Contract Law and Economics

CONTRACT LAW AND ECONOMICS
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ENCYCLOPEDIA OF LAW AND ECONOMICS, SECOND EDITION
General Editor: Gerrit De Geest

School of Law, Washington University, St Louis, MO, USA
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Contract Law and Economics
Edited by
Gerrit De Geest
Professor of Law, Washington University in St Louis, USA
ENCYCLOPEDIA OF LAW AND ECONOMICS, SECOND EDITION
Edward Elgar
Cheltenham, UK • Northampton, MA, USA
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© The Editor and Contributors Severally 2011
All rights reserved. No part of this publication may be reproduced, stored

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Contents
List of contributors vii
1. Introduction 1
Gerrit De Geest
PART I FORMATION AND INTERPRETATION
2. Precontractual liability 9
Eleonora C. Melato
3. Contractual mistake and misrepresentation 31
Qi Zhou
4. Duress 57
Péter Cserne
5. Gratuitous promises 80
Robert A. Prentice
6. Gifts, wills and inheritance law 96
Pierre Pestieau
7. Standard form contracts 115
Clayton P. Gillette
8. Interpretation and implied terms in contract law 125
George M. Cohen
PART II REMEDIES
9. Contract remedies: general 155

Paul G. Mahoney
10. Penalty clauses and liquidated damages 178
Steven Walt
11. Impossibility and impracticability 207
Donald J. Smythe
12. Foreseeability 225
Peter van Wijck
13. Option contracts and the holdup problem 239
Abraham L. Wickelgren
14. Warranties 256
Klaus Wehrt
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vi Contract law and economics
PART III LONG-TERM CONTRACTS
15. Long-term contracts and relational contracts 281

Nick van der Beek
16. Long-term contracts in the law and economics literature 314
Mireia Artigot i Golobardes and Fernando Gómez Pomar
17. Marriage contracts 360
Antony W. Dnes
18. Franchise contracts 384
Antony W. Dnes
PART IV PERSPECTIVES
19. Behavioral approaches to contract law 401

Ann-Sophie Vandenberghe
20. The civil law of contract 424
Ejan Mackaay
21. Unjust enrichment and quasi-contracts 454
Christopher T. Wonnell
Index 471
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Contributors
Mireia Artigot i Golobardes, Professor of Law, Universitat Pompeu

Fabra
George M. Cohen, Brokaw Professor of Corporate Law and Barron F.
Black Research Professor of Law, University of Virginia School of
Law
Péter Cserne, Senior Research Fellow, Tilburg Law and Economics Center
(TILEC), Tilburg University
Gerrit De Geest, Professor of Law and Director of the Center on
Law, Innovation & Economic Growth, School of Law Washington
University
Antony W. Dnes, Professor of Economics, University of San Diego
Clayton P. Gillette, Max E. Greenberg Professor of Contract Law, New
York University School Of Law
Fernando Gómez Pomar, Professor of Law and Economics, Universitat
Pompeu Fabra
Ejan Mackaay, Emeritus Professor of Law, University of Montreal
Paul G. Mahoney, Dean and David and Mary Harrison Distinguished
Professor of Law and Arnold H. Leon Professor of Law, University of
Virginia School of Law
Eleonora C. Melato, School of Law Washington University
Pierre Pestieau, Professor Emeritus, Université de Liège and member of
CORE, Université Catholique de Louvain
Robert A. Prentice, Ed and Molly Smith Centennial Professor of
Business Law, McCombs School of Business, University of Texas at
Austin
Donald J. Smythe, Professor of Law, California Western School of
Law
Nick van der Beek, Researcher, Utrecht University, the Netherlands;
ZBC MultiCare, outpatient clinic for dermatology, Hilversum, the
Netherlands; University of Wales
vii
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viii Contract law and economics
Peter van Wijck, Assistant Professor of Economics, Leiden University and

coordinator strategy development, Dutch Ministry of Justice
Ann-Sophie Vandenberghe, Assistant Professor Law and Economics,
Erasmus University Rotterdam
Steven Walt, Percy Brown Jr. Professor, University of Virginia School of
Law
Klaus Wehrt, Professor of Economics and Statistics, Hochschule Harz
Abraham L. Wickelgren, Bernard J. Ward Centennial Professor, University
of Texas School of Law
Christopher T. Wonnell, Professor of Law, University of San Diego School
of Law
Qi Zhou, Lecturer in Law, University of Sheffield
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1 Introduction
Gerrit De Geest
This volume provides an overview of the economic literature on contract

law. There follow 20 chapters, all written by experts in the field. Each
chapter offers a thorough review of the literature, an extensive bibliogra-
phy, and a personal reflection on avenues of future research. Only seven
of the 20 chapters are updated versions of chapters that appeared in the
2000 edition of the Encyclopedia of Law and Economics; the 13 other chap-
ters are completely new. This is in line with the ambitious nature of the
second edition of the Encyclopedia: to increase the coverage from five to 12
volumes, and from 4,300 pages to nearly double that size.
Contract law is one of the classic fields of law. It is also one of the first
studied by law and economics scholars. It started, in a sense, with Coase
(1960), whose seminal article can be interpreted as a call to solve exter-
nality problems through contract law. In the late 1960s, Birmingham,
Barton, and others started to analyze specific contract law doctrines (see,
for example, Birmingham, 1969; Barton, 1972). The first monographs on
law and economics (Tullock, 1971; Posner, 1973) each devoted separate
chapters to contract law. Since then, the literature has steadily grown.
Remarkably, many of these contributions appeared in American law
reviews – apparently more than for most other fields.
Economic analysis of contract law got an extra boost in the 1980s, when
institutional economics gained popularity and mainstream economists
started to study contracts. Economists started to see organizations as
solutions to principal-agent problems, and contracts as the archetypical
form of organization on markets. The central role that contracts play
in economic literature is illustrated by the fact that a recent synthesis of
industrial organization literature (by Bolton and Dewatripont, 2005) is
entitled Contract Theory. Summarizing this economic literature is not this
volume’s primary goal, though; our focus is on the literature that yields
implications for contract law. Even so, especially in Part III on long-term
contracts, the authors will refer to the industrial organization literature.
If we compare contract law with tort law and litigation law, we see
that contracts are analytically more complex than torts, but probably less
complex than litigation. A tort is analytically a bilateral incentive problem,
without much information exchange or strategic interaction. A contract is
also a bilateral incentive problem, but with extensive opportunities for
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2 Contract law and economics
information exchange and strategic interaction. Litigation is not only a

bilateral incentive problem with informational and game-theoretical com-
ponents, but it also involves externalities to the society as a whole, in the
form of subsidies, precedent-creation, and law enforcement. Because of
this complexity, the economic literature on contract law is probably not
so well developed as similar literature on tort law, but better developed
than similar literature on litigation. This differing degree of complexity
may also help to explain why there is probably less consensus on optimal
contract law than on optimal tort law (though more than on optimal
litigation law).
This volume is divided in four parts. Part I deals with contract forma-
tion and interpretation; Part II deals with remedies for breach; Part III
discusses long-term contracts; and Part IV offers some perspectives.
Part I starts with a review of the literature on precontractual liability
– a somewhat under-researched field, probably because it plays only a
minor role in American law as compared to civil law systems. Eleonora C.
Melato in Chapter 2 shows how the literature has analyzed the law’s effect
on how the contracting parties exchange information, invest, and behave
in a strategic manner.
In Chapter 3, Qi Zhou discusses contractual mistake and misrepresenta-
tion. A mistake may lead to inefficiency because goods may not end up in
the hands of the highest-value user. Even so, this does not imply that the
law should automatically avoid all mistaken contracts, since this would
also alter the incentives of parties to search for, disclose, and rely on
information. The author argues that a distinction should be made between
fraudulent misrepresentation (where the law’s goals should be to simply
deter the parties from deceiving), negligent misrepresentation (where
the law should induce the representor to take socially optimal care), and
innocent misrepresentation (where the law should shift attention to the
incentives of the representee).
Chapter 4 is devoted to duress. When parties are under pressure to enter
into contracts, there is no guarantee that the exchange is Pareto superior.
Yet defining illegal threats is difficult, since threats play a role in nearly
every negotiation. Similarly, it is hard to distinguish welfare-decreasing
duress from welfare-increasing adaptation of the contract to changed cir-
cumstances. Until recently, philosophers and economists have struggled
to come up with the precise criteria for duress, despite their emphasis on
the importance of voluntary exchanges. Duress seems to be a topic where
philosophers and economists can learn from law and economics scholars.
Péter Cserne illustrates the progress made in explaining doctrines such as
duress, necessity, and unconscionability.
The next two chapters deal with gratuitous promises, gifts, wills, and

Introduction 3
inheritance law. Common law contract doctrine traditionally refuses to

enforce promises that are not the product of a bargained-for exchange.
This stands in contrast to civil law systems, which tend to enforce gra-
tuitous promises, at least if certain formalities are fulfilled. Robert A.
Prentice summarizes in Chapter 5, the insights that economists have
brought to this discussion, though he concludes that narrowly defined
rational choice models may not be able to fully explain the intrinsically
social phenomenon of gift-giving. In Chapter 6, Pierre Pestieau surveys
recent theoretical and empirical work on bequeathing, and shows that
regulation and taxation have an undeniable effect on the level, pattern,
and timing of bequests.
Chapter 7 on standard form contracts, written by Clayton P. Gillette,
surveys a part of the literature that has grown exponentially in recent
years. In earlier times, economists looked favorably at standard term
contracts, emphasizing how such contracts saved on transaction costs.
Lawyers, in contrast, were more critical, observing the many abuses that
occur in practice when parties have no real opportunity to read, under-
stand, or negotiate contract terms. The new economic literature, which
uses behavioral models, seems to bridge that gap.
In the final chapter of Part I, Chapter 8, George M. Cohen surveys the
literature on interpretation and implied terms – another field that has
received increased attention from law and economics scholars in recent
years. Cohen concludes that optimal interpretation rules depend on
institutional context. A contextualist interpretation, which allows courts
to more easily intervene, is superior only when courts can easily assess
contextual evidence and police against opportunistic behavior, and when
extralegal enforcement is ineffective.
Part II of this volume deals with remedies. In the first chapter, Chapter
9, Paul G. Mahoney gives an overview of the general literature on rem-
edies for contract breach – probably the most researched topic of contract
law and economics. His survey illuminates the richness of the current theo-
retical apparatus, which takes numerous types of incentives and numerous
complications (including asymmetric information and strategic behavior)
into consideration.
Steven Walt reviews the economic literature on penalty clauses and
liquidated damages in Chapter 10. The common law refuses to enforce
penalty clauses (which are contractually stipulated damages that exceed
reasonable forecasts of damages). Legal economists have always been
puzzled by this doctrine. Walt finds that penalty clauses do make eco-
nomic sense under some conditions. He therefore concludes that a system-
atic prohibition of penalty clauses cannot be justified.
In Chapter 11, Donald J. Smythe discusses impossibility and

impracticability. Should parties be excused from their contractual obli-

gations when performance costs have increased substantially? The early
literature analyzed this issue in terms of risk allocation. Smythe shows
how more recent literature extends these original insights, for instance
by framing the problem in terms of an optimal damages problem, which
integrates the results with the literature on optimal contract remedies.
Peter van Wijck surveys the literature on foreseeability in Chapter 12.
The Hadley Rule limits damages for breach of contract to the level of
foreseeable losses. The main economic function of this default rule is to
induce parties to reveal information on the high potential magnitude of
the harm. Van Wijck argues that the Hadley Rule should not be seen as
a penalty default rule that is deliberately set at a level the parties do not
want. While efficiency gains of the Rule are somewhat limited because
default rules tend to be sticky, there are some empirical indications that
suggest that the Hadley Rule is the superior default rule when compared
to the full damages rule.
Recently, economists have started to apply option theory to contract
remedies. The idea is that a contract that is enforced through damages
can be seen as an option contract, because it gives the promisor an option
to either perform or pay damages. Abraham L. Wickelgren surveys this
literature in Chapter 13, and discusses in particular how option contracts
affect ex post holdups.
In the final chapter of Part II, Chapter 14, Klaus Wehrt reviews the lit-
erature on warranties. He shows that market practices tend to make sense
only when models include bilateral incentive problems and behavioral
aspects.
Part III of this volumes deals with long-term contracts. There is an
extensive theoretical economic literature on long-term and relational
contracts, written by institutional economists working in the field of indus-
trial organization. Nick van der Beek surveys this economic literature in
Chapter 15. The subsequent implications for law and contract drafting
are discussed in Chapter 16, written by Mireia Artigot i Golobardes and
Fernando Gómez Pomar. Finally, Antony W. Dnes reviews the literature
on two specific long-term contracts: marriage contracts, in Chapter 17,
and franchise contracts, in Chapter 18.
The final part of this volume, Part IV, consists of three chapters
that offer varied perspectives. In Chapter 19 Ann-Sophie Vandenberghe
reviews behavioral law and economics and its applications in the field
of contract law. She shows that the behavioral approach is very promis-
ing for consumer contracts, but still of limited value when it comes to
explaining general contract law. Ejan Mackaay, in Chapter 20, discusses
the economic literature on the typical features of contract law in civil

Introduction 5
law countries. Law and economics is a scholarly product developed in

common law systems, but Mackaay explains why it is equally applicable to
civil law systems. Mackaay pays special attention to some typical features
of civil law systems, such as codification, good faith, defects of consent,
cause, penalty clauses, force majeure, and specific performance. In the last
chapter, Chapter 21, Christopher T. Wonnell reviews the economic litera-
ture on unjust enrichment and quasi-contracts, a distinct though closely
related field.
References
Barton, J.H. (1972), ‘The Economic Basis of Damages for Breach of Contract’, Journal of
Legal Studies, 1, 277–304.
Birmingham, R.L. (1969), ‘Damage Measures and Economic Rationality: The Geometry of
Contract Law’, Duke Law Journal, 49–71.
Bolton, Patrick and Dewatripont, Mathias (2005), Contract Theory, Cambridge, MA: MIT
Press.
Coase, Ronald H. (1960), ‘The Problem of Social Cost’, Journal of Law and Economics, 2,
1–44.
Posner, Richard A. (1973), Economic Analysis of Law, Boston, MA: Little Brown.
Tullock, Gordon (1971), The Logic of the Law, New York: Basic Books.

PART I
FORMATION AND
INTERPRETATION

2 Precontractual liability
Eleonora C. Melato
1. Introduction
Precontractual liability is not one of the most popular topics among Law
and Economics scholars and the conspicuous absence, from the major
Law and Economics textbooks, of precontractual liability as an independ-
ent field of analysis might indicate that the topic was traditionally consid-
ered to be non-problematic. However, as we will see, the issues relating to
the precontractual stage are not trivial and deserve a careful treatment.
The fact that, at first, mainstream Law and Economics scholarship failed
to address the particular precontractual issues resulting from problems
otherwise addressed in relation to the contractual stage, can be more
properly explained by considering the evolution of Law and Economics
as a discipline stemming essentially from the Anglo-American theory of
contract law.
Law and Economics in its modern form has been developed by
American scholars trying to reach new insights into American common
law. The common law has traditionally refused to attach legal con-
sequences to acts performed by the parties before the formation of a
contract and has subscribed to what has been called the ‘aleatory view’
of negotiations (Farnsworth, 1987). The classic bargain theory of con-
tract law has endorsed this view. It is not surprising, then, that Law and
Economics scholars might at first have disregarded the precontractual
stage as an autonomous field of inquiry and analysis. The general view
was that precontractual liability simply did not exist in the common law.
It is true that the economic theory of contracts presents itself as a (better)
alternative to classic bargain theory, which is criticized for its excessive
dogmatism in defining what an enforceable contract is and for its inability
to foster efficient exchanges. But the generally accepted and established
economic models of contract law still focus exclusively on rules regulat-
ing the enforcement of contracts and on liability arising from a breach of
contract.
The common law, however, is full of hidden surprises. A famous com-
mentator repeatedly used the doctrine of promissory estoppel as an example
supporting his contention that classic bargain theory had been overtaken
and that the traditional distinction between torts and contracts had to be
revised (Gilmore, 1974). The inclusion of what has since been known as

‘promissory estoppel’ in the Restatement (First) of Contracts dates back to

the 1930s, and this inclusion was soon followed by a new academic interest
in reassessing the basics of contract law in light of the new development,
especially with regard to the recognition of the importance of protecting
the reliance interest (Fuller and Perdue, 1937). However, the wide influ-
ence that Gilmore’s book had on the legal environment had a major part
in stimulating a greater attention to promissory estoppel and to the reali-
zation that courts were applying promissory estoppel to achieve a variety
of goals in a variety of settings: not just to overcome the obstacle of lack
of consideration in the context of gratuitous promises, but also to enforce
promises made during precontractual negotiations even when a contract
was not ultimately formed. This realization made some legal scholars
wonder whether a new form of liability had been born (Knapp, 1997–98).
Law and Economics scholars did not fail to accept the challenge.
During the last 30 years, a number of authors addressed problems related
to the precontractual stage. Even though the number of papers in this field
certainly cannot be compared with the extensive literature that has been
devoted to other key problems in contract law, it nonetheless indicates
that the Law and Economics world was indeed well aware of the issues
surrounding the precontractual interaction between parties of a prospec-
tive contract. However, none of the models developed during those years
could form the basis of a consensus among Law and Economics scholars.
The various works on the subject widely differ not just in methodology
but also in the identification of the basic problem to be confronted when
analyzing precontractual negotiations.
This lack of a generally accepted framework of analysis is probably
what ultimately prevented precontractual liability from obtaining the
place it deserved in comprehensive treatises on the economics of the law.
Also, because of the lack of a generally accepted framework of analysis,
a uniform ‘label’ for the problems related to the precontractual stage is
absent in the literature. The expression ‘precontractual liability’ appears
in some of the titles (Farnsworth, 1987; Kostritsky, 1997; Schwartz and
Scott, 2007). Other authors address the problem as a problem of reliance,
referring to it as to a problem of ‘precontractual reliance’ (Bebchuk and
Ben-Shahar, 2001; Grosskopf and Medina, 2007; Scott, 2007) or, more
generally, of ‘efficient reliance’ (Craswell, 1989; Craswell, 1996). Another
important line of works focuses on the opportunism perspective (Shell,
1991; Cohen, 1991–92). An alternative way of looking at the problem
is from the point of view of ‘incomplete contracts’ (Kostritsky, 2004;
Ben-Shahar, 2004). Some authors are mostly concerned with the infor-
mational side of the problem (Craswell, 1988; Johnston, 1999; Johnston,
2003–2004).

Precontractual liability 11
Since the confusion surrounding the problem of precontractual liability

is not merely semantic, but rather a reflection of the fundamental lack of a
commonly accepted framework of analysis, attempting to rationalize the
various contributions on the topic is a particularly hard task. Though any
such classification would necessarily be approximate, and unable to fully
capture the complexity of each author’s legal and economic reasoning, I
still believe that it is worth trying.
A common theoretical basis is indeed present in the scholarship on
precontractual liability and it is represented by the explicit or implicit
affirmation that the ultimate goal of the law, in contract situations as
well as in precontractual settings, is the promotion of surplus-maximizing
exchanges. Now, the law can attempt to do so in a number of different
ways. The classification I propose distinguishes the models of precontrac-
tual liability on the basis of the incentives on which the parties focus in
order to promote surplus-maximizing exchanges. I have identified three
basic categories of models: first, those emphasizing the need to protect the
precontractual (efficient) reliance of the promisee; second, those focusing
more on the prevention of opportunistic behavior by the promisor; and
third, those advocating the necessity of fostering efficient information
exchange or efficient information gathering.
Although these three approaches may occasionally overlap, most of the
works on precontractual liability can find a more or less precise colloca-
tion in one of the three categories identified above. In addition, from a
normative perspective, Law and Economics contributions on precontrac-
tual liability can further be subdivided into two groups: those arguing for
the necessity of a new liability regime; and those describing the legal status
quo as already adequate to achieve efficiency. Common issues, such as the
effects of precontractual liability on the incentive to enter negotiations,
the appropriate damage measure for precontractual misconduct and the
problem of over-investment that may derive from a liability regime, are
also discussed toward the end of the chapter.
2. Protecting Precontractual Reliance

When two parties decide to engage in a transaction they usually have some
informal interaction which necessarily precedes the formation of a formal
binding contract. They speak with each other, they manifest in some way
their intention to negotiate, and they communicate their respective inter-
ests and expectations regarding the potential transaction. One of the main
purposes of the exchanges occurring in this early stage of negotiation is
to enable the parties to ‘test’ the actual feasibility of a mutually beneficial
transaction. During negotiations, an initially hypothetical contract begins
to take shape and, at a certain point in the process, it is not irrational for

the parties to begin to rely on the expectation of the successful formation

of a contract. Reliance may indeed be beneficial (for one party or for both)
because it can increase the size of the ‘pie’ (Craswell, 1996). Parties may be
in a position to make investments that will increase the net private surplus
of the transaction in the event of a negotiation successfully leading to a
binding contract, for example by reorganizing their business in order to
more fully and more promptly exploit the opportunities created by the
deal, once the deal is entered into. These investments are usually ‘relation-
specific’: they are going to be wasted if the negotiations fail and a binding
contract is not formed.
According to the traditional ‘aleatory view’ of negotiations, the parties
are free to retreat from the initiated negotiations at any time, for any
reason, and without legal consequences, so that each party bears the risk
that her investment will be wasted (Farnsworth, 1987). A common state-
ment in law and economics analysis on this point is that, in this contest,
the risk of losing the investment may lead to an incentive to under-invest,
thereby foregoing the opportunity to maximize the surplus obtainable
from the transaction. The under-investment problem has a far greater
impact than legal scholars and earlier law and economics works generally
believed. Early scholarship on the subject pointed out that the incentive
to under-invest created by the traditional common law rule of no liabil-
ity existed only when just one party had invested in reliance. Instead, as
shown by successive analysis, under-investment can still occur even if
both parties rely on the successful formation of the contract (and make
‘relation-specific investments’ based on that reliance) (Bebchuk and Ben-
Shahar, 2001). On the other hand, imposing liability in any case on a party
who retreats from an initiated negotiation (through, for example, a rule
of ‘strict precontractual liability’), besides having a deterrent effect on
the willingness to enter into negotiations in the first place, will probably
lead to over-investment because the other party will be fully protected
against the risk of unsuccessful bargaining and will not have any incentive
to restrain her investment effort (Bebchuk and Ben-Shahar, 2001). This
distortion will occur regardless of the magnitude of the damages imposed
by the rule. In fact, both expectation damages and reliance damages will
create suboptimal incentives for investment, because the party will inter-
nalize the benefits of the investment but not the costs, which are fully
borne by the retreating party.
An efficient legal rule should instead stimulate optimal investment.
From an economic perspective, the investment decision has the nature
of a cost-benefit analysis and the level of optimal investment can be deter-
mined through the application of a test analogous to the ‘Learned Hand’
test used for defining the efficient level of precautions in a negligence contest.

Briefly, investing is efficient whenever the potential benefit (weighted by

the probability that the contract will be formed) exceeds the potential loss
(weighted by the probability that the contract will not be formed) (Goetz
and Scott, 1980) (Craswell, 1996) (Katz, 1995–96). More explicitly, the
surplus increase that would be gained by investing in precontractual reli-
ance if the deal is ultimately closed must be weighed against the fact that,
if negotiations fail, the costs incurred for actions taken in order to increase
the surplus are lost and, in some cases, additional expenditures may even
be needed to undo any actions that are no longer desirable because of the
failure of negotiations.
In order to stimulate efficient investment decisions, the law may be
called on to supply some kind of protection for efficient reliance. Indeed,
the evolution of the doctrine of promissory estoppel may seem to demon-
strate that common law courts were not unaware of this problem, and tried
to provide some degree of protection for promisees whose precontractual
reliance was frustrated because of the ultimate failure of negotiations.
The legal instruments currently made available by American courts
may be sufficient to create optimal reliance investments. Farnsworth,
for instance, contends that the existing contract doctrines of promissory
estoppel, unjust enrichment and misrepresentation, particularly if consid-
ered together with the trend of modern courts to include lost opportunities
in the recovery measure, provide sufficient protection for the parties in the
case of failed negotiations, while an extension of the general obligation of
‘fair dealing’ in the context of precontractual negotiations is unnecessary,
if not harmful (Farnsworth, 1987). However, the exact scope of applica-
tion of those contract doctrines, and of promissory estoppel in particular,
is uncertain. Professors Schwartz and Scott show through case analysis
that courts are actually unwilling to attach liability for representation
made during negotiations, whether on the basis of promissory estoppel
or of any other doctrine. However, they find that liability is sometimes
efficiently imposed by courts to protect reliance investments made after
a ‘preliminary agreement’ has been reached (Schwartz and Scott, 2007;
Scott, 2007). The term ‘preliminary agreement’ is defined broadly to
include informal and even oral agreements from which it is possible to
identify an intention to pursue a profitable project, a division of invest-
ment tasks, and an agreement on an investment sequence. Parties create
preliminary agreements rather than complete contracts when their project
can take a number of forms and the parties are unsure which form will
maximize profits. Preliminary agreements are desirable because often they
are necessary condition to the realization of a socially efficient oppor-
tunity. By developing a bilateral investment model encompassing both
simultaneous and sequential investments settings, Schwartz and Scott

show that law can improve efficiency by awarding the promisee his verifi-
able reliance if the promisor has strategically deviated from the investment
sequence agreed upon in the preliminary agreement. Without this protec-
tion, the parties are discouraged from entering into beneficial preliminary
agreements and from engaging in relation-specific investments. On the
other hand, attaching liability in cases in which no agreement has been
reached will inefficiently and unnecessarily chill the parties’ incentive to
enter into negotiations. Case law analysis evidences an emerging legal rule
requiring parties to a preliminary agreement to bargain in good faith over
open terms. This new legal rule is regarded by the authors as a positive
step toward the efficient policy recommendation derived from the model.
However, requiring parties to bargain in good faith is unnecessary: in
order to enhance efficiency it is simply necessary to protect the promisee’s
reliance interest.
Another author finds that a review of case law shows, instead, that
courts do in fact grant recovery of precontractual expenditures even when
a ‘preliminary agreement’ is absent (Kostritsky, 2008). Kostritsky argues
that the problems characterizing precontractual negotiations without an
agreement and those present in the ‘preliminary agreement’ framework
identified by Schwartz and Scott are substantially the same: ex post hold-
up and the related under-investment problem. Thus, a liability default rule
providing for recovery of reliance expenditures is desirable in both con-
texts. In particular, legal protection may be necessary to curb the moral
hazard problem in situations of sequential investments, where the first
party to make an investment may be forced to accept less favorable terms
under the threat of losing what she had paid in reliance if the other party
breaks off the negotiations. According to Kostritsky, the courts’ willing-
ness to grant recovery even in the absence of an explicit agreement on the
investment sequence, evidence by case-law analysis, is therefore in line
with economic efficiency.
Along the same lines, Richard Craswell, linking his analysis to the
theory of incomplete contracts, focuses basically on the selection of an
appropriate default rule to be applied when parties have not explicitly said
whether they intended to be committed by their preliminary exchanges
(Craswell, 1996). Craswell considers the case of unilateral reliance. Since
optimal investments increase the size of the expected value of the transac-
tion, the non-relying party also benefits from the investment made by the
relying party because, depending on her bargaining power, she may be able
to appropriate some of the surplus created by investing in preparation of
the prospective conclusion of the deal. Hence, the non-relying party would
want to commit herself in some way or the other in order to induce the
other party to rely. Building on this intuition, Craswell concludes that the

optimal default rule would be a rule that recognizes the implied existence of
a commitment in those cases in which, ex ante, even for the party who now
seeks to withdraw, it would have been desirable to be committed in order to
induce efficient reliance. In other words, courts should impose liability only
when an enforceable commitment would have been necessary to induce an
efficient level of reliance (found by applying a Learned Hand formula-style
text). In addition, Craswell proposes the adoption of a ‘penalty default’
(Ayres and Gerlner, 1989), imposing a form of strict liability, in all those
cases in which a party with superior information about the probability of
performance explicitly recommends that the other party makes some kind
of reliance investment. This penalty default will assure that the party with
superior information would recommend that the other invest only when
relying is efficient. The conclusions reached in the paper are supported by
case analysis: Craswell finds that, in most instances, courts do in fact recog-
nize the existence of a commitment when reliance was efficient.
These attempts to reconcile case law with a law and economics perspec-
tive on precontractual liability have produced mixed results. Courts have
not always been consistent in the application of legal doctrines, such as
promissory estoppel, to precontractual claims, so that even those schol-
ars more convincingly campaigning for the overall efficiency of current
judicial approaches cannot help but wonder whether a greater degree of
definition would be helpful to reduce the uncertainty surrounding the
precontractual stage. Departing from case law analysis, some law and
economics scholars have searched for models able to provide clearer
normative recommendations.
Avery Katz also considers the doctrine of promissory estoppel. In addi-
tion, he develops some normative suggestions on how the doctrine should
better be applied (Katz, 1995–96). An important assumption of Katz’s
model is that judges (and juries) are not in a position to make a substan-
tive determination regarding optimal reliance. Accordingly, the Learned
Hand test is inapplicable (as is any rule that makes liability depend upon a
court finding of whether reliance was efficient) and the optimal rule should
rather assign liability by following the ‘least-cost-avoider’ paradigm. The
least-cost-avoider, in the traditional tort law scenario, is the party able to
take precautions to avoid the occurrence of an accident at the least cost.
In Katz’s unilateral investment model, the ‘least-cost-avoider’ is usually
the party with the greater bargaining power ex post: the party who has the
power to modify the terms of preliminary understandings once the reliance
investments have occurred. (A typical example of bargaining power ex
post is the position of the parties in the famous and groundbreaking case
Hoffman v. Red Owl Stores: Red Owl Stores, a supermarket franchisor,
promised that if Hoffman, a prospective franchisee, took certain steps

and raised a certain amount of capital, he would be granted a franchise.

Hoffman did what he was told but then the franchisor refused to close the
deal.)
An element that differentiates Katz’s analysis from most other models
of precontractual liability is the relevance given to the ‘time dimension’ of
the decision to invest in reliance. Katz interestingly notes that the balance
between the benefit of the investment and the risk that the investment will
be wasted if no contract is formed changes over time. At the beginning of
the negotiation process, the risk of waste is high. Later on, once the parties
have had the opportunity to better delineate the elements of the possible
transaction, the risk decreases. However, the benefit generated by the
investment also decreases in time: presumably, the sooner the investment,
the larger the profit. The optimization problem, therefore, should focus
on the identification of the optimal moment to begin investing in order to
maximize the expected benefit of the transaction. Building on this intui-
tion, Katz concludes that it is optimal to apply promissory estoppel when
the non-relying party has the greater bargaining power, ex post, so that she
will have an incentive to make an offer to stimulate investments when it is
optimal to rely. Conversely, if the relying party has the greater bargaining
power ex post promissory estoppel should not apply. In this situation, the
relying party is able to capture the full benefit of the investment, so that
incentives to rely at the optimal moment are only attainable by making her
also internalize the risk of wasted reliance. (This would be the case if, for
example, Red Owl had built a new supermarket in view of the prospective
deal. The franchisor would still have the power to dictate the conditions
of the deal because the investment made would not be wasted if the parties
do not ultimately agree: Red Owl owns a building that can be leased to
another franchisee willing to accept Red Owl’s conditions.)
This general unilateral investment model holds under the assumption
that both parties are risk neutral and that there is no information asym-
metry concerning the cost and the benefit of reliance and the risk of waste.
Relaxing these assumptions, efficiency may require different solutions.
In particular, risk aversion may lead the parties to rely too late, waiting
until they can be almost sure about the successful conclusion of the deal,
in order to minimize the risk of waste. Katz argues that the solution sug-
gested by the general model is still valid in this case, but risk aversion can
influence the view of who is the ‘least-cost-avoider’: it is efficient in this
case to place the risk of wasted reliance on the party that can bear that risk
more cheaply. When the parties have different attitudes toward risk, the
‘least-cost-avoider’ may not be the party detaining the bargaining power
ex post. In the case of asymmetric and imperfect information, moreover,
Katz proposes a solution similar to the one individuated by Craswell: the

party with superior information should be held liable for wasted reliance
by application of a ‘penalty default’.
One of the most recent law and economics works on precontractual
liability is a paper by Lucian Bebchuk and Omri Ben-Shahar (Bebchuk
and Ben-Shahar, 2001). They introduce a bilateral reliance model with a
major focus on the efficiency of ‘intermediate’ liability rules. An important
assumption of the model is that some relevant parameters, necessary for
the application of the proposed rules, are judicially verifiable.
The structure of that paper is reminiscent of the structure used in the
standard law and economics analysis of tort law. First, the two ‘polar’
regimes, no liability and strict liability, are considered. Under a regime of
no liability, each party will under-invest in reliance, because the rule does
not allow either of them to fully internalize the benefit of her investment.
Conversely, under a regime of strict liability (defined as a rule requiring
each party to fully compensate the other party’s reliance investment if a
contract is not formed), each party will over-invest, because the cost of her
reliance is shifted to the other party.
One of the principal contributions of the paper is the authors’ argument
against the diffuse idea that under-investment only occurs when just one
party makes precontractual investments. Intuitively, it may seem that
when both parties invest in reliance, the problem of under-investment
would diminish substantially: what causes under-investment is the risk
that the other party will walk away from the negotiations, but if both
parties rely, neither would want to walk away because both have some-
thing to lose (the precontractual investment that is wasted if the contract
is not formed). Bebchuk and Ben-Shahar show that this intuition is incor-
rect: under-investment is more closely related to the existence of a positive
surplus from the transaction than with the risk of a breakdown in negotia-
tions. The surplus depends on the investment of both parties. When the
parties’ investments are ‘strategic substitutes’ (the investment of one party
reduces the marginal value of the other party’s investment), one party’s
investment will be even lower when the other party also invests than when
the other party’s investment is zero. Conversely, when the parties’ invest-
ments are ‘strategic complements’ (the investment of one party increases
the marginal value of the other party’s investment), one party will invest
more when the other party also invests. Finally, when the parties’ invest-
ments are independent, the investment of one party does not depend on
whether or how much the other party invests.
After assessing these results, the authors propose and explore the impli-
cations of three different kinds of ‘intermediate’ liability regimes that
could potentially produce optimal reliance decisions.
The first proposed rule imposes full liability for precontractual reliance

on a party that bargains in an ex post opportunistic manner (that is, by

demanding a price that, taking into account the other party’s reliance
expenditures, would leave the other party with an overall loss from the
transaction). Under this regime, both parties make optimal investments
because neither can totally shift her costs to the other, but must bear a
fraction of the total cost that is equal to the fraction of the incremental
surplus she extracts from the investment.
The second rule is a cost-sharing rule: each party bears part of the total
reliance cost (that is, pays for part of the other party’s cost and recovers
part of her own cost). In order to achieve efficiency, the sharing formula
should be linked to the parties’ respective bargaining power. The rule,
therefore, imposes a great informational burden on courts. While conced-
ing that it is not plausible to assume that courts will be able to evaluate the
parties’ bargaining power accurately, the authors suggest that a sharing
formula that requires the parties to share reliance expenditures evenly
could nonetheless reduce distortions produced by polar regimes.
The third and final rule combines a strict liability standard with a
‘capped’ measure of damages. When negotiations break down, each party
will be liable regardless of her conduct, but recovery is limited to the part
of the reliance cost which does not exceed the hypothetical cost of optimal
reliance. If courts can correctly infer the level of optimal reliance, this rule
creates incentives for optimal reliance because each party must bear the
cost of any further investment beyond the point of optimal reliance, there-
fore correcting the over-investment problem linked with an unmodified
rule of strict precontractual liability.
Omri Ben-Shahar returned to the problem of precontractual liability,
analyzed this time from a gap-filling perspective, in a subsequent paper
(Ben-Shahar, 2003–2004). Ben-Shahar argues that the mutual assent
doctrine, according to which a contract is formed only when the positions
of the two parties meet and which creates an all-or-nothing separation
between precontractual and contractual stage, no liability and full con-
tractual liability may be too rigid to induce optimal reliance. Instead, the
author proposes a ‘no-retraction’ principle, imposing liability as a process
of ‘continuous convergence’ for obligations gradually emerging during the
parties’ relationship. More precisely, according to the no-retraction prin-
ciple, a party who manifests a willingness to enter into a contract at given
terms should not be able to freely retract that manifestation. The opposing
party should have the opportunity to bind the counterpart to her represen-
tations. The more innovative suggestion of Ben-Shahar’s article consists in
the fact that enforcement of the retracting party’s precontractual represen-
tations should be made according to the meaning intended by the retract-
ing party herself. Any gap should be filled with terms most favorable to

the retracting party. Following the economic analysis developed in his

previous paper co-authored with Lucian Bebchuk, the author contends
that this solution is superior to the traditional principle of mutual consent
because it provides incentives for optimal reliance by solving the holdup
problem. The most obvious objection to the proposed rule is that it may be
suboptimal from the perspective of allocative efficiency: given the option
to enforce precontractual representations, the parties may be locked into
unwanted contractual relationships, therefore missing the opportunity to
maximize the potential surplus. Ben-Shahar addresses this issue and con-
cludes that the possibility that liability could induce an inefficient choice
of partner, while real enough, will produce a fairly small expected loss,
because the parties should be able to take into account in their reliance
decisions the probability that a better partner will appear. According to
Ben-Shahar, moreover, the no-retraction principle would produce the
additional advantage of providing a more consistent treatment of pre-
contractual agreements, by eliminating the need to draw a defined line
between full liability and no liability and introducing instead a burden of
liability that is proportional to the ‘intensity’ of the agreement.
Reactions to the novelty of Ben-Shahar’s perspective have been mixed.
Ronald Mann expressed mixed appreciation and caution (Mann, 2003–
2004), while Jason Johnston arrives at a different cost-benefit result and
objects that the inefficiency potentially produced by the no-retraction
principle outweighs the efficiency improvements advanced by Ben-Shahar,
so that the current legal approach should still be considered superior
(Johnston, 2003–2004).
The paper, in all its novelty, is particularly at odds with Wouter Wils’s
widely cited contribution on precontractual liability (Wils, 1993). One of
the most important conclusions of Wils’s article is that liability should not
be attached to the act of breaking off the negotiations. The author deline-
ates two situations in which the precontractual behavior of one or both
parties creates inefficiency and/or unfairness and maintains that in those
situations, and in those situations alone, the law should supply some kind
of liability rule to correct the inefficiency. The first such situation is the one
in which one party misleadingly induces the other to incur costs in relation
to the prospective contract. When, for instance, one party has superior
information on the probability that the deal will go through, she may use
this superior information to misrepresent the likelihood of the deal and
induce the other party to invest in reliance more than she would do other-
wise. The incentive to misrepresent comes from the fact that the reliance
expenditures that one party incurs, as defined by Wils, increase the surplus
of the deal and both parties will receive a fraction of this surplus. Since
misrepresentation provokes inefficient reliance investments, the party with

superior information should be deterred by the prospect of liability. Wils

is very careful in pointing out that liability for costs misleadingly induced
should not be conditional on whether the liable party has broken off the
negotiations, because otherwise the parties would have an incentive to
wastefully drag out the negotiations to avoid liability. The second prob-
lematic situation is the one in which a party makes a costly but efficient
investment in anticipation of the deal, from which the other party retains
a benefit after the failure of the negotiations. In the absence of liability,
the party would not incur such costs because, although the investments
increase the final surplus from the deal, they are too expensive for the
party to take at her own risk. Here, efficiency calls for a rule imposing res-
titution of the benefits obtained out of the failed negotiations, to encour-
age the party to make such efficient but costly investments. Again, liability
for restitution should not be linked to the breaking off of the negotiations.
Rather, it should be attached to whatever party received benefits from
the other party’s action, irrespective of which party has broken off the
negotiations. Wils concludes that the common law doctrine of promissory
estoppel is able to solve efficiently the problem of misleadingly induced
costs and that the doctrine of unjust enrichment efficiently serves the goal
of encouraging efficient anticipatory expenditures. A more general rule of
precontractual liability is not desirable and the general principle should
be, as traditionally in the common law, that losses are left where they fall.
3. Preventing Opportunism
Preventing opportunism and protecting precontractual reliance are actu-
ally two sides of the same coin. Opportunism, also known as the hold-up
problem, is viewed by most scholars as one of the main causes of the under-
investment issue affecting the investment decisions of parties engaged
in precontractual negotiations (Bebchuk and Ben-Shahar, 2001). The
decision to devote a separate section to opportunism is based on organi-
zational reasons rather than logical necessity. Logically, the issues of pre-
venting opportunism and protecting precontractual reliance are inherently
linked. However, the structure of papers focusing on opportunism differs
strongly from that of works directly addressing the issue of the protection
of reliance. The thread of references evidences that these models are built
on the basis of partially different economic ‘fundamentals’.
The opportunism tradition owes much to Oliver Williamson’s delinea-
tion of the holdup problem (Williamson, 1979). According to Williamson’s
analysis, opportunism is especially relevant in contexts involving relation-
specific investments: by making investments which have the potential
of increasing the surplus of the relationship but which are sunk if the
relationship ends, the parties create a situation of bilateral monopoly, in

which both have incentives to appropriate the gains from contracting.

From the new institutional economics perspective, governance structures
attenuating opportunism and fostering trust are necessary to achieve
economic efficiency. In particular, protection of trust helps to minimize
transaction costs.
The necessity to legally protect trust is not unknown to American courts.
Some legal scholars went as far as to argue that the true key to understand
promissory estoppel case law is to move away from the common ‘reliance
protection’ justification and to recognize that the real rationale of the
use of promissory estoppel made by the courts is the protection of trust
whenever that protection turns out to be socially beneficial (Farber and
Matheson, 1985). Although it is probably untrue that the reliance element,
as Faber and Matheson have elegantly argued, has become irrelevant in
promissory estoppel cases, the emphasis placed on trust protection pro-
vides a different perspective on the precontractual liability problem and
links the analysis with the economic theory of opportunism.
Opportunism is in fact a behavioral phenomenon of general relevance
in contracting relationships. Economic theory traditionally studies oppor-
tunism in the context of long-term contracts, employment contracts in
particular. However, law and economics scholars, from early on, became
aware of the possibility of fruitfully exploiting the theory of opportunism
to analyze the problems arising during the precontractual stage. The same
mechanism that gives rise to the bilateral monopoly situation in relational
contracts is present also in precontractual negotiations settings. From this
perspective, regulation of the precontractual stage is appropriate because
opportunism undermines trust and raises transaction costs, therefore
preventing the formation of surplus-maximizing relationships. Following
this line of reasoning, Richard Shell proposed the creation of a new liabil-
ity rule dealing with opportunism in precontractual negotiations (Shell,
1991). Shell first exposes the ‘dilemma of trust’. Trust is beneficial because
it lowers transaction costs, therefore increasing the payoff obtainable from
the transaction. On the other hand, abuse of trust makes the trusting party
worse off than if she had not trusted to begin with. The parties in pre-
contractual negotiations are thus playing a prisoner’s dilemma game, in
which the unique Nash equilibrium is for both to adopt a distrust strategy.
This outcome is suboptimal because it limits the possible gains from the
transaction for both parties. An optimal regulation should give incentives
to adopt a trust strategy instead. Shell contends that non-legal mecha-
nisms, such as damage to one’s reputation, are insufficient to foster trust
and that in principle the costs of legal intervention are outweighed by its
benefits. However, the legal doctrines currently available to protect trust
in the precontractual stage are unnecessarily costly and complicated. Shell

explores possible alternatives. He concludes that imposition of a general

duty of good faith in precontractual negotiations, parallel to the corre-
sponding duty already existing for the contractual stage, is impractical:
the vagueness of the standard would allow courts to go beyond the goal of
punishing opportunism, succumbing to the temptation of punishing also
any other conduct they consider unethical. A better alternative, according
to Shell, would be the creation of a new liability regime designed specifi-
cally for the precontractual stage and allowing the victim of opportunistic
behavior, even in the absence of a specific promise, to recover the costs of
her relation-specific investments, with the exclusion of normal negotiation
costs.
The distinct relevance of the theory of opportunism is well evidenced by
Cohen (Cohen, 1991–92). Considering the question of which party should
bear the sunk costs associated with contract breach, Cohen distinguishes
two different traditions of contract law analysis: the ‘least-cost-avoider’
tradition and the opportunism tradition. The former tradition, first elabo-
rated in the context of tort law, suggests assigning the costs to the party
that can bear them more cheaply, because its principal goal is preventing
negligent behavior. Contrarily, the opportunism tradition places the costs
on the party that acts opportunistically, with the purpose of prevent-
ing opportunistic behavior. Analyzing this tradeoff, Cohen argues that
the ‘least-cost-avoider’ paradigm does not work well in contract law. In
contract contexts, the decision not to take precautions to minimize sunk
costs in the event of a breach is in most cases intentional and strategic,
not negligent. Therefore, at least when it is not possible to achieve both
goals contemporaneously (that is, because the least-cost-avoider and
the opportunistic party are not the same person), the goal of deterring
opportunism should prevail. In line with the new institutional economics’
call for legal regulation of opportunistic behavior, Cohen concludes that
contract law should grant a bigger role to the goal of deterring opportun-
ism. Opportunism is costly for society because, by killing trust between the
parties, it prompts them to spend more on precautions. Although the scope
of Cohen’s analysis generally embraces the contractual stage, Cohen’s
referring to Williamson’s description of the bilateral monopoly situation,
in which parties find themselves after the decision to make relation-specific
investments, acknowledges that the potential for opportunism may arise
even before any commitment has been made. Indeed, in the precontractual
stage, the parties are more vulnerable and opportunism is more profitable.
Therefore, Cohen’s results can be considered to hold even in the context of
precontractual negotiations.
Another model based on transaction costs economics and the oppor-
tunism tradition is the one elaborated by Kostritsky (Kostritsky, 1993).

Kostritsky first develops a bargain model: preliminary negotiations involve

elements of uncertainty, moral hazard and sunk costs, which give rise to
a potential for opportunistic behavior. Because of bounded rationality,
which is inseparable from the uncertainty that characterizes the precon-
tractual stage, opportunism cannot effectively be curbed by explicit con-
tract clauses, so that a legally supplied default rule is justified. To solve the
opportunism problem, Kostritsky proposes the adoption of new default
rule for the precontractual stage. This default rule should recognize an
‘implicit bargain’ and impose an obligation to perform according to its
terms. The form of this implicit bargain in the precontractual stage would
essentially be a promise to keep the counterpart informed of any change
in the willingness to reach a definitive agreement and an assumption of
liability for any step adopted by the counterpart before that communica-
tion of change of heart. Kostritsky contends that this formulation is prob-
ably the most similar to the one the parties would have agreed on in the
absence of the high transaction costs present in the precontractual stage.
This approach attempts to efficiently deal with opportunism by promoting
trust and stimulating reliance investments, while at the same time avoiding
the disincentive to enter negotiations that would follow a rule mandat-
ing enforcement of the definitive promise to conclude the contract. In
other words, the proposed rule can be characterized as an ‘interim liabil-
ity rule’, not linked to the final transaction, but still able to capture the
externalities problem (Kostritsky, 1997). The relevance of the opportun-
ism problem is also evidenced by courts’ rulings on promissory estoppel
cases, whose outcomes can be rationalized on the basis of opportunism
deterrence (Kostritsky, 2002). Kostritsky’s approach is further refined in
a subsequent paper, in which the author also introduces some behavioral
economics insights (Kostritsky, 2004).
4. Fostering Efficient Information Exchange or Information Gathering

The law and economics literature usually attributes two basic functions to
contract law: the optimization of the incentives to perform and the opti-
mization of the incentives to rely. A third function of contract law, which
has traditionally received less attention, is the optimization of incentives
to gather information on the probability of performance and to disclose
that information efficiently. The remedies for breach of contract can be
calibrated in such a way as to address the informational issue (Craswell,
1988, 1989). Those remedies, however, are available only once a contract
has been formed. To stimulate optimal information disclosure in the pre-
contractual stage, an independent basis for liability might be necessary.
During precontractual negotiations, the parties exchange information
in order to determine the worthiness of the proposed deal. Although the

negotiation process is mostly conflictual, the parties have a common inter-

est in a truthful exchange of information, because it allows them to save
negotiation costs when a deal turns out not to be profitable for one or for
both. The recognition of this mutual interest in information disclosure
suggests that the information issue in the precontractual stage could also
be analyzed from the point of view of cheap talk economics (Johnston,
1999). Johnston shows that the parties’ mutual interest in minimizing the
cost of useless negotiation can generate private incentives for informative
cheap talk, in the absence of liability. However, when the parties perceive
their interests as strictly in conflict, a message that is costless to send is
not credible. Thus, there are circumstances, that is, when a seller with
relatively high costs deals with potential buyers who have relatively high
costs of investigating and bargaining, in which potential legal liability for
unfulfilled optimistic talk (which now is no longer ‘cheap’) may be neces-
sary to create an incentive for informative precontractual communica-
tion. Applying his carefully developed model to existing legal doctrines,
Johnston concludes in favor of the efficiency of the use the courts made
of promissory estoppel. According to his case-law analysis, what triggers
liability in promissory estoppel cases is not just reliance, as commonly
believed, but performance: courts impose liability if and only if the speaker
has made an optimistic statement, observed that performance follows, and
remained silent, failing to discourage further performance. This approach
provides efficient incentives to disclose one’s actual beliefs as to the prob-
ability of a deal. The prospect of liability for the partial performance
forces a pessimistic party to engage in informative talks when she would
not otherwise do so.
5. Other Issues Related to Precontractual Liability
5.1. Incentives to Enter Negotiations

As critics of precontractual liability have pointed out, the imposition of
some kind of liability for conduct prior to the formation of a contract
may have negative effects on another relevant category of incentives:
the incentives for the parties to enter into negotiation in the first place.
Potential liability may increase transaction costs and discourage people
from negotiating, even when the transaction, if successful, would have
created a positive surplus. As Farnsworth pointed out, the traditional
common law’s aleatory view of negotiations ‘rests upon a concern that
limiting the freedom of negotiation might discourage parties from entering
negotiations’ (Farnsworth, 1987). To better support their call for a form of
precontractual liability, various authors have put some effort into trying
to rebut the reasoning behind this concern.

Bebchuk and Ben-Shahar dedicate the last part of their analysis to

addressing the issue of whether precontractual liability (in any of the
possible forms delineated in their paper) might discourage the parties
from entering negotiations (Bebchuk and Ben-Shahar, 2001). Assuming
that transaction costs are zero, a party will enter negotiations only if
her expected gain from the transaction (that is, the expected contractual
profit less the cost of reliance and the cost of precontractual liability) is
positive. The two ‘polar regimes’ of no liability and strict precontractual
liability may induce the parties not to enter negotiations even when the
contract that such negotiations will produce has a positive surplus. The
inefficient level of reliance that such regimes produce prevents the parties
from achieving the potential surplus. From this perspective, therefore, it is
impossible to say that a rule imposing liability for precontractual reliance
will certainly lead to fewer negotiations. The rule of capped strict liability,
proposed as an ‘intermediate’ rule by the authors, shares part of the inef-
ficiency of the ‘pure’ strict liability rule: since a party bears a fraction of the
total costs which differs from the fraction of the benefit she can extract, in
some situations she may get a negative payoff even if the total net surplus
is positive. In such cases, she will not enter negotiations. Conversely, the
other two ‘intermediate’ rules described (the one imposing liability for ex
post opportunism and the cost-sharing rule) link the fraction of the total
costs that a party must bear to the fraction of the benefit she is able to
internalize. Consequently, under these rules, parties will enter negotiations
whenever there is a potential surplus obtainable from the transaction. As
long as the precontractual liability rule is carefully designed, therefore, the
threat of a negative impact on the incentives to enter negotiations is not a
concern.
Ben-Shahar further considered the issue and pointed out, first, that pre-
contractual liability’s chilling effect on the incentive to enter negotiations
may be desirable in all the cases in which the parties begin negotiating for
reasons different than to transact (a situation which is not uncommon
and which has traditionally been one of the main territories of applica-
tion of promissory liability devices; Ben-Shahar, 2003–2004). But even
if the parties negotiate with the intent to conclude a surplus-maximizing
transaction, the proposed no-retraction principle will enhance, rather than
diminish, their willingness to negotiate, because it provides the parties
with some assurance that neither of them can exit unilaterally.
Schwartz and Scott openly admit that a chilling effect on the parties’
willingness to enter negotiations is present whenever the traditional rule
of no precontractual liability is modified (Schwartz and Scott, 2007).
However, they argue that this effect will not pose a serious danger as
long as courts follow their suggestion to recognize a binding preliminary

commitment only if three specific elements are present: an intention to

pursue a profitable project, a division of investment tasks, and an agree-
ment on an investment sequence. Both parties would want to commit in
order to increase the surplus available from negotiations, which is fostered
by efficient incentives to invest. Moreover, since the liability regime they
advocate is a default, a party who is unwilling to commit can always
contract out.
5.2. Selection of the Optimal Damage Measure

As is the case with contractual liability, the efficiency of any precontrac-
tual liability regime may be influenced by the measure of damages coupled
with it. Some authors dismiss this issue as unimportant. Avery Katz, for
instance, says that the dispute on whether the expectation or the reliance
measure of damage should be applied in promissory estoppel cases can
be regarded as a secondary issue, because both measures fully insure the
promisee against wasted reliance (Katz, 1995–96).
Although many authors, following Fuller and Perdue’s well-established
principle that when liability is based on reliance, compensation should be
based on reliance damages (Fuller and Perdue, 1937), seem to imply that
compensation for reliance expenditures should follow a finding of precon-
tractual liability, in some papers the issue is explored specifically and with
more depth of analysis.
Farnsworth, to support his conclusion that the existing legal doctrines
have the potential to efficiently protect parties in the precontractual stage,
identifies a judicial trend to include compensation for ‘lost opportunity’
in the calculation of the generally applied reliance interest (Farnsworth,
1987). According to the author, this damage measure would be the key to
a more extensive use of the doctrine of promissory estoppel in precontrac-
tual settings, because it would render precontractual claims substantial
enough to justify litigation.
Craswell argues that there is no economic rationale to prefer compensa-
tion of the reliance interest to other damage measures (Craswell, 1996).
Most damage measures, in fact, will give the parties incentives to rely too
much, and the reliance measure could prove to be the worst of all in this
respect. Instead, the proper damage measure should take into account
all relevant economic variables that may be affected by the magnitude
of compensation, in particular risk-bearing costs, incentives to search
for contracting partners, and incentives to investigate the profitability of
the proposed deal. The preference for the reliance measure identified in the
literature is probably motivated by the fact that the reliance measure is the
minimum measure necessary to give optimal incentives to rely. However,
parties in some situations may be willing to commit themselves to a larger

damage measure, for example in order to give their partner a positive

signal of their willingness to conclude the deal. These observations seem to
suggest that the choice of the optimal damage measure is possible only by
carefully considering each particular set of case facts, so that it is neither
desirable nor feasible to formulate a single, general, solution.
A similar intuition, that the proper damage measure depends on the
specific goals that need to be addressed in different contexts, can also be
found at the basis of Ben-Shahar’s argument (Ben-Shahar, 2003–2004).
The author presents his no-retraction principle as a liability rule that can
be coupled with different damage measures ‘depending on the underlying
objectives that the remedy seeks to promote’. In the context of precon-
tractual liability, where the social objective is to induce efficient reliance
despite the risk of holdup, however, Ben-Shahar specifically suggests that
the reliance measure should apply.
5.3. The Over-investment Problem

If the most commonly highlighted drawback of the traditional principle
of freedom of negotiation is the under-investment problem, its counter-
part is an over-investment problem that would arise, according to some
commentators, when precontractual liability is imposed.
Schwartz and Scott suggest that a partial solution to this problem is to
allow the relying party to recover just its ‘verifiable’ reliance costs when
the other party breaches the precontractual agreement (recall, in fact, that
Schwartz and Scott justify precontractual liability only for breach of a
precontractual agreement having some specified characteristics) (Schwartz
and Scott, 2007). The solution is only partial, however, because, as proven
in a formal appendix at the end of their paper, there is no analytical answer
to the question of whether a party will over-invest under a regime of pre-
contractual liability. The answer depends on the particular values assumed
by the relevant variables. By allowing just recovery of verifiable costs, the
problem is nonetheless limited. Schwartz and Scott conclude that the pro-
posed liability rule will cause over-investment only if an improbably large
fraction of the reliance costs is verifiable and the probability of breach is
unrealistically high.
According to Craswell, the over-investment problem is eliminated if one
accepts the possibility that courts can correctly assess the efficient level of
reliance that a party should adopt in a specific case. Courts should refuse
to impose liability whenever they find that the relying party had acted
‘unreasonably’ by relying too much (Craswell, 1996).
An original view on the over-investment problem, and on precontrac-
tual liability in general, is the one expressed in a recent paper by Grosskopf
and Medina (Grosskopf and Medina, 2007). These authors challenge

the traditional idea that the absence of legal regulation would produce
under-investment in the precontractual stage. Instead, they argue that,
if the parties operate in a relatively competitive market, competition is
often sufficient to stimulate optimal investment decisions. The analysis
shows that the real problem affecting the precontractual stage is the fact
that a party may have incentives to push the other to over-invest. This
perspective, which demonstrates the importance of taking into account
market structure, suggests that legal regulation may be necessary in some
circumstances, not to prevent under-investment, but rather to deter over-
investment.
6. Conclusion
The analysis of the mechanisms and of the behavioral aspects of parties
engaged in precontractual negotiations can still be considered an under-
developed field in law and economics. The issues related to precontractual
liability are surrounded by a veil of confusion both in the case law and
in the academic scholarship. However, law and economics scholars have
made several important contributions over the years. By drawing upon a
large array of different economic theories, these scholars have in various
ways improved the understanding of the precontractual stage as well
as of the functioning of a number of important contract law doctrines.
Although the absence of a commonly accepted framework of analysis has
probably prevented precontractual liability from claiming its deserved
place in general law and economics treatises, the issue, if not popular, cer-
tainly has not failed to stimulate a productive debate.
The ambiguousness of American courts’ attitudes toward precontrac-
tual liability has substantially increased the difficulty of identifying a com-
monly accepted analytical perspective. To achieve a better understanding
of the underlying economic issues, it would probably be necessary to sever
the analysis from the outcomes of judicial decisions and to forget for the
moment the idiosyncratic aspects of American common law. Comparative
law could be of some use. Precontractual liability is in fact one of the legal
issues on which, at least in principle, common law and civil law systems
differ the most. The civil law tradition has long recognized liability for
precontractual misconduct. A rigorous economic analysis of the rules
developed in civil law jurisdictions to address precontractual negotiations’
problems could help to clarify the structure and advance general under-
standing of the issue.
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Press.

3 Contractual mistake and misrepresentation
Qi Zhou
1. Introduction
A contractual mistake is the misperception of a party which induces him
to enter into a contract. Contractual mistakes can be divided into two
groups, viz. common and unilateral mistakes. The former are the mistakes
which are shared by both parties. The latter type comprises mistakes by
one party only, for example, the seller knows that the cow being offered for
sale is barren, but the buyer misbelieves that she is fertile. In most jurisdic-
tions, the law of contract law does not enforce a contract concluded on the
basis of a fundamental mistake.
From an economic perspective, a contractual mistake may lead to misal-
location of resources by inducing the party to make an incorrect appraisal
of the payoff derived from the transaction. However, this does not mean
that the legal remedy for mistake is economically justified, because the law
of contractual mistake also modifies the party’s incentives to search for
and disclose information prior to the conclusion of the contract. For their
part, scholars of law and economics have traditionally focused on how the
law can be designed not only to improve allocative efficiency, but also to
create incentives for the parties to undertake optimal search and disclo-
sure of information. Section 2 provides a brief critical review of relevant
economic theories of the law of contractual mistake.
From a legal perspective, misrepresentations can be categorised into
three types: (i) fraudulent misrepresentation – a false statement is made
intentionally by a contracting party for the purpose of inducing another
to contract with him; (ii) negligent misrepresentation – a false statement
results from a party’s failure to take reasonable care when making it; (iii)
innocent misrepresentation – a false statement is made by the contracting
party, even though he has taken reasonable care. Economic considerations
vary with the type of misrepresentation. For fraudulent misrepresenta-
tion, the economic question is how the law can be designed to deter parties
optimally from deceiving. Moving onto negligent misrepresentation, the
economic consideration focuses on adjustment of the law to induce the
representor to take socially optimal care. Finally, in the case of innocent
misrepresentation, the emphasis is directed to the representee. Because an
innocent misrepresentation cannot be avoided by the representor taking
socially optimal care, the law should be used to induce the representee to
31

take optimal precautions. All of the above issues are discussed in Sections
3 and 4.
2. Contractual Mistakes
2.1. Allocative Efficiency and Contractual Mistake

Allocative efficiency requires resources to move from lower to higher value
users. Efficiency is achieved when the resources move to the highest value
user (Ogus, 2006, p. 27). From an economic perspective, a contract is
viewed as a device for resource allocation. It is generally assumed that con-
tracts can achieve allocative efficiency to move the goods to their highest
value user, as well as ensuring that each step in the allocation process is a
Pareto improvement. However, success in achieving allocative efficiency
by contracting depends on the fundamental assumption that each con-
tracting party correctly assesses the payoff arising from the transaction.
A mistake can induce the party to make incorrect calculations, thereby
causing a misallocation of resources which moves the goods from a high
value to a lower value user.
Let V and E be the subjective values of goods for the seller and buyer
respectively. P stands for the contract price. If E $ P $ V, then any
improvement generated by the contract is a Pareto improvement. But if
the buyer mistakenly believes that E . V, while in fact E , V, the con-
tract is not a Pareto improvement, as the buyer is made worse off, and the
transaction is a misallocation of resources. Nonetheless, not every mistake
causes misallocation. If the mistake merely induces the party to miscalcu-
late P, but E . V still holds, the mistake causes only a redistribution of
wealth from one party to another, with no impact on allocative efficiency.
Based upon this economic argument, an efficient law of contractual
mistake should permit the rescission of contract only if the mistake leads
to misallocation (Zhou, 2008a, pp. 328–32).
2.2. Incentives and the Law of Contractual Mistake

The relationship between incentives and the law of contractual mistake
has been a predominant issue in the current law-and-economics literature.
Academic attention has been directed to the question of how the law can
be used to create the right incentives for the parties to acquire and disclose
information prior to the conclusion of the contract.
Offering a legal remedy for contractual mistake can motivate parties
to disclose private information. If the law permits a party to rescind a
contract on the ground of mistake, the non-mistaken party will not realise
the expected profit from the transaction. This creates an incentive for the
non-mistaken party to disclose private information to save the other party

Contractual mistake and misrepresentation 33
from making mistakes. As long as the cost of disclosure is lower than his
expected profit from the transaction, the party will have an incentive to
disclose.
But the legal remedy for contractual mistakes also creates a disincentive
for the parties to acquire information in the first place. A party’s incentive
to acquire information depends on his obtaining the property right to it in
order to generate a profit. The legal remedy for mistakes deprives the party
of the property right to his private information, as once the information
is revealed to another, the party starting with an information advantage is
unable to exclude the other from using it. Therefore, the economic ques-
tion is how to balance the incentive to disclose against the disincentive to
acquire information.
2.2.1. Deliberative acquisition v. casual acquisition It is generally agreed

that discussion of this issue starts with a groundbreaking paper by
Kronman (1978), arguing that the law should offer legal remedy to the
mistaken party for his mistake when the non-mistaken party acquires
information casually, whereas it should not provide legal remedy if the
information is acquired deliberately by the non-mistaken party. The
rationale underlying this argument is as follows. Casual acquisition incurs
no search cost to the non-mistaken party, so the legal remedy for mistake
will not undermine his incentive to acquire information in the first place.
If, by contrast, the information is deliberately acquired, there is a search
cost to the party, so the legal remedy for mistake will create a disincentive
for him to seek information (Kronman, 1978, p. 13).
Notwithstanding its great contribution to the literature, Kronman’s
argument has three limitations. First, as Kronman’s interest is in the issue
of how the law can create the incentive for information production, he
overlooks the issue of how it affects the allocation of resources. According
to him, the contract should be rescinded on the ground of mistake if the
non-mistaken party acquired the information casually. But if the subjec-
tive value of the non-mistaken party is higher than that of the mistaken
party, the rescission will result in misallocation of resources from the
higher value user to the lower. Hence, Kronman’s approach may lead to
the misallocation of resources (Zhou, 2008a, p. 332).
Secondly, Kronman assumes that the behaviour of information acqui-
sition is of a binary nature: the search cost is either zero or positive.
However, this cannot be held in reality, as the cost structure of informa-
tion acquisition is normally a continuum with zero at one end and infin-
ity at the other. The search cost of a contracting party lies somewhere
between these extremes. Therefore, it is impossible to distinguish delibera-
tive acquisitions from casual ones. For example, the reason why the buyer

in a second-hand shop was able to recognise an authentic painting by a

famous artist, which the seller did not identify, is that the buyer had spent
many years in studying for a Ph.D. in art history. The question of whether
the buyer’s tuition fees should be counted as a cost of information acquisi-
tion is a difficult one. In theory, searching behaviour should be seen as a
continuum rather than a binary phenomenon. The question to be asked
is not whether the information was acquired deliberately or casually, but
what is the optimal level of search cost which can be achieved by setting
the marginal search cost equal to the marginal benefit. Unfortunately,
given information deficiency, this theoretical analysis has barely any
practical value.
Thirdly, Kronman assumes that the more information is available, the
better it will be for society, but this is not always true. In the first place,
duplication of information will generate a cost to society. Thus, account
should be taken of what is the optimal amount of information. Again, in
theory, it would be at the level where the marginal benefit from the pro-
duction of information equals the marginal production cost. In addition,
from the standpoint of society as a whole, not every piece of information
is valuable. Some has only a distributive effect without improving alloca-
tive efficiency, while what is valuable to society is information which can
enhance allocative efficiency.
2.2.2. Productive v. redistributive information Another approach to

the problem of incentives is to distinguish socially useful from useless
information. Cooter and Ulen (2003, pp. 281–4) propose a distinction
between productive and redistributive information. Productive informa-
tion can be used to produce more wealth, for example, the discovery of
a vaccine for polio or the discovery of a shipping route between Europe
and China. In contrast, redistributive information creates a bargain-
ing advantage that can be used to redistribute wealth in favour of the
informed party; for instance, knowing before anyone else where a new
road is to be built conveys a powerful advantage in property markets.
Searching for redistributive information is socially wasteful. Therefore,
Cooter and Ulen conclude that the law should discourage expenditure of
resources on searching for redistributive information. One device to this
end is to rescind the contract when one contracting party makes a unilat-
eral mistake which is caused by the non-mistaken party’s non-disclosure
of redistributive information.
The argument of Cooter and Ulen appears to be based on the earlier
work of Hirshleifer (1971, p. 561), who made a distinction between ‘fore-
knowledge’ and ‘discovery’. Foreknowledge is knowledge that ‘will in due
time, be evident to all’; it is information that ‘Nature will autonomously

reveal’ and which ‘involves only the value of priority in time of superior
knowledge’. This type of information leads only to redistribution of wealth,
without increasing social welfare. Discovery, by contrast, is ‘the recogni-
tion of something that possibly already exists, though [it will remain]
hidden from view unless and until the discovery is made’ (Hirshleifer,
1971, p. 562). Discovered information can generate both private gains to
the owner of information and social wealth. Although Cooter and Ulen
use different terminology, the theme of their argument is much the same as
that of Hirshleifer, in that both seek to distinguish socially valuable from
socially valueless information and suggest that the law should provide
disincentives for acquisition of the latter.
But the shortcoming of Cooter and Ulen’s approach is also obvious.
In the context of contract law, it is impossible to draw a clear-cut distinc-
tion between productive and redistributive information: in most cases, it
is both. Recall their earlier example: they argue that information on the
discovery of a shipping route from Europe to China is productive. But
this information can also be redistributive. Imagine a contractual relation
between a Chinese exporter and a European importer. Assume now that
the Chinese importer knows of a new route; this information could reduce
his transportation costs substantially. If his European partner learns of
this information, he will not purchase the goods unless the Chinese firm
agrees to lower the price. But if the Chinese party conceals this informa-
tion from the European buyer, he can charge the same price and make a
higher profit. Thus, the information on the new route redistributes wealth
in the form of contract price from the European firm to the Chinese firm.
Conversely, the redistributive information may be of a productive kind.
Cooter and Ulen take the information concerning the intended building of
a new road as an example of redistributive information, but it may be pro-
ductive as well. If the owner of land adjacent to the road uses it for a purely
residential purpose, the new highway will reduce his subjective value on
the land, because of noise generated by passing vehicles. The sooner he has
the information, the sooner he will be able to sell the land to a person who
values it more highly and buy a new home. Thus, information of this kind
can speed up the process of resource allocation to the highest value user
(Eisenberg, 2003a, pp. 1666–73).
2.2.3. The remedy-based approach Instead of focusing on the type

of mistake, the remedy-based approach aligns the parties’ incentive via
adjustment of the legal remedy for mistakes: rescission. It is suggested that
if one party makes a contractual mistake, the law should give discretion
to the mistaken party to decide whether or not to rescind the contract; if
the mistaken party chooses to rescind the contract, that party should pay

the other party for the expectation loss in order to put the latter into the
position he or she would have been in if the contract had been perfectly
performed. The expectation loss is measured in the same way as damages
for breach of contract (Zhou, 2008a, p. 336).
In the light of this approach, if the mistaken party rescinds the contract,
he should compensate the non-mistaken party for his expectation loss.
This is just equal to his subjective value – the price at which he would
sell the goods. A rational party will have the incentive to rescind the con-
tract for the mistake only if his subjective value exceeds the other party’s
expectation losses; otherwise, he will choose not to rescind. Consequently,
other things being equal, it can be ensured that as long as the mistaken
party rescinds the contract, his subjective value will be higher than that
of the non-mistaken party and the rescission is allocatively efficient. If
the mistaken party waives the right of rescission, it is implied that his
subjective value is lower than that of the non-mistaken party, so that it is
now enforcement of the contract which is allocatively efficient. Therefore,
theoretically speaking, the remedy-based approach does not result in mis-
allocation of resources. In addition, it can create a sufficient incentive for
acquisition of information. Under the remedy-based rule, if the contract
is rescinded for a mistake, the non-mistaken party can claim the expecta-
tion loss from the mistaken party. Hence, after receiving compensation
from the latter, the former would be put into the position in which he
would have been had the contract been perfectly performed. The remedy-
based approach allows the party to capture all of the profits derived from
his private information, thereby creating a sufficient incentive for him to
acquire information (Zhou, 2008a, pp. 336–8).
2.2.4. Voluntary disclosure Another theory suggests that even without

legal intervention, a seller may still have an incentive to disclose private
information (Beales et al., 1981; Wonnell, 1991), since disclosure of
information can help sellers to distinguish themselves from other sellers
of homogeneous goods. In the absence of information, buyers are likely
to view all brands as of equivalent value, when they actually differ. Thus,
sellers of above-average brands are incentivised to reveal the special
qualities or features of their goods in order to distinguish them from
below-average competitors. Given these disclosures, buyers might begin
to perceive that the average value of non-disclosing sellers is lower. This
perception would in turn create a new incentive for those of the remaining
non-disclosing seller whose goods are above the average to disclose their
advantages. This would again lower the average of non-disclosing sellers
and so on, until every seller disclosed (Beales et al., 1981). Nonetheless,
the application of this argument is limited. First, it is assumed that the

market is competitive and that buyers are competent to process the infor-
mation, which is obviously not always true in reality. Secondly, the seller
only has incentives to disclose information which can increase the contract
price, and has no incentive to disclose information which will reduce it.
Normally, it is the latter kind of information which is needed to prevent
buyers’ mistakes. Therefore, despite the incentive of voluntary disclosure,
legal intervention is still necessary.
2.2.5. A competitive model Most of the above analysis is based upon

the two-party model that assumes no competition between sellers, so
that the incentive for acquisition of information is only to compete with
another party to capture a greater share of the contract surplus. Therefore,
mandatory disclosure of private information undermines the incentive to
search for information. However, this conclusion has to be modified if
the assumption of competitive market conditions is integrated into the
analysis.
Grosskopf and Medina (2006) suggest that furnishing relief for contract
mistakes does not always undermine the contracting party’s incentive to
acquire information, because the motive for acquisition of information is
sometimes driven by obtaining a competitive advantage over other con-
tractors. For example, in a competitive market, firms have a strong incen-
tive to acquire information in relation to consumers’ preferences in order
to improve the quality of their goods or services; an incentive which is not
affected by the rules of mistake in contract law. Therefore, the authors
provide two general propositions. First, the law should distinguish con-
ventional information which the contractor gathers to beat other com-
petitors by gaining a competitive advantage from exceptional information
which the contractor found when searching other than for that purpose.
Offering relief for a mistake in the former case will not weaken the con-
tractor’s incentive to gather information. Secondly, the contractor’s incen-
tive for gathering conventional information could be undermined in the
market where other competitors can freely use his information. Therefore,
the law should be adjusted to solve this type of free-rider problem by
excluding other competitors from accessing the information. For example,
in a contract on tender, the seller should be prohibited from revealing
information in a tender by one party to other competitors (Grosskopf and
Medina, 2006).
2.3. Common Mistake Rule v. Unilateral Mistake Rule

Another important question in relation to the law of contractual mistake
is whether the law should adopt the common mistake rule or the unilateral
mistake rule. Under the former, the contract is void only if both parties

are mistaken, while under the latter, it can be void even if only one party
is mistaken. Both efficiency features and the parties’ incentives under the
common mistake rule differ from those under the unilateral mistake rule.
Because there are more mistaken contracts to rescind under the unilat-
eral mistake rule, it is appropriate to assume that other things being equal,
this rule is more efficient, if a mistaken contract is more likely to cause
a misallocation of resources, because the more mistaken contracts are
rescinded, the more misallocations are corrected. Conversely, if a mistake
is unlikely to result in a misallocation, the common mistake rule is supe-
rior to the unilateral one, as the rescission of a mistaken contract which
generates no misallocation will, in itself, be a misallocation of resources
(Rasmusen and Ayres, 1993, p. 309; Zhou, 2008b, p. 259).
As to the incentive to disclose, both parties under the unilateral mistake
rule will have the incentive to disclose their private information. If one
party intends to exploit the other’s mistake by concealing private informa-
tion which might prevent the latter from making the mistake, the contract
will be void on the grounds of the unilateral mistake, so the former will be
unable to make a profit from concealing his private information. This in
turn motivates him to disclose his private information. Under the common
mistake rule, by contrast, he has no incentive to disclose, because now
the contract is held void and unenforceable if and only if both parties are
mistaken. If either party can make a profit from the other’s mistake by
concealing private information, he will not disclose, because the contract
cannot be void for the reason that only one party is mistaken. Therefore,
the best strategy for him is to conceal such information (Rasmusen and
Ayres, 1993, p. 309; Wonnell, 1991, p. 329).
Turning to the incentive to acquire information, it is clear that neither
party has such an incentive under the unilateral mistake rule, which
creates an incentive to disclose, prohibiting the exploitation of private
information. Therefore, there is no incentive to acquire such information
in the first place.
Although a party is allowed to benefit from using his private informa-
tion under the common mistake rule, his incentive to acquire information
is unpredictable. To illustrate, assume that a buyer is willing to buy both
high and low quality goods, but that he will offer a higher price for the
former. If the seller does not know whether the goods which he is about
to sell are of good or bad quality, does he have an incentive to investigate
under the common mistake rule? Probably not, because he can always
charge the buyer an average price, which is higher than the price for
poor quality goods. If they are discovered to be of good quality ex post,
the seller can always rescind the contract if the buyer was unaware of
the true quality. However, if the buyer is informed by acquiring private

information in the first place, the seller faces the risk of selling high quality
goods at an average price, which is less than they are worth. Thus, he will
seek information if the buyer does so. From the buyer’s point of view, he
has an incentive to search only if the seller does not search, because if the
seller can distinguish high quality goods from poor ones by acquiring extra
information, the seller will charge a different price for different quality
goods. There is thus no need for the buyer to search. If the seller does not
search, there is a risk for the buyer of purchasing poor quality goods at the
average price, which is more than they are worth. Therefore, the buyer has
the incentive to search only if the seller does not do so. This is a discoordi-
nation game, in which some sellers and buyers will search for information,
while others will not (Rasmusen and Ayres, 1993, p. 329).
It is also argued that compared with the common mistake rule, the
unilateral version enjoys the advantage of saving the transaction cost in
negotiating a contract clause to avoid mistakes when there is informa-
tion asymmetry between the contracting parties (Smith and Smith, 1990).
Consider the example of a seller who contracts to sell a ring to a buyer.
If the stone is a real diamond, he will sell it at £1,000; if not, the price will
be £200. If the seller does not know the quality of the ring, he will shift
the risk to the buyer by reflecting the possibility of the stone not being a
diamond in the contract price, offering it at £600 (£200 3 0.5 1 £1,000 3
0.5). If he does have information indicating that the stone is a diamond,
he will charge the buyer £1,000 and provide a warranty to that effect in
the contract. Therefore, all sellers with superior information will distin-
guish themselves by including such a warranty in the contract. Crucially,
any seller having information indicating that the stone in his ring is not a
diamond has an incentive to conceal that information and attempt to sell
the ring at £600, in competition with those sellers who have no informa-
tion superiority (Smith and Smith, 1990, p. 478). Consequently, sellers of
rings of unknown quality have to face the free-rider problem if they choose
to shift the risk of ignorance to the buyer by discounting the contract
price. However, if the buyer agrees to purchase the ring at £200 and adds
a clause in the contract which allows the seller to rescind the contract in
the case where the stone turns out to be a real diamond, sellers of rings
of unknown quality would definitely prefer to accept such a clause rather
than discounting the contract price, because this saves them from being
free ridden by sellers of false diamond rings. The unilateral mistake rule
functions as an ‘off-the-rack’ provision to an incomplete ‘bargained-for’
contract that stipulates that if the seller is mistaken about some essential
fact, he will get the goods back and the buyer the money. This saves the
seller’s transaction cost in negotiating such a clause with the buyer. In
contrast, if the common mistake rule applies, the buyer may argue that he

does not share the mistake. The seller cannot rescind the contract when
the stone turns out to be a diamond. Consequently, the warranty function
of the mistake rule is ineffective. Therefore, the unilateral mistake rule can
save more transaction costs than the common mistake rule when there is
an information asymmetry between the contracting parties.
2.4. Cross-purpose Mistakes

A cross-purpose mistake is a special type of common mistake which occurs
where one party intends to contract for one thing and the other party for
another. The classic example is the English case of Raffles v. Wichelhaus
(1864, 15 ER 375), where the parties entered into a contract for the sale of
cotton on a ship, the Peerless. In fact, there were two ships named Peerless,
one (Peerless I) which departed in October and the other (Peerless II) in
December. Notwithstanding the case report does not document explicitly,
it seems that the buyer believed himself to be purchasing the cotton on
Peerless I, and the seller believed that he had contracted to sell that on
Peerless II. The court refused to enforce the contract on the grounds of the
mutual misunderstanding as to the subject matter of the contract between
the parties.
From an economic perspective, the judgment of Raffles v. Wichelhaus is
inefficient, because it creates a chance for parties to behave opportunisti-
cally. Assume that the market price for cotton drops significantly after the
conclusion of the contract. It would not be unreasonable to infer that the
buyer would not demand delivery when the Peerless I docked in Liverpool
on 18 February 1863. When the seller tendered the delivery of cotton
on Peerless II, which arrived two months later, the buyer would claim
that there was a cross-purpose and the contract was unenforceable. The
rule of cross-purpose mistake thus allows opportunistic behaviour for a
contracting party to escape a bad bargain.
To solve this problem, a no-retraction principle is suggested (Ben-
Shahar, 2004). According to this rule, a party who manifests a willingness
to enter into a contract at given terms should not be able to retract freely
from this (Ben-Shahar, 2004, p. 1830). Instead of judicially declaring
the contract void when there is a cross-purpose mistake as to the subject
matter, the court should allow either party who claims that the contract is
valid to enforce the contractual terms claimed by the other party. Recall
the Peerless case. If the seller intends to enforce the contract, the contract
terms as to the subject matter should be Peerless I, which is what the buyer
claimed it to be. Under this proposed rule, the buyer is unable to escape
a bad bargain by exploiting the common mistake rule to argue that the
contract is void on the grounds of mutual misunderstanding (Ben-Shahar,
2004, p. 1856).

