Econ 522 Economics of Law Dan Quint Fall

Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 12

Logistics w Midterm and HW 2 will be returned at the end of lecture w HW 3 is online – due Fri Nov 5 1

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

Monday: how big a problem is trust? w Face to face: trust is not a problem w Every pair got maximum joint payoffs ($40), even split ($20 each) w In front of whole class: trust is not a problem w Every pair got maximum joint payoffs w In anonymous setting: trust is a bit of a problem Player A sent $6. 92 on average, so 69% of gains were realized w Player B got back $7. 78 on average w Of those who sent money, 27% got back nothing, including 30% of those who sent $10 w Of those who sent money, 34% got back less than they sent, including 37% of those who sent $10 3 w

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

In the anonymous treatment… Observ. Average received Avg payoff (player A) Average ROI % who got back 0 % who got back less 0 3 0. 33 10. 33 - 67% - 1, 2, 3 6 2. 00 9. 67 -22% 50% 4, 5, 6 21 6. 43 11. 33 26% 24% 7, 8, 9 8 7. 75 10. 38 4% 13% 38% 10 27 10. 96 10% 37% All 65 7. 78 10. 86 11% 27% 34% 5

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

Plane worth $500, 000 to you, price $350, 000 Incentives for reliance: example Cost: either $250, 000 or $1, 000 $x investment 600Öx increase in value of performance Additional value of plane Designer hangar with Starbucks - $480, 000 Functional heating - $240, 000 Metal poles, rigid roof - $120, 000 Plywood frame, canvas roof - $60, 000 0 00 40 , Investment in hangar $6 $1 $10 0, 0 0 $4 00 0, 00 0 $1 60 , 0 00 Tarp and rope - $6, 000 benefit 7

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

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

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

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

Regulations 12

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

One example of a regulation/immutable rule: derogation of public policy w Derogate, verb. detract from; curtail application of (a law) w Contracts which derogate public policy – that is, undermine a law or regulation – are not enforceable w Contracts which could only be performed by breaking a law w Contracts whose effect is to circumvent a law A (other factory) “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr” B (union) C (ownership) 14

One example of a regulation/immutable rule: derogation of public policy w Derogate, verb. detract from; curtail application of (a law) w Contracts which derogate public policy – that is, undermine a law or regulation – are not enforceable w Contracts which could only be performed by breaking a law w Contracts whose effect is to circumvent a law A (other factory) “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr” B (union) C (ownership) 15

Derogation of public policy w In general: contracts which can only be performed by breaking the law are not enforceable w But… “A married man may be liable for inducing a woman to rely on his promise of marriage, even though the law prohibits him from marrying without first obtaining a divorce. ” w “A company that fails to supply a good as promised may be liable even though selling a good with the promised design violates a government safety regulation. ” w “A company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation. ” w w “A promisor should be liable for breach if he knew that the promise was illegal” 16

Expectation damages: default rule or immutable rule? w Peevyhouse v Garland Coal and Mining Co (OK Supreme Court, 1962) w w w Garland contracted to strip-mine coal on Peevyhouse’s farm Contract specified Garland would restore property to original condition; Garland did not Restoration would have cost $29, 000… …but “diminution in value” of farm only $300 Original jury awarded $5, 000 in damages, both parties appealed Oklahoma Supreme Court reduced damages to $300 17

Expectation damages: default rule or immutable rule? w Seems like classic case of efficient breach Performing last part of contract would cost $29, 000 w Benefit to Peevyhouses would be $300 w Efficient to breach and pay expectation damages, which is what happened w w But… Most coal mining contracts: standard per-acre diminution payment w Peevyhouses refused to sign contract unless it specifically promised the restorative work w Dissent: Peevyhouses entitled to “specific performance” w 18

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

Ways to get out of a contract 20

Formation Defenses and Performance Excuses w Formation defense Claim that a valid contract does not exist w (Example: no consideration) w w Performance excuse Yes, a valid contract was created w But circumstances have changed and I should be allowed to not perform w w Most doctrines for invalidating a contract can be explained as either… Individuals agreeing to the contract were not rational, or w Transaction cost or market failure w 21

Incompetence w Courts will not enforce contracts by irrational individuals Children w Legally insane w w Doctrine of incompetence One party was not competent to enter into contract w Invalidates contracts which are not in best interest of that party w w What if you signed a contract while drunk? w You need to have been really, really drunk to get out of a contract 22

What if you signed a contract while drunk? w Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]” w Lucy v Zehmer (VA Sup Ct, 1954) 23

What if you signed a contract while drunk? w Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]” w Lucy v Zehmer (VA Sup Ct, 1954) 24

What if you signed a contract while drunk? w Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]” w Lucy v Zehmer (VA Sup Ct, 1954) 25

What if you signed a contract while drunk? w Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]” w Lucy v Zehmer (VA Sup Ct, 1954) 26

