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					                Contract Law

          An Economic Theory of Contracts

      Transaction costs, complete contracts,
       default terms and perfect contracts

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          Transaction costs and default terms

Contracts generally involve risks, since all future states of the
  world are not known

A complete contract is one that allocates all risks to either the
   promisor or the promisee

However the value of some of these risks will be greater than
  others (either they are more likely to occur or they are
  more costly if they do occur)

Will most contracts be complete? No!

Most contracts have gaps – unallocated risks
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Parties to a contract might find themselves in the following

1. A known and potentially costly risk is allocated in the
   contract – eg. a delivery point is agreed upon with the
   seller responsible for the safe arrival of the goods to that
   point and the buyer thereafter – an allocated risk

2. The costs of negotiating the allocation of the risk may be
   greater than the cost of the risk (either the risk is remote
   or the cost associated with the event is low), so that the
   risk is not allocated to either of the parties - a ‘gap’ is left
   in the contract – an unallocated risk

3. The risk itself may be unforeseen and hence not allocated -
   another gap- unallocated risk

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Rational gaps - cost minimizing gaps

If the ‘risk’ is allocated ‘ex ante’ then the parties must incur
    transaction costs (to negotiate allocation of the risk) - with

If the ‘loss’ is allocated ‘ex post’, then the parties will incur
    transaction costs (to allocate the loss) only if the event
    actually occurs – they might or might not have to actually
    do this

Consider the following transaction costs minimizing rule:

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if the cost of

       allocating a given risk > the expected cost of
                                 allocating the loss
then leave the gap

if the cost of

        allocating a given risk < the expected cost of
                                  allocating the loss
then fill the gap

This is the ‘private’ optimizing (cost minimizing) rule that
  agents would follow

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What is the cost of allocating a given risk?

         the up front transaction - costs of bargaining between
    the parties to the contract - these transaction costs will be
    incurred with certainty if the cost of the risk is allocated up

What is the expected cost of allocating the loss?

          (cost of allocating the loss) x
          (probability of the loss occurring)

    these transaction costs will be incurred only if the bad
    event happens

So we can re-write the ‘private’ optimizing (cost minimizing)
  rule as:

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if the cost of
allocating a given risk > (cost of allocating the associated
                              loss) x (probability of the loss
    then leave the gap

if the cost of
allocating a given risk < (cost of allocating the associated
                              loss) x (probability of the loss
    then fill the gap

Gaps left in contracts on the basis of the above rule are
  termed rational gaps - they minimize transaction costs

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          Example: Risk of patent infringement

Big Firm is contracting to buy an electronic component from
   Small Firm.

Small Firm relies on a number of patents to produce the
  component and any one of these patents might be
  challenged by a competitor at some future date.

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Big Firm believes that negotiating a contract clause to cover
   the possibility of contract failure due to patent infringement
   would costs $150,000.

If the contract was to fail due to a patent infringement lawsuit
    against Small Firm then Big Firm believes that the cost of
    sorting out the damages would be $750,000.

What must the likelihood of Small Firm being sued for patent
  infringement be before Big Firm would consider negotiating
  a ‘patent infringement claim clause’ in the contract with
  Small Firm?

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Recall:           if the cost of allocating a given risk >
                          (cost of allocating the associated loss) x
                          (probability of the loss occurring),

then the private maximizing strategy is to leave the gap

We know that for Big Firm the rule becomes:

    $150,000 > $750,000 x (probability of the loss occurring)

so that,

    $150,000/$750,000 > probability of the loss occurring

so that, if
              probability of the loss occurring < 0.2   (20%),

    the optimizing strategy is to leave the gap

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What about the contract values themselves – the investment,
  expected gains, investment in reliance etc? Why do we not
  consider these costs in deciding whether or not to negotiate
  a clause?