3. Fraudulent Misrepresentation
Fraudulent misrepresentation is the intentional passing of false informa-
tion by one party to induce another party to contract with him. Such
misrepresentation is socially undesirable not only because it can lead to
misallocation of resources, just as a contractual mistake does, but also
because it generates real social costs (Mahoney, 1992). First, it generates
precautionary costs, which are defined as the money, effort and time used
by the representee to prevent fraudulent misrepresentation. Secondly, the
resources invested in a fraudulent misrepresentation constitute a social
waste. Fraudulent misrepresentation is a type of opportunistic behaviour.
It does not increase social welfare, but merely transfers existing wealth
between the contracting parties. Thus, the more the parties spend on fraud-
ulent misrepresentation to capture a greater share of contract surplus, the
less surplus will remain. Any resource used in this way is totally wasted
from a social standpoint (Zhou, 2007, pp. 86–8). Therefore, the law should
deter fraudulent misrepresentation (Craswell, 2006, p. 600).
3.1. Legal Deterrence of Fraudulent Misrepresentation

According to Becker’s theory of legal deterrence (Becker, 1976), the law
will create effective deterrence if the following inequality is satisfied.
D $ 0P 2 V 0 (3.1)
Here, D represents the private legal remedy for fraudulent misrepresenta-

tion, which can refer to either damages or rescission. The right-hand side
of the formula is the representor’s net gain from the fraudulent misrepre-
sentation: P stands for the contract price and V for the maximum amount
the representee would be willing to pay or the minimum he would accept
on the basis of true information. If the seller is the representor and lies to
the buyer, he is able to charge him a higher price than if he tells the truth.
If the buyer is an untruthful representor, he is able to pay a lower price
than the seller would be willing to accept on the basis of true information.
The representor’s gain from the fraudulent misrepresentation can thus be
written as the difference between the contract price and the maximum the
representee would be willing to pay or the minimum he would accept on
the basis of true information, viz. 0 P 2 V 0 .
In reality, the enforcement of private legal remedies is not perfect, so
to make this model more workable, we must add a coefficient q, repre-
senting the probability of private legal enforcement. Unlike public legal
enforcement, private enforcement relies entirely on the victim to bring a
legal action against the injurer. In order for private legal remedies to deter
fraudulent misrepresentation effectively, the representee needs not only to

learn the truth, but must also convince the court of the representor’s mis-
representation. Due to the information asymmetry and the representee’s
cognitive limitations, he may fail to find out that the representor is lying,
or he may be unable to convince the court. In addition, high litigation
costs may prohibit the representee from bringing an action. Therefore,
in reality q is always less than one. The deterrence model of private legal
remedy for fraudulent misrepresentation can now be rewritten as:
Dq $ 0 P 2 V 0 (3.2)
From a policy perspective, this model indicates that the law can prevent
fraudulent misrepresentation by influencing the potential representor’s
decision ex ante, either by raising the probability of private enforcement
or by raising the damages recoverable by the representee (Zhou, 2007;
Craswell, 1999).
However, the use of private legal remedy to regulate fraudulent misrep-
resentation is not free; it also generates costs to society. Two types of cost
associated with private legal remedy can be easily identified, viz. adminis-
trative cost and the cost of legal intervention. Administrative cost is that
incurred by the operation of legal rules. It includes the time and effort
spent by both representor and representee in pre-trial negotiations and in
the litigation itself, as well as the public operating expenses of the courts.
The cost of legal intervention is the loss of social welfare which would have
been derived from those potential transactions that are deterred by the
intervention of the law in the private contracting process (Zhou, 2008b,
pp. 82–6).
If the objective of the law is simply to create effective deterrence of
fraudulent misrepresentation, there is no need to consider the cost of legal
remedy. It does not matter whether the left-hand side of inequality (3.2)
is set equal to or higher than the right-hand side; in both cases, the gain
from fraudulent misrepresentation is eliminated, so the representor has
no incentive to lie. For the same reason, there is also no difference, for the
purpose of improving the deterrence, between raising D and increasing q.
However, if it is assumed that the objective of the law is to improve
allocative (Kaldor-Hicks) efficiency, we must take the cost of applying
legal remedy into account. Indeed, much law-and-economics research
has convincingly shown that it is not always efficient to minimize a par-
ticular type of social cost by means of legal intervention, because of the
cost incurred by the legal instrument itself (Stigler, 1970); and this line of
argument is applicable to the law of fraudulent misrepresentation.
In general, it can be argued that an increase in the severity of legal sanc-
tion will improve deterrence, thus reducing the total number of acts of

fraudulent misrepresentation and consequently lessening the social cost of

fraud. But strict legal sanctions require a high level of legal intervention,
which will raise both administrative costs and legal intervention costs.
Applying the Kaldor-Hicks test, the law is efficient only if the cost gener-
ated by the law itself is outweighed by its benefit. In the current context,
the law is efficient only if the social cost generated by fraudulent misrepre-
sentation exceeds the aggregate of administrative cost and legal interven-
tion cost. Therefore, it must be Kaldor-Hicks inefficient if the objective of
the law is to eliminate fraudulent misrepresentation completely.
From an efficiency perspective, the law should balance the social costs
arising from fraudulent misrepresentation against the aggregate of admin-
istrative cost and legal intervention cost. The optimal legal remedy will be
one which minimizes both. Accordingly, the following three normative
propositions can be offered:
(1) If the cost incurred by the legal remedy exceeds the costs incurred by
fraudulent misrepresentation, the remedy is not desirable in terms of
efficiency.
(2) If the same amount of reduction in the costs incurred by fraudu-
lent misrepresentation can be achieved by different legal remedies,
economic efficiency favours whichever generates the least cost to
others.
(3) If different legal remedies cost the same, economic efficiency prefers
the one which makes the largest reduction in the cost incurred by
fraudulent misrepresentation.
According to the above propositions, if the left-hand side of inequal-

ity (3.2) exceeds rather than equals the right-hand side, this will result in
over-deterrence; consequently, the costs of private legal remedies will be
unnecessarily increased. In addition, if the same level of deterrence can be
achieved by increasing either D or q, we should choose whichever method
costs society less in terms of legal intervention (Zhou, 2008b, pp. 86–8).
3.2. Legal Remedies for Fraudulent Misrepresentation

Normally there are two private law remedies for a fraudulent misrepre-
sentation, one in tort law and the other in contract law. In tort law, the
representee is entitled to claim damages from the representor. The general
principle of measuring damages for misrepresentation is to use financial
compensation to put the representee in the position where he would have
been had no fraudulent misrepresentation been made, that is to say, the
representee can recover all of the consequential losses resulting from
relying on the fraudulent misrepresentation. In some jurisdictions, such as

the USA, the representee may even claim punitive damages; the amount
of damages recoverable will be subject to the jury’s discretion. Apart from
damages in tort law, the representee is also entitled to rescind the contract
on the grounds of fraudulent misrepresentation. As a general principle,
once the contract is rescinded, each party is obligated to return to the other
the value which he or she received from the other.
Despite a large amount of law-and-economics literature on legal rem-
edies for breach of contract, scholars have not paid sufficient attention to
the legal remedies for fraudulent misrepresentation. One economic issue
in this regard is whether or not a private legal remedy can create effective
deterrence. It is suggested that the deterrence of damages in tort law is
more effective than the remedy of rescission in contract law (Zhou, 2006),
because there is no upper limit to the level of damages, D. If the probabil-
ity of legal enforcement is imperfect (q , 1), D can always be increased to
achieve Dq $ 0 P 2 V 0 by setting D $ 0 P 2 V 0 /q. Notwithstanding a low
q will undermine legal deterrence, effective deterrence can be restored by
increasing D. In contrast, in the case of rescission, D is constant; deter-
rence can be improved only by increasing q. If the contract is rescinded
on the grounds of misrepresentation, neither party can realise its expected
interest from the contract. Thus D, the liability cost to the party, equals
his expected profit from the unconscionable contract, which is measured
as his expected profit from the transaction, 0 P 2 V 0 . If q 5 1, the inequal-
ity Dq $ 0 P 2 V 0 is satisfied. If q , 1, deterrence can be enhanced only
by improving the legal enforcement, q. Unlike the remedy of damages,
under rescission, D is fixed. Therefore, deterrence cannot be improved by
increasing D. This is why, in terms of deterrence, damages are a preferable
remedial alternative to rescission when legal enforcement is poor.
Craswell (1989) examines the relation between the representee’s reli-
ance on the information presented by the representor and the magnitude
of damages for fraudulent misrepresentation. He argues that neither
expectation damages nor reliance damages can induce the representor to
make true representation, nor induce the representee to place reasonable
reliance on the representation made by the representor. The problem is
attributable to the inelasticity between damages recoverable by the repres-
entee and the level of his reliance on the information provided by the rep-
resentor. Under both the expectation damages and reliance damages rules,
the representor’s incentive to deceive is unaffected by the rule, because
whether or not he makes a fraudulent misrepresentation will not increase
or decrease the amount of damages recoverable by the representee on the
action of breach of contract. Furthermore, the representee can recover all
of the reliance costs under both rules; he would therefore tend to over-rely
on the representation.

Craswell therefore suggests that to solve this problem the amount of

damages recoverable by the representee should be tied to the optimal level
of reliance. That is to say, the law should hold the promisor liable for the
value of the promisee’s expectation interest as it would have been if the
promisee had chosen the optimal level of reliance, given everything the
promisor had said about the probability of performance (Craswell, 1989,
p. 367). Under this rule, the promisee can only recover the amount of
damages up to the point where his reliance on the promisor’s statement is
reasonable. This rule, therefore, can prevent the promisee’s over-reliance.
On the other hand, if the promisor exaggerates the probability of perform-
ance, the reasonableness standard will also increase, so the damages recov-
erable by the promisee will also rise accordingly. This creates an incentive
for the promisor not to misstate the probability of performance.
3.3. Determination of Fraudulent Intention

It is notoriously difficult to judge whether or not a misrepresentation
is made fraudulently. Four main propositions are offered in the litera-
ture, none of which is perfect. As fraudulent misrepresentation is a type
of intentional tort, the economic propositions for intentional tort are
equally applicable. The first suggests that if a misrepresentation generates
a high probability of misleading the representee, it should be treated as
fraudulent (Zhou, 2009a; Landes and Posner, 1981, p. 129). It is true that a
fraudulent misrepresentation is more likely to mislead the representee than
a non-fraudulent one, but a misrepresentation with a low probability of
misleading can also be made fraudulently. If the gains from the fraudulent
misrepresentation are very great, even though the probability of mislead-
ing is low, it is reasonable to assume that the representor has an incentive
to deceive, as long as the gain discounted by the probability exceeds his
personal cost of making the misrepresentation. This proposition cannot
offer a legal standard to cover all fraudulent misrepresentations.
The second proposition is that if the costs to the representor of avoiding
the misrepresentation are negative, it should be held as having been fraud-
ulently made (Zhou, 2009a; Landes and Posner, 1981, p. 139). A negative
precautionary cost against misrepresentation indicates an investment in
the misrepresentation by the representor, which is clearly convincing evi-
dence of the intention to deceive. If the court had perfect information as to
the cost to the representor of making the misrepresentation, this proposi-
tion would be a valuable criterion to determine the intention to defraud,
but in reality, information asymmetry means that the court is unlikely to
be able to assess this cost.
The third proposition is that if the representor’s precautionary cost
against the misrepresentation is trivial relative to the representee’s resultant

losses, an intention to deceive should be found (Zhou, 2009a; Landes and

Posner, 1981, p. 133). This proposition does not intend to capture all types
of fraudulent misrepresentation, but only one type, reckless misrepresen-
tation. A misrepresentation made recklessly amounts to a fraudulent mis-
representation. The classical example is one who fails to disclose the false
element in a statement he has made when realising it later.
Like the third proposition, the fourth does not intend to provide a legal
standard for all fraudulent misrepresentations. It focuses on another type
of fraud, promissory misrepresentation (Ayres and Klass, 2005). Courts are
often very cautious about assigning legal liability for a misrepresentation
of promise. For example, in the UK, a misrepresentation as to a promise
in the future is not actionable, unless it is made intentionally. The primary
worry of courts is the chilling effect on informational behaviour caused by
legal errors. Compared with a misrepresentation of existing fact, it is more
difficult to determine whether or not the representor intended to perform
his or her promise at the time of representing. Frequently incorrect judg-
ments of intention by courts will increase the liability cost to the represen-
tor, which will deter parties from making any statement as to the future. It
is reasonably assumed that on average the benefit to society derived from
useful but not wholly accurate statements as to the future would exceed
the cost generated by promissory misrepresentation. Ayres and Klass
(2005, pp. 9–12) argue that this difficulty is caused by the binary approach
to determining the intention of fraud in the current law. According to this
approach, a promissory misrepresentation would be held either true or
false, with no shading between the two. This is contradictory to the way
in which parties actually make promissory representations. In fact, the
probability of performing is a continuum from zero at one end, gradually
increasing to 100 per cent at the other. The binary approach assumes that
there are only two types of promise, those which the promisor intends to
perform and those where there is the intention not to perform. It fails to
take the probability of performance into account. There is, in fact, a third
type of promise, where the party is uncertain of his intention, neither
intending to perform nor intending not to. The improvement suggested
by Ayres and Klass is that the court should adopt a continuum approach
to promissory misrepresentation by taking into account the representor’s
belief as to the probability of performance. A promise would then be held
fraudulent and draconian legal sanctions (punitive damages and criminal
law sanctions) would ensue only if the promisor knowingly or recklessly
misrepresented the probability of performance (Ayres and Klass, 2005,
pp. 73–82). This approach releases from severe legal liability for fraudu-
lent misrepresentation some promises which the promisor does not intend
to perform, thereby reducing the chilling effect of the current law.

4. Non-fraudulent Misrepresentation
4.1. Negligent Misrepresentation

A negligent misrepresentation is a false statement which induces the rep-
resentee to contract, as a result of the representor’s failure to take due care
when making the statement. A fraudulent misrepresentation differs from
a negligent one in the respect that the former is an intentional behaviour
and the latter is not, but merely a careless statement. Unlike fraudulent
misrepresentation, which is useless to society, a careless statement can be
a piece of valuable information, because it may turn out to be true. A law
which imposes a legal liability for every careless misrepresentation must be
inefficient, as it will overcome, or at least undermine, the parties’ incentive
to present information which is valuable but less accurate (Bishop, 1980,
p. 360). Thus, the law of negligent misrepresentation should aim not to
create a cost-effective deterrence of careless misrepresentation, rather to
create an incentive for parties to take the socially optimal level of care
when making a statement.
4.1.1. The optimal level of care Let H be the aggregate of the represen-
tee’s loss, the cost of legal intervention and the administrative cost, and let
p(x) be the probability of the representor making a careless misrepresen-
tation which causes cost H, given a level of care x, where p9(x) , 0, p0(x)
. 0, which indicates that a little more care taken by the representor would
reduce the probability that his statement is a misrepresentation; but when
the care taken by the representor reaches a given level, any additional
care that he takes will only reduce the probability of his making a misrep-
resentation by a negligible amount. To be efficient, the law of negligent
misrepresentation must minimize the total expected costs:
x 1 p(x)H (3.3)
Let x* denote the x that minimises the value of equation 3.3. This is the
socially optimal level of care which the representor should take. It is deter-
mined by the first-order condition 15 –p9(x)H, which indicates that the
marginal cost of care taken by the representor must equal the marginal
benefit in terms of the reduction in expected costs generated by the misrep-
resentation. An efficient law of negligent misrepresentation should induce
a party to take x* level of care when making a statement.
4.1.2. Negligent rule v. strict liability There are two types of legal liabil-
ity rule, negligent liability and strict liability, to induce the representor to
take optimal care. Under negligent liability, the representor is held liable

for the representee’s loss arising from relying on a careless misrepresenta-

tion only if he was negligent, that is, only if the level of care which he took
was less than the level of due care provided by the law. However, under
strict liability, the representor is liable for all of the representee’s losses
resulting from relying on the misrepresentation.
It is argued that the negligence rule is preferable to strict liability for the
purpose of inducing representors to take the optimal level of care. Under
the strict liability rule, the representor will himself assess the ex ante liabil-
ity cost. To achieve the socially optimal level of care, it is crucial that he
should take into account all of the costs resulting from the misrepresenta-
tion. But there is a disparity between his private cost and the social cost,
which would lead him to take the privately optimal level of care rather
than the socially optimal level. The representor’s private liability cost can
be measured as the representee’s losses resulting from acting on the misrep-
resentation, plus the representor’s personal litigation cost when he is sued
in the action of misrepresentation. But, from the standpoint of society as a
whole, the total cost has three elements: the representee’s personal losses,
the administrative costs, which comprise the litigation costs of both parties
and the resources, effort and time spent by the court, and the cost of legal
intervention. It is clear that in the representor’s calculation, he takes into
account neither the administrative costs of the representee and the court,
nor the cost of legal intervention. Indeed, the representor has no incentive
to take account of these costs in his calculation of the ex ante liability cost.
Consequently, his personal optimal level of care falls short of the socially
optimal level.
In contrast, under the negligence rule, it is for the court to decide what
the optimal level of care is. It is normally perceived that courts have an
informational advantage over representors as to the total cost generated
by misrepresentation. The court can set the optimal level of care on the
basis of all of the social costs resulting from the misrepresentation, then
use a private legal sanction (damages or rescission) to induce the repre-
sentor to take the socially optimal level of care. As long as the cost of
private legal sanction is greater than the precautionary cost of optimal
care, the representor will take optimal care. Under the negligence rule,
there is no need for the representor to decide what amount of care is
socially optimal; thus the negligence rule overcomes the problem of inad-
equate consideration by the representor of the total cost generated by the
misrepresentation.
4.1.3. Legal errors under the negligence rule Judicial error in identify-
ing negligence may always induce the representor to take excessive care,
regardless of whether the court is more likely to misperceive an innocent

Table 3.1 Level of care and probability of £100 loss
Level of care Cost of care Probability Expected Total social

(£) loss (£) loss (£)
None 0 15% 15 15
Moderate 3 10% 10 13
High 5 9% 9 14
representor as negligent or a negligent one as innocent. Consider the fol-

lowing example (Shavell, 1987, p. 217). The probability of the represen-
tor’s careless statement being a misrepresentation that would cause a loss
of £100 is related to the level of care, as shown in Table 3.1.
The socially optimal level of care, which is assumed to be due care, is
moderate. If there were no chance of the court making an error in the
assessment of the representor’s negligence, he would take moderate care
at a cost of £3, rather than high care, because that would involve a greater
cost (£5).
Suppose, however, that there is a 33 per cent chance that the court will
misperceive care by one level and a 5 per cent chance that it will misper-
ceive care by two levels. Therefore, there is a 33 per cent chance that no
care would be seen by the court as moderate care and a 5 per cent chance
that no care would be seen as high care. Further, there is a 33 per cent
chance that moderate care would be seen by the court as none and a 33 per
cent chance that moderate care would be seen as high care. There is also a
33 per cent chance that high care would be seen by the court as moderate
and a 5 per cent chance that it would be seen as none.
In this situation, taking high care is the best decision by the representor.
If he takes no care, his expected expenses will be 62% 3 15% 3 100 5 9.3
(since he will mistakenly escape liability 33% 1 5% 5 38% of the time). If
he takes moderate care, his expected expenses will be 3 1 33% 3 10% 3
100 5 6.33 (since he will mistakenly be found liable 33 per cent of
the time). Yet if he takes high care, his expected expenses will be only
5 1 5% 3 9% 3 100 5 5.45 (since he will mistakenly be found liable only
5 per cent of the time).
This example has two implications: (1) if taking more care reduces the
chance of being found negligent by judicial error, the representor may
decide to take more than due care, even where the chances of the court’s
overestimating care are as large as the chances of their underestimating it;
(2) despite the representor’s increasing his level of care, he may still face a
positive risk (5 per cent) of being found negligent. Thus, judicial error in
determining negligence is more likely to induce representors to take more

care than the optimal level, regardless of whether the court is more likely
to misperceive an innocent representor as negligent or a negligent one as
innocent.
4.2. Innocent Misrepresentation
4.2.1. Economic features of innocent misrepresentation From an eco-

nomic perspective, an innocent misrepresentation is a false statement
which the representor cannot avoid by taking the socially optimal level of
care. In other words, a misrepresentation is seen as made innocently if the
marginal loss resulting from it is outweighed by the representor’s marginal
precautionary cost. This is graphically illustrated in Figure 3.1.
The horizontal axis stands for the amount of precaution which the
representor takes, while the vertical axis represents the probability of his
statement being a misrepresentation. The line ML is the marginal social
loss generated by the misrepresentation, MP is the marginal cost of pre-
caution and P* is the standard of care which the law requires the represen-
tor to take. The socially optimal level of care is taken where MP 5 -ML.
Zone A is the area to the left of P* and Zone B that to the right of P*. Any
misrepresentation in Zone A will be held as negligent, because the actual
MP
ML
A B
0 P* 1
Figure 3.1 Innocent misrepresentation

level of care taken by the representor is lower than the socially optimal
level, P*. By contrast, a misrepresentation in Zone B will be seen as inno-
cent, because it could not have been avoided by the representor taking the
socially optimal level of care.
Figure 3.1 shows the difference in economic features between a negligent
misrepresentation and an innocent one: the former can be avoided by the
representor taking the socially optimal level of care, but the latter cannot.
In the case of negligent misrepresentation, the representor’s marginal
precautionary cost is lower than the marginal social loss resulting from
his misrepresentation. This implies that the social loss can be reduced
by taking additional precautions. When the marginal precautionary cost
rises to a level just equal to the marginal social loss, to take any further
additional care will not reduce the social loss, but increase it. This would
be the outcome of taking care against innocent misrepresentation, since
the representor’s marginal precautionary cost is higher than the marginal
social loss. Thus, the representor cannot avoid innocent misrepresentation
by taking the socially optimal level of care; and from the standpoint of
society, it is inefficient for him to take more care than P* to avoid making
an innocent misrepresentation. This economic analysis provides a valu-
able way of understanding the efficiency features of the law of innocent
misrepresentation – it would be inefficient for the law to create an incentive
for representors to take precautions against innocent misrepresentation.
Innocent misrepresentation also has economic features which distinguish
it from fraudulent misrepresentation. Unlike his fraudulent counterpart,
the innocent representor does not intend to pursue the outcome of mis-
representation. Therefore, he does not deliberately cause the waste of
resources in misleading the representee.
4.2.2. The no-liability rule and representee’s incentive Since it is ineffi-

cient for the representor to take precautions against innocent misrepresen-
tation, the economic question is how to use the law to create an incentive
for the representee to take care. The legal device to achieve this objective
is the no-liability rule, prohibiting representees from recovering the losses
resulting from acting on innocent misrepresentation. The no-liability rule
creates an incentive for the representee to take the level of care at which
the marginal precautionary cost is just equal to the marginal decrease in
his private loss caused by the innocent misrepresentation.
Although the no-liability rule can create a sufficient incentive to take
care against innocent misrepresentation, this is by no means to say that it
can lead the representee to take the socially optimal level of care. The main
demerit of the no-liability rule is that it cannot always create a socially
optimal incentive for the representee, as the actual level of care taken by

the representee under this rule is frequently higher than the socially optimal
level. This is attributable to the difference between the social loss and the
representee’s private loss occasioned by the innocent misrepresentation.
By way of illustration, take the English case of Leaf v. International
Galleries (1950, 2KB 86). Mr Leaf purchased a picture of Salisbury
Cathedral from International Galleries for £85. Prior to the sale,
International Galleries made an innocent misrepresentation that the
painting was by John Constable. Mr Leaf claimed for rescission of the
contract and his claim was rejected by the Court of Appeal. Assume that
if Mr Leaf had known that the painting was a copy, he would have been
willing to pay only £15 for it. But International Galleries would not have
been willing to sell the painting for less than £35, even though it was a
copy. Thus, the innocent misrepresentation brought a private gain of £50
(£85 2 £35) to International Galleries and a private loss of £70 (£85 2
£15) to Mr Leaf. From the standpoint of society as a whole, it generated a
social welfare loss of £20 (£70 2 £50), which is measured as the difference
between the private gain to International Galleries and the private loss
to Mr Leaf. Assume further that the probability of the statement made
by International Galleries being false was believed by Mr Leaf to be 10
percent. The ex ante social loss is £2 (£20310 per cent). In other words,
from the perspective of society, Mr Leaf should have invested no more
than £2 in the precaution. However, in determining the amount of care to
be taken, Mr Leaf will have taken his private loss rather than the social
loss into consideration. In this case, the ex ante private loss to Mr Leaf
would be £7 (£70310 per cent), which is £5 more than the social loss of £2.
It can thus be assumed that Mr Leaf would invest more in the precaution
than the socially optimal care demanded.
This example shows that under the no-liability rule, if the social loss
occasioned by the innocent misrepresentation is less than the private loss
to the representee, the actual care taken by the representee will be higher
than the socially optimal level. By the same token, the representee will
take inadequate care if the social loss is higher than his private loss. The
representee will take the socially optimal level of care only if the social
loss is equal to his private loss (Brown, 1973). If we examine the outcome
of misrepresentation in more detail, it is not difficult to see that most mis-
representations give rise to an adverse distributional effect on the parties,
generating a gain to one party (the representor), but at the same time
causing a loss to the other (the representee). In this case, the social welfare
loss occasioned by the misrepresentation is lower than the representee’s
private welfare loss. Thus it can be generally assumed that the actual care
taken by the representee under the no-liability rule will be higher than the
socially optimal level.

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4 Duress
Péter Cserne
1. Introduction: Economists Learning from Law?

In the law of contracts, duress is an excuse for non-performance. Virtually
all modern legal systems provide that a party who concluded a contract
under unacceptable pressure has a right to refuse performance or, if he has
already performed, a right to restitution. In short, victims of contractual
duress are allowed to avoid the offending agreement.
The purpose of this chapter is to provide an overview of the economic
analysis of contractual duress. The focus will be on the distinctive features
of the economic perspective on the duress doctrine, as developed in the
theoretical literature of law and economics. Before discussing the results of
economic analysis, the legal background and some non-economic theories
of duress are briefly presented. This detour may be justified by an argu-
ment put forward by Robert Cooter and Thomas Ulen in the introductory
chapter of their textbook. As they argue, the voluntariness of contracts is
a subject on which economists should learn from the law.
[E]conomists frequently extol the virtues of voluntary exchange, but economics

does not have a detailed account of what it means for exchange to be volun-
tary. . . . [C]ontract law has a complex, well-articulated theory of volition. If
economists will listen to what the law has to teach them, they will find their
models being drawn closer to reality. (Cooter and Ulen, 2008: 12)
Although this gesture of two economists towards lawyers is to be appre-

ciated, it cannot be taken at face value. First, large overlaps notwithstand-
ing, there are as many different ‘theories of volition’ as national (as well as
sub- and supranational) contract laws. More importantly, the ‘theory of
volition’ of contract law, well-articulated as it may be, is not well-founded
theoretically. The legal understanding of concepts such as voluntariness
usually half-knowingly reflects the philosophical or (pre-)scientific stand-
points of earlier ages (‘the metaphysics of the Stone Age’; Hart and Honoré
1985: 2) or expresses some folk-psychological notions. On the other hand,
what law as an institutionalized practice needs for its everyday operation
is not a theoretically sound definition but a uniform understanding of vol-
untariness. Even naive or common-sense ‘theories’ are able to provide this,
at least in so-called easy cases. Still, what the law says about voluntariness
could be called a ‘theory’ only in this practical sense. A further difficulty
57

is that this ‘legal worldview’ is not of much help in policy design. From a
purely legal perspective, it is impossible to answer normative questions as
to how the legally required degree of voluntariness of contract formation
should be regulated. As we shall see, law and economics scholars have
made considerable effort to re-conceptualize contractual duress in order to
make it both amenable to the analytical tools and subject to the evaluative
standards of economics.
Alongside Cooter and Ulen, commentators on comparative law and
economics have also argued that economic analysis should take doctrinal
details and the diversity of legal rules seriously. As they suggest, confront-
ing details and diversity may improve economic analysis not merely by
‘drawing the models closer to reality’ and thus increasing their practical
relevance, but also by delivering empirical data for testing hypotheses,
serving as a source of inspiration for new theories, and allowing the cor-
rection of the analyst’s home-country bias (De Geest and Van den Bergh
2004, p. xiii).
2. Law, Doctrine, and Philosophy

This section provides an overview of the legal rules on duress and briefly
comments on the relevant doctrinal and philosophical literature.
2.1. Legal Rules and Doctrines

Virtually all legal systems impose threshold conditions for the making of
enforceable contracts (Kötz 1997: 136–7, 209–13; Zweigert and Kötz 1998:
428–30; Probst 2001; Fabre-Magnan and Sefton-Green 2004; Schindler
2005). Even the rigid formalities of ancient Roman law, summarised in the
maxim voluntas coacta tamen voluntas est (coerced will is nevertheless a will;
Paulus D. 4.2.21.5), allowed for legal action against the party who forced
another into a transaction by tortuous or criminal conduct (Hartkamp
1971; Zimmermann 1990: 651–62). Besides incapacity and fraud, the most
common kind of abuse of the bargaining process is when the conduct of
one of the contracting parties has been subject to threat or actual coercion.
This may impair the enforceability of the resulting agreement.
In order to set aside the contract for duress under common law, tra-
ditionally a threat of bodily injury had to be established. Later, inspired
by the equity doctrine of undue influence, courts widened the scope of the
doctrine so that nowadays duress of a non-physical nature (that is, affect-
ing economic or reputational interests) suffices for the excuse to hold. In
the United States, section 175(1) of the Restatement (Second) of Contracts
provides: ‘If a party’s manifestation of assent is induced by an improper
threat by the other party that leaves the victim no reasonable alternative,
the contract is voidable by the victim’. A similar notion can be found in the

Duress 59
Unidroit Principles (1994) for international commercial contracts. Article

3.9 permits the avoidance of a contract on the ground of a threat which
is unjustified and ‘imminent and serious’ so as to leave the other party no
reasonable alternative. As in modern English law, the threat does not need
to be made against person or property but may also affect the reputation
or purely economic interests of the other party. Similar provisions can
be found in national contract rules of civil law jurisdictions under varied
names. The actual terminology refers to this defect of consent as illegal
threat (for example, in Germany, the Netherlands, and Greece), violence
(in France, Italy, and Spain), well-grounded fear (in Switzerland, Austria),
or force and fear (in Scotland).
Duress can arise in two main contexts: pre-contractual negotiations
and contract modification. In pre-contractual negotiations, it is a routine
bargaining tactic to exert some pressure on the other party. For the legal
system to discountenance the conduct of the contracting party and the
contract to be set aside, this pressure has to be illegal or illicit, as well as
of a certain magnitude. For example, threatening to abuse a dominant
position in the market (as far as contract law is concerned); to beat or
kill someone; to impound the goods of someone; or to get someone put
behind bars by perjury, are unacceptable bargaining tactics which make
the resulting contract voidable or void (Kötz 1997; Eidenmüller 2007).
Duress cases also concern the modification of contracts when one of the
parties to an existing contract wants it modified, and backs his wish with
a threat that otherwise he will not perform at all. If the threat is credible
and in fact acted upon, the other party has the option to sue for breach
of contract. But often this is not a realistic or expected response of the
coerced party. Rather, he gives in to the pressure, agrees to the modifi-
cation, and later wants to be excused from performing under the modi-
fied terms. Courts then take into account a number of circumstances in
deciding whether he is allowed to avoid his agreement on the ground of
duress (Kötz 1997; Hillman 1979). An ex post consideration is given to
such diverse circumstances as whether he gave in under protest or without
struggle; whether he (alternatively, an average person or a person with
exceptional firmness) could have been expected to stand firm and sue; the
time allowed to consider the suggested modification; his acquiescence or
otherwise after the modification; and the reasonableness of the modifica-
tion. Common law courts traditionally also had to inquire whether there
was ‘fresh consideration’ for the new promise. As discussed later in this
chapter (section 3.7), the extensive economic literature on the holdup
problem and contract renegotiation suggests rather different criteria for
determining whether the modification should be enforced.
The law usually imposes sanctions both when the coercer creates a

desperate situation for the other party and when he merely exploits the
necessity of the other (for this distinction see section 3.6 below). A special
variant of the latter case is when the threat originates from an identifi-
able third party. This case is again regulated differently in national legal
systems, depending on the state of mind (‘good faith’) of the other party
and the seriousness or imminence of the threat (Kötz 1997: 212–13).
As to the remedies, protection against duress is commonly afforded by
allowing the abused party to avoid the transaction, restoring both parties
to their pre-contractual positions. In other cases, the court does not sup-
press, but rather modifies the contract. As we shall see below (section
3.6), economic analysis provides a justification for this distinction in
remedies.
In sum, using a rather varied terminology, legal systems follow either
a means-oriented or a result-oriented approach to duress, or combine
the two. Means-oriented systems focus on the conduct of the coercer
(wrongdoer), especially on the nature of the threat as illegal, unwarrant-
able, unlawful, or immoral. Result-oriented systems focus on the effect of
coercion on the coerced party (victim), and specifically on the quality of
the fear induced; the reasonableness of the victim’s conduct in face of the
threat; and the presence or absence of reasonable alternatives.
When judges provide relief or render a contractual clause unenforce-
able, their reasoning is often difficult to analyse even in terms of the doc-
trinal categories of the very system the court is bound to interpret. When
it comes to practical applications, the function and domain of different
legal doctrines is much less neatly separated than in theory. As doctri-
nal boundaries are neither clear nor uniform, this chapter also covers,
along with duress in the narrow sense, contract law doctrines which are
sometimes used for similar purposes as duress. These different but related
doctrinal categories include necessity (when one party takes advantage
of the desperate situation of another), undue influence (one party abuses
a position of trust or confidence), and certain types of procedural uncon-
scionability (when the consent of one party is impaired). The doctrine of
economic duress (the exploitation of necessity) will also be covered. This
last doctrine was developed in England in the 18th century, to play a major
role in the judicial control of contracts in the 20th century. As Dawson
reconstructed (1947: 267–76), the main reason English courts developed
the common law doctrine of economic duress was to bar the enforcement
of credit contracts of ‘expectant heirs’ (young aristocrats with a tendency
to spend over their means), thus hindering their ability to take up large
credits with their family estate as security. Initially, judges were motivated
by and often made explicit reference to the policy purpose of conserving
certain social structures through maintaining real estate in the hands of

Duress 61
the aristocracy. Later, especially since the mid-20th century, economic

duress has been used to void contracts which, in the court’s view, resulted
from ‘structural inequality’ or the ‘inequality of bargaining power’. Below
(section 3.9) we will focus on this broader interpretation of economic
duress.
2.2. Juristic (Doctrinal) Theories

The so-called ‘classical theory of contract’ or ‘will theory’ was based on
the fundamental premise that a contract is the expression of the free will
of two consenting individuals (Gordley 1991). The binding force of a con-
tract derives from the mutual assent of the parties, that is, ‘the meeting of
their minds’. Starting from the 18th, dominant in the 19th, and still influ-
ential well into the 20th century, the will theory held that contract is an
expression of the concordant wills of two autonomous individuals.
In doctrinal literature, duress has been classified traditionally as a defect
of consent (‘overborne will’ theory). The classical theory of contracts
interpreted duress as one of the necessary conditions for the functioning
of the actual free will of the parties. More sophisticated juristic theories
accounted for the defects of voluntariness in contract formation, such
as mistake, fraud, and duress as the ‘constitutive limits’ of freedom of
contract (Kennedy 1982; Stewart 1997).
More or less influenced by these theories, national contract laws
developed elaborate rules for checking the voluntariness of contractual
agreements. While full voluntariness is an unattainable ideal, the consent
of an individual can be considered substantially voluntary if three condi-
tions are fulfilled (Pope 2004: 711–13). The individual is (1) in possession
of an abstract capability of making choices (even if the decisions are
foolish, unwise, or reckless, they can still be attributed to an autarchic
subject); (2) substantially free from controlling external influences such
as coercion, threat, or manipulation; (3) substantially free from epistemic
defects such as ignorance of the nature of one’s conduct or its foreseeable
consequences. These conditions, in turn, can be linked to different legal
doctrines regulating the validity of contracts. The rules of incapacity are
supposed to regulate that only people being capable of making choices (in
the above-mentioned abstract sense) can conclude a valid contract. The
contract law rules on fraud, duress, and undue influence serve to guaran-
tee the lack of certain external controlling influences. Substantial freedom
from epistemic defects is taken care of via rules on unilateral mistake,
mandatory disclosure, and other rules making consent more deliberate.
These rules, technically called formation defences, can be found among the
basic contract provisions of practically every civil code and of the common
law as well.

However, as argued by many (starting with Savigny in the early 19th

century; cf. Eidenmüller 2007: 23–4), coercion is not primarily a matter
of voluntariness. Even in the textbook example of entering into contract
under a your-money-or-your-life-type threat (signing an agreement at gun-
point), it is not the actual consent that is lacking: the victim of coercion is
acting voluntarily in the sense of evaluating his reasons for action. If such a
threat is illegal and the contract is void for duress, this is because of a nor-
mative judgement about the quality of the choices available to the coerced
party. Most coerced transactions are not lacking consent: rather they are
instances when either consent is obtained improperly or the alternatives
available for the coercee are such that consent has a different moral weight
than under normal circumstances. The ‘overborne will’ theory presents an
implausible picture of what happens to a person subject to duress.
What voluntariness means in a given contract formation setting is not
always easy to discern. Suppose there is full information, neither party
is subject to cognitive deficiencies and the contract is complete. In such
a case, the question is whether the constrained choice set of one party
renders his consent ‘involuntary’. If it does, then practically every contract
is ‘coerced’ because of the scarcity of resources and opportunities. On the
other hand, except for extreme cases such as actual physical force, psychic
torture or hypnotic trance, almost every exchange can be viewed as volun-
tary in the psychological sense of reflecting the choice of the individual.
Ultimately, the seemingly simple question of what constitutes volun-
tary consent is not a factual but a normative matter. The question is how
low or high the threshold of legally (or morally) acceptable constraints
on individual choice should be set. Traditional duress doctrine sets this
baseline relatively low so that only threats to the physical security of a
contracting party are considered to be below the threshold. When threats
to the reputation or the non-material interests of the party also establish
duress, the threshold is drawn somewhat higher. If legal doctrines are not,
is philosophy in a position to answer this normative question?
2.3. Philosophical (Moral) Theories

Political and legal philosophy have been traditionally interested in both
conceptual and normative aspects of coercion, be they political or private.
The current mainstream approach in analytical philosophy strives to
conceptualize coercion as an action-directing action which eliminates or
makes worse the alternatives available for the coerced party, thus chang-
ing his balance of reasons in a way preferred by the coercer. Starting with
the classical article by Nozick (1997 [1969]), philosophical analysis has
been concerned with drawing a distinction between (illegitimate) threats
and (legitimate) offers. While threats reduce the possibilities open to the

Duress 63
recipient of the proposal, offers expand them. Philosophers concentrate

their efforts on identifying those proposals or directives which count as
coercive and are, on this account, morally problematic (see, for example,
Wertheimer 1987; Honoré 1990; Smith 1997; Bigwood 1996; Stewart 1997;
Brady 1999; Taylor 2003; Owens 2007).
One of the difficulties with this approach is related to the specification of
a baseline against which the proposal is to be measured. The positioning
of this baseline is not self-evident. It may be statistical (what the offeree
can reasonably expect), empirical or phenomenological (what he in fact
expects) or moral (what he is entitled to expect). Whichever position is
taken, ‘the distinction between threats and offers depends on whether it
is possible to fix a conception of what is right and what is wrong, and
to determine what rights people have in contractual relations independ-
ent of whether their contracts should be enforced’ (Trebilcock 1993: 80).
While philosophers suggest broader theories to answer these questions,
economic analysts who are sceptical about this prospect criticise the
philosophical approach to coercion as irrelevant, indeterminate or incon-
clusive, and suggest economic interpretations instead (Trebilcock 1993:
78–101; Craswell 1995; Bar-Gill and Ben-Shahar 2005).
3. Economic Theories
The existing law and economics literature on duress focuses on two main
questions. On the one hand, it provides an explication of the various rules
and doctrines applied by courts, by identifying functions or goals they
serve within contract law. In this explanatory mode, economic analysis is
concerned with the impact of the duress excuse (under this or that inter-
pretation) on efficiency and distribution. On the other hand, economic
analysis also works out what efficiency as a normative criterion suggests
as the best way to deal with those problems that legislators and courts
are striving to solve with the help of duress and related doctrines. In this
evaluative mode, law and economics scholars criticise and eventually
suggest changes to the existing legal rules so as to bring them closer to the
normative goals contract law is supposed to serve.
3.1. The Private Ordering Paradigm

Freedom of contract is an ideologically charged notion which attracts
strongly held political views amongst both defenders and critics. Modern
Western legal orders attach a high value to freedom of contract by consid-
ering it a basic legal principle. Modern legal orders also set several limits
to this freedom, going well beyond punctual exceptions. The primacy
of autonomy has been traditionally supported by mainstream economic
theory as well. In neoclassical economics the

predilection for private ordering over collective decision-making is based on

a simple (perhaps simple-minded) premise: if two parties are to be observed
entering into a voluntary private exchange, the presumption must be that both
feel the exchange is likely to make them better off, otherwise they would not
have entered into it. (Trebilcock 1993: 7)
From an economic perspective, this presumption can be rebutted by

identifying either a contracting failure or a market failure. These two kinds
of failure provide an economic justification for the rules and doctrines of
contract regulation (Cooter and Ulen 2008: 232–8). Contracting failures
are problems of individual rationality. They are either cases of bounded
rationality, addressed by the rules on (in)capacity or cases of constrained
choice, addressed by the doctrines of duress, necessity, or impossibil-
ity. Market failures can be explained by three types of transaction costs
and addressed in contract law accordingly. Negative externalities often
justify the unenforceability of contracts which derogate public policy or
violate a statutory duty. Failures deriving from imperfect information are
addressed as fraud, failure to disclose, frustration of purpose, or mutual
mistake. The third type is structural or situational monopoly which leads
to the lack of competition, and is addressed by doctrines such as necessity,
unconscionability or lésion.
The operation of a modern market economy relies on freely negotiated
enforceable contracts. This not only requires, but implicitly assumes some
‘constitutive limits’ on freedom of contract (Kennedy 1982), namely those
minimal limitations which are necessary for the working of even a liber-
tarian (unregulated) contract regime. As Milton Friedman put it: ‘The
possibility of coordination through voluntary cooperation rests on the
elementary – yet frequently denied – proposition that both parties to an
economic transaction benefit from it, provided the transaction is bilater-
ally voluntary and informed’ (Friedman 1962: 13). This quote shows once
again how one of the most basic insights of economics rests on a standard
of voluntariness. As long as this standard cannot be substantiated within
economic theory itself, it refers back to law, philosophy or common
sense.
Law and economics scholars typically hold the view that economic
analysis should rely neither on doctrinal nor on philosophical accounts
of duress. Either criticising or ignoring doctrinal and philosophical
approaches, they strive for a distinctively economic interpretation of
duress. Their ultimate aspiration is not conceptual or explanatory though.
Rather, they are more or less directly involved in a normative analysis of
where to set the limits of freedom of contract (Kronman 1980; Buckley
1991; Trebilcock 1993: 78–101; Craswell 1993, 1995; Esposto 1999; Bar-
Gill and Ben-Shahar 2004a, 2004b, 2005; Buckley 2005: 148–51, 154–5;

Duress 65
Basu 2007; Hermalin et al. 2007: 54–5; Posner 2007: 115–18; Shavell 2007;
Cooter and Ulen 2008: 281–7).
3.2. Economic ‘Definitions’ of Duress: Incentive-based Theories

Duress thus provides a constitutive limit to the private ordering para-
digm. From an economic perspective, it refers to one class of cases when a
contract is most probably not welfare-enhancing and therefore should be
presumably void.
In their textbook, Cooter and Ulen (2008: 281–4) characterise duress
along similar lines. In their view, duress is a threat to destroy value (‘Pay
me $3000 or I will shoot you.’). It should be distinguished from bargains
where one party threatens not to create value (‘$3000 for my car is my final
offer, take it or I walk away.’). This distinction has two aspects. First, the
two types of threat differ in what happens when bargaining fails. In the
first case, failure to agree leads to destruction. In the second case, failure to
reach a bargain results in a failure to create a cooperative surplus. Second,
while successful bargains tend to create value, contracts concluded under
duress tend to shift resources from one person to another. In sum, Cooter
and Ulen suggest the following economic interpretation of duress: a
promise should be enforceable if it was extracted as the price of one’s
cooperation in creating value; a promise should be unenforceable if it was
extracted by a threat to destroy value. In order to deter destructive threats,
contracts made under duress should not be enforced.
Most economic theories are concerned with the incentive effects of the
duress doctrine. By and large uncontroversial are the cases of actual or
threatening physical or psychic coercion by the other party. Here, legal
rules, moral intuitions, and economic theory equally suggest the non-
enforcement of such contacts, be it for retribution, prevention or for
some other reason. In economic terms, voiding a contract concluded at
gunpoint is efficient because it maximises social welfare.
A points a gun at B saying, ‘Your money or your life’; B accepts the first branch
of this offer by tendering his money. But a court will not enforce the resulting
contract. The reason is not that B was not acting of his own free will. On the
contrary, he was extremely eager to accept A’s offer. The reason is that the
enforcement of such offers would lower the net social product by channelling
resources into the making of threats and into efforts to protect against them.
(Posner 2007: 115)
The main argument of the incentive theory is this: the non-enforcement

of contracts concluded under duress deters potential coercers from threat-
ening with socially wasteful coercion, as well as economizes on preventive
measures on the part of potential victims of coercion. In terms of this

incentive theory of duress, anti-duress rules have the function of discour-

aging parties from taking excessive and wasteful precautions against being
subjected to extortionate contractual terms. To put it another way, the
economic justification of the duress doctrine ‘is found in the phenomenon
of rent seeking: . . . we wish to discourage investments in coercion or
against coercion’ (Hermalin et al. 2007: 54).
In general, rules against duress ‘guarantee that resources remain in the
hands of the highest-value user’ (Esposto 1999: 145). Even if involuntary
transfers might improve the allocation of resources in particular cases,
if they were tolerated or supported by law as a rule, this would induce
people to insure and defend themselves against coercion privately. This,
in turn, would be undesirable because it would be more costly than public
law enforcement. The incentive effects generated by the non-enforcement
of certain contracts provide the ultimate criterion as to which threats
should or should not be discouraged. By assessing the welfare effects of
investments in threats and in precaution against threats, the theory relies
on assumptions about the relative costs of private and public measures
against coercion. To the extent that these variables are quantifiable, the
theory can also be tested empirically.
Instead of conducting an empirical analysis, economists usually refer to
relatively simple criteria or particular narrower contexts as to when non-
enforcement is economically justified. Based on such considerations, some
commentators claim that the criteria applied by courts roughly correspond
to what economic analysis would dictate (Shavell 2007). Thus the incen-
tive effects of the duress doctrine justify the voiding of contracts where one
party deliberately created (‘engineered’) the lack of adequate alternatives
for the other. Still, ‘[n]ot every threat will ground a claim of economic
duress. . . . For example, a seller’s assertion of a right to withdraw from
negotiations is a threat of non-contracting. Were it to constitute economic
duress, property owners would be required to sell their goods to anyone
who offered a derisory price for them. Since this would destroy property
rights, a distinction must be made between permissible threats and eco-
nomic duress’ (Buckley 1991: 38). In still other scenarios the net incentive
effect is less straightforward: here both legal rules and commentators’
views diverge. Besides ‘economic duress’, this applies to necessity and
contract modification. In these cases, discussed in more detail below, the
validity of an ex ante welfare-enhancing transaction is at stake.
To illustrate the divergent views, Anthony Kronman argued for a ‘mod-
ified Paretian approach’, in terms of which a coerced contract should be
enforced when the enforcement of the same kind of contract would make
most parties better off (Kronman 1980). In other words, Kronman ‘would
ask whether the welfare of most people who are taken advantage of in a

Duress 67
particular way is likely, in the long-run, to be increased by permitting the

kind of advantage-taking in question in the particular case’ (Trebilcock
1993: 82). To note, this approach reverses the conventional argument
of economists for voluntary exchanges and private ordering (volun-
tariness implies welfare-improvement): in order to establish whether a
certain transaction should be considered voluntary, one has to address its
hypothetical welfare effects.
In his The Limits of Freedom of Contract, Michael Trebilcock argued
that the enforceability of a coercive contract should be decided by asking
the following question (‘literal Pareto principle’): ‘Does this transaction
render both parties to it better off, in terms of their subjective assessment
of their own welfare, relative to how they would have perceived their
welfare had they not encountered each other?’ (Trebilcock 1993: 84).
For instance, even if an offer is exploitative in the sense that the contract
divides the gains from cooperation very unequally, as long as both parties
gain from the contract, the literal Pareto principle would dictate that it
should be upheld.
This approach has to face some difficulties too. As subjective assessments
of welfare are difficult to prove in judicial procedures, at the end of a complex
line of argument, Trebilcock tends to take the transactions on a relevant
competitive market as the normative benchmark for establishing whether
the coerced transaction should be enforced. ‘The competitive market price
functions in Trebilcock’s account not just as a measure of the substantive
fairness of the bargain, but as a determinant of the voluntariness of the
transaction’ (Stewart 1997: 230). For this comparison to work in practice,
one needs data about the prices on an actual, relevant, and essentially com-
petitive market. Another concern is that while the competitive market price
is arguably the closest practical measure of objective value in such situations,
it is at best correlated with the subjective welfare of individuals.
More generally, when economic theories focus on the effects of duress
rules on future contracts, they completely disregard the particulars of the
interaction between coercer and victim (Stewart 1997: 224–5). The reason
for this neglect of the particulars lies in the ex ante perspective of economic
analysis and its focus on questions of institutional design. Economic theo-
ries provide a prima facie case for freedom of contract: unless transaction
costs and information imperfections are prohibitive, individual exchanges
and the private ordering are preferable to the forced transfer of wealth, be
it through individual coercion or government redistribution. In the excep-
tional cases when voluntary transactions are impossible or impracticable,
tort law or the rules of restitution and unjust enrichment should provide
proper incentives (Calabresi and Melamed 1972; Bouckaert and De Geest
1995; Wonnell 2000).

3.3. Shavell: Duress as Holdup

In recent years, at least three further particular ways have been suggested
to re-conceptualise duress in economic terms. In the following sections,
these approaches are briefly discussed in turn.
In economics, the term most commonly used to capture duress and
necessity is holdup. Besides information asymmetry and externalities,
holdup situations provide a third general economic justification for limit-
ing freedom of contract (Shavell 2007). From an economic perspective,
duress, necessity, usury, contract modification, and several other problems
all represent cases of holdup and raise some common concerns.
Shavell’s analysis of contractual holdup (2004: 235–7; 2007) focuses
on the incentive effects of holdup and of legal intervention, as well as the
welfare effects of risk-bearing. His model has a clear normative starting
point: law should minimize social costs: ‘the costs of any efforts made prior
to the occurrence of situations of need, the costs of furnishing aid in situa-
tions of need, losses sustained in situations of need, and risk-bearing costs
where parties are risk averse’ (2007: 330). Shavell then identifies five incen-
tives generated by the possibility of holdup (2007: 330–31). First, holdup
can lead contractors to invest in wasteful efforts to engage in holdup.
Second, it can lead victims to invest in inefficient precautions to avoid
holdup or mitigate its consequences. Third, it can dilute the motivation of
potential victims to invest in socially beneficial activities. Fourth, holdup
may also represent a significant risk to risk-averse potential victims. On
the other hand, enforcing contracts with high holdup prices has a possible
socially beneficial effect by giving incentives to search for victims in situa-
tions of need, and to make related investments. Shavell then distinguishes
two scenarios: engineered and non-engineered holdup (2007: 325–6). The
first refers to the case when A creates an opportunity for himself to exploit
B. The second refers to the case when A does not create but only exploits
the necessity of B.
Based on a formal model, Shavell then argues that, in these terms, con-
tractual holdup may justify legal intervention. In the case of engineered
holdup, the contract should be voided since that will remove the prospect
of profit from it. In case of non-engineered holdup, for example a rescue
situation on the high seas, cost-minimisation would dictate price control.
‘In these circumstances, the policy of controlling the contract price is
preferable, as that policy can reduce the problems of holdup but still
allow contracts to be made’ (2007: 326). Although such administrative or
judicial price control faces severe practical difficulties, Shavell claims that
courts in practice solve holdup problems both in fresh contracts and in
contract modifications roughly along the lines suggested by his economic
model. We will come back to non-engineered holdup in section 3.6.

Duress 69
3.4. Bar-Gill and Ben-Shahar: Credibility Theory

Recently, in a series of papers, Oren Bar-Gill and Omri Ben-Shahar
(2004a, 2004b, 2005) have argued that the credibility of threats should be
the key variable in determining whether contracts concluded under threat
should be enforced. At the same time, they have criticised both philosophi-
cal commentators and legal doctrine for neglecting the issue of credibility
and in this way worsening the conditions of victims.
According to their approach, the
enforcement of an agreement, reached under a threat to refrain from dealing,

should be conditioned solely on the credibility of the threat. When a credible
threat exists, enforcement of the agreement promotes both social welfare and the
interests of the threatened party. If agreements backed by credible threats were
not enforceable, the threatening party would not bother to demand a conces-
sion, and would simply refrain from dealing – to the detriment of the threatened
party. The doctrine of duress, which predominantly controls such agreements,
only hurts the ‘coerced’ party. By denying enforcement in cases where a credible
threat exists, duress doctrine precludes the threatened party from making the
commitment that is necessary to reach agreement. Paradoxically, it is in those
circumstances where a threatened party has no alternative options or adequate
remedies that, under duress doctrine, she cannot secure an agreement. (Bar-Gill
and Ben-Shahar 2004a: 391)
Their model leads to the radical conclusion that ‘ex-post anti-duress meas-
ures, rather than helping the coerced party, might in fact hurt her. . . .
Anti-duress relief can be helpful to the coerced party only when the threat
that led to her surrender was not credible, or when the making of threats
can be deterred in the first place’ (Bar-Gill and Ben-Shahar 2005: 717).
This result is driven by how the authors model legal intervention. They
compare ‘the policy of enforcing [the contract or the] modification at the
agreed price with the policy of flat voiding of [the contract or] the modifi-
cation, not with the policy of price-conditioned voiding. . . . But if courts
can pursue a policy of price-conditioned voiding, courts can lower the
price without [removing the incentive to contract when it is socially ben-
eficial or, in the context of modification, without] causing breach’ (Shavell
2007: 340 n. 23).
3.5. Craswell: Institutional Competence

Richard Craswell, one of the few law and economics scholars open to
a serious dialogue with philosophers, has taken an ambitious approach
to contract rules, with interesting implications for duress. Craswell does
not attack philosophical theories of contractual duress frontally; rather,
he questions their relevance for legal policy. He argues that while these
theories are concerned with the philosophical justification of the morally

binding force of contracts (promises), they have ‘little or no relevance to

those parts of contract law that govern the proper remedies for breach, the
conditions under which the promisor is excused from her duty to perform,
or the additional obligations (such as implied warranties) imputed to the
promisor as an implicit part of her promise’ (Craswell 1989: 489). In short,
he claims that pure autonomy-based theories are indeterminate on impor-
tant aspects of contract law.
A related idea by Craswell concerns what he calls relative institutional
competence. He suggests that instead of waiting for philosophers to deter-
mine by abstract reasoning whether a contract was concluded voluntarily
or not, policy-makers should look at the capacities and competences of
the legislator, the judiciary and the contracting parties on the one hand,
and the available and desirable remedies on the other. Competence and
remedies, in turn, should determine the enforceability or otherwise of
the contract (term) in question. In this setting, the relevant question is
whether legislators or judges and juries have the resources, especially the
expertise to assess (establish, measure, qualify) the variables that a theory
of legislation or adjudication would require them to do.
Methodologically, Craswell’s analysis builds on the property rule–
liability rule framework suggested by Calabresi and Melamed (1972).
Adapting this framework to contract formation problems, he suggests
that in order to determine whether a contract was concluded voluntarily
or not, one first has to look at the remedies available, and then infer back
to the enforceability of the problematic term. A property rule protection
of contractual consent would mean that the contract is either enforced or
voided (unenforceable). A liability rule protection would mean that the
judge replaces the unreasonable terms with reasonable ones.
Craswell’s radicalism comes from the idea that it is not substantive
issues but the available remedies that determine whether a contract term
should be declared unconscionable or a contract should be voided for
economic duress. As far as law is concerned, a contract should be deemed
lacking voluntary consent when and only when the choice among the
available remedies, based on their respective costs and benefits, dictate
that. In determining which way to choose, Craswell explicitly speaks of
two factors: (1) the relative institutional competence of the judge and the
legislator to determine what is efficient; and (2) the position of the party
offering the contract (term) to modify his behaviour.
For duress, this theory implies the following. When A makes B sign a
contract at gunpoint, the availability of remedies dictates that the con-
tract should be voided and B should be protected by property rule. The
reason is that in such situations A can easily change his behaviour and
the circumstances surrounding the contract formation can be proven with

Duress 71
relative ease in front of a judge. On the other hand, when this is not the
case, the contract should be considered voluntary in the eyes of the law. In
some formulations, Craswell goes as far as to suggest that the definition
of duress should be directly based on this comparative analysis of compe-
tence. This would put the discussion in a clearly instrumental framework,
by detaching it from the moral discourse.
3.6. Duress and Necessity

Law usually imposes sanctions both when a coercer creates a desperate
situation for the other by a threat of harm and when he merely exploits the
pre-existing necessity of the other party. From an economic perspective, it
is important to distinguish these two kinds of threats: duress in the narrow
sense and the exploitation of necessity (Cooter and Ulen 2008: 285–7). This
duality of duress and necessity roughly corresponds to Steven Shavell’s
distinction between engineered and non-engineered duress (2004: 235–7),
viz. holdup (2007: 225–6), as discussed above or, in still other terms, to the
distinction between the endogenous (duress) and the exogenous (necessity)
origin of the dire situation (Bar-Gill and Ben-Shahar 2005).
Cooter and Ulen contrast duress and necessity in the following way
(Cooter and Ulen 2008: 285). Both constitute dire (as opposed to moder-
ate) constraints (they inhibit rational behaviour) and can therefore justify
promise breaking (non-enforcement). While duress is attributable to the
promisee who is acting in a threatening manner, necessity is attributable
to an action or omission of the promisor which has made his situation
desperate. This, in turn, provides a situational monopoly for the promisee
who can threaten the promisor with destructive inaction. An example of
contracting under necessity is the transaction between a driver running out
of gas on a remote road and a passer-by offering to sell him gas at an exor-
bitant price. They summarise the economic analysis of the two doctrines
as shown in Table 4.1.
While the enforceability of necessity contracts is not regulated as
Table 4.1 Duress vs. necessity
Legal Fact triggering legal Incentive Legal solution

doctrine doctrine (problem) (solution)
Duress Promisee threatens to Deter threats No enforcement of
destroy coerced promises
Necessity Promisee threatens not Reward rescue Beneficiary pays cost
to rescue of rescue plus reward
Source: Cooter and Ulen (2008: 308, table 7.5).

uniformly as duress, the economic literature analyses the regulation of

both types of contract in a similar manner, in light of the goal to minimise
the social costs (Shavell 2007). As discussed above, the main difference is
that the socially beneficial activity of potential rescuers should be incentiv-
ised by rewarding rescue. Models used are similar to standard economic
models of tort law: they take into account the incentive effects of necessity
contracts on the activity level and the level of care by the victim, the rescue
costs, and the investment made by potential rescuers, as well as the welfare
effect of risk-bearing.
There are two main policy recommendations derived from such models
(Cserne and Szalai 2010). First, in contrast to duress, contracts concluded
in necessity may increase social welfare (rescue may reduce net social
losses). Such contracts should not be declared void. Rather, an ex post reg-
ulation of the contract price is suggested. Second, the contract price should
reflect whether the other party (the rescuer) invested ex ante in increasing
his capacity to rescue or came to help the one in necessity accidentally.
Professional rescuers should be compensated with a higher reward.
By focusing on the latter issue, Cooter and Ulen distinguish three types
of rescue: fortuitous, anticipated, and planned (Cooter and Ulen 2008:
285–7). In order to give the right incentives for rescue in the three cases,
an increasing amount of rescue reward is required. Fortuitous rescue
uses resources that were available for the rescuer by chance. This is the
case with a passer-by who happens to have a full tank when he meets
the desperate driver and then offers to sell the driver some of his gas. In
this case, the rescuer needs to be compensated for the resources actually
used in order to ensure that he prefers to rescue the victim rather than
drive off. Anticipated rescue uses resources that were deliberately set
aside ex ante, in case they were needed for rescue. This is the case of a
passer-by who carries an extra five-gallon can of gas in case he runs into
stranded drivers. Anticipated rescue requires a larger reward in order to
give incentives for potential rescuers to set some resources aside ahead of
time. Finally, planned rescue is provided by someone who is deliberately
looking for people to rescue. This is the case with a patrol service set up
to rescue travellers who have run out of gas in remote areas. As planned
rescue requires active searching for people in distress as well as large
ex ante investments, this is the most costly of the three kinds of rescue.
Consequently, it requires the largest reward.
Shavell’s model (2007) also implies that if the contract price is higher
than the costs of the rescue plus a small reward, it should be reduced to
this amount. While this policy conclusion seems to be in line with how
some actual legal orders regulate the matter, it can be shown that cost-
based price control is optimal only in very specific circumstances (Buckley

Duress 73
2005: 194 n. 40, Cserne and Szalai 2010). More comprehensive models
suggest that the minimisation of the social costs of necessity may require
a significantly higher contract price. Price control in general, and cost-
based contract pricing in particular, only lead to efficiency under specific
assumptions.
3.7. Duress in Contract Modification

Besides bargaining for a ‘fresh contract’, duress is also relevant for the
modification of contracts. As discussed above, many contract modifi-
cations are entered into under circumstances where one of the parties
is dissatisfied with the original contract and is threatening to breach.
While the underlying economic considerations are similar, both the con-
tractual techniques available to handle the issue and the legal doctrines
regulating contract modification significantly differ in the two contexts.
Economists usually focus on how the parties can design an optimal
contract which is opportunism-proof, that is, only allows for renegotia-
tion when it is welfare-increasing. ‘In many circumstances, parties will
be reluctant to make specific investments in settings in which contract
renegotiation is possible; accordingly, it is, in principle, beneficial for
them to commit not to renegotiate if they can credibly do so’ (Hermalin
et al. 2007: 55).
From a law-and-economics perspective, the main issue about contract
modification is how the law should distinguish welfare-decreasing duress
from welfare-increasing adaptation of the contract to changed circum-
stances. In general, when a contract is renegotiated under duress, the
modification should not be enforced; if the contract is renegotiated under
changed circumstances, enforcement is efficient (Muris 1981; Aivazian et
al. 1984; Graham and Pierce 1989; Jolls 1997; Triantis 2000; Hermalin et
al. 2007: 55).
An example of duress in contract modification is the American case
Alaska Packers’ Association v. Domenico [117 F. 99 (9th Cir. 1902)]. The
captain of a boat hired a crew in Seattle for a fishing expedition to
Alaska. Once they reached Alaska, the crew demanded a substantial
wage increase. After their return to Seattle, the captain refused to pay the
higher wages, one of his claims being that the agreement to pay them was
made under duress. While the court justified its decision with the doctrine
of consideration, an economic reconstruction of the case would focus on
whether such contract modifications are welfare-increasing. The crew,
being in a situational monopoly, was threatening to destroy the value of
the captain’s investment if they did not get a wage increase. When a party
makes specific investments in the initial contract, she becomes vulner-
able to holdup in case of contract modifications. In such cases, efficiency

dictates that opportunistic modifications should not be enforceable.

On the other hand, to modify the example above, if circumstances had
changed in such a manner that the crew had to work more (for example,
because weather conditions deteriorated), their request for higher wages
should have been enforceable. In most modern legal systems, ‘a modifica-
tion made in proportionate response to new circumstances, unanticipated
at the time of contracting, would generally be enforced, while an outright
attempt to rewrite the original terms of the bargain would not’ (Hermalin
et al. 2007: 55).
3.8. Unconscionability – a Proxy for Duress?

A number of legal systems allow for the judicial control of contractual
fairness. Although such control is performed under different doctrinal
labels in different legal systems, it has two basic aspects: procedural and
substantive (Hatzis and Zervogianni 2006). The former (in American
terminology: procedural unconscionability) refers to the absence of a
meaningful choice by one party; the latter (substantive unconscionability)
refers to an allocation of the risks and burdens of the contractual bargain
which is unexpected or objectively unreasonable. While many commenta-
tors have criticised the unconscionability doctrine generally and substan-
tive judicial control particularly, a number of law and economics scholars
have argued that to the extent that the doctrine is interpreted as a proxy for
involuntariness in contract formation, it is justified economically (Epstein
1975; Schwartz 1977).
Richard Epstein interprets the unconscionability doctrine in this way.
Inefficient (welfare-reducing) contracts should not be enforced. Duress
provides a presumptive evidence of some underlying problem that justifies
the non-enforcement of the contract, but duress is sometimes too hard
to prove directly. If the consent was defective but due to the evidentiary
burden, some technicalities or practical difficulties of proof, the require-
ments of the duress defence are difficult to meet, unconscionability can
provide relief. As an empirical generalisation, gross disparity or value
inequality between the two parties’ performances may signal involuntari-
ness. Based on this generalisation, duress might be ascertained indirectly
through a combination of procedural and substantive fairness rules
(Epstein 1975).
Some American courts interpret the inadequacy of consideration in
a similar vein, as a proxy for some formation defect. ‘[I]nadequacy of
consideration is always potentially relevant as circumstantial evidence of
duress, mistake, fraud, or some other ground for setting aside a contract.
The less adequate it is, the stronger the evidentiary effect will be’ (Posner
2007: 101).

