Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2013 Lecture 14

Reminder • Midterm 1 on Wednesday, regular class time, in Education L196 • I’ll hold my usual office hours tomorrow, 2-4(but can’t stay late)

Last week: reasons a contract might not be enforced • Derogation of Public Policy • Incompetence • but not drunkenness • Duress and Necessity • Today: several others • performance became impossible • contract was premised on (certain types of) bad information • terms are overly vague or one-sided

One final point on duress

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

Example: Alaska Packers’ Association v Domenico (US Ct App 1902) • Captain hires crew in Seattle for fishing expedition to Alaska • In Alaska, crew demands higher wages or they’ll quit, captain agrees • Back in Seattle, captain refuses to pay the higher wages, claiming he agreed to them under duress • Court ruled for captain • Since crew had already agreed to do the work, no new consideration was given for promise of higher wage

A performance excuse:impossibility

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

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

Next doctrine for voiding a contract: impossibility • In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach • But there are exceptions • Change “destroyed a basic assumption on which the contract was made” • Efficiency requires assigning liability to the party that can bear the risk at least cost • How to determine who that is?

Who is the efficient bearer of a particular risk? • Friedman offers several bases for making this determination • Spreading losses across many transactions • Moral hazard: who is in better position to influence outcome?

Who is the efficient bearer of a particular risk? • Friedman offers several bases for making this determination • Spreading losses across many transactions • Moral hazard: who is in better position to influence outcome? • Adverse selection: who is more aware of risk, even if he can’t do anything about it? • “…The party with control over some part of the production process is in a better position both to prevent losses and to predict them. It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”

That’s why Hadley v Baxendale was “surprising” • Baxendale (shipper) could influence speed of delivery, Hadley could not • So Baxendale was efficient bearer of the risk of delay • Court ruled he didn’t owe damages for lost profits, forcing Hadley to bear much of this risk • Only makes sense as a “penalty default” • Rule creates incentive for Hadley to reveal urgency of this shipment

Contracts based onbad information

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

Fraud • Fraud: one party was deliberately tricked source: http://www.wyff4.com/r/29030818/detail.html

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 has to share information about hidden dangers… • …but generally not information that makes a product less valuable without making it dangerous • Exception: new products come with “implied warranty of fitness” • Another exception: Obde v Schlemeyer

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, Sup Ct of WA) • 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 (awarded damages)

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, Sup Ct of WA) • 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 (awarded damages) • Some states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects…

Failure to disclose? source: http://kdvr.com/2012/10/26/chinese-man-sues-wife-for-being-ugly-wins-120000/

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”

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

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) • Party that had information was not the party making decisions • 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

What About 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

What About 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

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

Uniting knowledge and control • Laidlaw v. Organ established: contracts based on unilateral mistake are generally valid • Agrees with efficiency: these contracts typically unite knowledge and control • What about Obde v. Schlemeyer? • The termites case was based on unilateral mistake • Court still upheld contract, but punished seller for hiding information • In that case, contract separated knowledge from control

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 • “Punish” the parties by refusing to enforce contract… • …so people will be more clear when they write contracts • But some exceptions • Parties may commit to renegotiating the contract “in good faith” under certain contingencies

Adhesion (I): “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…” • Contract is not binding if one party had no opportunity to review it before agreeing “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.”

Adhesion (II): What if a party chose not to review the contract? Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/

Adhesion (II): 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 anon-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.”

Adhesion • Contract of Adhesion: standardized “take-it-or-leave-it” contract 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 have “reason to believe that the other party would not agree if he knew the contract contained a particular term, the term is not part of the agreement”

What if you signed a contract that was dramatically unfair? • Under 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”

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

Econ 522 Economics of Law