The Economics of Contracts. "Never promise more than you can perform." -Publius Syrus (42 B.C.) "A verbal contract isn’t worth the paper it is written on." -Samuel Goldwyn (1882–1974)
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"Never promise more than you can perform."-Publius Syrus (42 B.C.)
"A verbal contract isn’t worth the paper it is written on."-Samuel Goldwyn (1882–1974)
Groucho:"That's in every contract, that's what you call a sanity clause." Chico: "You can't a fool a me, there ain't no sanity clause"-Groucho/Chico in A Night at the Opera (movie)
Components of a classic bargain
A bargain should have reciprocal inducement
A promise lacks reciprocal inducement
A contract typically entails delayed performance
A bargain requires cooperation. A contract may not exists because cooperation is lacking
Bargain theory may not enforce contracts that people want enforced, particularly if no consideration is given
A theory of law based upon Pareto efficiency is responsive
Investment of $1 could produce $2. The investor is promised $1.50
Payoff is difference in wealth before and after
Investment of $1 could produce $2. The investor is promised $1.50
Payoff is difference in wealth before and after
There is an efficient incentive for breaching when liability is equal to promisee’s foregone benefit
If invested with no breach, a $1 investment returns $1
Opportunity cost damages ≥
The plaintiff, George Hawkins, suffered a childhood accident that left a permanent scar on his hand. When Hawkins was 18 years old, his family physician, McGee, persuaded him to submit to an operation that the doctor asserted would restore the hand to perfection. In the operation, skin from the plaintiff’s chest was grafted onto his hand. The result was hideous. The formerly small scar was enlarged, covered with hair, and irreversibly worse. Hawkins prevailed against McGee in a suit alleging that the doctor had broken his contractual promise to make the hand perfect.
“ We, therefore, conclude that the true measure of the plaintiff's damage in the present case is the difference between the value to him of a perfect hand or a good hand, such as the jury found the defendant promised him, and the value of his hand in its present condition, including any incidental consequences fairly within the contemplation of the parties when they made their contract.”
Seaside Heights--A tattoo artist who draws better than he spells is in trouble with a customer who got more than he bargained for. The customer, Joseph Beahm of Woodbridge, wanted a tattoo on his right shoulder showing a knife stabbing into a man's back, with the words "Why Not, Everyone Else Does" accompanying it. But the tattoo artist, James Kastel of Body Art World, misspelled "else," making the tattoo read: "Why Not, Everyone Elese Does.“
Mr. Beahm wants the tattoo parlor to pay $2,100 for laser surgery to remove the misspelled word. The parlor offered Mr. Beahm his $100 back or alterations that would cover it up, but Mr. Beahm said no. Mr. Kastel said Mr. Beahm should have caught the mistake earlier. He was shown a rendering of the tattoo--including the mistake--before it was applied Aug. 7, Mr. Kastel said. Mr. Beahm says he wants to sue for $20,000 in damages. He is trying to hire a lawyer, he said yesterday. "Everywhere I go, people are making fun of me," Mr. Beahm said.
Question 7.1 p. 255
Think about the ease of finding substitute performance in each situation. Clearly, the law ought to encourage B to purchase the substitute widget after A repudiates at the lowest alternative price. (This is called “mitigating damages.”)
Note: This places the responsibility on B to remedy the uncertainty that A has created. A could just as well mitigate damages.
If A wanted to accept the risk, he could have purchased product for delivery for June 1 on June 1
A promise is made, then time elapses
During this time
- promisor might incur costs associated with performing (investing in performing)
- promisee might incur costs associated with the anticipation of the promise being fulfilled (invest in reliance)
Reliance costs - costs incurred by the promisee in order to increase the utility, profits, etc. resulting from the fulfilment of the contract
The investments in performance and reliance might take the form of time, effort, money or foregone alternatives
How much reliance should a promisee place on the fulfilment of the contract?
What is optimal reliance?
For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail
Should the blacksmith be liable for the loss of the kingdom?
Because the stationary wasn’t delivered
The envelope was not mailed
Therefore the payment for raw materials was not received
Therefore the raw materials were not delivered
Therefore the factory shut down
Should the delivery boy be liable? If not, why not?
Operations at the plaintiff’s mill were halted because of a broken crank shaft. The plaintiff ordered delivery of a new crank shaft from the defendant. The plaintiff’s employee told the clerk that a new shaft had to be delivered immediately. The clerk promised delivery by the next day. Because of neglect the shaft was not delivered for several days. As a consequence, the mill remained stopped and the plaintiff experienced substantial lost profits.
Expected savings from not having backup given the probability the part will be delivered on time
Expected loss of profits from plant shut down given the probability the part may not be delivered on time
In Hadley the expected savings from not having a backup were less than the expected loss from a plant shut down.
During the Summer, the Boy Scouts contract with Farmer Jones to buy 100 bushels of apples for their fall Apple Day promotion
– they pay $500 for 100 bushels which they expect to sell for $1,000 ($500 profit)
The Boy Scouts realize that the probability that Farmer Jones will not be able to supply the apples is 0.25 (25% due to hail, drought, etc.)
The Boy Scouts also know that their Apple Day will generate an additional $400 in revenue if they spend $150 in promotion (signs, TV ads, soliciting corporate sponsors, etc.). Net gain from reliance is $250 ($400 - $150)
Should the Boy Scouts undertake the promotion? Is it an ‘optimizing’ investment? [in addition, is it an ‘efficient’ investment?]