Duress 75
3.9. Economic Duress, Exploitation, and Fairness

There are many kinds of pressure on a person entering into a contract: the
law has to determine which are serious enough to authorise the claimant to
avoid his contract. As discussed above, when allowing formation defences
such as duress, the law may be more or less lenient. While the normative
justification of the duress doctrine is less problematic within its traditional
narrow boundaries (that is, when threat or actual coercion was used), it is
more controversial whether the doctrine should be used for paternalistic
purposes or to promote substantive fairness and ambitious policy objec-
tives, such as redistribution. In one view, the doctrine of duress should
protect the conditions of an autonomous choice only. Others argue that
the range and quality of opportunities available to the contracting parties
should also matter. Looking at the case law, the boundaries of the duress
doctrine are also relatively unclear (Giesel 2005).
In particular, it has been discussed in the legal literature for several
decades under what circumstances the law should void contracts for ‘eco-
nomic duress’ (Hale 1943; Dawson 1947). This is a particular instance of
the normative question indicated above as to where to draw the threshold
of voluntariness. To simplify a bit, the alternative is the following. Should
the ‘non-coercive exploitation’ (Feinberg 1983) of economic necessity
trigger the remedies for duress? Or should the lack of alternatives for
one contracting party, rather, count among those ‘legitimate inequalities
of fortune’ (Feinberg 1986: 196–7) that contract law should be neutral
towards?
Philosophically minded commentators who base their definition of
duress on the moral evaluation of the coerciveness of individual actions
sometimes argue for a broader construction of duress, implying a larger
regulative role for courts (for example, Zimmerman 1981; Radin 1996). To
recap, the main argument in the philosophical approach to coercion is that
the consequences of an exercise of autonomy depend on the opportunities
available to the individual. On this basis, many autonomy theorists argue
that what is called economic duress, that is, the lack of alternative ways to
procure income, should be considered a case of coercion.
While economic analysis cannot provide a definitive answer to this
question, it nevertheless provides arguments for a narrow construction
of the duress doctrine. These arguments refer, inter alia, to the long-term
incentive effects of invalidating contracts which are both ex ante and
ex post inefficient, and to the inadequacy of contract law for systematic
redistribution. We will focus on the first argument.
It follows from the very binding nature of contracts that the realiza-
tion of a previously known risk or in other words, ex post regret is not a
sufficient reason to allow withdrawal. From an economic perspective, the

question is about Pareto efficiency: if the transaction rendered both parties

to it better off, in terms of their subjective assessment of their own welfare,
relative to their position before their encounter, then the contract should
be held valid. Thus, regardless of the range of opportunities, when the
contract has improved the situation of the person in economic hardship,
the contract should be upheld.
Those who argue that individuals are entitled to some minimum level of
economic well-being or that certain resources should not be the subject of
contractual exchange and infer that the law of contracts should invalidate
contracts when the scope of choice for one party is limited by economic
deprivation, forget at least two things. The first is that invalidation is
not the only remedy available. Price control, administrative or judicial,
may be alternatives. The other point is related to what Margaret Radin
(1996), in a slightly different context, called the double bind effect. This
term refers to the problem that in many cases the prohibition of a trans-
action may actually worsen the plight of the individual whose welfare is
the central concern. For example, banning prostitution may eliminate an
income-earning option for poor women. Even in a case of deprivation,
one can say that the opportunity of choice does not reduce, but rather
increases, the individual’s welfare, relative to the other options available.
On the other hand, prohibition is unlikely to increase the welfare of those
concerned, and it ‘will almost never have the effect of enlarging the avail-
able choice set’ either (Trebilcock 1995: 374). If the normative criterion of
contract enforcement is based on individual preferences, then invalidating
contracts for ‘economic duress’ (or ‘exploitation’ or ‘commodification’) is
arguably an instance of unjustified paternalism or moralism.
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5 Gratuitous promises
Robert A. Prentice
1. Introduction
The ‘first great question of contract law’ is why some agreements
are enforced and others are not (Eisenberg 1979: 1). Standard Anglo-
American common law contract doctrine requires consideration for legal
enforceability of promises. Consideration is premised upon the notion of
reciprocity: something of value in the eyes of the law must be exchanged
for the promise to be enforced (Beale 2008: 3–4). Thus, the presence of a
bargained-for exchange formally demarks the critical fault line between
enforceable and unenforceable promises. Promises that are the product
of a bargained-for exchange are presumptively enforceable. Presumptive
unenforceability attaches to mere gratuitous promises, even if it is indis-
putable that their makers well considered and seriously intended them. In
the US, putting such a promise in writing or even under seal will not make
it enforceable (Farnsworth 2000: 396), which contrasts with the result in
civil law systems. Civil law systems tend to enforce gratuitous promises,
at least if certain formalities are observed, absent changed circumstances
such as ingratitude by the promisee or impoverishment of the promisor
(Dawson 1980: 29–196).
Naturally the common law recognizes exceptions which authorize
enforcement of certain promises in the absence of consideration. One
major exception arises from a promisee’s foreseeable reliance. The doc-
trine of promissory estoppel is very important, but outside the scope of this
discussion. Another significant exception involves charitable subscrip-
tions. A few other exceptions are occasionally allowed, such as firm offers
to sell goods under US law and promises under seal in Anglo-Canadian
law. Absent a recognized exception, gratuitous promises will not be
enforced even though courts will refuse to undo a completed gift.
This discussion will focus primarily upon the most-explored subset of
gratuitous promises – donative or gift promises. Other gratuitous prom-
ises, such as uncompensated contract modifications, will receive only brief
discussion, consonant with their treatment in the law and economics lit-
erature. Exploration of the economics of this issue is a bit of an academic
exercise because the courts that established current legal doctrine seldom
used explicit economic reasoning in doing so. Furthermore, the con-
scious economic analysis that has been brought to bear on the topic since
80

Gratuitous promises 81
the 1970s has not influenced the state of the law in an observable way.
Nonetheless, whether the notion of exchange that underlies the considera-
tion doctrine should ‘set the boundaries of the law of contract’ remains
an intriguing question (Calamari and Perillo 1977: 135), and economic
analysis has much to add to the search for a satisfactory answer to that
question.
2. The Traditional Rationale

What do bargained-for promises have – and gift promises lack – that leads
courts to enforce the former but not the latter? In 1941, Fuller suggested
the leading traditional (noneconomic) rationale for using the doctrine
of consideration to distinguish enforceable bargained-for promises from
unenforceable gift promises (Fuller 1941: 814–15). Fuller cited reasons of
both form and substance.
Regarding form, the consideration requirement first provides reliable
evidence that a promise was truly made. Second, enforcement of gratuitous
promises is denied as a cautionary matter to encourage proper delibera-
tion by promisors. Finally, consideration serves a channeling function by
aiming donors toward a means of indisputably signaling their intent,
such as by putting the promise under seal in former days, or setting up an
irrevocable trust in more recent times (Gordley 1995: 570).
Regarding substance, Fuller argued that the natural formality of
consideration should be reserved for relatively important transactions
and concluded that if gift promises are not wholly ‘sterile transmissions’
(Bufnoir 1900: 487), they are not far from it and are therefore undeserving
of the full force of the law.
Fuller’s arguments have been found reasonably persuasive, but not
completely satisfying. Consideration is not an impressive form of proof
that a promise was made, yet it remains a requirement for enforcement
even in situations where all parties concede that a promise was indeed
made. Fuller assumed that plaintiffs in gift promise cases are more likely
to lie than plaintiffs in cases involving bargained-for promises. He also
assumed that jurors are more likely to be misled by fraudulent testimony
in cases of gift promises than in cases of bargained-for promises. However,
there is little evidence for either assumption (Kull 1992: 53).
Fuller’s argument in favor of the cautionary function of consideration
rested on the observation that some people make gift promises while in
an emotional state. However, promisors also often act emotionally when
making bargained-for promises (as in the excitement of a live auction), yet
these promises are typically enforced. Additionally, Havighurst sampled
183 cases where promises were denied enforcement for lack of consid-
eration; in only three did absence of deliberation appear to play a role

(Havighurst 1942: 9). In short, there is little or no evidence that gift

promises are typically less well considered than bargained-for promises or
that the doctrine of consideration often plays a cautionary role in actual
cases.
Similarly, the channeling function is arguably no more important
regarding gift promises than bargained-for promises, because there is no
reason to believe that it is an easier matter to determine when a person is
serious about making a commercial bargain than when a person is serious
about making a gift promise (Havighurst 1942: 7). Neither the maker of
a gift promise nor the maker of a bargained-for promise need be capable
of sophisticated usage of the King’s English (or other language) in order
to clearly express his or her intent to be bound, not to be bound, or to be
bound only under certain conditions.
Finally, Fuller’s substantive claim that gratuitous promises do not gen-
erate sufficient social benefit to justify the costs of enforcement is plausible,
but only an assumption. A conclusion that gratuitous promises are merely
sterile transmissions is ‘no more obviously correct’ than the contrary
deduction (Kull 1992: 52).
Thus, the traditional rationale for the courts’ stated refusal to enforce
gratuitous promises is unconvincing on its own terms. Its apparent
shortcomings invited use of an economic lens to reanalyze, critique, and
extend the relevant arguments. Thus, economists have examined the issues
surrounding the consideration doctrine in order to determine if the tradi-
tional refusal to enforce gratuitous promises (with certain exceptions) is
consistent with sound economic principles, to determine whether there are
ways to improve the law, and to illustrate the theory that the law, particu-
larly judge-made law, is significantly shaped by a concern for achieving
efficiency (R. Posner 1977: 416). The remainder of this chapter is devoted
to an exploration of important points made in the relevant literature. The
discussion will disclose that economists have used different approaches,
launched analysis from inconsistent premises, and drawn contrary con-
clusions. Use of economic analysis regarding the issues surrounding con-
sideration often leads to ‘serious indeterminacies’ (Trebilcock 1993: 176).
This should not be surprising in such a complex area.
One caveat: Although economic analysis in this area has assumed
that the state of the law is as summarized above, in English law the
trend is to treat consideration as a formality that should not necessar-
ily prevent ‘finding of a contractual obligation if the requirement of a
common, agreed intention to contract is satisfied’ (Grubb 2007: 246–7).
Moreover, Kull has claimed that in the US, contrary to the stated law,
courts almost always enforce promises that have actually been made and
seriously intended either by manufacturing consideration or by finding

reliance so as to invoke promissory estoppel (Kull 1992: 43). An exten-

sive survey indicates that when US courts do state that a promise is not
being enforced due to lack of consideration, there are almost always
independent reasons unrelated to consideration that actually underlie
the decision (Wessman 1996: 816). Thus, economic analysis of the rule
as stated, but not necessarily as applied, may be all the more academic
in nature.
3. Why Do People Make Gifts?

The motivation of those who make gift promises is relevant to the question
of whether they should be enforced, yet traditional analysis ignored this
foundational question. Economic analysis has most commonly been based
on the assumption that most giving is altruistically motivated. Presumably
‘interdependent utilities’ account for most giving because donors derive
utility or welfare by improving the utility or welfare of others (R. Posner
1977: 412; Shavell 1991: 401). Many people seem to receive a ‘warm glow’
from giving to others (Andreoni 1990: 464).
Importantly, there are also significant nonaltruistic reasons for giving
gifts, although in order to simplify analysis economists and others often
ignore them. Sometimes people give to gain status by demonstrating to
others either that they are wealthy, or generous, or both. Also, people
often give in order to create or enhance trust in furtherance of an exchange
relationship. For example, an employer may signal an interest in establish-
ing a relationship with a job applicant by taking her out for an expensive
meal or may give exchange gifts to an established employee such as a raise
in salary in hopes that the employee will respond by continuing to work
with more rather than less diligence (E. Posner 1997: 567).
4. Why Do People Make Gift Promises?

Traditional analysis also ignores the fundamental question of why, if A
wishes to give something to B, A does not just do so. Why would A merely
promise to give a gift to B at some point in the future rather than giving the
gift now? Economists have pointed out several reasons, including that the
donors’ assets are not currently liquid, the donors may currently be able
to derive a higher rate of return or secure more tax advantages from the
assets than the donees, and the donors may wish to allow for contingencies
that would enable them to change their minds about giving the gift.
Perhaps the most important reason to make a promise of a future gift is
that it conveys information to the donees, allowing them to plan (Shavell
1991: 402). If A promises to give B a house next July, B can cancel plans to
buy a house next week. If X promises to pay for Y’s college education, Y
can quit her part-time job and begin studying for college entrance exams.

5. Are Gifts Valuable?

The legal system should not expend valuable resources enforcing trans-
actions that are useless or counterproductive. If gifts are simply wasted
exchanges and gift promises nothing more than harbingers of inefficient
transactions, then the law should encourage neither. Few doubt the worth
of exchange transactions which create value by transferring goods from
those who value them less to those who value them more. By contrast, on
its face, ‘[a] truly gratuitous, nonreciprocal promise to confer a benefit is
not a part of the process by which resources are moved, through a series
of exchanges, into successively more valuable uses’ (R. Posner 1986: 86).
Some economists have suggested that non-cash gifts are worse than merely
nonproductive, noting surveys indicating that on average people would
not pay nearly as much for the Christmas and other presents that they
receive as the givers paid for those same items. Thus, it has been suggested
that the Christmas gift-giving tradition alone constitutes a multibillion
dollar drag on the economy (Waldfogel 1993: 1328).
On the other hand, an economic argument for the value of gift-giving
can be based upon search costs being lower for the giver than the receiver
(Kaplan and Ruffle 2009: 24–5). Another claim is that gifts often transfer
money or money’s worth from more wealthy individuals to less wealthy
individuals. Because each individual dollar is valued more by the poorer
person than by the wealthier person, value is arguably created by the
redistribution, although perhaps not in amounts significant to the
economy. Regardless of this effect, other economists assume that gifts
must be valuable simply because rational donors would not make gifts if
doing so did not make them better off and donees presumptively would
prefer the gifts to nothing. Others point out, however, that this approach
double counts the donee’s benefit, ignores scenarios in which donees
can exploit donors, and ignores the adverse impact that gifts can have
upon third parties, such as where a donor injures his family’s reason-
able expectations by squandering his wealth on gifts to a paramour (E.
Posner 1997: 586–7). These arguments all raise empirical questions that
are unresolved.
Status-enhancing gifts are particularly questionable in terms of value
creation, although they may result in production of public goods (E.
Posner 1997: 601), as where a rich person demonstrates her wealth by
donating large sums to build a new library at a local college. Trust-
enhancing gifts seem potentially more valuable in that they can contribute
to future beneficial exchange relationships (Camerer 1988: S180), although
in some societies people may ruin themselves in an attempt to meet gift-
giving obligations under social norms (E. Posner 1997: 590).
All in all, economic analysis does not seem to settle the question of

whether gifts are sufficiently valuable to justify engaging the judicial

machinery of the state to enforce promises to make them.
6. Are Gift Promises Valuable?

Even a conclusion that gifts, on balance, create significant economic value
would not necessarily mean that gift promises do. Nonetheless, the tradi-
tional approach recognizes that enforcing gift promises permits promisees
to plan, ensures performance if the promisor dies before completing the
gift, allows the promisor to derive the satisfaction of having made an effec-
tive disposition, and protects the promisor’s ‘present aspirations against
defeat by a less worthy self’ (Eisenberg 1979: 8). While the mere making
of gift promises creates some value for both promisor and promisee, these
benefits would generally be increased by legal enforcement. For example,
if gift promises are legally enforceable, promisees can plan more concretely
and promisors can be more certain of the effect of their planned gifts.
Explicit economic analysis emphasizes that although it is obvious that
legal enforcement of gift promises can benefit promisees, such enforcement
can benefit promisors as well. While enforcement of gift promises would
cause promisors to suffer the cost of decreased freedom of action should
they later change their minds about wishing to make the gift, that enforce-
ment can also benefit them significantly. Most particularly, if a promisor’s
goal is to improve the welfare of the promisee, that goal is advanced by
enforcing a gift promise because enforcement allows the promisee to plan
with more certainty and therefore with more efficiency. Enforcing gift
promises arguably increases the gift’s net present value to promisees who
can now enjoy a greater certainty of actually receiving promised future
payments (R. Posner 1977: 412). This, in turn, increases the benefit to the
promisor who, at least in the setting of altruistic promises, presumptively
desires to maximize the gift’s beneficial effects for the promisee.
7. Should Most Gift Promises Be Enforced?

Previous discussion has indicated a lack of consensus among both econo-
mists and noneconomists regarding some of the foundational questions
in the area of gratuitous promises. There remains controversy regarding
why people make gifts and gift promises and whether gifts or gift promises
create value. Even if these matters were settled, it would not lay to rest the
larger issue of whether gift promises should generally be enforced. Even if
gifts and gift promises create substantial value, they might not create suf-
ficient value to justify the costs of their enforcement. On the other hand,
even if they create only minimal value, countervailing considerations
might not outweigh that value and enforcement could be good policy.
As noted earlier, noneconomists look at the same justifications (such as

evidentiary, cautionary and channeling functions of consideration) and

reach different conclusions. The official legal position is generally that gift
promises should not be enforced, although completed gift transactions
should not be undone. In practice, to the contrary, most clearly proven
and seriously intended gratuitous promises are enforced. Given this con-
tradictory state of affairs, it is unsurprising that various economic analyses
have also led to different conclusions. This is particularly true because
much analysis is based upon empirical assumptions that are unsubstanti-
ated.
Some economists have concluded that standard gift promises should
not be enforced because (a) most gift promises probably involve small
amounts and therefore any value their enforcement could create would
be outweighed by litigation costs and legal risk (the chance that judges or
juries may decide wrongly whether a gift promise was truly intended), and
(b) most gift promises are made within families where there are non-legal
means of punishing promise breakers, such as refusing to trust them in
future dealings, that are more effective than alternative means available in
exchange settings (R. Posner 1977: 416–17). These factual assumptions are
plausible, but not verified.
Another line of economic analysis emphasizes that while legal rules may
have an impact on whether parties live up to promises or not, they will also
impact whether and in what form parties choose to make promises in the
first place. Gift promises are beneficial in that they allow promisees to plan
and the more certain they are to be enforced, the more efficient the plan-
ning that promisees can undertake. However, promisors realize that they
may wish to change their minds, so the more certain that gift promises are
to be enforced, the more likely it is that promisors will either qualify their
promises or perhaps even refrain from making them at all. Enforcing gift
promises could, therefore, lead to fewer promises and fewer gifts. Social
value would be maximized by rules that provide the optimal balance
between the benefits of promising (better planning by promisees) and the
harmful effects of promising (fewer and more qualified promises), but
in a world of costly legal process and imperfect information, an optimal
balance may not be attainable. Ultimately, the current rule of nonenforce-
ment is arguably justified because self-sanctions against breach (shame
and guilt) are frequently effective. Furthermore, by tempering their reli-
ance on promises, promisees are often better able than promisors to adapt
to the risks posed by the fact that the promisor may regret having made
the promise (Goetz and Scott 1980: 1265, 1283, 1321–2).
Another approach focuses on a particular set of facts wherein an altru-
istic promisor signals her intent to give a gift, a promisee adjusts his or
her level of reliance, and then the promisor chooses the size of the gift to

maximize value. Donors often make gift promises because they perceive
value in donees’ reliance. As the donees increase their reliance on the
promises, donors perceive that their gifts will create greater value and,
consequently may give larger gifts. In such a setting, if the promisee knows
that the promisor will fulfill the promise, the promisee will choose a high
level of reliance, causing the donor to give a larger gift than he perhaps
would have liked. If the promisee cannot determine whether the promi-
sor is a more altruistic type (who will respond positively to a promisee’s
increased reliance) or a less altruistic type (who may not), presumably
more altruistic promisors can induce higher levels of beneficial reliance
simply by announcing their status. Under these assumptions there is no
reason to enforce the gift promise (Shavell 1991: 403–9).
However, what if the promisor is potentially a ‘masquerader’ who does
not intend to live up to the promise at all? In this setting, it may benefit
altruistic donors to make gift promises enforceable because they can then
more readily induce beneficial reliance by promisees. They can do so by
signaling their status as sincere donors through taking the steps necessary
to qualify their promises as binding, steps which masqueraders presum-
ably would not wish to take. However, as others have noted, making gift
promises enforceable may induce potential donors to refuse to make such
promises or to heavily qualify them, which can result in less reliance and
(in this model) smaller gifts (Shavell 1991: 403–9). Ultimately, this line of
argument may lead to the conclusion that donors should be able to bind
themselves through gift promises in order to distinguish themselves from
masqueraders so that promisees will increase their reliance, enhancing the
overall value of the gifts. However, donees might not wish for a regime
that enforced such promises because potential enforcement might cause
sincere donors who wish to reserve the option to change their minds not
to make promises at all. Thus, enforcement could render both donors and
donees worse off (Shavell 1991: 419–20). Are there enough masqueraders
in the world that their impact should be considered? As with other lines
of economic argument, this line of reasoning rests on empirical facts that
seem nearly impossible to determine.
Yet another approach distinguishes among the various motivations
for giving gifts, concluding that (a) altruistic gift promises should not
be enforced as routinely as exchange promises, and (b) when they are
enforced they should result in lower levels of damages than compara-
ble non-gratuitous promises. In general, a disappointed recipient of a
gift promise will suffer less damage than a disappointed promisee in an
exchange relationship (E. Posner 1997: 596–601). Similarly, recipients of
promises for trust-enhancing gifts of the signaling variety should seldom
be able to enforce those promises, for they can often lead to inefficient

equilibria in which donors try to outdo each other in giving numerous and
lavish gifts in order to avoid being thought untrustworthy. If allowed to
enforce such promises, promisees should again receive less in the way of
damages compared to promisees of exchange promises (E. Posner 1997:
603–4). According to this view, status-enhancing gift promises should
not be enforced, primarily because of various inefficiencies involved in
transferring property for such a purpose (E. Posner 1997: 601–2). Nor
should the courts enforce ‘exchange gift’ promises of the trust-enhancing
category because, among other reasons, such promises are bound up in the
ongoing relationship of the parties, making it likely that judicial enforce-
ment would do more harm than good to the parties’ trust relationship (E.
Posner 1997: 604–6). Given the difficulty of telling the difference between
the various motivations for making a gift or gift promise and the premise
that commercial promises are generally more socially valuable than gratu-
itous promises, the ultimate conclusion, on this view, is that courts should
be reluctant to enforce gratuitous promises.
Put together, these various streams of economic analysis bring to light
many interesting and important factors that should be considered but do
not create a clearly convincing rationale either for maintaining the current
stated legal rules regarding the nonenforcement of most gratuitous prom-
ises or for changing those rules.
8. Should Gift Transfers Be Undone?

Is there a defensible economic rationale for the stated rule that courts will
not enforce most gift promises when promisors change their minds (thus
protecting promisors), but will not reverse completed gift transactions
when promisors/transferors change their minds (thus protecting prom-
isees/transferees)? The accepted noneconomic answer seems to be that
delivery provides evidence that a gift was intended and that deliberation
occurred. This answer is not entirely satisfactory, since formalities that
also evidence intentionality and deliberation, such as a signed writing or
use of a seal, are insufficient to make donative promises enforceable, at
least in the US.
The most promising economic rationale for the differential treatment
of gift promises and completed gift transfers seems to lie in reliance costs.
One economic explanation provides that donees will generally keep reli-
ance costs low and discount the value of the promised gift by incorporat-
ing the risk that the donor will not fulfill the promise, thereby rendering
gift promises less valuable than completed gifts. However, the recipient of
a credible gift promise presumably will engage in potentially costly reli-
ance activities in anticipation of receiving the gift. Indeed, one of the main
reasons to make a donative promise rather than just to wait and give the

gift is to communicate information to the promisee so that the promisee

may incur reliance costs in order to make the gift more useful. Therefore, it
is not unreasonable to conclude that gift promises, even those not foresee-
ably leading to the type of specific reliance that provides the predicate for
a promissory estoppel claim, should be enforced in order to increase the
credibility of most gift promises.
However, an even stronger case can be made for refusing to undo
gift transactions that have been executed. It is more likely that one who
receives and possesses a gift will reasonably incur a higher level of reliance
costs than a mere promisee. Greater adjustments in consumption and
investment patterns are to be expected by one who has received the item
than by one who has simply received the promise of an item, particularly
where that promise is not legally enforceable.
Additionally, recipients of unenforceable gift promises need take meas-
ures to protect themselves from rescission only until the date the gift is
supposed to be delivered, whereas recipients of gift items in a legal regime
that allowed gift transactions to be reversed would have to take measures
to protect themselves from rescission for as long as the donor lives (or
perhaps longer). They would have to be concerned ten or twenty years
later that the item would be reclaimed and to take potentially costly pre-
cautions to account for that contingency. Because the amount of efficient
reliance is greater for transferees than mere promisees, it makes economic
sense to provide more legal protection for the former than the latter (E.
Posner 1997: 594). Furthermore, the ambiguity of ownership in a legal
regime where donors could rescind executed transfers would likely injure
both parties. What bank would loan money to B to build a house on a
tract of land that had been given by A when A might demand that the land
be returned in the middle of construction (Fellows 1988: 46)? A rule allow-
ing donors to reclaim gift items that have already transferred to donees
would prevent both donors and donees from achieving their goals in a
wide variety of settings.
9. Should Gift Promises to Charities be Enforced?

The accepted rule refuses to enforce most gift promises, but contains excep-
tions. One important exception in the US (but not under Anglo-Canadian
law) is for charitable pledges. Why should the law enforce a promise to
make a gift to a charitable endeavor when it refuses to enforce a similar
promise to make a gift to a friend or relative? The traditional explanation
for the exception is that courts favor charities because of the societal value
that they create. The public goods (for example, a new hospital wing or
university classroom building) produced by such gifts arguably justify the
exception (Gordley 1995: 577).

An alternative economic explanation is that charitable gifts tend to be

larger than other gifts and therefore better justify the judicial resources
and legal risk involved in their enforcement (R. Posner 1977: 420).
However, others question this assumption regarding the relative size of
charitable and non-charitable gifts (Eisenberg 1979: 7). Most workaday
commercial bargains also involve relatively small sums, yet the law views
them as enforceable.
Another view is that it makes more economic sense to enforce charitable
gift promises than intrafamilial gift promises because self-sanctions (guilt
and shame) are less likely to be effective enforcement alternatives in the
former case. Also, promisors can arguably qualify their promises more
effectively in cases of charitable gifts because social conventions often
prevent them from effectively doing so in family situations (Goetz and
Scott 1980: 1308).
Some economists, however, have suggested that enforcing such chari-
table pledges may be counterproductive. As noted earlier, a regime
that enforces such promises improves the reliability of the promise and
therefore enables more effective promisee reliance measures. However,
enforcement simultaneously reduces promisor flexibility and may cause
promisors to make fewer, smaller, and more conditional pledges. There is
no clear empirical evidence to resolve the question of whether an enforce-
ment rule or a nonenforcement rule would result, on balance, in more gifts
actually being transferred to charities, leaving this issue unresolved.
10. Should Promises Supported by Nominal Consideration be Enforced?

English courts enforce promises based on nominal consideration, on a
peppercorn. US courts are split on the question of whether promises sup-
ported by nominal consideration should be enforceable, even though it is
well recognized that courts are generally unconcerned with the sufficiency
of consideration, which is a matter for the parties to judge. Except in cases
of options and guarantees, most US courts have held that promises sup-
ported only by nominal consideration are not enforceable. Which is the
more defensible approach?
Many courts that refuse to enforce promises supported only by nominal
consideration conclude that it is not a ‘natural formality’. Another argu-
ment against enforcing such promises is that they often are simply dis-
guised gift promises and therefore should be unenforceable for all the
substantive reasons supporting the view that gift promises should not be
enforceable.
An interesting argument in favor of enforcing such promises is that
introduction of nominal consideration is a clear signal that the parties
actually wish to be bound. Additionally, there is little risk of legal error

regarding the parties’ intentions because there seems little doubt that
parties seriously intend a transaction when they go to the effort to pretend
that there is consideration. In many settings, social norms prevent parties
from bargaining over the terms of a promise; so, when parties are able
to expressly address consideration, there can be little doubt that their
expressed intentions correspond with their true desires (Gamage and
Kedem 2006: 1364–5).
11. Should Gratuitous Promises be Enforced if under Seal?

Gratuitous promises placed under seal are enforceable under Anglo-
Canadian law and in most civil law nations. Use of a seal or similar
formality to enable a promisor to make a gift promise binding arguably
makes economic sense by providing a relatively efficient means for a
promisor to signal his status as a sincere donor (rather than a masquer-
ader) and to ensure achievement of his own goals. The risk of legal error
is minimized so that it is arguable that the social benefits of enforcement
exceed the social costs. On this theory, and ignoring the fact that formali-
ties may solve problems of form but not satisfy substantive objections to
enforcement of gratuitous promises (such as the lack of value of gifts and
the nontrivial administrative cost of enforcing them), abandonment of
the seal in the US has been deemed a ‘mysterious development from the
standpoint of efficiency’ (R. Posner 1977: 419).
On the other hand, some have observed that because the ancient
requirement of a personal seal and melted wax could be a bit of a bother, it
began to be replaced by just the letters ‘L.S.’ As the ‘elements of ritual and
personification dropped away,’ the seal ‘not only ceased to be a natural
formality but became an empty device whose legal consequences were not
widely understood’ (Eisenberg 1979: 9). For those reasons, US courts and
legislatures stopped giving formal effect to gratuitous promises under seal.
Williston’s attempt to revive the formality in the US died with the near
total rejection of the Uniform Written Obligations Act (adopted only in
Pennsylvania), which would have recognized as binding any writing con-
taining an express statement that it was intended by the parties as legally
binding. A possible reason is the ease with which the ‘magic words’ could
be hidden in the boilerplate language of a form contract.
Others have pointed out that in many settings gift promisors might not
wish to be bound. However, if there are means to bind themselves (via a
seal or a writing) and others use these formalities, then gift promisors who
do not wish to be bound may feel forced to use the formalities to signal
their sincerity. Thus, the assumption, frequently made in economic analy-
sis, that promisors who take advantage of formalisms truly wish to be
bound may be erroneous (Gamage and Kedem 2006: 1305).

12. Should Improvidence or Ingratitude Bar Enforcement of Gift

Promises?
Civil law nations typically enforce gift promises, but not if promisees
have demonstrated ingratitude or promisors have suffered serious finan-
cial reverses. Should this rule apply in the UK for a promise under seal,
or the US for a promise to a charity? Some argue that these are sensible
grounds for refusing to enforce gratuitous promises and that the difficulty
that courts would have sorting out the factual questions surrounding such
issues justifies a policy of generally refusing to enforce gratuitous promises
(Eisenberg 1982: 662).
Others argue that these considerations present no basis for distinguish-
ing treatment of gratuitous promises from that of exchange promises.
Whether one is making an exchange promise (perhaps to purchase an
expensive vacation home) or a gift promise, a promisor should consider
not only his or her current financial status but also potential future devel-
opments, such as illness or disability. Also, just as a party to a commercial
transaction may suffer in the future if he or she acts rudely to the other
side, a donee who acts with ingratitude will suffer the loss of future gifts
(Fellows 1988: 33).
13. For Gratuitous Promises that are Enforced, What is the Proper
Measure of Damages?
Contract damage issues are intractable in most settings, including those
involving breach of gratuitous promises. Some argue that the most
common contract default damage rule – expectation damages – may
not be appropriate in this setting for several reasons. First, the theory of
efficient breach arguably has little application to gratuitous promises for
monetary payment. Second, the claim that expectation damages often
appropriately measure reliance costs makes more sense in exchange trans-
actions than in gift settings where recipients of donations typically incur
no opportunity costs by agreeing to accept a gift. Third, the expectation
measure may induce excessive reliance by failing to discount for the possi-
bility of breach. Finally, individuals often attach a higher value to out-of-
pocket costs than to forgone opportunities, suggesting that reliance costs
warrant more serious legal protection than lost expectancies (Trebilcock
1993: 186).
Nonetheless, reliance damages have several shortcomings as a poten-
tial default measure for gratuitous promises. First, given interdependent
utility functions, many donors may want their donees to be able to rely
upon their gift promises to the full value of the expectation. Second, expec-
tation damages can serve as a penalty default rule that motivates promi-
sors to clearly communicate contingencies with which they wish to qualify

their promises. And, third, measuring reasonable reliance costs in gratui-

tous promise cases is a highly speculative enterprise with attendant costs
that should not be foisted upon the taxpayer-subsidized court system.
Therefore, the expectation measure arguably remains the superior default
rule (that promisors may alter if they choose) (Trebilcock 1993: 186–7).
14. Contract Modification Promises

Thus far attention has been paid primarily to gift promises. What about
other promises that lack consideration, such as a promise to modify a con-
tract? In the US, if in the middle of performance of a contract A promises
to pay more to B than the original agreement (and nothing else changes in
the parties’ relationship), the promise usually is not enforceable if A was
purchasing services, but usually is enforceable notwithstanding the lack
of consideration if A was purchasing goods. The common law refusal to
enforce A’s promise to make additional payments, which can be charac-
terized as gratuitous since nothing was demanded of B in return, has been
overruled in cases involving sale of goods by legislation in the form of
the Uniform Commercial Code’s Article 2. Which approach makes more
economic sense?
Even the US common law has an exception to the consideration require-
ment in cases involving services where unforeseeable conditions prompted
the promise. Perhaps A hired B to dig a hole which will serve as the base-
ment for A’s new house. The promised $5,000 price seems too little when
B happens upon an unusual geological formation which neither party con-
templated that will make it exceptionally costly for B to complete the job.
A promises B an additional $5,000 to complete the job that he is already
obligated to perform. An economic argument in support of this exception
to the common law will also support the Uniform Commercial Code’s
general rule. Consider the possible motives that A might have to promise
the extra $5,000. First, it might give him a reputation for ‘fair dealing’
that will benefit him economically in the future. Second, it might avoid
driving B into bankruptcy which would often reduce the chances that B
could finish the job. Third, it may be cheaper for A to pay B the additional
$5,000 than to sue him and be forced to hire C to finish the job, especially
since C will charge a high price due to knowledge of the geological forma-
tion. For all these reasons, A will want B to finish the job, but B may be
unwilling to do so if A’s promise is not enforceable in court. Therefore, A
could benefit by a rule that enforces his promise though it lacks fresh con-
sideration (R. Posner 1977: 421). Overall, enforcement of such promises
seems to make economic sense because they are made in exchange rela-
tionships and serve to keep the contracting process flexible and serviceable
(Gordon 1991: 288).

15. Past Consideration/Moral Consideration

Concerning another category of promise lacking consideration, but not
strictly involving a gift, assume that A owes B $10,000, but B has been dil-
atory and the statute of limitations has run on the obligation. Or perhaps
A has discharged the claim in bankruptcy. No court would force A to pay
B pursuant to the contract. Nonetheless, assume that A promises B that
he will pay the $10,000 nonetheless. Or, in a related vein, assume that A’s
life is saved by B. A is grateful and promises to pay B $5,000 every year as
long as B lives. A pays for a few years and then discontinues payments. If
B sues for breach of contract in these scenarios, can he recover?
In the US, the promises to pay debts that are no longer legally binding
because of a discharge via bankruptcy or the statute of limitations, are
(notwithstanding their resemblance to gifts) enforceable despite a lack of
consideration. Some courts also enforce the promised gift made in the ‘life
saving’ scenario. All three are based upon a theory of ‘moral consideration’
that under traditional theory derives from notions of unjust enrichment.
Because of the benefits earlier conferred by B upon A, these are the sorts
of promises that A should have made and therefore the law should enforce
them.
Economic reasoning plausibly supports enforcement of these promises
based on ‘past consideration’ because, unlike with the typical gift promises
which arguably should not be enforced, these sorts of promises presumably
often involve substantial stakes (which justify the administrative expense
and legal risk involved in enforcing them) and are the sorts of promises
that are naturally made (so consideration is not needed to serve eviden-
tiary, deliberative, or channeling functions) (R. Posner 1977: 418–19).
16. Conclusion
Ultimately, traditional (noneconomic) analysis neither satisfactorily
explains the current state of the law of gratuitous promises nor makes a
strong case for an alternative. The same may be said for economic analysis
of the issues surrounding gratuitous promises, although economists have
added many useful insights to the discussion. Because gift-giving is as much
a social phenomenon as an economic one, additional light can be cast on
the debate by consulting works from sociology, psychology, and related
fields (Baron 1988–89; Eisenberg 1997; E. Posner 1997; Prentice 2007).
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6 Gifts, wills and inheritance law
Pierre Pestieau
1. Introduction
In this chapter, we want to focus on rather recent literature that studies the
interaction between preferences, institutions and bequests. More explic-
itly, we want to convey the now well-established idea that the level, the
timing and the pattern of bequests is the outcome of the underlying prefer-
ences of the bequeathing parents on the one hand and the prevailing legal
and fiscal institutions constraining bequests on the other.
To do so, we start with the setting in which bequeathing is effected, that
is, the complex network of family relations. The family is indeed the locus
of various transfers and exchanges, either in competition with, or as a com-
plement to, the state or the market. Admittedly, the distinction between
exchange and transfer within the family is not all that clear-cut. Even
though ‘pure’ transfers do not imply explicit counterparts, the simple fact
that they bring utility to the donor makes them less free than it might seem.
Our concern here is with the legal regulation and fiscal treatment of
exchanges or transfers between parents and children, which may be mon-
etary or in kind. In addition to wealth transfers such as bequests and gifts,
there is also the education that parents provide to their offspring through
an investment in both time and money, not to mention the transmission of
intangible social capital. There are also different types of assistance, often
in the form of services: these may be descending (providing accommoda-
tion or care to grandchildren) or ascending (care, visits or accommodating
elderly parents).
Even though we focus here on the most traditional type of intergen-
erational transfers, that is, bequests, all the other types play an important
role, either as a complement or as a means of exchange. We survey recent
work on the desirability of estate or inheritance taxation and of legal con-
straints imposed upon bequeathing. To deal with this issue, we introduce
a taxonomy of the main types of bequests and models of inheritance devel-
oped by economists over the last decades. Each of these models, which
focus on specific motivations for wealth transmission, is characterized by
the kind of relations existing within the family, the structure of prefer-
ences, the type of information held by each member of the family and, of
course, his or her own characteristics such as ability or life expectancy. It
will become apparent that this taxonomy is very different from the popular
96

Gifts, wills and inheritance law 97
image of inheritance and that the economic approach does not follow the
same track as the one adopted by other social scientists (Masson, 1995).
More importantly, we will point out the multiple and divergent implica-
tions that each of these types of inheritance may have when assessing the
desirability of fiscal and legal regulation of inheritance.
2. Taxonomy of Bequests
Inherited wealth is generally quite unequally distributed (a great deal
more than income). In countries like France, it accounts for a large part
of all wealth possessed (generally estimated at 40 percent) and represents
the largest descending monetary transfer, three times as much as wealth
received in the form of inter vivos gifts, for example.
Although the inheritor may very well not know the motivations behind
the decision to leave him or her a bequest, it is clear that they may be
diverse and sometimes contradictory. In fact, there exist three large cat-
egories of inheritance:
● accidental, or unplanned, bequests, characterized not primarily by

the desire to transmit wealth to offspring, but by precaution or con-
sumption deferred over an uncertain life span;
● voluntary, or planned, bequests, falling into different categories
depending on the motives for the transmission. They range from
pure altruism to paternalistic behavior all the way to the most
self-interested strategic exchange;
● capitalist, or entrepreneurial, bequests, which are the outcome of
accumulation for its own sake.
Our taxonomy of bequests is based on two dividing lines: the consum-

er’s horizon and the concern for family. Accidental bequests are typically
limited to the consumer’s life cycle. Voluntary bequests are essentially
based on family considerations. Capitalist bequests commonly have a
horizon that extends well beyond the lifetime of the wealth holder; they are
not primarily motivated by family considerations even though the dynas-
tic family is used as the channel allowing for the perennity of the estate.
These distinctions may sound superfluous. Yet, as we hope to make
clear, they are of crucial importance. The implications and consequences
that a bequest may have for the level and structure of estate duties (for
example) largely depend on the category it belongs to.
2.1. Accidental Bequests

Even if parents accumulate wealth only in provision for their old age, as
the theory of the life cycle claims, and have no particular desire to leave

something to their children, the latter will probably still receive an inher-
itance. This kind of bequest, termed accidental, is generally associated
with the concepts of precautionary savings and deferred consumption.
It owes its existence to three factors: the uncertainty over one’s life span,
the imperfection of capital markets (pertaining to, for example, annuities
or housing) and the impossibility of leaving a negative inheritance. In a
world of certainty, savings would be adjusted to match the needs of the
life cycle only; if annuities were available at an actuarially fair rate, one
could protect oneself against the risk of an excessively long and penniless
existence. Under these conditions, there seems to be no purpose in leaving
a bequest that is of no particular use in itself.
To illustrate the accidental bequest (see, for example, Davies, 1981),
let us take the case of a couple of retirees who are entitled only to a small
pension and have not taken out annuities. Anticipating a long and com-
fortable retirement, they have accumulated financial and real estate assets
that they hope to live on. They subsequently die in a car accident, leaving
their children an inheritance they were not counting on.
All things being equal, the accidental inheritance is larger should death
occur at the moment in the life cycle when wealth is at its peak, usually at
the end of the person’s working life. In this type of inheritance, there is no
exchange or altruism between parents and children. The children inherit
only because their parents did not live as long as they had expected to and
had not invested their savings in a life annuity.
One could raise the question of why annuity markets are not well
developed. There might be no demand for them because of some social
norms. In France, for example, buying annuities is viewed as an act of
distrust toward one’s children. This leads to another point about acciden-
tal bequests. Suppose that parents are altruistic toward their children but
would not leave them anything if fair annuities were available, because
their children are well-provided for through the secular growth in wages.
In the absence of annuities, these parents know that some bequest will
inevitably be left and may find this highly desirable.
2.2. Voluntary Bequests

In accidental bequests, the presence of neither children nor even heirs
is required. Voluntary bequests, on the other hand, depend on the pres-
ence of children. It was long held that intentional bequests were the norm
and, even more so, were motivated by altruism. The anthropology and
sociology of the family have since taught us, however, that many differ-
ent forms of voluntary bequests and family models exist. At one extreme,
there is the family in which solidarity and generosity prevail, while, at the
other extreme, there is the model of give and take in which exchange is

sometimes equitable and sometimes not. We will move gradually from

pure altruism to strategic exchange, which gives rise to an arrangement
rather unfavorable to children.
Altruistic bequests The stereotyped representation of inheritance clearly

corresponds to the model based on pure altruism; that is, parental love
and filial piety (classical references are Becker, 1974, 1975, 1989, 1991;
Becker and Tomes, 1979, 1986; and Barro, 1974). When making decisions
on consumption and savings, parents take into account their children’s
preferences while anticipating their income and future needs. Their utility
function implies that, in the absence of constraints, they will attempt to
distribute their incomes and those of their children over time so as to
smooth out the consumption of both parties. The concept of smoothing is
already present in the life cycle hypothesis, where the consumption path
is independent of the income path, but it is here extended to the infinite
duration of a dynasty (smoothing is clearly limited by the constraint of
nonnegative bequests when children are wealthier than their parents).
In this context, parents have two ways of raising their children’s
resources: human capital (education) transfers increase their wages and
nonhuman transfers, their financial wealth. The parents choose the amount
they wish to invest in their children’s education and that to be given them
in the form of inter vivos gifts or bequests. Their sole objective is to ensure
that consumption will be divided fairly either between them and their
children or among the children. Insofar as the return on education is vari-
able – at first it is a great deal higher than that of financial assets, before it
diminishes – parents cover educational costs until the return on education
is equal to that of physical assets; thereafter, they make inter vivos gifts or
bequests so as to maximize the utility of the extended family.
Choices such as these have immediate implications. If inequalities of
talents or fortune exist between parents and children or between children
themselves, intergenerational transfers will be tuned so as to reduce them
if not eliminate them entirely. Let us take the case of two brothers: one is
gifted and will have no problem acquiring a top-flight education, while his
brother, unable to obtain qualifications of any kind, will be forced to take
a menial job. In an altruistic environment, the latter should receive a great
deal more from his parents than his brother; however, it is probable that,
strictly in terms of education costs, the opposite will be true. In a model
where differences in talent are contingent on circumstances and where the
brothers enjoy the same standard of living thanks to their parents’ com-
pensatory transfers, the members of the following generation all start from
the same position. Thus, if parents are not prevented from exercising free
choice for reasons connected to their wealth, altruism or luck itself, there

should be great social stability within the dynasty. Intrafamily transfers

insure each member against the vagaries of fate or nature.
Yet, there are limits to parental choice; problems of incentives, moral
hazard and adverse selection cannot be avoided. In making their transfers,
parents would like to be sure that their children really need them and will
not rely on them to the extent of shirking responsibility for the rest of their
lives (see Bruce and Waldman, 1990; Linbeck and Weibull, 1988; Cremer
and Pestieau, 1993, 1996; Richter, 1992). But it is often argued that even
though parents cannot forgo problems linked to asymmetric information,
they are in a much better position than the government. This relative
superiority of the parents is often viewed as a key argument against any
public interference with private intergenerational transfers.
Moreover, parents may not be able to transfer as much as they might
wish. In this case, they will give priority to investments in human capital,
where the return is greater than that on physical investments. The latter
will thereby not be able to perform their role as buffers, and parent-child
as well as child-child inequalities may subsist.
Note that altruism in the neoclassical sense of the term is not to be con-
fused with generosity or disinterest. Quite often, one makes a distinction
between altruistic households, which leave positive (operative) bequests,
and those which are constrained by the nonnegativity constraint on
bequests (if they could, they would force their children into giving them
resources) and thus do not leave any. One cannot say that the former are
more altruistic than the latter.
Paternalistic bequests The paternalistic bequest shares the same blood-

line as the altruistic (see Blinder, 1974, 1976a; Modigliani and Brumberg,
1954). Paternalistic parents also accumulate savings with the intention of
transmitting them to their children. Yet, the amount and structure of the
bequest are based not on their children’s preferences, but rather on their
idea of what is good for their children, or uniquely on the pleasure they
might derive from giving. One often refers to the bequest-as-consumption
model because bequest appears in the parents’ utility function as any other
consumption goods. Although it is possible for paternalistic and altruistic
bequests to coincide, generally speaking, this is not the case. Paternalistic
bequests might consist of assets that the heir does not really need, such
as family possessions bequeathed inopportunely, that is, without the
economic situation of the children being taken into account.
A variant of the paternalistic bequest, put forward in particular by
Modigliani (1986), assumes that the amount of the bequest does not
depend on the absolute amount of the family’s resources, but rather on its
relative value within the generation to which it belongs, the idea being that

a family’s consumption needs tend to increase with economic growth from

one generation to the next.
Retrospective bequests We now come to a category of models that share

a number of common features: (i) the bequest is motivated by altruism
that is labeled ad hoc relative to pure altruism à la Barro and Becker; (ii)
information is limited and the forecast imperfect, so parents decide to
leave their children a bequest commensurate with what they themselves
received; (iii) the implicit rule ‘Do unto your children as you would have
liked your parents to have done unto you’ is rooted in social norms of
deferred reciprocity, as if bequests were made to one’s children in return for
inheritance received from one’s parent. This social, or rather family, norm
is related to what sociologists call habitus.
Usually these models are cast in a three-generation setting and lead to
social optimality if not the Golden Rule. However, this optimal equilib-
rium is not a market one but one that is based on a commitment to a per-
ennial norm. Even though this commitment is Pareto optimal, one cannot
exclude the possibility of rupture in the intergenerational social compact.
Bevan (1979), Bevan and Stiglitz (1979), Cigno (1995), and Cox and Stark
(2006) have developed models for this category of bequests.
Bequests based on pure exchange Intergenerational exchange was

common in traditional societies. Parents took care of their children until
they reached adulthood and promised to leave them an inheritance (often
their work tools). In exchange, children promised to look after their
parents once they reached old age, or even earlier in the event of failing
health. This type of bequest, known as bequest-as-exchange, is still prac-
ticed in rural areas and is related to the old-age security hypothesis that is
used to explain fertility.
There are a wide variety of bequest-as-exchange models; they have in
common that parents care about some service or action undertaken by
their children especially to secure old-age needs, and that the education
and bequests are the payment for this service or this action. They differ
in the nature of what is exchanged, in the timing of the exchange and in
the enforcement mechanism (courts, altruism, economic punishment or
rewards). Why not always rely on the market? When the market option
is rejected, it is primarily because of higher transaction costs. The family
is capable of carrying out the tasks of middlemen or insurers much more
cheaply than commercial companies. In addition, family members have
more complete information on the risk of illness or death when financ-
ing retirement and on individual talents and motivations when financing
education. In the traditional family, for instance, the weight of custom

and geographic immobility helped ensure that these engagements were

honored.
In Kotlikoff and Spivak (1981), exchange leads to an annuity-type con-
tract; in Cox (1987), one has an exchange of services; in Cox (1990), one
finds a scheme of loans by parents that are mutually advantageous; Desai
and Shah (1983) study the old-age security hypothesis within traditional
families.
In the same vein, Stark (1995), Becker (1993) and Cremer and Pestieau
(1993) have introduced the idea of ‘preference shaping’ through education
as a means to facilitate and secure exchange in general and support in par-
ticular. They consider a two-stage model. In the first stage, parents attempt
to inculcate values in their children; in the second, when those values (guilt
for misbehavior) have been imparted, children are ready to trade attention
for bequests in terms that are quite favorable to their parents.
The exchange-bequest models are most often cast in a setting imply-
ing efficient, if not fair, allocations between parents and children. Such a
setting mimics that of a competitive market economy. In a quite distinct
stream of literature, one finds the dissonant view of Buchanan (1983) who
focuses on the rent-seeking aspect of inheritance. He argues that this rep-
resents a substantial source of wasteful investment and a significant eco-
nomic inefficiency (this view is disputed by Anderson and Brown, 1985).
Strategic bequests In the modern family, it is easy and unfortunately

common for children not to come to the aid of their elderly parents.
However, filial ingratitude is hardly a new phenomenon. Two famous
literary representations come to mind. The misfortunes of Shakespeare’s
King Lear are well known, but Balzac’s Père Goriot experienced a hardly
less tragic fate: ‘He had given his heart and soul for twenty years, his
fortune in one day. When the lemon had been squeezed dry, his daughters
dropped the peel at the corner of the street.’ These two works show why
more than one parent has eschewed premature bequeathing.
This leads us quite naturally to a particular type of bequest, the strategic
bequest, which in many respects belongs to the bequest-as-exchange cat-
egory. It is one of the ways of enforcing exchange within the family when
there is a time lag between the giving and the receiving and there is no cred-
ible recourse to the legal power of the courts and the state (see Bernheim
et al., 1985. There are other bequest-as-exchange models with strategic
features, although less pronounced; see, for example, Cox, 1987).
The proposed model is of a family with two children. Each child wants
to receive as large an inheritance as possible; at the same time, spending
time with aging parents is costly (at least beyond a certain threshold) in
terms of forgone leisure or earnings in the market. The game follows a

precise chronology. First, the parents make a commitment as to the total

amount of the bequest and to a rule whereby this amount will be divided
up according to the level of attention provided by each child. For these
promises to be credible, the commitment must be binding. Thereafter,
the children do not cooperate with each other and each gives his parents
the amount of attention he considers optimal given the inheritance he
will derive from it. Following the death of both parents, the inheritance
is divided as stipulated. It is clear that the trump card in this game is held
by the parents. Operating according to the adage ‘divide and conquer’,
they extract the maximum from each of their children under the threat of
disinheriting them.
2.3. Capitalist Bequests

The term capitalist, or entrepreneurial, bequests evokes the image of the
entrepreneur found in Ricardo (1817) and classical economists in general
(see also Moore, 1979): an austere individual infused with the Weberian
Protestant ethic, investing everything he earns and extending the influence
of his decision making beyond his own existence. While accidental inherit-
ance touches all classes of society, this type concerns only the well-to-do.
(For an empirical test, see Arrondel and Lafferère, 1998, who distinguish
the behavior of wealthy households from that of the ‘top-heavy’ ones.)
The famous American billionaire Howard Hughes, who left behind a vast
financial empire but no direct heir upon his death a couple of decades
ago, comes to mind. This is the prototype of wealth so great that it may
not be consumed in a single lifetime. It has an existence of its own that in
a way exceeds its owner’s control. Even access to the annuity market and
knowledge of one’s lifespan would not change the situation in the least.
Parents in possession of such wealth, even those devoid of any concern for
their family, have no choice but to bequeath it, most likely to their children
in societies where the latter may not be disinherited. In any event, there
will be an estate whether there are children or not. Such is the example of
Alfred Nobel, who left his wealth not to his family but to the well-known
Nobel Foundation.
So far, we have focused on one factor: the very impossibility of spend-
ing an excessive amount of wealth in one generation (this applies to the 1
percent richest families, who, in most countries, possess nearly one-quarter
of all wealth). There is another motivation in capitalist bequest: the desire
to leave a perennial trace, a financial or industrial dynasty. One thus thinks
of individuals such as John D. Rockefeller. Children and grandchildren
are then needed not so much out of altruism, but as a necessary means of
perpetuation. There is a formal analogy between this type of bequest and
those left out of altruism in the Becker–Barro model.

Lying behind these types of bequests is a whole range of behavior, all

the way from pure altruism to selfish manipulation and absolute indiffer-
ence to the children. From a normative point of view, many will prefer
altruistic behavior, but in reality, one finds a little of everything (reality is
not as schematic as our categories).
What might the interest of this typology be? Is it important to know
if certain types of behavior become more frequent and others less so in
different times and places? (For the empirical evidence concerning the
relative importance of these types of inheritance, see Arrondel et al., 1997,
and Bernheim, 1991.) Might the likely shift in behavior in the direction
of exchange and strategic attitudes be indicative of a change in values?
This is not our most immediate concern. We are more interested in the
different types of inheritance because each has specific implications for
the desirability of adopting particular legal or fiscal regulation of giving
and bequeathing. Taking an example from a purely economic viewpoint,
taxing accidental bequests is harmless because it has no disincentive effect
on that type of saving. The other types of bequests, on the other hand,
can be badly affected by taxation. As stated, this is a purely economic
viewpoint. One might object from another viewpoint that any inheritance
taxation, regardless of the motivation, involves a repugnant confiscatory
aspect. We now turn to this debate.
3. Taxing Bequests
3.1. Two Polar Views1

Debate over inheritance and its legitimacy has often focused on whether it
should be taxed. Quite often, among political scientists and philosophers
more than economists, one finds two extreme positions. The first argues that
taxing inheritance would allow society to move toward more equality, espe-
cially equality of opportunities, without disrupting economic incentives,
particularly those concerning work and saving. This position, which can be
labeled as one of minimal liberty, assumes that a person has no right at all to
decide what should happen to his or her property after his or her death; in
this view, property rights do not include a natural right to bequeath (see, for
example, Haslett, 1994). The second position argues that taxing inheritance
is not only illegitimate but destructive because it disrupts the delicate frame-
work of incentives that regulate economic activities. This second position
is notably advocated by Bracewell-Milnes (1989) and by the Public Choice
1
For a presentation of these and other views, see Erreygers (1997); Masson
and Pestieau (1994).

school’s founders, James Buchanan and Gordon Tullock (see Buchanan,

1983, and Tullock, 1971). Tullock’s paper was followed by a number of
interesting comments (Greene, 1973; Koller, 1973; Ireland, 1973) and a
reply by Tullock (1973). Following this view, every person has the right
to decide what should happen to his or her property after his or her death.
Accordingly, the right of bequest is a natural right. Quite clearly, these two
positions are fostered by different attitudes toward liberty and equality.
They are concerned with basic principles and not with the actual implica-
tions for distributive justice and economic efficiency. Put another way, the
first position postulates rather than demonstrates that a 100 percent tax on
inheritance has no inefficiency effects and leads to a more equal distribution
of wealth and eventually of income. The second position, on the contrary,
finds any tax on bequests not only repugnant but inoperable as a means
of redistributing wealth. The majority of thinkers, and particularly of
economists, tend to take a middle position between the two extremes.
3.2. The Middle Position: a Trade-off Between Equity and Efficiency

The position generally taken on this issue of inheritance taxation is one of
pragmatism. Making explicit the objectives of taxing authorities, inherit-
ance taxation is deemed desirable if it can achieve some redistribution
across and within generations without hurting production and growth.
Actually, the extent of taxation will depend on the trade-off between
equity and efficiency and this is an empirical and not an ideological matter.
If, for example, it can be shown that equity can be achieved without much
efficiency cost, then taxation of bequests and inter vivos gifts is desirable
(for two recent surveys on these issues, see Cremer and Pestieau, 2006, and
Boadway et al., 2010).
The taxonomy of bequests above is very useful in coping with this issue.
Indeed, wealth-transfer taxation will have allocative (efficiency) and redis-
tributive (equity) implications that depend heavily on the type of bequest.
We start with the redistributive implications. The clear dividing line on
this matter is between (unconstrained) altruistic bequests and all others.
In an altruistic world consisting of identical (dynastic) families, we should
let the pater familias redistribute resources across and within generations.
Estate taxation is then undesirable. However, if income differences are
wider across families than within families, there arises a delicate trade-off
between two types of redistribution: public and private. The case for
estate taxation is enhanced if between-families inequality is higher than
within-family inequality and if the efficiency cost of public redistribution
is not much higher than that of private redistribution. This is true only
of altruistic bequests. For all other types of bequests, estate taxation is
always desirable on redistribution grounds.

Let us now turn to efficiency considerations and analyze the alloca-

tive effects of a distortionary estate tax. We assume that the government
runs a balanced budget and that the tax revenue is spent on public goods
that enter agents’ utility in an additive way. In other words, we focus on
just the uncompensated price effect of wealth-transfer taxation. In the
altruistic model, when bequests are operative before and after the tax
change, estate taxation discourages capital accumulation.2 In the case of
accidental bequests, estate taxation has no effect on saving. In the other
models, bequest-as-consumption or bequest-as-exchange, taxing bequest
is equivalent to taxing a particular type of future consumption.
Does that mean that basically it is not desirable to tax wealth transfer ?
Not at all. Even when such a tax has a depressive effect on the capital-labor
ratio, it can still increase welfare, granted that the overall economy is
dynamically inefficient – namely, there is too much capital. Further,
even with dynamic efficiency, the desirability of a wealth-transfer tax is a
general equilibrium matter that ought to be dealt with in the framework of
optimal taxation theory.
This section, as well as the current state of the literature on estate taxa-
tion, may leave the reader with the impression that the issue is so compli-
cated that nothing can be said. Our own reading of the theoretical literature
on inheritance taxation and of the empirical literature on the relative
importance of alternative forms of bequests is that progressive inheritance
taxation is desirable for both efficiency and equity reasons. The problem,
if any, is one of compliance. In open economies with mobility of financial
capital, the implementation of inheritance taxation is very difficult. Most
OECD countries collect less than 0.5 percent of their tax revenues through
inheritance taxation in spite of rather high statutory rates.
4. Freedom of Bequeathing
4.1. Equal Division: Some Evidence

The debate over the treatment of intergenerational transfer is not restricted
to the issue of taxation; for taxation is only one way to restrict the freedom
of bequeathing. In fact, one source of debate has been the opposition
between the Anglo-Saxon view and the Napoleonic view of inheritance.
The first implies freedom of bequests, the only restriction being estate
2
See, however, Bernheim and Bagwell (1988) who argue that, with pure altru-
ism and marriage, we are all interconnected through bequests and this makes all
taxes nondistortionary. They use this overall neutrality argument to emphasize the
limits of altruism.

taxation (the tax base is the total amount of the estate left by the deceased,
and the tax liability is independent of the number or quality of heirs).
Note that when there is no will, equal sharing is the rule. The Napoleonic
view implies equal sharing of the estate among children, but for a limited
part that the deceased can allocate freely by writing a will. Within the
framework, one has a so-called inheritance tax, whereby the tax base is
the amount received by each heir and the rates depend on the degree of
consanguinity.
These different legal regimes can play an important rule in shaping
wealth distribution. It is therefore interesting to see their actual implica-
tions by comparing the French and the American situations. Let us con-
sider the US estates cases. Tomes (1981, 1988a and 1988b), whose work is
based on heirs’ declarations, concludes that exact equality is achieved in
one-fifth of the cases and ‘approximate’ equality in less than half. Other
authors, who confine themselves to information contained in probate
records, find a much greater incidence of equal sharing. In families with
two children, for example, exact equality is observed in approximately 70
percent of the cases (63 percent in Menchik, 1980a; 87 percent in Menchik,
1988; 81 percent in Bennett, 1990; 63 percent in Joulfaian, 1993; 69 percent
in Wilhelm, 1996) versus only 22 percent in Tomes. Moreover, primogeni-
ture represents less than 10 percent of the cases, and the frequency of equal
sharing is higher among wealthy households. Finally, the transmission of
an indivisible professional asset often leads to unequal sharing only if there
is no other wealth that can compensate children left out of the professional
bequest. There is thus hardly any doubt that equal sharing is the most fre-
quent official practice in the US. Does that mean that making equal estate
sharing mandatory in the US would not be binding for most households
and would thus have no consequence? Not necessarily. As the strategic
bequest model shows, what matters is the threat of disinheritance, even
though the final outcome is equal sharing.
In France, less than 8 percent of the estates are unequally divided (see
Arrondel and Lafferère, 1992). These cases concern mainly the rich (con-
trary to the situation in the US) and the self-employed with many children
and an illiquid or indivisible bequest (professional assets, real estate).
Moreover, inheritance shares remain generally equal, the redistribution
among siblings being achieved mainly through previous gifts (80 percent
of the cases).
It remains to determine whether unequal shares compensate the
less-privileged child. There is some evidence in the US that girls, assumed
to receive less education or to care more for parents, are slightly advan-
taged (Menchik, 1980a, 1980b; Bennett, 1990). Otherwise, evidence is
mixed. Tomes (1981, 1988a, 1988b) finds significant compensatory effects,

but other authors (Menchik, 1988; Wilhem, 1996) do not find any sig-
nificant correlation between children’s observable characteristics and the
relative amount of inheritance received. This ambiguous conclusion is also
drawn for France by Arrondel and Lafferère (1992). Indeed, the French or
American studies (apart from Tomes’s) can tell when unequal estate divi-
sion occurs, but not explain the rationale underlying the distribution.
4.2. Inheritance Rules: Motivations and Implications

Inheritance rules are not necessarily imposed by law. In this matter, as in
many others, tradition and custom are a much more effective way to regu-
late bequeathing. Bergstrom (1996), for example, refers to several anthro-
pological studies that examine particular rules such as ‘partible patrilineal
inheritance’ in central Tibet, whereby ‘in families that had male offspring,
inheritance was in principle divided equally among them; in families that
had no sons, inheritance was passed to a daughter’.
Certainly there are many rules besides those of traditional equal division
and (male) primogeniture. Each of them, enforced by law or by tradition,
has or had a reasonable explanation and interesting implications. For
example, as shown by Brenner (1985), the equal-division rule was imposed
in the English Middle Ages during a rather short period characterized by
‘the mistreatment of both stepchildren by step-parents and younger chil-
dren by their older brothers and sisters’ (p. 96). Cyrus Chu (1991) explains
the practice of primogeniture in education in imperial China: the whole
family pooled its money to subsidize just one child for his human capital
investment in the hope that he would move up the social ladder and bring
honor and prestige to the family (see also Van de Gaer and Crisologo,
2001, who study inheritance rules in the Philippines).
The economists are, however, much more interested in the implications
than in the historical cause of alternative inheritance rules. A number
of scholars (Stiglitz, 1969; Pryor, 1973; Blinder, 1973, 1976b; Atkinson,
1980; Davies, 1982; Laitner, 1988, 1991; Van de Gaer, 1997) have thus
studied the expected effects of alternative inheritance rules combined
with marriage patterns on the distribution of wealth. Not surprisingly, in
these models, where compensatory bequests are assumed away, random
marriage and equal division are strong factors of wealth equality.
In all this investigation, fertility is assumed fixed. It is, however, interest-
ing to note that fertility can be affected by inheritance rules. The French
case is enlightening in that respect. Until the Revolution, each region had
its own customs. As shown by Rosental (1991), fertility was much higher
in regions subject to primogeniture than in regions subject to equal divi-
sion. In the latter, the only way to avoid splitting a family’s property was
to have at most two children.

4.3. Wills and Strategic Bequests

Quite interesting in the debate over the freedom of bequests is the fact
that the alternative positions range from one giving all the power to the
parent-donor to one implying a confiscatory 100 percent inheritance tax.
One can view the practice of many countries, that is, imposing an effec-
tively small inheritance tax along with mandatory equal estate division
among children, as an intermediate position that limits the discretionary
power of parents.
In a society where equal estate sharing is the rule, there is less risk of
opportunism on the side of the testator. In fact, with such a rule, there is
little room for wills. Empirically, there are fewer wills in countries such
as France and Germany where the equal division rule applies, than in the
US or the UK where there is full freedom of bequest. As pointed out by
De Geest (1995) in reviewing literature on the economics of wills, ‘Much
remains to be said about the forms of opportunism which testaments can
prevent as well as create’ (p. 13). In the models of strategic bequests dis-
cussed above, the testator fully uses the possibility of opportunism that
is given to him or to her by the legal practice of wills. Accordingly, the
testament is not the outcome of a contract; it can be revoked at any time,
and its content can even be kept secret. Not only the testament can be kept
secret, but also the size of the estate. Note that in Bernheim et al. (1985),
the outcome is efficient even though the testator gets all the trade surplus.
Yet, this only works if the inheritance rules and the size of the estate are
known by the competing heirs. It would be an interesting avenue for future
research to study the economics of wills through the alternative models of
strategic and exchange bequests.
When equal division is imposed, there is no room for strategic bequests
and it is not even certain that the outcome is efficient. In a number of
papers (Cremer and Pestieau, 1996), it appears clearly that the only way
to induce children to perform and not to shirk responsibility while waiting
for an inheritance is to allow their parents the possibility of disinheriting
them. At equilibrium, there is no disinheriting but its threat is necessary.
In these models, one sees that mandatory equal division is clearly a source
of inefficiency or, to put it otherwise, that freedom of bequeathing is a
factor of efficiency.
5. Conclusion
In this chapter, we have presented a number of alternative models of
inheritance and then discussed the implications of each of them for the
desirability of inheritance taxation. It appears that the dividing line is
clearly between models with altruistic bequests that are fully operative and
all the other inheritance models.

In many countries, the debate on inheritance taxation and on the

freedom of bequeathing is lively. The practical problem inherent in inherit-
ance taxation is that whatever the quality of arguments presented in favor
of such a taxation, in reality it brings little revenue to the state regardless
of the statutory rates. In all OECD countries, inheritance and gifts taxa-
tion represent less than 1 percent of all public revenues. Yields are not only
low, but often deemed unfair. After all, estate taxation is often called ‘the
tax on sudden death’.
The issue of whether bequeathing should be constrained is of a slightly
different nature. It is interesting to remember that at one point in its history
equal sharing was imposed in the UK because there were too many cases
of unfair treatment of stepchildren (see Brenner, 1985). Equal sharing
avoids that kind of inequity, but, at the same time, it prevents parents
from compensating their children for unequal incomes or opportunities.
One has the feeling that, in a number of countries, the trend is now in favor
of increasing freedom of bequeathing. This hopefully implies an increasing
trust in the judgment and the maturity of individuals in dealing with the
intergenerational distribution of resources.
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7 Standard form contracts
Clayton P. Gillette
Standard form contracts, sometimes referred to as ‘boilerplate’ or adhe-

sion contracts, constitute a category of contracts that are presented to a
party for acceptance or rejection without substantial additional negotia-
tion. A standard form contract may be drafted by the party who presents
it or by a third party, such as a trade association. Early commentary on
standard form contracts assumed that the absence of bargaining indicated
the superior market position of the drafter, usually the seller of goods or
provider of services. As a result, these contracts were thought to have a
poor fit with conceptions of volitional consent that underlie the neoclas-
sical basis for enforcement of contracts. Kessler (1943), Slawson (1971),
and, to a lesser degree, Rakoff (1983), exemplify this position. In eco-
nomic terms, this literature contends that standard form contracts tend
systematically to be identified with the presence of market failures. Courts
also concluded that standard form contracts implied superior bargaining
power and the imposition of terms on the adhering party. In Henningsen
(1960), for instance, the court noted an absence of competition for war-
ranties and inferred an inequality of bargaining power from the fact that
(1) a substantially similar limited warranty was found in virtually all auto-
mobile contracts, and (2) the warranty was presented to the consumer as a
condition for purchasing the automobile.
1. Benefits of Standard Form Contracts

Subsequent literature identified more socially useful roles for standard
form contracts, analogous to the benefits that arise from standardization
in product markets. First, standard form contracts reduce transactions
costs. In the strongest form of this claim, the drafter provides terms con-
sistent with those for which the parties ultimately would have bargained.
If, for instance, the standard form allocates risks to the parties best posi-
tioned to avoid or insure against them, then presumably the terms reflect
the positions most parties in similar positions would have preferred and
the absence of bargaining does not imply a lack of consent. This might
be the situation, for instance, where a standard form contract evolves from
repeated interactions between sophisticated market actors.
Second, standard form contracts generate benefits associated with
network externalities. As developed in the legal literature, standardization
115

of contracts confers learning effects as courts and parties agree on mean-

ings of potentially vague terms, while competition among suppliers of
contract terms generate contracts that reflect optimal terms (Kahan and
Klausner 1997; Klausner 1995; Chakravarty and MacLeod 2004). Repeat
players may prefer standard forms that reduce uncertainty about the
meaning of contract terms.
Third, standard forms facilitate control of agency costs in mass market
transactions (Rakoff 1983, p. 1223). If agents are authorized to negoti-
ate terms, principals will have to monitor agents to ensure that contract
modifications do not adversely affect the pricing models under the original
contract. Agents may attempt to raise their productivity by offering terms
that shift to their principals risks that the original terms allocated to the
other party. Should those risks materialize, the principal rather than the
agent will be required to bear the related costs. The agent has little incen-
tive, and potentially insufficient information, to price the reallocated risks
accurately. As a result, any reallocation of risks that the agent negotiates
may fail to reflect the additional expected losses that the principal bears.
Standard form contracts reduce agency costs by negating the authority
of agents to agree to any changes to the original terms of the contract.
Assuming that the initial allocation reflects a ‘fair’ price for the risks that
the other party agrees to bear, the resulting reduction in agency costs
should result in contractual terms that are agreeable to both parties.
2. Market Failure Explanations – Transactions Costs, Externalities, and

Monopoly
These rationales for standard form contracts implicitly assume that stand-
ard forms arise in well-operating markets, so that their terms approxi-
mate those to which the parties would have agreed had costly bargaining
occurred. Critics of standard form contracts question the existence of these
conditions and instead identify characteristics that would allow standard
forms to endure notwithstanding the inclusion of inefficient terms. The
fact that a term is common throughout an industry cannot of itself be evi-
dence of its efficiency. The pervasive use of a term throughout an industry
is consistent with either of two diametrically opposed phenomena. It may
represent perfect competition so that each firm in the industry takes terms
dictated by the market. Or it may be evidence that firms within the indus-
try have oligopoly power and thus have the capacity to impose onerous
terms on counterparties. One cannot assume that standard terms reflect an
equilibrium solution that has evolved to minimize transactions costs, even
when the contract is between repeat players. Indeed, while transactions
costs may explain the evolution of efficient terms, they may also explain
how inefficient terms could survive in standard form contracts. A drafter

Standard form contracts 117
could introduce a term, the inefficiency of which is too minor to induce the
other party (who will inefficiently bear the expected loss) to incur the costs
necessary to bargain for an alternative term.
Network effects of standard form contracts may similarly generate
spillover costs. Klausner (1995) argued that promulgation and widespread
acceptance of terms could generate lock-in effects and dilute incentives for
contractual innovation. Goetz and Scott (1985) and Davis (2006) examine
how the objectives of the drafter of widely adopted standard form con-
tracts affect the extent to which terms align with socially optimal contract
terms. Inertia within the organization, production costs, the objective
functions of agents within the promulgating organization, and the capac-
ity to attract users of standard forms will necessarily affect the quality of
the contract terms that pervade a network. The solution to that potential
problem, however, may lie more with state-supplied or subsidized alterna-
tive contract terms than with the regulation of privately supplied terms.
Much of the more recent literature, therefore, has been dedicated to
an exploration of whether the conditions of well-operating markets can
be assumed to be satisfied. Katz (1998) argued that there was little evi-
dence to support most market failure explanations for standard form
contracts. He contended that actors with significant market power would
be unlikely to utilize their position to dictate terms in standard form con-
tracts. Monopolists would depress quantity rather than quality in order
to maximize profits, and oligopolists still tend to compete over prices even
when other contract terms are standardized. While Katz recognized that
standard form contracts could increase barriers to entry by setting high
quality standards, and that standard forms would deny some inframar-
ginal buyers the ability to obtain the products or preferences they desired,
he doubted whether government regulation of contract terms could
improve the situation. Kornhauser (1976) offered an explanation of why
firms that had oligopoly power might coordinate on terms rather than
only on price. He suggested that sellers in such markets could use standard
forms to implement agreements not to compete on certain dimensions,
such as warranty coverage, that could facilitate price coordination that
maximized profits.
3. Market Failure Explanations – Asymmetric Information and

Disincentives to Read
Katz identified the presence of asymmetric information as the leading
justification for regulation of contract terms. Legal defenses to enforce-
ment of contract terms, such as unconscionability, are consistent with this
argument, insofar as application of the defenses typically depend on the
drafters’ possession of information that adherents to the contract lack.

