George Mason School of Law
Contracts I
Why Enforce Contracts
F.H. Buckley
[email protected]
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Next Day
 Contract Law in the State of Nature
2
Contracts I
1. Why Enforce Contracts
3
Contracts I
1. Why Enforce Contracts
2. Where Contracts Should Not Be
Enforced
4
Contracts I
1. Why Enforce Contracts
2. Where Contracts Should Not Be
Enforced
3. Formation of Contracts
5
Contracts I
1. Why Enforce Contracts
2. Where Contracts Should Not Be
Enforced
3. Formation of Contracts
4. Consideration
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Contracts I
1. Why Enforce Contracts
2. Where Contracts Should Not Be
Enforced
3. Formation of Contracts
4. Consideration
5. Relational Contracts
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A Law and Econ Perspective
Tony Kronman’s Comment
Dean Henry Manne,
George Mason
Insider Trading and the
Stock Market 1965
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A Law and Econ Perspective
Le mot de Tony Kronman
Dean Henry Manne,
George Mason
Insider Trading and the
Stock Market 1965
9
Ronald Coase,
U. of Chicago
The Problem of Social Cost
1960
A Law and Econ Perspective
Le mot de Tony Kronman
Dean Henry Manne,
George Mason
Insider Trading and the
Stock Market 1965
10
Ronald Coase,
U. of Chicago
The Problem of Social Cost
1960
Hon. Richard Posner
University of Chicago
Economic Analysis of Law 1973
A Preliminary Question
 Who cares if we enforce contracts?
 The nihilism of the 1970s: What’s
wrong with this contract?
 “If one person does not lose, the other
does not gain.” Augustine
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A Preliminary Question
 Who cares if we enforce contracts?
 The nihilism of the 1970s: What’s
wrong with this contract?
 Consumerism: It’s always Williams v.
Walker-Thomas
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The Young Lawyers
ABC 1970-71
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So why enforce contracts?
 Casebook suggests two principles
 An “Autonomy Principle”
 The Efficiency Norms of Law and
Economics
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Autonomy
 How am I more free if I subject
myself to fetters?
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Autonomy
 How am I more free if I subject
myself to fetters?
 Ex post vs. ex ante
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Promising and Efficiency Norms
 The benefit afforded by promissory
institutions is a greater assurance of
performance
 Which is strengthened when contractual
sanctions are added to moral ones.
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Promising and Efficiency Norms
 The benefit afforded by promissory
institutions is a greater assurance of
performance
 So why is that important?
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Promising and Efficiency Norms
 The benefit afforded by promissory
institutions is a greater assurance of
performance
 So why is that important?
 Let’s assume that contract enforceability
has something to do with societal wealth
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20
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Heritage Ranking of Economic
Freedom
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1
Hong Kong
89.7
0.0
2
Singapore
87.2
1.1
3
Australia
82.5
-0.1
4
New Zealand
82.3
0.2
5
Switzerland
81.9
0.8
6
Canada
80.8
0.4
7
Ireland
78.7
-2.6
8
Denmark
78.6
0.7
9
United States
77.8
-0.2
10
Bahrain
77.7
1.4
Where does contract law come in?
 What is the relationship between
promising and wealth?
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Where does contract law come in?
 What is the relationship between
promising and wealth?
 Between enforceable promises and
wealth?
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Where does contract law come in?
 What is the relationship between
promising and wealth?
 Between enforceable promises and
wealth?
 How about bare promises without
contract enforcement?
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David Hume
Does the sanction provided by non-legal
promissory institutions suffice?
Men being naturally
selfish, or endow'd only
with a confin'd
generosity, they are not
easily induc'd to perform
any action for the
interest of strangers,
except with a view to
some reciprocal
advantage
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The possibility of defection destroys trust
Hobbes, Leviathan 14.18 (1651)
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
If a covenant be made wherein neither of the parties
perform presently, but trust one another, in the
condition of mere nature (which is a condition of war of
every man against every man) upon any reasonable
suspicion, it is void…

