of the Notes
- O. Digression on simplified
- A. In thinking through the logic of a
problem, whether in physics, mathematics, or economics, we
frequently use simplified pictures, designed to bring out the
particular issue we are interested in.
- B. For example, we worth out the logic of
Newtonian motion by analyzing the trajectory of cannonballs in
a vacuum--without worrying about the fact that in a vacuum, the
cannoneers would die before they could fire their
- C. Similarly, much of what we are doing in
this course involves deliberately simplified pictures, intended
to let us think through the logic of one problem or
- D. After doing so, one is better equipped
to deal with the much messier conditions of real life
- I. Contract Law:
- A. Why have encforceable contracts?
- 1. Why not do everything on the spot market?
- 2. Because transactions occur over time: Building a
- a. If I pay at the beginning and contracts are not
enforceable, you take my money and don't build the house.
- b. If I pay at the end, then when you are finished I
decide to "renegotiate" the contract. After all, I am the
only customer for a house built on my property; if you
don't want to accept my (new) price you can't tear down
the house instead.
- 3. The Coase Theorem should prevent inefficient
breaches, but ...
- 4. Once the transaction has started, you are locked into
a bilateral monopoly
- 5. With significant bargaining costs.
- 6. Some of which can be avoided by contract.
- 7. Note that one function of the contract is simply to
define the obligations--which may not always be clear
otherwise. If the land floods while the house is being
built, who is responsible for the additional building costs?
- B. Does contract enforcement have to be by
- 1. In many cases, it can be by reputation, desire for
repeat dealings, etc.
- 2. In order for reputation with third parties to be
relevant, third parties must have some way of knowing which
party to the contract failed to live up to his agreements.
- 3. Which can be done by direct investigation in small,
- 4. Otherwise by arbitration, either after the fact with
an arbitrator who has a good reputation, or
- 5. By the parties agreeing on the arbitrator when they
sign the contract--and making the fact public then.
- 6. And in some trust-intensive industries we observe
dominance by close knit ethnic groups
- a. A striking case is the old dominance of the
diamond industry in NY by orthodox jews.
- b. Who were forbidden by their religion from suing
each other, but ...
- c. Had good arbitration/reputation institutions.
- 7. An alternative to reputation is posting a bond--with
a bonding agency that has a good reputation.
- 8. And there are less explicit bonding
- a. William Marshall story. When Stephen threatened to
execute Gilbert Marshall's son, given him as a hostage,
Gilbert replied that he had three more sons--and the
hammer and anvil to make more. Stephen didn't carry
through on his threat, and William grew up to become the
best knight in Europe and, before he died, regent of
England (for John's minor son).
- b. Big public announcement of a joint project. If it
later falls through, both parties look bad.
- c. More generally, making it possible for the other
party to injure you--in a way which isn't profitable to
him, since ...
- d. We only want him to do it when you break the
- 9. But while such mechanisms cover many transactions,
there are many more which they don't cover, hence a role for
government contract enforcement.
- C. Do we need contract law? Why not just
enforce the contract as it is written:
- 1. We need a definition of when a contract exists.
- a. Does a unilateral contract count? If I post a
reward offer for finding my lost pet, is that an
enforceable contract? What if you never read it? If I
announce that I will pay my nephew's college tuition--and
later change my mind?
- b. What about a contract signed under duress--your
money or your life? What is the price for saving a
- c. What if both parties agree to a contract--but
there is some confusion in communication such that they
have different ideas of what they agreed to?
- d. What if, hidden in fine print on page three of
your auto rental contract, was "I agree to give
everything I own to Hertz?"
- 2. There is never enough fine print to cover all
contingencies, so we need some rules for filling in the
- 3. Do we want to enforce all contracts as written?
- a. Assassination contracts?
- b. Marriage contracts with their own divorce rules?
- c. Contracts the court believes are unwise? Should
courts exercise paternalism?
- II. Why should we or shouldn't we enforce
- A. Argument for--efficient rules
- 1. Any change that produces net benefits can be combined
with a price change to make it an improvement for both
parties, so ...