The concern about asymmetric information is also consistent with the

assertion that standard form contracts are most problematic in consumer
markets for mass-marketed goods, where sellers, as repeat players, have
opportunities to construct self-serving contract terms, the value of which
occasional buyers cannot evaluate. For instance, sellers could include a
warranty disclaimer or an arbitration clause in a standard form contract
without reducing the price of goods by an amount that reflects the fair
value of the warranty or reduced costs related to arbitration because the
consumer has insufficient information about product failure rates or the
costs of dispute resolution.
Indeed, consumer buyers may fail to read terms at all, given an assumed
low likelihood of product failure, an inability to negotiate about disfa-
vored terms, and high costs of becoming informed about expected risks.
The high costs related to reading suggest that few consumers will actu-
ally read standard contract terms, an assumption confirmed by surveys
concerning online contracts (Hillman and Rachlinski, 2002). Although
failure to read may be rational, sellers could exploit buyer inattention to
insert terms without risk that buyers will object. Sellers may subsequently
assert that failure to read does not dilute the enforceability of the contract,
as long as the buyer had an opportunity to examine the contract terms
prior to conclusion of the contract. Buyers may accept the application of
the term, notwithstanding the possibility of legal defenses to its enforce-
ment. Stolle and Slain (1998) offer experimental evidence that exculpatory
clauses that are inserted into contracts deter the propensity of buyers to
seek relief for defects.
Failure to read may present a particular characteristic of contract terms
that are presented to the consumer simultaneously with delivery of the
goods, notwithstanding that negotiations over some terms, such as price,
occurred previously. Courts have disagreed about the enforceability of
subsequently presented terms in these situations, often referred to as
‘rolling contracts’. Hill (1997) upheld the validity of terms presented at the
time of delivery of consumer goods, while Step-Saver Data Systems Inc.
(1991) concluded that a box-top license presented at the time of purchase
did not become part of the parties’ agreement where prior conduct was
sufficient to conclude a contract.
Schwartz and Wilde (1979 and 1983) questioned the assumption that
failure to read necessarily precludes the development of standard form
contracts with terms that reflected efficient terms or consumer preferences.
They observed that consumers vary in their propensity to search for and
analyze terms. Where competitive sellers cannot tell ex ante whether they
are dealing with an informed or an uninformed buyer, and assuming a
minimal number of reading buyers, they will offer all buyers terms that

would be offered to reading consumers in order to capture the marginal

buyer. As a result, consumers who read terms protect inframarginal non-
readers from potentially overreaching sellers. The survey evidence noted
above, however, indicates that it is not clear whether the condition of a
minimal number of reading buyers necessary to reach that result can be
satisfied. Schwartz and Wilde (1983) contended that if consumers as a
group anticipate failure rates that are either unbiased or pessimistic, then
sellers will respond with contract terms that are consistent with consumer
beliefs. Only if consumers routinely understate failure rates will sellers be
able to exploit consumer ignorance. Schwartz and Wilde believed that
consumers would not systematically be too optimistic, so the conditions
of seller overreaching would be rare. They did, however, suggest that
the state could promote competition among drafters by subsidizing the
production of price lists and important contract terms that firms offer.
Schwartz and Wilde (1979) argued that competitive sellers will not
exploit consumer inattention if it is costly for sellers to distinguish between
reading and nonreading buyers. There may, however, be situations in
which sellers can distinguish ex ante between reading and nonreading
buyers at low cost. Gillette (2004) speculated that if business buyers are
more likely to read than consumer buyers, then sellers may be able to
separate buyers into different subgroups and offer each subgroup a dif-
ferent contract. Only the subgroup populated by readers would receive
value-maximizing terms. A seller that sells computers, for instance, may
offer value-maximizing warranty terms on computers that are likely to
be used for business purposes, while exploiting informational advantages
with respect to computers likely to be purchased for consumer purposes.
4. Discretionary Enforcement of Terms

Gillette (2004) argued that the absence of explicit assent to standard con-
tracts may be less problematic than neoclassical contract theory implies,
because the drafter does not intend to deploy nominally oppressive terms
in the absence of circumstances that would warrant their use to constrain
opportunistic buyers. In those circumstances, even ostensibly one-sided
contract terms may provide efficient solutions to conditions that are not
readily susceptible to bargaining, so that state invalidation of terms would
reduce net efficiency. Ostensibly one-sided terms, for instance, might be
inserted into contracts by sellers who could not determine ex ante whether
adhering parties are likely to act in good faith, but might be able to make
an ex post determination of bad faith conduct. Sellers would then exer-
cise discretion to invoke a pro-seller term in the event that they faced a
bad faith buyer, but waive the clause in dealings with a good-faith buyer.
This argument had precedent in claims by Klein (1980) that a grant of

discretion to one party could efficiently constrain counterparties who are

not easily disciplined by markets or whose opportunistic behavior cannot
readily be detected or verified by third parties.
Bebchuk and Posner (2006) extended this claim. They predicted that
parties who have a reputation for fair dealing could efficiently employ nom-
inally one-sided contracts with counterparties, such as consumers, who do
not have robust reputations, if the former assert contractual rights only
in response to egregious behavior by a counterparty. Where, for instance,
sellers’ practices are known to buyers, buyers may accept a contract that
omits a term that the buyer prefers, believing (correctly) that sellers will
honor the nonexistent term in a state that the buyer believes will material-
ize. A buyer, for instance, may be willing to accept a short return-period
term for a good if the buyer knows that the seller accepts goods for a longer
period of time as long as the seller does not suspect buyer abuse. Johnston
(2006) also suggested that ostensibly one-sided standard terms may not
reflect actual practices of contract enforcement. He suggested that these
terms serve as a basis for post-contract bargaining. He claimed, contrary
to the argument that standard forms are intended to limit the discretion
of agents, that standard form contracts allow agents discretion to grant
exceptions in order to maintain relationships with counterparties who can
be identified as co-operative or value-enhancing in future dealings.
5. Behavioral Explanations for Standard Form Contracts

Efficiency claims about standard form contracts have also been challenged
under principles derived from behavioral economics that suggest adherents
to proposed contracts will undervalue adverse events. Korobkin (2003)
contended that adhering parties will typically price only a limited number
of contract attributes. Assuming that virtually all adhering parties focus
on the same attributes, drafters of standard forms will be able to intro-
duce self-serving inefficient terms on less salient attributes. For instance,
if, at the time a contract is concluded, buyers underestimate product or
service failures and thus do not anticipate the need to resolve conflicts with
sellers or providers, buyers may ignore the consequences of a standard
clause that requires arbitration of disputes or that precludes the use of
class actions for small-value contracts. As a result, sellers will be able to
include arbitration clauses without a commensurate reduction in contract
prices. Bar-Gill (2004) and Mann (2006) contended that contracts offered
by credit card issuers are particularly susceptible to cognitive biases,
because consumer cardholders will either ignore or underestimate possible
subsequent events, such as post-default increases in interest rates, due to
naïve hyperbolic discounting. This possibility may justify greater judicial
supervision of contracts through doctrines such as unconscionability and

greater use of mandatory terms, or, more conservatively, require more

conspicuous disclosure of terms that might adversely affect cardholders
and of the expected costs to consumers of these terms.
Gabaix and Laibson (2006) proposed that firms might hide, or shroud,
information from their consumers by failing to disclose ‘add-on’ costs
that were required by initial investments. For instance, the purchase of
a printer might entail subsequent purchase of printer ink cartridges of a
certain type, and myopic consumers might fail to anticipate some of the
related costs. Although Gabaix and Laibson’s analysis focused on sequen-
tial contracting behavior, where a contract of purchase at one period
(the printer) required another contract of purchase at a subsequent time
period (the replacement printer cartridge), the same phenomenon could
exist within a single contract if consumers focus on a salient term and
are myopic with respect to the probability that another term of the same
contract might be relevant. For instance, consumers who underestimate
the probability that they will default on credit card payments may fail to
pay sufficient attention to a term that dramatically increases interest rates
in the event of default. Gabaix and Laibson, however, also proposed that
consumers could benefit from learning effects and therefore might not be
subject systematically to biased contracts.
5.1. Empirical Examination of Claims about Standard Form Contracts

More recent scholarship has empirically tested some of the theoretical
claims about the presence and effects of one-sided clauses. Ben-Shahar
and White (2004) examined long-term supply contracts in the automo-
tive industry. They found that terms of standard form contracts used
by different manufacturers varied within the industry, but consistently
contained one-sided language that favored the drafter and extracted
value from counterparties, notwithstanding the relational nature of the
contracts and the sophisticated nature of the adhering party. The authors
allow, however, for the possibility that the parties’ practices vary from the
obligations in the written terms.
Marotta-Wurgler assembled a database of end-user license agreements
for software and analyzed terms to determine frequency, bias, and pricing.
Marotta-Wurgler (2007a) concluded that licenses revealed a bias in favor
of the software company that drafted the contract relative to contract
law default terms. For instance, contract terms disclaimed warranties
that would have been implied at law. She also discovered that larger and
younger firms offer more one-sided terms, but that, contrary to exploita-
tion explanations, firms offered similar terms to both business buyers and
consumers. Marotta-Wurgler (2008) found little evidence for the argu-
ment that firms in concentrated software markets or with high market

shares impose one-sided terms on consumers relative to the terms offered

by firms in less concentrated software markets or with low market shares.
Marotta-Wurgler (2009) investigated software products sold online to
determine whether terms presented after purchase are more pro-seller than
terms available pre-purchase. She concluded that there was no evidence
that terms presented in the later stages of rolling contracts were especially
unfavorable to consumers.
6. Interpretation of Standard Form Contracts

The possibility that a standard form contract reflects a market failure has
also affected the manner in which courts interpret them. General prin-
ciples of contract interpretation include construction of any ambiguity
against the interests of the drafter. American Law Institute § 206 (1981).
Application of this principle induces drafters to avoid ambiguity and thus
reduce both uncertainty in contract terms and the costs (both litigation
costs and error costs) related to third-party contract interpretation. In
the case of standard form contracts, however, an additional justification
for the principle includes reducing the scope of terms that reflect market
failures. In addition, courts may interpret a standard form contract to
effectuate the reasonable expectations of the average adherent. One con-
sequence of that rule is to extend a restrictive reading of the contract even
to sophisticated adherents who have greater than average knowledge of an
ambiguity in the contract, (American Law Institute § 211 (1981)). In rec-
ognition of the failure of many parties to read standard form contracts, an
additional principle provides that where the drafter has reason to believe
that the party manifesting assent to the contract would not do so if he or
she knew that it contained a particular term, that term is not part of the
agreement. This last principle arguably ensures that an element of assent
informs even standard form contracts, but grants significant discretion to
courts to determine the terms to which reasonable parties would agree.
7. Administrative Approval and Regulation of Standard Form Contracts

Leff (1970) implied that the propriety of standard form contracts could
best be resolved by assigning bureaucratic agencies the role of evaluating
terms ex ante, as opposed to ex post judicial invalidation of terms deemed
onerous. Leff analogized the terms in mass-market contracts to manu-
factured goods of sufficient complexity to exceed the comprehension of
average consumers. Since a regulatory apparatus was employed to address
information asymmetries in the latter context, Leff proposed similar solu-
tions in the contractual setting. Sellers could submit potentially controver-
sial terms and either approve them in a manner that would estop courts
from subsequently invalidating them, or could signal to buyers which

clauses were appropriate. Some countries have adopted similar procedures

for pre-approval of contract terms. Deutch (1985) and Becher (2005)
discuss the Israeli model. It is unclear, however, how frequently these
administrative procedures are utilized by drafters of contracts.
Alternatively, agencies could prohibit terms that were deemed exploita-
tive of informational advantages or of cognitive biases. For instance,
regulations of the Federal Reserve Board prohibit credit card issuers from
including in credit card contracts clauses that apply post-default penalty
interest rates to prior purchases except in limited circumstances.
Agency analysis necessarily differs from judicial evaluation in that the
former takes place through an ex ante analysis, while the latter takes place
ex post with an identifiable adherent who claims an injury. Biases inher-
ent in the different perspectives of regulation and litigation may affect
outcomes. Terms that might appear to be inappropriate ex post in an
individual case might have been a good bargain ex ante for the class of
buyers as a whole.
Pre-approval of contracts does implicate the incentives of regulators
and private parties involved in the approval process. Agencies may be
vulnerable to influence either by trade associations or consumer groups
that promulgate or evaluate standard form contracts. As a consequence,
it is unclear whether ex ante approval of terms will cause less deviation
from optimal terms than either judicial regulation or reliance on extralegal
constraints on seller opportunism, such as reputation.
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8 Interpretation and implied terms in
contract law
George M. Cohen
1. Introduction and Scope

Questions of how courts interpret, and should interpret, contract terms
and when courts imply, and should imply, terms to which the contracting
parties have not explicitly agreed loom large in contract disputes and in
the legal literature on contract law. In the last decade, these questions have
received increased attention from law and economics scholars.
Contract law draws a distinction between interpretation and implied
terms, as well as between these doctrines and other contract law doctrines.
Interpretation refers to the process by which courts ascertain the meaning
of express terms. Implied terms are those that courts deem to be part of the
contract even though the parties did not expressly agree to them. Implied
terms are sometimes used to ‘fill gaps’ that parties have left in their con-
tracts, such as when parties leave out the time of performance and courts
read in a reasonable time term. Implied terms can also refer to terms that
limit the application of existing terms, the most notable example being
the doctrine of good faith. Interpretation and implied terms are closely
related concepts. For example, if the question is whether to read in an
exception to an express term, such as a price or quantity term, that could
be viewed either as an act of interpreting the express term or of implying
an additional term (the exception). Similarly, if a contract contains a ‘best
efforts’ clause, determining what that clause requires is a question of inter-
pretation, although the specific content a court reads into such a vague
term could easily be viewed as an act of implication. On the other hand, if
the contract contains no such clause, a court may have to decide whether
to imply a best efforts obligation, and if it does, it has to determine the
content of that obligation, which may involve considerations similar to
those for interpreting an express best efforts clause. Some questions of
interpretation, however, are typically viewed as not involving questions of
implication. An example would be a dispute over the meaning of the word
‘chicken’.
Although a contract need not be written to raise questions of interpreta-
tion and implied terms, many discussions of these topics assume a written
contract, which is perhaps more common than oral contracts. Written
125

contracts often call into play the parol evidence rule, which renders inop-
erative certain agreements made prior to, or in some cases contemporane-
ously with, a final, or ‘integrated’, writing. Although the parol evidence
rule is technically neither a doctrine of interpretation nor implied terms,
but rather determines which terms are part of an enforceable contract,1
it often is discussed in conjunction with doctrines of interpretation and
involves many similar considerations and so will be included here.
In some sense, all contract disputes involve questions of interpretation
and implied terms. Most contract law doctrines, such as formation, excuse,
and damage rules, can be viewed as implied terms. And express terms that
add to or trump background doctrines often require interpretation. But
contract law has generally used the labels ‘interpretation’ and ‘implied
terms’ more narrowly, to refer to questions of contract performance and
breach, rather than questions of formation, excuse, defense, or remedy.
That is, the legal issue addressed by these doctrines is whether one or more
parties have performed as the contract requires, or have breached. The
key exception is the doctrine of indefiniteness, which deems unenforceable
certain contracts whose gaps courts decline to fill in, and so is often viewed
as a formation doctrine. Even the indefiniteness doctrine, however, is a
performance doctrine to the extent that it concerns only missing perform-
ance terms. Courts never hold a contract to be indefinite because it lacks
a liquidated damages clause, for instance. Other than the indefiniteness
exception, I will generally follow the conventional focus on performance
and breach here, recognizing that many of the economic arguments have
broader application to other doctrinal areas of contract law.
2. Complete or Incomplete Contracts

Economic analyses of contract law tend to start with the idealized concept
of a ‘complete’ contract, though this term has perhaps engendered more
confusion than clarity. Traditionally, a complete contract refers to one
that provides a complete description of a set of possible contingencies
and explicit contract terms dictating a performance response for each of
these contingencies.2 Contingencies include changes in ‘exogenous’ eco-
nomic variables, such as a production cost increase. But they also include
‘endogenous’ behavioral responses, such as falsely claiming a cost increase
or seeking refuge from a now-disadvantageous bargain behind a contract
term intended to serve a different purpose. Economic analyses generally
conclude that if a contract is complete, there is no efficiency-enhancing
1
Burton (2009, chapter 3).
2
Al-Najjar (1995); Hart and Moore (1988).

Interpretation and implied terms in contract law 127
role for a court other than to enforce the contract according to its terms;
that is, incompleteness is a necessary, though not sufficient, condition for
an active court role in interpretation and implied terms.
But because no real-world contracts are fully complete in this sense,
the concept of completeness does not get us very far. The concept can
be rescued in one of three ways. One way is to view completeness as a
useful theoretical benchmark, similar to perfect competition. Just as some
markets are close enough to being perfectly competitive that the perfect
competition model is a useful predictor, so some contracts, or at least
the contract terms at issue in a dispute, may be complete enough that no
reasonable interpretation or implied term questions arise. Stated this way,
however, completeness comes close to being simply a tautology. The ques-
tion is what criteria can courts use to determine when a contract or term is
complete in this sense. Shavell defines a ‘specific term’ as one that identifies
a particular action for a given contingency and a ‘fully detailed complete’
contract as one that has a specific term for each contingency.3 But a ‘con-
tingency’ can itself be defined with more or less specificity and we still need
a criterion for deciding what the optimal level of specificity is.
A second way to rescue completeness is to recognize that contracting
parties can make a contract complete by using general ‘catchall’ clauses
that state what happens in all unspecified states of the world.4 If these
‘general terms’ cover all possible contingencies, the contract can be con-
sidered ‘obligationally complete’.5 For example, a catchall clause might
state: ‘The price term will be x, and will apply regardless of any change
in circumstances or conduct by either party.’ Alternatively, the parties
could include a catchall term that dictates an interpretive methodology
that makes the contract complete. For example, the parties might include
a clause that directs courts not to interpret or imply terms, either gener-
ally or in circumscribed ways. But although contracting parties often
use merger clauses, which direct a court to apply a particular interpre-
tive methodology (that is, do not look beyond the writing), they do not
seem to use express catchall clauses that are broad enough to make con-
tracts complete (though there is some question whether broadly stated
‘non-interpretation’ or ‘non-implication’ clauses would be enforceable).
Even if parties did write catchall clauses, those clauses themselves would
often require interpretation.6 Moreover, contracting parties often use
3
Shavell (2006, p. 295).
4
Hermalin and Katz (1993, p. 236); Hadfield (1994, p. 160, n. 5).
5
Shavell (2006, p. 295).
6
Charny (1991).

contracting clauses that are the exact opposites of completeness catchalls:

general clauses such as ‘good faith’ or ‘best efforts’ clauses signal contract-
ing incompleteness, as opposed to completeness.7
Of course, clauses that are not expressly stated as catchalls could be –
and sometimes are – understood that way. For example, Schwartz and
Scott (2003, p. 573) seem to have this notion of completeness in mind when
they define it to mean that the ‘writing expresses the parties’ solution to the
contracting problem at issue’. Formalism or textualism, discussed below,
commonly assumes this form of completeness.8 But reading an express
contractual term as a catchall, that is, applicable in all states of the world
without exception, is itself an act of interpretation or implication that
requires justification, at least in the legal realm.9
A third way to rescue completeness, more common in formal eco-
nomic modeling, is to tie the concept of completeness to the efficient use
of available information. A complete contract is one that makes full use
of the private information available to the contracting parties, even if it
does not expressly specify the response to every contingency.10 But the
fact that parties may in a simplified model be able to write ‘economically
complete’ contracts does not answer the question of whether in a given
legal dispute they have in fact written one. And the ability and willingness
of private parties to write economically complete contracts in the real
world is unclear. We do not seem to see, for example, contracts of the type
described by Hermalin and Katz, in which the contract leaves the quantity
and price unspecified, and then after some period one party names the
price and the other names the quantity.
It seems fair to say, however, that many if not most contracts are
incomplete, or at least the question of their completeness is itself a legiti-
mate question for judicial interpretation. A more limited claim would be
that incomplete contracts make up a large share of disputed contracts.
Incomplete contracts may nevertheless be efficient contracts. The costs
of contractual completeness would often exceed the benefits, just as the
costs of reducing crime or pollution or accidents to zero would exceed the
benefits.
Scholars have offered numerous reasons why the costs of contractual
completeness are often high, leading parties to write incomplete contracts.
Many emphasize the direct costs of negotiating and drafting complete
7
Hadfield (1994, p. 163).
8
Richard A. Posner (2005, p. 1590).
9
Hadfield (1994, p. 160).
10
Hermalin and Katz (1993, pp. 235, 242).

contracts. The future is unpredictable and identifying and contracting over

how parties should respond to remote contingencies may not be worth the
time and effort,11 or may simply be beyond the capabilities of parties who
are only boundedly rational.12 Even if drafting more detailed terms would
be relatively cheap, parties may intentionally make certain contract terms
ambiguous to sidestep contentious issues, which could blow up the deal.13
Alternatively, parties may have asymmetric information and one party
may strategically withhold information that would facilitate more com-
plete contracting.14 Parties may also find certain contract terms too costly
to monitor or enforce ex post.15
Incompleteness and ambiguity may also result from unintended ‘formu-
lation error’, which is costly to avoid.16 In fact, such error may be more
common in complex contracts with many terms. Parties may find it diffi-
cult or undesirable to keep track of all the terms and ensure their internal
consistency. They may not want to revisit terms already agreed on because
that may open up new areas of disagreement. Agency cost problems may
also lead to error from unintended incompleteness. Lawyers may fail to
‘clean up’ negotiated contracts because they may not want to risk having
their mistakes and oversights exposed.17
Not only may the direct costs of achieving contractual completeness be
high, but the opportunity costs may be high as well because other ‘govern-
ance mechanisms’ might be superior substitutes for ex ante contracting
and strict court enforcement.18 One important set of alternative govern-
ance mechanisms involves extralegal enforcement, including social sanc-
tions and reputation, ex ante vertical integration, ex post renegotiation,
and arbitration. Parties may write incomplete contracts if they think those
contracts are likely to be ‘self-enforcing’ so that court enforcement is not
necessary and may even be unavailable if the contract is considered too
‘indefinite’.19 Parties may even intentionally draft ambiguous contracts to
increase the potential costs of litigation, as a kind of bond against litigat-
ing.20 On the flip side, insisting on more complete contract terms may be
11
For example, Richard A. Posner (2005, p. 1583); Shavell (2006, p. 289); Geis
(2006, pp. 1675–8).
12
Eggleston et al. (2000, pp. 122–5).
13
For example, Richard A. Posner (2005, p. 1584); Geis (2006, pp. 1680–82).
14
Eggleston et al. (2000, p. 109).
15
Eggleston et al. (2000, pp. 110–12, 119–22).
16
Goetz and Scott (1985, p. 267, n. 11).
17
Hill (2009, p. 204).
18
Al-Najjar (1995).
19
Scott (2003).
20
Hill (2009, p. 208).

taken by a contracting party as a signal that the other party is litigious or

untrustworthy.21
The other key alternative governance mechanism is interpretation and
implied terms supplied by courts. Courts may be able through interpre-
tation and implied terms to provide the necessary flexibility – efficient
adjustments to contingencies – that an incomplete contract otherwise
lacks. Courts may be superior to nonlegal institutions such as reputation
because reputation effects may be weak due to such things as cognitive dis-
sonance, optimism about the ability of a party with a poor reputation to
change, the difficulty of knowing when a contracting partner has behaved
badly, and the last period problem.
The question of contract interpretation and implied terms then is really
a question of when court use of these devices is a superior governance
mechanism for facilitating efficient contracting. From an economic per-
spective, the nature and scope of court intervention should depend on the
extent of and reason for contractual incompleteness, at least if courts can
determine these at reasonable cost. In general, the role for courts in inter-
preting contracts and implying terms expands as contracts become more
efficiently incomplete.
3. Incomplete Contracts and Presumed Contractual Intent

As noted above, scholars and courts generally agree that if a contract
is complete, courts should enforce the contract according to its express
terms, at least barring any concerns with third party interests. But what
should a court do if a contract is incomplete, or its completeness is reason-
ably contested? Economists and courts start from the presumption that
courts should follow the intention of the parties. To admit incomplete-
ness, however, is to admit that the intention of the parties is uncertain,
or at least disputed. Thus, actual intent will either be costly for courts to
ascertain or, as Lipshaw (2005) stresses, nonexistent.
The next best solution is to use presumed or hypothetical intent. Under
this approach, courts adopt the term,22 or interpretive methodology,23 the
parties would have chosen had they bargained over the matter. A common
variant is the majoritarian default approach, under which courts try to
identify the terms or methodology most contracting parties would want.
But how is presumed or majoritarian intent determined?
There are two main interpretive methodologies on which economic
21
Hill (2009, pp. 209–10).
22
For example, Richard A. Posner (2005, pp. 1585, 1586, 1590).
23
Schwartz and Scott (2003, p. 569).

analyses focus.24 In the first, courts presume that complete contract-

ing is both feasible and desirable. This presumption has both a positive
and a negative component. On the positive side, the express terms of the
contract, interpreted as catchalls, are presumed to best approximate the
parties’ intentions and deemed to create a complete contract. This meth-
odology is usually referred to as textualism or literalism, especially if the
presumption is not rebuttable by evidence extrinsic to the express terms.
On the negative side, if parties fail to write a complete contract, the incom-
pleteness is presumed to be inefficient, whether unintended or strategic,
and the court’s approach should be to deter this behavior and encourage
complete contracting.
The second interpretive methodology involves a presumption that con-
tractual incompleteness is unavoidable and/or desirable, for reasons such
as those discussed in the previous section. The courts then fill in the gaps
or interpret terms by presuming the parties intended to contract with refer-
ence to some standard external to the express terms.25 A methodology that
relies on these presumptions is usually referred to as contextualist, though
contextualism is not a singular methodology. One branch of contextual-
ism focuses on the kind of evidence courts should consider as relevant to
proving the parties’ intentions. Sometimes this evidence comes from the
parties themselves, whether through testimony about negotiations, or
the parties’ conduct under the existing contract (course of performance)
or prior contracts (course of dealing). Sometimes, the evidence concerns
the conduct and understandings of other similarly situated contracting
parties. This evidence includes trade usage or custom, or other norms and
fairness conventions.26
Another variation of contextualism focuses not so much on evidence
as on economic theory and business practice more generally. Under this
approach, courts might presume the parties contracted with the expecta-
tion that courts would fill in any gaps with a joint maximizing implied term
that would have been written by rational parties under conditions of low
transaction costs.27 Similarly, courts may make a ‘best guess’ about which
party is the superior risk bearer or what term or interpretation would
make ‘commercial sense’.28 The meaning of these concepts can often be
contested. Ben-Shahar (2004), for example, argues that if parties inten-
tionally leave gaps, courts should fill these gaps with terms most favorable
24
Hadfield (1994, p. 161); Hadfield (1992).
25
Hadfield (1992, p. 259).
26
Eggleston et al. (2000, pp. 114–15).
27
Goetz and Scott (1981).
28
Richard A. Posner (2005, pp. 1603–7).

to defendants. Geis (2006) challenges this argument on the ground that it

may frustrate the intentions of parties who see intentional gaps as ‘embed-
ded options’ either to accept the interpretation of the other party or take a
chance that a court will enforce their preferred interpretation.
The choice between textualist and contextualist methodologies often
comes down to which presumption better approximates the parties’ inten-
tions, which in incomplete contracts are uncertain and contestable. For
example, suppose a buyer rejects goods delivered later than the time of
delivery specified in the contract after the market price drops below the
contract price, even though the buyer has always allowed late deliveries
before. A court might be called upon to decide whether to imply a limita-
tion on the buyer’s ability to reject, perhaps by using the doctrine of good
faith. A textualist would argue no on the ground that such implication
would be contrary to the parties’ intentions as expressed in the time of
delivery term. A contextualist would argue yes on the ground that imply-
ing a limitation on the buyer’s right of rejection would best effectuate the
parties’ intentions. Economic analysis can help to identify the conditions
under which the different interpretive methodologies are more likely to
approximate the parties’ intentions, and whether courts are better off
pursuing a pure interpretive strategy or a mixed one.
4. Negotiating and Drafting Costs

A key economic argument for an expansive court role in interpreting
and implying terms is that court willingness to engage in these practices
enables and encourages parties to write less complete contracts than they
otherwise would. Writing less complete contracts saves on drafting and
negotiating costs so long as the court-supplied interpretations and terms
sufficiently approximate the parties’ intentions.29 Thus, if the costs of court
interpretation and implication are low, contract law rules that promote
such acts facilitate efficient contracting. Even if contracting parties would
write incomplete contracts anyway, for reasons independent of the law
of interpretation and implied terms, that law may still promote efficiency
if it leads parties to view court enforcement as less costly than extralegal
enforcement.
Moreover, the higher the ex ante transaction costs of drafting and moni-
toring, the more likely it will be efficient for a court to adopt broader rules
of interpretation and implied terms that encourage parties to contract less
explicitly, because it will more likely be cost-effective for the parties to rely
on contextual evidence such as trade usages. If courts take too restrictive
29
Shavell (2006).

a view of interpretation and implied terms, the development of cost-saving

interpretive devices might be discouraged in favor of more complete, but
costlier, writings.30 Alternatively, too few contracts might be formed ex
ante, as the promisor’s costs rise to cover an anticipated remedy that the
promisee does not value at this cost. And too much performance might
occur ex post, as the promisor performs even when the cost of doing so
exceeds the value of performance.31
One approach courts can take is to identify categories of contracts
in which ex ante contracting costs appear to be high. A classic example
of high-transaction costs contracts is principal-agent contracts usually
referred to as ‘fiduciary’. These contracts typically involve complex
tasks for which the principal cannot easily measure the agent’s effort or
outcome, thus making express contracting difficult.32 Other categories of
high contracting cost situations might include contracts between unso-
phisticated parties or long-term contracts. But problems of incomplete-
ness and ambiguity can arise in any contract, despite the best efforts of
sophisticated parties and their lawyers.
5. Litigation Costs
Although the reduction of ex ante contracting costs is a potentially large
benefit of an expansive court role in interpretation and implied terms,
that benefit must be balanced against the costs. One potentially significant
cost is the cost of litigation. Law and economics scholars often argue that
contextualism is associated with higher litigation costs than textualism.
For example, allowing more contextual evidence may encourage parties
to spend more on litigation because the marginal benefit of expendi-
tures to develop such evidence is higher than under a textualist regime.33
Alternatively, allowing contextual evidence may undermine certainty and
therefore make settlement less likely.34
A number of scholars have argued that the optimal contract rules of
interpretation and implied terms are determined by the tradeoff between
ex ante negotiation and drafting costs and ex post litigation costs.35 Posner,
for instance, posits a simple model in which as parties spend more on
drafting a more complete contract, the likelihood of litigation decreases,
30
Burton (1980, p. 373).
31
Easterbrook and Fischel (1993, p. 445).
32
Easterbrook and Fischel (1993, p. 426); Cooter and Freedman (1991,
p. 1051).
33
Katz (2004, pp. 530–31).
34
For example, Goldberg (2006, p. 163).
35
Richard A. Posner (2005); Katz (2004, pp. 525–6); Kraus and Walt (2000).

as does the cost of any litigation that occurs and the likelihood of court
error. On the other hand, as parties spend less on ex ante contracting and
rely more on extrinsic evidence to prove their intent, drafting costs go
down but expected litigation costs rise. As a result, allowing more evidence
is not always desirable; the question is whether the benefits exceed the
costs. In balancing contracting and litigation costs, it is important to keep
in mind that contracting costs are certain and incurred across all contracts,
while litigation costs, though often much larger than contracting costs, are
incurred in only a small fraction of contracts.36
Concern with litigation costs helps explain doctrines such as the parol
evidence rule, which limits the role of the jury and prevents parties from
introducing evidence of prior negotiations or agreements when they have
drafted a contract sufficiently complete as to be deemed ‘integrated’.37 In
addition, many courts use the four corners rule to determine whether a
writing is integrated for purposes of the parol evidence rule or to deter-
mine whether a term is ambiguous for the purpose of applying the plain
meaning doctrine of interpretation. The four corners rule is a textualist
doctrine that bars the use of contextual evidence extrinsic to the writing to
prove integration or ambiguity. Judge Posner argues that the four corners
rule is based on the assumption that parties prefer ex ante contracting to
the expense and uncertainty of a jury trial.
Schwartz and Scott argue that if courts adopt a contextualist method-
ology, the higher litigation costs that will ensue under that regime will
have an additional, indirect effect: they will encourage parties to write less
complete contracts than they otherwise would prefer.38 The benefits of
express terms would be discounted by the higher costs of enforcing those
terms, as well as the risk that courts would incorrectly refuse to enforce
those terms in favor of some implied term or contextualist interpretation.
That argument depends on the assumption that the expected costs and
risks that contextualism will undermine a writing that correctly expresses
the parties’ intentions exceed the expected benefits of contextualism in
avoiding litigation over, and enforcement of, a writing that incorrectly or
incompletely expresses the parties’ intentions. Moreover, there is a paral-
lel concern under textualism: parties will have an incentive to write more
complete contracts than they would otherwise prefer. Greater complexity
can in fact lead to more litigation, as the chance that terms will conflict or
support alternative conduct increases.
36
37
38
Schwartz and Scott (2003, pp. 587–9).

6. Default versus Mandatory Rules

Even if contracts are generally incomplete and court interpretation and
implication are appropriate, economists generally agree that the rules
governing interpretation and implication, like other contract rules, should
be default rules rather than mandatory rules. Default rules are rules that
parties can contract around, whereas mandatory rules apply regardless
of the parties’ intentions. Implied terms that serve as ‘gap fillers’, such as
a reasonable price term, are usually viewed as paradigmatic examples of
default rules in the sense that all the parties need to do to contract out of
the implication is to specify the missing term, such as price. Other implied
terms, such as the duty of good faith and the duty of loyalty in fiduci-
ary contracts, are usually considered mandatory in the sense that parties
cannot write contract terms broadly disclaiming these duties. The usual
critique of mandatory terms is that because they disregard the intentions
of the parties, they make worse off parties who prefer terms other than
those mandated. For example, if a court imposes a stronger performance
obligation on an obligor than the parties intended, then future obligors
will extract a higher price, which is more than the obligee wanted to
pay (else he would have paid for it originally).39 Economists sometimes
defend mandatory terms if there are third party concerns, or asymmetric
information between the contracting parties.40
The distinction between default and mandatory terms is not always so
clear, however, once one allows for the possibility of efficiently incomplete
contracts and unclear intent. For example, whether one views the duty of
good faith or the duty of loyalty as mandatory depends on how well one
thinks those doctrines track contractual intent. If parties intend to write
incomplete contracts for which they expect courts to fill in the gaps, the
duties of good faith and loyalty might easily be viewed as defaults. That
view is further supported to the extent that if the parties want a particular
obligation that conflicts with what courts ordinarily view as good faith
or loyalty, and they specify that obligation, courts will generally enforce
it.41 On the other hand, if one believes that courts use the duties of good
faith and loyalty to fill in gaps that the parties did not want to be filled (for
example, to preserve private discretion rather than court discretion), or
to reject or ignore obligations the parties thought they had fully specified,
then the duties look more like mandatory rules.42
39
For example, Easterbrook and Fischel (1993, p. 431).
40
For example, Shavell (2006, pp. 310–11).
41
Easterbrook and Fischel (1993).
42
For example, Goldberg (2006, chapter 5).

Another example is the doctrine of indefiniteness, under which courts

will sometimes decline to fill gaps the parties have left in contracts. The
doctrine could be viewed as a default rule if one is willing to presume that
when the parties have left ‘too many’ gaps for the courts to fill, they do not
have contractual intent, and if they do have such intent they will override
the default by filling in the terms themselves. Alternatively, the doctrine
could be viewed as a mandatory rule if one assumes that the courts use it
to refuse to fill in gaps when the parties wanted them to.
On the other hand, implied terms, intended to serve as gap-filling
defaults, could instead become de facto mandatory rules if it is difficult for
courts to determine whether parties, when they use express terms, intend
to contract out of implied terms or merely to supplement them.43 That is,
it may be difficult for courts to tell in a particular case whether the parties
intended to incorporate implied terms by writing an incomplete contract,
or whether they intended the express terms they used to create a complete
contract. The more courts favor and encourage implied terms and common
usages, the more costly it becomes for the parties who want to contract out
of those terms to do so. Ostensible default rules begin to look more like
mandatory rules. The courts’ choice of interpretive strategy, therefore,
may affect not only the parties’ incentives to contract more expressly, but
also their ability to contract around the implied default rule.
The default rule concept can be applied not only to implied terms but
also to interpretive methodologies such as textualism and contextualism.
Although scholars generally agree that these methodologies should be
defaults, some argue that interpretive rules themselves are at least to some
extent mandatory.44 Others take the position that interpretive rules are
in effect defaults, because parties have many ways to contract for their
preferred interpretive methodologies, including choice of law and choice
of forum clauses, as well as merger and no-oral modification clauses.45
Schwartz and Scott argue further that it is easier for parties to contract out
of a textualist regime (for example, by writing trade usages into their con-
tracts) than it is to contract out of a contextualist regime.46 It is not clear,
however, why it is easier to write a contract that says that the usages of
the widget trade will apply than to write one that says that no trade usages
will apply, or the usages of the widget trade will not apply, or no usages
will apply except for the usages of the widget trade. It is true that if courts
43
44
Shavell (2006, pp. 292, 307, 310–11); Schwartz and Scott (2003, p. 583).
45
Katz (2004, pp. 506–12).
46
Schwartz and Scott (2003, pp. 584–5).

presume most contracts are written in ‘majority talk’, then by definition

fewer parties would have to contract around than if courts did not make
that presumption,47 but it is not clear why trade usage presumption would
not be ‘majority talk’ for parties in a particular trade.
7. Superior Risk Bearer

Law and economics analyses of contract doctrine often make use of the
superior risk bearer concept, which views contractual nonperformance as
analogous to a tort accident, and assigns contract risks to the party better
able to bear those risks on the assumption that the parties would have
wanted this result. The application of the superior risk bearer concept to
implied terms and interpretation depends in part on the methodological
presumptions one adopts. A contextualist is more likely to presume that
a contract is efficiently incomplete, and so more likely to view the parties
as having reasonably left a gap with respect to a given contingency, a gap
that a court should fill. The contextualist would then apply the superior
risk bearer concept at the gap-filling stage by asking which party is better
situated to bear the risk they failed to contract over.
A textualist is more likely to presume that if an incomplete contract
occurs, the incompleteness is the accident, not the underlying contingency.
Thus, the party who fails to protect himself against a contingency in the
contract is the superior risk bearer, because that party has failed to take
cost-effective ‘contract-based precautions’.48 On this view, courts should
use the doctrines of interpretation and implied terms to encourage the
parties to ‘facilitate improvements in contractual formulation’,49 which in
this case means encouraging more complete contracts, that is, the greater
use of express written terms or more precise language. If a court is willing
to ‘insure’ parties through flexible interpretations and implied terms it
creates a classic moral hazard problem: the parties have less incentive to
write good contracts themselves.
The textualist approach would favor strict interpretation of doctrines
such as the parol evidence rule and the indefiniteness doctrine to encour-
age parties to write more complete contracts. By giving more weight to the
written document and limiting the extrinsic evidence courts can consider,
the parol evidence rule encourages parties to put all aspects of their agree-
ment into their written contracts.50 By requiring that contracting parties
47
48
Cohen (1992, p. 949).
49
Goetz and Scott (1985, p. 264).
50
Eric Posner (1998).

include key terms to make the contract enforceable, the indefiniteness doc-
trine encourages parties to include these terms.51 The question, however, is
whether such contract-based precautions are invariably cost-effective.
An alternative approach to the superior risk bearer question is to ask
which party is the cheaper contract drafter, namely the party in a better
position to clarify a term or to identify what should happen in the event of
some contingency. This approach explains such interpretive rules as contra
proferentem, under which ambiguities are construed against the drafter.
This rule encourages the party in the better position to draft a more com-
plete contract to do so. Similarly, if one of the parties is a repeat contractor
or is assisted by legal counsel and the other is not (as in many consumer
contracts), imposing liability on the repeat and represented contractor in
cases of contractual ambiguity or incompleteness will encourage that party
to improve the terms of its contracts. In addition, if one of the parties has
an informational advantage (for example, a party with idiosyncratic pref-
erences), imposing liability on that party could encourage similarly situ-
ated parties in the future to reveal the information. Because the party with
the informational advantage is not always the contract drafter, there may
be a tension between this criterion and the contra proferentem doctrine.52
In some cases, the doctrine of mistake may excuse a drafter who makes
a drafting error, especially if the other party should have noticed it. Of
course, there may not always be a ‘cheaper contract drafter’, or if there is,
the necessary precautions might not be cost-justified.
A variant of the superior risk bearer argument that does not involve
encouraging more complete contracting is giving the party who has the
ability to cheaply discover a particular meaning the incentive to do so. A
contextualist rule that can be justified under this argument is the rule that
contracting parties ‘in the trade’ are bound by trade usages, even if they
did not know about them. This rule not only encourages the parties in a
trade to develop such usages but also to familiarize themselves rapidly
with these usages, hence reducing the need for heavily lawyered docu-
ments.53 By the same token, the textualist ‘plain meaning rule’ could be
viewed as a way of encouraging contracting parties to learn the common
(one might even say implied) meaning of words, thus reducing the need
for and costs of elaborate definition and explanation. In addition, the
Restatement has a rule under which if the first party has reason to know
the meaning attached by the second party and the second party has no
51
52
53
Warren (1981).

reason to know of the first party’s meaning, the second party’s meaning
prevails. The first party’s negligence makes it the superior risk bearer of
the misunderstanding.
8. Opportunistic Behavior
Putting the risk on the superior risk bearer, whether the risk is the
underlying contingency causing contractual disruption or the risk of an
imperfectly drafted contract, is one fault-based approach to questions of
interpretation and implied terms. A second fault-based approach focuses
not on encouraging efficient contracting, but on deterring opportunistic
contractual behavior (though obviously the two overlap). Opportunism
can be broadly defined as deliberate contractual conduct by one party
contrary to the other party’s reasonable expectations based on the parties’
agreement, contractual norms, or conventional morality.54 Alternatively,
opportunism is an attempted redistribution of an already allocated
contractual pie, that is, a mere wealth transfer.55
Opportunistic behavior is costly. It ‘increases transaction costs because
potential opportunists and victims expend resources perpetrating and
protecting against opportunism’. Muris (1981, p. 524). Moreover, oppor-
tunistic behavior makes complete contracting extremely difficult. Even if
contracting parties could anticipate all of the possible changes in economic
variables, they would have a much harder time anticipating and protect-
ing against opportunistic behavior by the other party. At the extreme, the
greater the concern one contracting party has with the possible opportun-
istic behavior of his contracting partner, the less likely he will be to want to
contract with that partner at all. Because contracting parties cannot solve
all problems of opportunism on their own, courts can potentially reduce
transaction costs by imposing liability on the ‘most likely opportunist’.
But there are difficulties with using courts to deter opportunism. In
particular, opportunism is often ‘subtle’, that is, difficult to detect or
easily masked as legitimate conduct.56 Whether a contracting party is
legitimately relying on an express term of the contract, for example, or
opportunistically exploiting it to justify conduct the parties did not origi-
nally expect depends on the parties’ intentions, which, as we have seen, are
often uncertain and contested. Lipshaw (2005) contends that the concept
of opportunism will rarely be helpful in litigated cases because it requires
the identification of an ex ante intent that may not exist.
54
Cohen (1992, p. 957).
55
Muris (1981); cf. Burton (1980, p. 378).
56
Muris (1981, p. 525).

Other scholars are more optimistic that courts can identify opportun-
istic behavior and in fact can use the concept to help determine uncertain
intent. Thus, Judge Posner argues that courts should hesitate to interpret
a contract in such a way as to permit conduct that would ordinarily be
understood as opportunistic.57 Similarly, Muris argues that courts should
hesitate to attribute to contracting parties an intention not to have courts
police against opportunistic behavior.58 Moreover, courts may be able to
identify ‘objectively verifiable circumstances that act as surrogates for the
existence of opportunism’ Muris (1981, p. 530). For example, the risk of
opportunism is greater whenever one party has an asymmetric information
advantage over the other. Thus, in the fiduciary context, courts adopt, via
the duty of loyalty, a strong presumption of wrongful misappropriation by
an agent when that agent has a conflict of interest, engages in self-dealing,
or withholds information from the principal.59
In addition, courts may be able to identify risks that the parties allo-
cated and risks that they did not contemplate. If the court finds that the
parties intended that the contract assign a particular risk to one of the
parties, such as a change in market price, and that risk materializes,
the court should be skeptical of attempts by the disadvantaged party
to escape his obligations via a different contract term. For example, a
buyer in a requirements contract may suddenly experience a large drop in
‘requirements’ after the market price has fallen below the contract price,
or a large increase in requirements after the market price has risen above
the contract price. In these cases, the court should suspect opportunism, or
in legal terms, a violation of the implied obligation of good faith. On the
other hand, if the court finds that a change in economic circumstances was
not contemplated by the contract, the court may infer a lack of opportun-
ism. For example, if the buyer’s requirements decrease or increase because
of a change in costs or technology subsequent to the contract, the buyer’s
behavior is likely not opportunistic (is in good faith) because the very
purpose of the requirements contract is to assign some risk of variation in
the buyer’s needs to the seller. Goldberg (2006, chapter 5), however, criti-
cizes this kind of analysis because he believes the purpose of requirements
contracts is to provide discretion to one party, and implicitly assumes that
the parties’ preference for preserving private discretion takes priority over
their interest in deterring opportunistic abuses of discretion.
Another example of objectively verifiable circumstances on which courts
57
58
Cf. Muris (1981, p. 573, n. 138).
59
Cooter and Freedman (1991, p. 1054).

can focus is ex post transaction costs. For example, if parties are likely to
undertake ‘interpretation-specific investments’ or investments that ‘are
especially vulnerable to changes in contractual interpretation’, they may
favor a more expansive approach to interpretation to reduce the risk of
opportunism.60 On the other hand, if the market for substitute perform-
ance is thick, opportunism is less likely and contextualism less necessary.61
Although this distinction may be useful in establishing general presump-
tions, it is of limited help in deciding specific cases. Litigated cases tend to
be precisely those in which ex post transaction costs are likely to be high;
otherwise, the cases would be settled.
Although opportunism is often discussed as an ex post problem, oppor-
tunism can occur ex ante as well. For example, the drafter of a standard-
form contract might try to sneak in one-sided but inefficient terms into
the fine print.62 By the same token, under a strict parol evidence rule, a
party might intentionally make oral statements that the other party relies
on as part of the contract, and then leave the provision out of (or put or
leave a contradictory provision in) the writing. On the other hand, under
a more flexible parol evidence rule, a party might intentionally ‘pad’ the
negotiation record with statements that the party knows will be rejected
by the other party both orally and in writing, in the hopes that the first
party can later convince the court that these statements were in fact part
of the contract (a common practice in legislative history).63 Katz (2004,
p. 531) questions how often this problem will really occur because in
most cases parties will have equal access to negotiating history and can
observe and counter blatant, self-serving attempts to manipulate parol
evidence.
Still, opportunism, whether of the ex ante or ex post variety, may help
explain why courts tend to be much more skeptical of evidence that the
parties can easily manipulate (especially prior negotiations) than evi-
dence over which the parties have less control (such as trade usages).64
Concern with opportunism may also explain the motivation behind
the use of merger clauses as well as one reason why they should not be
interpreted too broadly. Parties may find it difficult to predict in advance
which negotiation tidbit the other side might seize on later,65 so they
may find it necessary to write a broad clause that excludes them and not
60
For example, Katz (2004, p. 530).
61
62
Katz (2004, p. 531).
63
Eric Posner (1998, pp. 564–5).
64
Katz (2004, p. 532).
65
Eric Posner (1998, p. 572).

worthwhile to expend resources on identifying exceptions that may be

jointly maximizing.
Scholars disagree about whether the problem of opportunistic behav-
ior supports textualism or contextualism. Schwartz and Scott (2003, pp.
585–6) argue that contextualism creates a greater likelihood of opportun-
ism because parties can always falsely allege some contextual evidence,
such as a ‘private language’, that courts may incorrectly find to be true.
Kostritsky (2007), by contrast, argues that either textualism or contextual-
ism can lead to opportunistic behavior, so courts should focus on deter-
ring opportunism rather than on definitively choosing one or the other
interpretive methodology. Because contextualism and textualism are both
useful for deterring different types of opportunism, we should therefore
expect – and we find – that courts are never completely committed to one
or the other. Even the most contextualist courts may reject or restrict evi-
dence they deem to be too self-serving or backed up merely by the say-so
of one of the litigants rather than objectively demonstrable evidence.
And even the most textualist courts may blink when a narrowly literalist
reading of a contract flies in the face of the parties’ evident intentions.
9. Joint Fault and Multiple Contingencies

A further difficulty in applying fault concepts such as superior risk bearer
and most likely opportunist to questions of interpretation and implied
terms is that in many contractual disputes, both parties can be viewed
as at fault to some extent. In these cases, courts may have to make judg-
ments about the relative fault of both parties to decide whose behavior it
is more important to deter in a particular case. In particular, if one party
is the least cost avoider of some contingency while the other party regrets
the contract for other reasons and is opportunistically seeking to avoid
its obligations, courts face a ‘negligence-opportunism tradeoff’.66 To take
a classic example, suppose a builder promises to use a particular brand
of pipe in building a house but inadvertently substitutes a different, but
functionally equivalent brand, a fact not discovered by the owner until the
house is nearly completed. The owner refuses to make the final payment
on the house. The court must choose between placing liability on the neg-
ligent builder or the potentially opportunistic owner. There is an economic
case to be made that opportunism – if sufficiently proved – is more costly
behavior and deterrence of that behavior should take priority.67 On the
other hand, the more likely it is that the builder ‘built first and asked ques-
66
Cohen (1992, pp. 983–90).
67
Cohen (1992).

tions later’ (Goldberg 1985, p. 71), the more willing courts should be to
find for the owner by implying a condition.
The negligence-opportunism tradeoff can also be created by the concur-
rent occurrence of two contingencies. Suppose that a buyer rejects goods
delivered late after a market price drop and the seller sues. There are two
contingencies here: the price drop and the late delivery. The contract
assigns the risk of the price drop to the buyer and the late delivery to the
seller. Textualism will not resolve this dispute: either the price term or the
time of delivery term cannot be read absolutely. It is not sufficient to say
that only the seller has breached, because what constitutes a breach and
the consequences of that breach are precisely what is at issue. Nor can it be
said that only the seller could take precautions here because neither party
could do anything about the price drop and the buyer did not cause the
delay in delivery. If the buyer’s rejection is viewed as opportunistic behav-
ior, then refraining from such behavior could be viewed as a ‘precaution’.
Depending on the circumstances, there is an economic argument to be
made for implying a good faith ‘limitation’ on the buyer’s ability to escape
its obligations.
10. Characteristics of Contracting Parties

Party characteristics unrelated to fault may also affect the optimal
approach to interpretation and implied terms. One such characteristic is
the parties’ attitudes toward risk. Katz argues that relatively risk-averse
parties will prefer contextualism because that reduces the variance of
results among judges by equalizing the ‘information sets’ of more and
less experienced judges (2004, pp. 527–8). By contrast, Schwartz and
Scott argue that risk-neutral contracting parties, such as many businesses,
would support textualism. They discuss a model that assumes that parties’
respective payoffs increase under favorable interpretations and decrease
under unfavorable interpretations, court interpretations are unbiased, and
there is some positive probability that textualism will yield the answer the
parties intended (Schwartz and Scott 2003, pp. 573–7). They argue that the
parties will invest resources in drafting until each term represents the mean
possible judicial interpretation. Contextual information would therefore
produce no benefits because it could only reduce variance, and risk-neutral
parties care only that interpretations are right on average and do not care
about reducing variance.
Bowers (2005) criticizes the Schwartz and Scott risk neutrality argu-
ment on a number of grounds. First, large interpretive variance could
lead to more ‘chiseling’ behavior by the parties, so that even risk-neutral
parties would care about reducing interpretive variance to discourage such
behavior (Bowers 2005, p. 601). Further, the parties’ asymmetric abilities

to ‘manipulate the context’ and mislead the court may call into question
the assumption that the mean of the distribution of error is zero (2005, p.
602). More generally, if allowing contextual evidence would enable courts
to reach the mean interpretive result at lower total cost, including the
costs and uncertainty associated with opportunism, contextualism would
be superior. In addition, the very assumption of risk neutrality is to some
degree in tension with contracting itself, which is at least in part about
reducing risk (2005, pp. 596–7). If parties are willing to expend resources
to reduce risk by contracting, it is hard to rule out a priori the possibility
that parties might prefer court adjustments ex post that further reduce risk
in a cost-effective way. Contracting parties do not demand enforceable
coin flips to resolve their disputes.
Another potentially relevant characteristic is the degree of homogene-
ity among contracting parties and transactions. Some scholars argue that
the more likely contracting parties are heterogeneous, the more inefficient
an expansive approach to implied terms and interpretation will likely be,
because contracting parties will more likely be unhappy with the court’s
implied terms and interpretations and want to contract out of them. By
contrast, the more likely contracting parties are homogeneous and engage
in repetitive transactions with low transactional variance, the more likely
a contextual approach will be efficient because it will foster the develop-
ment of more standardized terms by trade groups, lawyers, and the parties
themselves.68 Other scholars, however, argue that heterogeneous parties,
such as one-shot contractors and parties with asymmetric information,
have higher renegotiation costs, and so are more likely to favor broader
court intervention through interpretation and implied terms, whereas
more homogeneous parties in commercial subcommunities are able to rely
more on renegotiation as well as extralegal sanctions and so prefer more
formalistic approaches by courts.69
The relative bargaining power of the parties may also be important,
though scholars again draw different inferences from this characteristic.
Schwartz and Scott (2003, p. 580) argue that if the seller has bargaining
power, it will not lose as much from adverse interpretation and so would
not be willing to pay for a contextual interpretation even if that party
would benefit from that methodology. Ben-Shahar (2009), by contrast,
argues that courts should set default rules in a way that benefits parties
with bargaining power, because they would have been likely to obtain
those benefits had the parties bargained over them explicitly.
68
69
Katz (2004, pp. 528–9).

11. Court Competence and Error

An alternative approach to interpreting and implying contractual terms
is to focus not on the contracting parties, but on the court or other deci-
sionmaker, such as a jury or arbitrator. The degree of court competence,
error, and independence can help determine the optimal interpretive strat-
egy. At one extreme, if courts are highly competent and honest, and can
accurately interpret contextualist evidence at relatively low cost, then such
evidence should always be allowed to interpret or imply terms, at least if
the cost of producing such evidence and related litigation costs are not too
high. At the other extreme, if courts are incompetent and corrupt, or make
too many mistakes in interpreting or implying terms (or can reduce those
mistakes only at high cost), then textualism becomes superior if the trans-
action costs of contracting are lower than the expected savings resulting
from fewer court errors.70
Scholars disagree, however, over whether strict approaches to interpre-
tation and implied terms, such as textualism, lead to more court error than
broader approaches, such as contextualism. Hadfield (1994) develops a
formal model of good faith clauses in intentionally incomplete contracts
with probabilistic court error, from which she deduces that courts of
low competence should not follow bright line rules, but instead should
use more flexible standards. Bright line rules correspond to textualism,
whereas standards correspond to contextualism. Bright line rules may
compound rather than ameliorate court error by a court of limited compe-
tence, because a bright line rule setting forth a required action will so often
be ‘wrong’. Thus, parties may respond to a bright line rule by engaging in
inefficient behavior encouraged by the rule. Standards, by contrast, are
more likely to encompass the ‘efficient’ response, and so the parties will be
more willing to engage in optimal behavior.
Other scholars, however, conclude that contextualism is more likely
to lead courts astray. Schwartz and Scott (2003, p. 587) posit that con-
textualism creates more opportunity for court error, because there are
many possible ‘private languages’ that parties could falsely assert, and
contextualism does not lead courts to reach correct interpretations on
average. Goldberg studies a number of cases in depth and concludes that
‘courts seem rather oblivious to the economic context when interpreting
contracts’, which might be facilitated or exacerbated by the considera-
tion of contextual evidence (2006, p. 163). These conclusions result from
optimism about the likelihood of a textualist approach to yield the result
the parties intended, as well as skepticism about the ability of courts to
70
Richard A. Posner (2005, pp. 1592–3); Eric Posner (1998, pp. 542–44).

understand the economic context and police manipulated contextual evi-

dence. One might suppose, however, that if the economic context points
clearly toward a particular interpretation, it would not be so hard for good
lawyers to enlighten judges about that context. Moreover, manipulation
of contextual evidence can be reduced by such means as insisting on objec-
tively verifiable evidence such as trade usage,71 imposing a higher burden
of proof, restricting the role of the jury,72 or seeking indicia of opportun-
ism.
Another argument for textualism based on court error draws inferences
from an alternative governance mechanism: arbitration. Arbitrators are
generally thought to have greater expertise in particular business contexts
than courts. This greater expertise enables arbitrators to evaluate con-
textual evidence such as trade usages at lower cost and with fewer errors
than courts. Thus, because parties can easily contract for arbitration, one
can infer that their failure to do so suggests a majoritarian preference
for textualism.73 Parties may choose arbitration for reasons other than
expertise and interpretive methodology, however, including lower costs,
greater privacy, and the tendency of arbitrators to make middle-of-the-
road rulings.74 The last feature of arbitration may arise out of a concern
with arbitrator error; middle-of-the-road damage awards may substitute
for judicial review.75 Bernstein (1996, 1999, 2001) takes a somewhat differ-
ent tack, arguing that contracting parties who deal in specialized markets
often prefer private dispute rules and procedures because those rules and
procedures are more formalistic, which she argues supports the conclusion
that contracting parties do not favor contextualist interpretation. But the
formalist approaches of specialized decisionmakers may simply reflect
the fact that they already have internalized much of the relevant context,
so the marginal benefit of additional contextual information is relatively
low. Thus, the preference of parties for formalistic decisionmaking in this
setting does not imply a similar preference in more generalist courts, where
the variance of expertise, and hence the marginal benefit of contextual
evidence, is greater.76
Court error may affect not only the parties’ substantive intentions
under the contract, but also their preferred interpretive methodology,
namely the choice between textualism and contextualism itself. The
71
Bowers (2005, p. 610).
72
73
74
75
76
Katz (2004, pp. 526–7).

contracting parties may prefer textualism and express that preference

through merger clauses, though in fact these clauses do not really
endorse textualism but rather exclude certain types of contextual evi-
dence, most typically prior negotiations.77 If courts err in determining
the parties’ methodological preference (by declining to enforce merger
clauses strictly, for example), they may choose contextualism too often.78
But once again, this conclusion depends on the assumption that if courts
use textualism (this time to decide the parties’ methodological prefer-
ence), they will err less often because the costs to the parties of accu-
rately expressing their methodological intentions are low. One would
think, however, that the costs to the parties of drafting a particularized
methodological term are quite high. Not only is methodological prefer-
ence merely a second-order concern for the parties, it is difficult for the
parties to predict how court error will likely impact the wide variety
of possible disputes they might have, and methodological preference
terms (unlike substantive contract terms) have no contractual use to the
parties outside of litigation. As a result, it is not obvious a priori that
choosing a textualist approach to determine the parties’ methodological
preference minimizes court error.
Suppose, for example, that the parties generally prefer a textualist
approach and expect interpretation x of some term. There are actually
three ways the court could err. The court could take a contextual approach
but reach interpretation x. Or the court could take a textual approach and
reach interpretation y. Or the court could take a contextual approach and
reach interpretation y. Although the parties might prefer the textualist
approach, it might be more important to them that the court gets the term
right, however the court does it. If courts are more likely to choose the
desired interpretation x using a contextual approach and interpretation
y using a textual approach – either because the parties underestimate the
courts’ competence with respect to that term or because their expressed
preference for textualism inaccurately conveys the parties’ correct esti-
mate of the courts’ competence in this instance – then error costs could be
reduced if the court ‘mistakenly’ used a contextual approach.
To give a simple numerical example, suppose the court can choose
either a textualist or contextualist methodology. If it chooses textualism,
the likelihood of interpreting the term the way the parties want is 0.4; if
it chooses contextualism, the likelihood of interpreting the term the way
77
Bowers (2005, pp. 603–4, n. 63).
78
Schwartz and Scott (2003, pp. 589–90); Eric Posner, (1998, pp. 547–8,
570–71).

the parties want is 0.6. Suppose further that ex ante the parties would
value the court’s using textualism and choosing x at 100; would value the
court’s using contextualism and choosing x at 80; would value the court’s
using textualism and choosing y at 50; and would value the court’s using
contextualism and choosing y at 10. Thus, the parties prefer textualism to
contextualism, but prefer the right outcome more. The expected value if
the court uses a textualist approach is (0.4 x 100) 1 (0.6 x 50) 5 40 1 30 5
70. The expected value if the court uses a contextualist approach is (0.6 x
80) 1 (0.4 x 10) 5 48 1 40 5 88 . 70.
The point is that the possibility of court error does not always argue
in favor of textualism. Both textualist and contextualist methodolo-
gies lead to court error. The real question is which methodology has the
lowest error rate and at what cost. It is hard to answer this question in the
abstract. This may help to explain why courts do not use pure interpre-
tive methodologies, but tend to switch back and forth depending on the
circumstances – choices that themselves are subject to error.
12. Agency Costs and Third Party Interests

Many analyses of interpretation and implied terms assume a simple con-
tracting situation in which the same two monolithic parties negotiate,
draft, perform, and litigate the contract and no third parties have any
rights or interests in the contract. Real world contracting often diverges
from these assumptions. For one thing, many contracting parties are enti-
ties, which act only through agents. Different agents may be involved at
different stages of the contract. Entity parties may use various contract
terms to protect against undesired conduct by agents. For example, a sales
or purchasing agent may make extravagant promises during negotiations
that the entity does not want to be bound by. Entities may use merger
clauses, and may prefer textualism, to solve this problem. Thus, one can
argue that courts should be sensitive to the likelihood of agency cost prob-
lems in deciding on an interpretive methodology.79
As with many of the other factors, however, agency cost problems do
not invariably favor textualism. For example, although sales and purchas-
ing agents may act contrary to the interests of the entity, in-house counsel
who review the contracts and draft the final terms are also agents who may
act contrary to the interests of the entity by drafting unnecessarily complex
and overly formalistic documents that serve their own self-interest in
avoiding liability. If lawyer agency problems are greater than the agency
problems associated with negotiating agents, contextualism may be the
79
Katz (2004, p. 533).

optimal interpretive strategy.80 Another problem with the agency cost

argument for textualism is that it considers only one side of the contract
and ignores the interests and perhaps reasonable expectations of the other
side, which may legitimately fear being lured into the contract on false pre-
tenses and so may favor a contextualist approach. Moreover, the agency
cost problem may implicate some kinds of contextual evidence, such as
prior negotiations, more than others, such as trade usage.
A related problem is that third parties other than the original parties
who agreed to the contract often have an interest in the contract. For
example, the contract may be assigned, one of the original parties may
merge or go bankrupt or die, a non-party may guarantee performance, or
a lender or investor may base decisions on contractual obligations.81 These
third parties may not know all the contextual evidence the drafting parties
know and may not be able to discover such evidence at low cost. It may
therefore be in the interest of the original contracting parties to use clauses
such as merger clauses and to prefer textualism more generally to make
third parties more willing to deal with the original contracting parties on
favorable terms.82 Again, however, this conclusion does not invariably
hold. For example, the third party may be privy to the original negotia-
tions, may be aware of relevant trade usages, or may be able to find out
the relevant contextual information from the original parties at low cost.
Moreover, the third party’s interests might not be implicated in a given
dispute or the third party might not have relied on the specific text of the
contract.
13. Summary
To a large degree, the economic approach to interpretation and applied
terms parallels the approach in other areas of contract law. Court inter-
vention, which in this case means a greater willingness to imply terms and
use a contextualist methodology for discerning contractual intent, is most
justifiable when contracts are efficiently incomplete and extralegal enforce-
ment is relatively ineffective, when courts can accurately assess contex-
tual evidence and police against opportunistic behavior at relatively low
cost, and when parties can easily contract for stricter rules. Many of the
economic factors, however, can cut in either direction, depending on the
circumstances. Therefore the institutional and contractual context matters
greatly in deciding what approach efficiency-minded courts should take.
80
Katz (2004, p. 534).
81
Burton (2009, p. 200).
82
Katz (2004, pp. 534–5).

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PART II
REMEDIES

9 Contract remedies: general
Paul G. Mahoney*1
1. Introduction
The principal remedy for breach of contract in Anglo-American law is an
award of money damages. The preferred measure of damages is the expec-
tation measure, under which the promisee receives a sum sufficient, in
theory, to make him indifferent between the award and the performance.
Other damage measures, and other remedies such as specific perform-
ance and rescission, are available in special circumstances. This chapter
discusses the basic design of the remedial system.
A. THE GENERAL PROBLEM
2. Sanctions and Incentives

A contract is an exchange of promises or an exchange of a promise for
a present performance, and the parties enter into it because each values
the thing received more than the thing foregone. These values are based
on expectations about the future because some or all of the contractual
performance will occur in the future. When the future diverges from what
a party expected, he may conclude that the performance he will receive
under the contract is no longer more valuable than the performance he
must provide. He has, in the terminology of Goetz and Scott (1980), expe-
rienced a ‘regret contingency’ and now would prefer not to perform and
not to receive the promised performance from the other party.
Absent a system of contract remedies, a party who regrets entering into
a contract will not perform unless he fears that the breach will result in
sanctions by the other party (who might have required security for the
performance) or by third parties (who might revise their opinion of the
breacher and reduce their economic and/or social interactions with him
accordingly). The economic function of contract remedies, then, is to
alter the incentives facing the party who regrets entering into the contract,
which will directly affect the probability of performance and indirectly
affect the number and type of contracts people make, the level of detail
* Paul G. Mahoney thanks Eric Talley and two anonymous referees for
helpful comments.
155

with which they identify their mutual obligations, the allocation of risks
between the parties, the amount they invest in anticipation of performance
once a contract is made, the precautions they take against the possibility
of breach, and the precautions they take against the possibility of a regret
contingency.
An administratively simple system of remedies would aim to reduce the
probability of breach to near zero. That could be achieved by the routine
(and speedy) grant of injunctions against breach, backed by large fines
for disobeying the injunction, or by imposing a punitively large monetary
sanction for breach. This would give promisees a high degree of confidence
that the promised performance will occur and induce a high level of invest-
ment in anticipation of performance. In the standard parlance, this would
be a ‘property’ rule because it would entitle the promisee to the perform-
ance except to the extent the promisor could negotiate a modification on
terms acceptable to the promisee.
3. Efficient Contracts and Efficient Nonperformance

Were it possible to enter into complete state-dependent contracts (that is,
contracts that identified every possible contingency (state) and specified
the required actions of the parties for each), parties would be willing to
be bound to contracts even were the sanction for breach punitive. Such
contracts would require performance in some states but excuse it in others,
in such a way that each party would be willing ex ante to be absolutely
bound to perform the required actions in all states. Shavell (1980) defines
a ‘Pareto efficient complete contingent contract’ as a complete state-
dependent contract to which no mutually beneficial modifications could
be made, viewed at the time of contracting. We will call such contracts
‘efficient’. In doing so, we will assume unless otherwise stated that the
parties are risk neutral, each party’s objective is to maximize his wealth,
post-contractual renegotiation is prohibitively costly, performance is all or
nothing (that is, partial performance is not possible), and the contracts do
not create uncompensated gains or losses for third parties.
Under what conditions would an efficient contract excuse perform-
ance? Shavell demonstrates that the contract would require performance
in all circumstances except those in which nonperformance would result
in greater joint wealth. An example will illustrate the point. Imagine that
Seller agrees to manufacture and sell to Buyer a machine that Buyer will
use in its own manufacturing process. The value of the machine to Buyer
is $300; however, Buyer has an opportunity to make certain alterations
to his manufacturing plant, at a cost of $50, which will increase the
value of the machine to $375. Such investments by a promisee in antici-
pation of performance are called ‘reliance expenditures’ or ‘reliance

Contract remedies: general 157
investments’ in the literature, and we will use the terms interchangeably.

Assume for the moment that the future can be represented as a set of
two possible states; Seller’s production cost is $200 in one state and
$400 in the other. An efficient contract would require Seller to make
the machine in the low-cost state but not in the high-cost state. In the
high-cost state, the joint wealth of the parties is greater if Seller does
not perform than if it does. This can be seen by comparing the cost of
performance to Seller ($400) with the benefit to Buyer ($300 or $375,
depending on whether Buyer makes the reliance investment). The con-
tract price is irrelevant as it is transferred from Buyer to Seller and does
not affect their joint wealth.
Both parties can be made to prefer this contract to one that requires per-
formance in both states. They can allocate between themselves the extra
wealth created by the efficient contract, and there will be some allocations
under which each party’s expected gain exceeds the expected gain from the
contract that always requires performance. By choosing such an alloca-
tion, each party will be better off at the time of contracting and willing to
be bound to perform or not perform as required. In the literature, a breach
that occurs in circumstances in which an efficient contract would excuse
performance is called an ‘efficient breach’.
4. Barriers to Efficient Contracting; Remedies as a Substitute for Efficient

Contracts
To reiterate, faced with an efficient contract, courts would have the simple
task of requiring strict adherence to its terms. Unfortunately, the writing
of efficient contracts is no easy task. It is costly to bargain over remote
contingencies and the parties may lack the foresight to deal with all possi-
ble states. Moreover, the parties may not have equal access to the informa-
tion necessary to tell which state occurs. In the above example, Seller may
know whether the cost of manufacturing the machine is $200 or $400, but
Buyer may be unable to observe Seller’s cost or verify Seller’s assertions
about cost.
Given these barriers to efficient contracting, the law faces a more
complex problem than that of compelling adherence to efficient contracts.
Instead, it must take incomplete contracts and augment them by damage
measures that induce behavior that mimics reasonably closely the behav-
ior that an efficient contract would require. A particular damage measure
can be termed ‘efficient’ with respect to a particular decision if it creates an
incentive for the relevant party to make the same decision it would under
an efficient contract. Because standard damage measures allow a promisor
to breach and pay compensatory (rather than punitive) damages, they are
called ‘liability’ rules in contrast to property rules as defined above.

5. Other Approaches
An alternative framework for the design of damage measures is offered by
Barton (1972). He poses the problem as one of designing damage measures
that would induce the parties to make the same decisions regarding per-
formance or breach, and reliance prior to performance or breach, that they
would make were the parties divisions of a single, integrated firm and had
the sole objective of maximizing the value of the firm. Shavell and Barton
each show that the objective of an efficient regime of contract damages is
to cause the parties to maximize their joint wealth. Both approaches start
from a wealth-maximization definition of efficiency and assume away
third party effects. Unsurprisingly, then, both conclude that damages rules
should maximize the joint wealth of the parties.
A more recent perspective on contract damages is to consider money
damages as an option under which, for example, Seller may purchase
Buyer’s entitlement to Seller’s performance. The option expires on the
date fixed for performance and its strike price is the damage award (which
may from the parties’ perspective be a random variable). The value of
the option is reflected in the contract price (see Mahoney, 1995; Ayres
and Talley, 1995; Scott and Triantis, 2004). This literature derives from
the more general use of option theory to analyze decision making under
uncertainty (see Dixit and Pindyck, 1994). We will make occasional
reference to the options perspective below.
The growing and influential literature on contract theory has less direct
relevance to the study of contract remedies. For the most part, that litera-
ture attempts to determine how contracting parties can solve problems of
hidden action (moral hazard) or hidden information (adverse selection).
In doing so, the models typically assume that the actions required of the
parties under their contracts are enforced perfectly. Alternatively, some of
the models posit no enforcement at all and seek to determine whether a con-
tract can be designed such that it will always be in the interests of each party
to take the required actions in all states. Bolton and Dewatripont (2005)
and Laffont and Martimort (2002) provide comprehensive introductions
to the main techniques and results in contract theory.
B. THE STANDARD DAMAGE MEASURES
6. A Taxonomy of Damage Measures

Contract damages in Anglo-American law are compensatory. That is,
they are paid to the promise and measured by the promisee’s loss from the
promisor’s nonperformance rather than, for example, the promisor’s fault.
The preferred measure is the expectation measure – that is, the amount of
money that will make the promisee indifferent between performance and

damages. It should be noted at the outset that this formulation of the

measure of damages is not fully accurate; there are a number of limiting
doctrines, discussed in Chapter 4620 in Posner (2000), that often reduce
money damages below the promisee’s subjective valuation of the perform-
ance. There is also some evidence that courts award greater damages for
breaches that appear opportunistic (see Cohen, 1994). As courts express it,
however, the preferred measure of damages is the amount necessary to put
the aggrieved party in the same position as if performance had occurred,
which is known as the expectation measure.
Fuller and Perdue (1935) provide the standard taxonomy of contract
damage measures. They identify three different ‘interests’ of the promisee
that are affected by a breach – expectation, reliance, and restitution – and
state that the most common damage measures provide compensation for
one of the three. The expectation interest is measured by the net benefit
the promisee would receive should performance occur, as described above.
The restitution interest consists of any benefit the promisee has provided
the breaching party. For example, if a seller agrees to make monthly deliv-
eries of a commodity in return for fixed payments due 60 days after each
delivery and the buyer repudiates the contract after receiving and retain-
ing two deliveries but making no payments, restitutionary damages would
restore to the seller the value of the delivered goods. The reliance interest
is measured by the promisee’s wealth in the pre-contractual position.
Reliance damages provide compensation both for any benefit conferred
on the breaching party and for any other reliance investments made by the
promisee in anticipation of performance to the extent such investments
cannot be recovered.
Craswell (2000) criticizes Fuller and Purdue’s normative identification
of the three damages measures with three ‘interests’ of the promisee on the
grounds that those interests have no necessary normative significance. As
our concern is principally descriptive, however, we will not be concerned
with that aspect of the three-part taxonomy of contract remedies. To a
more limited extent, Craswell also argues that Fuller and Purdue’s tax-
onomy is misleading. Courts apply a wide variety of approaches to finding
the remedy that will adequately compensate the promisee, some of which
do not map easily onto the expectation-reliance-restitution trilogy. Most
commentators sidestep this problem by viewing it as one of measuring
expectation damages in certain circumstances rather than as a conceptual
limitation of the taxonomy itself, and we will follow that convention.
Scott and Triantis (2004) mount a broader conceptual attack on the
notion that money damages should compensate the promisee for its lost
expectation. They note that a number of contract doctrines excuse per-
formance under certain circumstances and parties often draft contracts

that add additional conditions under which performance is not required.

The ability to breach and pay damages is, moreover, an additional excep-
tion to the obligation to perform. This means, Scott and Triantis argue,
that contracts have embedded within them a set of explicit and implicit
options under which the promisor may either perform or pay a price.
Under that reasoning, contract remedies should be designed to assure that
these options are correctly priced rather than to compensate the promisee
for the value of the lost performance. Although this perspective poses a
theoretical challenge to the notion of compensatory damages, its practical
significance is more obvious in the case of liquidated damages.
In most instances, the restitution measure will provide the lowest recov-
ery and the expectation measure the highest. One complication is how to
treat other contractual opportunities that Buyer passed up in order to
enter into the contract with Seller. Analytically, these seem similar to reli-
ance investments and are often treated as such. In a competitive market,
where Buyer could have entered into another contract at an identical price
had he not contracted with Seller, the reliance measure and the expecta-
tion measure will converge approximately. ‘Approximately’, because the
value of the alternative contract is a function of the probability that it
will be performed (see Cooter and Eisenberg, 1985) and of the damage
remedy if it is not performed, and thus the problem is somewhat circular.
When analyzing the difference between expectation damages and reliance
damages below, we will assume that they differ and that Buyer’s expecta-
tion interest exceeds his reliance interest. We will also assume that the
reliance interest equals or exceeds the restitution interest, although we will
relax that assumption in Section 12 below.
7. Incentives within an Existing Contract: The Decision to Perform or

Breach
The expectation measure leads to efficient decisions to perform or breach
an existing contract, given a fixed level of reliance (see Barton, 1972;
Shavell, 1980; Kornhauser, 1986). This can be illustrated using the example
set out above. Assume that the contract price for the machine is $250 and
that Buyer makes an irrevocable decision to invest $50 in reliance, an
investment that has no value absent the contract. When production costs
are $200, Seller will manufacture the machine and Buyer will pay $250 for
it. Buyer then obtains a machine worth $375 to him for a total expendi-
ture (contract price plus reliance expenditure) of $300. The transaction
increases Buyer’s wealth by $75. When production costs are $400, Seller
will breach. The expectation measure seeks to make Buyer as well off as if
Seller had performed. Seller’s breach relieves Buyer from his obligation to
pay the contract price. Accordingly, if Seller pays Buyer damages of $125,

Buyer will be in the same position as if Seller had performed, having paid
out a non-recoverable $50 in reliance and received $125, for a net increase
in wealth of $75.
So long as Buyer is awarded $125 in the event of breach, Seller will
breach only when the cost of performance exceeds $375, the value of the
performance to Buyer. Compare this result to that obtained under the reli-
ance measure. Under the reliance measure, Seller must compensate Buyer
for his $50 reliance investment. Assume for a moment that there is a third
possible state under which Seller’s cost of production is $350. Performance
would be efficient because its value to Buyer exceeds its cost to Seller.
Seller will perform under a rule of expectation damages, because the
damage award of $125 exceeds Seller’s net loss from performance ($350
cost minus the $250 contract price). Under a rule of reliance damages,
however, Seller will breach and pay $50 rather than perform at a loss of
$100. More generally, it is obvious that under expectation damages, only
when the production cost reaches $376 will Seller become better off by
breaching and paying damages then by performing and losing the differ-
ence between his production cost and the contract price. The expectation
measure, unlike the reliance measure, causes Seller to internalize fully the
effect on Buyer’s wealth of Seller’s decision to perform or breach.
These results turn on an assumption of costly renegotiation. If rene-
gotiation is costless, the Coase Theorem (Coase, 1960) holds that the
damages rule will not affect whether trade occurs ex post. After the promi-
sor’s costs are revealed, the parties will renegotiate to reach the efficient
breach/perform decision no matter what incentives the damages rule pro-
vides. Some critics have therefore argued that much of the literature on
damage remedies is beside the point, as the choice of remedies should be
informed principally by an analysis of transaction costs (see Friedmann,
1989; Macneil, 1982). Friedmann analyzes potential transaction costs in
a variety of contractual settings and argues that overcompensatory rem-
edies (remedies that provide compensation to the promisee in excess of the
expectation interest) will generally be efficient.
8. Incentives within an Existing Contract: The Decision to Rely

While the expectation measure produces efficient decisions to breach given
a fixed level of reliance, it does not produce efficient levels of reliance. In
general, expectation damages result in excessive reliance expenditures
because they cause Buyer to act as if performance were always efficient.
In the example, Buyer will always spend $50 to increase the value of per-
formance from $300 to $375, because either (1) the performance will be
forthcoming or (2) Buyer will be compensated for the lost $375 in value.
In the high-cost state, however, the parties’ joint wealth would be greater if

Buyer refrained from investing. Seller would be liable for damages of $300
less the $250 contract price, or $50. By contrast, if Buyer relies, he receives
$125 in damages as shown above and increases his wealth by $75 net of
the reliance expenditure. Unlike the no-reliance case, where Buyer gains
$50 and Seller loses $50, here Buyer gains $75 and Seller loses $125. The
difference reflects the fact that the $50 expenditure is wasteful in the high-
cost state. Expectation damages, then, do not cause Buyer to internalize
fully the effect on Seller’s wealth of Buyer’s decision to make a reliance
investment.
The reliance measure is subject to the same objection. Under the reli-
ance measure, Buyer will recover $50 if it invests that amount in reliance.
Once again, Buyer’s investment decision will be made as if the investment
is not risky, even though it is (because performance is inefficient in some
states). Indeed, reliance damages create a perverse incentive for Buyer in
some circumstances. Assume for a moment that Seller’s production cost
is $310. Under the reliance measure, Seller will pay damages of $50 rather
than perform and suffer a loss of $60 ($310 minus the $250 contract price).
Breach deprives Buyer of a $75 gain (showing again that any measure
of damages less than the expectation measure induces inefficient breach
decisions). Buyer may be able to avoid breach, however, by making an
additional (and we will assume wasteful) reliance expenditure of $11. Now
reliance damages amount to $61, and Seller performs. Thus the excessive
breach problem can be cured in part, but at the cost of excessive reliance.
In general, as Shavell (1980) demonstrates, the reliance measure will result
in greater (inefficient) reliance expenditures than the expectation measure.
However, expectation damages do better than reliance damages at induc-
ing efficient breach decisions, and do no worse than reliance damages
at inducing efficient reliance decisions. Accordingly, given the various
assumptions outlined above, the expectation measure is preferable on
efficiency grounds.
Edlin and Schwartz (2003), drawing on Edlin (1996), show that liq-
uidated damages can cure the incentive to overinvest. The intuition is
straightforward. Expectation damages lead to overinvestment because
they award the promisee’s expected net payoff given its actual investment.
Thus, more investment leads to a larger damages award. Because liqui-
dated damages are by hypothesis fixed without regard to investment, the
promisee cannot improve its payoff by overinvesting.
Schweizer (2005) shows that in a very general game-theoretic setting in
which the courts can identify efficient conduct, there is always a damages
measure that creates incentives for efficient behavior at all stages and
therefore would prompt both efficient reliance and efficient performance/
breach decisions. The analysis is nicely intuitive as it demonstrates that

the optimal remedial scheme satisfies the standard minmax property of

optimal strategies. However, efficient outcomes require liability for ‘fault’,
which amounts to any inefficient behavior (including inefficient reliance).
The analysis therefore puts an unrealistically high burden on courts. As
Schweizer notes, in a contractual setting in which the parties specify a non-
state-contingent price and output, the promisee may still have an incentive
to make excessive reliance investments. The frequency with which such
contracts are observed suggests that the magnitude of the overinvestment
problem is often modest.
The analysis to this point has assumed risk neutrality. A risk-averse
Buyer would have additional cause to prefer the expectation measure
to the reliance measure, because the former eliminates variability from
Buyer’s outcome. At the same time, the expectation measure introduces
greater variability into Seller’s outcome than does the reliance measure.
It is accordingly possible that where both parties are risk averse, they
may find that a sum of damages greater than the reliance measure but
less than the expectation measure offers the highest joint utility level. The
precise formulation of the damage amount would depend on the parties’
comparative levels of risk aversion (see Polinsky, 1983). It seems plausible
that courts have not tried to alter damage measures to accommodate risk
aversion (except to the extent specific performance can do so, as discussed
in Section 10 below) because of the administrative and error costs that
would result.
9. Incentives at the Stage of Contract Formation

Friedmann (1989) and Macneil (1982) argue that a better understanding
of the costs of post-contractual renegotiation is necessary for making effi-
cient remedial choices. While this point is correct, it is also worth paying
attention to the effect of remedies on pre-contractual negotiations.
The price Seller will require to enter into a contract is increasing in the
damage measure. Returning to our example, when Buyer makes a $50
reliance expenditure and Seller breaches, again assuming no opportunity
costs, Buyer’s wealth decreases by $50. Buyer can be no worse off from
entering into the contract so long as the remedy for breach is at least $50.
Will Buyer be willing to pay more for the more generous expectation
measure, and will Buyer and Seller prefer the resulting contract to one that
provides for reliance damages only? As Friedman (1989) notes, the differ-
ence in remedies affects the contract price, the quantity contracted, and the
quantity actually consumed, with effects that vary with market structure
and utility functions. In general, however, the range of contract prices for
which the contract increases both parties’ wealth will be greater under
a reliance measure than an expectation measure. That is, the reliance

measure will create a greater bargaining range, which might increase the
number of contracts entered into.
The choice of remedies where pre-contractual as well as post-contractual
incentives are analyzed remains an underdeveloped area. Friedman (1989)
provides a formal analysis of expectation and reliance for two contexts in
which those measures diverge. The first is the case of a breaching buyer
who has contracted to purchase from a monopolist selling at a single price.
The second is the case of a breaching buyer in a competitive market where
the seller does not know its production cost in advance but the buyer does.
Friedman demonstrates that neither damage remedy dominates the other
under those conditions. Friedman’s analysis is limited, however, by his
assumption that reliance is fixed and exogenous. The situations he ana-
lyzes, moreover, have the desired formal characteristics (expectation and
reliance measures diverge), but are probably not very common.
A possible alternative would be to start by assuming that the expecta-
tion and reliance measures diverge without specifying market structure
in detail. A model could then be developed in which the choice between
expectation and reliance damages affects the structure of the contract,
the decision to breach, and the decision to rely. Such a model might shed
light on the type of market conditions under which expectation or reli-
ance damages would be more nearly optimal. It would also be valuable to
consider carefully whether there are plausible conditions under which the
cost of negotiating around an inefficient damages measure at the time of
contracting is greater or less than the cost of renegotiating at the time of
performance.
C. ALTERNATIVE DAMAGE MEASURES
10. Specific Performance

Disappointed promisees are not always awarded money damages; under
appropriate circumstances, they may seek the equitable remedy of specific
performance. A decree of specific performance requires the breaching
party to perform according to the contract. The principal criterion for
awarding specific performance is a demonstration that money damages
are insufficient to compensate the promisee for the lost performance.
Traditionally, this was most often found when the breaching party was
a seller who had agreed to sell a ‘unique’ good. Real estate has long been
presumed in many jurisdictions to be unique, while other goods such as
artworks and heirlooms are often found to be unique.
Specific performance is analogous to a punitive sanction that seeks to
deter breach absolutely. In order for it to have that effect, we must assume
that renegotiation is costly. It would then seem clear that expectation

damages are preferable to specific performance, because the latter would

sometimes result in performance even though nonperformance would
result in greater joint wealth. On the other hand, it should be clear that
the assumption that courts can adequately calculate a sum of money suf-
ficient to make the promisee indifferent between damages and breach is
not always accurate, particularly where cover is not possible. In such cir-
cumstances, the courts are left to estimate the subjective value that Buyer
attaches to the performance. This is not a fatal objection if we believe that
courts will guess correctly on average, but if they systematically underesti-
mate Buyer’s surplus, the monetary remedy will result in too much breach,
just as specific performance results in too much performance.
Kronman (1978) started the law and economics debate on specific
performance by employing a framework similar to that of the prior para-
graph. He notes that specific performance is a property rule in the sense
defined in Section 2 above; it effectively assigns the promisee an absolute
entitlement to the goods from the moment the contract is made. This does
not make sense in most instances because renegotiation (meaning a trans-
fer of the property right back to the promisor) is costly and the result will
be an inefficiently high level of performance. The danger of undercompen-
sation, which would result in an inefficiently low level of performance, is
normally lower because there is often a substitute price available. When,
however, there is no substitute price available (the case of ‘unique’ goods),
the danger of undercompensation likely outweighs the cost of renegotia-
tion. Accordingly, the legal rules, in a rough manner, promote efficiency.
Schwartz (1979) argues that undercompensation is not merely an iso-
lated problem limited principally to goods for which there is no obvious
substitute, but is built into the structure of money damages. The reluc-
tance of courts to award damages that are uncertain, difficult to measure,
or unforeseeable (see Chapter 4620 in Posner, 2000), or to provide com-
pensation for emotional harm resulting from a breach, makes money
damages systematically undercompensatory. Schwartz argues that the
resulting inefficiencies are likely greater than those resulting from rene-
gotiation costs, and accordingly that specific performance, rather than
money damages, should be the default remedy.
Bishop (1985) adopts a similar analytical approach but argues that both
Kronman and Schwartz have overgeneralized their arguments. He catego-
rizes contract breaches based on the identity of the breaching party (buyer
or seller), the type of contract, and the alternative transactions available to
buyer and seller. He identifies another cost of awarding specific perform-
ance when renegotiation is possible. When the parties may renegotiate
so that the promisor pays a sum of money to be released from perform-
ance, that sum may exceed the value of performance to the promise. As a

consequence, the promisee will be tempted to behave opportunistically in

hopes of causing a breach and satisfying the conditions for specific per-
formance. Bishop argues that in some categories the problem of excessive
breach resulting from undercompensation will dominate, and in others the
problem of excessive performance resulting from renegotiation costs and
opportunism will dominate.
The relative magnitudes of the inefficiencies generated by costly rene-
gotiation and undercompensation are empirical questions and to date
the literature does not provide data from which we could confidently
identify the preferred remedy. Accordingly, Mahoney (1995) takes a dif-
ferent approach to the problem, using the option methodology outlined
above. The methodology is first employed to confirm the argument made
by Craswell (1988) that were renegotiation costless and money damages
perfectly compensatory, risk-averse contracting parties would always
prefer money damages to specific performance. The intuition is that enter-
ing into a contract with a money damages remedy is analogous to holding
a hedged position in a commodity, whereas the identical contract with a
specific performance remedy is analogous to holding an unhedged posi-
tion. The variance of possible outcomes is greater for both parties with the
unhedged contract and they will accordingly prefer money damages. In
the face of costly renegotiation and undercompensation, we can still make
some sense of the case law using the option heuristic. Many contracts
involving ‘unique’ goods are prompted by the buyer’s desire to specu-
late on the future value of the land, artwork, and so on, and speculation
involves holding an unhedged position. Thus buyer and seller would likely
prefer specific performance. Other cases in which specific performance has
been consistently awarded (long-term contracts to supply a fuel input to a
public utility or other regulated entity) can be explained by noting that the
buyer is likely more risk averse with respect to price fluctuations than is the
seller, and specific performance better accommodates that distinction.
11. Liquidated Damages

We began the analysis of damages by arguing that court-awarded damages
function as a substitute for complete state-dependent contracts. The
court’s application of an efficient damages rule creates appropriate incen-
tives to perform or not perform, rely or not rely, and so on, and thereby
saves the parties the trouble of drafting their contract to provide for all
contingencies.
Some parties, however, choose to create a tailor-made incentive struc-
ture by specifying the amount of damages payable in the event of breach.
Courts have adopted a skeptical attitude toward these so-called liquidated
damages clauses.

A detailed discussion of the scholarly literature on liquidated damages

appears in Chapter 4610 in De Geest and Wuyts (2000).
12. Rescission/Restitution
Courts divide contract breaches into ‘partial’ and ‘total’ breach. A partial
breach gives the promisee the right to seek a remedy but not to refuse
his own performance. The classic example is when a builder constructs a
house that contains a minor deviation from the agreed architectural plan.
The builder must compensate the owner for the difference in value (in
theory, the difference in subjective value to buyer, but it will usually be dif-
ficult to convince a court that this differs substantially from the difference
in market value). The owner may not, however, refuse to accept delivery of
the house and to pay the agreed price. A total breach, by contrast, permits
the promisee to refuse to render his own performance. In effect, a total
breach permits the promisee to rescind the contract.
As courts express it, a promisee can respond to a total breach by
seeking expectation damages or by rescinding and seeking recovery of
any value he has provided to the breaching promisor. The latter alterna-
tive is equivalent to the restitution measure of damages (although in some
circumstances the promisee may seek return of the performance in kind
rather than its monetary equivalent). Restitution is also a remedy in quasi-
contractual situations, such as when parties partly performed a contract
that is voidable for mutual mistake, but the following discussion will be
limited to restitution damages as a remedy for breach.
In the typical case, expectation damages will exceed restitutionary
damages and the promisee will seek the former. There are two instances,
however, in which we would expect the promisee to seek the latter. The first
is when the promisee is risk averse and prefers the certainty of the return of
money or property that he has given the promisor to the uncertainties of a
jury’s assessment of his expectation and the additional litigation costs that
would be incurred in the attempt. The second is when the contract was a
losing deal for the promisee, so that his expectation is negative. Where the
promisee has provided something of value to the promisor that cannot be
easily returned, but can be valued in a judicial proceeding, the promisee
may be better off receiving that value in cash than receiving the promised
performance.
This might be thought a remote possibility, but it occurs in a number of
reported cases. The textbook example is one in which a builder agrees to
build a house for an owner and the builder’s costs turn out to be greater
than expected, making the contract a losing one for the builder. The
owner, however, later decides it does not want the house and repudiates
the contract when the house is partly completed. The builder’s expectation

is negative because of the unexpectedly high costs of construction, so

the builder seeks restitution. Restitution in this instance is measured by
the value the builder has conferred on the owner, or the market value
of the nearly completed house. By hypothesis, this exceeds the contract
price.
When promisees have attempted to recover reliance damages for a
losing contract, courts have concluded that the expectation measure puts
an upper bound on the recovery (see L. Albert & Son v. Armstrong Rubber
Co.). By contrast, some courts have permitted a promisee to recover resti-
tution damages in excess of expectation (see Boomer v. Muir). This seeming
inconsistency has been largely ignored in the law and economics literature.
The most useful discussions appear in a symposium issue of the Southern
California Law Review in 1994. In it, Kull (1994) provides an analysis of
restitution that is similar in many respects to Bishop’s analysis of specific
performance. Money damages are not always an adequate substitute for
performance and the damage calculation is in any event uncertain. Thus
where the promisee has provided something of value to the promisor that
can easily be returned, the promisee may prefer to rescind the transaction,
putting both parties back in the pre-contractual position. For example, the
promisee may have paid in advance for a good or service that the promi-
sor fails to provide. Taking litigation costs into account, the promisee may
prefer to rescind the transaction and retrieve the advance payment.
Rescission and restitution will likely minimize the costs associated with
breach where a seller delivers goods that do not conform to the contrac-
tual specifications. The perfect tender rule, recognized under the common
law and the Uniform Commercial Code, permits a buyer to reject noncon-
forming goods even if the variation is minor. As noted by Priest (1978),
the administrative costs involved in calculating the difference in value
between the goods as delivered and as promised will likely exceed the cost
of returning the goods to Seller and money to Buyer. The costs associated
with salvaging the nonconforming goods might also be minimized by the
perfect tender rule, as in many instances it will be cheaper for Seller to
find another purchaser for the goods than it will be for Buyer to adapt the
goods to Buyer’s own use.
On the other hand, where the contract is a losing one for the promisee
and the promisee has conferred a benefit on the promisor that cannot
easily be returned, the remedy of rescission and restitution is potentially
overcompensatory. Kull argues that the threat of opportunistic behavior
(that is, socially wasteful efforts to exploit an inefficient remedy to obtain
an unbargained-for benefit) will be substantial for such contracts. The
promisee can turn a loss into a gain by inducing breach by the promi-
sor (or convincing a court that mutual uncooperativeness constituted or

resulted from such a breach). By contrast, the perfect tender rule permits
a buyer to behave opportunistically by unreasonably claiming that goods
are defective when their market value has declined, but because the goods
can be returned to Seller, the parties are spared the additional cost of a
court proceeding to determine their value.
D. CALCULATION OF EXPECTATION AND RELIANCE

DAMAGES
13. A Categorization of Approaches to Calculating Damages

There is consensus that the expectation measure is usually superior to reli-
ance or restitution damages. A separate but no less important question is
how expectation and reliance are to be defined and measured in typical
contractual settings. Parties’ valuations are often unknown to one another
(or ‘unobservable’ in contract theory parlance) and to the court (‘unveri-
fiable’), and promisees have an incentive to overstate their valuations,
making the calculation of expectation damages difficult in some settings.
Cooter and Eisenberg (1985) present a very helpful categorization and
analysis of alternative calculation methods. They identify five broad cat-
egories and note that the calculation of money damages in reported cases
usually falls into one of these categories. They are:
(i) Substitute price Often there is a spot market for the contractual
performance at the time and place that performance was due, most
obviously if the performance consists of the delivery of a marketable
commodity. In such an event, Buyer can respond to Seller’s breach by
cover, or the purchase of the commodity on the spot market. (Seller can
respond to a breach by Buyer by selling on the spot market.) The differ-
ence between the contract price and the price at which cover occurred
or could have occurred is then a measure of the cost of making Buyer
(or Seller) indifferent between the contract and the substitute perform-
ance. We should note, however, that the substitute price measure can be
overcompensatory when a promisee chooses not to cover but instead to
sue for the difference between the contract price and the spot price. That
choice itself suggests that the promisee may value the commodity at less
than its market price.
(ii) Lost surplus When cover is unavailable, Buyer’s expectation can be

thought of as the lost consumer surplus from the contract. In our ongoing
example, if Buyer cannot cover, he loses the difference between his valu-
ation of the machine ($300 or $375, depending on reliance) and the $250
contract price. The analysis of Seller’s lost producer surplus from Buyer’s

breach is analogous. The lost surplus measure is feasible only when a court
can verify the promisee’s claimed valuation.
(iii) Opportunity cost If a market exists for the performance, Buyer

could have entered into a contract to obtain the identical performance
from a different seller. The value to Buyer of the best alternative contract
available at the time of the contract with Seller is an important compo-
nent of his reliance. This value cannot be measured objectively because
Buyer did not enter into this hypothetical contract and we do not know
whether the hypothetical contractual party would have performed.
Assuming that the probability of performance of the alternative contract
is high, however, then the increase in value (if any) of the alternative
contract between the time of contracting and the time specified for per-
formance is a good measure of reliance (augmented by any out-of-pocket
expenditures in reliance on the contract with Seller). In a competitive
market, the value of the original and substitute contracts would be the
same at all points in time and the opportunity cost measure will equal
the substitute price measure (a conclusion consistent with Fuller and
Perdue’s conclusion that expectation and reliance damages are equal in a
competitive market).
(iv) Out-of-pocket cost This is the amount of reliance investment, less

any salvage value of that investment. Out-of-pocket cost is the most
common measure of reliance damages; a more complete measure of reli-
ance damages is out-of-pocket cost plus opportunity cost.
(v) Diminished value So far we have ignored partial performance. In

the real world, however, performance is often rendered but is defective or
incomplete. In such cases, an appropriate measure of Buyer’s lost expecta-
tion is the difference between Buyer’s valuation of the promised perform-
ance and his valuation of the actual performance.
As these alternative methods of calculation should make clear, the

measure of damages is usually straightforward and uncontroversial where
cover is possible. The accepted measure of damages in such cases is the
difference between the cover price and the contract price, which is easy
to apply and provides appropriate incentives regarding the decision to
perform or breach. The difficult questions arise when there is no perfect
substitute for the performance (or there is room for debate about whether
the substitute is adequate) or where the manner or timing of the breach
causes harm that cannot be remedied by cover. We will provide two
examples of cases that arise frequently and that have been much discussed

in the literature, in which there is debate over the appropriate means of

measuring the non-breaching party’s expectation.
14. Example 1: Anticipatory Repudiation

Common law judges and scholars initially found anticipatory repudiation
– a definitive statement by a promisor, made prior to the time for perform-
ance, that he intended to breach – extraordinarily vexing. Some concluded
that any such statement must be without legal effect; the performance was
due on a particular date and breach could therefore only occur on that date
(Williston, 1901). Courts eventually came to the view that the promisee
could treat the repudiation as a breach (Hochster v. De La Tour), but found
it more difficult to decide how damages should be measured. The most
famous early case, Missouri Furnace v. Cochrane, held that the appropriate
measure was the difference between the contract price and the spot price
at the time specified for performance. The Uniform Commercial Code, by
contrast, encourages prompt cover, presumably in the futures market. As
noted by Jackson (1978), the legal literature on anticipatory repudiation
from the early part of this century is voluminous. Jackson argued that in
applying the Uniform Commercial Code’s provisions on cover to anticipa-
tory repudiation, courts should fix damages at the difference between the
contract price and the futures price at the time of repudiation. He noted
that the Missouri Furnace method is systematically overcompensatory.
Imagine, for example, that Seller breaches a contract to supply a commod-
ity in the future and that the spot and futures prices at the time of repudia-
tion are higher than the contract price. Over a large number of contract
breaches, however, the spot price at the time of performance will sometimes
be higher, and sometimes lower, than the contract price (in present value
terms). Whenever it is lower, Buyer will not bring a damages action because
he has been made better off by the breach. He is under no obligation to
share this gain with Seller. When the spot price is higher than the contract
price, Buyer will recover the difference between the two. Averaged over
a large number of contracts, buyers in the aggregate receive more than
would be required to make them as well off as they were under the con-
tract. Awarding the difference between the contract price and the futures
price, by contrast, puts each buyer in the position he occupied prior to the
repudiation and at a lower average cost to sellers.
We might simplify Jackson’s argument by noting that the Missouri
Furnace rule replaces a forward contract by an option with a strike price
equal to the forward price. Because the value (prior to expiration) of an
option with a strike price of X is always greater than the value of a forward
contract with a contract price of X, the Missouri Furnace damage measure
is overcompensatory.

15. Example 2: The Lost-volume Seller

Sellers in a competitive market have often argued that the Substitute
Price measure of damages, which awards them the difference between
the contract price and the spot price, is undercompensatory. In many
instances, there is little or no difference between the contract price and the
spot price, and accordingly the damage award is trivial. Sellers contend,
however, that they are not ‘made whole’ by selling in the spot market; the
seller had the capacity to sell to both the substitute buyer and the original
buyer at the market price, and the breach reduced their sales volume by
one unit. Thus in place of two sales and two profits, they have received
only one sale and one profit. Courts have often awarded the so-called
‘lost-volume seller’ an amount of damages equal to its ordinary profit on
one sale. In the well-known case of Neri v. Retail Marine Corp., Retail
Marine, a dealer in boats, agreed to sell a boat to Neri at a fixed price.
Retail Marine ordered the boat from the manufacturer but Neri repudi-
ated the contract. Retail Marine sold the boat to another customer for the
same price and successfully sued Neri for the profit it would have made
on the sale to him. The court concluded that Retail Marine, as a dealer,
had an ‘inexhaustible’ supply of boats, and Neri’s breach deprived it of a
profitable sale.
There is a substantial law and economics literature on the lost-volume
seller. An early contribution appeared in an anonymous student-written
comment (Anonymous, 1973). The comment noted that in a perfectly
competitive market, each seller would choose output by equating marginal
cost with demand and the demand curve would be presumed horizontal.
At the chosen output, the firm’s marginal cost would be rising and there-
fore any additional sale would be at a cost in excess of the price. Because
the seller could not, in fact, satisfy additional buyers at the market price,
the breach and resale would create no ‘lost volume’. A seller with market
power (that is, one facing a downward-sloping demand curve) might be
able to make additional sales at a profit. However, by hypothesis, such a
seller could eliminate the ‘lost volume’ by reducing its price and making
an additional sale. Thus the standard contract price minus cover price
measure would fully compensate such a seller.
Goetz and Scott (1979) provide an additional argument against award-
ing lost profits to the retailer who has market power. They note that the
breach removes the breaching buyer as a competing seller. The buyer
presumably breaches because it no longer wants the good at the contract
price. In lieu of breaching, however, the buyer could complete the pur-
chase and then resell the good. This resale, if made in the same market in
which the retailer operates, shifts the demand curve facing the retailer to
the left by one unit. Once again, if we compare the retailer’s position after

the breach to its position assuming no breach but resale by buyer, there is
no lost volume.
Goldberg (1984) disputes Goetz and Scott’s analysis. He first argues
that the observation that a non-breaching buyer could sell in competition
with the retailer is unrealistic. In fact, he argues, the buyer, lacking exper-
tise, would have to engage the services of a retailer. The retailer’s usual
markup is a reasonable estimate of the fee the retailer would charge for his
services. Accordingly, the award of lost profit to the retailer approximates
the result that would obtain if the buyer purchased and resold.
Goldberg also argues that it is inaccurate to say that the retailer ‘saves’
the marginal cost of a sale when the original buyer breaches and then
incurs that marginal cost when the substitute buyer appears. He contends
that the retailer’s cost of servicing an additional buyer consists principally
of the cost of ‘fishing’ for a buyer, or convincing the marginal buyer to
purchase (represented, perhaps, by costs of advertising, wages paid to
salespeople, and so on). That cost is irretrievably lost once a contract is
concluded with the original buyer and must be incurred again in order to
induce another buyer to purchase. More recently, Scott (1990) argues that
Goldberg’s equation of marginal cost with the cost of ‘fishing’ is inaccu-
rate; for some goods, the cost of delivery and preparation for delivery are
significant, and those costs are not incurred twice when a buyer defaults.
Cooter and Eisenberg (1985) provide an analysis similar to Goldberg’s,
but focus on the seller with market power. They argue that many sellers
hold price at a constant level reflecting expected demand and marginal
cost over some period, rather than constantly adjusting price to reflect
realized demand. Such sellers can lose volume in a particular period.
Goldberg also notes that consumer demand is decreasing in the damage
measure. Accordingly, were the legal rule to shift suddenly from a sub-
stitute price damages measure to one awarding lost profits, the demand
curve facing the retailer would shift downward, offsetting the benefit of the
higher damage awards. Whether consumers and producers would prefer
the resulting contract to one that provides only substitute price damages
again depends on comparative levels of risk aversion.
It appears that the literature on the lost-volume seller is at an impasse.
Selecting the best damages requires detailed information about market
structure. A better avenue of inquiry would be to pay attention to actual
contractual practice. Many sellers of custom goods require non-refundable
deposits, which in effect contracts for a lost-profits measure. Other sellers
permit a buyer to return an item for a full refund for some period after
delivery, which in effect contracts for an even more lenient approach
than the substitute price measure. It seems likely that greater ground will
be gained by analysis of the characteristics of markets in which varying

cancellation/return policies are used than by further refinements of the

theoretical arguments.
E. CONCLUSIONS
16. The Puzzle of Overcompensatory Remedies and Some Suggestions for

Further Research
Most of the prior analysis can be summed up as follows: when valuations
are observable and verifiable, money damages measured by the prom-
isee’s valuation (or expectation) provide reasonably good incentives for
efficient pre- and post-contractual behavior. Problems arise, however,
when there are significant informational asymmetries between the parties
and/or between each party and the court. Such asymmetries raise two
pervasive issues in contract law. The first is subjective value. The existence
of potentially overcompensatory remedies such as specific performance,
liquidated damages and restitution can be attributed to judicial recogni-
tion that money damages measured by the promisee’s expectation will
sometimes undercompensate because courts use objective indicators of
value that may diverge from the promisee’s subjective valuation. Only a
few brief attempts have been made, however, to explore subjective value
as a unifying theme in contract remedies (see De Alessi and Staaf, 1989;
Muris, 1983).
The second issue is opportunism. The possibility that a remedy, although
designed to be perfectly compensatory, will in fact undercompensate
(overcompensate) may encourage the breaching party (non-breaching
party) to use the defect in the remedy to gain bargaining leverage over
the other party. The risk of opportunism is the likely reason why courts
have not responded to the problem of subjective valuation by instituting
overcompensatory remedies across the board.
A worthwhile avenue for additional work would be a careful com-
parison of the ways in which courts have or have not managed to reduce
the risk of opportunism across a range of remedial choices. A promising
approach to this question appears in the liability rule versus property rule
literature. When neither party knows the other’s true valuation of the
contract, each has an incentive to over- or under-state his valuation in an
attempt to capture as much as possible of the gains from contract modifi-
cation or cancellation. The result is to make agreement more costly. The
costs imposed by asymmetric information, which we will call ‘bargaining
costs’, are a subset of the costs of reaching a deal. The key question is
whether the choice of remedy affects bargaining costs.
A specific application to liquidated damages is offered by Talley (1994).
He uses the mechanism design branch of game theory to analyze the

effects of different enforcement rules on bargaining costs, concluding

that enforcement of liquidated damages that exceed actual damages ex
post creates significant bargaining costs. By refusing to enforce penalty
clauses, courts may make it more likely that the parties will bargain to an
efficient outcome. The argument is unique in offering a plausible economic
justification of the ex post component of the liquidated damages rule.
Ayres and Talley (1995) employ game theory to argue that bargaining
costs are generally lower under liability rules than under property rules.
The intuition is as follows. Going back to our contract between Seller
and Buyer, imagine that Seller wishes to breach and believes Buyer’s
valuation of the contract to be uniformly distributed on the interval [$300,
$400]. Consider a rule that provides for damages of $500 in response to
Seller’s breach. Buyer’s offer to rescind the contract for a payment of $400
would provide Seller with no new information – Seller already knows that
Buyer’s valuation is no greater than $400. Now consider a rule providing
for damages of $350. Buyer might now conceivably offer to cancel the
contract in return for a payment from Seller (if Buyer’s valuation is less
than $350), or it might offer Seller a payment to forego breach (if Buyer’s
valuation is more than $350). Thus the type of offer that Buyer makes
conveys information about its valuation and ameliorates the bargaining
costs resulting from asymmetric information. Johnston (1995) offers an
analogous argument to show that bargaining costs can be lower under a
‘standard’, in which an entitlement is dependent on a discretionary judi-
cial determination, than under a ‘rule’, in which the entitlement is more
precisely defined.
Kaplow and Shavell (1995) criticize Ayres and Talley’s analysis on the
grounds that it is not a marginal analysis. They argue that in most contexts
in which bargaining is impossible or prohibitively costly, liability rules
will dominate property rules for the reasons outlined in our discussion of
expectation damages above. Thus for liability rules to dominate property
rules where bargaining is possible does not prove that they generate lower
bargaining costs; the latter point would be proved conclusively only if
liability rules dominate property rules to an even greater extent where
bargaining is possible than where it is impossible.
The more general question is the design of remedies that will create
optimal incentives for the parties to reveal their actual valuations or other
private information. Although the contract theory literature is interested
in the question of credibly eliciting private information, it focuses princi-
pally on the design of contracts themselves rather than on the design of
the institutional structure of contracting, which would include remedies.
There is accordingly room for additional study of the remedial system’s
effects on information revelation.

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10 Penalty clauses and liquidated damages
Steven Walt* 1
1. Introduction
The common law of contracts refuses to enforce contractual stipulations
of damages courts deem penalties. Although sometimes formulated dif-
ferently, doctrine characterizes a stipulation a ‘penalty’ that either unrea-
sonably forecasts expected or actual damages arising from breach, or sets
damages that are easily ascertainable by a court. Damage stipulations
that either reasonably forecast expected or actual damages, or provide for
damages that are difficult to ascertain judicially, are deemed ‘liquidated
damages’ and enforced. For most legal economists and many traditional
legal scholars, the penalty doctrine is puzzling. Contracting parties agree
to stipulate damages from breach, as they do for any other contract term,
because they anticipate that the stipulation maximizes their joint surplus.
A ‘performance terms’ doctrine specifically regulating the performance
terms of a contract, such as risk of loss or warranty provisions, therefore is
undesirable, and contract law does not contain one. For the same reason,
a penalty doctrine specifically regulating damage stipulations also seems
undesirable.
This chapter critically surveys the recent economic literature on penalty
clauses. Almost all of this work appeared between 1977 and 1996, with
a few contributions appearing in the late 1990s. It differs from early law
and economics scholarship on penalty regulation in both method and
substance. The early work evaluated penalty regulation informally. In
contrast, much of the strictly economic recent work formally models the
effects of damages clauses on investment in performance, breach and trade
under prescribed conditions. Some of the law and economics literature
relies on psychological findings about decision making to explain or justify
the penalty doctrine. Unlike earlier work, researchers are more systematic
in their analysis and more careful about the normative implications of
their results. While most (but not all) recent work does not support the
penalty doctrine, the research bases its conclusion on the doctrine’s impact
on specifically identified variables isolated for study. Penalty clauses may
* I thank Paul Mahoney for comments on a previous draft and Michael Zadd
for assistance in the preparation of this chapter.
178

Penalty clauses and liquidated damages 179
have different efficiency effects on variables not studied. The early and
more recent work also differ in substance, in their evaluation of penalty
clauses. Earlier work generally found that efficient damages stipulations
are not overcompensatory (Goetz and Scott, 1977; Schwartz, 1990). In
contrast, more recent scholarship finds that optimal contracts can contain
penalty clauses (Edlin, 1996, 1998).
The more systematic recent work is also nuanced in its normative
implications. It finds that penalty clauses can produce inefficient perform-
ance or efficient breach under some conditions, and efficient or inefficient
investment or trade also under other conditions. Penalty clauses can
have anticompetitive effects on the size of product markets in which they
are used. They also can produce inefficient breach at the same time they
induce efficient investment. Thus, whether penalty clauses maximize social
welfare depends on the robustness of the specified parameters as well as an
assessment of the comparative impact of the clauses on the variables iden-
tified. This conclusion resembles the conclusion usually drawn from work
on the efficiency of traditional damages measures: none of these measures
is unambiguously efficient because each measure impacts different vari-
ables affecting contract performance differently (Posner, 2003; Craswell,
1988). In critically surveying the recent literature, this chapter argues that
it does not support anything remotely resembling existing penalty regula-
tion. Edlin and Schwartz (2003) survey much of this work, for different
purposes.
2. The Legal Regulation of Penalty Clauses

Damage provisions a court finds unenforceable are designated ‘penal-
ties’; those it finds enforceable are designated ‘liquidated damages’. The
traditional common law rule voids stipulations of damages that bear no
reasonable relation to the damages expected to be suffered from breach
(Ibbeston, 1999). Courts also traditionally invalidated damage provi-
sions where damages anticipated from breach were not difficult to prove
(Farnsworth, 2004). Both applicable statute and the trend in case law are
less restrictive. Under section 2-718(1) of the Uniform Commercial Code,
damages may be stipulated in an amount reasonable in light of anticipated
or actual harm caused by the breach (Uniform Commercial Code, 2008).
Section 356 of the Restatement (Second) of Contracts describes the same
rule extracted from case law (Restatement, 1981). Thus, damages stipula-
tions that are ex ante unreasonable but reasonable in relation to actual
damages are enforceable. For the same reason, stipulations are enforce-
able even when anticipated damages are easily provable, as long as they
are reasonable in relation to expected or actual damages. Although provi-
sions deemed penalties are unenforceable, the remainder of the agreement

is enforceable, and resort to default remedies for breach remains available.

By contrast, civil law systems generally enforce damage provisions, what-
ever their amount. The contract law of some of these systems allows courts
to reduce or increase the amount provided if it is manifestly excessive or
inadequate (Hatzis, 2002; Mattei, 1995; Council of Europe, 1978).
Stipulated damages are either exclusive or optional remedies for the con-
tracting parties. They are exclusive if the contract expressly or implicitly
so provides; otherwise, the breach victim has recourse to default remedies,
as under section 2-719(2) of the Uniform Commercial Code (Uniform
Commercial Code, 2008). Most courts restrict the remedies available
when a stipulated damage provision is optional. They make available the
right to specific performance, where appropriate, but not damages. This
restriction is puzzling. To vet a damage provision, a court must determine
actual damages or the reasonableness of the damages stipulated in rela-
tion to actual damages. In both cases, the court therefore needs to gauge
the extent of the victim’s loss from breach. Preventing the victim from
measuring its loss by damages is odd when the court has measured loss,
particularly when the loss may be less than the amount stipulated in the
damage provision.
The rules regulating damage provisions are limited in two respects.
First, they forbid only damage stipulations that are excessive in relation
to expected or actual damages. Courts frequently enforce provisions that
stipulate damages in amounts less than the expected or actual damages
from breach (Scott and Triantis, 2004). Thus, penalty regulation does not
apply to ‘underliquidated’ damages. Contract law allows enforcement
of contract provisions that exclude recovery of consequential damages
resulting from breach. These damage limitation clauses effectively under-
liquidate damages. At most, the regulation therefore protects against
overcompensation of the breach victim, not her undercompensation.
Second, penalty regulation does not apply to some contract clauses that
function as damage provisions. An important example is ‘take or pay’
clauses. A ‘take or pay’ clause requires the buyer to accept the entire
quantity contracted for at the contract price or pay for a stipulated
minimum quantity at the unit price. Such clauses are useful to sellers
because they avoid the need for sellers to prove market damages or the
size of their variable unit costs. Courts sometimes enforce ‘take or pay’
clauses by characterizing them as part of the buyer’s performance obliga-
tions, not a stipulated remedy for breach (Gillette and Walt, 2008). The
clauses nonetheless function as stipulated remedies, apparently immune
from penalty regulation. A full justification of existing penalty regula-
tion must account for these two limitations. None of the accounts in the
literature justifies both of them.

3. Arguments Against Penalty Regulation

Damage stipulations are costly to write. If the promisee’s valuation of
performance were observable to both parties and verifiable to a court,
the promisor’s breach decision unaffected by contract provisions and the
parties’ investment in performance of the contract impossible, damage
provisions would not be written. Because a court could accurately deter-
mine the promisee’s loss from the promisor’s breach, such provisions
would not be needed to fix damages accurately. Promisors could offer
the particular contract each promisee demanded based on the different
value the promisee placed on the promisor’s performance without the
need for damages provisions to convey this information to the promisor.
Damage provisions could not affect the efficiency of the promisor’s deci-
sion to breach or perform, by assumption. Nor could these provisions
induce investment in contract performance and therefore the size of the
parties’ joint surplus, because such investment is impossible. None of these
assumptions is realistic. Early research studied the effect of a damage stip-
ulation on the breach decision when valuations are verifiable, the parties
symmetrically informed and specific investment in the contract infeasible
(Clarkson et al., 1978; Muris, 1984; Posner, 1977). Under these conditions
penalty clauses induce inefficient breach decisions. More recent formal
and informal models relax one or more of these strong assumptions. They
show that, under specified conditions, either damage provisions are not
penalties or penalty provisions can induce efficient performance. The
former result makes penalty regulation superfluous; both results make it
undesirable.
3.1. Unverifiable Valuations

As with any contract term, contracting parties have an incentive to select
an efficient measure of damages from breach. This is because an efficient
damage measure maximizes the joint surplus. If courts accurately meas-
ured damages from breach, the parties would not stipulate damages. The
stipulation would yield no benefits and is costly to write. The law govern-
ing damage stipulations assumes that courts accurately measure damages.
However, the assumption is unrealistic. Parties sometimes attach idiosyn-
cratic values to performance. They sometimes also prefer not to disclose
private information to a court that otherwise could establish the value they
attach to performance (Ben-Shahar and Bernstein, 2000). Even identifying
the relevant markets by which to measure market price can be difficult.
For these reasons, courts make errors in determining the loss from breach.
Judicial errors in measurement of loss increase the contract price. This is
because contract price reflects damages payable in the event of breach,
and judicial error increases the cost of breach for the breaching party. If

the parties on average can accurately estimate damages, they can reduce
the contract price by stipulating damages. A damage stipulation reduces
contract price when the negotiation costs of the stipulation are less than
the sum of proof and error costs from reliance on a court to measure
damages.
Goetz and Scott (1977) present an early informal model incorporating
judicial error in measuring damages. The value of performance is observ-
able to the parties but unverifiable to a court. Renegotiation is infeasible
and a damage stipulation is implicitly assumed to have no effect on the
choice of contracting partner or investment in performance of the con-
tract. The parties decide to breach or perform the contract. With these
assumptions, Goetz and Scott show that only stipulated damages induce
an efficient breach decision. The promisor will perform when the cost of
its performance is less than the promisee’s loss in value from breach; it
will breach when its performance cost is greater than the promisee’s loss
in value from breach. Courts make errors in determining loss from breach
because the promisee’s value is unverifiable to it. Thus, without a damage
stipulation, the promisor will either inefficiently perform or inefficiently
breach. Because the value of performance is observable to the parties, on
average their estimation of loss from breach is accurate. A damage stipula-
tion therefore induces the promisor to make an efficient breach decision:
to perform when the cost of doing so is less than the promisee’s loss in
value from breach and to breach when the converse holds.
Stipulated damages are not penalties in Goetz and Scott’s model: they
measure the actual loss to the promisee from breach. Thus, penalty regula-
tion is superfluous. It also is undesirable because the judicial unverifiabil-
ity of valuations makes courts likely to mistakenly find damage provisions
to be penalties. Penalty regulation is undesirable even if optimal damage
provisions sometimes are penalties, although Goetz and Scott do not draw
this conclusion. If courts cannot verify valuations, they cannot accurately
measure loss from breach. As a result, they cannot reliably determine
when a damage provision is a penalty and when it sets compensatory
damages. Courts therefore cannot regulate damage provisions effectively
even if they sometimes are overcompensatory. Judicial error in valuation
is enough to condemn penalty regulation.
Other elements of Goetz and Scott’s presentation are irrelevant to the
model of efficient breach with unverifiable information about loss. In par-
ticular, the model is introduced as part of a model of an ‘efficient insurer’.
The two models in fact are independent, and the model of efficient breach
has more general application. Damages stipulations serve as insurance
when a risk-averse promisee and risk-neutral or risk-preferring promi-
sor agrees to shift the promisee’s loss from breach to the promisor. The

premium paid by the promisee includes loss that is covered by the damage
stipulation but difficult to prove ex post. Critics complain that promisees
usually will not insure against non-pecuniary loss (Croley and Hanson,
1995; Talley, 1994; Rae, 1984, 1982). Even if the criticism is correct, prom-
isees will not buy insurance in excess of their expected loss. Stipulated
damages instead will underliquidate the promisee’s full damages, not serve
as penalties. More important, the criticism goes to damage stipulations as
insurance, not to Goetz and Scott’s efficient breach model (Walt, 2003).
The model depends only on error in judicial measurements of loss from
breach, not on the parties’ attitudes toward risk. Parties stipulate damages
to induce efficient breach decisions without regard to their risk prefer-
ences. The stipulation allows them to reduce the price of their contract.
3.2. Unverifiable Performance

Breach can be observable to the parties but difficult for a court to detect.
Penalties can induce efficient breach when courts cannot observe whether
the parties have performed the contract. A court’s determination of
performance is based on evidence supplied by the litigating parties, and
evidence submitted is fabricated or used for self-interested purposes
(Sanchirico and Triantis, 2008; Scott and Triantis, 2006). The court’s veri-
fication of breach depends on the amount and accuracy of the evidence
presented to it. Thus, although verification of breach often is treated as a
binary and exogenous variable, verification is more realistically considered
to be a continuous and endogenous variable. Where judicial verification is
imperfect, the promisor will not always be held liable for its breach. The
promisor therefore might breach when its performance is efficient. To
deter inefficient breaches, damages must be multiplied by the inverse of
the probability of detection (Craswell, 1999, 1996; Polinsky and Shavell,
1998; Klein, 1980). Damages therefore must be greater in amount than the
actual loss. For this reason, damage provisions that stipulate penalties can
induce efficient breach. Where renegotiation is feasible, penalty clauses
encourage bargaining when litigation is more costly. They also affect
litigation cost, reducing the breach victim’s cost of proving damages and
effectively placing on the breacher the burden of proving that the damages
provision is a penalty.
The role of penalties in deterring breach often is limited. This is because
damage stipulations do not function as damage multipliers in many con-
tracts. Some contracts contain only precise material terms that describe
aspects of performance that are easily observable by the parties and courts.
Courts will not fail to detect breach in these contracts. Damage multipliers
therefore serve no role in inducing efficient performance of contracts with
only precise material terms. However, commercial contracts frequently

contain a mix of precise and vague terms (Scott and Triantis 2005, 2006).
The vague terms include best efforts, good faith or material adverse
change of conditions clauses. Although such terms allow judicial error in
determining the promisor’s performance obligations, they are unlikely to
induce inefficient performance, for two reasons. First, unless the judicial
error is biased in favor of the promisor, the mean error rate is zero and the
promisor’s incentives to breach therefore are unaffected. Bias is unlikely
because a court’s findings about performance are based on evidence pre-
sented by both contracting parties. Second, nonremedial contract provi-
sions and noncontractual devices can deter breach. Damage multipliers
are not needed. This is because the promisor incurs nonrecoverable litiga-
tion costs in defending against an allegation of breach. Burdens of proof
and presumptions adverse to it increase its litigation costs. They can be set
so that the sum of the promisor’s litigation costs and liquidated damages
exceeds its gains from breach (Choi and Triantis, 2008). By increasing
litigation costs, contractual and noncontractual devices can serve as
substitutes for damage multipliers to deter breach. Stipulated damages
with damage multipliers assure efficient performance only in contracts
with vague terms lacking such substitutes. Relatively few contracts are
of this sort. Thus, asymmetries in information, investment incentives, or
unverifiable valuations are more likely to explain the presence of the use of
stipulated damages clauses in the vast range of other contracts.
3.3. Asymmetric Information About Valuations

Contracting parties might not observe the promisor’s cost of performance
or the value of performance to the promisee. In this case, information
about cost and value is private to the promisor and promisee, respectively.
Under limited conditions, parties will agree to a set contracts that produce
efficient trades: the promisor profits and its promisees select the contracts
each prefers to other contracts offered. Stole (1992) and Schwartz (1990)
show that promisee-buyers select contracts containing different amounts
of stipulated damages depending on the value each attaches to perform-
ance. In their models, a seller with monopoly power makes a set of offers
to sell a good to buyers with different valuations for the good. The menu of
offers is rich enough to accommodate any valuation revealed by a buyer.
Offers differ in price and the amount of the liquidated damages clause
accompanying them. The promisor-seller knows the distribution of valua-
tions buyers place on the good, but not each buyer’s particular valuation.
Investment in performance is excluded and renegotiation is infeasible.
Stole and Schwartz model the buyers’ choice of contract as a screening
game. Buyers reveal their valuations to their seller by selecting a contract
with a specific price and liquidated damages clause. The seller, who has

market power, can therefore price discriminate and charge each buyer a
price equal to its revealed valuation. Knowing this, a buyer must trade
off the desire for compensation if the seller breaches against the desire
not to pay a price equal to its revealed valuation (Edlin and Schwartz,
2003). Buyers will not select contracts with damage stipulations above
their actual valuations because contract price will be above the value of
performance to them. However, the buyers will select damage stipula-
tions equal to or below their actual valuations. Buyers with the highest
valuations select contracts with fully compensatory damage stipulations:
they desire to protect their high valuation more than their desire to avoid
paying a higher contract price that results from their revelation of valu-
ation. Buyers with lower valuations select contracts with undercompen-
satory stipulations: they desire lower-priced contracts more than they
desire to protect their low valuations. Each type of buyer gets the type of
contract optimal for it.
However, the outcome in Stole and Schwartz’s models might not be
socially optimal. Underliquidated damage stipulations result in efficient
trades because buyers are not offered a blended price. Each buyer instead
is offered a price-damages proposal associated with its revealed valuation.
No buyer therefore exits the market because price is above this valuation.
But contracts with underliquidated damages induce inefficient breach
because the promisor does not have to pay damages equal to the buyer’s
value. Instead, the promisor will breach when its performance cost is
greater than the amount of the damages stipulation, which is less than the
buyer’s actual value. Thus, there is a tradeoff between inefficient breach
and efficient trade produced by underliquidated damages. These stipula-
tions maximize social welfare only if the magnitude of inefficient breach (a
cost) is less than the magnitude of efficient trade (a benefit). This inequal-
ity in turn depends on the distribution of different valuations among the
population of buyers. For instance, if most buyers have high valuations,
they will select contracts with compensatory damage stipulations. There
will therefore be few inefficient breaches accompanying efficient trade. On
the other hand, if most buyers have low valuations, contracts with under-
liquidated damage stipulations will dominate. Sellers therefore frequently
will breach inefficiently.
The role of underliquidated damages as a screening device is consist-
ent with an aspect of existing penalty regulation: courts regularly enforce
underliquidated damages. However, screening does not justify judicial
scrutiny of any damage stipulation. Efficient trade instead requires the
enforcement of all damage stipulations as written, even penalty clauses.
Buyers reveal their different valuations by selecting offers with different
damage stipulations. The fact that buyers will not accept price-damage

proposals with damages set above actual value to them is irrelevant. Offers
with different stipulated damages enable trade when the promisor-seller
cannot observe information about the promisee-buyer’s valuation. The
screening mechanism works whether damages in the offers are under-
or overliquidated. Thus, screening does not support existing penalty
regulation, which scrutinizes overliquidated damages.
3.4. Unverifiable Investment: Selfish Investment

Investment in a contract’s performance can increase the joint surplus by
reducing the cost or value of performance, or both. However, default
remedies encourage the breach-against party to make inefficiently high
investments. Expectation damages gives the breach victim an award equal
to its value from performance. If the contract is performed, it will get its
value from performance. If the contract is breached, expectation damages
give it the returns on the investment had the contract been performed.
In this case too, the breach victim receives the value performance would
have given it. Thus, the breach victim receives the return on its investment
whether or not the contract is performed. In deciding to invest, it therefore
does not take into account the likelihood that breach would be efficient.
For this reason, the breach victim will overinvest in the contract’s per-
formance (Shavell, 1980; Rogerson, 1984; Sloof et al., 2006). Courts could
reduce the incentive to overinvestment by reducing recoverable damages
by the amount of overinvestment (Goetz and Scott, 1977; Cooter, 1985).
However, this requires courts to observe the breach victim’s investment.
The requirement is too strong.
When remedies are unavailable, contracting parties also might under-
invest. Some investments increase the joint surplus but have less value if
deployed elsewhere. Nonredeployable investments enable the noninvesting
party to appropriate through efficient renegotiation some of the returns
from the investments (Williamson, 1985). Anticipating this, a party will
not make investments that maximize these returns. Thus, even when the
contract is performed, performance produces less value than it would have
produced with investment. It would be a coincidence if the incentives to
underinvest and overinvest generally cancel each other.
Research in contract design shows that penalty clauses can play a role in
producing efficient investment incentives. The research exploits the insight
that damage measures that decouple recoverable damages and investment
can induce efficient investment. An expectation measure, for instance,
calculates loss from breach net of the breach victim’s cost of invest-
ment. It does not decouple damages and investment: the breach victim
recovers its loss from breach less its investment (and reliance generally).
Expectation damages therefore encourage the breach victim to overinvest

in its performance of the contract. In contrast, damages measures that fix

damages without regard to investment separate recoverable damages and
investment. Because fixed damages measures make damages invariant
to investment, investment can affect the breach victim’s net return from
breach. Thus, such fixed damages measures force the breach victim to take
into account the effect of its investment on its net returns if the contract
is breached. As a result, ‘decoupled’ damage measures can be written to
encourage efficient investment incentives.
A penalty clause is a type of fixed damages measure that decouples
damages and investment. The simplest type of contracts which give effi-
cient investment incentives are those in which only one of the contracting
parties can invest in performance. Investment is unverifiable and ‘selfish’:
it benefits only the investing party, either by reducing its performance
costs or by increasing the value it receives from performance. Edlin (1996,
1998) describes the design of contracts of this type which produce efficient
investment. The key is to structure the contract so that only the investing
party will breach and it receives all the returns from its investment. Three
conditions assure this. (1) The contract price is set below the investing
party’s marginal cost of performance. This induces the noninvesting party
to enter the contract and not breach. At the same time, the below-marginal
cost price gives the investing party an incentive to breach. (2) The level of
performance demanded by the contract is set so high that efficient renego-
tiation is unlikely. This assures that the noninvesting party never has the
opportunity to appropriate through renegotiation any of the returns from
investment. (3) The noninvesting party makes a nonrecoverable payment
to the investing party large enough to make sure the contract is profitable
for the investor. The payment is needed to induce the investor to enter the
contract.
The first and third conditions are particularly important. Condition
(1) assures that only the investing party is likely to breach. Expectation
damages gives the noninvestor the value performance of the contract
would have given it. Thus, any residual value produced by investment goes
to the breacher. The breacher therefore will calibrate the costs and benefits
of its investment to make efficient investment decisions. Strictly, condition
(3) does not require that the large nonrefundable payment to the investing
party be transferred up-front. It is sufficient that the noninvestor be obli-
gated to pay the investor this amount. More important, the noninvestor
must not be able to recover its up-front payment or cancel its payment
obligation if it breaches. Otherwise, the investing party’s incentive to
overinvest is reinstated (Edlin, 1996, 1998; Edlin and Schwartz, 2003).
Investment increases the investor’s profit from performance and therefore
also its expectation damages from the noninvestor’s breach. The large

damage award reduces the amount of the up-front payment the investor
must refund or the payment obligation the investor must reduce. This
gives the investor an incentive to invest even when investment is inefficient.
The investor’s incentive to invest efficiently remains when the investor’s
payment is nonrefundable. Because the large payment to the investor is
unrelated to the investor’s damages from breach, it is a penalty.
3.5. Unverifiable Investment: Bilateral and Cooperative Investment

The contract design literature identifies other contracts in which penalty
clauses promote efficient investment. Two types of contracts are notewor-
thy. One type involves contracts in which both contracting parties can
make investments that benefit only the investing party. These investments
are ‘bilateral’. Edlin and Reichelstein (1996) show that a contract cannot
be written that gives efficient investment incentives to both parties under
an expectation damages remedy. They also demonstrate that specific
performance will produce efficient investment in contracts with bilateral
investment. Edlin and Schwartz (2003) show that penalty clauses have
the same effect on bilateral investment. The intuition behind Edlin and
Reichelstein’s result can be described in general terms. Efficient investment
discounts the investment by the probability of its returns. Expectation
damages gives the breach victim its profit, which takes into account
returns from investments in performance the victim has made. The remedy
therefore encourages overinvestment by the victim, as noted above. Where
the contract is efficiently renegotiated, part of the return from investment
is appropriated by the noninvesting party. This encourages the inves-
tor to underinvest in performance. The investor’s incentive to invest is
efficient when its incentive to overinvest is balanced by its incentive to
underinvest.
Edlin and Reichelstein notice that contracts subject to expectation
damages cannot balance the incentive to overinvest against the incen-
tive to underinvest for both contracting parties. This is because expecta-
tion damages do not give the breacher the full returns on its investment.
Instead, the breacher keeps only returns, if any, above the amount of the
breach victim’s loss from breach. Because the noninvestor appropriates
part of the returns from investment when renegotiation is efficient, the
breacher’s incentive to underinvest remains. Thus, the breacher’s incentive
to overinvest will not offset its incentive to underinvest. The breacher’s
investment incentives therefore will be inefficient. Setting the performance
obligations of the contract high gives the breacher efficient investment
incentives. Because renegotiation of this contract is remote, the non-
breacher is unlikely to appropriate part of the returns from the breacher’s
investment through renegotiation. The breacher’s incentive to underinvest

therefore is weak. Thus, the breacher’s weak incentive to overinvest will

dominate its weaker incentive to underinvest. However, a high perform-
ance standard increases the breach victim’s incentive to overinvest because
expectation damages give it the returns on its investment. The breach vic-
tim’s incentive to overinvest therefore will dominate its diminished incen-
tive to underinvest. By contrast, contracting involving selfish investment,
described in Section 3.4, do not have this result. This is because the level
of performance set by the contract is high so that only the investing party
will breach. In these contracts, the likelihood of an efficient renegotiation
of the contract is remote and the incentive to underinvest therefore weak.
Contract penalties restore efficient investment incentives to both parties.
To see this, recognize that breach will not occur when performance under
the contract is inefficient. The parties instead will renegotiate to obtain
efficient performance. Because both parties can gain when performance
is efficient, their renegotiation shares the surplus from efficient perform-
ance. The inefficient contract either sets performance above or below
the efficient level. A penalty enables the nonperforming party to obtain
a renegotiated share even when contract performance is set inefficiently
high. This is because it serves as credible threat to the performing party:
the penalty will be enforced if the performing party does not share the
efficiency surplus from performance at the lower, efficient level. The per-
forming party’s loss from performing under the contract or paying the
penalty is greater than its loss from performing at the lower level. Thus,
the performing party will renegotiate to share the returns from perform-
ing at the lower, efficient level. The nonperforming party’s share of the
returns encourages it to overinvest in the contract. At the same time, the
nonperforming party’s incentive to underinvest remains when contract
performance is set inefficiently low. This is because the performing party
can appropriate by renegotiation a share of surplus from modifying the
performance level upward to an efficient level. The nonperforming party’s
incentive to overinvest therefore balances its incentive to underinvest. The
previous reasoning applies to both contracting parties. Thus, penalties
encourage both parties to make efficient investments.
This result is limited to bilateral investment. Che and Chung (1999)
demonstrate that expectation damages and stipulated damages both
give inefficient investment incentives when investment benefits only the
noninvesting party. This sort of investment is ‘cooperative’: it benefits
the noninvestor while not diminishing the investor’s cost of contractual
performance. Cooperative investments produce positive externalities. As
a result, when renegotiation is infeasible, a contracting party will not make
them. This is because the party receives the same return whether or not it
invests. If the counterparty breaches, expectation damages do not increase

the investor’s award, because cooperative investment does not reduce

its costs of performance. If the counterparty performs, investment again
does not increase the investor’s returns, for the same reason. A damages
stipulation can encourage cooperative investment by setting damages
above the cost of performance. But the stipulation produces inefficient
trade when the damages set exceed the noninvestor’s valuation of per-
formance. Renegotiation eliminates trading inefficiencies and encourages
cooperative investment. However, it makes an initial contract superfluous,
because the parties can bargain for a share of the surplus from such invest-
ment. A damages stipulation clause therefore is not needed to encourage
cooperative investment (Che and Hausch, 1999).
3.6. Unverifiable Investment and Contract Design

The second type of contract that encourages efficient investment is one
in which a penalty clause induces the disclosure of accurate informa-
tion about investment. As before, investment, costs and valuation are
unverifiable. The contracting parties can observe them; the court cannot.
Realistically, cost and valuation depend on investment in performance.
Writing a contract with terms specifying these variables is useless because
a court cannot ascertain whether performance complies with the contract.
Ex post bargaining after investment has been made and costs and valua-
tions realized can be costly. Models of ‘mechanism design’ show that the
parties can devise a procedure or mechanism which elicits from them accu-
rate private information about investment, cost and valuation (Moore and
Repullo, 1988; Moore, 1992; Paltry, 2001; Bolton and Dewatripont, 2005).
Under the narrow conditions of the models, a court enforces the contract
based on the information elicited. Some of the contracts in these models
use penalties to induce accurate disclosure of private information.
A very simple model involves two risk-neutral parties: a seller and a
buyer. The parties contract for the seller to produce and deliver a good
to the buyer. Only the seller can invest in performance, which reduces the
seller’s production cost. The contract specifies the following mechanism
to fix the contract price of the good, adapted from Schmitz (2001): the
buyer and seller both report the seller’s cost and the buyer’s valuation of
the good to a court. If their reports match, the good is traded at a price
equal to the buyer’s reported valuation, unless the reported costs exceeds
the reported valuation. If the reports differ, no trade occurs and both the
buyer and seller each pay a large penalty to the court. The parties’ agree-
ment prohibits renegotiation of the contract. Under these conditions,
making a truthful report is a weakly dominant strategy for each party. If
the party’s report is truthful and the other party’s report also truthful, the
good is traded as long as the buyer’s reported valuation exceeds the seller’s

reported cost. The party is better off than if it lied: lying results in no trade
and assessment of a large penalty against the party. If a party’s report is
truthful and the other party’s report lies, no trade results and a penalty is
assessed. In this case, the party is no worse off in the circumstances than if
its own report were truthful. Because the same reasoning applies to both
parties, both have an incentive to truthfully report costs and valuation to
the court. The penalty gives the parties part of their incentive to submit
truthful reports.
Two of the model’s key assumptions are unrealistic. The model assumes
that the parties’ commitment not to renegotiate is irrevocable, as do most
mechanism designs (Tirole, 1999; Maskin and Tirole, 1999; Bolton and
Dewatripont, 2005). If the parties’ choices produce the no-trade outcome,
they have an incentive to renegotiate rather than pay a penalty to the court.
The threat of the no-trade outcome is not credible because renegotiating
to trade makes both parties better off. Recognizing this, each party might
choose to submit an untruthful report of valuation and costs. To deter
selection of this off-equilibrium strategy, the mechanism in the contract
must be enforced (and known by the parties to be enforced). Courts gener-
ally will not enforce a contract clause prohibiting renegotiation. Even with
judicial enforcement, the parties remain free to renegotiate on their own
to avoid paying a penalty (Brooks, 2002). To prevent renegotiation, the
mechanism must be implemented so that there is no gap in time between
its use and enforcement of its outcome (Maskin and Moore, 1999). Maskin
and Tirole (1999) suggest in passing that the mechanism might be imple-
mented before an arbitrator, who enforces the clause. But arbitration still
does not guarantee that the no-trade penalty will be enforced in the simple
mechanism above. The parties must pay the penalty to the arbitrator, and
they have an incentive to renegotiate on their own to avoid doing so. Their
arbitration agreement might require establishment of standby letters of
credit to assure payment, but parties worried about arbitral self-dealing
will reject the arrangement. Whether a commitment not to renegotiate is
irrevocable obviously is an empirical question. However, it appears that
renegotiation remains possible in many cases.
The other key assumption is that the no-trade penalty will be imple-
mented. This too might be unrealistic. Existing law does not allow courts
to collect penalties as dictated by the parties’ agreement. A court’s
authority to impose penalties instead is given by statute expressly or by
jurisdictional grant. Courts usually are not authorized to do so simply
because parties submit conflicting reports to them. True, the parties’
contract perhaps could select a jurisdiction’s law which will enforce its
penalty provision. Combined with a choice of forum clause, the choice
of law might guarantee that a court or arbitrator will order a no-trade or

other penalty. However, other jurisdictions might refuse to enforce the

judicial order or arbitral award, deeming it an unenforceable penalty. This
limits enforcement when the cooperation of courts in other jurisdictions is
required. Again, a standby letter of credit or other payment device could
assure payment of the penalty to the court or arbitrator. But concern
about judicial or arbitral self-dealing might dissuade the parties from
assuring payment of the penalty. Although penalties sometimes can be
implemented through artful drafting and payment design, they frequently
will not be enforceable.
4. Implications for Existing Penalty Regulation

Existing penalty regulation assumes that penalties are undesirable and
that parties sometimes put penalty clauses in their contracts. The research
described above denies this assumption. It finds that the damage stipula-
tions either are not penalties or that penalties can provide efficient incen-
tives to breach, investment or trade. The former finding makes penalty
regulation superfluous; the latter finding shows that penalties sometimes
are desirable. None of the research supports penalty regulation. It cannot
because existing doctrine does not take into account the different variables
the research identifies as affecting efficient investment, breach and trade.
In vetting damage stipulations, penalty regulation assumes that courts
accurately estimate the parties’ valuations from performance. By contrast,
models with symmetric but unverifiable information assume that courts
make measurement errors. Screening models with asymmetric informa-
tion require courts to enforce damage stipulations as written. Mechanism
designs also require enforcement of penalties in order to induce disclosure
of private information about valuations to the court. Penalty doctrine
voids damage stipulations that are penalties. This undermines the role of
damage stipulations in promoting efficient trade. Existing doctrine also
does not take into account the effect of penalties on incentives to invest in
contract performance. Its application therefore is indifferent to whether
investment is one-sided, bilateral or beneficial to both parties. For all of
these reasons, a penalty doctrine that incorporated the variables identified
by the research above would look very different from existing regulation
of damage stipulations.
5. Arguments for Penalty Regulation

Several arguments in the more recent literature support some form of
penalty regulation. Penalty clauses can create externalties by deterring
entry into a product market. They also can lead to inefficient signaling in
contracts with asymmetric information. And contracting parties might
incorporate penalty clauses in their contracts because they systematically

misjudge the likelihood of breach. These arguments are either unconvinc-

ing or, if convincing, apply only in limited settings. None supports penalty
regulation in its present form.
5.1. Deterring Efficient Entry

A contract with a penalty clause might benefit both contracting parties.
However, the clause makes it less likely that one party (the ‘buyer’) will
breach by buying from a lower-priced seller. This reduces the size of a
potential entrant-seller’s market and therefore the likelihood of entry by
more efficient sellers. Consequently, other buyers pay a higher price for the
relevant product. Penalty clauses do not deter entry completely. Entrants
who are sufficiently efficient to offer a price below that of the incumbent
seller by the amount of the penalty still will enter. The penalty clause
merely transfers some of the entrant’s surplus to the buyer and incumbent
seller. However, penalty clauses deter entrants who are only moderately
more efficient than the incumbent. By deterring entry, penalty clauses
create a negative externality for other buyers.
Aghion and Bolton (1987) and Chung (1992) describe models in which
penalty clauses deter efficient entry. In Aghion and Bolton’s model, a
monopolist seller enters into a contract with a buyer that contains a
penalty clause. Both the incumbent seller and buyer expect sellers with
lower marginal costs to enter but cannot identify them in advance. The
penalty clause enables the incumbent and buyer to collude to exercise
monopolistic power against more efficient entrants. Without the penalty
clause, entrants could offer the buyer a lower price and the buyer would
breach its contract with the incumbent. The buyer would pay damages to
the incumbent equal to its lost profits, and the entrant retains the economic
surplus from its lower costs. With a penalty clause, an entrant must offer
the buyer a price below the incumbent’s price by an amount equal to the
amount of the stipulated penalty. This is the amount the buyer must pay
the incumbent in damages if it breaches by buying from the entrant. The
penalty clause therefore enables the incumbent and the buyer to extract a
portion of the economic surplus from the entrant: the incumbent captures
a portion of it in the penalty, and the buyer in the lower price it pays the
entrant. The difficulty is that it allows the extraction of surplus from the
entrant only when entry occurs. Potential entrants whose marginal costs
are not lower than the incumbent’s price by the amount of the penalty will
not enter. In this case, the penalty clause inefficiently deters entry.
Segal and Whinston (2000) extend Aghion and Bolton’s result to set-
tings in which production involves economies of scale and incumbents can
make discriminatory offers. In these settings, incumbents can use penalty
clauses to exploit externalities among buyers. The presence of economies

of scale means here that entry is not profitable for a rival if a minimum
number of buyers have entered into contracts containing penalty clauses
with an incumbent monopolist. Discriminatory offers allow the incum-
bent to make different offers to buyers to achieve the minimum scale
needed to deter entry. In this way, the incumbent can lower its monopoly
price to entice the minimum number of buyers to agree to contracts with
penalty clauses. Agreeing to a contract with a penalty clause is rational
for each buyer because it gives her a lower price than otherwise. Having
obtained contracts with these buyers, the incumbent can make offers with
higher monopoly prices to remaining buyers. Thus, buyers who agree to
contracts with penalty clauses increase prices for remaining buyers. They
therefore impose a negative externality on remaining buyers. As in Aghion
and Bolton’s model, penalty clauses thereby enable the incumbent to
inefficiently deter entry by more efficient rivals.
Spier and Whinston (1995) study the effect of investment on deterring
entry when renegotiation is possible. They assume that the monopolist
incumbent seller can invest to increase the profit from its contract with
the buyer and that renegotiation is costless. When a buyer receives a
lower-priced offer from a more efficient entrant, it will renegotiate with the
incumbent to eliminate the penalty clause. Their renegotiation allocates
the buyer’s surplus from the entrant’s offer between the buyer and the
incumbent, according to their bargaining power. Renegotiation therefore
undoes the deterrent effect of a penalty clause on entry. However, invest-
ment deters entry even when renegotiation occurs. This is because the
incumbent’s investment in performance reduces its costs and therefore
increases its profit from performance. An entrant therefore must offer a
lower price to the buyer sufficient to cover the incumbent’s expectation
damages resulting from the buyer’s breach. Because investment increases
the incumbent’s profit from performance, it increases the incumbent’s
expectation damages. Thus, the incumbent has an incentive to overinvest
in the contract. If the buyer breaches when a more efficient entrant enters,
investment increases the incumbent’s expectation damages. This deters
entry by moderately more efficient rivals. If entrance does not occur, its
investment again increases its profit from performance.
The incumbent’s overinvestment in Spier and Whinston’s model results
from its market power. In order to extract some of an entrant’s surplus
from entry, the incumbent and its buyer set high stipulated damages.
This gives the incumbent a monopolistic advantage over a more efficient
entrant: entry is profitable for a rival only when its marginal costs are
below those of the incumbent by the amount of the stipulated damages.
High stipulated damages in turn encourage the incumbent to overinvest
in the contract’s performance because it recoups its investment whether

or not the buyer breaches. The incumbent’s incentive to overinvest is not

present when its contract lacks high stipulated damages. In this case, the
entrant pays only the incumbent’s expectation damages from breach and
keeps the economic surplus from its lower-priced offer.
The possibility that penalties can create barriers to efficient entry does
not justify penalty regulation. This is because the rationale’s central
assumption of market power is unlikely to hold in the broad range of
settings in which penalty regulation applies. In markets where buyers
can identify competing sellers, they can determine with certainty whether
entry will occur. Buyers need not agree to contracts with penalty clauses in
advance of entry. Rival sellers in these markets therefore can induce buyers
to reject contracts from sellers with penalty clauses by offering them lower-
priced contracts. Incumbents and rivals compete for the buyer’s business,
driving down price to a competitive level. The buyer gets a lower price and
the entrant keeps the surplus from its lower-priced contract. Where sellers
lack market power, the rationale that penalty clauses have anticompetitive
effects on price does not justify penalty regulation. The penalty doctrine
nonetheless applies even to contracts in competitive markets.
More generally, the penalty doctrine applies broadly, without regard
to the market structure in which contracting occurs. It holds for contracts
to which both monopolist and competitive sellers are parties. As noted
in Section 4, it also applies without regard to whether investment in con-
tractual performance is feasible. Penalty regulation applies too even when
renegotiation is infeasible. At best, market power might justify a presump-
tion against the enforcement of stipulated damages clauses. For example,
a monopolist incumbent justifiably might bear the burden of proof that
a damages stipulation in its contract is not a penalty. Or the incumbent
might be required to show that its penalty clause does not deter efficient
entry. Such proposed allocations of proof apply only to monopolists.
They do not resemble penalty regulation, which applies generally in all
market settings. Thus, the conditions described in Aghion and Bolton’s
model, and its extensions, are not robust enough to justify existing penalty
regulation.
5.2. Inefficient Signaling

Penalty clauses can inefficiently signal information about the quality of a
contracting party’s performance. Under specific conditions, banning them
induces parties to provide an efficient amount of information. Aghion and
Hermalin (1990) describe a model of financial investment under asym-
metric information in which legal restrictions on contracts can increase
welfare. The model assumes a number of entrepreneurs need financing
for their projects. Projects are of two sorts: those with a high probability

of success (‘good’ projects) and those with a low probability of success

(‘bad’ projects). Entrepreneurs know whether their projects are good or
bad; investors do not. The outcomes of projects are verifiable, so that con-
tracting parties can contract on them. However, the quality of a project
is known only to entrepreneurs; it is not contractible. Lastly, the model
assumes that entrepreneurs are risk-averse and investors risk-neutral or
risk-averse.
Entrepreneurs get financing from investors in return for a promise to
repay a larger amount if the project succeeds or if it fails. Because investors
likely will not be repaid in full if the project fails, they prefer to invest in
good rather than bad projects. Entrepreneurs therefore want to signal in
their investment contracts that their projects are good. A promise to repay
a large amount conveys this information. At the same time, the promise
imposes a risk of significant loss on the entrepreneur whose project fails,
which is a cost to it.
To indicate that it has a good project, a good entrepreneur will offer an
investment contract with a large repayment promised. A bad entrepreneur
may or may not mimic the same signal. If it sends the same signal, inves-
tors will find the signal uninformative and conclude that the entrepreneur
is offering the project of average quality. Investors will demand an invest-
ment contract with a repayment promise for an average project. If the
bad entrepreneur sends a different signal or none at all, investors will be
able to identify the project as ‘bad’. Investors therefore could distinguish
good from bad projects and invest accordingly. The pooling equilibrium
in which both types of entrepreneurs signal and the separating equilibrium
in which only good entrepreneurs signal can be inefficient. Good entrepre-
neurs in both equilibria assume risks of significant repayment obligations.
Because entrepreneurs are assumed to be risk-averse and investors can be
risk-neutral, this risk might more efficiently be allocated to investors. A
restriction on signaling can make both good and bad entrepreneurs better
off than in the equilibria identified. With the restriction in force, investors
will consider all projects to be of average quality. Good entrepreneurs
avoid the cost of taking on excessive risk of significant repayment, and bad
entrepreneurs have their bad projects considered average.
Aghion and Hermalin’s model of asymmetric information might justify
voiding penalty clauses in contracts. Assume that contracting parties are
of two types: ‘good’ and ‘bad’. Good types are likely to perform accord-
ing to the contract; bad types are unlikely to do so. While the performing
parties know their own type, their counterparties do not. Counterparties
prefer good types to bad types because they are unlikely to be compen-
sated fully in the event of nonperformance and good types are more likely
to perform. To signal that it is a good type, a good type can promise to pay

a penalty if it fails to perform. Bad types might mimic this signal or not, as
in Aghion and Hermalin’s model. The resulting equilibria are inefficient if
the promised penalty allocates to the good or bad risk-averse promisor a
risk that is more efficiently borne by risk-neutral counterparties. If penalty
clauses in contracts are void, these inefficient equilibria will not result.
Aghion and Hermalin’s model does not justify existing penalty doctrine,
for at least two reasons. First, as Aghion and Hermalin acknowledge, their
model only shows that legal restraints on contracts can increase welfare.
It describes a mere possibility. Whether restrictions in fact increase
welfare depends on the robustness of the conditions underlying the model
(Hermalin et al., 2007). However, the model’s underlying conditions are
fragile. The superiority of a ‘no signaling’ equilibrium depends on the
particular shape of risk-averse good and bad entrepreneurs’ respective
indifference curves. A good entrepreneur with a project that will almost
certainly succeed (a ‘very good’ entrepreneur) might prefer to signal
the project’s above-average quality. It values the larger reduction in the
investment contract price associated with a very good project more than
avoiding the small risk of its project failing. At the same time, a bad entre-
preneur with a project that is almost certain to fail (a ‘very bad’ entrepre-
neur) might prefer to signal that its project is below average. The very bad
entrepreneur is more concerned with avoiding the repayment obligations
associated with average projects than obtaining the advantageous invest-
ment contract price attached to average projects. A ‘no signaling’ equi-
librium makes both types of entrepreneur worse off: the very good type,
because it cannot distinguish itself from bad entrepreneurs, and the very
bad type because investors will infer that its project is of average quality.
More generally, the continuum in quality of actual contracts is unlikely to
exhibit the specific quality of projects assumed by Aghion and Hermalin’s
model. The same is true for the potentially wide range of contracts with
penalty clauses. This is consistent with Ayres’s finding that corporate
charters and by-laws do not exhibit excessive signaling (Ayres, 1991).
Second, existing penalty doctrine applies more broadly than models of
asymmetric information allow. These models find that legal restrictions
on contracts can improve on equilibria produced with parties with private
information signal excessively. Implementing these restrictions requires
courts to identify inefficient signaling equilibria (Posner, 2003). Courts lack
the information needed to do so. (Adler reaches a similar conclusion with
respect to judicially created penalty default rules for damage limitations
(Adler, 1999).) More important, models of asymmetric information do
not support penalty regulation when contracting parties are symmetrically
informed. When parties have no private information about performance,
their contracts are efficient (Hermalin and Katz, 1993). Legal restrictions

on penalties therefore cannot improve on these contracts. However,

penalty regulation is not sensitive to the information parties possess.
Courts void penalty clauses in contracts without regard to whether parties
are symmetrically or asymmetrically informed. For this reason, models of
asymmetric information do not support existing penalty regulation.
5.3. Cognitive Error

Some scholars maintain that stipulated damages clauses often are the
product of systematic errors made by the contracting parties in estimating
damages from breach (Eisenberg, 1995, 1998; Marrow, 2001). They con-
clude that these cognitive errors justify penalty regulation. Their conclu-
sion relies on laboratory studies documenting that experimental subjects
systematically make choices and probabilistic judgments that violate
standard axioms of rational choice theory (Kahneman and Tversky, 2000;
Gilovich et al., 2002; Camerer, 1995). Subjects make different choices in
response to differently formulated but equivalent descriptions of options.
They exhibit different preferences among options depending on the proce-
dure for eliciting preferences. Subjects also show more aversion to losses
relative to an initial level of assets than they are attracted to gains from
the same asset level. In some experimental contexts, they underestimate
or overestimate the likelihood of events. These and other findings suggest
that people exhibit a range of cognitive errors in making decisions (Jolls et
al., 2000; Kahneman and Tversky, 1996). Contracting parties who make
cognitive errors could draft stipulated damages clauses that inaccurately
forecast the damages from breach. Accordingly, penalty regulation might
be a justified legal response to the tendency to make cognitive errors in
estimating damages.
Eisenberg (1995, 1998) defends penalty regulation based on the apparent
ubiquity of three documented cognitive biases. One bias estimates prob-
abilities by the ease with which a type of event can be recalled or imagined.
This bias is the result of the ‘availability heuristic’: a simple rule of thumb
that estimates likelihoods by their availability to recall or imagination. A
second bias is ‘overconfidence’: the tendency to underestimate the likeli-
hood that one’s judgment is inaccurate. The third bias is representative-
ness: the tendency to base probability judgments on the extent to which
evidence is representative of a category. Eisenberg postulates that all three
biases often operate among contracting parties to produce systematic
inaccurate damage stipulations. The bias favoring availability apparently
gives prominence to the intention to perform, which is salient, not to the
possibility of breach, which is remote in recall. Contracting parties subject
to this bias underestimate the probability of breach. Overconfidence
about performance also leads parties to underestimate the likelihood of

breach. Similarly, the representativeness bias induces the parties to take

their intention to perform as representative of the likelihood that they
will intend to perform in the future. All three cognitive biases produce
inaccurate stipulated damages provisions. In contrast, these biases appar-
ently do not operate when parties draft the terms of contract perform-
ance. Eisenberg concludes that, consistent with existing penalty doctrine,
systematic cognitive error justifies special judicial scrutiny of stipulated
damages provisions only.
Eisenberg suggests that cognitive error likely operates when there is a
gross disparity between estimated and actual damages. Accordingly, he
proposes that courts invalidate a stipulated damages provision where
such disparity exists, unless the parties specifically intended the provision
to apply to the situation in which breach occurred. The specific intent to
apply stipulated damages to this situation signals that the damages stipula-
tion is the product of rational contract design, not cognitive error. Under
the proposal, the defendant bears the burden of establishing the specific
intent to apply the stipulation to the situation in which breach occurred.
Because parties might specifically intend penalty provisions to apply, the
proposal revises existing penalty regulation without abandoning it, as
Eisenberg acknowledges.
For at least four reasons, cognitive error does not justify penalty regula-
tion, even in the revised form advocated by Eisenberg. First, the experi-
mental evidence of cognitive bias is insufficiently robust to support such
regulation. Penalty doctrine applies generally, without regard to the type
of contract or the characteristics of the contracting parties. Accordingly,
parties must exhibit cognitive biases in most contract settings. However,
laboratory studies document bias in limited experimental environments.
These environments are not sufficiently representative to allow reli-
able extrapolation to nonexperimental settings, including exchange
(Lowenstein, 1999; Hillman, 2000; Walt, 2003). For instance, parties over-
confident about their skills or optimistic about their future might under-
estimate their risk of breach or its consequences (Camerer and Lovallo,
1999; Brenner et al., 1996). However, individual debiasing techniques,
organizational safeguards in firms and interfirm competition can mute or
prevent the bias from operating (Romano, 1986; Arkes et al., 1987; Heath
et al., 1997; Kadous et al., 2006). As important, individual differences in
sophistication and capacity make generalizations about the prevalence of
bias unsound (Mitchell, 2002). Because laboratory studies do not support
a finding of systemic cognitive bias generally, a gross disparity between
estimated and actual damages does not signal cognitive error.
Second, there is no general theory specifying the conditions under which
specific cognitive biases operate. This makes penalty regulation difficult to

implement effectively. Consider ‘ambiguity aversion’: the preference for

options with precise probabilities over options with unknown or impre-
cise probabilities. Studies show that experimental subjects are averse to
ambiguity in limited settings (Fox and Tversky, 1985). Contracting parties
averse to ambiguity will prefer liquidated damages, which can be made
precise, to uncertain damages estimated ex post by a judge or jury. In
drafting damages provisions, the parties might therefore carefully consider
the likelihood of breach and resulting loss (Hillman, 2000). Their atten-
tion to the array of risks of breach in turn might diminish or eliminate
any tendency to be overconfident about performance. In this case, the
parties’ bias toward overconfidence might not produce inaccurate damage
estimates. Thus, the effect of cognitive bias on the accuracy of stipulated
damages cannot be predicted without specifying the conditions under
which bias operates (Rachlinski, 2000). The cognitive error justification of
penalty regulation does not specify these conditions.
Third, the assumed ubiquity of cognitive error makes it likely that
courts too are subject to cognitive bias (Rachlinski, 2000). As a result,
courts are unlikely to scrutinize damages stipulations effectively. They will
overestimate the parties’ ability to fix damages accurately at the time of
contracting and void damages stipulations that are reasonable forecasts ex
ante of actual damages. Guthrie et al. (2001, 2007) present experimental
evidence of cognitive bias among judges that could produce this result.
Their experimental judicial subjects exhibit hindsight bias: the tendency
to use known outcomes to assess the likelihood at an earlier time of the
occurrence of events (Guthrie et al., 2001, 2007). Judges with hindsight
bias judge past events to have been more predictable than they actually
were. Guthrie et al.’s judicial subjects also overestimate their own abilities
to interpret information accurately (Guthrie et al. 2001). Courts subject
to these biases will do a poor job at scrutinizing damages stipulations. In
vetting stipulated damages, hindsight bias will lead courts to overestimate
the ability of contracting parties at the time of contracting to set damages
that approximate actual damages. This bias is reinforced when judges
overestimate their own abilities to accurately assess the ease of estimat-
ing damages ex ante. In combination, the biases induce courts to void
damages stipulations that were reasonable ex ante but disproportionate
to actual damages. They lead courts to find the stipulations to be penal-
ties that penalty doctrine, properly applied, deems enforceable liquidated
damages. Because even specialist courts appear to be subject to cognitive
bias (Rachlinski et al., 2006), they too might scrutinize damages stipula-
tions poorly. For all three reasons, cognitive error does not justify penalty
regulation. At most, damage stipulations are properly voided when they
are demonstrated to be the result of cognitive error in a particular case.

