the point of view of my utility,
Contract I sign >= Best Alternative >= Doing Nothing
Following breach,
expectation damages restore me to the value of performance of the contract I signed
opportunity cost damages restore me to the value of performance of the next-best alternative
reliance damages restore me to the value of having done nothing So
Breach + Expectation Damages >= Breach + Opp Cost Damages >= Breach + Reliance D
If we subtract off the value of the breached contract in each case, we see that
(Of course, damages are not always calculated perfectly, so there may be instances in which this is violated. We’ll see examples of this next time.)
Expectation Damages
Opportunity Cost Damages
Reliance Damages
$100
$80
$15

36. Hawkins v McGee (“hairy hand case”)
Hawkins had a scar on his hand
McGee promised surgery to “make the hand a hundred percent perfect”
Surgery was a disaster, left scar bigger and covered with hair
In the examples so far – the airplane, and the football ticket – we could use market prices to calculate damages
In some situations, the value of a contract is subjective, making things a bit harder
Still, the principle is the same, it’s just a question of how to actually do the calculation.
A dramatic example of this is a 1929 case from New Hampshire, Hawkins v McGee, “the hairy hand case.”
George Hawkins had a scar on his hand from touching an electrical wire when he was young
A local doctor, McGee, approached him about having the scar removed, and promised to “make the hand a hundred percent perfect hand.”
Skin from Hawkins’ chest was grafted onto his hand
But the surgery was a disaster: the scar ended up bigger than before, and covered with hair
Hawkins successfully sued McGee; the issue on appeal was how high to set the damages.
To get a view of what’s going on, consider Hawkins’ preferences over two types of goods: his hand, and money. (Indifference curves.)

37. Hawkins v McGee (“hairy hand case”)$
+ Expectation Damages
+ Opp Cost Damages
Expectation Damages
Reliance Damages
Opp Cost Damages
+ Reliance Damages
Initial Wealth
To get a view of what’s going on, consider Hawkins’ preferences over two types of goods: his hand, and money. He could have a scar on his hand; a perfect hand; he could have gone to a different doctor who promised him improvement but not perfection; and he could have the hairy hand he had after surgery. Indifference curves.
Hawkins started out at the red dot – with a scarred hand, and some initial amount of money.
The doctor promised him the green dot – a perfect hand (but less money, since he would have to pay for the surgery)
Now he’s stuck with a hairy hand. And about to get more money (damages).
Reliance damages would get him back to the same level of well-being as before
The next-best doctor might have gotten him to the orange dot – a pretty good hand.
Opportunity cost damages would get him to the level of well-being he would have had by going to the next-best-doctor
Expectation damages would get him to the level of well-being he expected from the successful operation.
(Of course, there is still the question of how to calculate these indifference curves, since they are clearly subjective
There is also the question of whether it even makes sense to think that money can compensate for something like a disfiguring injury
But this is at least the principle.)
Once again, we see that the promised benefit (performance) is better than the next-best option, which is better than doing nothing
So expectation damages are bigger than opportunity cost damages, which are bigger than reliance damages
This ranking should hold whenever all three damage levels are calculated correctly
(The textbook gives examples of reasons that damages might be calculated incorrectly in real life – for example, if someone’s subjective valuation of a promise was very different from an objective, “market”-based measure – and in those cases, the order could be switched)
Hand
Hairy
Scarred
Next best doctor
100% Perfect

38. Other court-ordered remedies
Restitution
Return money that was already received
Disgorgement
Give up wrongfully-gained profits
There are three other types of damages that are sometimes ordered, which aren’t all that interesting, but are worth knowing.
Restitution is basically just forcing someone to pay back whatever money they’ve already received
I contract to buy a house and make a down payment
The seller breaches
If nothing else, he is required to return my down payment
This is sort of a minimal remedy, but it at least is very easy to implement.
Disgorgement is a similar concept, requiring someone to give up whatever profits they have wrongfully gained
Directors of a corporation have a duty to stockholders to act in a certain way
This is a very vague duty, not a list of specific things they are required to do
Suppose a director acts in a disloyal way, which is costly to the company but profitable to himself
Disgorgement damages would require the director to give up whatever profits he earned to the victim, in this case, the stockholders
Perfect disgorgement damages take away the director’s incentive to commit fraud

39. Other court-ordered remedies
Restitution
Return money that was already received
Disgorgement
Give up wrongfully-gained profits
Specific Performance
Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes used when seller breaches contract to sell a unique good
Like injunctive relief
Specific Performance is when, instead of ordering money damages, the court orders the promisor to live up to the promise
I contract to buy a particular house from you
It’s a beautiful house, in a historical neighborhood, and there are no others like it available
After we sign an agreement, you find a more eager buyer, and try to breach our agreement
The court might order you to follow through with the sale to me – this would be specific performance
In some civil law countries, specific performance rather than monetary damages is the traditional remedy for breach of contract
In common law, when a good has substitutes, money damages are traditionally the remedy, since the promisee can use that money to buy a substitute good if he so chooses
Specific performance is sometimes ruled for sale of goods without any substitutes
Specific performance can also be seen as an analog to injunctive relief in property law – your promise now belongs to me, so you’re not allowed to get out of it unless I choose to release you

40. Expectation damages vs. specific performance
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 cost $29,000
But “diminution in value” of farm was only $300
Original jury awarded $5,000 in damages, both parties appealed
OK Supreme Court reduced damages to $300
We said earlier that expectation damages will always lead to efficient breach
By equating liability with the social benefit of performance, we force promisor to internalize the externality of breach, so he breaches only when efficient
However, there is a case that illustrates how this can sometimes go wrong, when expectation damages aren’t appropriately measured
The case is Peevyhouse v Garland Coal and Mining Company (OK Sup Ct, 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)
Both parties stipulated 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.)
Original jury awarded Peevyhouse $5000 in damages; both sides appealed to OK Sup Ct
Peevyhouse saying this was less than the service that had been promised
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.

41. Expectation damages vs. specific performance
At first, sounds like a perfect example 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
(Peevyhouses seemed to value condition of property much more highly than change in market value)
At first glance, this seems like a nice example of efficient breach
Performing the last part of the contract would cost $29,000
The benefit to the Peevyhouses would be $300
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
one was later impeached, and others resigned
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.

42. Think about Peevyhouse in terms of penalty defaults
Contract promised restoration work, didn’t specify remedy if it wasn’t performed
Which default rule works better:
Default rule allowing Garland to breach and pay diminution fee?
Default rule forcing Garland to perform restoration 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 serve as a penalty default

43. Party-designed remedies
Remedy for breach could be written directly into contract
But common law courts don’t always enforce remedy terms
Liquidated damages – party-specified damages that reasonably approximate actual harm done by breach
Penalty damages – damages greater than actual harm done
Civil law courts are generally willing to enforce penalty damages
But common law courts often do not
We mentioned that in some cases, the remedy for breach can be built directly into the contract
Some contracts stipulate an amount of money that a party would have to pay if he were to breach the contract
Others might specify a “performance bond” – an amount of money deposited with a third party, that would be paid to the promisee upon breach
Or a contract might specify a different process for resolving any disputes, such as agreeing to submit to binding arbitration or some other process
(This is what happens with disputes among diamond merchants, which are never resolved in court.)
For some reason, courts are often hesitant to enforce remedy terms in contracts
Rather than enforce the contract as written, courts sometimes set aside remedy clauses and impose their own remedies
One type of remedy that courts will often refuse to enforce is penalty damages
Penalty damages are damages that are greater than the actual harm that occurred
(“Liquidated damages” refer to party-specified damages that are a reasonable estimate of the actual harm done by the breach; penalty damages are any damages that are greater than that)
Civil law courts generally enforce penalty damages
But common law courts often set aside penalty damages, and only enforce liquidated damages

