Law and Economics - Contracts

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by Richard A. Posner


To understand the economic approach to contract law, one must first understand the economic approach to contracts. The essential economic problem that contracts solve is that of commitment. Many, probably most, value-maximizing exchanges depend on certain events occurring in the future. If A wants B to build a house for him, he must pay for the house, either as it is being built or at the end of construction, and B of course must actually build the house, and moreover, the house must be built in such a way that it will not collapse prematurely. In other words, the success of the exchange of B’s labor for A’s money depends on future acts by both A and B. Since the future is uncertain and the acts are within the power of self-interested persons, the parties need to make provision for the possibility that either one will fail deliberately or unavoidably to perform his contemplated acts, and they also need some assurance, whether given by law or by concern for reputation (and thus for the ability to engage in future transactions), or more commonly by both, that the provisions agreed upon should either party fail to perform will be complied with.

An essential premise of the economic approach is that the people who engage in transactions have a better sense of the terms that will maximize value than a court would have; and so the cornerstone of an economically inflected law of contracts is that the court will enforce whatever terms the parties agree upon. Of course, there are exceptions; the “parties know best” rationale assumes that the parties have the requisite mental capacity to determine where their self-interest lies; so want of capacity (as where one of the contracting parties is a child) is a defense to the enforcement of a contract. But what is not assumed is that the parties have the same information or the same ability to assesss the information that both possess. The reason is the importance of preserving incentives to determine value, which requires that a person who discovers value be able to profit from the discovery by making an advantageous exchange; he could not do this if he had to disclose the true value of the good to the party on the other side of the transaction. Failure to reveal private information must, however, be distinguished from fraud, which is a defense to the enforcement of a contract: misrepresentations designed to induce favorable contract terms redistribute social wealth without increasing it; there is no beneficial effect on incentives, and so the misrepresentation imposes deadweight costs both on the party who does the misrepresenting and on potential victims (in the form of efforts to avoid being deceived).

Another defense is duress, which can be given a precise economic meaning. A contractual promise is induced by duress when the contract would not have been made on the terms complained of (or modified—demands for modification of an existing contract are a common site for charges of duress) if one party had not had a monopoly position in relation to the other party. An example would be an actor who minutes before the curtain rose on opening night demanded a raise and refused to perform unless the raise was promised; such a promise would be unenforceable as having been procured by duress.

An exception to the “parties know best” principle that is mysterious to economists is that the parties may not agree upon a penalty for breach, that is, the stipulation of an amount of damages for breach that exceeds a reasonable estimate of the actual damages that a breach would be likely to cause. The parties are permitted and indeed encouraged to include in their contract a “liquidated damages” clause, which fixes the amount of damages that the court will award for a breach, but to be enforceable, and avoid condemnation as a penalty, the amount fixed must be a reasonable estimate of the damages likely to flow from a breach.

The refusal to enforce penalty clauses is obviously related to the refusal to award punitive damages for a breach of contract, the latter refusal being an implication of the important economic concept of “efficient breach.” A breach is efficient (in the technical economist’s sense of “Pareto superior”) if the contract breaker, having found a more attractive alternative use of the resources that he had committed to performing the contract, can compensate the other party to the contract for the costs to that party of the breach; for there is then an overall net gain in value from the breach. Punitive damages would discourage efficient breaches by making the cost of breach to the party that had broken the contract greater than the cost of the breach to the victim.

The rule forbidding penalty clauses may seem a corollary of the efficient-breach concept, since the enforcement of such clauses would prevent some efficient breaches. But that is incorrect. In deciding whether to include such a clause, the parties will weigh the costs in preventing either of them from taking advantage of a more attractive transactional opportunity should it appear in the course of performance against the benefits of the clause, which may include deterring breaches likely to impose heavy costs not reflected in the measures that courts use to assess damages in contract cases and the value of a penalty clause as a signal of likely performance of the contract: since a penalty makes a breach particularly costly to the party committing the breach, his willingness to accept such a clause is a signal of his confidence that he will not break the contract, a signal that may make the other party more willing to do business with him.

The concept of efficient breach explains another important feature of contract remedies, and that is the refusal of courts to grant the victim of a breach of contract injunctive relief (called “specific performance” in the law of contracts) unless he can show that his damages remedy is inadequate. It is sometimes argued that the rule in the European legal systems is the opposite—that injunctive relief is the presumptive rather than the extraordinary remedy for a breach of contract—and that the European rule is superior because it exempts the courts from the difficult and uncertain task of actually estimating the damages from a breach. The party who is enjoined can pay the other party to dissolve the injunction if the breach is in fact efficient, and negotiations between the parties will, consistent with the basic premise of freedom of contract, provide a cheaper and more accurate determination of the actual damages from the breach.

Neither point is convincing. The European courts in fact rarely grant specific performance of contracts; damages is the standard remedy, just as in Anglo-American jurisprudence. And injunctive remedies work badly in contract cases because they create the situation known in economics as “bilateral monopoly,” the situation in which two parties can bargain only with each other rather than being able to buy or sell in a market. If A is enjoined from breaking his contract with B, the price for dissolving the injunction will be set exclusively by negotiations between A and B, and the negotiations may be protracted and even unsuccessful, as each party tries to engross as much as possible of the surplus from a successful transaction. Suppose the cost to A if he is forced to perform is $100 (it might actually be infinite, if the breach had been involuntary) and the benefit of performance to B is $60. At any price between $60 and $100 both parties will be better off if the injunction is dissolved. But naturally each party wants as much of the $40 surplus as possible, and so B hold out for a price as near to $100 as possible and A for a price as near to $60 as possible. A court, in contrast, can merely require A to pay B $60 in damages for breaking the contract. Of course, a judicial determination of damages is not costless, and may be fraught with uncertainty. But remember that the parties are free to specify the damages that the court shall award in the event of a breach; provided the specification does not create a penalty, it will be enforced, and the court excused from the bother and uncertainty involved in a judicial determination of damages.

There are other devices, besides willingness to enforce liquidated-damages clauses, by which the judicial system seeks to minimize the cost and uncertainty involved in judicial enforcement of contracts, the uncertainty being particularly great in the American system with its heavy reliance on trial by jury. In general, promises are not enforced unless they are supported by “consideration,” that is unless the promisee has given or promised value. The existence of consideration is some evidence that a contract was actually made, but the court will not inquire into the adequacy of the consideration because that would violate the “parties know best” principle. Nonreciprocal promises are sometimes enforced also, if there are objective circumstances indicative that the promise was intended to be enforceable, as where the promisee incurs costs in reasonable reliance on the enforceability of the promise, or even where the promisor had a “moral” obligation that his promise sought to fulfill (as where the promisee had rescued the promisor from some dreadful menace). This latter case illustrates the fundamental economic proposition that being able to make an enforceable promise increases rather than diminishes economic freedom; a person who derives utility from rewarding his rescuer can increase that utility by binding himself legally to his promise of a reward. A further illustration is the “unilateral” contract: if A offers a reward for the return of his pet cat, and B finds and returns the cat, B is legally entitled to the reward even though there was no negotiation between him and A. The existence of this entitlement increases the likelihood that the cat will be found and returned, and so benefits A even though—in fact by—placing him under a legal obligation.