Fourth, penalty regulation reduces the incentive of contracting parties to

forecast damages accurately. Parties avoid the cost of inaccurate damages
stipulations produced by cognitive error, because courts effectively will
rewrite damage stipulations. In drafting damages stipulations, they there-
fore will underinvest in avoiding cognitive error or its operation. Judicial
estimations of damages are superior to party-provided estimates only
if courts are better positioned than parties to measure loss from breach
accurately. But courts usually are comparatively poorly positioned. The
assumed ubiquity of cognitive bias means that courts too exhibit bias in
vetting stipulated damages. In addition, parties often have better infor-
mation about the value of the contract than courts (Goetz and Scott,
1977; Ben-Shahar and Bernstein, 2000). Thus, penalty regulation imple-
mented by courts subject to cognitive error likely results in suboptimal
measurement of damages.
6. Conclusion
The literature on optimal remedies shows that the normative implications
of traditional damage measures are ambiguous. Contract remedies affect
the selection of contracting partner performance, investment, breach and
renegotiation. None of the traditional damage measures is optimal with
respect to all of these variables (Craswell, 1996, 2003). The recent litera-
ture on penalty regulation supports a similar conclusion with respect to
stipulated damages. Stipulated damages affect investment in performance,
breach and trade. Penalty clauses can induce efficient investment in the
contract while also inducing inefficient performance. Under other condi-
tions they produce efficient trade while also encouraging inefficient breach.
In different conditions, penalties encourage efficient breach when breach is
difficult to detect. The recent literature shows that no damage stipulation,
whether a penalty or liquidated damages, likely is optimal with respect
to investment, breach and trade. Rather, the optimal damage stipulation
under realistic conditions likely must trade off its incentive effect on these
variables. Existing penalty regulation unjustifiably assumes that penalties
have an overall inefficient incentive effect.
Penalties may or may not produce efficient incentives even with respect
to an isolated variable such as investment. The recent literature shows that
the effect of penalties on the incentive to invest is sensitive to the nature
of the investment, market power and contract design. Penalties induce
overinvestment when only the breach victim benefits from investment.
They also encourage overinvestment by a monopolist when it uses its
market power to deter entry by more efficient rival suppliers. On the other
hand, penalties induce efficient investment when investment benefits only
the investor and only the investor can breach. Penalties in well-designed

contracts also can encourage efficient investment by inducing contracting

parties to reveal accurate information about investment when the informa-
tion is not verifiable by courts. Taken together, recent work demonstrates
that penalties do not have an unambiguous effect even on investment.
The work has a normative implication for existing penalty regulation.
It shows that penalty clauses can be efficient under specific conditions,
depending on the nature of investment in performance or whether valua-
tions are observable to the parties or verifiable to a court. For their part,
even contributions arguing that penalties can be inefficient specify specific
conditions, such as cognitive bias or market power, in which penalties
result in inefficient investment, trade or breach. Some of the conditions
specified require courts to obtain information often unavailable to them,
such as valuations among contracting parties or the character of invest-
ment. Nonetheless, all of the work evaluates the efficiency of penalties by
isolating particular variables. A fair implication of the work as a whole
is that rules regulating stipulated damages, if any, should take these
variables into account. Penalty doctrine does not do so. Instead, it applies
generally, without regard to the variables identified in the literature. It
is therefore insensitive to the character of investment, the verifiability
of valuations among parties, or market structure. Penalty doctrine also
applies whether or not valuations are observable to the parties or whether
breach is difficult to detect. Because it does not incorporate such vari-
ables, penalty regulation is unlikely to enforce efficient penalties clauses
and void inefficient penalty clauses. For this reason, penalty doctrine is
remote from the scheme of penalty regulation (if any) justified by the
recent literature.
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of Contract Remedies’, Michigan Law Review, 83, 341–403.

11 Impossibility and impracticability
Donald J. Smythe
1. Introduction
Once parties have made a contract, should they ever be excused from the
performance of their obligations? This is the question addressed by the
doctrines of impossibility and impracticability. These provide affirma-
tive defenses to complaints seeking specific performance or damages for
alleged breaches of contract. They may be interpreted as default rules that
provide an implied term in every contract excusing the parties from their
obligations in the event that some contingency causes their performances
to become impossible or impracticable. As such, they are often referred
to as excuse doctrines. This chapter will survey the law and economics
literature on the role of excuse doctrines in contract law.
The doctrine of impossibility is usually only applied in circumstances
in which a party’s performance has become physically impossible, such
as when a painter dies before fulfilling a contractual promise to complete
a painting. The doctrine of impracticability, on the other hand, may be
applied in circumstances in which a party’s performance is physically
possible but will cause severe hardship, such as when the costs of build-
ing a bridge rise so much that the party that contracted to build it will be
forced into bankruptcy if compelled to perform. These two doctrines are
closely related to the doctrine of frustration of purpose, which may apply
in circumstances in which the essential purpose of a contract has been frus-
trated, such as when a party rents rooms specifically to view a coronation
procession that is subsequently cancelled.
It is widely believed that until the middle of the nineteenth century
the common law almost always required that contractual obligations be
performed (see Gordley 2004 for a skeptical discussion). The doctrine the
courts most commonly applied was the ‘rule of absolute liability’. This
rule was relaxed, however, in Taylor v. Caldwell, an English case in which
the court excused both parties from their performances when the music
hall one had contracted to rent from the other was destroyed by a fire,
thus establishing the doctrine of impossibility. The doctrine of frustration
was established in Krell v. Henry, another English case in which a party
was excused from paying for a room it had contracted to rent to view
King Edward VII’s coronation when the coronation parade was cancelled
due to the King’s illness. This case, and others, expanded the range of
207

circumstances under which the common law would excuse performances

beyond those which made them physically impossible.
A number of American cases have further expanded the range of cir-
cumstances in which contractual performances may be excused. In Mineral
Park, for instance, the defendants were excused on the grounds that their
performances were ‘impracticable’. Mineral Park and similar cases thus
established the doctrine of impracticability. The Restatement (Second) of
Contract Law now devotes more attention to this doctrine than to either
impossibility or frustration of purpose, and the Uniform Commercial
Code (UCC) has made it the principal excuse doctrine for American sales
contracts. The modern trend in the common law has clearly been in the
direction of expanding the grounds on which excuse will be granted.
In the civil law tradition, the doctrine of impossibility can be traced
back to Roman law (the common law doctrine of impossibility also has
important roots in Roman law; see Gordley 2004 for an overview). A
separate doctrine allowing excuse because of changed circumstances
evolved out of Canon law. Although European jurists and scholars
struggled with these separate strands of doctrine with varying degrees
of success, and although their legal systems borrowed in different ways
from the two legal traditions, most civil legal systems have ended up
with excuse doctrines similar to those in the major common law systems.
This is probably more than mere happenstance. In any modern market
economy, it is inevitable that parties will occasionally seek to be excused
from their contractual obligations. All modern legal systems have there-
fore established rules or principles to govern when parties should be
excused from their contractual obligations and when they should be
required to perform. Practical considerations appear to have influenced
both common and civil law systems to adopt similar excuse doctrines
(Zweigert and Kotz 1998).
The earliest contributions to the law and economics literature on excuse
doctrines emphasize their role in promoting efficient risk-bearing. These
early contributions have been widely cited and are therefore discussed in
the next section of this chapter. The contributions immediately subsequent
to these generally elaborated on the analysis of how the excuse doctrines
might affect the efficiency of contractual risk allocations. These subsequent
contributions are discussed in the third section of this chapter. Another set
of contributions analyzed the potential for damage limitations and price
adjustments to enhance justness and efficiency. These are discussed in the
fourth section. The most recent contributions to the literature have ana-
lyzed the role of the excuse doctrines in long-term or relational contracts.
These are discussed in the fifth section. The sixth section offers some con-
cluding comments.

Impossibility and impracticability 209
2. The Early Literature: Efficient Risk-Bearing

The first modern economic analysis of excuse doctrines was by Posner and
Rosenfield (1977). Posner and Rosenfield assume that one of the central
purposes of contract law is to reduce the costs of transacting by provid-
ing economically efficient default rules to fill the gaps in contracts. They
argue that efficiency generally requires assigning contractual risks to the
party that is the least-cost risk-bearer. Thus, in the face of changed circum-
stances that give rise to an impossibility or impracticability claim, a party
should be excused from its contractual obligation if the other party is the
superior risk-bearer; the party should not be excused if it is the superior
risk-bearer. As Posner and Rosenfield conceive of the problem, a party
can be a superior risk-bearer if it is better able to prevent the risk from
materializing, or if it is able to insure against the risk at lower cost. Some
parties may be able to insure against risks using portfolio diversification
strategies, others may have to purchase an insurance policy or simply
self-insure. Posner and Rosenfield argue that from an economic efficiency
standpoint, a promisor should be excused from performing if it could not
reasonably have prevented the event that makes its performance impos-
sible or impracticable, and if the promisee could have insured against the
risk of its nonperformance at lower cost.
As a practical matter, however, Posner and Rosenfield note there are
judicial costs to undertaking particularized inquiries. Thus, applying the
economic efficiency standard in every case would create legal uncertainties;
at the ex ante stage of their transaction, parties might not be able to predict
how courts will reallocate the risks in their contracts through the applica-
tion of excuse doctrines. They argue therefore that the economic efficiency
standard should be used to establish rules to apply to categories of cases
rather than the circumstances of individual cases. Indeed, they argue that
this is essentially how American courts have applied the excuse doctrines. In
contracts between a corporation and an employee for personal services, for
instance, both parties are able to assess the risks of the employee’s death and
each is best able to evaluate how it would impact them (or in the employee’s
case, her estate) and thus insure against the death in the most appropriate
way. Thus, when an employee dies, courts typically discharge the employ-
ee’s estate from any obligation for damages, as well as the corporation from
any obligation for payment. Similarly, in contracts for the supply of special-
ized equipment, the supplier is best able to evaluate the degree to which the
equipment is specialized and the costs of converting it to alternative uses.
Thus, in cases where a buyer seeks an excuse from an obligation to purchase
specialized equipment because its performance has become impossible,
courts have granted discharges. This is efficient because the supplier can
spread the risks of such discharges across its contracts with all buyers.

Although they acknowledge that courts have not always been consist-
ent, Posner and Rosenfield argue that similar tendencies may be found in
other categories of cases. They thus argue that their analytical framework
is a useful guide to the case law. In that respect, they offer not only a
normative economic analysis but a positive one. Indeed, in their view, the
application of excuse doctrines by courts generally illustrates the ‘implicit
economic logic of the common law’ (Posner and Rosenfield 1977, p. 84).
A paper by Paul Joskow (1977), published simultaneously with Posner
and Rosenfield’s, focused on the application of the impracticability doc-
trine in the Westinghouse case. Westinghouse had contracted with several
utilities to deliver uranium fuel for their nuclear power plants at fixed
prices. The costs of the uranium ore used to produce the uranium fuel
rose much more rapidly than Westinghouse expected and it was faced
with the prospect of large financial losses if forced to honor its fixed price
contractual commitments. Joskow argues that uranium costs were driven
upwards by the failure of the industry to increase its long-term supply
capacity enough to meet demand. In fact, Westinghouse itself unwittingly
contributed to the failure by contracting to supply utilities with uranium
fuel at unrealistically low and essentially fixed contract prices, while
maintaining a short position in the market for uranium ore. Uranium ore
suppliers were unwilling to invest in new capacity unless buyers such as
Westinghouse were willing to commit to long-term purchase contracts.
When the demand for uranium eventually drove the spot prices of both
uranium fuel and uranium ore higher, Westinghouse was trapped between
contractual obligations to supply uranium fuel at low and essentially fixed
prices and the need to buy uranium ore at high spot market prices.
Joskow estimates that as of January 1, 1975 Westinghouse had obliga-
tions to supply about 60,000 tons of uranium fuel at base prices between
$8 and $10 per pound with minor cost escalation adjustments (primarily
for certain labor and materials costs) over the period from 1975–88; over
the same period it had contractual commitments from suppliers for only
14,000 tons of uranium ore and only about 6,000 to 7,000 tons of uranium
ore inventories. By June, 1975 the spot price of uranium ore had risen to
$22 per pound; by December, 1975 it had risen to $35 per pound. Thus by
the middle of 1975 Westinghouse was short about 40,000 tons of uranium
ore that it would need to purchase over the next ten or twelve years at spot
prices that were prospectively three or four times the prices at which it had
contracted to supply uranium fuel. On September 8, 1975 Westinghouse
announced that it would not honor its commitments, on the grounds that
its performance had become impracticable under the UCC.
As Joskow notes, the truly puzzling aspect of the case is why
Westinghouse placed itself in this position. One possibility, of course,

is that it was behaving strategically and hoping the Atomic Energy

Commission would forestall any significant price increases by releas-
ing some of its stockpile of uranium reserves. Or it might have hoped
that import restrictions would be lifted and it would be able to obtain
uranium ore at cheap prices from foreign suppliers. While it is possible
Westinghouse was pursuing a rational strategy, Joskow suggests it was
more likely that Westinghouse simply made a mistake. At the time it
made its commitments to supply uranium fuel, it was focused primarily
on nuclear power plant construction and not on securing uranium ore
supplies. The resulting debacle may thus have been a consequence of a
failure at Westinghouse’s corporate level to exercise adequate command
and control over the nuclear division.
Joskow’s economic analysis focuses on the relative costs of risk-
bearing, much like Posner and Rosenfield’s. He notes that in a case such
as Westinghouse, a narrow interpretation of impracticability places the
burden of risks on the promisor, thus encouraging the promisor to insure
against the risks; a wider interpretation places the risks on the promisee,
thus encouraging the promisee to insure against the risks. If the scope
of the doctrine is appropriately defined, the costs of transacting will be
reduced. Joskow interprets the test for impracticability under the UCC to
require several conditions: (1) that an underlying condition of the contract
must fail, (2) the failure must have been unforeseen at the time of contract-
ing, (3) the risk of the failure must not have been assumed by the party
seeking excuse, (4) the performance must have been made impracticable,
and (5) the seller must have made all reasonable attempts to ensure that
the source of supply would not fail. He conjectures that as it is currently
applied, the test probably reduces transaction costs on the whole and pro-
motes economic efficiency.
In Joskow’s view, an appropriate application of the impracticability
test would preclude Westinghouse from qualifying for an excuse. First
of all, he argues that well-informed industry participants should have
expected uranium prices to rise. Thus, the failure of uranium prices to
remain stable could not have been reasonably unforeseen. Moreover, the
purpose of a fixed price contract is to assign the risk of price increases to
the seller; thus, Westinghouse assumed the risk by committing itself to a
fixed price contract. And Westinghouse certainly failed to do everything
possible to insure itself an adequate source of supply. Even if all the other
requirements were met, Joskow doubts whether Westinghouse should be
able to meet the impracticability requirement given the size of its prospec-
tive losses. In all these respects, Joskow’s analysis accords with Posner
and Rosenfield’s. Both of these early contributions focus on efficient risk-
bearing and argue for narrow applications of excuse doctrines.

3. Extensions of the Efficient Risk-bearing Theories

Bruce (1982) seeks to refine Posner and Rosenfield’s approach to the
economic analysis of excuse doctrines by elaborating on the role of imper-
fections in information in the optimal assignment of liabilities and the
manner in which it could affect parties’ incentives to mitigate damages.
He assumes, additionally, that the rules should also be constructed taking
the legal costs of resolving disputes and parties’ negotiation costs into
account. In cases where parties are equally knowledgeable about a risky
event and neither can mitigate its consequences, he argues that excuse
doctrines should be applied using a negligence standard with a contribu-
tory negligence defense. This would require courts to determine whether
the promisor took the appropriate precautions to mitigate damages and
whether the promisee failed to take precautions that could have avoided
them. Bruce argues that where parties have asymmetric information, the
logic of Posner and Rosenfield’s argument for assigning the liability to the
better-informed party falls apart if the parties are able to contract around
their rule. Thus, where the promisor is less well informed about the pro-
spective size of the promisee’s damages and would be discharged under
Posner and Rosenfield’s analysis, the promisee could pay the promisor to
accept responsibility for a breach of contract.
Perloff (1981) attempts to answer a question that Joskow (1977) had
raised: Why would somebody make a commitment to buy under a long-
term fixed price contract other than to insure against fluctuations in the
price? He notes that in an Arrow-Debreu world of full information and
complete contingent claims markets, there would be no need for excuse
doctrines, but that in a second-best world of asymmetric, limited informa-
tion, incomplete futures markets, and other imperfections, contractual
discharge might be able to improve economic welfare. To illustrate this, he
constructs a model in which transaction costs preclude risk-averse sellers
from hedging against price fluctuations by executing futures contracts. In
this context, a discharge of the seller’s obligations if the spot price at the
time for performance exceeds the ex ante expected price by a sufficient
amount could serve as a substitute for the kind of contingency clause the
seller might have negotiated in a contract with a risk-neutral buyer to
hedge against price fluctuations.
Perloff notes that some of his results conflict with Posner and Rosenfield’s.
In his model, for instance, it may be efficient for a risk-averse seller to pay
damages to a risk-neutral buyer under particular market conditions.
Whereas it is always optimal for the risk-neutral party to bear the risks in
Posner and Rosenfield’s model, it is not necessarily so in Perloff’s model
because a court’s decision to grant an excuse will have general equilibrium
effects not captured in Posner and Rosenfield’s analysis. He argues that

Posner and Rosenfield’s analysis is a special case of his own in which dif-
ferent sellers’ outputs are never positively correlated. He concedes that
there are significant costs to judicial inquiries and that courts may not be
able to ensure that excuses will always improve welfare, but argues that
since courts are only rarely asked to intervene, they may nonetheless be
able to apply excuse doctrines in ways that improve welfare overall, espe-
cially if they follow relatively simple legal rules.
White (1988) analyzes excuse doctrines using principles from the eco-
nomic analysis of contract breach (Shavell 1980; Polinsky 1983). She
argues that courts should forego a separate analysis of whether a discharge
from contractual obligations is justified and focus instead on the appropri-
ate damages remedy for the party’s breach. In some cases, the appropriate
damages would be zero, but in most cases positive damages should be
levied on a nonperforming party. She further argues there are three ways
in which breach of contract rules can enhance economic efficiency: by pro-
viding incentives to perform if performance is efficient; by discouraging
the promisee from making inefficient reliance expenditures; and by mini-
mizing the costs of risk-bearing. Since the amount of damages necessary
to ensure efficient risk-bearing is always positive, regardless of whether
the buyer and seller are risk-neutral or risk-averse, discharging a contract
will increase the risk faced by both parties overall. Moreover, since it is
equivalent to zero damages, it will also encourage inefficient breach.
White thus argues that judges should treat discharge cases as breach of
contract cases, and assess damages according to the risk preferences of the
parties, the amount of the contract price paid in advance, and the degree
to which the parties can influence whether or not the adverse event occurs.
She argues that in cases where performance becomes impossible, courts
will often look to whether or not the contract price was paid in advance.
She claims that in Krell v. Henry, for instance, the lessee made a partial
payment in advance; when the lessee sought an excuse, the court granted
it, but did not require the lessor to return the advance payment. This
implicitly assessed damages against the lessee. In cases where performance
has merely been made impracticable because of a significant cost increase,
such as the Suez canal cases, the efficient amount of damages will always
be positive.
Sykes (1990) analyzes conditions under which contractual discharge will
be efficient given that an event occurs that makes a party’s performance
impracticable. He assumes that contracting parties can anticipate the con-
tingencies that might give rise to impracticability claims and make rational
decisions ex ante about whether to incur the transaction costs of negotiat-
ing customized contract clauses or to bear the expected costs of having the
excuse doctrines apply by default. Sykes notes that the impracticability

doctrine can be characterized as a two-tier damages rule since zero

damages will apply if the defense is accepted, but positive damages will be
awarded if it is rejected. He thus treats the impracticability defense as a
two-tiered damages rule and compares it to the expectation damages rule
that would otherwise ordinarily apply.
In Sykes’s model, uncertainty arises from the promisor’s costs. With
zero transaction costs, the parties would negotiate a Pareto-efficient con-
tract that allocates the risk of price fluctuations optimally. If transaction
costs are positive, on the other hand, the parties’ contract will be second
best. He assumes the parties negotiate a fixed price contract. If the promi-
sor’s realized costs exceed the fixed contract price, the promisor may then
seek to be discharged from its contractual obligations. Under an expecta-
tion damages rule, the promisor would perform if and only if its costs
were less than the value of the performance to the promisee. But of course
this places all the risk on the promisor, which may be suboptimal. The
question thus is whether and when a discharge of the promisor’s obliga-
tions will improve the efficiency of the risk allocation enough to offset the
inefficiencies of encouraging breach when performance would be optimal.
This treats contractual excuse as a second-best solution to the contracting
problem in the presence of transaction costs.
Sykes’s analysis suggests that if the promisor is risk-neutral, the expec-
tation damages rule will always be at least as efficient as the impracticabil-
ity defense. This follows from the simple observation that if the promisor
is risk-neutral (and the promisee is not a risk-preferer), there can be no
efficiency gains from shifting risks from the promisor onto the promisee by
accepting an impracticability defense. If the promisor is sufficiently risk-
averse and the promisee is risk-neutral, however, accepting the impracti-
cability defense may improve efficiency. If the promisor and the promisee
are both risk-averse, then it becomes difficult to draw any general conclu-
sions. Whether accepting the impracticability defense will be second-best
depends on a host of factors, including the parties’ relative degrees of
risk-aversion, their wealth, the probability distribution of the promisor’s
costs, etc. Given the information that courts would require to ensure that
they accepted the impracticability defense only when it would be welfare-
increasing, Sykes concludes that is difficult to conceive of a discharge rule
that would reliably increase economic efficiency. Although he does not
argue for the abolishment of excuse doctrines, he suggests they should
be applied only in particular cases, such as those involving supervening
illegality or crop failures.
Triantis (1992) provides an analysis of the doctrine of impracticability
as a problem in the allocation of risks under uncertainty. He extends the
traditional model of decision-making under uncertainty to explain the

contractual allocation of unknown risks. In this respect, he challenges

the conventional assumption that parties are unable to allocate the risks
of unanticipated events contractually. To this end, he applies behavioral
models of decision-making under uncertainty rather than the more con-
ventional models of decision-making under imperfect information. The
behavioral theories he applies are based on models in which individuals
cannot assign unique probability distributions to given risks, but must
contemplate that random events could be generated by more than one
probability distribution. It is worth noting that this approach to uncer-
tainty is less radical than some others because it assumes that decision-
makers can at least define the universe of possible random events. There
are, in that sense, no truly unforeseeable contingencies.
In this framework, contractual risks are allocated through an implicit
price for risk-bearing. Although Triantis notes that some risks are inevi-
tably unanticipated, they generally can be folded into broader categories
of risk that are allocated contractually. For instance, a party might not
be able to foresee the risk of a terrorist attack that closes an important
shipping route, but they probably will be able to foresee the possibility
of the closure of the shipping route, if for some other, undefined reasons.
Thus, the contract may allocate the risk of the closure to the shipper for
some implicit price, and the shipper should then bear the risk regardless of
whether the specific event which causes the closure was itself foreseeable.
The risks of unforeseen contingencies are thus allocated at a broader level
of aggregation. Although Triantis acknowledges that this aggregation
of risks may not always be optimal, he argues that unknown risks are
typically remote and exogenous. Moreover, he cites empirical research by
behavioral theorists to argue that contracting parties can and do address
the risks of truly unforeseeable contingencies by making adjustments in
their assessments of the broader risks associated with their contractual
obligations.
Triantis argues that the same cognitive limitations that plague the
individual parties to contracts also impede the courts. Thus, he argues it
is unlikely that any court could allocate contractual risks more efficiently
than the parties themselves. Since excuse doctrines are more like muddy
standards than bright line rules, courts must apply them on a case-by-case
basis under diverse facts. This makes the outcomes of the cases difficult to
predict and only adds to the uncertainty inherent in the contracting envi-
ronment. Given most parties’ aversion to risk, the application of excuse
doctrines by courts increases the ex ante costs of contracting. Moreover,
because of the courts’ cognitive limitations, they will often fail to identify
the superior risk-bearer and their interventions will generally not improve
ex post efficiencies or redress inequities either. Triantis concludes that the

continued existence of the doctrine of impracticability ‘only serves to pre-

serve the confusion and uncertainty as to its application and scope’ and
that ‘[t]he role of contract law should be limited to the interpretation and
enforcement of the parties’ risk allocations’ (Triantis 1992, p. 483).
4. Arguments for Damages Limitations or Price Adjustments

Some authors have argued that unforeseen circumstances may warrant
damage limitations or price adjustments even if a full discharge is not
warranted and that price adjustments may be preferable to discharge
even when it is warranted. Walt (1990), for instance, argues that a party
should only be liable for losses attributable to risks it was compensated
to bear under the terms of the contract. For example, if 20 percent of
an increase in costs was foreseeable at the time of contracting, and if the
seller was compensated for bearing that risk under the contract, in the
event the seller breaches, its liabilities should be limited to 20 percent of
the cost increase. In principle, the same reasoning could be used to argue
for a price adjustment, although Walt does not develop that line of argu-
ment. Walt contends that such an approach would be consistent with the
Uniform Commercial Code and within the competence of the courts.
Trimarchi (1991) develops a case for price adjustments based on a cri-
tique of the efficient risk-bearing theories and using a transaction costs
argument. As he points out, the efficient risk-bearing theory does not suit
all circumstances in which a party might seek an excuse. In some cases,
certain risks, such as those associated with inflation or international crises,
may be systematic and thus affect the economy as a whole. Trimarchi
argues there may be no efficient risk-bearer of such systematic risks.
Efficient insurance in these contexts would require hedging, but because
futures markets are incomplete, hedging will in many cases be impossible.
Self-insurance, on the other hand, is merely a form of gambling. In other
cases, a risk of a loss to one party may correspond to a windfall gain to the
other. Suppose, for instance, that the seller’s costs increase, but the buyer’s
benefits under the terms of the contract increase even more. The seller’s
loss would be the buyer’s windfall. Trimarchi argues that requiring the
seller to insure against such a loss would not only be unjust but also inef-
ficient because the seller’s planning and organization would be disrupted
(presumably causing a loss of organizational rents), even if it was not
forced into bankruptcy (and if it was, valuable goodwill would be lost).
Trimarchi’s alternative analysis is based on a conception of incom-
plete contracts. He argues, for instance, that parties would rarely intend
that a fixed price clause assign all the contractual risks associated with
price fluctuations. Indeed, he observes that most of the risks that might
give rise to an impossibility or impracticability claim are so improbable

that they would normally be overlooked. Even if the parties did foresee
the risks, they would probably ignore them anyway since psychological
considerations normally impede parties from negotiating explicitly over
highly unlikely contingencies that might give rise to significant contractual
difficulties.
Trimarchi contends that a discharge of the seller’s obligations or an
adjustment of the contract price might be warranted when a contractu-
ally unallocated risk arises in the face of an unforeseeable risk. If the risk
was unforeseeable, then it was incalculable and efficient risk-bearing was
impossible. In theory, a discharge would allow the parties to renegotiate
the contract price and complete their transaction. In some respects, this
would be preferable because it would respect the parties’ autonomy and
allow them to adjust the contract price using their private information
and based on their own preferences. Trimarchi observes, however, that
transaction costs might be saved if the price was adjusted by the courts
or if some procedural rule was used to facilitate the parties’ adjustment of
the price.
Renner (1999) analyzes the contractual risks posed by inflation and
reaches similar conclusions. Since parties may not anticipate the true
rate of inflation, an excuse would benefit the seller if the contract price
increased more than the inflation rate and it would benefit the buyer if the
contract price rose more than the inflation rate. If courts granted excuses
under these circumstances, the parties would bear the risks of relative price
fluctuations they had contracted to avoid. If courts adjusted the contract
price to accommodate the inflation rate, on the other hand, then the risks
of relative price fluctuations that the parties agreed upon in their contract
would not be disturbed. Renner thus contends that when unanticipated
inflation disrupts parties’ agreements, price adjustments are always prefer-
able to excuses. Renner recognizes that individualized court adjustments
would be costly and so she argues that these are justified only when the
risk of loss at stake is particularly large, but that a standard rule governing
price adjustments should apply when the risk at stake is small.
5. Impossibility and Impracticability in Long-term Contracts

Most of the analyses of excuse doctrines in long-term contracts have
eschewed a focus on risk-bearing. In an early contribution, Williamson
(1985a) extends his transaction cost theory of the firm to the analysis
of contracts and uses transaction cost theory to analyze the role played
by excuse doctrines. In Williamson’s transaction cost theory of the firm
(see Williamson 1979), actors are assumed to be boundedly rational, in
the sense that Herbert Simon explains as ‘intentionally rational, but only
limitedly so’ (Simon 1961), and also opportunistic, in the sense that they

are ‘self-interest seeking with guile’ (see Williamson 1985b for a thorough
discussion). Williamson argues that transaction costs depend on the
frequency with which transactions recur, the degree of uncertainty inher-
ent in the environment, and the asset specificity of any investments the
transactions require. In principle, his transaction cost theory applies to
short-term contracts as well as long-term ones, but the most interesting
implications are for long-term contracts.
High transaction costs preclude parties from negotiating long-term
contracts that are complete. Since long-term contracts frequently require
significant investments in specific assets, it will often be in the parties’ best
interests to make adaptations in the face of unanticipated contingencies
because the failure of their transaction will generally mean a failure to
recoup a return on specific investments. They might include an arbitra-
tion clause in their contract to facilitate such adaptations. If they do not
do so, Williamson suggests that this is likely because they considered
the contingency that warrants an adaptation too unlikely or the costs of
arbitration too high, or the impairment of other incentives too severe.
One could conclude, then, that strict enforcement should be preferred
over an excuse. Williamson argues, however, that this would generally
operate to the advantage of the party that is better able to calculate the
risks and costs of remote events in advance. It would certainly encourage
the parties to engage in more detailed negotiations and thus incur greater
transaction costs at the bargaining stage of their contracts. Moreover, as
Macaulay (1963) observed, such detailed negotiations might impede some
agreements from being reached.
Williamson argues that contract excuse doctrines could help to mitigate
some of the ex ante transaction costs, particularly if one party is more sophis-
ticated than the other. He distinguishes two cases: one in which the contract
is silent regarding potentially problematic contingencies; the other in which
the contract attempts to cover some, but not all, problematic contingen-
cies. He argues that in the latter case, the less sophisticated party should
have been alerted to the risks of the contract, and since it made no effort to
broaden the protections, it should be subject to strict contract enforcement
(as should the more sophisticated party). In the former case, however, con-
tract discharge is easier to justify since neither party was put on alert by the
other’s negotiation of special protections from some remote contingency.
In addition, he argues that since the excuse doctrines encourage parties to
be adaptive in the execution of their contracts, they may provide additional
benefits. But since there are significant judicial costs to applying the excuse
doctrines, he concludes that the case in their favor is limited.
Goldberg (1985, 1988) addresses excuse doctrines in two separate arti-
cles. In the first, like Perloff (1981), he seeks to answer the question Joskow

(1977) posed: Why would anyone commit to a long-term fixed price

contract? Goldberg (1985) argues that parties have many ways of adjust-
ing prices to changed conditions both ex ante and ex post. They can, for
instance, include price acceleration clauses in their contracts; alternatively,
they can renegotiate prices even in a fixed price contract. This latter option
might be attractive to both parties if it prevents the aggrieved party from
‘working to the rules’ and undermining the value of the contract to the
other without breaking the letter of the contract. Although the options are
imperfect, they do not necessarily argue for courts to grant an excuse.
Goldberg (1988) argues that parties would not normally agree to excuse
one another’s performances because of changed market conditions at the
ex ante stage of their contract. Although he concedes that price conces-
sions are common, he argues that they are usually only given for consid-
eration. In his view, parties are much more likely to agree to excuse the
other’s performance if the supervening events giving rise to the request
are unrelated to market conditions. An excuse in the face of an unantici-
pated price increase, for instance, would only redistribute income between
the parties. An excuse in the face of some supervening event that would
otherwise dramatically increase the costs of performance for one without
significantly increasing the benefit for the other would, on the other hand,
alleviate a serious moral hazard problem. As a general matter, such moral
hazard problems increase transaction costs for both parties at the ex ante
stage of a long-term contract.
Goldberg argues that this distinction helps to explain much of the case
law. The Suez cases, for instance, involved an event which affected market
conditions and courts generally declined to grant excuses. Goldberg notes
that the closing of the Suez canal was not subsequently added to the force
majeure clauses in most shipping contracts. In the coronation cases, such
as Krell v. Henry, excuses were granted but in at least one (Chandler v.
Webster), the discharged renter was denied reimbursement of a deposit.
He argues that this Solomonic solution is now common in the hotel indus-
try and generally agreeable to most parties. It essentially treats a hotel
reservation as an option contract. Since the modern practice is consist-
ent with the application of the doctrine of frustration in the coronation
cases, he argues the courts in those cases probably applied the doctrine of
frustration appropriately.
Scott (1987) analyzes the role of excuse doctrines in long-term contracts
using a game-theoretic conception of parties’ strategic interactions. In his
theory, parties negotiate an assignment of risks in their contracts, but since
they cannot allocate all the risks ex ante – either explicitly or implicitly –
they may seek adjustments during the course of their agreement in order
to accommodate unanticipated contingencies. Once the contract has been

made, however, they have less incentive to accommodate the other’s requests
for adjustments than they did ex ante. They are thus inevitably confronted
during their contract with the choice between adjusting the contract coop-
eratively or behaving non-cooperatively and resisting the adjustment. He
argues the parties’ interactions can be analyzed using a repeated prisoner’s
dilemma game in which they must decide whether to behave cooperatively
or non-cooperatively each time there is an unanticipated contingency. The
parties will generally rely on tit-for-tat strategies and social norms to regu-
late their behavior, but if either of them responds non-cooperatively they
may decide to enforce the contract legally. The question then is whether the
courts should enforce the contract as written or grant an excuse.
The parties’ difficulties in enforcing their contract will usually be exacer-
bated by imperfect information. They will usually only have limited under-
standings about how an unanticipated contingency will affect the other.
They may also have imperfect information about the actions of the other
party in the preceding period. In addition, they may have high discount
rates and they may face significant uncertainty about the duration of their
transaction. This increases the costs of enforcing their contract through
the usual cooperative and retaliatory interactions that comprise tit-for-tat
strategies. Reputation effects and extra-legal enforcement mechanisms
may help the parties maintain a cooperative equilibrium, but these may
themselves be costly and may not be as effective in contracts between
commercial actors as they are between family members.
Scott argues that contract law offers two valuable mechanisms for
reducing errors in the initial assignment of contractual risks. The first is
the implied contract term. These are typically provided by many common
law doctrines, such as impossibility and impracticability. The problem is
that these doctrines can only be constructed through carefully adjudicated
cases over a long period. Custom and usage of trade may offer some guid-
ance to the courts in constructing these implied terms, but not enough to
eliminate all uncertainty over judicial interpretations. Scott thus argues
that particular circumstances will usually require that express contract
terms supersede any terms implied by the courts. The second mechanism
for reducing errors in the assignment of contractual risks is the ‘express
invocation’ – a term that carries an unambiguous meaning that the courts
can then apply. Scott argues that certain force majeure clauses can evoke
such meanings. The usefulness of standardized terms, however, is limited
to standardized contractual arrangements. Parties will have difficulty in
establishing terms for more innovative arrangements.
Scott argues that even if the costs of judicial inquiries are high, courts
may nonetheless play an important role in resolving contract disputes.
If one party seeks an adjustment and the other declines the request, the

parties may become involved in a series of spiteful and unproductive

interactions. Judicial intervention may help to control these spiteful inter-
actions because courts can serve as a neutral and legitimate arbiter of the
parties’ dispute. Additionally, the power of an aggrieved party to invoke
legal enforcement provides a credible threat of severe retaliation against
the other party that has defected from a cooperative equilibrium. To this
end, strict legal standards that can be applied clearly and decisively may
help courts to enforce the initial assignment of contractual risks better
than loose ones. Scott argues that this may explain why courts are so reluc-
tant to apply the doctrines of impossibility and impracticability. Since the
unanticipated contingencies that give rise to excuse defenses will usually
involve contractual ambiguities and interpretative difficulties, courts may
generally prefer to adhere to the principle of party autonomy instead, and
force the parties to rely on their strategic interactions and social norms to
resolve their disputes between themselves.
Smythe (2002, 2004) constructs a game-theoretic model of parties’ inter-
actions over the course of a long-term – or ‘relational’ – agreement and
uses it to analyze the roles of contractual enforcement and contract excuse
doctrines. In his model, the parties must transact in the face of uncertainty
about future contingencies. Since transaction costs are high and/or the
parties are boundedly rational, they cannot allocate the risks of all pos-
sible contingencies in a complete contingent claims contract and so their
agreements are necessarily incomplete. He argues that they therefore enter
into long-term agreements, with the understanding that they will adapt the
terms in the face of new contingencies as the need arises. In the face of an
unforeseen contingency, one of the parties may then request an adjustment
or an excuse from its obligation. The other must decide whether to comply
with the request or deny it. This leaves open the possibility of two types
of opportunism: the party requesting the excuse may have done so when
under the spirit of their agreement the request was not justified, and the
other party might deny the request for an excuse when under the spirit of
their agreement the request should have been granted. In the face of such
opportunism, the agreement will unravel. The prospect of the agreement
unraveling increases the uncertainty faced by the parties at the outset of
their transaction.
In Smythe’s model, the parties’ design their agreement to be largely self-
enforcing. In the face of the uncertainty raised by the prospect of unfore-
seen contingencies, the parties may respond by making their agreement
less than fully cooperative. Since their incentives to deviate from the agree-
ment decline as the cooperativeness of the agreement declines, this may
enable them to proceed with a mutually gainful transaction even in the
face of significant uncertainty. In Smythe’s model, however, even a small

decrease in the cooperativeness of the agreement can have a significant

impact on the profitability of their transaction. A relatively small decrease
in their cooperativeness in any one period might not matter much, but a
decrease in their cooperativeness in every period over the course of a long-
term agreement might matter a great deal. Moreover, the decrease in the
parties’ cooperativeness would usually be accompanied by a decrease in
the size of any initial investments they might make towards the profitabil-
ity of their transaction. This would, of course, compound the impact of the
uncertainty on the profitability of their transaction.
The parties will attempt to reduce the uncertainty by adopting an effec-
tive governance structure for their transaction. The governance structure
might rely on social norms and the parties’ business ethics, but it may also
include the strictures of a formal contract. Executing a contract for the
transaction is a means of opting in to the possibility of legal enforcement
of the parties’ obligations. If, in the face of some problematic unforeseen
contingency, one of the parties demands an excuse from its obligations
and the other denies the request and demands performance, the former
has the option of turning to the courts to enforce the contract. The courts
will then have to decide whether to enforce the contractual obligation or
grant an excuse. Courts can make two kinds of mistakes: if they enforce
the contract when an excuse is justified, they will accommodate the enforc-
ing party’s opportunism; if they grant the excuse when one is not justified,
they will accommodate the excused party’s opportunism.
The possibility of both kinds of judicial mistakes increases the ex ante
uncertainty faced by the parties if they execute a contract for their trans-
action. If courts apply the excuse doctrines inappropriately, therefore,
this will increase the costs of contracting and possibly discourage parties
from transacting altogether. Of course, if courts typically only enforce
contracts when they should and grant excuses when they are justified,
this will decrease the ex ante uncertainty faced by the parties and reduce
the costs of contracting. This will increase the longevity and cooperative-
ness of their agreements, the size of their initial investments, and decrease
their reliance on other, less efficient governance structures. Smythe (2004)
argues that the manner in which the doctrine of impracticability has
been applied by most American courts has probably helped to reduce the
uncertainty and costs of contracting. Moreover, as long as courts allow
parties to contract around the rule, any harm that it might do can at least
be mitigated.
6. Conclusion
The earliest economic analyses of excuse doctrines focused on their role
in promoting efficient risk-bearing. Subsequent studies extended the early

ones by incorporating the analysis of excuse doctrines into more general

frameworks for the analysis of contract damages claims, by elaborating on
other ways in which the courts might affect risk allocations through their
applications of excuse doctrines, and by suggesting other ways in which
the parties might allocate risks contractually. The most recent analyses
have focused on the role of excuse doctrines in long-term contracts. The
focus of these studies has been on whether the application of the excuse
doctrines will generally impede or enhance the parties’ efforts to enforce
their agreements autonomously. In light of the most recent studies, it seems
reasonable to predict that future work in this area is likely to elaborate on
the role of the excuse doctrines in long-term contracts, using theories and
methods from behavioral law and economics.
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12 Foreseeability
Peter van Wijck
1. Introduction
The general aim of damages for breach of contract is to put the claimant
into as good a position as if the contract had been performed. There are,
however, a number of principles which limit the compensatory damages.
One of these is the principle of ‘foreseeability’. The famous English case
of Hadley v. Baxendale (1854, 9 Ex. 341, 156 Eng. Rep. 145) can be con-
sidered ‘the fountainhead of the limitation of foreseeability’ (Farnsworth,
2004, p. 792). Burrows (2007, p. 1630) summarizes the ‘perhaps best-
known of all English contract cases’ as follows.
The claimant’s mill was brought to a stand-still by a broken crank-shaft. The
claimant engaged the defendant’s carrier to take it to Greenwich as a pattern
for a new one, but in breach of contract the defendant delayed delivery. The
claimant sought damages for loss of profit arising from the fact that the mill
was stopped for longer than it would have been if there had been no delay. The
court held that the loss of profit was too remote and therefore the carriers were
not liable for it.
The rationale of the decision appears in what came to be known as the

two rules of Hadley v. Baxendale (Farnsworth, 2004, p. 793). The first rule
was that the injured party may recover damages for loss that ‘may fairly
and reasonably be considered [as] arising naturally, i.e. according to the
usual course of things, from such a breach of contract itself’. The second
rule went to recovery of damages for the loss other than ‘arising naturally’
– to recovery of what has come to be known as ‘consequential’ damages. It
denied recovery of consequential damages unless the loss was ‘such as may
reasonably be supposed to have been in the contemplation of both parties,
at the time they made the contract as the probable result of the breach of
it’. These two rules constitute a single foreseeability rule with two tests of
foreseeability (Landa, 1987, p. 456).
The Hadley rule is a default rule, that is, parties may contract around
the default. A high-value buyer may be prepared to pay a higher price in
order to increase the probability of performance. The possibility to con-
tract around the default is crucial. As Barnett (1992, p. 868) puts it: the
advantages of the Hadley rule are unobtainable unless parties are free to
manifest their consent to terms different from those supplied by Hadley
and to have a court honor their consensual choice.
225

The central question in the law and economics literature on foreseeabil-

ity is whether the foreseeability rule is efficient.
2. Early Formulations
Ayres and Gertner (1989) and Bebchuk and Shavell (1991) are the first
papers that extensively analyze Hadley from a law and economics per-
spective. The basic notions can, however, be found in a number of earlier
papers. Goetz and Scott (1980, p. 1300) argue that ‘the limitation on
damages for unforeseeable consequences of breach increases the effi-
ciency of promissory activity by stimulating the provision of information
between bargainers’. Or ‘Limitations on damage recovery encourage the
parties to share information about contingencies that would potentially
exacerbate the consequences of a breach’ (Goetz and Scott, 1983, p. 986).
A similar point is made by Barton (1972, p. 296), Bishop (1983, p. 255) and
Kornhauser (1986, p. 718): the purpose of the contract remoteness rule
of Hadley v. Baxendale is to encourage efficient transfer of information.
According to Bishop (1983, p. 257).
analytically the rule in Hadley v. Baxendale is a rule designed to minimize

adverse selection. . . . cheap information is the best antidote to adverse selec-
tion problems. So in contract the promisor is entitled to assume ‘usual risks’
unless he is notified to the contrary, whereupon he can demand and obtain a
high price.
In another view, Hadley is seen as a mechanism to allocate risk to the

most efficient risk avoider (Hause, 1983, p. 164).
Ayres and Gertner (1989) provide a theory of how courts and legisla-
tures should set default rules. They suggest that efficient defaults would
take a variety of forms that at times would diverge from the ‘what the
parties would have contracted for’ principle. They introduce the concept
of ‘penalty defaults’. Penalty defaults are purposefully set at what the
parties would not want – in order to encourage the parties to reveal
information to each other or to third parties (especially the courts). They
further distinguish between tailored and untailored defaults. A ‘tailored
default’ attempts to provide a contract’s parties with precisely ‘what they
would have contracted for’. An ‘untailored default’ provides the parties
to all contracts with a single, off-the-rack standard that in some sense
represents what the majority of contracting parties would want.
Ayres and Gertner (1989, pp. 92–4) distinguish between two basic
reasons for incompleteness of contracts. First, contracts may be incom-
plete because the transaction costs of explicitly contracting for a given con-
tingency are greater than the benefits. Second, a party might strategically
withhold information that would increase the total gains from contracting

Foreseeability 227
in order to increase her private share of the gains from contracting. The
possibility of strategic incompleteness leads them to suggest that efficiency-
minded lawmakers should sometimes choose penalty defaults that induce
knowledgeable parties to reveal information by contracting around the
default penalty. From an efficiency perspective, penalty default rules can
be justified as a way to encourage the production of information. The very
process of ‘contracting around’ can reveal information to parties inside or
outside the contract. Penalty defaults may be justified as giving both con-
tracting parties incentives to reveal information to third parties, especially
courts, or giving a more informed contracting party incentives to reveal
information to a less informed party.
According to Ayres and Gertner (1989, p. 101), the holding in Hadley
operates as a penalty default. The default can be understood as a purpose-
ful inducement to the miller as the more informed party to reveal that
information to the carrier. Informing the carrier creates value because if
the carrier foresees the loss, he will be able to prevent it more efficiently.
Hviid (1996) shows that default rules can also serve as a means of avoiding
inefficient information revelation.
Johnston (1990, p. 617) argues that Ayres and Gertner fail to take
account of strategic incentives in bargaining. To get the contract in the
first place, the promisor generally wants to persuade the promisee that
the breach probability is low. The promisor wants a profitable contract,
but risks not getting any contract at all by seeking to extract a high price
from the promisee in exchange for insuring against losses above what the
default provides. Thus, the promisor will not have an interest in bargain-
ing around the default. Ben-Shahar and Bernstein (2000, p. 1888) speak
about a ‘secrecy interest’, an interest to keep information private.
In a response, Ayres and Gertner (1992, p. 736) say that Johnston con-
vincingly demonstrated that a shipper’s incentive to reveal information
depends upon the incidence of market power. In their original model,
competition drove carriers to price at zero profits.
Like Ayres and Gertner (1989), Bebchuk and Shavell (1991) examine how the
Hadley rule may provide incentives to transfer information. Furthermore,
they analyze the possibility that the Hadley rule would be undesirable.
The main building blocks of their model are as follows (Bebchuk and
Shavell, 1999, pp. 1619–20). There are two kinds of buyers: a majority of
normal, low-valuation buyers, and a minority of high-valuation buyers.
The probability of breach, depends on the level of precautions taken by
sellers. The valuations of buyers are assumed not to be directly observable
by sellers. Thus, for sellers to be able to tell buyers apart, and to use dif-
ferent levels of precautions for different types of buyers, communications

between buyers and sellers must take place. And such communications are
assumed to involve costs in themselves.
The benefit of the Hadley rule is that, when separation between low- and
high-valuation buyers is desirable, it will occur in the least costly way. For
under the Hadley rule, communications will take place in the small minor-
ity of cases in which buyers have high valuation.
Their analysis also identified reasons as to why the Hadley rule might
be undesirable (Bebchuk and Shavell, 1999, p. 1621). In particular, they
showed that, when communication enabling sellers to separate buyers does
not occur, the Hadley rule will be inferior to the rule of unlimited liability.
The reason is, on the one hand, that the advantage of the Hadley rule in
inducing communication in the least costly way is then moot. On the other
hand, the Hadley rule suffers from a disadvantage: when sellers face the
entire pool of low- and high-valuation buyers, the unlimited liability rule
is superior to the Hadley rule because the former rule provides incentives
for sellers to choose the optimal, blended level of precautions.
3. Is Hadley a Penalty Default?

In a recent paper, Eric Posner (2006) claims that Ayres and Gertner did
not provide any persuasive examples of penalty default rules; their best
example is the Hadley rule, but this rule is probably not a penalty default
rule. Based on a survey of American contract law, Posner concludes that
there are no plausible examples of penalty default rules that solve the
information asymmetry problem identified by Ayres and Gertner. Posner
claims that the penalty default rule is a theoretical curiosity that has no
existence in contract doctrine.
According to Ayres (2006), Posner’s claim comes from his restrictive
reading of what constitutes a penalty and especially from his restrictive
definition of what constitutes a contractual default. Ayres discusses a
number of opinions where judges think that the result is equivalent to a
penalty default. Furthermore, there are a large number of law review arti-
cles that explicitly deal with penalty or information-forcing defaults. Ayres
presents a lengthy list of assertions that these defaults currently exist.
Ayres (2006, p. 612), however, admits that Hadley can be seen as a
majoritarian (that is, not a penalty) default. The Hadley rule is majoritar-
ian in the sense that a majority of contracting parties would prefer the rule
that deters the strategic withholding of information by an unrepresentative
minority.
4. A Typology
Hadley is often presented as an example of ‘information-forcing default
rules’ (for example, Scott, 1990, p. 606). Eric Posner (2006, p. 573) notes

Foreseeability 229
Table 12.1 Typology of default rules
Full damages default rule Hadley default rule

Majority of 1. Minoritarian full damages 2. Majoritarian Hadley
buyers place a default rule default rule
low value on ● Incentive for majority ● Incentive for minority (i.e.
performance (i.e. the low-value buyers) the high-value buyers) to
to contract around the contract around the default.
default.
Majority of 3. Majoritarian full damages 4. Minoritarian Hadley
buyers place a default rule default rule (penalty
high value on ● Incentive for minority default)
performance (i.e. the low-value buyers) ● Incentive for majority (i.e.
to contract around the the high-value buyers) to
default. contract around the default.
that both majoritarian and penalty defaults are information-forcing. A

majoritarian rule is information-forcing because the minority types will
contract out of it if transaction costs are low enough, revealing both
their valuations and the valuations of the majority that does not opt out.
The only difference between the two rules is that more parties opt out
of – or would prefer to opt out of – a penalty default rule than out of a
majoritarian default rule, everything else held equal.
The question of whether the Hadley rule constitutes a penalty default
depends on the distribution of valuations. A useful typology, inspired by
Geis (2005), is obtained if we distinguish between a case where the major-
ity of buyers place a low value on performance and the case where the
majority of buyers place a high value on performance.
Ad 1. Minoritarian Full Damages Default Rule

If parties do not contract around the full damage default, the supplier
will base precaution (and the price of the product) on the buyers’ average
value. Consequently, there is an incentive for low-value buyers, that is, the
majority of buyers, to contract around the default. If the low-value buyers
contract around the default, this yields a separating equilibrium. On the
one hand, this leads to an increase in transaction costs; on the other hand,
there’s a benefit of optimal precaution.
Ad 2. Majoritarian Hadley Default Rule

If parties do not contract around the Hadley default rule, the supplier will
base precaution on low-value buyers. Consequently, there is an incentive
for high-value buyers to contract around the default. If the high-value

buyers do contract around the default, this yields a separating equilib-

rium. The majoritarian Hadley default economizes on transaction costs,
because there is an incentive for a minority of buyers to contract around
the default. The transaction costs may be smaller than the benefits of
increased precaution.
Whether the majoritarian Hadley default rule is more efficient than the
minoritarian full damages default rule depends on the transaction costs of
both types and the distributions of both types.
Ad 3. Majoritarian Full Damages Default Rule

If parties do not contract around the full damage default, the supplier will
base precaution on the buyers’ average value. Consequently, there is an
incentive for low-value buyers, that is, the minority of buyers, to contract
around the default. The majoritarian full damages default economizes
on transaction costs. From an efficiency point of view, a separating equi-
librium is better than a pooling equilibrium if the transaction costs are
smaller than the benefits of decreased precaution for low-value buyers.
Ad 4. Minoritarian Hadley Default Rule

There is an incentive for high-value buyers, that is, the majority of buyers,
to contract around the default. In this case, Hadley is a penalty default:
most buyers would not select this rule in advance. A separating equilib-
rium is obtained if the majority of buyers contracts around the default.
From an efficiency point of view, 4 may be better than 3 if the majori-
tarian full damages default rule yields a pooling equilibrium, that is,
if the low-value minority does not reveal its type under a full damages
default rule. The minoritarian Hadley default may lead to a separating
equilibrium. And this would be efficient if the increase in transaction costs
is smaller than the net benefits of increase precaution for the high-value
buyers (cf. Geis, 2005, pp. 909–10).
Generally, there will not be merely ‘high-value’ and ‘low-value’ buyers. In

practice, the distribution of valuations can take many forms. A relevant
distinction is between a positively skewed distribution (many low-value
buyers) and a negatively skewed distribution (many high-value buyers)
(Geis, 2005, p. 899).
5. Optimal Default Cap on Contract Damages

According to Bar-Gill (2006), the foreseeability doctrine in effect speci-
fies a threshold level of harm. Harm below the threshold, ordinary harm,
is always recoverable. Harm above the threshold is recoverable only if
it is communicated to the other party at the time of contracting. Bar-

Foreseeability 231
Gill addresses the question of what constitutes the optimal threshold.

What harm should be recoverable by default, and when should specific
communication be required?
His starting point is the observation that most previous accounts assume
two discrete levels of damages – low damages and high damages – and
ask whether the default rule should allow recovery for only low damages
(limited liability), or for both low and high damages (unlimited liability).
Rather than asking whether liability for breach of contract should be
limited or unlimited, Bar-Gill asks where on the continuum of damages
levels the limit should be placed.
The optimal damages cap achieves the right balance of pooling and
separation, minimizes communication costs, and optimally controls the
entry and exit of low-valuation buyers. Bar-Gill derives (numerically) the
optimal default cap on contractual damages in a model with a continuum
of buyer types and perfect competition among sellers. When communica-
tion costs are low, the optimal cap is significantly higher than the damages
incurred by the average buyer. A better performance technology reduces
the optimal damages cap. Greater homogeneity among buyers increases
the optimal cap.
6. Stochastic Damages
As typically modeled, the Hadley default rule serves to distinguish two con-
tractual types who differ in a single respect. The common type places a low
value on contract performance and will, therefore, suffer low damages in
the event of default. The exceptional type places a high value on perform-
ance and will, therefore, suffer high damages in the event of default. Adler
(1999a, p. 1551) points out that it is not realistic to assume that values, and
thus damages, are certain. If damages are stochastic, a high-value type can be
described not as a party who will suffer high damages in the event of breach
but as one who is highly likely to suffer damages in the event of breach.
In Adler’s ‘enriched Hadley model’, a high-value type could decline to
contract explicitly for expansive liability, however low the transaction
costs. Such defection from a limited-liability default would induce her
counterpart to charge not only for the higher level of anticipated liability,
as is assumed in the standard Hadley model, but for the higher prob-
ability of even ordinary liability. The charge would not be the product of
market power but would reflect the revealed actual cost of efficient service
and expected liability. A high-value type can avoid the full cost of service
and expected liability if she accepts the default rule and remains indis-
tinguishable from the low-value type. The high-value type will weigh the
expected cost against the expected benefit from inclusion in a ‘pool’ with
low-value types. The cost is limited protection for a valuable shipment.

The benefit is a subsidy from low-value types. Depending on this balance,

the penalty-default rule may not yield separation from the pool even if the
transaction costs of defection do not present an obstacle.
According to Ayres and Gertner (1999, p. 1592), Adler should be cred-
ited with identifying this additional reason why privately informed parties
may be reluctant to contract around default rules. But showing that it
may be harder to induce information revelation with a particular type of
penalty default is not an argument in favor of setting ‘hypothetical’ or
‘majoritarian’ defaults.
Bebchuk and Shavell (1999, p. 1618) argue that Adler’s contribution
should be regarded as a natural extension of their analysis, rather than a
sharp departure from it.
The upshot of the discussion is that penalty defaults are efficient in a
narrower set of circumstances ‘than previously understood’, and that
determination of the appropriate default rule is more difficult than prior
analysis of the Hadley case might suggest (Adler 1999b, p. 1629).
7. Stickiness
Default rules tend to be sticky. Opting out of a default generates transac-
tion costs. Where these costs are high, parties may find themselves stuck in
a default. In the literature, factors beyond drafting costs are recognized as
potential causes of stickiness.
Building on earlier work, especially Bernstein (1993), Spier (1992), and
Johnston (1990), in a recent paper Ben-Shahar and Pottow (2006) suggest
that the stickiness problem is broader and more prevalent than previously
perceived. The basic idea is as follows (Ben-Shahar and Pottow, 2006,
p. 652).
In the presence of a default rule – or, more precisely, in the presence of a famil-
iar and commonly utilized background provision, be it a common law doctrine,
a business norm, or a boilerplate contractual term – a transactor might fear that
proposing an opt-out from the default will dissuade his potential counterparty
from entering into the agreement. The fear is that the counterparty will suspect
that the proposer’s decision to deviate from the norm and use an unfamiliar
provision hides some unknown problem: in short, that it is a ‘trick.’ The coun-
terparty, seeking to rationalize why the deviation was proposed, may construct
a negative account and attribute some undesirable reason for the departure by
the proposer. Depending on the plausibility of the imputed negative account,
the counterparty will either exact an offsetting discount or avoid entering
into the contract altogether.
The stickiness problem also applies to the Hadley default. Paraphrasing

Johnston (1990, pp. 616–17), Ben-Shahar and Pottow (2006, pp. 658–9)
present the following example. A shipper who highly values safe carriage

Foreseeability 233
of goods might be inclined to contract out of default rules of limited

carrier liability and ask for higher liability coverage. But in so proposing
such a high-insurance opt-out, she would reveal to the carrier her higher
value attached to full performance of the contract and thus expose herself
to having a greater share of her surplus extracted by the carrier through
a price adjustment that would more than account for the greater liability.
Facing this expropriation risk, the shipper might prefer to remain silent
and accept the suboptimal liability coverage; the default arrangement will
stick.
Following Bernstein (1993), Ben-Shahar and Pottow (2006, p. 662)
point to an additional factor that may lead to sticky defaults. A departure
from the ‘norm’ – a proposal to incorporate terms that are not the stand-
ard, default terms – may in and of itself raise suspicion. The inherent sus-
picion toward proposals to opt out may stem from the adverse messages
about the deviating party’s treatment of relational norms – that she will be
unlikely to resolve disputes in a collaborative and informal manner.
8. Empirical Findings
Reflecting on three decades of economic analysis of contract law, Eric
Posner (2003) argues that the economic approach does not explain the
current system of contract law nor does it provide a solid basis for criticiz-
ing and reforming contract law. He reflects, inter alia, on the literature
regarding the Hadley rule.
One default rule could be better than the other, depending on the dis-
tribution of valuations, the cost of revealing information, the relative bar-
gaining power of the party with private information and the uninformed
party, and related factors. If there are more low-value shippers than
high-value shippers, the expansive liability rule requires more bargaining
around, and therefore more transaction costs, and thus might be subop-
timal. According to Posner (2003, p. 837), the relevant variables are too
complex and too hard to determine.
Geis (2005, p. 900) argues that Posner’s critique echoes a broader cry
for empirical analysis throughout legal scholarship. Early empirical work
on the Hadley rule includes Danzig (1975), Epstein (1989), and Landa
(1987). Geis takes up the task of empirically assessing Hadley in three
simple markets. Drawing upon willingness-to-pay research in the field of
marketing, Geis first estimates the distribution of buyer valuations for a
can of Coca-Cola, a piece of pound cake, and an ergonomic pen. Monte
Carlo simulation is then used to model complex interactions between mul-
tiple variables and the overall impact of alternative default rules on social
welfare.
Economic theory suggests that if many buyers place a low value on

performance while few buyers place a high value on performance – and if

a buyer’s valuation is private, unobservable information – then the Hadley
rule may be preferable to a rule that awards full expectation damages.
Under these circumstances, a Hadley default may force private informa-
tion to be revealed in a way that encourages efficient precautions against
breach and minimizes transaction costs from bargaining around the
default. If the valuation distributions are reversed, the Hadley rule may be
inefficient, and a full-damages default might be better.
Geis’s primary claim is that a Hadley default rule is more efficient than
a full-damages default rule in the simple markets studied. His extended
claim is that markets with similar conditions might also benefit from the
Hadley rule. However, these findings are subject to four important quali-
fications. First, the Hadley rule is not preferable when high-value buyers
systematically have a much greater chance of incurring consequential
damages. Second, a full damages default outperforms Hadley when most
of the efficiency gains from information revelation go to low-value buyers.
Third, the Hadley rule is not optimal when the transaction costs of con-
tracting around the default rule are much greater for high-value buyers
than low-value buyers. Finally, the analysis assumes perfect competition,
and introducing seller power into the empirical model might change the
results (Geis, 2005, p. 903).
9. Optimal Precision
Using the same methodology as Geis (2005), Geis (2006) investigates the
optimal precision of legal default rules. Should lawmakers pick just one
simple default rule for an entire legal system, or should they design more
complex default rules? Lawmakers could conceivably adopt more complex
defaults, tailored to the most salient variables in the economic models of
Hadley. The recovery of unforeseeable consequential damages might, for
example, be linked directly to buyer valuations for a market or contract-
ing party. Geis’s main claim is that simple default rules often do seem
better than complex ones – at least for the markets and rules used in his
experiment.
10. Timing and the Efficiency of Precaution and Breach

Eisenberg (1992) argues that one major cost of the Hadley principle is that
it provides inefficient incentives for the rate of performance. The principle
allows the seller, in determining whether to breach, to disregard reason-
ably foreseeable costs that are not probable costs or that become known
before breach but after the contract is made. The principle of Hadley v.
Baxendale conflicts with the theory of efficient breach. Under that theory,
if the reasonably foreseeable losses that the buyer will incur as a result of

Foreseeability 235
breach exceed the gains to the seller, the seller should perform. However,
under the principle of Hadley v. Baxendale as traditionally formulated and
applied, the seller need not perform, because he will not be liable for those
losses unless they are both reasonably foreseeable and probable not only
at the time of breach, but at the time the contract is made. In effect, the
principle of Hadley v. Baxendale gives greater weight to the efficient rate of
precaution than to the efficient rate of performance. Eisenberg (1992, pp.
596–7) is of the opinion that this strikes the wrong balance.
Essentially, Eisenberg’s point is about a well-known discussion in the
literature on contract damages. Damages that lead to efficient reliance
may induce inefficient breach (cf. Oman, 2007, pp. 851–60).
Eisenberg (1992, p. 599) claims that reasonable foreseeability should be
determined at the time of the breach, so that in deciding whether to breach
the seller must consider all the costs that it should reasonably foresee will
be incurred by the buyer as a result of breach. Application of the foresee-
ability standard at the time of breach, rather than at the time the contract
is made, gives precedence to the rate of efficient breach over the rate of
precaution.
The idea that foreseeability should be determined at the time of breach,
rather than at the time the contract was made, can also be found in earlier
papers (Danzig, 1975, pp. 282–3 and Hause, 1983, p. 169). The Hadley v.
Baxendale time of contracting limitation may be justified by an obligor’s
need to calculate allocated risks ex ante in evaluating terms and attractive-
ness of the contract. Without such a rule, the injured party has an incentive
to withhold disclosure of the unusual consequences of nonperformance
until after the contract price is negotiated (Goetz and Scott, 1983, p. 987).
11. Policy Implications

The central question in the law and economics literature on foreseeabil-
ity is whether the foreseeability rule is efficient. The basic idea is that the
Hadley rule is a default rule that gives high-value buyers an incentive
to contract around the default. The fundamental insight is that courts
and legislature should not simply select default rules that the majority of
contracting parties would have wanted. A ‘majoritarian approach’ leads
to a minimalization of transactions costs. Defaults may give incentives to
contract around the default. By contracting around the default, parties
may reveal private information. Ayres and Gertner (1989, p. 95) recom-
mend a greater and more explicit legal sensitivity toward the ways in
which different defaults will affect the resulting contractual equilibrium.
They conclude that penalty defaults should be used if it results in valuable
information revelation with low transaction costs (Ayres and Gertner,
1989, p. 128).

