Econ 522 – Lecture 10 (Oct 7 2008)
Before we start, a quick example, not directly related to the course, on how economists
look at the world differently than everyone else.
There’s a well-publicized story recently of a 90-year-old woman in Akron, Ohio, Addie
Polk, who became sort of a symbol of the current mortgage crisis when she shot herself
while a bank was trying to evict her after foreclosing on her home.
Obviously, a tragic story – that someone at that point in her life was being thrown out of
her home, and that she was desperate enough to try to kill herself. (She shot herself twice
in the upper body, was hospitalized, and lived.)
Friday, I saw an article online that Fannie Mae had decided to give her the house – to
forgive the remaining balance on the mortgage, and allow her to keep it.
To most people, a sweet end to a sad story – a big company “doing the right thing” to
address a sad situation.
I saw the article as a link from an economics blog I read. It was under the heading “No,
no, no!” And the comment after a quote from the article was:
“In other words, the taxpayers are now subsidizing self-injury.”
(In fact, this serves as a kind of example of the incentive problem of bailouts in general.
After the fact – once the situation has already occurred – giving her the house may seem
quite reasonable, just like rescuing a failing institution (or several) may seem necessary.
But in terms of incentives; if people anticipate that they’ll be “rescued” if their business
starts to fail, it creates an incentive to take unreasonable risks. Just like if people expect
they can keep their house by shooting themselves, it may create an incentive for a
behavior we don’t really want to encourage. We’ll have to see whether there are any
more foreclosure-related suicide attempts.)
Last Thursday, we asked the question of what promises the law should enforce, and
introduced contract law as the attempt to answer that question.
We talked about one early attempt to answer the question, the bargain theory of
contracts, and some of the problems with it.
o Under the bargain theory, promises are legally enforceable if they were
given as part of a bargain; there are three elements that must be present,
offer, acceptance, and consideration
We showed an example of an agency game, where my inability to commit to a
future action (in that case, returning your investment) led to a breakdown in
…we said that the first purpose of contract law is to enable cooperation, by
turning games with noncooperative solutions into games with cooperative
…and we argued that efficiency generally requires a promise to be enforceable if
both the promisor and the promisee wanted it to be enforceable when it was
o A question I got after class…
We saw an example of how asymmetric information can inhibit trade…
(the example of you being unable to buy my used car, because I “know too much”
about its condition and have no incentive to tell you what’s wrong with it)
…and claimed that the second purpose of contract law is to encourage the
efficient disclosure of information
We discussed the fact that efficiency sometimes requires breaching a contract…
…and said that the third purpose of contract law is to secure optimal commitment
…and argued that setting the promisor’s liability equal to the promisee’s benefit –
expectation damages – accomplishes this goal
We introduced the idea of reliance, that is, investments made by the promisee to
increase their benefit from the promise…
…and said that the fourth purpose of contract law is to secure the optimal level of
…and then we ran out of time.
Today, I want to go back over the example of efficient breach, since I think I went
through that a bit fast… do an example of reliance… then move on to default rules and
We begin with an example of efficient breach. Suppose that I build airplanes, and you
contract to buy one from me. You value the airplane at $500,000. We agree on a price of
$350,000. It will simplify the example if we assume you paid me up front; so let’s
assume this contract was money-for-a-promise: you already paid up front and I promised
to deliver a plane. (This doesn’t really matter much, it just makes all the numbers
The rule for efficient breach is:
If [ Promisor’s Cost ] > [ Promisee’s Benefit ] Efficient to breach
If [ Promisor’s Cost ] < [ Promisee’s Benefit ] Efficient to perform
Since the promisee’s benefit is known to be $500,000, it is efficient to perform whenever
the cost of building the airplane is below $500,000, and efficient to breach whenever the
cost is above $500,000.
Since the promisor only looks at his own private cost and benefit when deciding whether
to breach or perform,
If [ Promisor’s Cost ] > [ Liability ] Promisor will breach
If [ Promisor’s Cost ] < [ Liability ] Promisor will perform
In the case of perfect expectation damages, the promisor’s liability would be the amount
of benefit the promisee would have received, which is $500,000; this leads to the
promisor performing whenever the cost of building the airplane is less than $500,000,
which is exactly what efficiency would require. Setting the promisor’s liability at any
other level would lead to some instances of either inefficient breach (if liability were too
low) or inefficient performance (if liability were too high).
(Why? First, suppose liability were $350,000 – I can get out of building you the plane by
returning your money. If the cost of building it rises to $400,000, though, now I’ll refuse
to build the plane; but it would be efficient for me to build it.
So what, you might ask? If transaction costs are low, we can just negotiate again and
agree that you’ll pay me $450,000 for the plane. But if I can get out of a promise just by
returning your money, it might be tempting for me to do this too often, just to try to raise
the price. Suppose the true cost stays the same; but I know you agreed to pay $350,000,
so you must value the plane more highly than that. So I go to you with a made-up story
about one of my workers threatening to quit unless he gets a raise, I tell you my costs
went up, and you can only have the plane if you’re willing to pay me $400,000. If it’s
too easy to get out of a contract, agreements become meaningless. And if transaction
costs are high – say, you’re mad because I breached the first contract, and don’t want to
deal with me anymore – then you don’t get your plane, even though it would be efficient
for me to build it.
On the other hand, suppose it was too hard to get out of a contract. Suppose that contract
law specified that if I breach a contract, I owe you $10,000,000. Now my costs actually
go up, and it would cost me $1,000,000 to build you a plane. I go to you and say, “look, I
know I promised you a plane, but it would cost me $1,000,000 to build, can we just agree
to undo the deal?” And you say, “sure, just give me the $1,000,000.” And I say, “Why?
You were only going to get $500,000 of benefit out of the plane.” And you say, “Yeah,
so what? If you don’t give me a plane, you owe me a lot more than that. Give me
$1,000,000, or else.”
What’s the problem with that? Well, in a static world, nothing – me having to pay you
$1,000,000 to get out of my promise is annoying to me, but it’s not inefficient. But now
go back to when we were originally agreeing to the contract. If I know there’s a small
chance my costs will go way up, and if contracts are strong enough that you could do this
to me, then maybe I don’t want to take the risk of making the promise in the first place.
So now even though it might be efficient for me to agree to build you a plane, I’d be
afraid to make that promise.
On the other hand, if the cost to me of breaching the contract – my liability – is exactly
equal to your benefit, there is no problem. I’ll still build the plane exactly when it’s
efficient for me to build the plane – whether or not transaction costs are low enough that
we could renegotiate. We’ll see later that expectation damages doesn’t perfectly solve
the problem of efficient signing – being willing to sign the right contract in the first place
– but at least it doesn’t make this problem too severe.)
So that’s efficient breach. Next, reliance. You’ll recall that reliance is any investment
the promisee makes that increases the value of performance. So you contract to buy my
painting, and go buy a frame for it; or you contract to buy an airplane from me, and you
start building a hangar.
Since reliance increases the value of the promise to you, it increases my liability for
breach under the concept of expectation damages as we’ve defined them. (That is, if I
break the promise, I’m responsible for making you as well off as you would have been if
I had kept my word; so if you’ve built a hangar, now I have to reimburse you for the
value of the plane with a hangar, rather than without a hangar.) So reliance increases my
losses under breach. But you don’t take that into account when deciding how much to
invest in reliance, so there is no guarantee that the level of reliance will be efficient.
We’ll use the same example – you contract to buy a plane from me. You value the plane
at $500,000, and agree to pay $350,000 for it. Let’s assume that this time, the bargain is
promise-for-a-promise – you agree to pay on delivery. And there are expectation
Now you have the option of building yourself a hangar. Building a hangar costs $75,000,
and increases the value of owning a plane from $500,000 to $600,000.
Suppose that it’s most likely that building the plane will cost me $250,000; but that
there’s some probability p that it will instead cost $1,000,000. Clearly, if it costs
$1,000,000, I won’t build it; I’ll just breach the contract and accept that I have to pay you
Let’s look at what happens in each case.
First, suppose the cost of the plane is $250,000, so I build it. Our payoffs (in thousands):
If you relied (built the hangar): you get 600 – 75 – 350 = 175
I get 350 – 250 = 100
If you didn’t rely (build) you get 500 – 350 = 150
I get the same 350 – 250 = 100
Now look at the case where the cost of sheet metal went through the roof and I choose to
breach. Assuming I owe perfect expectation damages as we’ve defined them – that is,
enough to make you as well off as if I’d performed…
If you relied (built the hangar): Your surplus would have been 600 – 350 = 250
from the plane, so I owe you 250 in damages
And you paid 75 to build the hangar
So you end up with payoff of 175
I get –250 (since I have to pay you 250 in damages)
If you didn’t rely (build) Your surplus would have been 500 – 350 = 150, so
I owe you 150 in damages, which is your payoff
I get –150 after paying you damages
So whether or not I perform, you get 175 if you relied, 150 if you didn’t. So clearly,
reliance makes you better off.
But then the question is, is reliance efficient? That depends on how likely I am to breach.
If you rely, our combined expected payoffs are
(1–p) (175 + 100) + p (175 – 250) = 275 (1–p) – 75 p = 275 – 350 p
If you didn’t rely, our combined expected payoffs are
(1-p) (150 + 100) + p (150 – 150) = 250 – 250 p
So the total social gain from you building the hangar is
(275 – 350 p) – (250 – 250 p) = 25 – 100 p
So it turns out that when p < ¼, reliance is efficient – it increases our combined payoffs.
When p > ¼, reliance is inefficient – it decreases our combined payoffs.
This is indicative of a more general idea: when the probability of breach is low, more
reliance tends to be efficient; when the probability of breach is high, less reliance
tends to be efficient.
But if my damages cover your benefit whether or not it’s efficient, then you don’t care
about the risk of breach – you end up just as well off whether or not I breach. So you’ll
clearly choose the higher level of reliance, whether it’s efficient or not. This will
sometimes lead to overreliance – more reliance than is efficient.
So how do we fix this? Cooter and Ulen adjust their definition of expectation damages in
the following way:
Perfect expectation damages restore the promisee to the level of well-being he would
have had, had the promise been kept, and had he relied the optimal amount.
(This is why they attach the word “perfect” to expectation damages)
Thus, the promisee is rewarded for efficient reliance – this increases his payoff from
performance of the promise, and also increases his payoff from breach, since it increases
the amount of damages he receives. But the promisee is not rewarded for excessive
reliance – overreliance – since damages are limited to the benefit he would have received
given the optimal level of reliance.
It’s a nice idea, but it seems like it would be very hard in general for a court to determine
after the fact what the optimal level of reliance was. (It might also be hard for the
promisee to know this, since he may not know the probability of breach.)
What is actually done in practice? One important legal doctrine is that liability is
generally limited to a level of reliance that is foreseeable.
Reliance is foreseeable if the promisor could reasonably expect the promisee to
rely that much under the circumstances
Reliance is unforeseeable if it would not be reasonably expected
American and British law tend to define overreliance as unforeseeable, and
An example given in the book is a telegraph company failing to transmit a stockbroker’s
message, resulting in millions of dollars in losses. The telegraph company could not
reasonably expect the stockbroker to rely that heavily on one message, and so would not
be liable for the extent of the losses.
Another example: the rich uncle’s nephew, when he was promised a trip around the
world, went out and bought “a white silk suit for the tropics and matching diamond belt
buckle”. After the uncle refuses to pay for the trip, the nephew sells the suit and belt
buckle at a loss, and sues his uncle for the difference. The court might find the silk suit
foreseeable reliance, but the diamond belt buckle unforeseeable, and only award him the
loss on the suit. (The book points out that “in American law, gift promises are usually
enforceable to the extent of reasonable reliance.”)