- 2. A sensible lawyer or other contract draughtsman will
look for the efficient terms in order to maximize the gain,
then try to get as much of the gain as possible for his
side, rather than picking inefficient terms biased towards
- 3. What about a monopoly?
- a. Can he charge any price he like, and combine it
withthe most favorable possible terms to him?
- b. No--monopolies don't sell their goods for an
- c. They are constrained by what customers will pay
(more precisely, by how much they can sell at what
price), so moving to a more efficient contract and
compensating themselves in the price makes them better
off, except ...
- 4. That contract terms might be a device for
- a. I have two customers, one of whom will pay $10 and
one $15; currently I charge $10 and sell two units--at
$10 each, since I don't want to lose the first customer.
Assume I can't charge them different prices, perhaps
because I don't know which is which.
- b. A change in contract terms will make the first
customer worse off by $1, the second by $5, and benefit
me by $4--so it is inefficient, with a net cost of $2.
- c. I make it, cut my price to $9, losing $2 in sales
revenue but gaining $4 in more favorable contract terms.
- d. So in such situations, where inefficient contract
terms are a device for price discrimination, we might get
- e. For example tie-in sales.
- f. But note that price discrimination has some
benefits--it may make it possible to produce a product
that could not otherwise cover its costs, or
- g. Make the product available to people who would not
buy it at the profit maximizing single price.
- B. Obvious exception--third party
- 1. Assassination contracts are not enforceable
- 2. Nor contracts agreeing to keep silent about illegal
- 3. Except for the marriage contract--which includes an
enforceable obligation not to testify against your spouse.
- C. Second exception--parties we believe
incompetent. Children and the insane.
- D. Shakier exception--parties we believe
incompetent because we are sure those terms cannot be in their
- 1. Consumer repossession agreements--might be in the
consumer's interest if he is a bad credit risk, and cannot
otherwise buy consumer goods on credit.
- 2. Penalty clause in a contract: An agreement that the
breaching party must pay a large penalty to the other party,
representing more than the actual cost of the breach.
- a. Maybe it is the best solution to adverse
selection--I know I won't default and you don't, so I
"tell" you convincingly by agreeing to a penalty clause.
- b. Maybe it compensates for the risk of
judgement-proof breach--someone who breaches and then
- c. Maybe it reflects distrust of the court's ability
to correctly measure damages... in fact
- d. It is simply the private version of a property
rule (you can only breach with the other party's
consent--or bad things happen to you) instead of a
- e. Which we think reasonable in settings where
transaction costs are low and/or courts are expensive or
- III. Does a contract
- A. Economics of a one sided reward
- 1. If such offers are known to be enforceable, more lost
goods will be returned at a given reward.
- a. Posner doesn't think so, but that is because he
hasn't followed through the analysis.
- b. If, in equilibrium, fewer were being returned,
then the professional lookers would have more incentive
to look, not less.
- c. This is equivalent to the question of whether
adding a low cost producer can raise market price.
- d. Or whether a new freeway can slow traffic.
- 2. The cost of offering a given reward will be higher,
however, since you have to pay even if the finder didn't
know about the reward.
- 3. So people will be less willing to post rewards.
- a. So the net effect might be fewer lost goods
- b. Or more, depending on which effect is stronger.
- 4. Not making the contract enforceable results in a form
of price discrimination--but since the offerer cannot
control the terms, it may or may not benefit him.
- B. Economics of offer without
- 1. My rich uncle says he will pay my college tuition. I
quit my job. He changes his mind.
- 2. He is liable under the doctrine of detrimental
- 3. Not clear if this is really a contract, or an odd
sort of tort.
- C. Zero-sided contracts--emergency medical
- 1. A doctor finds someone injured and unconscious,
treats him, bills him.
- 2. And collects.
