1 / 36

Econ 522 Economics of Law

This lecture covers the need for contracts, enforcement of promises, breach of contracts, reliance, default rules, and the fifth purpose of contract law. It explores the efficient allocation of risks and the role of default rules in minimizing transaction costs.

blevinsr
Download Presentation

Econ 522 Economics of Law

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Econ 522Economics of Law Dan Quint Spring 2010 Lecture 11

  2. Grading • HW 1: end of class today • Midterm: Wednesday

  3. Contracts: the story so far… • Why do we need contracts? • Which promises should be enforced? • First purpose: enable cooperation • Second purpose: efficient disclosure of information

  4. Contracts: the story so far… • Breach of contract • Breach is efficient when cost to perform > benefit • Breach will happen when cost to perform > liability • Expectation damages: liability for breach = anticipated benefit • Leads to breach exactly when breach is efficient • Third purpose: secure optimal commitment to performance • Reliance • Reliance is efficient when expected benefit > cost • Or (Probability of performance) X (Increase in value) > cost • Reward any reliance  overreliance • Fourth purpose: secure optimal reliance • Hadley v Baxendale, foreseeable reliance

  5. Default Rules

  6. Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps

  7. Default rules • Gaps: risks or circumstances that aren’t specifically addressed in a contract • Default rules: rules applied by courts to fill gaps • Writing something into a contract vs leaving a gap • Allocating a loss (ex post) • Versus allocating a risk (ex ante), before it becomes a loss

  8. What should default rules be? • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue • This will be whatever rule is efficient

  9. What should default rules be? • Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue • This will be whatever rule is efficient • Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules • Do this by imputing the terms the parties would have chosen if they had addressed this contingency

  10. Default rules • Don’t want ambiguity in the law • So default rule can’t vary with every case • Majoritarian default rule: the terms that most parties would have agreed to • In cases where this rule is not efficient, parties can still override it in the contract • Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate

  11. Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it?

  12. Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it? • Construction company is efficient bearer of this risk • So efficient contract would allocate this risk to construction company • Should prices be adjusted to compensate?

  13. Default rules • Example: probability ½, the cost of construction will increase by $2,000 • Construction company can hedge this risk for $400 • Family can’t do anything about it • Price goes up – who pays for it? • Construction company is efficient bearer of this risk • So efficient contract would allocate this risk to construction company • Should prices be adjusted to compensate?

  14. Default rules • So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases • Most contracts can leave this gap, save on transaction costs • In cases where this rule is inefficient, parties can contract around it

  15. Default rules: a different view • Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules” • Sometimes better to make default rule something the parties would not have wanted • To give incentive to address an issue rather than leave a gap • Or to give one party incentive to disclose information • “Penalty default”

  16. Penalty defaults: Hadley v Baxendale • Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk • If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent • So Hadley might hide this information, which is inefficient • Ayres and Gertner: Ruling in Hadley was a good one, not because it was efficient, but because it was inefficient… • …but in a way that created incentive for disclosing information

  17. Penalty defaults: other examples • Real estate brokers and “earnest money” • Broker knows more about real estate law • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this

  18. Penalty defaults: other examples • Real estate brokers and “earnest money” • Broker knows more about real estate law • Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this • Courts will impute missing price of a good, but not quantity • Forces parties to explicitly contract on quantity, rather than leave it for court to decide

  19. When to use penalty defaults? • Look at why the parties left a gap in contract • Because of transaction costs  use efficient rule • For strategic reasons  penalty default may be more efficient • Similar logic in a Supreme Court dissent by Justice Scalia • Congress passed a RICO law without statute of limitations • Majority decided on 4 years – what they thought legislature would have chosen • Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…” • “Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.”

  20. Regulations

  21. Default rules versus regulations • Default rules can be contracted around • Some rules cannot – immutable rules, or mandatory rules, or regulations • 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 • So additional regulations can only make things worse • But when people are not rational, or when there are transaction costs/market failures, regulations may help

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

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

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

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

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

  27. We can also think about Peevyhouse in terms of penalty defaults • Which works better in this case: • Default rule allowing Garland to breach and pay diminution fee? • Default rule forcing Garland to perform restorative 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 work as a penalty default

  28. Ways to get outof a contract

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

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

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

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

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

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

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

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

More Related