Certain contracts are unenforceable unless written; this reduces the uncertainty of determining by the methods of litigation whether the parties to a breach of contract suit actually had a contract, or what its terms are. Also important is the “parol evidence” rule, which limits evidence of the meaning of a contract if the evidence concerns the precontractual negotiations between the parties and is sought to be used to contradict what the contract itself provides, and the “four corners” rule, which provides that if a written contract is clear on its face the parties will not be permitted to introduce evidence (“extrinsic” evidence, that is, evidence beyond what the contract itself says) to contradict that clear meaning. An important exception, however, is that extrinsic evidence may sometimes be introduced to show that the contract, while clear on its face, is actually unclear when the real-world context of the contract is understood. This is referred to as “extrinsic ambiguity.” For example, the contract might use a word in a technical sense that would not be apparent to a judge reading the contract, who would interpret the word in its ordinary-language sense; or the contract might use a name to designate the subject of the contract, yet it might turn out that there were several possible subjects of that name. But consistent with minimizing the costs and uncertainties of judicial determination of contract terms, many courts will not allow extrinsic ambiguity to be demonstrated by subjective evidence—a party merely saying that the contract says X but we meant Y—but only by objective evidence, such as the existence of a trade usage concerning particular terms, or the demonstrable fact that there were several subjects to which the name in the contract could have referred.

Courts could take the position that if a contract is unclear, it is unenforceable; and this might be thought a rule that would have desirable incentive effects, by inducing negotiating parties to take greater care to provide for any and all contingencies that might occur during the (future) course of contract performance. For much of the time when a court “interprets” a contract, it is really completing it by filling a gap that the parties had not foreseen, rather than just determining the “real” meaning of the contract, which one of the parties has simply refused to acknowledge. By being willing to do this, however, the courts reduce transaction costs. Parties to contracts do not have to devote inordinate resources to anticipating and providing for every possible future contingency; instead, they can leave it to the courts to fill in missing terms when and if a dispute arises. Although judicial determinations are not costless, the costs are incurred only when a dispute arises, in contrast to contractual transaction costs, which are incurred in every contract. Suppose that if contracting parties had to provide for every contingency that might arise, they would incur an extra $1000 per contract. Suppose the cost to the parties and the judiciary of litigating a dispute over contractual meaning would be $50,000, but only 1 percent of contracts result in such litigated disputes. The aggregate cost of judicial intervention is $500 ($50,000 x .01) per contract, and this is less than the additional transaction costs that would be incurred if courts forbear to “interpret” unclear contracts.

In addition to ad hoc interpretation, courts invent and enforce certain implied terms in contracts. These are “default” terms in the sense that the parties can if they wish contract out of them. They are referred to as “implied” because they represent the judges’ best guess of terms that the parties would have chosen if they had made explicit provision for the contingency to which the term relates. To the extent the judges guess right, transaction costs are reduced because parties do not have to write the implied terms into their contracts. Among commonly implied terms are that each party will perform its side of the contract in good faith (in other words, will not act opportunistically, as by taking advantage of a temporary monopoly that the circumstances of performance may create) and that the contract will be discharged without liability if performance by one side or the other turns out to be impossible.

The latter rule may seem inconsistent with the general principle that contractual liability is strict (in contrast to the general rule of tort liability), meaning that a party who fails to perform is liable for breach of contract even if his failure was not willful or negligent. The reason for this strict liability is that contracts perform an important insurance function. Remember that contracts are intended to govern future performance. The future is inherently uncertain, and risk (in the sense of variance of possible outcomes) is a cost to risk-averse persons. The disutility of risk can be reduced by insurance, and one form of insurance is a contract that compensates one or both parties for the risk of nonperformance (if both parties are “insured” by the contract, then it is really risk sharing rather than risk shifting, but sharing also reduces variance and hence risk). The defense of impossibility is a method of risk shifting even though it creates an exception to the general rule that contractual liability is strict, for it reduces the risk of damages liability to the performing party. The presumptive refusal to enjoin breaches operates in the same direction, as does the important rule that only foreseeable damages are recoverable for contract breaches. The effect of this principle is that any idiosyncratic damages from breach of contract rest with the victim unless the parties provide otherwise, the theory being that the victim, knowing the risk, is in a better position to do something about it. The something may be insuring against it, or actually preventing it from occurring, by taking precautions; either way, the net social disutility of breach is reduced.

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