- 3. What if the injured person doesn't want the
treatment--he is a Christian Scientist or an attempted
- 4. From the supply side, it is irrelevant--it costs just
as much to treat him--but
- 5. It isn't worth as much--from the demand side, the
value of the treatment is zero.
- 6. The right rule would seem to be no payment if the
treatment is unwanted, and a payment if the treatment is
wanted scaled up a little to compensate the doctor for the
risk that his patient will turn out to be a Christian
Scientist, but ...
- 7. That rule would be an invitation to fraud--by people
who converted to Christian Science after receiving the
- D. Mistake: General rule is that the party
in the best position to avoid it is responsible.
- 1. If there was a problem in transmission, the party
that chose the communication medium.
- 2. If ambiguity in the agreement, it is interpreted
according to trade practice.
- E. Making sense of
the idea of duress:
- 1. Real duress--when you demand my money or my life and
I offer a check instead, should I be free to stop payment?
- a. If I am, either you don't take the check or you
take it and then kill me so I can't stop payment.
- b. But if I am not free to stop the check , that
increases your incentive to find me alone, point a gun at
me, and say "your money or your life." Most people have
more money in their checking account than in their
- c. So whether such agreements should be enforced
depends on the elasticity of supply of such situations
(if such contracts are enforced, how much does that
increase their frequency) and how much they ameliorate
situations that would have occurred anyway.
- d. For example, we may want to enforce parole/ransom
rules during wartime--getting paid ransom isn't why you
were captured, but it may be a good reason not to kill
- 2. Semi-real duress: The sinking ship or the starving
traveller in a snowstorm.
- a. It isn't duress in the previous sense, because the
tug isn't the reason your ship is sinking.
- b. Do we want to let the tug bargain for the full
value of the sinking ship?
- c. Yes if we want the right incentive for tugs to
steam around looking for ships in trouble.
- d. No if we want the right incentive for ships to
stay out of trouble.
- e. This is our old problem of dual causation in a new
- f. There is much to be said for some prearranged
rule, whatever it is, since bargaining costs may be
excessive if the water is rising past your ankles while
- g. And admiralty law provides for a "reasonable"
- h. Analogous case in the snowstorm.
- i. Posner gets this wrong--worries about "excessive"
efforts when the efforts to rescue due to getting the
full value are efficient.
- j. This is not like the patent race or the sunk
treasure case, because if another rescuer or salver is
expected in ten minutes, the first one isn't going to be
able to get a very high price.
- 3. Bogus duress: "Contracts of adhesion" (take it or
leave it form contracts); the argument for efficiency does
not depend on bargaining.
- a. Consider the sort of contract that a consumer
faces when he rents a car or an apartment, buys a
computer program, ... .
- i. It is drawn up by the other party in a standard
form, applied to many transactions, and ...
- ii. Although he may have a choice as to some
optional terms, the consumer's basic choice is to sign
or not to sign.
- iii. Does this count as a sort of "duress," since
one party cannot bargain about the terms?
- iv. And does that imply that the arguments for
freedom of contract do not apply to such contracts?
- 4. Innocent explanation: Form contracts reduce drafting
costs, eliminate the problem of the firm having to control
the employee who negotiates the individual contracts.
- 5. The argument for freedom of contract still applies,
since the firm, in drafting the contract, will take account
of benefits and losses to its customers. Anything that makes
the terms of the deal more attractive to the customer will
also increase the amount he is willing to pay.
- 6. The freedom of contract argument even applies to a
monopoly. The more unfavorable the contract is to the
consumer, the lower the price the monopolist will be able to
charge and still sell his goods. Although a monopolist has
no competitor, his customers still have the alternative of
not buying the good at all--which is why monopolists to not
charge an infinite price.
- 7. Although the argument does not always hold in the
case of a monopolist, since (inefficient) contract terms
might be a device for profitable discriminatory
pricing--charging a higher (pecuniary plus nonpecuniary)
price to those consumers who will still buy at a higher
- 8. Courts sometimes refuse to enforce the terms of form
contracts on the grounds that they represent a sort of
duress. These arguments suggest the courts are wrong.