Reliance is part of the issue in the famous case of Hadley v Baxendale, a precedent-
setting English case decided in the 1850s. I give a link to the actual court decision on the
syllabus. Here is Cooter and Ulen’s summary of the case:
Hadley owned a gristmill; the main shaft of the mill broke; and Hadley hired a
shipping firm where Baxendale worked to transport the shaft for repair. The
damaged shaft was the only one in Hadley’s mill, which remained closed awaiting
return of the repaired shaft.
The shaft was supposed to be delivered in one day; Baxendale decided to ship it by boat
instead of by train, and as a result, it arrived a week late. Hadley sued for the profits he
lost during that extra week in which the mill was shut down. Quoting again:
The shipper assumed that Hadley, like most millers, kept a spare shaft. The
shipper contended that Hadley did not inform him of the special urgency in
getting the shaft repaired. The shipper prevailed in court on the damages issue,
and the case subsequently stands for the principle that recovery for breach of
contract is limited to foreseeable damages.
The ruling was that the lost profits were not foreseeable – the court specifically listed
several circumstances in which a broken crankshaft would not force a mill to shut down –
and that Baxendale was only liable for damages he could reasonably have foreseen.
However, this isn’t just a question of reliance; part of the issue is that Hadley knew about
the urgency of getting the crankshaft fixed quickly, but did not tell Baxendale. We’ll
come back to this question of information shortly.
If transaction costs are 0, then the two sides to a contract could spell out exactly what
should occur in every possible contingency – what happens if the cost of sheet metal
rises, what happens if my uncle wants my painting, what happens if a shipment is
delayed, and so on. This would make contract law much simpler – courts could simply
enforce the letter of the contract, since nothing was left unclear.
However, in reality, some circumstances are impossible to foresee; and even if they
weren’t, the cost and complexity of writing a contract to deal with every possibility
would make perfect contracts unworkable.
Risks or circumstances that aren’t specifically addressed in a contract are called gaps;
default rules are rules that the court applies to fill in these gaps.
Gaps can be inadvertent or deliberate. Our contract to sell you my painting might not
have addressed my uncle wanting the painting because I didn’t know he was coming to
visit, or because I never would have imagined he would be so excited about it. On the
other hand, we could have imagined that it was at least possible for the price of raw
materials for building an airplane to go up significantly; however, we might have felt it
was such a remote risk that it was not worth the time and effort to build it into the
Cooter and Ulen point out the decision to leave a gap or fill it (specifically address a
particular contingency) is the difference between the need to allocate a loss after it has
occurred (ex post) versus the need to allocate a risk before it becomes a loss (ex ante). In
the first case, allocating the risk, the cost of adding it to the contract is definitely incurred;
in the second case, allocating a loss that has occurred, the cost of allocating the loss is
only incurred when the loss occurs. Thus, it is often rational to leave gaps when the risk
is very remote. (On the other hand, it is usually cheaper to allocate a risk ex ante than a
loss ex post.)
So the courts must decide what “default rules” should apply to circumstances that are not
addressed in a contract, that is, what rules should fill the gaps that are left in imperfect
contracts. The next obvious question is: what should these default rules be?
Cooter and Ulen answer this question by going back to the Normative Coase Theorem:
the law should be structured to minimize transaction costs. Since filling a gap in a
contract requires some cost, the default rule should be the rule that most parties would
want if they chose to negotiate over the issue. This way, most contracts will not have to
address this particular rule – they can use the default rule – and therefore avoid additional
And the rule that most parties would want is whatever rule is efficient.