For he that performeth first hath no assurance the other will
perform after, because the bonds of words are too weak to
bridle men's ambition, avarice, anger, and other passions,
without the fear of some coercive power; which in the
condition of mere nature, where all men are equal, and
judges of the justness of their own fears, cannot possibly be
supposed. And therefore he which performeth first doth
but betray himself to his enemy.
The Prisoners’ Dilemma
Underlies Hobbes’ Insight
 A simple game that has become the
dominant paradigm for social
scientists since it was invented about
1960.
 How the game works – and why
didn’t it work for Dilbert
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The paradox of the PD game
 While cooperation is collectively
rational, defection is individually
rational.
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The paradox of the PD game
 While cooperation is collectively
rational, defection is individually
rational.
 The undersupply of cooperation is
“the tragedy of the commons.”
Garrett Hardin, The Tragedy of the
Commons (1968).
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Hollywood gets in the act
Russell Crowe as John Nash
in “A Beautiful Mind”
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The need for poetic license
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Modeling PD games
 Game theoretic problems: payoffs for
each player depend on actions of both
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Modeling PD games
 Game theoretic problems: payoffs for
each player depend on actions of both
 Two possible strategies: A party
cooperates when he performs valueincreasing promises, and defects
when he breaches
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Modeling Two-party choice
Cooperate
Player 1
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Modeling Two-party choice
Player 1
Defect
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Modeling Two-party choice:
Player 2
Player 2
Cooperate
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Modeling Two-party choice
Player 2
Player 2
Defect
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Modeling Two-party Choice
Both Cooperate
Player 2
Cooperate
Cooperate
Player 1
Defect
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Both
cooperate
Defect
Modeling Two-party Choice
Both Defect
Player 2
Cooperate
Defect
Cooperate
Player 1
Defect
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Both defect
Modeling Two-party Choice
Sucker’s payoff for Player 1
Player 2
Cooperate
Cooperate
Player 1
Defect
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Defect
Player 1
cooperates,
Player 2
defects
Modeling Two-party Choice
Player 1’s temptation to defect
Player 2
Cooperate
Cooperate
Player 1
Defect
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Player 1
defects,
Player 2
cooperates
Defect
Bargains as a Prisoner Dilemma game
Cooperation: Promise and Perform
Defect: Promise and Breach
Player 2
Cooperate
Joint
Cooperate
cooperation
Player 1
Defect
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Player 2:
Sucker’s
payoff
Defect
Player 1:
sucker’s
payoff
Joint
defection
Plugging in payoffs
First number is payoff for Player 1,
Second number is payoff for Player 2
Player 2
Player 1
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Cooperate
Defect
Cooperate
3, 3
-1, 4
Defect
4, -1
0, 0
What should Player 1 do if he knows
Player 2 will cooperate?
Cooperate
Cooperate
3
Defect
4
Player 1
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What should Player 1 do if he
knows Player 2 will cooperate?
Cooperate
Cooperate

Player 1
Defect
46
3
4
What should Player 1 do if he
knows Player 2 will defect?
Defect
Cooperate
-1
Defect
0
Player 1
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What should Player 1 do if he
knows Player 2 will defect?
Defect
Cooperate

Player 1
Defect
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-1
0
Defection dominates for Player 1
Cooperate
Player 1
Defect
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Cooperate
Defect
3
-1


4
0
What should Player 2 do if he knows
Player 1 will cooperate?
Player 2
Cooperate
Defect
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Cooperate
Defect
3
4
What should Player 2 do if he knows
Player 1 will cooperate?
Player 2
Defect
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Defect
3
4

Cooperate
Cooperate
What should Player 2 do if he knows
Player 1 will defect?
Player 2
Cooperate
Defect
-1
0
Cooperate
Defect
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What should Player 2 do if he knows
Player 1 will defect?
Player 2
Cooperate
Defect
-1
0
Defect
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
Cooperate
Defection dominates for Player 2
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Cooperate
Defect
Cooperate
3

4
Defect
-1

Player 2
0
Defection dominates for both
Players
Player 2
Cooperate
Defect
Cooperate
Defect
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0
Modeling Two-party Choice
Player 2
Cooperate
Defect
Cooperate
Both
cooperate
Player 1
cooperates,
Player 2
defects
Defect
Player 1
defects,
Player 2
cooperates
Both defect
Player 1
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Joint Cooperation
Everyone promises and performs
The food is
better at
the
Tattaglias…
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I’m
worried
about
Tessio…
Joint defection
Can these gentlemen be acting efficiently?
An inefficient honor code
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Sucker’s payoff
Sucker performs, other party defects
GONERIL
Hear me, my lord;
What need you five and
twenty, ten, or five,
To follow in a house where
twice so many
Have a command to tend
you?
REGAN
What need one?
KING LEAR
O, reason not the need…
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Defector’s Payoff
Defector breaches, sucker performs
"I can make them voting machines sing
Home Sweet Home."
"Don't write anything you can phone.
Don't phone anything you can talk.
Don't talk anything you can whisper.
Don't whisper anything you can smile.
Don't smile anything you can nod.
Don't nod anything you can wink."
Gov. Earl K. Long
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Modeling Two-party Choice
Player 2
Cooperate
Defect
Cooperate
Both
cooperate
Player 1
cooperates,
Player 2
defects
Defect
Player 1
defects,
Player 2
cooperates
Both defect
Player 1
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PD games help to explain why we do
dumb things
 Over-fish lakes and oceans
 Pollute
 Arms race
 Fail to exploit bargaining gains
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Joint Defection
The Tragedy of the Commons
and the Law of the Sea
)
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How about promises without
contract law?
 You want to buy a 1956 Ford…
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Promises without contract law
 You want to buy a 1956 Ford…
 Of the remaining 1956 Fords, half are
worth nothing (“lemons”) and the
other half are worth $5000 (“beauts”)
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Promises without contract law
 You want to buy a 1956 Ford…
 Of the remaining 1956 Fords, half are
worth nothing (“lemons”) and the
other half are worth $5000 (“beauts”)
 The seller tells you it’s a beaut.
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Promises without contract law
 You want to buy a 1956 Ford…
 Of the remaining 1956 Fords, half are
worth nothing (“lemons”) and the
other half are worth $5000 (“beauts”)
 The seller knows which kind of car he
has but you can’t tell them apart
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Promises without contract law
 Of the remaining 1956 Fords, half are
worth nothing (“lemons”) and the
other half are worth $5000 (“beauts”)
 The seller knows which kind of car he
has but you can’t tell them apart
 What would you pay for one?
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Promises without contract law
 Of the remaining 1956 Fords, half are
worth nothing (“lemons”) and the
other half are worth $5000 (“beauts”)
 The seller knows which kind of car he
has but you can’t tell them apart
 The trick: Seller’s willingness to sell is
a signal
 Akerlof, The Market for Lemons, 84 Q.J.
Econ. 488 (1970)
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Promises without contract law
 Of the remaining 1956 Fords, half are
worth nothing (“lemons”) and the
other half are worth $5000 (“beauts”)
 The seller knows which kind of car he
has but you can’t tell them apart
 Question: Is the seller satisfied with
this result?
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Contract Law as a solution
 Suppose that the defector is
penalized through legal sanctions so
that the incentive to defect
disappears.
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What if contracts are prohibited?
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What if contracts are prohibited?
Marriage is more
than a contract;
it’s a covenant…
Rembrandt, The Jewish Bride 1666
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What if contracts are prohibited?
But it’s less
than a contract
if the parties
have
unilateral
exit rights
under
no-fault
divorce laws
Rembrandt, The Jewish Bride 1666
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Marriage, Divorce, Natality
 What did no-fault divorce do to the cost of
matrimonial fault?
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Marriage, Divorce, Natality
 What did no-fault divorce do to the cost of
matrimonial fault?
 Under fault, the straying party pays if he wants a
divorce—or if his spouse seeks one
 So fault is costly in a fault regime
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Marriage, Divorce, Natality
 What did no-fault divorce do to the cost of
matrimonial fault?
 So how do you think no-fault divorce laws
affected divorce levels?

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Bring and Buckley, 18 Int. Rev. Law & Econ. 325 (1998)
Marriage, Divorce, Natality
 How would you expect the parties to
react to the increased probability of
divorce?
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Marriage, Divorce, Natality
 How would you expect the parties to
react to the increased probability of
divorce?
 Fewer marriages
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Marriage, Divorce, Natality
 How would you expect the parties to
react to the increased probability of
divorce?
 Fewer marriages
 Increased female participation in the labor
force
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Marriage, Divorce, Natality
 How would you expect the parties to
react to the increased probability of
divorce?
 Fewer marriages
 Increased female participation in the labor
force
 Increased human capital investments by
women
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Marriage, Divorce, Natality
 How would you expect the parties to
react to the increased probability of
divorce?
 Fewer marriages
 Increased female participation in the labor
force
 Increased human capital investments by
women
 And what about kids?
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Children as marriage-specific assets
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20
15
Series1
Series2
10
5
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
Divorce rate 1965-83 ———
Natality rate for married couples 1965-83 ———
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Absent legal barriers, will the parties
always write a binding contract?
 The Coase Theorem: Parties will enter
a binding contract to exploit all
bargaining games unless prevented
from doing so by transaction costs
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Absent legal barriers, will the parties
always write a binding contract?
 The Coase Theorem: Parties will enter
a binding contract to exploit all
bargaining games unless prevented
from doing so by transaction costs
85
So what are transaction costs?
 Give examples of things that get in
the way of bargaining
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So what are transaction costs?
 Too many parties? Eg, pollution
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So what are transaction costs?
 Emergencies? No time to bargain
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So what are transaction costs?
 Information processing problems?
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War as a Prisoner’s Dilemma Problem
So why doesn’t the Coase Theorem Work?
Uccello, Battle of San Romano
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War as a Prisoner’s Dilemma Problem
The Coase Theorem and Informational Problems
Irwin McDowell
First Manassas
July 21, 1861
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War as a Prisoner’s Dilemma Problem
The Absence of a Bargaining Space
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War as a Prisoner’s Dilemma Problem
Agent Misbehavior
Sir Charles Napier:
“peccavi!”
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All we are saying is …
Give Contracts a Chance
Iranians employing
the defect strategy
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Is there no cooperation without
binding contracts?
95
Cooperation without Law?
 Voting
96
Cooperation without Law?
 Voting
 No littering
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Cooperation without Law?
 It’s 1998. There are two plans for an
online dictionary. One is Encarta,
promoted by Microsoft, whoich hires
editors. The other relies on
individuals to submit entries for free…
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Wikeconomics
 It’s 1998. There are two plans for an
online dictionary. One is Encarta,
promoted by Microsoft, which hires
editors. The other relies on
individuals to submit entries for free…
99
Open Source Software
Linux Mascot
100
Crowdsourcing
101
Bloggers vs. Mainstream Media
102
George Mason School of Law
Contracts I
Bargaining Games
F.H. Buckley
[email protected]
103