- 9. Although we have not considered the separate issue of
contracts sufficiently complicated so that the consumer does
not really know what he is signing.
- IV. What should
contract law be like? Filling in the
- A. Parties have an incentive to negotiate
to an efficient contract, since any change in terms that
increases the size of the pie provide gains for the parties to
divide among themselves.
- B. So if the court wants to fill in the
blanks as the parties would have, it can try to figure out the
- 1. This is a good idea if the court favors efficiency.
Or favors giving the parties what they would have agreed to.
- 2. And maybe even if it doesn't, since if courts don't
write in the terms the parties would have agreed to, parties
will write longer contracts, which is costly.
- 3. But one can still imagine courts accepting that cost
either because they don't favor efficiency, or ...
- 4. Don't believe in rationality.
- 5. Which raises the same issues as the question of
freedom of contract.
- C. Who should bear risks? We've been here
- 1. The party who can best risk spread.
- 2. The party who can best control the risk: moral
- a. Himalayan photographer. If he doesn't tell the
photo labs that his six rolls of film cost thirty
thousand dollars to get, they don't owe him thirty
thousand when they lose the film.
- b. Risk of strike, factory burning down, is best
controlled by the producer--who owns the factory and
negotiates with the workers, but ...
- c. Risk of buyer deciding he doesn't need the product
is best controlled by the buyer.
- 3. The party who best knows the risk--adverse selection.
- 4. Note that this is relevant both to negotiating the
contract and to filling in the details.
- D. What happens if someone breaches the
- 1. Objective. Efficiency:
- a. Efficient breach--breach if and only if it makes
the parties on net better off.
- b. Efficient contracting--adverse selection.
- c. Efficient reliance. Explain.
- d. Note that the breach/reliance issue is an example
of the Coaseian joint causation problem.
- 2. Nothing: no enforceable contract. Inefficient breach?
Not if Coase Theorem applies.
- 3. Breach forbidden--specific performance. Inefficient
performance. Not if ... .
- 4. Expectation damages:
- a. Give the right incentive to breach.
- b. The wrong incentive to rely.
- c. the wrong incentive to sign if there is asymmetric
- 5. Reliance damages:
- a. Wrong incentive to breach.
- b. Wrong incentive to rely.
- c. Right incentive to sign if breaching party has the
- 6. Liquidated damages--agree in advance on what the
damages will be if a breach occurs.
- a. Right incentive to rely--because damages don't
depend on reliance expenditures.
- b. Right incentive to breach if and only if the
amount agreed on is what expectation damages would be.
- c. Right incentive to sign if and only if the amount
agreed on is what reliance damages would be.
- d. Note that the disadvantage here is that there is
less information available when the contract is signed
than when breach is contemplated.
- e. On the other hand, the negotiation is happening in
a competitive framework before the contract is signed,
and in a bilateral monopoly when breach is contemplated.
- f. Penalty clause--liquidated damage equivalent of
- 7. Property/liability issue:
- a. Specific performance or penalty clause is like a
property rule--you need the other party's permission to
breach the contract.
- b. Expectation or reliance damages are like a
- c. Liquidated damages amount to Coasian bargaining
aimed at producing a liability rule rather than a
- V. Consumer fraud, liability, etc.
- A. Distinguish the argument for default
- 1. Who can more cheaply control
- 2. And has better information: The Himalayan
photographer doesn't get his thirty thousand dollars back
when Walmart loses his film.
- 3. And can more easily bear the risk
- B. From the argument for non-waivable
- 1. If the consumer knows he is ignorant, he can insist
on a guarantee, etc.
- 2. If consumers do not know that they need a guarantee,
how do we get the laws imposing a non-waivable--given that
the consumers are also the voters?
- C. Does having the court decide
(non-waivable or default) case by case make more sense than a
- 1. Better tailored to the facts, but ...
- 2. Less predictable.
- 3. Did you buy the lawnmower under a rule of caveat
emptor or caveat venditor? Only the Supreme Court knows.