The selection of appropriate defaults depends on a number of variables

and it is hard to gather the relevant data. The qualifications and exten-
sions formulated in more recent papers suggest that this is a complicated
task.
Adler (1999a) concludes that the determination of the appropriate
default rule is more difficult than prior analysis of the Hadley case might
suggest. He considers his paper also a caution to a judge or legislator.
A judge, in particular, might feel ill equipped to adopt the appropriate
rule. Perhaps a legislature, with greater investigative resources than the
courts, should strive to fill contractual gaps where separation of parties
by type is the goal. Moreover, any lawmaker properly skeptical of her
ability to choose the correct default rule based on an analysis of pooling
and separating equilibria might appropriately weight more heavily any
other relevant consideration (Adler, 1999a, p. 1582). Ayres and Gertner
(1999, p. 1609) agree that courts and other lawmakers will often lack
crucial information in order to determine beforehand whether a particular
penalty will be effective in inducing separation. They argue, however, that
Adler ignores that policymakers can often assess after the fact whether a
particular penalty is effective in inducing separation. ‘Ex ante assessment
is often not possible, but ex post assessment may be sufficient to warrant
experimentation with penalty defaults.’
Reflecting on extensive discussions, Ayres (2006, p. 617) maintains that
different defaults have different informational effects and induce different
degrees of separation. At the end of the day, lawmakers should still take
these differences into account when picking among competing defaults.
In theory, the optimal damage cap depends on a number of parameters.
In practice, however, courts will be unable to compute the optimal damage
cap (Bar-Gill, 2006, p. 648). A relevant insight is that the optimal cap will
be significantly above average damages.
Another complication is that default rules tend to be sticky. Ben-Shahar
and Pottow (2006, p. 669) discuss the policy implications of stickiness.
For example, policymakers should arguably place even more emphasis on
setting accurate defaults, because departure costs might be higher than previ-
ously thought. As for the effect on penalty default rules, however, there are
more complex considerations. On the one hand, the premise that parties will
easily opt out of them to avoid the penalty may be more difficult to defend
when there is widespread stickiness that stifles tailoring. On the other hand,
harsh enough penalty defaults can overcome the stickiness effect, and once that
effect is overcome, the increased prevalence of deviation will, in and of itself,
attenuate the stickiness of the default rule even further.
In the end, empirical research is needed to establish the behavioral con-

sequences of the Hadley rule. This research is still in its infancy. There are,

Foreseeability 237
however, some indications that the Hadley rule tends to be more efficient
than the full damages default (Geis, 2005).
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23, 432–43.

13 Option contracts and the holdup
problem*
Abraham L. Wickelgren
1. Introduction
Any contract that is enforced through money damages, as opposed to
specific performance, is, in some sense, an option contract. The perform-
ing party has the option to perform or pay damages. That said, contracts
are normally only referred to as option contracts if it ‘is a promise which
meets the requirements for the formation of a contract and limits the
promisor’s power to revoke an offer’ (Restatement (Second) of Contracts
Section 25). Economic analysis of option contracts has been recent, and
it has almost exclusively focused on the efficacy of option contracts as a
solution to the holdup problem.1 While, as Katz (2004) has noted, both the
optimal design of option contracts and the special doctrinal treatment of
option contracts are worthy of detailed analysis, this chapter will follow
the existing literature and focus on the conditions under which option con-
tracts provide a robust solution to the holdup problem. In reviewing this
literature, the chapter will find that the details of the model, and in par-
ticular, the bargaining process, are critical in determining whether or not
the holdup problem is a significant and inevitable feature in a non-trivial
number of contractual situations.
The next section of this chapter describes the holdup problem in detail
and discusses its importance to creating a coherent theory of firm bounda-
ries. It also introduces the mechanism by which option contracts might
provide a contractual solution to the holdup problem. Section 3 discusses
the extent to which option contracts can provide a robust solution to the
holdup problem in situations where parties must invest in the relation-
ship simultaneously. Section 4 discusses the efficacy of option contracts in
sequential investment settings. Section 5 concludes.
* I thank Ronen Avraham for helpful comments.

1
Katz (2004) is an important exception. Scott and Triantis (2004) and
Avraham and Liu (2006), among others, also discuss options embedded in con-
tracts, though they do not focus specifically on explicit option contracts.
239

2. The Holdup Problem

The holdup problem occurs when parties to a relationship have an incentive
to under-invest in their relationship (relative to the amount that would maxi-
mize the expected surplus from their relationship) because, while each party
bears all the cost of its investment, the benefits of the investment are shared
between the two parties. This can happen if the profitability of the relation-
ship between two parties depends on the magnitude of the relationship-
specific investments. An investment is relationship-specific if it creates
substantially more value if the two parties deal with each other than if they
do not. Of course, there will be no holdup problem if the investments can be
precisely specified in advance and easily verifiable by a court ex post.2
If one or both of these conditions are not satisfied, then the relationship-
specific investments are non-contractible in the sense that it is not pos-
sible to write a contract requiring a specific investment level that can be
enforced in court. In this case, a holdup problem can emerge because the
contract between the two parties may need to be renegotiated after the
investment cost is sunk. Typically, holdup models assume that there is too
much uncertainty ex ante (before the investments are made) to write a con-
tract that will specify an efficient trade in every possible contingency. In
these models, because at least some features of the efficient trade must be
negotiated after the parties have invested, there is the potential for holdup.
This problem was first identified and discussed in Williamson (1975, 1985),
Klein et al. (1978), Grout (1984), and Hart and Moore (1988). Holdup
has played an important role in the recent literature about determining
the optimal boundaries of the firm as a way to mitigate holdup problems
(Grossman and Hart 1986; Hart and Moore 1990).
This literature on the importance of holdup in the theory of the firm
has spawned a large number of articles suggesting that holdup is not as
serious a problem as many have suggested. These articles argue that there
are contractual solutions that can solve the under-investment problem
that holdup creates. If this is the case, then the theories of the firm that
rely on the choice of firm boundaries to mitigate holdup problems are
built on an improper foundation. The main proposed contractual solution
to the holdup problem involves the use of option contracts. Determining
the ability of option contracts to solve the holdup problem is critical to
assessing the large literature on the theory of the firm that is based on the
existence of a holdup problem.
2
In fact, even if investments cannot be specified in advance but the court can
verify not only the investments but whether or not they are efficient ex post, then
there should also be no holdup problem.

Option contracts and the holdup problem 241
As Rogerson (1992) has shown, if initial contracts can preclude rene-

gotiation, the contracts can solve the holdup problem quite generally.
As a legal matter, however, prohibiting parties from renegotiating a
contract is difficult, if not impossible. Thus, defenders of the incomplete
contracts theory argued that once it is recognized that contracts must be
renegotiation-proof, the holdup problem re-emerges. In the early 1990s,
most papers examining renegotiation-proof contractual solutions to the
holdup problem focused on contracts that specified the renegotiation pro-
tocol (Chung 1991; Aghion et al. 1994).3 Because there was some criticism
of the realism of specifying a renegotiation protocol in advance, much of
the subsequent literature on solutions to the holdup problem focused on
option contracts.
3. Option Contracts in Simultaneous Investment Settings
3.1. Option Contracts and the Basic Holdup Problem

Nöldeke and Schmidt (1995) is one of the first papers to suggest that option
contracts could achieve first-best investment levels in standard holdup
models even without being able to contractually specify the renegotiation
process in advance.4 Their paper re-considers the Hart and Moore (1988)
model of the holdup problem. In this model, at date zero, a buyer and a
seller contract over the terms of trade for one unit of an indivisible good.
At this time, they specify two prices. The buyer pays the seller p1(p0) if
the good is (is not) traded at date 2 (the court can only verify whether
trade occurred or not). Between date 0 and date 1, the parties make
relationship-specific investments. These investments are selfish in that the
seller’s investment affects only her cost of production, c, and the buyer’s
investment affects only his valuation, v, of the good to be traded.5 These
investments are observable to the parties, but they are non-verifiable, so
they cannot be contracted upon. At date 1, both parties observe both the
level of the investments and the state of the world (the seller’s cost and
the buyer’s valuation). Also at date 1, the parties have the opportunity to
renegotiate the contract.
At date 2, the seller decides whether or not to exercise her option to
3
MacLeod and Malcomson (1993) showed that if there was some contract-
ible variable correlated with investment levels, then the first best can generally be
achieved.
4
Hermalin and Katz (1993) proposed a fill-in-the-price contract that effec-
tively served as an option contract and showed how, under certain assumptions,
this could generate first-best investment levels even with renegotiation.
5
Contract theorists use the term selfish without any pejorative connotation.

deliver the good (the effective strike price of this put option is p1 2 p0) and
the buyer decides whether to accept delivery. In Hart and Moore, trade is
effectively a mutual option. Since they assume the court can only verify if
trade occurred, no trade occurs (resulting in a payment of p0) if either the
seller does not deliver or the buyer refuses delivery. If there is no trade at
date 2, then the good loses all value to the buyer.
Holdup can occur only because there is uncertainty about whether or
not trade is efficient. If trade were always efficient, then a simple fixed price
contract would induce efficient investment by both parties. The reason is
that if trade is efficient, a fixed price contract will never be renegotiated
since doing so can never make both parties better off. Thus, the seller will
obtain all the gains from her cost reduction and the buyer will obtain all
the gains from his investments that increase the value for the good. This
gives both parties efficient incentives to invest.
Since trade may not be efficient, however, fixed price contracts some-
times need to be renegotiated. In Hart and Moore’s model of renegotiation,
either party may obtain the surplus from renegotiation depending on the
resolution of the uncertainty. This means that both parties have too little
incentive to invest to increase the surplus from the relationship since with
positive probability they will not benefit from this increase in surplus.
Nöldeke and Schmidt (1998) alter the Hart and Moore model by assum-
ing that a court can verify whether the seller delivered the good. Thus, in
their model, only the seller has the delivery option (if the seller delivers, the
buyer pays p1 regardless of whether or not he accepts delivery). Nöldeke
and Schmidt show that, even with uncertainty regarding the efficiency of
trade, once a seller-option contract is feasible, this contract can induce
first-best investment levels despite renegotiation. The key to their result is
that they assume a renegotiation process which effectively gives all the bar-
gaining power to the buyer.6 As a result, the buyer necessarily has efficient
incentives to invest because he receives all the surplus from renegotiation
(thus, he does not share any of the increase in surplus he creates via his
investment).
The seller’s incentives are efficient by designing the original contract to
6
Their renegotiation game has each player sending a new contract to the other
party. Then the seller has to decide whether to deliver the good before she knows
whether the buyer has agreed to her offer. Thus, by sending any new contract offer
to the buyer, she only gives the buyer an option to use the new or the old contract.
As a result, only the buyer’s renegotiation offer really matters. He makes this
offer only if it is necessary to induce the seller to behave efficiently. Moreover, in
this case, since the buyer is effectively making a take it or leave it offer, the buyer
obtains all the surplus from renegotiation.

balance two offsetting distortions. The seller’s incentive to trade under the
original contract is given by p1 2 p0. If this is small, then trade will rarely
be optimal for the seller under the original contract (only if she gets a
very favorable cost shock, so that c , p1 2 p0). Thus, since she will rarely
want to trade under the original contract, this contract gives her very little
incentive for cost reduction. Of course, the contract will be renegotiated
to induce trade if v . c . p1 2 p0. Since the buyer receives all the surplus
from renegotiation, the seller’s incentives for cost-reducing investment are
too small if p1 2 p0 is small.
On the other hand, if p1 2 p0 is large, then p1 2 p0 . c is quite likely, so
the original contract provides very strong incentives for the seller to reduce
costs (since trade will occur with high probability under this contract). If
p1 2 p0 . c . v, then the contract will be renegotiated to stop the seller
from trading. So, in these cases, cost-reducing investment has no social
value, but it still has private value to the seller since it raises the amount
the buyer must offer the seller not to trade. Thus, if p1 2 p0 is large, the
seller’s incentives for cost-reducing investment are too large. By choosing
p1 2 p0 appropriately, these two conflicting effects can be perfectly bal-
anced to induce the seller to invest efficiently.7 Notice, however, that if the
buyer had the option to refuse delivery, as in Hart and Moore (1988), this
scheme would not work since the buyer would simply refuse delivery in
this case rather than renegotiate the contract.
3.2. Product Complexity, Cooperative Investment and Holdup

After Nöldeke and Schmidt, incomplete contract theorists worked on
developing new models in which the holdup problem is more robust. These
models can be divided into two types: complexity models and cooperative-
investment models. Segal (1999) and Hart and Moore (1999) show that
complexity in the environment can prevent option contracts from solving
the holdup problem. These models assume that at date 0 there are a large
number of potential goods (widgets) that the parties might find it benefi-
cial to trade at date 1. One of these widgets will be the one that maximizes
the surplus from trade (the special widget), but at date zero no one knows
which widget is the special widget. Thus, the date 0 contract cannot specify
the widget to be traded. At date 0.5, the seller can make a cost-reducing
7
Edlin and Reichelstein (1996) also show that balancing conflicting incen-
tives for over and under-investing can produce efficient investment incentives. The
conditions under which the first best is achievable are somewhat more restrictive,
but their bargaining protocol is somewhat more general. In particular, it does not
assume that one party effectively has all the bargaining power in the renegotiation
game.

investment which only affects the cost of production for the special widget.
That is, the greater the investment, the greater the probability that the
special widget (whichever one that turns out to be) will cost c1 instead of c2,
c1 , c2. The cost of the other (generic) widgets are evenly spread between
c1 and c2. At date 1, the parties can renegotiate their date 0 contract and
trade. In this model, trade of the special widget is always efficient.
Holdup emerges unless the seller has all the bargaining power in the
renegotiation game (and if the buyer were to make an investment, holdup
would occur in this case as well). Renegotiation always guarantees that
the special widget will be traded. The gains from renegotiation depend
on the surplus from trading the special widget rather than the widget that
would be specified absent renegotiation. This surplus depends on the cost
of the producing the special widget. As long as the buyer shares some
of the surplus from renegotiation, the buyer obtains some of the benefit
from the seller’s cost-reducing investment. This gives the seller insufficient
incentives to invest in cost reduction.
In the Hart and Moore (1999) and Segal (1999) models, option contracts
cannot eliminate this holdup problem because even these contracts are
subject to renegotiation. For example, a contract that gives the buyer the
option to specify which good to trade at date 1 would induce the buyer to
choose the most expensive widget. If this is not the special widget, then this
allows the buyer to gain some additional surplus from renegotiating this
contract to specify the special widget after he has chosen the most expen-
sive widget. Similarly, giving the seller the option to choose the widget at
date 1 would induce her to choose the cheapest widget. Investment raises
the probability that the special widget is cheaper than all the generic ones.
But, if there are many generic widgets, one will always be very close in cost
to the special widget even when the special widget only costs c1. Thus, the
seller’s benefit to having the special widget cost c1 instead of c2 is very small
if there are generic widgets whose cost is close to c1.
Che and Hausch (1999) developed the cooperative investment model of
the holdup problem.8 In this model, instead of a seller’s investment only
affecting her cost of production and a buyer’s investment only affecting his
value for the good, the investments have externalities. That is, the seller’s
investment increases the buyer’s valuation and the buyer’s investment
reduces the seller’s cost.9 They show that for an arbitrary division of the
8
Che and Chung (1999) and MacLeod and Malcomson (1993) also have
models of cooperative investments.
9
The investment can have selfish effects as well, but for simplicity I’ll focus on
the case in which the investment has only cooperative effects.

surplus from renegotiation, if investments are sufficiently cooperative, no

ex ante contract can solve the holdup problem. Even more significantly,
they show that there is no ex ante contract that can improve investment
incentives over not contracting ex ante at all.
In their model, parties contract at date 0. At date 1, each party makes
a relationship-specific investment that can affect both parties’ payoff
from trade. At date 2, the state of the world is revealed. At date 3, if
the initial contract had option components, the party with the options
makes its selection. At date 3.5, this contract can be renegotiated. At
date 4, the final contract is enforced and players receive their payoffs.
The effect of cooperative investments in this model can be easily illus-
trated using a limited version of this general model. Suppose only the
seller can make an investment, e, that affects only the buyer’s valuation
for the good, v. If renegotiation were not possible, a simple buyer-option
contract would solve the holdup problem. Let e* be the efficient level of
investment. If at date 0, the parties wrote a contract that gave the buyer
the option to buy the good at a price of p 5 v(e*), then the buyer would
only buy the good if the seller invested at least e ≥ e*. The seller would
have no reason to invest any more than this amount. Thus, investment
would be efficient.
Notice, however, that the buyer receives no gains from trade (ex post).
Thus, with renegotiation, the buyer can do better by refusing to exercise
his option at date 3. By so doing, now the buyer and the seller renegoti-
ate the contract at date 3.5. For any date 1 investment e, the surplus from
renegotiating after the buyer has chosen no trade is v(e) 2 c. Say the
buyer receives a fraction l of the surplus from this renegotiation. Then the
seller’s ex post payoff is (1 2 l)(v(e) 2 c). Unless l 50, the seller will have
insufficient incentives to invest since she bears all the cost, but obtains only
a fraction (1 2 l) of the benefits. Thus, with renegotiation, option con-
tracts cannot solve the holdup problem if investments are cooperative.
3.3. Option Contracts in Product Complexity and Cooperative

Investment Models
Lyon and Rasmusen (2004) take issue with both the complexity model of
Hart and Moore (1999) and Segal (1999) and the cooperative investment
model of Che and Hausch (1999). They argue that in a more realistic
bargaining model for the renegotiation game, buyer option contracts can
solve the holdup problem in both cases. Their basic argument rests on
what they call their Axiom of Unilateral Action. This axiom states that if
a player has an option, he can exercise this option at any time up until the
last period of the game when trade must occur. If this option yields this
player (the buyer in their paper) a non-negative payoff, then the seller can

refuse to renegotiate at any time, knowing that at the last moment when
trade must occur, the buyer will exercise his option.
Recall that in the Hart and Moore model, the prospect of renegotiation
would induce a buyer with an option contract to choose the most expen-
sive widget even if this was not the special widget that maximized his
payoff. He would do so because this would force the seller to pay him more
to agree to substitute the lower cost special widget. Lyon and Rasmusen
argue that this conflicts with their Axiom of Unilateral Action. That is,
they argue that the seller should be able to refuse the buyer’s attempt at
renegotiation because she knows that at the moment it becomes time for
the buyer to order the widget, he will switch to choosing the special widget
(regardless of what he claimed before) because that maximizes his payoff
and he has the power to do so unilaterally. As long as the original contract
gives the buyer this continuing option, the prospect of renegotiation will
not create holdup because the threat to choose the wrong widget is not
credible (so there will be no renegotiation).
Similarly, in the Che and Hausch model, Lyon and Rasmusen argue
that the buyer’s attempt to refuse delivery (decline to exercise his option)
will not be credible, hence will not induce the seller to renegotiate the con-
tract. The seller can ignore the buyer’s attempt to renegotiate the purchase
price after declining the option knowing that the buyer will always decide
to exercise this option in the last period. As long as the original contract
keeps the option open, which it is in the parties’ joint interest to do because
holdup reduces the total surplus to be shared, the buyer-option contract
will not be renegotiated. Hence, it will solve the holdup problem.
Wickelgren (2007) argues that the Lyon and Rasmusen critique is not
always robust if the trading opportunity is durable (that is, if the trade
remains efficient for a long time). Notice that both the product complex-
ity models and the cooperative investment models assume that trade must
occur on a fixed date. That is, there is only one opportunity to trade; if
the trade date passes, all gains from trade evaporate. If the trading oppor-
tunity is durable, then there will be many (perhaps an infinite number)
of dates in which there are gains from trade, though these gains will be
discounted the later the trade occurs. With a durable trading opportu-
nity, Wickelgren argues that holdup is a robust feature of the cooperative
investment model.
The reason relates to the outside option principle of Shaked and Sutton
(1984): in an infinite-horizon bargaining game, a player’s unilateral option
that eliminates any need for continued bargaining will only affect the
outcome of the bargaining game if it gives that player a greater payoff than
he would have in the bargaining game without this option. In this case, the
outside option is ‘binding’. If an outside option is not binding, then this

player has no incentive to exercise the option since she is better off using
the threat of delay to obtain a share of the surplus from the bargain (it is
this threat that drives the surplus sharing in standard bargaining models
without outside options).
In the cooperative investment model, the buyer’s option is not a binding
outside option. The reason is that to induce the seller to invest efficiently,
the buyer option contract must allocate all the surplus to the seller. Thus,
if there is a durable trading opportunity, after investments are sunk, we
have a bargaining game in which the buyer and seller bargain over the
trade price and the buyer has a unilateral option to purchase at a fixed
price. Because this fixed price gives the buyer no surplus, it represents a
non-binding outside option. Thus, according to the outside option prin-
ciple, it does not affect the bargaining outcome. Wickelgren shows this
occurs so long as the opportunity is durable enough (the bargaining game
is long enough). It is not necessary for the bargaining game to be infinite-
horizon.
In the product complexity model, by contrast, simply making the trading
opportunity durable does not undermine the effectiveness of buyer option
contracts. Unlike the cooperative investment model, the option contract in
the product complexity model can allocate significant surplus to the buyer.
By so doing, it can make the option contract a binding outside option.
As Shaked and Sutton have shown, if the outside option is binding in a
bargaining game with discounting, then trade occurs at the option price.
Thus, Lyon and Rasmusen’s Axiom of Unilateral Action applies and the
buyer option contract is not renegotiated. That said, Wickelgren shows
that the holdup problem can re-emerge (at least under certain parameter
values) with a slightly modified version of the Hart and Moore/Segal
model. Imagine that instead of the trade just being a one-time decision,
the seller must deliver a widget (of the type specified by the buyer) every
period. The buyer can, however, in any period change the type of widget
he orders. In this variation of the model, the buyer’s choice of widget type
is no longer an outside option. Instead, it is a disagreement point. That is,
it determines the payoffs of the parties while bargaining, but does not elim-
inate the gains from renegotiating this choice in the future. This changes
the bargaining game in a way that makes the buyer’s threat to choose the
most expensive widget credible in some circumstances.10 As a result, the
10
Holdup re-emerges either if the buyer has all the bargaining power (makes
all the offers) or in an alternating offer game in which there is one widget which
increases the seller’s costs (over the special widget) by more than it decreases the
buyer’s value.

buyer option contract would be subject to renegotiation, undermining the

seller’s incentive to invest.
3.4. The Importance of Timing

Evans (2008) has a very general model of the holdup problem that encom-
passes both the product complexity models of Hart and Moore (1999)/
Segal (1999) and the cooperative investment model of Che and Hausch
(1999). It also allows the trading opportunity to be durable. He then con-
siders a simple option contract of the following form as a way of solving
holdup problems. The initial contract gives the seller an indefinite option
to supply a good. The description of the good and the price in the option,
however, are left to be specified by the buyer after both parties have
invested and observed the state of nature. Despite the fact that a court
cannot observe either the state of nature or the amount each party invests,
he shows that the fact that this option can be exercised at any time can
create an equilibrium in which both parties invest at the first-best level
even when this contract can be renegotiated.
This result is driven by the assumption that the seller can exercise this
option immediately after rejecting an offer from the buyer as well as after
the buyer has rejected an offer from her.11 The reason this is critical is
that it creates multiple equilibria in the renegotiation game. There is an
equilibrium like one in the Rubinstein (1982) game in which the surplus is
shared among the players. But, there is also an equilibrium in which the
buyer believes the seller will always exercise this option if no other con-
tract is agreed to (an equilibrium that echoes Lyon and Rasmusen’s (2004)
Axiom of Unilateral Action). The reason this equilibrium exists even with
a durable trading opportunity, whereas it does not in Wickelgren’s (2007)
model, is precisely because Evans allows the seller to exercise his option
after the buyer has rejected her offer, but before the buyer has an oppor-
tunity to counter-offer. As Shaked (1994) has shown, Shaked and Sutton’s
(1984) outside option principle does not hold under this alternative
assumption.
This second equilibrium allows the buyer to potentially punish the seller
for not investing at the first-best level. This occurs because this second
11
Shaked (1994) first showed that there can be mulitple equilibria in a bargain-
ing game with outside options if the outside option can be exercised either after
rejecting an offer or having an offer rejected. In a different context, Schwartz and
Wickelgren (2009) suggest that one party exercising an inefficient outside option
after her offer is rejected is unrealistic. Their objection, however, does not apply
to the equilibrium in Evans (2008), because in this model exercising the outside
option is efficient.

equilibrium is selected when the seller does not invest efficiently, while
the Rubinstein equilibrium is selected if she does. Similarly, if the buyer
deviates from efficient behavior, a change in the equilibrium selected in
the renegotiation game can allow the seller to punish the buyer for these
deviations. It is important to note, however, that since Evans’s result relies
on multiple equilibria, he does not show that option contracts generate a
unique equilibrium that solves the holdup problem.
This result is, however, somewhat restrictive in another way. It relies
on there being a sufficiently large surplus from acting efficiently that
changing how that surplus is divided based on the investments of the
players provides a sufficiently large punishment to deter opportunistic
behavior. That is, the holdup problem arises in regular contracting situ-
ations because the share of the surplus to be divided is fixed (due to the
assumption of a unique equilibrium in the renegotiation game). Privately
optimal investment with a fixed share of the surplus (less than one) is typi-
cally less than the socially optimal level of investment. But, if there is a
discontinuous jump in one’s share of the surplus if one invests efficiently,
then, provided this jump is large enough, one can generate efficient incen-
tives to invest even if the actual share one receives is less than one. Of
course, the larger is the total surplus to be divided, the easier it is for any
given increase in one’s share to induce efficient investment incentives.
Thus, Evans’s result that option contracts can solve the holdup problem
relies on the surplus being large enough. If one relaxes the budget-balance
constraint, so that the contract can specify a third party getting a large
payout if parties do not follow their equilibrium strategies, this can
always be satisfied. But, if one imposes the budget balance constraint (so
that payouts to third parties are not allowed), the surplus may not always
be large enough for Evans’s option contract to induce efficient investment
from both parties.
It is important to note that the equilibrium in Evans (2008) does not
satisfy a monotonic sharing rule. That is, in the typical bargaining game,
whenever the surplus increases, each party gets a larger payoff. Evans’s
renegotiation game does not satisfy this monotonicity property because
of the shift from one equilibrium to another in the bargaining game that
results from small changes in investment. Thus, because a small increase in
surplus can change the equilibrium selected, it can make one party worse
off.
This discussion illustrates that when the trading opportunity is durable,
whether or not an option contract can solve the holdup problem depends
on a critical feature of the bargaining model in the renegotiation game.
If rejecting an offer in anticipation of a player (either the offeror or the
offeree) exercising her option does not delay trade relative to accepting

the offer, then there is an equilibrium in which option contracts can solve
the holdup problem, though this is not necessarily the unique equilibrium.
This is a critical feature of the Evans (2008) model. On the other hand, if
trade happens sooner when an offer is accepted than when it is rejected
even though rejection will be followed by one party exercising her option
to trade (as is the case in Shaked and Sutton (1984)), then option contracts
cannot, in general, solve the holdup problem. The reason is that the incen-
tive to avoid delay will induce renegotiation even though the option is
‘in the money’. Moreover, if the allowable time for renegotiation is long
enough, even if waiting for the other party to exercise her option causes
only a very small delay in trading versus accepting an offer, this delay can
lead to a renegotiated agreement that leads to a very different allocation
of the bargaining surplus than would occur if the option were exercised.
Thus, the distortion in investment incentives caused by renegotiation can
be quite substantial as long as there is any extra delay caused by rejecting
an offer and waiting for the other party to exercise the option as opposed
to simply accepting the new offer.
4. Option Contracts in Sequential Investment Settings

While most models of option contracts and holdup focus on the case of
simultaneous investment, a few papers have considered whether option
contracts can solve the holdup problem in a sequential investment setting.
Nöldeke and Schmidt (1998) consider a model of sequential investments
and argue that option contracts can be effective in solving the holdup
problem even in a situation where investment has some cooperative fea-
tures. In their model, two parties invest to add value to a physical asset.
Thus, total net surplus in their model is v(a, b) 2 a 2 b, where a and b
are the investments of the two parties, A and B. A invests at date 1 and B
invests at date 2. At date 0, the parties can write an initial contract allocat-
ing ownership of the physical asset. At date 3, the parties can renegotiate
this contract to generate the efficient outcome.
They assume that the parties split this surplus with share l going to
A and share 1 2 l going to B. If the parties cooperate in period 3, they
realize the full value from the asset v(a, b). If A owns the asset, then he
realizes the value v(a, bb) absent cooperation. If B owns the asset, her
disagreement payoff is v(aA, B); a, b H [0, 1]. That is, if A owns the asset,
then he can only realize part of the value from B’s investment without B’s
participation. This reflects the fact that some of B’s investment is human
capital investment in how to use the asset. These are simply disagreement
points, because in period 3 the parties always agree to cooperate. If B
owns the asset, for example, then to induce A to cooperate, B must offer
A a payment of l(v(a, b) 2v(aA, B)), since v(a, b) 2 v(aA, B) is the added

surplus to be obtained from cooperation and l is the share of that surplus

that A can command by agreeing to cooperate.
If the parties could commit not to renegotiate the ownership structure
(though they still bargain to cooperate to obtain the full surplus from the
asset), a simple option contract, similar to the one in Nöldeke and Schmidt
(1995) will achieve the first best if B always invests efficiently given A’s
level of investment.12 The contract has A owning the asset, but B having
the option to buy the asset in period 2.5 (after both investments have been
made) for a price of p 5 lv(aa*,b*) 1 (1 2 l)v(a*,b*) 2 b (where a* and b*
represent the first-best investment levels). This price equals B’s net payoff
from owning the asset, assuming both A and B invest efficiently. Thus, if
a ≥ a*, then B has a non-negative net payoff from investing efficiently and
exercising her option to buy the asset. A will choose a* to induce B to exer-
cise her option, which gives A the full surplus from the relationship.
Nöldeke and Schmidt argue that this contract is robust to renegotia-
tion. In their model, once investments are sunk, after date 2, the parties
always negotiate to an efficient use of the asset regardless of the ownership
structure. Thus, the only time renegotiation of the ownership structure
contract would occur is between period 1 and 2. Notice, however, that A
obtains the entire surplus under the original contract if it invests efficiently
in period 1. It cannot do better than this since B can always choose not to
invest and get zero. So, A has no incentive to renegotiate at this time unless
this is necessary to induce B to exercise its option in period 2.5. Under this
contract, if A invests efficiently, this is not necessary. So, there will be no
renegotiation and both parties invest efficiently.
Edlin and Hermalin (2000) challenge the idea that option contracts can
by themselves solve the holdup problem in a sequential investment setting.
They argue that the Nöldeke and Schmidt (1998) option contract is only
robust to renegotiation because of the particular timing in their model,
timing that Edlin and Hermalin argue is not realistic. That is, Nöldeke and
Schmidt assume that the second investor, B, must invest prior to deciding
whether or not to exercise her option. If, instead, B could delay investing
until after letting her option expire, then she would have an incentive to do
so. To see this, notice that prior to investing, the strategy of investing and
then exercising the option gives B a zero payoff (the price equals her net
payoff from owning the asset). Thus, if B can let the option expire and then
renegotiate, as long as B gets some surplus from this renegotiation, she will
be better off doing so than investing and exercising her option. But, if B
does this and obtains some surplus, this means that the price B pays for the
12
This will be the case if a and b are independent (∂2v/∂a∂b 50) or if a 5b 51.

asset will no longer increase one for one with the increase in value of the
asset due to A’s investment. That is, A must share some of the increased
surplus it created through its investment. This will lead A to under-invest
anticipating this renegotiation; the holdup problem re-emerges.
Nöldeke and Schmidt argue that because the holdup problem makes
both A and B worse off ex ante, they have an incentive to write the date
0 option contract so that B’s option never expires. If that is the case, they
argue that now B has no credible threat to renegotiate. A will simply refuse
any renegotiation offers, knowing that B will invest, and exercise her
option in the last period before the value of the asset disappears. As Edlin
and Hermalin point out, however, this only works because there is a last
period in which B can invest, and if she does not do so, the asset becomes
valueless. If delay reduces the value of the asset (or, to put it more gener-
ally, the trading opportunity is durable), then the outside option principle
(Shaked and Sutton 1984) implies that B’s option is not a binding outside
option. Thus, renegotiation should give B some surplus, creating the
holdup problem. As the discussion above indicates, however, this is con-
tingent on there being additional delay caused by waiting for an option to
be exercised after rejecting an offer relative to accepting that offer.13
5. Conclusion
Whether or not option contracts can solve the holdup problem depends
greatly on the details of the renegotiation process. If contracts cannot
be renegotiated, then one can use option contracts to solve the holdup
problem quite generally.14 If renegotiation is possible, then the effective-
ness of option contracts is less clear. When the trading opportunity is
not durable (that is, there is a definite point at which the trade in ques-
tion no longer creates any surplus), then option contracts are also quite
effective in solving holdup because it is difficult to credibly threaten not
to exercise an in-the-money option before the trading opportunity disap-
pears. This makes renegotiation to the disadvantage of the non-option
holder unlikely, since the non-option holder can rely on the option holder
to exercise his option absent renegotiation. Since it is this renegotiation
that tends to undermine the effectiveness of option contracts, the holdup
problem does not appear to be very robust in settings with non-durable
trading opportunities.
13
In the Edlin and Hermalin model, the holdup problem can only be solved if
the marginal effect of A’s investment on A’s value without B is at least as great as
the marginal effect of this investment on total surplus.
14
See Davis (2006) for a mechanism that might make renegotiation unlikely.

If the trading opportunity is durable, however, having an in-the-money

option does not guarantee that the option holder will exercise this option.
She may prefer to delay doing so in order to obtain a more favorable agree-
ment through renegotiation. Whether or not this is possible depends criti-
cally on the bargaining model for the renegotiation process. Wickelgren’s
(2007) critique of the effectiveness of option contracts relies on the assump-
tion that in the renegotiation process, the fastest way for a non-option
holder to commence trade is to accept an offer by the option holder. That
is, his results rely on the fact that accepting an offer leads to trade faster
(even if only a fraction of a second faster) than rejecting an offer – even if
one expects the offeror to exercise her option at the earliest opportunity
after rejection. If this is the case, then option contracts may often not be
able to solve holdup problems. In such cases, a theory of the firm that uses
asset ownership as a vehicle for minimizing holdup problems has the poten-
tial to be convincing. If, however, accepting an offer need not lead trade to
happen any sooner than rejecting an offer and relying on the exercise of
the other party’s option to trade, then, as Evans (2008) has shown, option
contracts can solve the holdup problem quite generally (though this equi-
librium is not unique). In this case, the theory of the firm must be based on
something other than using asset ownership to mitigate holdup problems.
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14 Warranties
Klaus Wehrt
1. Introduction
A good can be defined by the set of its properties. Some of the properties
are observable before purchase. According to Nelson (1970), we call these
attributes search properties. Other characteristics cannot be observed. We
call these characteristics experience properties, when their true quality
is only revealed some time after the purchase (for example, function-
ability, duration). Otherwise they have to be classified according to
Darby and Karny (1973) as credence properties (for example, therapeutic
influence).1
Warranties control the quality of the experience characteristics of a
good. However, if we take a look at what happens in reality, we dis-
cover that warranties are actually only offered for a subgroup of the set
of experience characteristics.2 Commonly, the guarantee expires after a
certain time period after the purchase, and therefore only those experience
properties are covered which may reveal themselves within the warranty
period. Apparently, the warranty is not a panacea against bad products.
What is a warranty? The warranty is a promise by the seller to take
contractually specified measures in case the performance of the purchased
item is bad. Such measures3 are typically money-back warranties,4 price
reductions,5 subsequent-improvement,6 or replacement warranties.7 The
warranty condition has to be met before the buyer gets warranty compen-
sation. Normally the warranty condition states that the purchased unit has
to become defective, that is, the bought item breaks down, parts of it do
not work normally or the item is in a bad condition.
The defect may be the result of either of two different situations. The
1
The economics of credence goods are investigated by Dulleck and
Kerschbamer (2006).
2
See Priest (1981).
3
For a comparison of the different measures, see Wehrt (1995a), Friehe and
Tröger (2008).
4
See Mann and Wissink (1988, 1990).
5
See Grossman (1981), Cooper and Ross (1985).
6
See Wehrt (1995a).
7
See Mann and Wissink (1990), Gal-Or (1989).
256

Warranties 257
first is when a deficiency in the technical development of the product

has caused a constructional flaw. In this case, the defect is inherent in
every item of the product and the average quality of the good is bad.
The second concerns shortcomings in the production process which may
cause a manufacturing flaw. In this case, only a fraction of the items sold
will become defective. If one looks at the warranty as an instrument that
signals high product quality, it is obvious that the supplier of a product
with a constructional flaw is not going to offer a warranty. Only in cases
where the supplier was unaware of the constructional flaw before putting
the product on the market, will the supplier erronously offer a warranty.
These considerations may explain why the warranty literature focuses on
the manufacturing flaw.
The present chapter is divided into two parts. Section A addresses uni-
lateral problems of moral hazard and adverse selection in a ‘one-shot’ rela-
tionship and, if need be, how they can be solved by warranties. In Section
B, bilateral problems are discussed. First, we will discuss the problems in
a ‘one-shot’ game. Afterwards, we will introduce long-term relationships.
The analyses will explain why warranties are often partial, restricted in
magnitude and duration.
A. WARRANTIES IN AN UNILATERAL CONTEXT
2. Warranties as a Device of Insurance

The simplest type of problem is the following: risk-averse consumers
demand goods from risk-neutral sellers. A certain fraction of the sold
items will become defective after a period of use. When signing the pur-
chase contract, neither the consumers nor the sellers know which units
will be critical, but the parties process symmetric information about the
average probability of failure. This failure probability p cannot be influ-
enced, either by the seller’s investment in the manufacturing process or by
the consumer’s care-taking.
The seller offers the product at price p. He faces constant unit costs of
production: c . 0. In case of a defect, he has to compensate the consumer
by means of a warranty payment: w (0 ≤ w ≤ p). His profits V can be
expressed as:
V5p2c2p*w
The consumer values a faultless item at q (≥ p) monetary units. A defective

item causes him a loss of L. The utility function U is defined over the mon-
etary income. It expresses the risk aversion of the consumer and therefore
increases with decreasing rates: U′ . 0, U″ , 0. Expected utility is:

EU 5 (1 2 p) * U(q 2 p) 1 p * U(q 2 p 2 L 1 w)
Assuming a constant profit on the side of the suppliers makes the

product price dependent on the magnitude of the promised warranty: p 5
p(w). A Pareto-optimal allocation requires marginal utility to be identical
in situations both with and without a product defect. We therefore have:
w* 5 L.
This resource allocation will be achieved automatically in the long run
in a competitive market. Figure 14.1 offers an illustration. Every point
of the diagram represents a price-warranty combination. Price-warranty
combinations along the vertical axis insure the seller against product
risks because no warranty compensation has to be paid at all, whereas
the buyer will be fully insured if a combination from the vertical line w
5 L is taken. Free market entry drives the product price down to unit
cost level: c 1 p w. The straight line V 5 0 represents this zero-profit
level. The slope of this zero-profit line depends on the failure probabil-
ity of the product. It is steep if the probability of failure is high, and
relatively flat if the probability is low. The tangency point between the
indifference curve EU1 and the zero-profit line represents the competi-
tive equilibrium. This equilibrium is stable. A firm considering a smaller
p Insured
Insured
suppliers
EU0 consumers
V=0
EU1
L' w=L w
Figure 14.1 Insurance against product defects

Warranties 259
warranty level has to be aware that the consumers will look for lower
prices in case of lower warranty levels. Reducing the warranty level from
L to L9 lowers the firm’s cost and therefore the product price by p*(L
2 L9). For such an offer, a risk-neutral consumer would bid for a price
which is p (L 2 L9) monetary units smaller. He would therefore be indif-
ferent with respect to the choice of either offer. Risk-averse consumers
would fear, in addition to the pure monetary effect, the risk exposure
which is caused by the now only partial warranty. Therefore they would
refuse the new offer.
Our first result is: warranties protect risk-averse consumers against
manufacturing flaws. Consumers prefer a ‘full’ warranty, unrestricted in
magnitude and duration.
3. Warranties as a Signal of Quality

Signalling literature can be traced back to Spence (1973), who wrote
an article on ‘Job Market Signaling’. Grossman (1981, p. 479) argued
‘that when firms have tools available which they could use to convey
information they will do so’. With warranties, we have such a tool of
information transfer. Assume there are two types of manufacturers. The
type S produces at small unit costs cS but has a large rate of defective
units pS, whereas type H has higher unit costs cH but a smaller quota of
defective items pH. Let us assume that the customers know about the
market average failure rate, but they are uninformed about the firm-
specific quota. Let us suppose furthermore that there are enough poten-
tial suppliers of each type to satisfy the market demand within the whole
market.
When offering the product without a warranty, firms of type S would
get the whole market demand at price p 5 cS, because the customers are
not able to distinguish between these two types of firms. It is not useful for
customers to buy at price p 5 cH. By charging this price, low-quality firms
may pretend to sell items of high quality.
Firms of type H may start to advertise, in order to inform the consumers
about the high quality of their products.8 Like statements about price, as
long as the right to make untrue statements is not sanctioned, advertis-
ing signals can be imitated by low-quality suppliers. However, in extreme
cases where misleading advertisements are hardly sanctioned by the law,
advertising can be taken as a specific form of a warranty. Even without
legal sanctions, if – in a long-term relationship – wrong advertising leads
8
Noll (2004) compares warranties and advertisement as different measures to
assure product quality.

to the loss of former reputation, it works like a warranty (advertising then

may signal quality).9
It is because of the legal system that warranty commitments become
credible signals. Putting aside those cases in which a firm is dissolved
before the defects of their sold products are revealed,10 the legal order
enforces warranty claims. Therefore, a firm which promises a warranty
has to be aware of the resulting warranty costs in the future. Since low-
quality suppliers face higher defect rates, they have to expect higher war-
ranty costs. It is therefore cheaper for firms of type H than for firms of type
S to use the warranty signal. Hence, they will do so and offer a full war-
ranty which is preferred by most buyers anyway. Nevertheless, when they
observe the supplementary warranty of competing high-quality suppliers,
firms of type S will also offer a warranty. The competitive outcome as to
which type of producer finally succeeds in serving the market then depends
on the answer to the question: will the higher warranty costs of low-quality
firms be less than the original differences in unit costs of production?
Referring to the model of the previous paragraph, we know that risk-
averse consumers prefer to be fully insured against the monetary loss of a
product defect: w 5 L. They favour a full warranty when contracting with
either type H or S firms. Their expected utility therefore equals:
EUi 5 U(q 2 pi),
where i 5 S, H. If and only if pH ≤ pS, which means that cH 1 pH L ≤ cS 1

pS L, firms of type H will be able to serve the market. See Figure 14.2 for
an illustration. The diagram includes the zero-profit lines of two represent-
ative firms of type S and H. The point of intersection determines a specific
partial warranty provision. Given this warranty provision, both firms face
the same costs. Expanding the warranty further, the sharper warranty-cost
increase for firms of type S creates a competitive disadvantage: the addi-
tional warranty costs in comparison to high-quality suppliers exceed the
original unit costs difference. Therefore – according to this example – firms
of type H offer their products at the cheapest price. The tangency point A
between the zero-profit line VH and the indifference curve EUH represents
market equilibrium.
Notice that the diagram contains two overlapping systems of indif-
ference curves. The system EUH informs us about the expected utility of
9
For more information on this topic, see Milgrom and Roberts (1986),
Kihlstrom and Riordan (1984), Schmalensee (1978), Nelson (1974).
10
Compare Bigelow et al. (1993), Noll (2004).

Warranties 261
p
Insured Insured
suppliers consumers
VS = 0
B EUS
VH = 0
A EUH
EUS'
cH
cS
w=L w
Figure 14.2 Signalling high quality
representative customers if they contract with firms of type H, the system

EUS informs about contracting with type S. The intersecting curves EUS9
and EUH represent the same level of expected utility. Since they intersect at
a full-warranty price, consumers do not care about the firm-specific defect
rate. Under full warranty the same price leads to the same expected utility,
irrespective of which type of firm will sell. To distort the equilibrium, low-
quality firms therefore have to make an offer in the south-eastern area of
the EUS9 curve. Since such offers would cause losses, firms of type S would
refrain from doing so. Hence the tangency point A characterizes a stable
competitive equilibrium.
The outcome is Pareto optimal. Since the consumers prefer to be insured,
the tangency points A and B are the only candidates for a Pareto optimum
under the restriction of zero profits. A dominates B because the expected
utility of the representative consumer is higher with lower prices.
The assumptions of the original model can be altered in several respects:
1. The individual losses differ. Risk-averse consumers prefer a war-

ranty coverage which compensates for their individual losses. Firms
will then come up with offers varying in warranty coverage. Low-
quality firms serve customers with small individual losses, whereas

high-quality firms serve the more sensitive clientele. The outcome

is Pareto optimal. It does not deviate from the outcome that would
occur if firms had truthfully disclosed their failure rate and offered
insurance against defective items (see Spence 1977, p. 570).
2. A monopolist serves the market. The monopolist would increase
warranty coverage as long as the marginal buyer’s willingness to pay
increases with this coverage (Grossman 1981, p. 475). Problems arise
in cases where the individual losses differ: the social planner would
look at inframarginal buyers to control warranty coverage, whereas
the monopolist observes the marginal buyer’s willingness to pay
(Spence, 1975).
3. The market structure is oligopolistic. Gal-Or (1989) showed that the
informational content of warranties is limited, as multiple equilibria
may exist.
4. Warranties as an Incentive to Invest in Quality

It was Priest (1981, pp. 1307–19) who emphasized the ‘Investment Theory
of Warranty’. According to his interpretation, the warranty is a device
which controls the efforts taken by the manufacturer and the consumer to
maintain a functioning product. The only relevant variable in a unilateral
case – as discussed here – is the effort the manufacturer exerts to keep the
failure rate optimal.
As with the situations described in previous paragraphs, the customers
are interested in being fully insured against the loss caused by a potential
product breakdown: w 5 L. The seller, who, by assumption, is also the
manufacturer, thus internalizes the buyer’s potential losses. The manu-
facturer therefore has to choose a level of quality investment x* which
minimizes unit costs of production plus expected losses:
c(x) 1 p(x) * L
Assuming c9 (0) 5 0, c9 ≥ 0, c0 . 0, p9 , 0, p0 . 0, there exists an optimal

positive level of quality investment. This level will be chosen by the
manufacturer. His investment will thereby be guided by the following
consideration: the effect of a quality investment is to reduce the defect
rate. Evaluated in monetary terms, this effect has to be weighed against
avoided losses. For any additional quality investment to be taken, the loss-
reducing effect has to be larger than the costs of this investment.
5. Underestimated Failure Rates

Spence (1977, p. 563) already showed that no warranties will be offered
in a competitive market where risk-neutral customers systematically

Warranties 263
underestimate the failure rate p. In case of risk-averse consumers, only a

partial warranty will be offered.
Let r(p) be the failure rate which is perceived by the buyers: r(p) , p.
Let us assume further p(w) denotes the competitive price which is charged,
if a warranty of extent w is combined with the product. Expected utility
can then be expressed as:
EU 5 [1 2 r(p)] * U(q 2 p(w)) 1 r(p) * U(q 2 p(w) 2 L 1 w)
Maximization with respect to w then leads to the outcome:
Ur (q 2 V 2 c 1 (1 2 p) * w 2 L) [ 1 2 r (p) ] / r (p)
5 .1
Ur (q 2 V 2 c 2 p * w) [1 2 p ] / p
Hence the representative consumer prefers a partial warranty: w* , L.

Figure 14.3 illustrates the special case in which the underestimation of
the failure rates leads to the outcome that consumers are no longer inter-
ested in warranties. The slope of the zero-profit line VS 5 0 indicates the
true quota of defective items of supplier S. However, consumers expect
a failure rate that corresponds to the slope of zero-profit line VS9 5 0.
They believe that the quota is one-third of the true quota. Clearly, their
p
Insured Insured
suppliers consumers VS = 0
Q VH = 0
EUS′
R VH′ = 0
EUH′
Z VS' = 0
P
X
cH
EUH″
cS
T
EUS″
w=L w
Figure 14.3 Underestimated failure rates

system of indifference curves has to be constructed according to the

wrongly assumed quota. The first-best choice of these consumers would
be a price-warranty combination as shown by point P with a full war-
ranty. However, these customers have to realize that the desired contract
is not offered in the market. Offering this contract would create losses for
firm S, because the true rate of defective items is higher than the custom-
ers expected. The minimum price firm S would claim for a full warranty
contract is determined by point Q. The representative consumer values
this offer with expected utility EUS9 and concludes that there exists a more
valuable contract (utility EUS0) without a warranty indicated by point T.
Given this situation, we now assume that high-quality firms of type H
are also in the market and sell the same product with a smaller rate of
defective items. The corresponding system of indifference curves is char-
acterized by the EUH lines. Compared with firms of type S, the offer of the
H type is of higher social value, because the full-warranty price of these
firms determined by point R is less than the full-warranty price of firms S
determined by point Q. Consequently, it should be expected that firms of
type H serve the market. However, just as the customers underestimate the
rate of defective items of firms S, the rate of defective items of firms H is
underestimated by a factor of 3 (see line VH9 5 0).
The current offer of firms S, selling the product without a warranty
as indicated by point T, leads to utility EUS0. The full-warranty contract
indicated by Z creates the same utility. Moreover, Z is also a point on the
indifference curve EUH0. Therefore we have: EUS0 5 EUH0. The curve EUH0
intersects the ordinate at a price level which is less than cH. Consequently,
as cH is the minimum price firms H have to charge for their goods without
a warranty, the consumers expect that the utility of the offer characterized
by point X is less than EUS0. So, the offer T is preferred to X.
The awkward consequence of this example is that the consumers choose
the wrong firms and the wrong warranty contracts. Therefore, we have to
ask the question, can the market failure be corrected?
Basically there are three ways of legal interference. The most restrictive
kind of intervention is to introduce a mandatory legal warranty over the
typical lifetime of the product. However, this type of interference should
only be applied in situations where the rate of failure is exclusively deter-
mined by the firm. If it is also influenced by inherent attributes of failure
inclination on the side of the buyer,11 by the intensity of use12 or by buyers’
11
Wilson (1977), Rothschild and Stiglitz (1976).
12
Emons (1989b).

Warranties 265
care,13 then partial warranties would fit better. The second type of legal
intervention is a disclosure rule which obliges the sellers to reveal the true
failure rate before the purchase is made.14 I expect that a third alternative
will solve the problem with lower social costs: if firms are allowed com-
parative advertising, then the firm discriminated against will undertake the
job to inform the buyers about the true quota of failure.
B. WARRANTIES IN A BILATERAL CONTEXT
6. Warranties in a One-shot Relationship

Observations in reality contradict the picture of long-lasting, fully com-
pensating warranties.15 Warranties are always limited in duration. Mostly,
the warranty periods cover only a part of the lifetime of the product. Often
the warranty periods are restricted to one year. Warranties which last for
three or more years can rarely be found, although the lifetime of consumer
durables often exceeds ten years.
According to the scope of warranties – German standard form contracts
predominantly specify subsequent improvement or subsequent delivery –
one often detects clauses which exclude the warranty with regard to certain
uses or which make the validity of the warranty dependent on the buyer’s
intermediate input. Exclusions of warranties are typical for retailing and
commercial uses. Often these exclusions are directed against aggressive use
or non-compliance with regular maintenance. Commonly, the operation
of certain fragile parts falls under the warranty, but the warranty coverage
expires if attempts are made to open the product. On the other hand, parts
housed deep within the product, inaccessible to the consumer’s influence,
are often protected by an extended warranty.
This short overview makes clear that the organization of warranty
contracts is essentially determined by the consumer’s potential influence
on parts of the product. However, the consumer’s influence on the failure
rate has not yet been investigated. Therefore, we have to extend the analy-
sis to bilateral warranty problems, situations in which both parties, the
manufacturer as well as the user, control the product’s failure rate.
According to the investment theory of Priest (1981), every bilateral war-
ranty problem is a mixture of different unilateral problems and hence can
be reduced to its elementary ingredients. This view presupposes that it is
13
Priest (1981); Kambhu (1982); Cooper and Ross (1985).
14
Grossman (1981).
15
See Priest (1981, p. 1319) for a detailed empirical investigation of warranty
contracts.

a certain type of defect which points to the responsibility of, respectively,

the seller or buyer. If this approach was correct, then the optimal warranty
contract would have to stipulate a full warranty for those product risks
which are under the control of the manufacturer and a full warranty exclu-
sion for those risks which are under the control of the consumer. However,
in addition to the elementary unilateral problems and their combinations,
there is a real bilateral problem which cannot be decomposed. The optimal
control of many of the product risks calls for a certain combination of
seller’s and buyer’s care. Take, for instance, the case of a car engine. Its
safe functioning requires the necessary mechanical and electronic adjust-
ments on the part of the manufacturer, as well as responsible behaviour on
the part of the driver. The breakdown probability increases if any of the
parties fail to perform their duties.
The problem of bilateral investments is addressed in articles by Kambhu
(1982), Cooper and Ross (1985), Mann and Wissink (1988) and Emons
(1988). All these models assume that warranty promises are enforceable.
Clearly, if warranties could not be enforced (compare Bigelow et al. 1993;
Noll 2004), sellers would cheat on the warranty and the outcome would
be minimum product quality. Therefore, I also assume an enforceable
warranty. Let the damage function d be dependent on the manufacturer’s
quality investments x and the consumer’s costs of care-taking y:
d(x, y) 5 p(x, y) * L
Furthermore, let px , 0, pxx . 0, py , 0, and pyy . 0. The representative

consumer is risk neutral. Let us assume that his willingness to pay for an
intact item is q. His utility is measured in money terms and equals his will-
ingness to pay. Then the expected utility is:
EU 5 q 2 p * (L 2 w) 2 y 2 p
The seller’s profit is:
V5p2x2p*w
Maximization of the joint surplus with regard to x and y leads to the

following first-order conditions:
2 px(x, y) * L 5 1 and 2 py(x, y) * L 5 1
Now we have to answer the question whether the parties will control
their quality and maintenance as described by the first-order conditions.

Warranties 267
Thereby we assume two steps in the decision-making process. During the

first step, the parties compete; while unobserved by the other party, they
choose a certain level of investment. Afterwards they cooperate, fixing a
warranty compensation that maximizes the joint surplus.
For the first step, the following first-order conditions are relevant:
2 px(x, y) * w 5 1 and 2py(x, y) * (L 2 w) 5 1
A comparison with the Pareto conditions reveals a degree of tension.

Pareto-optimal quality investments by the manufacturer require a war-
ranty level of w 5 L, whereas Pareto-optimal care-taking by the consum-
ers presupposes a level of w 5 0. Therefore, a joint surplus-maximizing
allocation is impossible;16 a ‘second-best’ solution will be the outcome.
Let the functions x1(y, w) and y1(x, w) describe the level of investments
a party will choose given the warranty promise w and the investment of
the other party x or y, respectively. Let the pair [x°(w), y°(w)] denote the
point of intersection of both functions. It represents the Nash equilib-
rium for the non-cooperative part of the game. When jointly arriving at
a conclusion about the level of the warranty, both parties anticipate their
reciprocal pattern of unobserved behaviour (Cooper and Ross 1985, p.
109). They consequently maximize their joint surplus under the restriction
of the Nash equilibrium, described above:
max EU 1 V 5 q 2 p * L 2 x 2 y
w
subject to x 5 x°(w) and y 5 y°(w).

The first-order condition requires:
x°9(w) * [2px(x, y) * L 2 1] 1 y°9(w) * [2py(x, y) * L 2 1] 5 0
According to the first-order conditions of unobserved party behav-

iour, we have: 2 px(x, y) 5 1/w and 2 py(x, y) 5 1/(L 2 w), respectively.
Therefore the first order condition is:
L L
x°r (w) * a 2 1b 1 y°r (w) * a 2 1b 5 0
w L2w
On condition that x°9 . 0 and y°9 , 0, the outcome will always be a

partial warranty which, on the one hand, is greater than zero, but, on the
16
See Cooper and Ross (1985, p. 107).

other hand, is less than one. Namely, if the degree of warranty coverage
w/L converges to one, the first term of the above equation vanishes. The
derivative is thus negative. If the degree of coverage converges to zero, the
second term disappears. Hence the derivative is positive. However, as is
indicated by the equations for party behaviour, the conditions of x°9 . 0
and y°9 , 0 are not always fulfilled. Its validity depends on the magnitude
and the sign of pxy (complementary or substitutionary investments).
The outcome of the bilateral model is:
1. Parties who feel unobserved when carrying out their product invest-
ments normally agree to a partial warranty.
2. This voluntary agreement solves the bilateral problem in a suboptimal
manner.
Kambhu (1982) raises the question whether or not legal rules can be
designed which solve the problem of suboptimal incentives. He starts from
the assumption that any warranty rule has to be ‘balanced’, which means
that the seller, in paying the warranty, loses the same amount the buyer
gets. According to Kambhu (1982), no legal warranty rule exists which
offers both parties Pareto-optimal incentives. This result becomes quite
clear, if one considers the restrictions under which the legislator has to
develop the warranty rule. He has to accept that the legal consequence of
the rule cannot depend on unobservable constituent facts.
Deviating from the above analyses, Emons (1988) examines the case of
a voluntary warranty in which the quality investments of the manufacturer
and the consumer’s precautional measures do not continuously vary. He dis-
tinguishes two levels of, respectively, quality investments and care-taking.
His conclusions are: if risk-averse consumers in a competitive market
benefit from a full warranty more than from an incentive-compatible war-
ranty, only a second-best solution is feasible, because from the set of a high
and a low level of care, consumers will choose the low level. However, if the
benefit of full insurance is lower and if the incentive-compatible warranty is
extensive enough not to destroy the seller’s quality-assuring incentive, then
the levels of quality and care will be optimal. Emons’s (1988) last result
is crucially predetermined by the assumption of discontinuous variables.
With continuous variables, a full warranty coverage is necessary to assure
the optimal quality investment of the seller. However, this coverage will
eliminate the consumer’s incentive to handle the good carefully.
Mann and Wissink (1988) discussed the case of a voluntary money-back
warranty. The buyer is allowed to return the product within a period speci-
fied beforehand. The authors conclude that under extreme conditions, the
double-sided moral-hazard problem is solved by the first-best levels of

Warranties 269
care-taking. However, the assumptions of the model used are not realistic.
On the one hand, the authors implicitly presuppose a very short period of
exchange. This is assumed because buyers do not derive any benefit from the
use of the product. On the other hand, the model presupposes that within
this period, buyers detect all possible shortcomings of the product. So it
seems that the authors are really investigating the case of a search good.
7. Warranties in a Long-term Relationship: The Model

The outcome of the above analysis is that in a one-shot relationship with
enforceable warranties, the first-best levels of parties’ investments in
quality and care-taking, respectively, cannot be achieved in general. This
section now aims to examine the question whether the market outcome
will improve if buyers purchase from sellers who have a good reputation.17
Deviating from the analysis of the last paragraph, I assume unenforceable
warranties. This assumption, which complicates the incentive problem, is
used to show how reputation really works.
Consumer durables are the types of goods for which warranties are
most important. Consumers remember the experiences they had with
typical brands. These experiences are shared with other customers by
word-of-mouth communication. Therefore, companies which have sold
brands that customers disliked may lose part of their reputation and there-
fore future sales. The mere possibility of future losses may give the seller
an incentive to make adequate quality investments.
The following model (see Wehrt 1995b) assumes a perfectly competitive
market. A multitude of sellers offer the same product with different war-
ranty commitments in the market. However, the brands differ with respect
to unobservable quality investments and therefore have varying failure
probabilities. Consumers also influence failure probabilities by their care
investments.
Satisfied consumers reward their sellers with a certain reputation. This
reputation is earned, if during the previous period the seller at least deliv-
ered the quality he had signalled by price beforehand and if he kept the
given warranty promise. A firm’s reputation in period t, then, is a function
of the quality-warranty package of the previous period: Rt 5 (xt21, wt21).
The earned reputation allows the firm to ask a price in the next period
which corresponds to its reputation: pt(Rt) 5 pt(xt21, wt21). Firms which
have never earned a reputation or which have abused it are avoided by
consumers.
17
For further models of reputation with regard to product quality, see Ely and
Välimäki (2003), MacLeod (2007), Hörner (2002).

A reputational equilibrium can be defined by four conditions (see

Shapiro 1983):
1. Every buyer chooses the quality-warranty package and the level of

care-taking which maximizes his consumer surplus.
2. Buyers’ expectations come true: A seller whom the buyers expect to
meet a certain level of quality investments and to keep his warranty
promise, performs in this way: (xt, wt) 5 Rt 5 (xt21, wt21).
3. In every partial market, defined by a certain level of promised quality
and warranty, supply equals demand.
4. Market entrance and market exit are not profitable.
The consumers are assumed to behave in a risk-neutral way. They can

be distinguished by their willingness to pay q and the certain loss L that a
breakdown of the purchased item causes. Thus expected utility is:
EUqL 5 q 2 p * (L 2 w) 2 y 2 p
where q e [0, ∞), L e [0, q]

According to the first-equilibrium condition, a consumer of type
qL maximizes his expected utility with respect to the variables y, x, w.
Therefore, we have three marginal conditions:
2 py(xqL, yqL ) * (L 2 wqL ) 5 1
2 px(xqL, yqL) * (L 2 wqL) 5 px
p(xqL, yqL) 5 pw
The optimal values of the three variables yqL, xqL, wqL do not vary with
respect to the consumer’s willingness to pay q, but as the appearance of
the individual loss L in the first two conditions shows, they depend on
L. Consumers with identical individual losses are members of the same
class. They prefer a certain level of quality, warranty and own care-taking.
Therefore, a firm with a certain reputation serves the consumers of a
certain class.
The reputational equilibrium also requires that sellers have no incentive
to abuse their reputation once it has been built up. A seller who exploits
his reputation earns profits only during the next period. After that period,
customers will avoid him. Therefore that seller’s profit is
V1 5 p(x, w) 2 x0,

Warranties 271
where x0 determines the costs of the minimum quality. If the firm keeps
its reputation Rt permanently, it will earn profits during all subsequent
periods. Using the interest rate r, discounted future profits can be stated
as:
V2 5 {p(x, w) 2 x 2 p. * w} * (1 1 r) / r.
Defending the firm’s reputation requires profits V2 to be at least as high as

profits V1. Therefore we have:
p(x, w) ≥ x 1 p * w 1 r {x 1 p * w 2 x0}
In the above, the term in the third position of the inequality stands for the
quality premium the seller earns from complying with his reputation. On
the other hand, according to equilibrium condition 4, the profitability of
market entrance has to be prevented. A seller who enters the market will
earn the following stream of profits:
V3 5 x0 2 x 2 p * w 1 {p(x, w) 2 x 2 p * w} / r.
These profits are not allowed to exceed zero. It follows therefore that:
p(x, w) ≤ x 1 p * w 1 r {x 1 p * w 2 x0}.
If we compare the first condition above which prevents the seller from
milking its reputation on the one hand and the second condition which
assures that market entry is not profitable on the other hand, equality
arises. The price function calculates the equilibrium prices sellers with dif-
ferent quality-warranty reputations will realize.
Under the restriction of this price function, customers are not interested
in buying with a guarantee: w 5 0. Inspection of the price function shows
that if buyers consider purchasing from another partial market in which
the offered guarantee is one monetary unit instead of no warranty, they
have to be aware that the price will increase not only by factor (1 1 r) p,
but that it will further increase, as sellers in this new partial market have
to take into consideration that their customers are more careless because
of the offered warranty. On the other hand, having chosen the optimal
levels of quality and care-taking under the premise of no warranty, a
consumer’s net benefit is lower than the price increase, because expected
utility will only grow by a factor of p when switching to the other partial
market. Consolidated with the price increase, the net effect is thus nega-
tive. Therefore, risk-neutral consumers will decide against the warranty.

With respect to this outcome, the first-order conditions of consumer

behaviour will be simplified to:
2 py(xqL, yqL) * L 5 1
2 px(xqL, yqL) * L 5 1 1 r
The important result therefore is: risk-neutral parties will approximately

choose first-best levels of quality investments and care-taking, if the dis-
count rate of future profits is small enough.
So, even in a situation where warranties are not enforceable, there is a
realistic chance that parties will choose optimal quality and care invest-
ments.
8. Warranties in a Long-term Relationship: Discussion

What are the main variables that influence the magnitude of the discount
rate r? The interest rate r connects the periods of usefulness. It therefore
represents a measure of the speed with which the information about the
experience characteristics of the purchased goods spreads to the buyers.
According to the model, agreements will only be contracted at the begin-
ning of a period. Hence, the earliest learned experiences can be applied is
at the beginning of the next period. In this case, the discount rate r – and
therefore the quality premium – is indeed determined by the length of the
period of usefulness.
When applying the model to the real world, two additional effects have
to be taken into account. On the one hand, consumers do not buy to order
at the beginning of a new period, but at different points in time during a
current period. Therefore learned experiences begin to spread to the buyers
immediately after a product defect is detected. In this case, it is not only the
length of the period of usefulness that influences the discount rate r, but
rather the length of time that passes until the defect is discovered. So those
kinds of flaws which immediately reveal themselves after the purchase (for
example, compatibility) lead to a small discount rate, whereas other types
of flaws which appear after a long period of use (for example, durability)
result in higher discount rates. Smaller deviations from the optimal quality
investments can therefore be expected with regard to easily detectable
product failures, larger deviations with respect to hidden defects.
On the other hand, information needs time to spread to the consumers.
A seller who has misrepresented his reputation will not lose his customers
overnight, but in relation to the speed with which the information about the
quality of his product diffuses. This aspect increases the interest rate r.
The model presupposes risk-neutral consumers. If consumers are assumed

Warranties 273
to behave in a risk-averse way, then voluntary warranty contracts will be

observable. Buyers of this type are ready to accept a mark-up that exceeds
the expected monetary value of the warranty. Below a critical threshold of
the discount rate r, they therefore prefer a warranty. However, the seller’s
quality premium which is necessary to let him comply with the given war-
ranty promise, increases in proportion to how late the experience charac-
teristics of the product will reveal themselves. Therefore, even risk-averse
consumers are not interested in buying insurance against those defects which
can only be detected at a late stage. These offers are too expensive. This
aspect explains why warranties are fully compensating but limited in dura-
tion, rather than partially compensating and unrestricted in duration.18
If the legal order enforces warranties, then the quality premium is no
longer necessary to make the seller comply with the warranty promise. The
sole function of the quality premium then is to assure the seller’s quality
investments. However, the enforced guarantee is also an instrument of
quality assurance. For instance, in the case of a full warranty, the seller
has no chance to externalize failure costs to his buyers. Therefore buyers
profit twice from an increase in the warranty coverage. First, it offers more
compensation in case of a defect. Secondly, it reduces the quality premium
and possibly – if the monetary effect of the diminished quality premium
exceeds the additional costs of the expanded warranty – makes the product
cheaper. This effect explains the outcome of the altered model. In case
of enforced guarantees and a positive discount rate r, even risk-neutral
consumers prefer positive warranty coverage (see Wehrt 1995b, p. 172).
9. Conclusions and Outlook

The purpose of this chapter is to give a brief overview of the approaches
and the literature written in the field of product warranties. Starting with
unilateral problems, we discovered a contradiction between the types
of warranty contracts we observe in reality (partial warranties) and the
optimal design of such contracts as derived from the analysis (full warran-
ties). Hence it could be that market failures explain the deviation between
‘what is’ and ‘what should be’. An explanation was offered by considering
the possibility that customers systematically underestimate firms’ rates
of defective items. In this case, a wrongly assessed failure rate makes
consumers erroneously decide against a full warranty.
Expanding the analysis to bilateral problems, we found out that the
problem’s optimal solution changes. The original gap between model
18
Other explanations for this aspect are offered by Emons (1989b) and Cooper
and Ross (1988).

and reality disappears. Certainly, specified partial warranties form the

optimal contract. However, we have to conclude that the optimality of
this contract is due to the restrictions of unobservability. Its optimality is
not due to a world in which either party is fully informed about how the
other party handled the product. But even a legislator has to accept that
he cannot get access to the best of all worlds.
Finally, we looked at repeated purchases. As the seller often sells the same
product, consumers have a broader basis for drawing inferences about the
seller’s quality investments. Therefore, the veil of ignorance lifts slightly and
an additional step in the direction of the best of all worlds can be made.
However, within the European Community, EC Directive 1999/44, which
aims at the harmonization of national warranty law amongst the member
states, prescribes that all national legislations have to comply with a statu-
tory minimum of warranty duration of two years. In addition, the EC
Directive lays down the remedies which can be taken against the seller if the
sold product is in a bad state and its sequence of application. After fruitless
trials of subsequent performance – according to the choice of the buyer:
subsequent delivery or subsequent improvement – or if the seller refuses, the
buyer is allowed to rescind the sales contract or to claim a price reduction.19
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PART III
LONG-TERM
CONTRACTS

15 Long-term contracts and relational
contracts
Nick van der Beek*
For a long time the study of long-term contracts enjoyed relatively little
attention in the law and economics agenda. This is now changing. These
contracts are used in a variety of situations, notably franchise, supply chains
and the sharing of intellectual property. This chapter discusses the main eco-
nomic literature on long-term contracts. Section 1 discusses the properties of
long-term transactions and presents an analysis of the comparative advan-
tages of long-term contracts from the perspective of the new institutional
economics. As many long-term contracts are incomplete, a discussion of the
fundamentals of the incomplete contract literature is the subject of section
2. Then a further methodological shift is made by going into the complete
contracting literature on the soft budget constraint in section 3, followed by
a discussion of repeated hidden actions in section 4. Section 5 builds on the
relational characteristics of long-term contracts through a discussion of the
relational contracting literature. Finally, some avenues for further research
are discussed in section 6. As usual, a bibliography is included.
1. The Long-term Relationship

An analysis of a contractual arrangement, or a group of contractual arrange-
ments, must start with the question of why contracts exist. Contracts do
not create welfare on their own, but instead facilitate the creation of welfare
by supporting efficient transactions, especially if the transaction contains
an element of non-simultaneous exchange (Cooter and Ulen, 2007; Shavell,
2004; and De Geest, 1994, pp. 98 ff). According to the economics of govern-
ance, which is part of the new institutional economics, it is the transaction
which should be the basic unit of analysis (Williamson, 1985, 1991, 2002;
and 2005). The economics of governance, and transaction cost econom-
ics in general, studies how various alternative governance mechanisms
(that is, different contractual arrangements) facilitate the allocation or
choice problem (Williamson, 1988, p. 66; 2002). As such, it supplements
* The author thanks Antoon Spithoven for his comments on an earlier version
of this chapter. The chapter has benefited from the remarks of two anonymous
referees; their cooperation is much appreciated.
281

neoclassical economics (Williamson, 2002, p. 438). The transaction cost

theory, following John R. Commons, takes the transaction as the unit of
research and makes use of two important behavioral assumptions that
differ from those of neoclassical economics (Williamson, 1985, pp. 44 ff).
The first is opportunism, meaning that economic agents seek to maximize
their own utility without regard to the consequences their action or choice
have for other parties’ well-being. The second is bounded rationality,
meaning that people are ‘willingly rational, but only limitedly so’.
Transaction costs economics defines three dimensions of a transaction:
frequency, asset specificity and uncertainty (Williamson, 1985). Frequency
simply refers to the number of times that the transaction takes place. A
one-time transaction is significantly different from one that is repeated
over and over again. For example, information problems are compounded
in a repeated or continuing interaction, as we will see in sections 3 and 4.
Asset specificity is the degree to which the resource required for the
transaction creates more value for the current transaction compared with
the value it would create when employed in the second-best transaction.
Think, for example, of an experimental laser with a unique wavelength,
developed for a particular specialist treating patients with a rare disease.
Because the device cannot be used to treat any other condition, if the
current transaction is unsuccessful, the producer cannot make any money
from the device. For a classic discussion of the influence of asset specifi-
city, see Joskow (1988). When, as in the example, the asset has no alterna-
tive use, it is said to constitute a sunk investment: once the investment is
made, it cannot influence the continuation decision, creating the risk that
the investing party is not able to recoup the added benefits of his invest-
ment. This is known as a holdup situation, following Klein et al. (1978).
The economic consequence of a holdup situation is inefficient levels of
investment. Section 2 contains a more elaborate discussion.
The third dimension of the transaction, uncertainty, introduces the con-
stant need for adaptation resulting in a requirement for flexibility. Usually,
actions and investments need to be adjusted to the requirements of the
parties and the external environment. If those variables are not fixed, the
parties deal with risk and uncertainty (Knight, 1921). If potential events
can be described, or at least have utilities assigned to them, and agents are
able to assign some (subjective) probability to their occurrence, then the
agents are dealing with risk. The difference with uncertainty is that for those
events, agents do not have a probability measure. Risk can be analyzed
using Von Neumann and Morgenstern utility functions (Von Neumann
and Morgenstern, 1944) and Savage’s model of subjective expectations
(Savage, 1954), but uncertain events cannot. For an illustration of the dif-
ference between risk and uncertainty, think of a clinical trial for a new and

Long-term contracts and relational contracts 283
revolutionary type of drug. The producer faces a risk in that either the treat-
ment is effective or not. The outcomes are fixed and known, although the
subjective probabilities assigned to these outcomes might differ between the
CEO, the head of the research group, and those participating in the trial.
Side effects, on the other hand, constitute uncertainty. It is very possible
that the drug causes a biochemical reaction no one has ever observed before,
and therefore is unanticipated. Neither Williamson nor Coase makes a dis-
tinction between risk and uncertainty. In terms of flexibility, it does matter
whether one faces risk or uncertainty: risk can be anticipated and planned
for, uncertainty by definition allows exclusively for ex-post solutions.
Therefore, flexibility matters with uncertainty. Risk and uncertainty require
the alignment of actions and investments; parties coordinate among them-
selves and respond to the external environment. At the core of the problem
created by risk and uncertainty lies the conflict between personal interests,
mutual interests and the need to adapt to external factors.
What characterizes the transaction that takes place in a long-term rela-
tionship? These transactions are not instantaneous; they take time to com-
plete. In a dynamic environment, this implies change and thus uncertainty.
Additionally, long-term transactions take time because not all the neces-
sary conditions for trade are fulfilled at the outset, for example, because
special equipment has to be produced or special training is required. Often
these preparations involve specific assets. In broad terms, the long-term
transaction distinguishes itself in the combination of uncertainty and
specific investments (Ménard, 2004).
Now that we have characterized the long-term transaction, it is time to
investigate how it relates to long-term contracts. The key linking long-term
transactions to long-term contracts is governance: in order to realize the
potential gains of trade or corporation, order must be brought out of chaos.
Otherwise, the opportunistic nature of the parties will make cooperation
impossible. With the help of contracts, parties create a private order, thereby
mitigating the hazards resulting from opportunism and bounded rational-
ity (Williamson, 2002, p. 439). Long-term contracts, or hybrids as they are
known in the new institutional economics lexicon (Ménard, 2004), are a gov-
ernance mechanism. The analysis of governance mechanisms is an important
topic in the new institutional economics. This literature builds on the work
of Coase and Williamson, focusing on the triangle consisting of transaction
costs, contracts and property rights (Ménard, 2008, p. 282).1 In his seminal
1
There is a distinction between the definition used in neoclassical econom-
ics and in the property rights literature (Allen, 2000). See also for a discussion
on the definition of transaction costs (De Geest, 1994, p. 41 ff). The property

article of 1937, Ronald Coase made the crucial and path-breaking observa-
tion that both markets and firms serve the common purpose of organizing
transactions. The firm was more than just the neoclassical unit of production;
it was a way of organizing transactions outside the market. This idea focuses
on the question of why a plethora of mechanisms govern transactions, rather
than one single efficient mechanism. The answer lies in the observation that
all governance mechanisms have their costs of organizing transactions,
where no single mechanism dominates the others over the whole range of
transactions. For example, for some transactions the costs are lowest if they
are organized by the market, and for other transactions the costs are lowest
when organized within a firm (Coase, 1937). Although it took quite some
time before this insight by Coase was operationalized, since then much work
has been done on comparative institutional research, most notably in what is
now known as transaction cost economics and its derivative, the economics
of governance (Williamson, 1988, p. 65; 1998, p. 75). Comparative institu-
tional analysis (for example, Williamson, 1985, 1991) has applied Coase’s
insight to the microeconomic level. Williamson coined the following term for
governance structure of the firm: hierarchy.
For the purpose of this chapter, we shall limit ourselves to a discussion
of the following three mechanisms: the Market, Hybrids and Hierarchies.
Although transaction cost economics also investigates other mechanisms,
among them regulation, these three are – according to the literature – the
most relevant. The market is a narrower concept than that of neoclassical
economics. It is a way of organizing transactions where all parties remain
independent and coordinate through the price system. Hierarchies are
best characterized by their reliance on command as a coordination device
rights definition has a broader scope, looking at the costs of establishing and
maintaining property (or ownership) rights, that is, ‘the right to use an asset, the
right to appropriate returns from that asset and the right to change the form and/
or substance of that asset’ (Williamson, 1985, p. 27) with reference to Furubotn
and Pejovich (1974, p. 4). These transaction costs make long-term cooperation
necessary in the situation where one cannot purchase a certain asset in very small
quantities, for example, a part of a piece of real estate. Therefore, partnership
among three medical doctors, mutually purchasing a piece of real estate, is an
efficient answer to capital market imperfections. The neoclassical definition of
transaction costs, on the other hand, focuses on the costs associated with the
transfer of property rights, for example, the costs of finding a suitable trading
partner. In those situations, the problem is not one of property rights, that is,
the good can be purchased on the market in a sufficiently small or large quan-
tity, but instead the problem is that effectively transferring ownership rights
from one party to another is costly. In addition to the search costs mentioned
above, one might think of the cost of drafting and enforcing a legal contract.