They give an example: a construction company has contracted to build a house for a
family, and there is some risk of a worker strike at the company which would delay
completion of the house. They suppose that the company can bear the risk of a strike at a
cost of $60, and that the family can bear the risk at a cost of $20. (It might be cheaper for
the family to bear the risk because they could stay with friends for a while if the house
were delayed; if the company held the risk, it might have to pay for a hotel for the
family.) (Also note that these numbers are low not because a strike would have low
costs, but because a strike might be fairly unlikely, and so the expected cost is fairly low.)
If the risk were not addressed by the contract, the default rule would apply.
If the default rule were for the construction company to bear the risk, this would be
inefficient in this case. The parties could create an additional $40 of surplus by
overruling the default rule (addressing the risk). So as long as the transaction cost of
allocating the risk were not too large, they would choose to do so, but incur this
On the other hand, if the default rule were for the family to bear the risk, they would not
need to address the risk in the contract, and would not incur the transaction cost.
This brings Cooter and Ulen to their fifth pronouncement:
The fifth purpose of contract law is to minimize transaction costs of negotiating
contracts by supplying efficient default rules.
They also offer a simple rule for doing this:
Impute the terms to the contract that the parties would have agreed to if they had
bargained over the relevant risk.
That is, figure out what terms the parties would have chosen if they had chosen to address
a risk, and let those be the default rule.
Of course, you don’t want a lot of ambiguity in the law, so you don’t want the default
rule to vary constantly with the particular circumstances of a given case; so what’s more
practical to do is to set the default rule to the terms that most parties would have agreed
to. This is called a majoritarian default rule. In circumstances where this is not the
efficient rule, the parties are still free to contract around it, that is, to put terms in the
contract that overrule the default rule.
Of course, if the parties had chosen to address a particular risk, it’s safe to assume that
they would have allocated it efficiently – that is, as long as the parties were choosing to
consider a risk, they would allocate it in the way that led to the highest total surplus, and
then compensate the party who bears the risk for bearing it. Thus, this is what the court
would need to do to figure out the efficient default rule: it should figure out the efficient
allocation of risks, and then adjust prices in a reasonable way.
The book gives an example of this. Go back to the house construction example, but with
different numbers. Suppose the family and the company sign a contract. The
construction company knows that with probability ½, the price of copper pipe will go up
in such a way as to increase the cost of construction by $2000. So in expectation, the cost
of construction will be $1000 higher due to this risk. The company can hedge against
this risk (by buying copper pipe in advance and then paying to store it somewhere) at a
cost of $400. Assume that the family has no reason to know anything about the cost of
copper pipes, and therefore does not anticipate the risk or have any way to mitigate it.
The company chooses not to hedge this risk, the price of copper pipes goes up, the
company builds the house and bills the family $2000 more than they had expected. The
family refuses to pay, and the case goes to court. The original contract does not mention
the risk of soaring copper prices.
So how would the court address this? First, the court must decide to whom the contract
would have allocated this risk, if it had addressed it. Then it must adjust prices to reflect
In this case, the cost of bearing the risk would be $1000 to the family (since they have no
way to mitigate it), but $400 to the company (since hedging the risk is cheaper than
bearing it). So the company is the efficient bearer of the risk; so an efficient contract
would have allocated this risk to the company.
Next, the court must consider whether the price should be adjusted. In this case, the court
might rule that the risk of a spike in copper prices was foreseeable. The construction
company was the efficient bearer of risk, and foresaw, or should have foreseen, that this
risk was present; so the court could assume that the price the parties negotiated already
included compensation for bearing this risk.
On the other hand, there are some risks that are unforeseeable. Suppose that the leader of
the copper miners’ union in Peru died, and there was a battle to succeed him, and that his
replacement called a strike to flex his muscles, and that this strike was what led to the
increase in copper prices. Here, it’s reasonable that neither party would have foreseen the
In this case, the construction company might still be the efficient bearer of this risk –
since they might be able to make changes to the construction plan to use less copper and
more of other materials. But since the risk was unforeseen, it was not included in the
negotiated price. So the court might adjust the price paid to the construction company, to
compensate them for the risk; but then still hold the construction company responsible for
the extra $2000 in costs. Thus, the ruling might be that the family should pay some
smaller amount – say, $700 – which is what the company would have needed to receive
as compensation for bearing this risk – but that the company was then responsible for the
rest of the $2000.
(The book then continues this story to give another example of overreliance and breach –
check it out if you’re still confused about these points.)
So the rule in Cooter and Ulen is fairly straightforward: courts should set default rules
that are efficient in the majority cases, so that most parties can leave that risk unaddressed
and save on transaction costs, while parties can contract around this rule in circumstances
where it is not efficient.
Ian Ayres and Robert Gertner offer a very different take on default rules, in the article
on the syllabus, “Filling Gaps in Incomplete Contracts: An Economic Theory of
Default Rules.” Rather than setting default rules to be what the parties would have
wanted, they argue that in some instances, it is better to make the default rule something
the parties would not have wanted; either to give the parties an incentive to specifically
address an issue rather than leaving a gap, or to give one of the parties an incentive to
disclose information. They refer to this type of intentionally-inefficient default rule as a
Ayres and Gertner argue that in some cases, gaps are left not because the of the
transaction costs of filling them, but for strategic reasons. One party might know that the
default rule is inefficient; but negotiating around the default rule would require him to
give up some valuable information, so he might be tempted not to.
Consider again the case of Hadley v Baxendale, the miller with the broken crankshaft.
While the crankshaft is en route, Hadley’s mill is not operating, so he’s losing money.
Baxendale, the shipper, is the only one who can influence when the crankshaft is
delivered; so he is likely the efficient bearer of this risk. (It was his choice to ship the
crankshaft by boat, rather than by rail, that led to the delay.)
If the default rule were for Baxendale to be responsible for any lost profits, however,
Hadley has no incentive to make clear how important it is that the crankshaft be delivered
promptly. In fact, he is likely to not want to mention it; if he made it clear how important
the crankshaft was, then Baxendale might be able to charge him a higher price for
delivery! So a default rule holding Baxendale responsible for lost profits due to delay
would lead Hadley not to disclose the urgency of his shipment, which would pretty
clearly be bad.
On the other hand, a default rule that Baxendale is not responsible for lost profits seems
to be inefficient – we just argued that Baxendale is the efficient bearer of this risk. So
this gives Hadley an incentive to try to negotiate different terms in the actual contract.
Over the course of doing so, the urgency would become apparent; Baxendale would take
on the risk, but would also know the costs of delay, and could plan around them better.
So Ayres and Gertner argue that the ruling in Hadley was a good one, not because the
default rule was efficient, but because it was inefficient in a way that created good
incentives: the incentive for the better-informed party to disclose information. (In this
sense, the default rule is a “penalty default:” it penalizes the better-informed party, giving
an incentive to contract around the default.)
They give other examples where penalty defaults are used in the same way. Consider a
real estate broker who is brokering the sale of a house by a private seller to a private
buyer. When a buyer’s offer is accepted, he puts down a deposit, called “earnest money,”
to show that he is serious; if he then backs out of the deal, this earnest money is lost. The
question remains, how should the earnest money be divided between the seller and the
Both the broker and the seller are inconvenienced by the breach; it’s not really clear who
is the efficient bearer of this risk. However, what is clear is that the broker is probably
better informed about the laws of real estate contracts. The broker is a professional, who
does this type of transaction for a living. The seller might be selling a house for the first
If the default rule allowed the broker to keep the earnest money, the broker has no reason
to bring this up when negotiating a contract with the seller. But the seller might not know
to bring this up; the seller might have no idea about earnest money, and not realize that
this was another point that could be negotiated with the broker.
On the other hand, if the default rule gave the earnest money to the seller, the broker
would clearly know this, and would have a clear incentive to raise this with the seller, and
then they could negotiate whatever was the efficient allocation of the earnest money.
Thus, whether or not it’s efficient, a default rule favoring the less-informed party once
again gives an incentive to disclose information, which may be desireable.
Ayres and Gertner give another compelling example of penalty defaults used for a
different purpose. When a contract does not specify a price for a good, courts will tend to
impute whatever the market price was at the time of the transaction. However, when a
contract does not specify a quantity, courts will refuse to enforce the contract – in effect,
setting a quantity of 0. That is, the default rule for price tends to be market price, while
the default rule for quantity tends to be 0.
A quantity of 0 cannot possibly be what the parties would have wanted – nobody would
go through the hassle of signing a contract in order to transact no goods. So what is the
reason for this default rule?
Ayres and Gertner argue it is a penalty default, to force the parties to decide on a
quantity. But why should the parties be forced to decide on a quantity and not a price?
This is because it’s easier (cheaper) for the court to fill in the price than the quantity. The
rule for figuring out the price the parties would have agreed to is easy – the court can
usually ascertain the market price of a given good on a given date without much
difficulty. However, if the court had to impute the quantity the parties would have
wanted, this is much more difficult – the court would have to figure out the marginal
value of an incremental unit of the good to each side to figure out the efficient amount to
transact. Thus, shifting the burden of calculating the right quantity from the parties in the
contract to the courts is inefficient; so the default rule forces the parties to decide on the
Ayres and Gertner do not argue penalty defaults should always be used, only that they are
appropriate in certain circumstances. They basically argue that we need to look at why
parties to a contract leave a particular type of gap. When gaps are left due to transaction
costs of filling them, efficient defaults make sense. However, when gaps are left
strategically – by a well-informed party who chooses not to contract around an inefficient
default in order to get “a bigger share of a smaller pie” – penalty defaults may be more
(In the conclusion to their paper, they cite an analogous view in a dissent by Supreme
Court Justice Scalia. The Court was asked to supply a default statute of limitations for a
RICO (racketeering/corruption) statute where the legislature had not specified a statute of
limitations. The majority set the statute of limitations at 4 year, figuring that’s what the
legislature would have chosen had they remembered to specify a statute of limitations.
Scalia proposed no statute of limitations; he was “unmoved by the fear that this… might
prove “repugnant to the genius of our law”; he pointed out, “indeed, it might even prompt
Congress to enact a limitations period that it believes appropriate, a judgment far more
within its competence than ours.”)
It’s a pretty cool article – take a look if you’re interested.
Default rules are rules which hold when a contract leaves gaps, but which parties to a
contract are free to contract around. (That is, by specifying a rule for a particular
situation, they “overrule” the default.) If the default rule did not hold shippers liable for
unforeseen losses, Hadley and Baxendale could still choose negotiate a contract under
which the shipper was liable for all losses.
However, there are some rules that cannot be contracted around. Ayres and Gertner refer
to these as immutable rules. Cooter and Ulen refer to them as mandatory rules, or as
regulations. Their Fifth Purpose of Contract Law, which we mentioned earlier, is
The fifth purpose of contract law is to minimize transaction costs of negotiating
contracts by supplying efficient default rules AND REGULATIONS.
What are the circumstances where regulations, or mandatory rules, or immutable rules
make sense? That is, in what circumstances should a rule be made that individuals are
not able to voluntarily contract around?
Going back to Coase, if individuals are rational and there are no transaction costs, private
negotiations (in this case, contracting) will lead to efficiency, so any additional regulation
would be inefficient. Conversely, regulation may be efficient in situations where
individuals are not rational, or there are transaction costs or market failure.
We look at a bunch of these cases.
WE ENDED HERE
The first thing we said – that individuals are rational – is not always the case, and courts
generally do not enforce contracts made by irrational individuals. Several ways that this
children cannot sign binding contracts
the legally insane cannot sign binding contracts
courts will not enforce contracts signed under “dire constraints”, specifically,
duress and necessity
Necessity is when I’m at the point of starvation, and someone comes along and offers me
a sandwich for $10,000. I don’t have it on me, so I sign a contract agreeing to pay him
$10,000 and I eat the sandwich. Or I’m on a boat that’s about to sink, and another boat
offers me a ride back to shore for a million dollars. In either case, the contract would not
be upheld, since I signed it out of necessity.
Duress is similar, but the uncomfortable situation is being caused by the other party. This
is when someone kidnaps my child, and I agree to pay ransom to get her back. The
contract is not enforceable, because I agreed to it under duress. Much as everyone loves
the idea of “making him an offer he can’t refuse” from the Godfather, courts would not
uphold a contract signed at gunpoint. (Of course, whether you want to breach a contract
with the Mafia, or sue the Mafia, is a separate question.)
There are a number of other situations in which private contracting would not necessarily
lead to efficient results, and therefore there is potential gain from regulation. The book
categorizes all of these situations as “transaction costs,” but they are worth talking about
One is spillovers, that is, when a contract between two parties (A and B) has an effect on
another party (C). In many cases, this can be thought of as an externality. A is a power
plant, and signs a contract with B to provide power; but generating more power generates
more pollution, which harms C. In these cases, the remedy is generally not through
contract law, but through other branches of law – property and nuisance law, or torts, or
other areas. In this case, the contract between A and B would be upheld, and C could sue
A for damages under nuisance law.
One exception to this is contracts that deliberately “tie one’s hands” in negotiations.
Suppose that B and C are labor and ownership at some factory, and are engaged in
negotiations over wages. B wants the workers it represents to earn $15 an hour, C is
offering $10, and negotiations are ongoing.
Now B turns around and signs the following contract with A: B promises to go to work
for A for $1 an hour if he ever signs a contract with C for less than $15 an hour. The
intent of this contract is purely to strengthen his bargaining position with C – by “burning
his bridges”, that is, by making it much more painful to back down from his demands.
Clearly, this contract between A and B would have an effect on C.
(The notion of burning your bridges comes from Sun Tzu’s The Art of War: “When your
army has crossed the border [into hostile territory], you should burn your boats and
bridges, in order to make it clear to everybody that you have no hankering after home.”
By taking away your option of retreating, you make it clear that you’re serious about
In the U.S., however, unions have a statutory obligation to bargain “in good faith”; the
contract between the union (B) and firm A would make B violate this obligation; so the
contract would be ruled to be unenforceable.
Contracts may be deemed unenforceable if enforcing them would derogate public
policy. In this example, enforcing the contract between A and B would derogate
(undermine) B’s statutory obligation to bargain in good faith. There are other examples
of contracts which would derogate public policy. The book gives the example of a victim
of a crime offering a policeman a reward for solving the crime. The police’s job is to
solve crimes; allowing rewards might distort the focus toward crimes with rewards, away
from more important crimes without rewards.
Another example would be a contract among competitors to act as a cartel, similar to a
monopoly. A contract that fixed prices, say, would derogate laws designed to foster
competition, and would therefore be unenforceable.
A contract to buy illegal drugs would similarly be considered unenforceable.
In spite of this principle, however, there are examples where, even though one side
performing would require laws to be broken, a contract is still enforced, that is, a remedy
is still supplied for breach. Three examples from the book:
“A married man may be liable for inducing a woman to rely on his promise of marriage,
even though the law prohibits him from marrying without first obtaining a divorce.”
“A company that fails to supply a good as promised may be liable even though selling a
good with the promised design violates a government safety regulation.”
“A company that fails to supply a good as promised may be liable even though producing
the good is impossible without violating an environmental regulation.”
In all these examples, the liability should rest on the party that knew, or should have
known, that it was committing to something illegal. Similar to the reasoning in Ayres
and Gertner, putting the liability on the informed party gives them an incentive to be
honest (or in these cases, to not enter into this type of contract). Thus, Cooter and Ulen
argue that the promisor should be liable for breach if he knew (or should have known)
that the promise was illegal but the promisee did not. On the other hand, the promisor
should not be liable if he did not know the promise was illegal and the promisee did.