- VI. Information and
Incentives: Laidlaw v
- A: Organ, with advance news of the treaty
of Ghent which ended the war of 1812, ordered lots of tobacco
from Laidlaw, at a low price reflecting the effect of the war
on tobacco prices.
- 1. When the news of the end of the war--and the end of
the blockage of New Orleans--became public, Laidlaw tried to
cancel the contract.
- 2. The Supreme Court didn't let him.
- 3. Did Organ, by not telling Laidlaw why he was buying
the tobacco, commit fraud? Should the contract have been
- B. The argument for the court's position is
that producing information is a useful activity, and you can't
make money doing it if, once the information is produced, you
have to give it away.
- C. Consider the more general case of
- 1. Speculation produces a social benefit by reallocating
resources from times when they are plentiful to times when
(an expert can predict that) they will be scarce--the
successful speculator buys low and sells high.
- 2. By buying grain before other people anticipate the
coming shortage he drives up the price early, giving other
people an incentive to use less grain (slaughter hogs early,
for example, to save their feed for human consumption),
produce more food of other sorts, etc.
- 3. So when the shortage hits and the speculator puts the
grain he bought back on the market, the famine is less
severe and the price does not go up as high as if he had not
- D. This only works if the speculator has
secure property rights.
- 1. If, when the famine happens, a mob seizes his barn
full of grain, or the government confiscates it, speculation
won't pay and won't happen.
- 2. And when there are bad harvests, people will starve
- 3. Which suggests that the belief that speculators cause
famine may be one of the most lethal errors in human
- 4. It is a result of applying a useful rule of thumb in
an inappropriate context.
- a. The rule is "cui bono"--to find out who is
responsible for something happening, first figure out who
benefits by it.
- b. It doesn't work in the case of production, since
producers benefit by high prices but the act of producing
increases supply and so makes prices lower than they
would otherwise have been.
- E. The successful speculator produces a
benefit and gets a reward, but the latter is not equal, or even
closely related to, the former. The relation between the
private value of his activity and the social value of his
activity is correct qualitatively (if he makes money he is also
doing good) but not quantitatively (he might do a little good
and make a lot of money, or vice versa).
- 1. Even in a case where elasticities are low, so that
the speculator produces only a small reallocation and a
small benefit, he might still get a large profit--since his
speculation means that resources belong to him instead of to
someone else at the instant when their price goes up.
- 2. So we might get inefficient speculation--spending
$1000 dollars to get information whose private value is
$1100 but whose social value is only $100.
- 3. aka rent seeking.
- VII. Contracts, a summary.
- A. It is useful to be able to commit
yourself to binding agreements.
- 1. Legally enforceable contracts are one way of doing so
- 2. Reputational enforcement is an alternative in many
- a. In some contexts it does not work
- b. It is dependent on reliable information about who
was in the wrong
- c. But has the advantage of providing market
incentives to judge correctly.
- B. Figuring out what is the efficient
contract arises in three different contexts.
- 1. Drafting contracts. Efficiency improvements increase
the size of the pie, giving a gain to be divided between the
- 2. Filling in blanks in contracts, by court or
- a. Argument B1 above implies that the efficient rule
is what they would have agreed to
- b. And it is also the rule that makes the world a
- 3. Modifying contracts contrary to their language
- a. On the grounds that the modified version is more
efficient, which makes the world a better place
- b. The problem being that B1 above implies that the
parties have already agreed to the efficient rules, and
since they probably know more about what rules are
efficient than you do, you are likely to be making the
world a worse place
- c. Unless you have good reason to think that the
argument for efficiency does not apply in this
case--fraud, for example, or mistake.
- C. Two important (and closely related)
issues in designing the efficient contract are who should bear
the risk if something goes wrong and what happens if one party
breaches the contract.
- D. Another important issue is whether the
contract was formed in a fashion that leads to a valid (and
presumptively efficient) contract--i.e. the issue of
of the Notes
Back to the
Table of Contents
to the class home page