- increase in value of performance from reliance is $250 = $400 -$150
- probability of performance is 0.75 (1 - 0.25)
- increase in cost of breach from reliance is $150
- probability of breach is 0.25
Expected gain to promisee from reliance:
($250) x (0.75) = $187.50
Expected loss to promisee from breach:
($150) x (0.25) = $37.50
Yes, the Boy Scouts should undertake this investment in reliance since their expected gain from reliance is greater than their expected loss from reliance
Revenue = $1,000 plus $400 (from reliance) $1,400
Costs Apples $500
Investment in reliance $150
Total costs $ 650
Profit $ 750
What if the Boy Scouts make the above contract and farmer Jones breaches the contract? What are optimal damages?
What would perfect expectation damages be?
Original investment (payment to Farmer) $ 500
Investment in reliance $ 150
Expected gain after ‘optimal reliance’ $ 750
Perfect expectation damages $1,400
“money back guarantee”
the profit from breach >
(the probability of being caught in breach of trust) x (the profit from breach of trust)
Punitive action may be needed to deter misappropriation
Monetary Damages or Specific Performance?
Actual Cash Value (Market Value) or Replacement Cost?
Specified in insurance contract
Car (ACV = RC)
Roof (ACV < RC)
Old home (ACV < RC)
B offers $100,000 C offers $118,000
With zero transactions costs asset will find its way to the most valued user.
Claims by Defendants in Contract Disputes
Should the contract be enforced?
“… To permit plaintiff to recover under such circumstances would be to offer a premium upon bad faith, and invite men to violate their most sacred contracts that they may profit by their own wrong. That a promise to pay a man for doing that which he is already under contract to do is without consideration is conceded by respondents. The rule has been so long imbedded in the common law and decisions of the highest courts of the various states that nothing but the most cogent reasons ought to shake it. …. “
“In 70 BC, an ambitious minor politician and extremely wealthy man, Marcus Licineus Crassus, wanted to rule Rome. Just to give you an idea of what sort of man Crassus really was, he is credited with invention of the fire brigade. But in Crassus' version, his fire-fighting slaves would race to the scene of a burning building whereupon Crassus would offer to buy it on the spot for a tiny fraction of it's worth. If the owner sold, Crassus' slaves would put out the fire. If the owner refused to sell, Crassus allowed the building to burn to the ground. By means of this device, Crassus eventually came to be the largest single private land holder in Rome, and used some of his wealth to help back Julius Caesar against Cicero.”
The Richmond ran upon some rock while returning from a whaling voyage. The whaling ships Frith and Panama came upon the Richmond while she was floundering. They saved the crew and took on her cargo of whaling oil and whalebone after a forced auction. The price paid was considerably below the competitive market price. The captain of the Richmond claims that the auction was forced on him under duress and necessity. Therefore, this does not represent a valid sale.
Should the auction be set aside on efficiency grounds? Is this similar to what Crassus did?
We want an incentive to rescue, assuming there is
no duty to rescue the cargo.
We want individuals to seek rescue.
Should a contingency be included in the contract or should there be a gap in the contract?
Taylor rented the music hall for a concert. Between entering into the contract and the date of the performance the building was destroyed by fire. Since the performance was no longer possible, Taylor requested damages for the expenses he had incurred in advertising the concert and preparing for the concert.
“… The principle seems to us to be that, in contracts in which the performance depends on the continued existence of a given person or thing, a condition is implied that the impossibility of performance arising from the perishing of the person or thing shall excuse the performance.”
[Does this assume optimal precautions by the theater owner?]
An individual reserves a hall for a wedding. In the event that the wedding is called off, the value of the agreement would be destroyed. Even though the promisee could still literally perform the obligation by reserving and providing the hall for the wedding, the purpose for which the contract was entered into was defeated. Apart from a nonrefundable deposit fee, the promisor is ordinarily discharged from any contractual duty to rent the hall.
If the cow was a breeder, she was worth at least $750; if barren, she was worth not over $80. The parties would not have made the contract of sale except upon the understanding and belief that she was incapable of breeding, and of no use as a cow. It is true she is now the identical animal that they thought her to be when the contract was made; there is no mistake as to the identity of the creature. Yet the mistake was not of the mere quality of the animal, but went to the very nature of the thing…If the mutual mistake had simply related to the fact whether she was with calf or not for one season, then it might have been a good sale, but the mistake affected the character of the animal for all time, and for its present and ultimate use. She was not in fact the animal, or the kind of animal, the defendants intended to sell or the plaintiff to buy.
Immediately preceding the purchase, Organ had been informed that the Americans and the British had signed the Treaty of Ghent. This would have a positive impact on the price of tobacco. Not knowing the treaty had been signed; Laidlaw sold the tobacco at the lower pre-treaty price. Was this fraud? Given the unilateral information is there a valid contract? Did the plaintiff have the duty to inform the defendant of the recent news?
“Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.”
Defense against the enforcement of a contract because the conditions were unfair to one party
Keeping an inventory of items that will be demanded only in emergencies is extremely costly, and may be cost justifiable only if the merchant knows that should there be an emergency the items can be sold at a higher than normal price. This is an objection to a general windfall-profits tax.
Is the controlled price just compensation?
Reimbursement at cost of performance when it is greater than enhanced market value assumes: