Chapter 9 Topics in the Economics of Contract Law I. Remedies as incentives A. Alternative remedies Different remedies create different incentives for the parties to a contract. Our focus is how different remedies affect the incentives each party has to act in an economically efficient manner. 1. Expectation damages Perfect expectation damages (PED) are meant to leave the promisee indifferent between performance and nonperformance of the contract. The baseline is value to promisee if contract was performed. Damages then are equal to the difference between the net value of performance of the contract and no contract. 2. Reliance damages In this case, the injury that is caused by breach focuses on the costs the promisee has incurred as a result of relying on the contract. As such, perfect reliance damages (PRD) are meant to leave the promisee indifferent between no contract and breach of the contract. The baseline is no contract. Damages then are equal to the promisee s net reliance costs. 3. Opportunity cost damages In this case, the injury that is caused by breach focuses on the costs the promisee has incurred as a result of foregoing alternative contracts. As such, perfect opportunity cost damages (POCD) are meant to leave the promisee indifferent between breach of the contract and performance of the next best contract. The baseline is value to promisee of the next best contract. Damages then are equal to difference between the net value of performance of the next best contract and no contract. 4. The typical relationship between PED, POCD and PRD and the problem of subjective value a. Generally speaking, PED > POCD > PRD Why? Efficient reliance costs are included in PED and OCD. Best contract is at least as good as the next best contract. Next best contract is at least as good as no contract. Implications for efficiency? b. The difference between subjective values and market prices can distort the relationship between PED, POCD and PRD. 5. Restitution Restitution simply requires that, in the event of breach, the promisor must give back anything the promisee gave the promisor in exchange for the promise. As such, restitution is a minimal remedy.
6. Disgorgement Disgorgement damages are intended to eliminate the injurer s profit from doing wrong. As such, if a promisor breaches a contract by doing something wrong and profits from the wrongdoing, perfect disgorgement damages would leave the promisor indifferent between performing the contract and breaching and paying damages equal to the gain from having breached. Compare this to perfect expectation damages. 7. Specific Performance This remedy simply requires the promisor to perform the contract. (In the event that the court orders specific performance, the parties to the contract can subsequently negotiate an alternative settlement, e.g., breach with damages paid to the promisee.) Note that an advantage it has over damages is that the court does not have to estimate the value of performance to the promisee. Availability of substitutes and the probability of errors by the courts when estimating damages are important considerations when deciding between damages and specific performance. Specific performance is especially attractive in cases involving special/unique goods and services. 8. Party-designed remedies: Liquidated damages i. The contract contains explicit terms specifying the remedy in the event of breach. ii. Courts are not overly fond of party-designed remedies that include punitive sanctions and generally refuse to enforce such clauses in a contract. However, this may discourage efficiency to the extent that the punitive clause represents an explicit ex ante allocation of risk. Penalty clauses can also convey information about a promisor s reliability and thus facilitate the creation of efficient contracts. B. Models of Remedies: Damages versus Specific Performance 1. Efficient breach and performance: Unfortunate versus fortunate contingencies a. An unfortunate contingency increases the cost of performance and, thus, the incentive for breach. In choosing between damages and specific performance in this case, we have already shown that perfect expectation damages will create incentives for efficient breach. In the case of specific performance, the outcome will be efficient so long as the parties can subsequently negotiate an efficient solution to the dispute. All that changes under these circumstances is the distribution of wealth. In those instances where negotiation is not possible (due to high transactions costs) the result will be inefficient when the costs of performance exceed the value of performance to the promisee. Thus, damages dominate specific performance, but specific performance is viable when transactions costs are low. In addition, it is important to recognize that this assumes that the court can accurately estimate damages. Further explanation If we assume that the court can accurately measure expectation damages, damages dominate specific performance as remedy for breach. This is because perfect expectation damages will always result in the efficient outcome, regardless of the level of transactions costs between the parties to the contract.
Specific performance, on the other hand, will also result in an efficient resolution of the dispute so long as transactions costs are low. However, if transactions costs between the parties are high, the court order of specific performance will result in an inefficient outcome if the costs of performance exceed the benefits of performance. This is because bargaining can t take place and the promisor will therefore be forced to perform. (Recall that breach is efficient whenever the costs of performance exceed the benefits from performance.) The fact that damages dominate specific performance notwithstanding, if the subject of the contract is unique (e.g., a rare painting), the assumption that the court can accurately measure expectation damages may become untenable. This is because the court must ascertain the subjective value that the promisee attaches to performance of the contract, which is not an easy feat. Thus, when transactions costs are sufficiently low there is good reason for preferring specific performance to damages in the case of an unfortunate contingency. When transactions costs are high and we are dealing with a unique good or service, the court must balance the (likely) possibility of incorrectly estimating damages against the possibility that, in the event that the court orders specific performance, an inefficient outcome will result if the costs of performance exceed the benefits of performance because bargaining can t take place. Obviously, the problem is not easily solved. b. A fortunate contingency makes nonperformance more profitable than performance. In this case, both remedies lead to the efficient outcome, only the distribution of income varies. However, specific performance may entail more transactions costs and, in this sense, may be less desirable than damages. At the same time, specific performance enables the court to avoid answering the question of how much value the promisee attaches to performance. Depending on how costly this latter process is, specific performance may entail lower overall costs. (Note this observation applies to the case of unfortunate contingencies as well.) Further explanation In this situation it is easy to show that, ignoring the costs of settling the dispute in the courts, perfect expectation damages and specific performance both result in the efficient outcome, regardless of the magnitude of the transactions costs incurred by the parties in the process of bargaining (see pp. 241-243 of the text for a discussion of this point). However, digging deeper, we need to consider the transactions costs incurred by the court in the process of settling the dispute. Once again, if we are dealing with a unique good, it may become very expensive for the court to determine the level of perfect expectation damages. Thus, even though the transactions costs incurred by the different parties in the process of moving the good or service to its most highly valued use may be higher under specific performance than they would be if the court awarded expectation damages, the savings realized by the court s order of specific performance (because the court no
longer has to estimate the subjective value the promisee attaches to performance) may outweigh the transactions costs incurred by the various parties. This is especially likely in the case of a unique good or service. C. Summary: Choosing Between Damages and Specific Performance Type of Contingency Unfortunate Contingency Fortunate Contingency PED always efficient SP may or may not be efficient depending on TCs among the parties to the contract Both remedies are efficient wrt the outcome, but may differ wrt TCs Need to consider TCs between the two parties (bargaining) Type of good (has implications for the court s TCs) Unique Standard Unfortunate Contingency Parties TCs Fortunate Contingency Parties TCs Low High Low High Good Unique Good Unique Std. Std. D. Investment in performance and reliance: Skip this section
II. Formation Defenses and Performance Excuses (What Promises Should Be Enforced? Revisited) A. Incompetence Competent people should protect the interests of incompetent contractual parties or assume the liability for failure to do so. Thus, the court should rule to the benefit of the incompetent party. This will give competent parties the correct incentives when dealing with incompetent parties. Consider the incentives effects if this rule is not followed. B. Dire constraints and remote risks 1. Duress: involves extraction of a promise under threat to destroy, e.g., agree to the following or suffer the consequences! Contracts created under these conditions should not be enforced because they destroy, as opposed to create, value. However, we need to take care to distinguish between forbidden threats and permitted demands. 2. Necessity: involves extraction of a promise under threat to fail to act, e.g., rescue someone in need. Consider different types of rescue (aid to someone in need): fortuitous, anticipated, and planned. In each case, rescue should be rewarded by enforcing the contract, but the court should regulate the contract (i.e., adjust the terms) where necessary to ensure that the reward encourages the optimal level of investment in rescue. In other words, compensate the rescuer for her costs plus a small reward as an incentive for others to engage in rescue. 3. Impossibility: precludes performance physically or economically. A contingency has arisen that destroys a basic assumption on which the contract was made. In this case, liability for nonperformance should be allocated to the party who could reduce or spread the risk of nonperformance at least cost. Example: A performer is injured in a sky-diving accident and cannot make a scheduled appearance. 4. Frustration of purpose: In this case, some event occurs subsequent to the formation of a contract that makes performance pointless. In this case, liability for nonperformance should be allocated to the party who could bear the risk at least cost. Think about hotel booking arrangements. 5. Mutual mistake about facts: In this case, the contingency arises before the parties enter into the contract. Once again, the efficient remedy depends on the relative costs of dealing with contingencies; in this case, misinformation about facts. Depending on whether the promisor or the promisee could insure more cheaply against the mistake about facts, the contract should be enforced or not enforced. Example: Employment agency sends a firm a temporary employee thought to possess certain skills. 6. Mutual mistake about identity: In this case there is no meeting of minds. Such contracts should not be enforced given their potential to destroy value.
C. Information The presence of asymmetric information could inhibit or preclude the formation of contracts that are, in fact, mutually beneficial. Therefore, contract law should encourage the efficient disclosure of information within the contractual relationship. 1. Unilateral mistake: Once again, we need to distinguish between productive information and redistributive information. The former can be used to produce new wealth, the latter does not. Thus, we want to create incentives that encourage investment in the former and discourage investment in the latter. This view yields the following set of principles regarding contract disputes involving mistake: i) enforce contracts based on differences in productive information, ii) enforce most contracts based on differences in mixed information, and iii) set aside contracts based on differences in purely redistributive information. 2. Duty to disclose: The focus here is on safety information that helps people avoid harm. Failure to disclose such information could result in considerable costs. From an efficiency perspective, the benefits of such info are likely to exceed the costs. When bargaining over the terms of a contract, parties should divulge safety information. This can avoid high costs later on. Example: sell a car with defective brakes without telling buyer. 3. Fraud and misrepresentation: usually results in the destruction of value. Contracts formed under such circumstances should therefore not be enforced. Don t worry, I just had the brakes checked and they re fine! Marry a millionaire D. Monopoly 1. Contracts of adhesion: Here the focus is on standard form contracts which vary from those with both fixed and variable terms to those with only fixed terms, i.e., take-itor-leave-it contracts. In deciding how to treat such contracts, the focus should be on whether such contracts increase or decrease competition. If the contract is the result of monopoly power or efforts to behave like a monopolist, enforcement should be denied because the contract promotes inefficiency. However, if the purpose of such contracts is to minimize transactions costs and enhance competition with respect to variable terms, it should be enforced. Note that to the extent that fixed terms allocate risks to the party who can bear the risk at least cost, such terms reduce transactions costs and promote efficient behavior. Examples: Contract for a loan. There are lots of competitors so the standard form saves TCs. In this case, firms can compete on the basis of price: New car warranties. 2. Unconscionability: This area is somewhat vague and entails paternalistic behavior by the courts. In some cases, viewing contracts as unconscionable can actually hurt the group the ruling was intended to protect by making the procurement of goods even more costly or impossible. a. substantive unconscionability: price is utterly disproportionate to market value b. procedural unconscionability: circumstances or procedures violate norms of fairness.