Econ 522
Economics of Law
Dan Quint
Fall 2016
Lecture 13
Monday…
 What default rules should fill in the gaps?



C&U: impute the terms the parties would have wanted – allocate
each risk to efficient bearer of that risk
(Friedman: several ways to tell who that is)
Ayres & Gertner: use default rules to penalize one or both parties
from withholding information
 Reasons a contract might not be enforced



Derogation of public policy
Formation defenses (incompetence, but not drunkenness)
Performance excuses
 Today: more reasons a contract might not be enforced

But first…
1
Another experiment:
is trust a problem?
2
We motivated contracts with an agency
(trust) game
Player 1 (you)
Don’t
Trust me
Player 2 (me)
(100, 0)
Share profits
(150, 50)
Keep all the money
(0, 200)
 Without binding contracts, might be no reason for me to
return your money, so no reason for you to trust me
3
To see if trust is a problem, we’ll use a
similar game as an experiment
 Player A starts with $5


Chooses how much of it to give to player B
That money is quadrupled
 Player B has $5, plus 4x whatever A gave him/her

Chooses how much (if any) to give back to player A
 So for example…



if player A decides to send $3…
then B has $5 + $12 = $17, and can send A any amount up to 17
and keep the rest…
…and A ends up with $2 plus whatever B sends
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To see if trust is a problem, we’ll use a
similar game as an experiment
Player 1
Send 0
x
Send 5
Player 2
Return 0
y
Return 5 + 4x
((5 – x) + y, (5 + 4x) – y)
 Player 1 gets whatever he kept, plus whatever 2 sends him
 Player 2 gets 5, plus four times what 1 sends him, minus
whatever he sends to player 1
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We’ll try this game three different ways
 Anonymously – A and B don’t know who each other are

we’ll use student ID numbers to identify players, and play on paper
 Privately – A and B don’t interact, but will learn who each
other are after the game


still on paper, but with names, so B sees A’s name
after class, Nathan will email A with B’s name
 Publicly – A and B play out loud in front of the class
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Back to work:
dire constraints
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Dire constraints
 Necessity



I’m about to starve, someone offers me a sandwich for $10,000
My boat’s about to sink, someone offers me a ride to shore for
$1,000,000
Contract would not be upheld: I signed it out of necessity
 Duress



Other party is responsible for situation I’m in
“I made him an offer he couldn’t refuse”
Contract signed at gunpoint would not be
legally enforceable
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Duress
source: http://news.yahoo.com/man-sues-former-hostages-saysbroke-promise-190902970.html
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Friedman on duress
 Example



Mugger threatens to kill you unless you give him $100
You write him a check
Do you have to honor the agreement?
 “Efficiency requires enforcing a contract if both parties
wanted it to be enforceable”


He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?


Makes muggings more profitable  leads to more muggings
Tradeoff: refuse to enforce a Pareto-improving trade, in order to
avoid incentive for bad behavior
10
Friedman on duress
 Example



Mugger threatens to kill you unless you give him $100
You write him a check
Do you have to honor the agreement?
 “Efficiency requires enforcing a contract if both parties
wanted it to be enforceable”


He did – he wants your $100
You did – you’d rather pay $100 than be killed
 So why not enforce it?


Makes muggings more profitable  leads to more muggings
Tradeoff: refuse to enforce a Pareto-improving trade, in order to
avoid incentive for bad behavior
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What about necessity?
 Same logic doesn’t work for necessity



You get caught in a storm on your $1,000,000 sailboat
Tugboat offers to tow you to shore for $900,000
(Otherwise he’ll save your life but let your boat sink)
 Duress: if we enforce contract, incentive for more crimes
 Necessity: if we enforce contract, incentive for more
tugboats to be available to rescue sailboats

Why is that bad?
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What about necessity?
“Should I motor around looking for sailboats to save?”

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
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Social cost = private cost = value of my time
Social benefit = probability x (value of boat – cost of tow)
Private benefit = probability x (price I can charge – cost of tow)
If tugboat captain can charge the whole value of the boat,
he spends efficient amount of time saving sailboats!
So maybe we should enforce this contract…
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What about necessity?
“Should I sail today?”






Suppose tugboat is there to rescue me if there’s a storm
Social benefit = private benefit = how much I enjoy sailing
Social cost = probability x cost of tow
Private cost = probability x price he can charge
If tugboat captain can only charge cost of tow, I sail efficient amount
If he can charge the whole value of the boat, I undersail!
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Friedman’s point
 Same transaction sets incentives on both parties

Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”


Least inefficient price is somewhere in the middle
And probably not the price that would be negotiated in the middle of
a storm!
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Friedman’s point
 Same transaction sets incentives on both parties

Price that would be efficient for one decision, is inefficient for other
 “Put the incentive where it would do the most good”



Least inefficient price is somewhere in the middle
And probably not the price that would be negotiated in the middle of
a storm!
So makes sense for courts to overturn contracts signed under
necessity, replace them with ex-ante optimal terms
 More general point


Single price creates multiple incentives
May be impossible to get efficient behavior in all dimensions
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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
17
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
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A performance excuse:
impossibility
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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
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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”
21
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

We’ve seen several ways to determine who that is
22
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
23
Contracts based on
bad information
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Contracts based on faulty information
 Four doctrines for invalidating a contract

Fraud

Failure to disclose (sometimes)

Frustration of purpose

Mutual mistake
25
Fraud
 Fraud: one party was deliberately tricked
source: http://www.wyff4.com/r/29030818/detail.html
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What if you trick someone by withholding
information?
 It depends
 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
 Under the common law, less so




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
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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)
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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…
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Failure to disclose?
source: http://kdvr.com/2012/10/26/chinese-man-sues-wife-for-being-ugly-wins-120000/
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