Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2011 Lecture 13

Monday… • 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

Contracts based onbad information

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

Fraud and Failure to Disclose • Fraud violates “negative duty” not to misinform • 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”) • Common law: seller is not forced to disclose everything he knows • Must warn about hidden dangers • Need not share information that makes product less valuable but not dangerous • Exception: new products come with “implied warranty of fitness” • We’ll see another exception shortly

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

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

Another principle: 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

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

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 this creates an incentive to gather information

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

Back to duty to disclose • Under common law, seller required to inform buyer about hidden safety risks, but 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

Back to duty to disclose • Under common law, seller required to inform buyer about hidden safety risks, but 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 • Many states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects…

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

Other reasons a contract may not be enforced

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

Fairness • Bargain theory: courts ask only whether a contract was part of a bargain, not whether that bargain was fair • Hamer v Sidway (drinking and smoking) • But two common law doctrines to get out of extremely one-sided contracts • Adhesion • Unconscionability

Contracts of adhesion • Adhesion: standardized “take-it-or-leave-it” contracts • Friedman calls it “bogus duress” • One extreme version: “shrink-wrap licenses” • “By opening the box, you have already agreed to…” • More general problem: people never read the fine print…

Adhesion? Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/

Adhesion? • 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.”

Unconscionability • Overly one-sided contract may not be enforced • Terms “such that 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” • 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” • Similar concept in civil law: lesion

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.”

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

Remedies for breachof contract

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

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

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

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

Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Michigan 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 face paint and giant foam finger

Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Michigan 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 face paint and giant foam finger • 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)

Ranking damages ContractI Sign BestAlternative Do Nothing ³ ³ = = = Breach +ExpectationDamages Breach +Opportunity Cost Damages Breach +RelianceDamages ³ ³ ExpectationDamages Opportunity CostDamages RelianceDamages ³ ³ $100 $80 $0-20

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

Hawkins v McGee (“hairy hand case”) $ + Expectation Damages + Opp Cost Damages Expectation Damages Reliance Damages Opp Cost Damages + Reliance Damages Initial Wealth Hand Hairy Scarred Nextbestdoctor 100%Perfect

Recapping different types of damages • Expectation damages • Give promisee benefit he would have had from performance • Opportunity cost damages • Give promisee benefit he would have had from next-best contract • Reliance damages • Give promisee benefit he would have had from doing nothing • Expectation Dam ³ Opp Cost Dam ³ Reliance Dam • But order can be reversed when calculated incorrectly

Other court-ordered remedies • Restitution • Return money that was already received • Disgorgement • Give up wrongfully-gained profits

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

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

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses 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

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses 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 have no reason to believe restorative work will get done • So Peevyhouses better off refusing to sign • Even though mining and restoring Pareto-dominates

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Penalty damages Peevyhouses Sign Don’t Garland Coal (0, 0) Restore property Don’t, pay penalty (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

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!

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

Econ 522 Economics of Law