44. Penalty Damages Peevyhouse v Garland Coal
Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000
Penalty Damages
Peevyhouse v Garland Coal
Peevyhouses only wanted farm strip-mined if it would be restored to original condition after
Suppose coal extracted worth $70,000
Garland paid $25,000 for rights to mine it
Restoration work would cost $30,000
Diminution of value was $300
So liquidated damages would be $300
Suppose Peevyhouses got $40,000 of disutility from land being left in poor condition
It’s unfortunate that penalty clauses are often not enforced, because they could be useful in some instances
In particular, they could be helpful when one party to a contract places a high subjective value on performance
Go back to coal mining example we saw earlier, Peevyhouse v Garland Coal
The Peevyhouses only wanted their farm strip-mined if the land could be restored to its original condition
They seemed to value the condition of their farm much more highly than “market value”
Had they known the coal company would refuse to perform the restoration work, and instead only pay them damages, they might have refused to agree to the contract in the first place
We can illustrate this with a simple dynamic game
Suppose the coal extracted was worth $70,000 (net of costs), and Garland Coal agreed to pay $25,000 to mine it
Recall that restoration work would have cost around $30,000, but damages for refusing to do it were assessed at $300
Suppose that the Peevyhouses got $40,000 of disutility from the land not being restored

45. Liquidated damages If damages limited to liquidated damages…
Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000
Liquidated damages
Peevyhouses
Sign
Don’t
Garland Coal
(0, 0)
Restore property
Don’t, pay damages
(25,000, 15,000)
(-14,700, 44,700)
If damages limited to liquidated damages…
Peevyhouses shouldn’t believe restorative work will get done
So Peevyhouses better off refusing to sign
Even though mining and restoring Pareto-dominates

46. Penalty damages If penalty clauses in contracts enforceable…
Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000
Penalty damages
Peevyhouses
Sign
Don’t
Garland Coal
(0, 0)
Restore property
Don’t, pay penalty
One way to address this in a contract would have been to write into the contract a $40,000 penalty in the event that the restorative work was not completed
If this was enforceable, it would ensure that the mining company followed through with the restorative work
That is, it would change the game to this:
Now, the Peevyhouses are assured of getting their land restored
So they’re happy to agree to the contract
But, if common law courts don’t uphold penalty clauses, this won’t work
Another example: suppose you’re hiring a contractor to build a house, and you place a very high value on its being completed by a particular date
You are happy to pay $200,000 to get the house built, but insist on a $50,000 penalty if it’s not ready on that date
Now suppose there are lots of contractors who could potentially build the house
If you offer this deal to lots of them, the ones who accept are likely the ones who are most confident in their ability to finish the house on time
Since you value this highly, this may be efficient
And this may be the easiest (or the only) way for you to elicit this information
If there is no penalty clause, every contractor will try to convince you he’s 100% certain he’ll finish on time
But if someone accepts the $50,000 penalty clause, they’re probably pretty sure
(25,000, 15,000)
(25,000, 5,000)
If penalty clauses in contracts enforceable…
Write contract with $40,000 penalty for leaving land unrestored
Now restoration work would get done, so Peevyhouses willing to sign
But if courts won’t enforce penalty damages, this won’t work

47. Penalty clauses
Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus
I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
So in some instances, penalty damages seem beneficial
Especially if one party would not agree to a mutually beneficial contract without them
So it seems like the fact that they’re not enforced is a problem
However, it turns out, most things you could accomplish with penalties, you could restate in a different way with a performance bonus
Go back to the house-building example
I’m happy to pay $200,000 to get the house built by a certain date
But I insist on a $50,000 penalty if it’s not ready on time
We could alternatively write the contract this way:
I pay $150,000 for the building of the house
And I pay an additional $50,000 performance bonus if the house is completed by a certain date
Courts generally have no problem enforcing contracts with bonuses in them, so this would likely be enforced as written
But it has the same effect as the contract with the penalty
(Under either contract, the builder gets $200,000 for finishing the house on time, and $150,000 for finishing it late.)

48. Penalty clauses
Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus
I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
Similarly, Peevyhouse example
Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is not restored
Equivalently, get $65,000 for mining rights, pay $40,000 bonus if restoration is completed
But, if intent of contract is too transparent, still might not be enforced
Similarly, go back to the Peevyhouse example
Instead of a $40,000 penalty that might not be upheld, the Peevyhouse contract also could have been rewritten as a bonus
We imagined that Garland paid $25,000 to mine the coal
Suppose the contract were written in this way:
Garland pays the Peevyhouses $65,000 to mine the coal
The Peevyhouses pay Garland a $40,000 bonus if the resoration work is completed
This would create exactly the same incentives as a $40,000 penalty clause
(In this case, though, the intent of the contract might have been so transparent that it still might not have been enforced)