There will be many such risks in any given contract setting

Some of these risks can be grouped under general provisions
  of the contract – ‘act of war or insurrection’ clause, ‘FOB’,
  ‘act of god’

Sometimes there are standard ‘trade clauses’ which cover
  known risks in a given market setting – ‘rain check’, ‘rain

Nonetheless, all contracts will be incomplete

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Gap-filling by courts

What if a contract fails due to an unallocated risks and the
  parties cannot agree on an allocation of the loss

How should the courts fill gaps left by the parties to a

Courts might ‘impute’ contract terms which the parties
  omitted - fill the gap – provide default terms

An efficient default term allocates the loss to the party
  which could have borne the risk ex ante at least costs
(This is the party that would have been responsible for the risk had it
   been allocated ex ante – why?)

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If the courts always impose efficient default terms then:

- both parties are potentially better off, since efficient default
   terms lead to a minimization of the costs of dealing with
   the risk

- parties to a contract can avoid (minimize ?) the transaction
   costs associated with negotiating these terms in every

Contract law should minimize transaction costs of
  negotiating contracts by supplying efficient default
  terms when it becomes necessary to do so

Does this mean that every time a contract fails and there is a
  gap in the contract, the parties will end up in court?

No, recall ‘bargaining in the shadow of the law’
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Hypothetical bargain

How do courts arrive at efficient default terms? Two

1. Courts need only impute the terms to the contract that the
   parties would have agreed to had they negotiated over the
   risk - the courts must decide who would have been the
   more efficient risk bearer ex ante.

2. Was the risk foreseen, or should it have been foreseen, by
   one of the parties – if so the costs of the risk was likely
   already included in the negotiated contract price.

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A rule of common law:

     the promisor must bear the costs of `reasonably
     expected costs of breach’, while the promisee
     must bear the costs of ‘unforeseeable costs of
     breach’, unless the promisor is notified of such

If a risk is known to the promisor, then the
   promisor is responsible for that risk
   – otherwise the promisee is responsible

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Does this make sense?

     - It provides a clear rule for the courts and the parties to a

     - If the risk is known then the promisor can ‘price it into’ the
     contract, or explicitly negotiate for the promisee to assume the

     - If there is some unusual risk (unforeseen to the promisor) but
     known to the promisee, then the burden is on the promisee to
     make the promisor aware of this risk

Note that all of this might be difficult in practice

Often the court must rely on the ‘customs of the trade’ in
   order to determine what each party knew or should have
   known about the facts involved

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     Example - Who should be responsible for
         the weather? – see note package A-I

Power Company in New York State has a contract to provide
   power to Major Manufacturer
Power Company buys its power from Quebec Hydro
A bad winter storm interrupts the Quebec Hydro power supply
Major Manufacturer loses power and $1,000,000 in profits
Major Manufacturer sues Power Company for breach of contract

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It is known that:

  - Major Manufacturer could have built a back-up gas fired
  power plant for use in emergencies at a cost of $500,000

  - Power Company could have made a risk sharing agreement
  with Southern Power Company to supply each other with extra
  power in case of emergency at a cost of $100,000 annually
  (i.e. share a grid).

Efficient default term: Power Company could have borne the risk
   at a lower cost than can Major Manufacturer, therefore it
   should be forced to compensate Major Manufacturer for its loss
   of profits

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What if Major Manufacturer only lost $50,000 in profits?

Then the loss does not justify compensation, since it would be
  more expensive to avoid the loss ($100,000) than the loss

It would be inefficient to force the Power Company to incur
   $100,000 in cost to avoid a $50,000 loss

What if another customer, Minor Manufacturer who lost
  $150,000 in profits could have supplied back-up power by
  buying a portable generator at an annual cost of $2,500?

Should Minor Manufacturer be compensated by the Power
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              Example – foreseeability

In 1990 Grain Transport contracts with Farm Co-op to
   transport 1,000 tons of grain per week from point A to
   point B at a cost of $10,000 per year, for a three year
After two years Grain Transport begins billing Farm Co-op at
   the rate of $12,000 per year, citing increases in the cost of
   fuel as the reason
Farm Co-op refuses to pay the additional $2,000 per year and
   Grain Transport sues
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Suppose that:

- Grain Transport knew, or should have known, that there was
   a 50% chance that the cost of fuel might increase by
   $2,000 per year during the third year of the contract,
   implying that the expected increase in fuel costs was
   $1,000 (0.5 x $2,000)

- further, at the time the contract was made, Grain Transport
   could have contracted to buy fuel for the third year of the
   contract, at the 1990 price, for an additional charge of

- Farm Co-op had no special knowledge of the market for fuel
   and could not have foreseen the possible increase in fuel

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The court is likely to decide that:

1. The hypothetical bargain which Grain Transport and Farm
    Co-op would have made, would have allocated the risk of
    increased fuel prices to Grain Transport

      - it was the most efficient bearer of that risk

2. Who pays the $2,000 loss due to increased fuel costs?
   Grain Transport.

3. But who pays the ‘hypothetical’ hedging costs of $500?
   (The amount Grain Transport could legitimately charge as
   the costs of dealing with the risk)

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Can Grain Transport, at least, charge Farm Co-op an amount
  equal to the costs of doing what the court found it should
  have done?

No, Grain Transport knew, or should have known, that the
  price of fuel might go up.

Therefore, whatever price it agreed to in the original contract
  should have ‘priced in’ the risk of fuel price increases.

If Grain Transport did not include such a risk premium in its
   contract price, then that is its own fault and there is no
   reason to make Farm Co-op pay after the fact.

It cannot charge its customer ‘after the fact’ for the cost of a
   bad event the risk of which its customer was unaware.

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          Example – foreseeability again
Martha leases a condo from Rentcorp as of January 1st

Rentcorp contacts her on December 25th to inform her that the
  condo will not be available until February 1st

Martha is required to move into a local hotel for the month of
  January at a cost of $2,000

Rentcorp agrees to pay the $2,000 in hotel costs - this is less
  than the additional $4,000 it would have cost Rentcorp to
  make the condo available by January 1st

Martha informs Rentcorp that she had intended to run her
  consulting business from her condo and that she must now
  rent office space, install telephones, etc. and the cost of
  disruption to her business will be an additional $5,000

Rentcorp tells her that it will not pay for the business
  interruption costs – Martha sues for breach of contract
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What would Rentcorp have done if they had all of the

Rentcorp knew, or should have known, that Martha might be
  required to live in a hotel for a month at a cost of $2,000

    - since it would have cost Rentcorp $4,000 to complete the
    condo on time, Rentcorp would have selected the ‘efficient’
    option of delaying the completion of the condo and paying
    Martha the $2,000 in alternative living costs

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However, at the time it decided to delay completion of the
  condo, Rentcorp had no reason to know that Martha was
  going to operate a business from the condo

     – they could not have known about the additional $5,000 in
    business interruption cost

     – had Rentcorp known it could have spent the extra $4,000
    to complete the condo by January 1st

    – this would have been the efficient option

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But since Martha did not inform Rentcorp of these ‘unusual’
  (unexpected to Rentcorp) costs, Martha is liable for the
  business interruption expenses of $5,000

This is a case of ‘over-reliance’ on the part of Martha.
  Rentcorp should not be required to pay for losses it caused,
  but had no reason to know might occur

Not knowing the possibility of the business losses, Rentcorp
  could not account for them in its decision making.

Again, the court must take account of the ‘customs of the
  trade’ and what each party knew or should reasonably have
  known about the facts involved

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          Perfect contracts and market failures
Will a court ever set aside (negate) explicit terms in a
  contract? Yes.

When courts alter the terms of a contract they are said to be
  regulating the contract - completely analogous to
  ‘regulation’ of markets – government is interfering with
  what would otherwise be a voluntary private transaction

Governments regulate markets towards ‘efficiency’ when there
  is a ‘market failure’ of some sort

Courts regulate contracts toward ‘efficiency’ in order to correct
  the effects of market failures when they arise in a given

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To begin with, consider the notion of a perfect contract

perfect contract in a contract which is:

    - ‘complete’

    - all relevant information has been exchanged between the

    - every possible future state of the world has been
    considered and all resulting risks have been allocated to the
    party who can bear them most efficiently

    - since all risks have been allocated to the party which can
    bear them most efficiently (at least costs) a perfect
    contract is ‘efficient’ - all possible gains from bargaining
    have been exhausted - there are no unexploited
    cooperative surpluses remaining

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There are no ‘gaps’ or ‘market failures’ in a perfect contract

There is no need for the courts to ‘regulate’ the contract
  (overturn explicit terms of the contract) due to market

The parties only need the courts to enforce the contract

When will the parties negotiate such a ‘perfect contract’?

Recall the Coase theorem, rational (maximizing) parties will
  negotiate a perfect contract when transaction costs are zero

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If transaction costs are zero, it is costless to develop
    information and allocate risks - all risks will be allocated to
    the party which can bear them most efficiently and each
    benefit is allocated to the party which values it most

Any contract negotiate between rational individuals, under
  zero transaction costs, will be complete

Will this ever actually happen? NO! Transaction costs are
  never zero.

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How and why do contracts deviate from

          1. Individual rationality

          2. Transaction costs

          3. Spill-overs (externalities)

          4. Information deficiencies

          5. Monopoly

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Individual rationality

-   a rational individual is one who has complete and stable

- individuals such as children or the insane are ‘legally
   incompetent’ and cannot commit to an enforceable contract

- individuals who make contracts under ‘duress’, some
   external threat not accounted for in the terms of the
   contract, are not acting in their own rational self-interest

- contracts made by a desperate promisor, in ‘necessity’ -
   duress and necessity are situations in which a promisor
   faces a ‘dire’ constraint prior to making the promise

- if the dire constraint follows the promise and results in the
    inability of the promisor to fulfil the promise, then this is
    termed ‘impossibility’ (firm’s plant burns down)

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Transaction costs

Successful contract negotiation involves:


If these transaction costs are greater than the available social
    surplus, successful contract negotiation is precluded

This results in the loss of the available social surplus

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Spill-overs (externalities)

Third parties suffer, or benefit, from contracts which they are
  not directly involved in - externalities

Private contracts will be inefficient since they will not account
   for third party costs or benefits

Third parties cannot enter into the bargaining because of
  transaction costs

Corrective action by the courts usually occurs under property,
  tort, crimes or regulation and not contract law per se.

The exception is when a court refuses to enforce a contract
  when it derogates public policy – anti-combines
  agreements, contracts which ‘tie the hands’ of one party to
  a negotiation (bargaining in good faith), contracts to carry
  out some illegal activity (supply illicit drugs, etc.)
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Information deficiencies

At times one or more parties to a negotiation lacks essential
   information relevant to the contract negotiations

    - someone lied, withheld information, mistakenly failed to
    transmit, or saved money by not transmitting, an
    interpretation error

Ignorance is rational if the cost of acquiring the information
  exceeds the expected benefit of having it
      - not bothering to read the fine print when you buy a
        TV set

Ignorance is irrational when you stand to gain more from
  having the information, than it cost to acquire
      - finding out which is the ‘best’ professor offering a
        first year course
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Information deficiencies which can void a contract:

Fraud - lying by omission or by misinforming – if one party
   has more, or more accurate information information then
   that party has a duty to share the information

Frustration of purpose - occurs when both parties lack
   important information, so that both parties premise the
   contract on misinformation

Mutual mistake - each party acts on different but incorrect

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Potential buyers have only one (or a few oligopoly) potential
  sellers with which to negotiate

This imbalance of market power is usually dealt with through
  regulation and not contract law

Exception - doctrine of unconscionability which some courts
  have used to overturn ‘unfair’ contracts

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                  Next section

We will the economics of long-run relationships

Are contracts necessary?

Why is it that you accept many promises without
 the protection of contract law?

11/5/09                Contract_D                 39

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