What if you signed a contract while drunk? w Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]” w Lucy v Zehmer (VA Sup Ct, 1954) w The Borat lawsuits 27

What if you signed a contract while drunk? w Only unenforceable if you were “intoxicated to the extent of being unable to comprehend the nature and consequences of the [contract]” w Lucy v Zehmer (VA Sup Ct, 1954) w The Borat lawsuits w Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for Make Benefit Guileless Americans In Film” w Moral of story: don’t get drunk with someone who might ask you to sign a contract 28

Another formation defense: dire constraints 29

Dire constraints w Necessity I’m about to starve, someone offers me a sandwich for $10, 000 w My boat’s about to sink, someone offers me a ride to shore for $1, 000 w Contract would not be upheld: I signed it out of necessity w w Duress Other party is responsible for situation I’m in w Someone makes me an offer I can’t refuse w 30

Friedman on duress w Example Mugger threatens to kill you unless you give him $100 w You write him a check w Do you have to honor the agreement? w w “Efficiency requires enforcing a contract if both parties wanted it to be enforceable” He did – he wants your $100 w You did – you’d rather pay $100 than be killed w w So why not enforce it? Makes muggings more profitable leads to more muggings w Tradeoff: don’t enforce Pareto-improving trade, in order to avoid incentive for bad behavior w 31

Friedman on duress w Example Mugger threatens to kill you unless you give him $100 w You write him a check w Do you have to honor the agreement? w w “Efficiency requires enforcing a contract if both parties wanted it to be enforceable” He did – he wants your $100 w You did – you’d rather pay $100 than be killed w w So why not enforce it? Makes muggings more profitable leads to more muggings w Tradeoff: don’t enforce Pareto-improving trade, in order to avoid incentive for bad behavior w 32

What about necessity? w Same logic doesn’t work for necessity You get caught in a storm on your $10, 000 sailboat w Tugboat offers to tow you to shore for $9, 000 w (Otherwise he’ll save your life but let your boat sink) w w Duress: if we enforce contract, incentive for more crimes w w w Here: if we enforce contract, incentive for more tugboats to be available for rescues – how is that bad? Social benefit of rescue: value of boat, minus cost of tow Say, $10, 000 – $10, 000 = $9, 990, 000 If tugboat gets entire value, his private gain = social gain So tugboat captain would invest the efficient amount in being available to rescue you So what’s the problem? 33

What about necessity? w What about your decision: whether to sail that day w w w w w 1 in 1000 chance of being caught in a storm If so, 1 in 2 that a tugboat will rescue you Private cost of sailing: 1 in 2000 you lose boat, 1 in 2000 you pay tugboat captain value of boat $10, 000/2000 + $10, 000/2000 = $10, 000 So you’ll choose to sail if your value is above $10, 000 Social cost: 1 in 2000 boat is lost, 1 in 2000 boat is rescued $10, 000/2000 + $10, 000/2000 = $5, 005 Efficient to sail when your value is above $5, 005 When your value from sailing is between $5, 005 and $10, 000, you undersail If the price of being towed was just the marginal cost, you would sail the efficient amount 34

Friedman’s point w Same transaction sets incentives on both parties w Price that would be efficient for one decision, is inefficient for other w “Put the incentive where it would do the most good” Least inefficient price is somewhere in the middle w And probably not the price that would be negotiated in the middle of a storm! w 35

Friedman’s point w Same transaction sets incentives on both parties w Price that would be efficient for one decision, is inefficient for other w “Put the incentive where it would do the most good” Least inefficient price is somewhere in the middle w And probably not the price that would be negotiated in the middle of a storm! w So makes sense for courts to overturn contracts signed under necessity, replace them with ex-ante optimal terms w 36

More general point w Single price can create multiple incentives w Often impossible to set them all efficiently Already saw this with remedy for breach w Expectation damages: efficient breach, but inefficient signing w Include gains from reliance: overreliance w Exclude gains from reliance: inefficient breach w 37

Real duress versus fake duress w Court won’t enforce contracts signed under threat of harm w “Give me $100 or I’ll shoot you” w But many negotiations contain threats “Give me a raise, or I’ll quit” w “$3, 000 is my final offer for the car, take it or I walk” w w The difference? Threat of destruction of value versus failure to create value w A promise is enforceable if extracted as price of cooperating in creating value; not if it was extracted by threat to destroy value w 38

Example: Alaska Packers’ Association v Domenico (US Ct App 1902) w Captain hires crew in Seattle for fishing expedition to Alaska w In Alaska, crew demands higher wages or they’ll quit w Captain agrees w Back in Seattle, refuses higher wages, claiming duress 39

A performance excuse: impossibility 40

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

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

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

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

Contracts based on bad information 45

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

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

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

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

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

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

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

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

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

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

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

Midterms 57

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