Table 15.1 The relative performance of governance structures
Markets Hybrids Hierarchies

Incentive intensity 11 1 2
Administrative control 2 1 11
Autonomous adaptation 11 1 2
Coordinated adaptation 2 1 11
Contract law regime 11 1 2
and the necessary authority one party exercises over others. Hybrids are a
mix of market and hierarchy; parties remain autonomous entities and are
bound by the sharing of pooled resources.
Given the insight that no governance mechanism dominates the others,
we are forced to ask what are the strengths and weaknesses of the various
mechanisms and how this translates to the dimensions of the transaction.
For this purpose, the discrete alignment hypothesis has been put forward.
It claims that each governance form must be tailored to fit the character-
istics of the transaction (Williamson, 1991). Transactions can be distin-
guished according to their characteristics in terms of incentive intensity,
administrative control, autonomous adaptation, coordinated adaptation,
and contract law regime. Governance mechanisms differ with regard to
their effect on these characteristics. Efficient governance requires that a
transaction is governed by that mechanism that fits its characteristics best.
If we use these dimensions to rank the aforementioned governance mecha-
nisms, the list shown in Table 15.1 emerges (Williamson, 1991; Ménard,
2004).
The incentive intensity refers to the degree to which pay is sensitive
to increased effort. In markets, the harder you work, the larger your
reward. Likewise, administrative control shows to what degree pay is
related to following orders. If you structurally neglect the orders of your
superior, your career is quickly over. The low incentive intensity and high
administrative control of hierarchies implies that working hard in viola-
tion of direct orders will not make you a wealthy person. These elements
constitute the instruments of the governance mechanism. Governance
mechanisms also influence the way agents respond to changes. This is
important as ‘adaptation is the central economic problem’ (Williamson,
1991). Two modes of adaptation are distinguished: autonomous adapta-
tion, where people respond to changes without consultation or discussion
(for example, responding to a higher price by increasing output), and coor-
dinated adaptation, where some form of communication between agents
precedes the realignment of actions (for example, a series of consultations

within a factory preceding a series of orders). The effect of both methods

of adaptation differs: autonomous adaptation assures that the actions of
the agents are aligned with the external environment, whereas coordinated
adaptation ensures that the actions of the agents involved are aligned.
Finally, the institutional environment, that is, the public order, of the
governance mechanisms differs. Whereas markets are governed by hard
and fast rules typical of classic contract law, hybrids are related to neo-
classical contract law, with a higher degree of flexibility through the use
of open norms. Finally, hierarchies tolerate only a very limited amount of
interference from the courts – to put it bluntly, the firm is its own court of
ultimate appeal.
The term hybrid is used to indicate ‘autonomous entities doing business
while mutually adjusting without the help from the market and sharing
technology, capital, products and services without any form of unified
ownership’ (Ménard, 2004). Think for example of clusters, networks,
symbiotic arrangements, supply chain systems, franchise arrangements, or
partnerships, to name just a few organizations which qualify as hybrids.
As parties remain autonomous, long-term contracts are an essential part
of these governance mechanisms. Although for a long time the stability of
hybrids was questioned, they are now accepted as a separate governance
mechanism (Williamson, 1985; Ménard, 2004, 2008). Key elements are
that (a) the parties remain autonomous, that is, they retain most deci-
sion rights, (b) they coordinate via some mechanism other than the price
system and (c) some assets are shared or pooled, that is, these assets do
not belong to a single entity but remain the property of the participant.
This latter property also links the hybrid arrangement with the long-term
transaction: pooling only makes sense with some continuity (Ménard,
2004, p. 352). This definition emphasizes the hybrid as an intermediate
governance form separating markets and hierarchies: like the market, and
unlike hierarchies, the parties involved in the transaction remain separate
legal entities. However, unlike the market, and very much like hierarchies,
the price mechanism is not the central method of coordinating actions;
there is always some form of mutual decision-making, introducing a
degree of authority. The combination of pooled resources, autonomy and
specialized coordination systems causes hybrids to promote investment
in relation-specific assets when risk or uncertainty is consequential. The
degree to which risk and uncertainty are consequential depends on the
influence of adjustment on the total value of the transaction. If the value
of the transaction, holding actions fixed, does not respond to a change in
the environment, risk and uncertainty are non-consequential. On the other
hand, if getting things right is a matter of complete success or utter failure,
the uncertainty and risk are highly consequential.

When combining resources, the assets might be complements or sub-

stitutes. Early work in the field of transaction cost economics and the
property rights literature focused on complementary assets; for example,
production lines and distribution networks. Although it was initially
assumed that hybrids were also built around complementary assets, later
research showed that hybrids often concern assets which are substitutes;
for example, combining each other’s resources in order to achieve the
minimum efficient scale (Ménard, 2008, p. 295). The type of specific assets
in hybrids extends beyond the classic physical assets such as real estate,
inventory and machinery. Loasby (1994) emphasizes that in hybrids
human assets play a major role. This may be because of the human capital
intensity of the product, for example, legal services by a network of law
firms, or because of the specialized nature of the human capital required,
for example, specific training for a unique machine. See Ménard (2008, p.
356) for more examples and references.
Uncertainty and risk also have their effect on the long-term contract:
rather than containing a perfect and complex plan, such as predicted by
many of the neoclassical-based contract theoretical models, they contain
huge gaps and rely on additional formal governing bodies. A striking
property of the long-term contracts used in hybrids is their relative sim-
plicity and lack of detail. They are a framework, containing clauses that,
for example, specify the selection of partners and related quality criteria,
stipulate the duration of cooperation, contain adaptation clauses such
as index clauses and delegation of authority, and stipulate some form of
dispute resolution and similar safeguards. More detailed rules are created
during the relationship using ex-post mechanisms such as formal govern-
ing bodies (Ménard, 2008, p. 299).2 Through this set-up, hybrids are able
to cope with the problems of sharing assets in an uncertain environment
while retaining the autonomy of the parties. Eger (1995) discusses some
options that contracting parties may choose between for the optimal mix
of autonomy and bonding, or rigidity and flexibility as this trade-off is
better known. The reader is reminded that the optimal degree of flexibility
and rigidity depends to a large degree on the extent that the matter under
investigation concerns some pooled resource and consequential risk or
uncertainty. Those aspects of cooperation in which no pooling exists can
be expected to rely relatively more on hard and fast rules than on ex-post
mechanisms. Similarly, issues of risk require less flexibility than uncertain
2
Arguably the delegation of authority can also be seen as a formal governing
body. See the discussion of the incomplete contract literature for the notion of
transferable control.

events, as the latter is hard to plan for since the parties, by definition, have
no information on the potential states of nature.
The sharing of rents, for example, is a classic source of potential con-
flict: at some point, the rents of the transaction need to be shared, and
the sharing of rents is a classic non-cooperative game. At the same time,
the rules on the sharing of rents must not interfere with the adaptation.
A major issue with long-term contracts therefore is securing cooperation
without foregoing the benefits of decentralization.
Because of the incomplete nature of the long-term contract, hybrids rely
heavily on relational aspects. Where the market transaction is to a large
degree anonymous, identity matters in long-term contracts (Goldberg,
1980; Buton, 2002; Williamson, 1985). As we will see in the discussion
below, both problems of dynamic commitment and relational contracting
as a complement to formal contract clauses benefit from efficient screening
ex ante. When the participants in a long-term transaction taking place in
a hybrid invest substitutable assets, it is natural to expect that there is less
informational asymmetry between them than in transactions requiring
complementary investments.
The autonomy of the parties also introduces an element of competition,
strengthening the incentives that face the parties. This competition is com-
prised of two dimensions. First, there is competition within the relation-
ship, where the contracting parties (especially, for example, in franchise
contracts) might be direct competitors in a certain market. Second, there
is competition among hybrids, potentially luring away existing partners or
introducing new ones. While the first element of competition helps ensure
that the participants retain productive efficiency at the interim stage, the
second type of competition helps to mitigate some dynamic commitment
problems at the ex-post stage by introducing new projects.
The formalism of the governing bodies varies with the degree to which
the uncertainty is consequential. If the uncertainty is of relatively low
importance, parties rely on trust (relational contracting). At the other end
of the scale, where correctly adapting to uncertainty is of major impor-
tance, governing bodies that have a large degree of autonomy and author-
ity are created. Parties are able to coordinate actions through the formal
governing bodies, allowing for coordinated adaptation, but at the same
time, the parties can keep a sufficient stake in the transaction to foster
efficient incentives and autonomous adaptation.
The new institutional economics literature discussed above provides us
with an elegant framework to analyze hybrids and long-term contracts.
The rest of this chapter contains discussions of separate strands of litera-
ture that help to explain some of the observed properties of hybrids. The
incomplete contract literature shows us that ex-post mechanisms, designed

at the ex-ante stage, can indeed overcome limitations in contracting tech-

nology, even though it limits itself to the study of risk and tells us nothing
about uncertainty. Likewise, the repeated adverse selection literature
explains why hybrids can cope with the soft-budget constraint syndrome
using screening and ex-post competition. The literature on repeated
moral hazard also emphasizes the need for ex-post competition, while
the literature on relational contracting offers another example of ex-post
mechanisms that benefit from the ex-ante screening possible in hybrids.
2. The Incomplete Contracting Approach

Long-term contracts are incomplete, often both literally and economically.
Literal incompleteness refers to the situation where the contract does not
deal with all possible situations, either because there is no clause dealing
with the current problem (linguistic under-determination) or because some
contractual clauses conflict in the particular circumstance (literal over-
determination) (Hermalin et al., 2007). Both situations are part of the
general class of ‘unforeseen contingencies’, meaning that the contract does
not foresee a way of dealing with the current circumstances, regardless of
the fact that the parties have or could have foreseen the situations them-
selves. One explanation for this kind of incompleteness is transaction costs
(Dye, 1985). With regard to linguistic over-determination, it has been sug-
gested that this serves as a mechanism that postpones the decision regarding
which rule applies to the time when it is necessary, if it is necessary. Because
of the linguistic over-determination, the parties, by using the interpretative
process, are more or less free to choose among the n possible rules, but at
the same time are bound to that and that set only, which implies that ‘agree-
ing now to argue later’ is an ex-post mechanism (Hart and Moore, 2004).
Although linguistic interpretation is problematic in daily practice, it does
not warrant a need for regulation nor can it be a starting point for analysis
if it does not have some effect on social welfare (Kaplow and Shavell, 2002).
In short, linguistic incompleteness must have economic consequences, that
is, there must be an incomplete contract in economic terms.
The complete-contracting literature relies on the lessons from the Nash
implementation literature (Maskin, 1999 (original 1977); Moore and
Repullo, 1988; Maskin and Moore, 1999). Given rational actors, com-
plete contracts, no collusion and costless communication it is, according
to Maskin (1999), in principle possible to incentivize parties that observe
the same piece of information to truthfully reveal it to a third party, for
example, a court. The incomplete contract literature deviates from the
complete contracting assumption in an attempt to create a theory that
explains the prevalence of highly incomplete contracts in practice. As
noted above, long-term contracts in particular are incomplete as they serve

as a framework, distributing decision-making authority in addition to the

classical hard and fast rules.
The incomplete contract literature to a large degree is based on meth-
odology developed by Grossman, Hart and Moore in their influential
literature on property rights (Grossman and Hart, 1986; Hart and Moore,
1990). It has been used to analyze the above-mentioned holdup problem.
For a more detailed discussion, consider a buyer and a seller who wish to
trade a ‘widget’. This widget must be produced, and in order to produce
the widget the buyer must make an investment i. The level of investment
determines the cost of producing the widget in a stochastic manner. The
cost is either low, cL, or high cH, with the probability of the costs being
low Pr(cL) equaling the level of investment. At the same time, the buyer
must make an investment j in order to use the widget. This investment
determines his valuation of the widget. That is, valuation is either vH or vL
and Pr(vH) 5 j. The important thing to note is that the investment costs,
f(i) for the seller and y(j) for the buyer, are sunk. Once the money is spent,
there is no way to recover it. For simplicity, assume that trading is ex-post
efficient if and only if the high valuation and low cost events occur.
The utility functions of the buyer and the seller are:
UB 5 qv 2 P 2 y(j)
US 5 P 2 qc 2 f(i)
Expected social welfare, being the sum of both functions for all possible
situations, is:
W 5 ij(vH 2 cL) 2 y(j) 2 f(i)
This equation states that social welfare consists of the value created when
trade takes place (the difference between a high valuation and low costs),
corrected for their expected occurrence (i 3 j), minus the costs of invest-
ment (y 3 f). This equation is concave in i and j, and has one optimum,
which we can derive from its first-order conditions.
dW
5 i (vH 2 cL) 2 yr ( j) 5 0 S i (vH 2 cL) 5 yr ( j*)
dj
dW
5 j (vH 2 cL) 2 fr (i) 5 0 S j (vH 2 cL) 5 fr (i*)
di
If we assume that the parties cannot write a contract based on the

valuation, cost or their investment, but instead establish the price ex post

according to a certain sharing of the spoils with a share a going to the

buyer and 1 2 a going to the seller, where 0 , a , 1, then the seller and
buyer have the following expected utility functions:
EUB 5 ija(vH 2 cL) 2 y(j)
EUS 5 ij(12 a) (vH 2 cL) 2 f(i)
With regard to their choice of investment levels, both agents choose the
level of j relative to i that maximizes their expected utility:
j* 5 argmax EUB S ia (vH 2 cL) 2 yr ( j) 5 0 S ia (vH 2 cL) 5 yr ( j)

j
i* 5 argmax EUS S j (1 2 a) (vH 2 cL) 2 fr (i) S j (1 2 a) (vH 2 cL)

i
5 fr (i)
From these equations, it becomes clear that there will be too little invest-
ment compared with what is socially optimal. The problem is that each
party will try to get a piece of the other’s investment. The consequence is
that the investing party never recoups the full benefit of his investment,
diminishing his incentive to invest.
Note that we have some pooling of resources (i and j) among two oth-
erwise autonomous entities, so that the lesson carries over to long-term
contracts: if transactions like these are organized via a market mechanism,
underinvestment will occur. Following this insight, economists have tried
to answer the question of under which conditions the underinvestment
problem can be overcome with long-term contracts. One approach of
especial interest for the study of long-term contracts is the renegotiation
design approach.
Renegotiation Design and Option Contracts

In essence, renegotiations are an ex-post mechanism, as the terms of trade
are determined ex-post. Rather than being dependent on a third party,
such as in the case of spot markets or index clauses, here the position and
bargaining power of the contracting entities fully determine the outcome.
Renegotiation design builds on the observation of Hart and Moore
(1988). In that article, the effect of a given ex-post bargaining game is
analyzed. Aghion et al. (1994) extend the analysis by allowing the parties
to design the renegotiations. This is done by allowing parties to choose
not only a default price and quantity, but also a division of bargaining
power through the application of contract terms that make one of them

more impatient than the other (for example, time-based penalty clauses).
Additionally, they mould the renegotiation process in a Rubinstein-Stahl
revolving-offer model of bargaining with outside options (Binmore et al.,
1986). The revolving-offer model of bargaining describes the following
bargaining game, based on Muthoo (1999). Two players, A and B, need
to divide an amount of wealth ð . 0. In each round, one player has the
right to make an offer describing the share each player would get under
agreement (xA, xB)3 and the other player has the right to accept or decline.
If the player chooses to decline, the roles are reversed and he gets the right
to make the offer, and the other player gets the right to accept or decline.
Declining is not without its consequences; with each extra round, the value
of agreement decreases. More specifically, the utility function of player m
is described by Um 5 xme2mtD,4 that is, his share xm of the total wealth
ð corrected for the depreciation rate rm (the rate at which postponement
makes the agreement less attractive for player m) multiplied by amount
of time spent tD. The depreciation factor can be redefined as e2r tD ; dm
m
.5 A depreciation factor of 1 would imply that the player does not care
about waiting – rather, he is very patient; a factor of 0, on the other hand,
would imply extreme impatience – the deal only creates value today. These
extremes are excluded in the model.
Theoretically, the game could go on forever without the players reach-
ing any agreement. Also, each player has an incentive to make an offer
which is most interesting for himself. So, would each player make an ‘all
mine’ offer, which the other would decline and replace with a ‘no, all mine’
counter-offer, until one has to budge? Note that this would be wasteful,
as the value of the deal decreases with each round, a fact that would not
concern a player directly, as long as his or her share is large enough. The
answer turns out to be no. There exists a unique subgame perfect equilib-
rium (Selten, 1965) for this game, with agreement being reached in the first
round. Assume, for the sake of argument, that the players are symmetrical,
that is, they have similar depreciation factors. Each player understands
that, in order to convince the other player to accept the offer, he must at
least offer a share x0 equal to what the other expects to get when making
an offer. Working backwards, we note that after n rounds, the value of the
deal has been completely lost due to depreciation. After that, each player
is indifferent between each division of value, as Um 5 0 for all (xA, xB).
Therefore, the player making an offer just before the value is completely
3
Naturally, 0 , xA1 xB≤ ð, 0 , xm≤ ð.
4
rm . 0, t ≥ 0, D . 0, m 5 A, B.
5
0 , dm , 1.

lost (say A) offers B nothing and keeps the last bit of value for himself. B
though, realizes that he can preclude A’s capture of the last bit of value by
using his right to make an offer in the round before, with A getting the value
he would get from the penultimate round and keeping the rest of the value
for himself. This reasoning goes on until round 1. In that round, player
A makes the equilibrium offer with A acquiring the value lost by waiting
and the rest of the value being shared according to their relative deprecia-
tion factors. Effectively, each player acquires what the other would lose
by waiting. The model has some nice properties in that (a) agreement is
reached in the first round, (b) as a consequence, efficiency is retained since
no depreciation occurs, and (c) the division of bargaining power depends
on the relative depreciation factor of the players. The outside option model
extends the standard-revolving offer model by allowing a third option for
the player who receives an offer. In addition to accepting or declining, he
can also opt for an outside option, in which case the players receive a pay-
off wm, with wA 1 wB , ð. The outcome of the game can potentially change,
because the outside option might be more attractive to one player than the
equilibrium offer under the standard model. If this is the case, the other
player will offer a bigger share, equal to the outside option. It serves as a
sort of threshold for the equilibrium offer.
Aghion et al. (1994) apply these insights through the introduction of
option contracts. This creates outside options, and penalty clauses are
used as instruments to make parties more impatient, that is, to set the
bargaining powers. Since their inquiry was made from a purely economic
standpoint, they do not address what such a contract should look like
and to what extent it is legally feasible. Take the game discussed above
and now allow the parties to write a contract in stage one which allocates
the ex-post bargaining powers á and an option contract r, specifying a
quantity and price, which both parties can call. The trick is to allocate
the bargaining power to the buyer and at the same time make the outside
option the best choice for the seller, regardless of the state of the world.
Note that decreasing the bargaining power of the seller implies lowering
his equilibrium share and thereby making the outside option more attrac-
tive. The result is similar to the previous long-term contract and renego-
tiation model: since the seller expects to get its outside option regardless
of the actual state of the world, he has an incentive to minimize costs and
therefore choose i*. The buyer, being the residual claimant and expecting
the seller to invest efficiently, also chooses the efficient investment level j*.
This model is relevant for the study of long-term contracts in that it dis-
cusses the use of an ex-post mechanism designed at the ex-ante stage, but
furthermore, this is possible without having to rely on unrealistic contract
clauses. Note, though, that the model does rest on the assumption that

parties will not renegotiate after the default option is chosen and deals
with risk, not uncertainty.
Noldeke and Schmidt (1995) study the influence of specific perform-
ance and option contracts on the underinvestment result. They show that
option contracts can create both the required allocation of bargaining
power and the efficient default price. The bargaining power in the ex-post
trade is allocated by giving the right to decide whether the good is deliv-
ered or not to the seller. Ex post it is the buyer who must convince the
seller to take the efficient action, which is done by offering the seller a sum.
Noldeke and Schmidt define a contract that creates the choice between
a default price P0, which is paid if no trade occurs, and an option price
P1, which the buyer must pay if the trade goes ahead. Define P1 5 P0 1
K, where K is the extra price to be paid in case of a trade. Specifically, K
determines the way the game is played.
If K , cL, the seller will never use the option to sell the good, even if that
is efficient. If è 5 (vH, cL), trade is efficient and the seller will offer the buyer
a renegotiated price PB1 5 P0 1 cL, which the seller accepts, as it leaves him
indifferent between no trade, which earns him P0, and trade against the
renegotiated conditions, which earns him PB1 2 cL 5 P0.
If cL , K , cH, the seller will always wish to trade if è 5 (vi, cL). The
buyer, on the other hand, would prefer not to trade if v 5 vL. In that case,
the buyer offers the seller a renegotiated price for no trade PB0 5 P1 2 c.
The seller again is indifferent between the options of producing the good
or accepting the new price, as in both cases he earns P1. Ex-post trade is
once again efficient.
Finally, if K . cH, the seller always prefers to produce the good.
Analogous to the first situation, the buyer now offers the seller not to
produce in exchange for a price PB0 5 P1 2 c, where c is either cL or cH
when è ≠ (vH, cL), resulting in ex-post efficiency.
With ex-post efficiency being guaranteed, what happens to the incentives
to invest? First, note that the investment level is a function of K. If K , cL,
the seller always receives P0 and therefore has no incentive whatsoever to
invest and chooses an investment level of 0. If K . cH, the seller prefers the
low-cost state to the high-cost state, as he gains cH 2 cL in a low-cost state.
So, for a large enough K, his investment level will become 1. This relation-
ship of i and K is continuous, implying there exists a level K which induces
an efficient investment level for the seller. Second, because the buyer is the
residual claimant, given the efficient investment level of the seller, he too
has an incentive to choose the socially optimal investment levels.
The preceding shows that option contracts are indeed able to allocate
bargaining power and set prices so that efficient trade and investment are
feasible.

Aghion et al. (2002) and (2004) apply a partial contracting methodol-

ogy where contracting on authority is allowed. Here too the problems of
incomplete contracts can be reduced, although here on the basis of the
transfer of decision-making authority. As observed in the new institu-
tional economics literature, transfer of authority (the creation of formal
governing bodies) helps to alleviate the problems created by imperfect
contracting technology in an environment of asymmetric information.
Although the incomplete contract literature has come in for serious
criticism regarding its foundations (Tirole, 1999), there are some general
lessons for the study and design of long-term contracts: institutions
matter. The use of ex-post mechanisms, such as renegotiation design
and contractible control, helps to alleviate the underinvestment problem
typical of pooling arrangements among autonomous entities.
What is interesting with these models is that they all apply some ex-post
mechanism in order to solve the problems created by the limitations in
contracting technology. As we have seen in the discussion of the new insti-
tutional economics literature on hybrids, long-term contracts are usually
accompanied by the presence of various formal governing bodies or rely
on some third-party signal such as index prices. Thus, part of the incom-
plete contract literature explains the observed use of ex-post mechanisms.
The notion of transferable control perhaps comes closest to the reality of
contracting, with mechanisms more focused on who is allowed to decide
about what rather than directly creating the applicable rule. As such,
transferable control and renegotiation design share characteristics with
relational contracts, which are discussed below.
3. Dynamic Commitment
The complete contracting literature has analyzed the influence of repeated
interactions on information problems such as hidden action and hidden
information. From this literature, two strands are of interest for the study
of long-term contract: dynamic commitment and repeated moral hazard.
The problem of dynamic commitment, or the lack of it, is illustrated by
the Coase conjecture: a monopolist selling a durable good over multiple
periods in a market with hidden valuation is in effect in competition with
itself. A related problem of lack of dynamic commitment relevant for the
study of long-term contract is the soft budget constraint syndrome (Kornai
et al., 2003), a discovery of economists studying firms in socialist econo-
mies that faced shortages. The softness of the budget constraint refers to
the likelihood that another party bails out the failing firm. In the context
of socialist economies, that third party is the government, but in different
contexts, private entities, for example, trading partners, banks, and other
suppliers of capital, act as a supporting organization. There are various

motives for supporting organizations to bail out a budget-constrained

firm: paternalism, political motives, fear of damage to the reputation of
the supporting organization, large negative consequences (for example,
when the constrained firm is too big to fail), and corruption. However, the
motive most applied in economic research is the lack of credible enforce-
ment: ex post, that is, after the budget constraint entity has failed, it is in
the best interests of the supporting organization to bail out the failed firm.
Such bailouts are not necessarily one-time events and are by no means
an unexpected event, rather the contrary. The problem is not the bailout
itself, but rather the effect an expected intervention has on the behavior of
the budget constraint entity. The softness of the budget constraint dimin-
ishes the incentives to produce efficiently or adapt, with a loss of welfare as
a result. A similar problem of dynamic commitment is the ratchet effect, in
essence the mirror image of the soft budget constraint problem. Instead of
being too soft with the agent, here the principal cannot commit not to be
too hard (Berliner, 1952). The classic example is the behavior of manag-
ers of Soviet firms foregoing a bonus if production exceeded targets. They
anticipated that, if they achieved such a target, the government would
respond by raising the targets for the next year. By foregoing a bonus in
the initial year, the managers avoided facing increasingly difficult targets
in the future.
A major contribution to the theoretical study of the soft budget con-
straint syndrome in the contract theory literature is Dewatripont and
Maskin (1995), where the problem is modeled as a dynamic commitment
problem. An investor faces a risky investment decision. He must choose
among a number of projects, each of which is either good or bad. All
projects require an initial investment of I, but bad projects require an
additional investment and have a lower return than good projects. The
investor does not know the type of an individual project at the outset. A
manager, who knows the type of the project, runs the project. If a project
is successful, the investor receives a pay-off of R and the manager receives
a non-monetary pay-off of B, after which the game ends. If a project fails,
the project is either liquidated, resulting in a pay-off for the investor and
manager of L and s respectively, or rescued, which costs the investor an
additional investment resulting in a pay-off of r for the investor and b for
the manager. Let a denote the proportion of good projects and set I ,
r , R, 2I . r, B . b . 0 . s and L , r 2 I. The dynamic commitment
problem presents itself here through the sequential optimality of refinance:
although from an ex-ante perspective, the investor would be unwilling to
finance bad projects as 2I . r. But after the initial investment is sunk, he
cannot do better than to refinance, as liquidation gives L, which is strictly
less than the expected pay-off from refinance, r 2 I. Managers of bad

projects, anticipating the refinancing, offer bad projects as they expect

a positive pay-off. If the investor could commit not to refinance failed
projects, he would be better off as managers of bad projects would refrain
from offering them, since that would give them a negative pay-off of s. As
a consequence, the investor would always chose a good project, raising his
expected pay-off from a(R 2 I) 1 (1 2 a)(2I 2 r) to R 2 I. Responses to
the soft-budget constraint include trying to relax the information asym-
metry through screening (Berglöf and Roland, 1998), avoiding repeated
interactions (Dewatripont and Maskin, 1995) and allowing the entry of
new projects (Berglöf and Roland, 1998).
Given the properties of long-term transactions as described by the new
institutional economics, the soft budget constraint can pose a significant
problem. The pooling of assets, especially those that are substitutable,
creates the potential for dynamic commitment problems: if one party at
some point delivers assets of lower quality, it may well be optimal for the
other party to increase its own share rather than accepting a sub-optimal
outcome. Yet the contract theory literature suggests that hybrids are
remarkably well suited to dealing with the hazard of soft budget con-
straints. First, as most hybrids are created around a pooling of substituta-
ble assets, the initial informational asymmetry is to some extent mitigated.
The emphasis on selecting the right partners, caught by the phrase ‘iden-
tity matters’, in effect describes a screening mechanism. Screening becomes
more effective as the entity potentially rescuing a failing partner has more
expertise. This has been brought forward to explain why the soft budget
constraint syndrome occurred less within the aircraft industries of the
USSR compared with its computer industries. There was a lot of knowl-
edge on the design of good military aircraft, whereas the computer indus-
try was in its infancy. In addition to this screening at the door, hybrids
are also characterized by a significant degree of competition, both within
hybrids and among hybrids. In effect, this introduces new projects, thereby
creating a credible threat not to refinance or bail out. If the expected value
of new projects is sufficiently large, they become an attractive alternative
to bailing out failing partners. So, in short, hybrids can be expected to
suffer less from soft budget constraints than hierarchies. Without these
safeguards, the transaction costs would be higher for these kinds of long-
term transactions as hierarchies would suffer from soft budget constraints,
while attempts to avoid repeated interactions, in effect opting for the
market mechanism, would diminish incentives to invest in pooled assets.
Although hybrids retain a degree of competition, this is undeniably
lower compared with competition in the market. This is helpful in an
environment where some good projects take more time to complete, but
ad interim cannot be distinguished from bad projects, a situation studied

in von Thadden (1995). Take the example above and introduce a second
potential project for the good type. Whereas the first took one period and
resulted in an investor pay-off of R, the new project takes two periods
and requires an interim refinance of I, but it results in a pay-off of P .
2R . 2I for the investor and b . 2B for the manager. If a good long-term
project is terminated, it results in a pay-off of L and s for the investor and
manager respectively. The problem here is that the impossibility of distin-
guishing between projects at the intermediate stage results in a coordina-
tion problem among managers of good projects. They are only willing to
select the long-term project if they expect the investor to refinance. A hard
budget could result in too few good long-term projects being selected.
Hybrids can mitigate this problem as they, to a degree, control the level
of competition and thus the hardness of the budget constraint. By limiting
the competition, they create a credible commitment to refinance second-
period projects. Additionally, because of the intensive ex-ante screening,
investing in long-term projects would be efficient for hybrids even when
the ratio of good projects is low.
Even though both the classic holdup problem and the soft budget
constraint syndrome include sunk investments, they differ in that the soft
budget constraint is the result of dynamic consistency problems, whereas
the classic holdup problem is one of incomplete contracting. If we were to
allow complete contracts in the Williamson model, the holdup problem
would be solved as the contracting parties want and they would hold each
other to their earlier promises. In the case of soft budget constraints, com-
plete contracts do not change the outcome as the supporting organization
wants to refinance, rather than being forced to refinance.
4. Repeated Hidden Actions

Hidden actions are now a classic part of microeconomics. From the static
framework, consisting of one (potentially multidimensional) action and
one (potentially multidimensional) output, it is known that hidden actions
pose a problem because of the combination of informational asymmetry
and either a risk-averse agent or a wealth-constrained agent (Laffont
and Martimort, 2002). A natural extension of the static framework is the
introduction of multiple actions, consumption and output. The literature
on repeated moral hazard has done just that (Chiappori et al., 1994). A
straightforward method for introducing dynamics is a repeated version of
a static game; a principal and a risk-averse agent play a series of consecu-
tive games of moral hazard, with each action-output pair being independ-
ent of the preceding one and the wealth of the agent varying depending on
the outcome of the games. The question then is whether a renegotiation-
proof contract exists. A (long-term) contract is renegotiation proof if the

continuation of the contract ad interim is a Nash equilibrium; sticking

to the contract must always be optimal, otherwise the parties would tear
up the contract and write a new one. The efficacy of a long-term contract
depends on whether the principal is able to observe and control the savings
of the agent. If the agent’s risk attitude changes with his endowments, the
principal has an incentive to keep the agent as risk-averse as possible, that
is, to keep him poor. That way, the incentive contract retains the biggest
‘bang’ for the buck.
Unfortunately for hybrids and therefore for long-term contracts, due
to the retained autonomy of the participating parties, information about
financial status is likely to be private. In such a situation, renegotiation-
proof long-term contracts are feasible only under very rare conditions
(Fudenberg et al., 1990). The ‘contract as a framework’ approach, where
parties write one general contract at the start of the relationship and write
more simple contracts for specific transactions, gives rise to repeated
interactions which enable the parties to cope with the problems created by
repeated moral hazard. The value of repeated interaction in situations of
hidden actions comes from two sources. First, if the number of outputs rel-
ative to the number of actions is sufficiently large, the principal has more
signals at his disposal. These signals are the foundation for the rewards and
punishment of the agent. Better information allows for a more accurate
assessment of the agent’s actions. This improves the agent’s incentives not
only because he is more likely to be rewarded for his effort and punished
for shirking, but also because it additionally decreases the risk that the
(risk-averse) agent is facing, thereby lowering the risk premium the princi-
pal pays the agent (see, for example, Hart and Moore, 1988). Second, the
repeated interactions give the agent the opportunity to self-insure, thereby
further decreasing the costs of risk (Fudenberg et al., 1990).
5. Relational Contracting
Hybrids are based on incomplete contracts. As we have seen above, this
incompleteness creates the need for additional mechanisms. One such
mechanism is the relational contract. Like the repeated-hidden-action
models, relational contracting is based on the notion of an ongoing rela-
tionship. Rather than building credible threats by making the promises
legally enforceable, relational contracts are based on actions and expecta-
tions regarding the continuation of the relationship. This is best illustrated
by the prisoner’s dilemma (see Table 15.2).
Two players, A and B, face the static game depicted in Table 5.2. The
problem from an economic point of view is that, although (Up, Left) max-
imizes social welfare, each party has an incentive to defect because what
is socially optimal is not privately optimal. If A chooses Up, B is better

Table 15.2 The prisoner’s dilemma
B
Left Right
A Up (10,10) (1,18)
Down (18,1) (4,4)
off opting for R as this gives him 18 rather than 10. Likewise, A prefers
(Down, Left) to (Up, Left). Even if we were to assume that only B would
have an incentive to choose something other than the social optimum,
(Right, Up) is also no equilibrium because A can do better by moving
down, since 1 , 4. As each player anticipates the defection of the other,
the only attainable outcome (Nash equilibrium) is (Down, Right). Twelve
units of welfare are lost in the static game.
Now let us analyze an infinite repetition of this game, with each player
having a low discount value (that is, both value future pay-offs, although
not necessarily as much as current pay-offs). If both players adopt a simple
trigger strategy, choosing to cooperate if the other has cooperated in
the previous round and defect otherwise, repetitions solve the prisoner’s
dilemma for a certain number of rounds. To see this, note that in each
round a player chooses between receiving a short-term gain of cheating
now or the long-term gain of cooperation. If a player cheats, he gets 18 in
this round rather than 10, but can expect to receive no more than 4 there-
after. On the other hand, if a player cooperates, he can expect to receive 10
forever. The discounted value of a sum of money received for an infinite
number of rounds is $/r, where $ is the amount of money received and r the
discount value. So infinite cooperation is possible if 18 1 4/r , (111/r)10,
with each player playing the equilibrium strategies described above.
Relational contracts serve as a complement to legal contracts. When
legal contracts are unable to regulate all future contingencies efficiently,
that is, when they are incomplete, relational contracts can fill in some of the
gaps. For example, relational contracts are based on optimal responses to
observed events, rather than verifiable events. Additionally, relational con-
tracts can adapt quickly to changes in the environment, as their efficacy is
not based on past promises but on current actions and expectations about
the future. However, unlike the options contracts analyzed in the incom-
plete contract literature, parties cannot structure the relational contract. It
is fully determined by variables that are usually exogenous, such as the dif-
ference in pay-off from cooperation and defection and the discount value.
The study of relational contracts has been extended by allowing for
shocks in the exogenous variables and by introducing hidden actions and

hidden information. The latter problems are discussed in Levin (2003).

There it is shown that relational moral hazard contracts are similar to com-
plete contracting moral hazard contracts when the agent is risk-neutral and
has limited liability. The self-enforcement constraint introduces limits on
the maximum reward and punishment, which are such that they determine
the implemented rewards and punishments. In the same paper, it is shown
that the efficiency as the top property of complete contracts no longer holds.
Additionally, bunching is optimal when the number of types exceeds two.
Therefore, although relationships are stressed in the literature on hybrids,
the relational contract literature suggests that parties are wise to choose
different solutions when it comes to hidden actions and information.
6. Further Research
Although considerable progress has been made in the field of long-term
contracts, an important limitation is the methodology used in the study of
behavior under uncertainty. Much of the literature discussed above uses
the framework developed by Savage (1954). This allows for subjective
probabilities, that is, although it is objectively fully determined whether a
flip of the coin results in heads or tails, we do not know the actual outcome
beforehand and hold subjective expectations instead. However, the agent
its required to know at least all potential outcomes, that is, the state space
is objective. This is problematic as it takes away the potential of surprise:
it does not allow for uncertainty, but only for risk, in the definition of
Knight (1921). It is very unrealistic to assume that a researcher already
knows all future theories of physics, including those whose inventor has
not yet been born. Therefore, although these models hold some valuable
lessons for the design of long-term contracts, they do not tell us the whole
story. The objective state space assumption also overstates the efficacy of
planning as it rules out surprises. The study of ex-post mechanisms, which
play such an important part in long-term contracts, would greatly benefit
from the introduction of a subjective state space.
Another avenue of research, which can be expected to develop sooner,
is the relationship between hybrids and growth. The relationship between
institutions and growth has received considerable attention in the past and
is far from new in the economics literature. There is, however, a debate in
the growth literature that indirectly relates to hybrids. That debate is on
the relationship between human capital and economic growth. As noted
above, human capital plays a crucial role in hybrids. This then raises the
question whether hybrids, if supported by efficient institutions, support
smart growth because of their effect on human capital. Other authors
have stressed the importance of entrepreneurship for growth in a capital-
istic society (Baumol et al., 2007). They view entrepreneurs as small firms

engaged in innovation. The transactions in which such entities are engaged

can be expected to have characteristics that make hybrids the optimal gov-
ernance form. If indeed entrepreneurs are a driving force behind long-term
growth, and if their transactions require autonomy, involve specific assets,
and take place under uncertainty, then efficient institutions supporting
hybrids should foster growth. These questions are open for research.
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16 Long-term contracts in the law and
economics literature
Mireia Artigot i Golobardes and
Fernando Gómez Pomar
1. Introduction
Contracts increase the likelihood of cooperation in economic and social
interaction by making binding commitments credible and less costly. This
is also true of cooperation over extended periods of time, even in the pres-
ence of other modes of inducing and stabilizing cooperation in protracted
interactions. The economic literature1 dealing with contract issues and,
more specifically, on long-term relationships has differentiated between
long-term contracts and contracts that extend over a long period of time,
often called relational contracts.2 Relationships that last a long time may
be governed by a long contract or by many short contracts, because they
do not necessarily require a certain type of contract, a given contract
length, or even a formal contract at all. While all long-term contracts are
contracts that tend to last a long time and share certain common charac-
teristics, not all contractual relationships that involve significant duration
are drafted as long-term contracts.
From a law and economics perspective, three major dimensions of long-
term contracts are to be highlighted:3 the existence of specific investments,
their inherent – added – incompleteness, and the complexities of the issues
arising from breach and termination.
Specific investments are investments, the value of which depends on
whether they are used by parties within the contractual relationship or
outside it.4 A pure specific investment has value for the contract between
the parties but is worth nothing outside it, or whenever the contract ends.
Hence, in light of the relation-specific value of the investment, the party
undertaking such an investment is particularly vulnerable, being subject
to the strategic behavior of the other party in the contract and given that
outside the contract the value of the investment vanishes. Such specific
1
Williamson (1985).
2
Hviid (1999).
3
De Geest (2006).
4
Becker (1962).
314

Long-term contracts in the law and economics literature 315
investments strongly influence the parties’ strategies and their incentives

to cooperate. This situation is what in economics is often referred to as
the holdup problem under which parties would reach a Pareto outcome
if they were to cooperate but because of the risk involved in cooperating,
they do not reach their first-best solution and therefore do not maximize
the returns of the contract between the parties.
A second major characteristic of long-term contracts is the higher degree
of uncertainty that is inherent in such a contract, and the impossibility of
drafting a complete contract that could foresee and resolve all the poten-
tial contingencies that might take place during the life of the contract.5
Any contract faces the tough challenge of including all necessary clauses
to give solutions to potential issues affecting the contractual relationship
between the parties.6 This is an especially important issue in long-term
contracts. For that reason, long-term contracts often include renegotia-
tion clauses so that they can be adjusted to any new circumstances faced
by the parties and by the contract during its life span.7 Incompleteness is
by no means a unique characteristic of long-term contracts, but it is an
especially critical question considering the goals and threats to long-term
relationships between parties entering into them.
Finally, long-term contracts typically present increased opportunity
for a failure of legal remedies against breach of contract. Due to the
long duration of the interaction, the multiplicity of types and events of
relevant contractual conduct, the proliferation of instances of potential
shading and shirking by the parties, the chances that these non-complying
contractual behaviors can be shown, in a sufficiently convincing manner,
to a court or other external adjudicator, are significantly lower than in a
spot contract with a smaller range of contractually relevant behaviors.
Moreover, typical remedies such as specific performance and damages are
harder to assess and enforce. These complexities grow even larger inside
supply and distribution chains, where the cost of detecting and collect-
ing evidence of these instances of breach, and adequately deterring them
5
Schwartz (1992).
6
Salanié (1997) defines a complete contract as one that considers ‘all variables
that may have an impact on the conditions of the contractual relationship during
its whole duration have been taken into account when negotiating and signing the
contract’. It should be noted that under this definition, a contract would be com-
plete, despite not regulating all potential foreseeable circumstances, if there were
no change of circumstances that affected the contract.
7
Some authors consider that whenever parties have no need to revise or rene-
gotiate the contract, such contracts could be considered comprehensive contracts.
Hart (1995).

increases with the size, territorial, and product scope of the network. The
likelihood that specific contract clauses over remedies in the long-term
contract can address these problems seems low.
This chapter will be structured as follows: section 2 will present the
major differences between long-term and short-term contracts; section 3
will discuss the most important parameters affecting the optimal contract
length; section 4 will present other issues inherent in long-term contracts;
section 5 will describe the major issues on contract drafting and design;
section 6 will discuss the major differences between contract renegotiation
and breach; section 7 will present the consequences of termination and
breach; section 8 will briefly present the empirical literature on long-term
contracts. The chapter will end with some brief conclusions.
2. Long-term Versus Short-term Contracts

Despite the particular features and complexities presented by long-term
contracts, their legal nature and regulation do not differ significantly from
the regulation of short-term contracts or contracts in general.
Contracts are legal instruments that allow parties to establish binding
commitments that serve as mechanisms for creating value, as well as for
deciding how such value will be divided.8 Legal systems typically establish –
with some variation across legal traditions – a set of requirements in order
to have an enforceable contract beyond what could be a simple agreement
between two parties. Among these elements there is one that requires that the
agreement meets a minimum level of definiteness9 so that parties, for the con-
tract to be enforceable, need to be in a reasonable position and have enough
information to understand and agree on the contract terms, and in the case
of breach or disagreement between them, the courts have sufficiently precise
information on what the contract required, so as to be able ex post to solve
the grievances of the contract parties and award damages, if appropriate.
Protracted relationships may be governed by long-term or by a series
of short-term contracts. However, their content is likely to look quite dif-
ferent. While both kinds of contract include basic contract requirements
such as a reasonably defined contract object, and normally include the
exchange price, long-term contracts may also include governance terms
over the long run, re-adjustment provisions, remedies for the long run,
and parameters that may affect the parties’ bargaining position within the
contractual relationship.
8
Goldberg (1995).
9
In general, see also Zweigert and Kötz (1998). For French law, see Philippe
(2005). For Dutch law, Asser and Hartkamp (2000).

The choice between a short contract – or a series of short contracts – or

a long-term contract depends on which type of instrument best fits the
preferences and nature of the parties’ relationship. There will be several
dimensions of the contract that will differ depending on whether the
contract is short term or long term.
Despite the common legal requirements on many matters for both kinds
of contract, issues such as definiteness, uncertainty and specific invest-
ments will differ because of the characteristics of the legal instrument.
Further, long-term contracts will often generally include many aspects
that are not considered necessary in the context of short-term contracts.
For instance, the need to define and specify contract terms will differ
depending on the length of the contract, or on whether it will be necessary
to make a significant amount of specific investments. So, in a long-term
contract, it will probably be necessary to be less precise, and to leave more
scope for discretion by the contracting parties in order to be able to adjust
the contract terms to the circumstances in relation to the parties’ needs.
For that reason, long-term contracts tend to be more open-ended. But at
the same time, given that parties are aware of the risk arising from specific
investments, they will also be more interested in defining the consequences
they will face in the case of contract break-up.10
Some voices in the literature have discussed whether long-term con-
tracts require different rules because of the specific problems presented
by the specific investments contract parties must make, and the inherent
incompleteness that derives from the lack of information available to
contracting parties when the contracts are drafted.11
There is no general criterion under which certain relationships should be
governed by long-term contracts or under a series of short-term contracts.
In other words, there is no optimal contract length at an abstract level, and
the optimal contract will depend on the nature of the parties’ relationship
and the nature and goals of the contract they have entered into.
However, there are certain issues on the performance of short-term and
long-term contracts that have been widely discussed in the literature. For
example, whether parties have complete or incomplete information availa-
ble, short-term contracts perform differently from long-term contracts. At
the same time, depending on whether the parties’ commitment or the role
of specific investments are important elements in the relationship, short-
10
Goldberg and Erickson (1987); Joskow (1988); Solís-Rodríguez and
González-Díaz (2009).
11
De Geest (2006).

term or long-term contracts may be preferred. Fudenberg et al.12 identified

sufficient conditions – all public information is contractible, there is no
information asymmetry when the contract is entered into and contracts
are renegotiated – for short-term contracts to achieve the same outcomes
as long-term contracts. These elements are developed below.
2.1. Complete Information

Under perfect conditions, parties envisaging a long-term relationship
would enter into a long-term contract considering all potential contingen-
cies that they would be able to foresee and contract over. Given that they
would be able to anticipate all potential contingencies between them, rene-
gotiation would not be necessary in principle.
It is worth noting that if parties had perfect information and renegotia-
tion were not costly, long-term contracts would be preferred whenever
one of the parties’ investments was a sunk cost and the contract would
represent a way to smooth consumption.13 If renegotiation was not neces-
sary, contract terms could be governed either through a series of short-
term contracts or with a single long-term contract. Further, if parties
did not place a specific value on commitment and had access to perfect
information, short-term contracts would be equivalent to long-term con-
tracts.
Sometimes the need for specific investments by contracting parties is
an important element in entering into long-term contracts. One of the
major problems of specific investments is that often they are not con-
tractible. However, if there is perfect information, or such investments
are observable so that the other contracting party can observe whether
these investments are made, Dutta and Reichelstein,14 using a single vari-
able in a multi-period context, noted that the hold-up problem present
in long-term contracts is significantly mitigated. Hence, when there is
perfect information, or specific investments are verifiable, investment
incentives will depend on the weight placed on them being verifiable, and
not on whether the contract entered into is a short-term or long-term
contract.
Therefore, where parties successively negotiate contracts and there is
perfect information accessible to both of them, short-term contracts can
be as efficient as long-term contracting when they are entering into a new
12
Fudenberg et al. (1990). See also Salanié and Rey (1990) and Chiappori et
al. (1994).
13
Some have suggested that in these cases long-term contracts serve as a sub-
stitute for an efficient credit market. Crawford (1988).
14
Dutta and Reichelstein (2003).

contract.15 Hence, under perfect information conditions, even for pro-

tracted relationships, short-term contracts may be equivalent to long-term
contracts.
2.2. Incomplete Information

When there is incomplete information on the part of either one or both
parties, the outcomes under long-term and short-term contracts may
vary significantly. Further, the possibilities and costs of renegotiating the
contract may be relevant for the performance of short- and long-term
contracts.16
One of the major advantages presented by short-term contracts is the
possibility they offer of inter-temporal smoothing so that parties can
adjust to the information asymmetries between them. When some future
outcomes are uncertain, when there are risks involved during the life of
the contract, or unobservable actions by the parties that may affect the
outcome of the contract, short-term contracts seem to present significant
advantages.17 However, the advantages are not always so clear cut.
Short-term contracts do not necessarily solve inter-temporal trade-offs.
Rey and Salanié18 claim that under asymmetric information, commit-
ment – present in long-term contracts – becomes an essential element in
the interaction, one that causes long-term contracts to strictly dominate
short-term contracts. This advantage ensues from the fact that the incen-
tive problems created by private information not revealed by contract-
ing parties, are generally better overcome through ex ante commitment
than through solving conflicts ex post, which will result in inefficiencies.19
However, because long-term contracts can rely and observe in the second
period the returns of the investment made, this could generate incen-
tives to invest, which could result in a better performance by long-term
contracts in such a context, as some of the literature shows.20
The problems presented by private information, though, may be over-
come by eliminating the possibility of renegotiation. Even where there is
asymmetric information, short-term contracting could implement optimal
15
Using a multi-period agency model, where at the beginning of each period
one of the parties (the principal) can propose a contract to the other (the agent), on
a take-it-or-leave-it basis. Rey and Salanié (1990).
16
Freixas et al. (1985).
17
Rey and Salanié (1990).
18
Rey and Salanié (1990).
19
For an analysis of long-term contracts with private information, see Baron
and Besanko (1984).
20

renegotiation-proof contracts.21 Leading indicator variables may become

useful if the principal is confined to renegotiation-proof contracts even
though there are authors who still prefer long-term commitment whenever
possible rather than the information provided by indicator variables.22
2.3. The Importance of Commitment

One of the elements that may be crucial when determining the choice
between short-term and long-term contracts is the importance of commit-
ment in the context of the contract and related to this, whether renegotia-
tion is feasible and if so, costly. Given the higher commitment inherent in
long-term contracts,23 renegotiation is not generally so essential and may
be avoided. This is important because renegotiating between parties may
be costly and therefore, long-term contracts could imply important savings
in transaction costs.24 But, as mentioned above, even when renegotiation is
not costly, long-term contracts will still be preferred whenever one of the
parties’ investments represents a way to smooth consumption.25
Leaving renegotiation aside, under perfect information, commitment
solves the parties’ inter-temporal trade-offs. Therefore, long-term con-
tracts will be preferred to short-term contracts whenever they cannot solve
such trade-offs outside the relationship.26 So, if one of the contracting
parties – or both – cannot solve inter-temporal trade-offs outside the con-
tract, some commitment will be necessary to achieve long-term efficiency
21
Malcomson and Spinnewyn (1988).
22
Sliwka (2002).
23
Malcomson and Spinnewyn (1988), in the context of a principal-agent
model under asymmetric information, show that, whenever there is no renegotia-
tion, a long-term contract can perform better than a short-term contract when one
of the parties – principal or agent – commits to a payoff which is lower than the
potential outcome under a short-term contract. Therefore, long-term contracts
have some commitment element that cause them to be preferred to a series of
short-term contracts.
24
Hart and Holmstrom (1987).
25
Crawford (1988). Some have suggested that in these cases long-term con-
tracts serve as a substitute for an efficient credit market.
26
There is abundant literature discussing the importance of commitment as a
mechanism to solve inter-temporal trade-offs whenever there is no access to credit
markets. If both parties had access to perfect credit markets, if they cared only
about the present value of the outcome and not about the time frame, there would
exist a number of optimal contracts, all of which would have the same present
value of the contract outcome in every state of nature, at least one of the contracts
would meet all conditions for an optimal short-term contract and therefore would
be equivalent to a long-term contract with commitment. See Rey and Salanié
(1990).

and long-term contracts will then present an important advantage over

short-term contracts. If inter-temporal trade-offs or commitment is not
that important, short-term and long-term contracts may be equivalent.27
But when there are moral hazard problems involving inter-temporal
risk-sharing, long-term contracts will dominate a sequence of short-term
contracts.28 Accordingly, long-term contracts will in general dominate
sequences of spot contracts.
The value of commitment has been widely discussed in the literature.
Williamson29 suggested that short-term contracts have emerged in order to
avoid the difficulties of specifying and enforcing the contingencies inherent
in long-term contracts.30
2.4. The Possibility of Renegotiation

As mentioned above, in light of the commitment element inherent of long-
term contracts, the need for renegotiation is reduced significantly.31
When renegotiation is costly, the transactions costs of long-term con-
tracts will be lower than for short-term contracts and therefore long-term
contracts will be preferred.32 But if, instead, renegotiation is costless, and
parties have perfect information, long-term contracts will still be preferred
whenever the contract represents a way of smoothing consumption for at
least one of the parties involved.33
2.5. The Importance of Specific Investments

Dutta and Reichelstein34 identified the conditions under which optimal
long-term contracts induce larger investments and less reliance on
27
Rey and Salanié suggest that short-term contracts could be interpreted as
loan contracts which could enable the principal of the contract to implement the
optimal long-term contract without being constrained by short-term considera-
tions. Rey and Salanié (1990).
28
Lambert (1983) and Rogerson (1985).
29
Williamson (1985).
30
See Dye (1985), for a first attempt, and Hart and Holmstrom (1987).
31
Malcomson and Spinnewyn (1988), in the context of a principal-agent
model under asymmetric information show that, whenever there is no renegotia-
tion, a long-term contract can perform better than a short-term contract when one
of the parties – principal or agent – commits to a payoff which is lower than the
potential outcome under a short-term contract. Therefore, long-term contracts are
endowed with some commitment element that may cause them to be preferred to a
series of short-term contracts.
32
Hart and Holmstrom (1987).
33
Crawford (1988). Some have suggested that in these cases long-term con-
tracts serve as a substitute for an efficient credit market.
34

indicator variables compared to short-term contracts, and the conditions

under which parties do better with a series of short-term contracts than
with a long-term contract. In the context of principal-agent contracts,
they conclude that long-term contracts create incentives for the agent to
overinvest – or to invest inefficiently – due to an existing moral hazard
problem by which the agent knows that he will not assume any risk for
overinvesting or for not making the most efficient investment decision
on behalf of the principal. In these cases, the principal does better with
several short-term contracts that may entail agent rotation; that is, there
may be a new agent in the second period. As a consequence, the agent’s
incentives to overinvest are controlled because he knows he may be
replaced in the next period.
Chiappori et al.35 show, in turn, that in order for the performance of
short-term and long-term contracts to be equivalent, two conditions are
necessary: renegotiation should not be possible so that the commitment
value of long-term contracts would be reduced and short-term contracts
should allow the smoothing of consumption.36 But it should be noted that
the length of long-term contracts is not the most important or essential
parameter; what is important is to what extent a contract of a given length
locks the parties into the relationship.37
3. Factors to Consider when Determining the Optimal Contract Length

As explained above, depending on the context, the parties’ interests, their
size, characteristics, informational structure, and their attitude towards
risk, a long-term contract may or may not perform better than a series
of short-term contracts. There is no general optimal contract for all
situations but an optimal contract and an optimal length for each kind of
relationship.
The relationship between performance and contract length has been
widely studied.38
3.1. Contract Length/Contract Price Trade-off

When one of the contracting parties is more risk averse than the other,
this party is willing to trade a lower consideration for a longer contract.
35
Chiappori et al. (1994).
36
Fudenberg et al. (1990); Malcomson and Spinnewyn (1988); and Rey and
Salanié (1990).
37
The length that should be considered is the nominal length of the contract.
See Aghion and Bolton (1987).
38
Particularly in the context of sports’ contracts, see Krautmann and
Oppenheimer (2002), Maxcy (1997, 2004).

Therefore, higher certainty in terms of a longer contract will compensate

for a lower contract price.39
Further, when there is high uncertainty regarding the contract price
relative to uncertainty in production, long-term contracts will be preferred
to a series of short-term contracts.40
3.2. Contract Length and Attitudes towards Risk

The attitude of contracting parties towards risk has also an effect on
the contract length. Intuitively, it is easy to foresee that the more risk
averse one of the contracting parties is, the more eager this party will be
to insure.41 This means that when a contract party is risk averse, she will
prefer a long-term contract rather than a series of short-term contracts.
3.3. Contract Length and Incentives to Invest

In theory, a long-term binding contract should be able to induce more
investments from the parties. However, the literature suggests that the
evidence is not so conclusive.42 Even though short-term contracts result in
underinvestment, the optimal long-term contract may result in under- or
over-investment depending on the importance of agency problems.43
What the literature seems to agree on is in the fact that contract length
is determined as a trade-off between the costs of entering into a new
contract – the costs of re-contracting – and the costs associated with the
incompleteness of the contract.44
3.4. Contract Length and Parties’ Performance

Contract length may also affect the incentives of the parties to perform,
and it could be expected that the longer the contract term, the lower the
return on parties’ performance.45 Given the unverifiability of performance
in regard to many dimensions of the parties’ obligations, however, the use
of quasi-rents within the relationship, enhanced by the presence of specific
39
Krautmann and Oppenheimer looked at the relationship between player
salaries and contract length, and suggested that when players are more risk averse
than club owners, they are willing to receive a lower salary in exchange for a longer
contract. Krautmann and Oppenheimer (2002).
40
Maxcy (1997; 2004).
41
Maxcy (1997; 2004).
42
43
44
Williamson (1985) and Aghion and Bolton (1987).
45
Krautmann and Oppenheimer analyzed the players’ return to performance
by contract length and concluded that the returns to performance decline with
contract length. Krautmann and Oppenheimer (2002).

investments, requires indefiniteness in the contract term, which is easier to

obtain with a longer-term contract with the possibility of termination.46
Further, the longer the contract lasts, parties’ performance tends to
vary depending on the point reached in the life of the contract. Maxcy et
al.47 looked for ex ante behavior, before the new contract is signed and ex
post behavior, once the contract is signed and concluded that there was
high performance in the last year before a new contract was signed and
such performance would diminish after the first year after the contract
had been signed. So performance may not be smooth across all contract
phases.
4. Other Important Issues Inherent in Long-term Contracts
4.1. Long-term Contracts and the Creation of Barriers to Entry

The first to note the competitive importance of long-term contracts for
parties entering into them were Aghion and Bolton.48 In a well-known
1987 paper, they noted that an implicit effect of long-term contracts is the
bilateral monopoly created by this kind of contract between the parties.
By locking themselves into a long-term contract, parties significantly
reduce the probability of entry by third parties, so that competitors are
denied market access. Therefore, the size of the market of the other con-
tracting party is reduced where each contracting party may become a
monopolist with respect to each other. This situation may be exploited by
the other party in order to maximize the surplus obtained from the other
contracting party.
This has led many authors in the economic literature to consider long-
term contracts to possess strong anti-competitive elements, because the
monopoly created by the parties implies a negative externality of reducing
the scope of the competitive alternatives potentially offered to the object
of the contract.49
Aghion and Bolton50 first claimed that long-term contracts were in
46
See, infra, section 6 on contract renegotiation and breach and section 7 on
termination and remedies.
47
Maxcy et al. compared performance for a three-year average contract length
in both the year before and the year after a new contract is negotiated. In light of
this, they presented a theoretical model in which long-term contracts are desired
by sport clubs in order to mitigate both market uncertainty and uncertainty about
athletes’ future productivity. See Maxcy et al. (2002).
48
Aghion and Bolton (1987).
49
Sibley (2002).
50
Aghion and Bolton (1987).

general socially inefficient because they were frequently signed for entry-
prevention purposes so that they would block and deter entry. They
showed that the contract length will depend on the informational assump-
tion about the incumbent’s costs and finally, whenever there is asymmetric
information, the length of the contract will signal the incumbent’s cost.
Long-term contracts would be preferred by sellers who faced a threat of
entry into the market in order to prevent the entry of more cost-effective
producers.
One of the key assumptions of Aghion and Bolton was that the entrant
could observe the incumbent’s costs when making any entry decision.
Poitevin51 showed that by changing this assumption and considering that
the incumbent signals both to the buyer and to the entrant, the results of
Aghion and Bolton change significantly. If, instead, the entrant cannot
observe the incumbent’s costs,52 Poitevin shows that the nominal length
of the contract does not signal the incumbent’s costs since the incumbent
always signs a contract regardless of its cost level; second, entry will be
completely deterred.53
Rasmusen et al.54 noted that long-term contracts should not be inter-
preted as exclusionary instruments based on parties being a monopoly
and therefore having market power, but as exclusionary agreements that
enable an incumbent monopolist to exclude its rivals cheaply by exploiting
customers’ inability to coordinate their actions.55
Segal and Whinston56 extended Aghion and Bolton’s analysis and
assumed that long-term contracts were complete barriers to entry so that
contracting parties could monitor and enforce a fully exclusionary con-
tract. The resulting bilateral monopoly between contracting parties and
the risk created by specific investments lead to a contractual dynamic that
directly impacts on third parties, such as financial partners or banks, for
example.57 Anticipating such a scenario, contracting parties are hesitant
51
Poitevin (1992).
52
Poitevin justifies modifying this assumption and considers the case where
the entrant cannot observe the incumbent’s costs in the literature on ‘expectational
entry deterrence’ such as Milgrom and Roberts (1982).
53
Poitevin (1992).
54
Rasmusen et al. (1991).
55
In Rasmusen et al.’s model, they consider the scope of entry deterrence by
allowing more than one customer, so that fixed costs are covered. Under these
assumptions, they found two pure-strategy Nash equilibria in which either enough
customers signed an exclusionary agreement and deterred entry or no customers
signed the agreements. See Rasmusen et al. (1991).
56
Segal and Whinston (2000a).
57
Dailami and Hauswald (2000).

to make relationship-specific investments without adequate contractual

protection.58
A common assumption of the above-mentioned papers is that the exclu-
sive contract between the incumbent and a final consumer exerts some
externality on third parties so that exclusive dealing is extremely powerful
in deterring entry. Fumagalli and Motta59 modified a major assumption of
the literature and assumed that one of the parties, instead of being a final
consumer, was a firm that used the input bought either from the potential
entrant or from the incumbent in order to resell it on a final market.60
Hence, such firms would compete in a downstream market where profits
would depend on the one hand on the input price, which would determine
their input demand, and on the other hand, on the price paid by other
competing buyers. In their model, they showed that downstream com-
petition could eliminate the incumbent’s incentives to exclude based on
two effects: first, by making the demand of a single buyer large enough to
attract entry, the negative externality that a buyer would exert on others
by accepting an exclusive agreement would disappear and second, it could
enhance profitability when more efficient than rivals. Consequently, they
noted that the potential for using long-term contracts as anti-competitive
instruments would significantly depend on the intensity of competition in
downstream markets.61
4.2. Specific Investments and Contracting Forms

In a contractual relationship, both parties may need to make certain
investments in order to fully exploit the gains from trade. These invest-
ments may be necessary for any, or almost any, kind of contractual rela-
tionship or they may be specific to the obligations imposed by the contract
itself, so that they will not be valuable outside the contract or outside the
parties’ relationship. Thus, specific investments, once made, cannot be
used in other relationships or businesses or have no value outside the con-
tract or the parties’ relationship. Hence, their value within the contract is
always higher than it would be in any other alternative use.
The consequences and risks inherent in making investments in a rela-
tionship are very different for the contracting parties depending on whether
the investments are general or specific. So, while general investments may
be used in other contractual relationships and, therefore, do not entail an
58
59
Fumagalli and Motta (2006).
60
61

inherently high risk, specific investments are very risky because they are
not valuable in other contractual contexts and become sunk costs.62 These
specific investments are especially important in the context of long-term
contracts because the discrepancy between the value of the assets within
and outside the relationship often tends to be positively associated with the
length of the contract. Moreover, in a long-term contract, due to a higher
lock-in effect, one would expect more acute conflict between the parties in
the contract,63 given that the party who has made higher specific invest-
ments is in a more vulnerable position than the other and will be more
likely subject to the possibility of holdup.64 Of course, in some, or even
many, settings, specific investments are crucial for adequately exploiting
the gains from the interaction, and are essentially unavoidable.
Williamson65 distinguished between four different kinds of specific
assets: physical capital specificity, which stems from investments that
involve tools or other physical assets that have higher value in their
intended use rather than in any other use; human capital specificity, which
results when individuals enhance their human capital, the value of which is
higher in the relationship than outside it; dedicated assets, which are made
– in a factory plant, for example – because they have a certain value where
they are invested and not in any other place; and site specificity, which
refers to the quasi rents generated by savings in inventory and transport
costs under vertical integration, for example. A fifth kind of asset specifi-
city, time specificity, refers to assets that must be used in a certain order or
under a certain schedule.66
The most important holdup risks are manifest in breach of contract or
in unilateral renegotiation.67 Goldberg points out that exposure to the
risk of holdup depends on the access to market alternatives, so that the
more difficult it is for contracting parties to have access to alternative
markets, the more significant the risk of opportunistic behavior would be.
If, instead, parties were to have access to market alternatives, they would
not be so vulnerable to other parties’ strategic behavior and this could
62
For an application of specific investments in the natural gas context, see
Hubbard and Weiner (1986).
63
See Klein (1980); Williamson (1985).
64
De Geest (2006).
65
Williamson (1983).
66
Masten et al. (1991); Pirrong (1993); Williamson (1991).
67
See infra. These risks do not only affect contracting parties, given that they
are also transferred to debt-holders of contracting parties who would be indirectly
vulnerable to opportunistic and strategic behavior by the contracting parties. See

minimize the price divergence between the contract price and the opportu-
nity costs of the parties.68
From a structural perspective, Joskow examines the role of specific
investments in the choice of vertical integration or entering into long-term
contracts, and notes that the relevance of specific investments in vertical
relationships strongly determines the decision to integrate vertically or
enter into contracts.69
In general, there are two instruments that the literature has discussed
in order to minimize the expected costs of making relationship-specific
investments: vertical integrating70or entering into a long-term contract.71
It should be noted that neither of them is generally better than the other.
Coase famously suggested that when the relationship between transac-
tion costs and organizational form is not precise, there is more than one
organizational response to a transaction costs problem.72
Further, Holmström and Roberts claim that the relationship between
transactions costs and organizational form is many-to-many: there are
different governance tasks and various instruments for managing them.
Each task can be addressed by more than one instrument, and each instru-
ment can, alone or in combination with others, be used to address more
than one task.73 However, the two major instruments will be discussed
now.
(i) The vertical integration temptation There is support for the exist-
ence of an important relationship between specificity and the structure of
vertical relationships.74 Specific investments made by contracting parties
often affect the structure of vertical relationships,75 and even the risk of
opportunism will sometimes drive contract parties away from contracts
and toward vertical integration.76
When the value of the investments made by contracting parties is
68
Goldberg (2000).
69
Joskow considered that the allocation of risk between buyers and sellers
is also an important factor in the context of vertical relationships: see Joskow
(1990).
70
Joskow (1990).
71
In the context of coal markets, see Joskow (1990).
72
Coase (1988).
73
Gilson et al. (2009).
74
Hart (1988); Williamson (1985); Klein (1980); and Joskow (1988).
75
Joskow (1990).
76
Industrial organization theory predicts that when parties in the supply chain
have to make transaction-specific investments, they will vertically integrate. See

mutually dependent, each investor tries to induce the other to invest first
in order to extract more favorable terms once an irrevocable commitment
has been made and the specific investments are sunk costs. In order to
avoid that, many parties understand that placing both assets under the
control of a single owner, and therefore vertically integrating, unblocks
this situation because the incentives and risk of holdup disappear.77
This is what happened with the famous acquisition by General Motors
of Fisher Body, where General Motor merged vertically with Fisher Body,
a maker of auto bodies. When this case was analyzed in the early literature,
the merger was thought to reflect a market failure or contracts as a result of
asset specificity – specific investments – and opportunistic behavior.78 The
discussion evolved, with vertical integration between the two companies seen
as a response to an interest in improving the coordination of production and
inventories, as well as assuring General Motors an adequate supply of auto
bodies and access to the talent of Fisher Body officers.79 However, opinion
today is divided and there is still discussion regarding the motivation that
resulted in the merger between General Motors and Fisher Body.80
(ii) Contractual solutions to the holdup problem When a contract is

used to govern a transaction in which the consequences from holdup
are significant due to the presence of relationship-specific investments,
contracting parties, aware of the problem, may well try to solve it ex ante
and incorporate safeguards in the contract in order to protect these invest-
ments from opportunistic behavior from the other party.81
But when parties decide to draft a contract in order to minimize the risk
of holdup, the major challenge contracting parties face is drafting a suf-
ficiently complete contract so as to adequately mitigate the risk of appro-
priability of the specific investments made by one of them.82 Empirical
research on this issue shows that the existence and relevance of specific
investments is positively correlated with contractual completeness. 83
77
78
Klein et al. (1978); Williamson (1985); Hart (1995).
79
Casadesus-Masanell and Spulber (2000).
80
See Coase (2000, 2006) and Klein (2006), where the author claims that the
contract adjustment between General Motors and Fisher Body demonstrates the
importance of distinguishing between a threat of an inefficient holdup and the eco-
nomically efficient way in which it takes place.
81
Poppo and Zenger (2002); Goldberg and Erickson (1987); Joskow (1988).
82
Joskow (1988); Goldberg and Erickson (1987); Poppo and Zenger (2002);
Reuer and Ariño (2007).
83
See Poppo and Zenger (2002); Goldberg and Erickson (1987); and Joskow
(1988).

But contract drafting does not entirely solve the contract risks or hold-
up problem presented by specific investments and the parties’ incentives
to appropriate these investments made by the contracting parties. The
problem of contract drafting and of completeness is that while it solves
certain issues, such as being able to address and anticipate potential con-
tractual risks, including the risk of appropriability, it also reduces contract
flexibility so that specificity sometimes makes it difficult to adjust to poten-
tial contract risks that are not foreseeable when the contract is drafted.84
In this sense, the commitment necessary to create incentives for making
specific investments increases the contract surplus but at the same time
conflicts with the flexibility needed in long-term transactions.85
Further, the contractual solution to relationship-specific investments
could also entail significant costs in terms of litigation86 and might not
be a perfect instrument. Joskow noted that a long-term contract could
help protect specific investments made by buyers and sellers but it is very
imperfect given the impossibility of drafting a complete contract that, once
signed, and once specific investments are sunk, cannot adapt to changes in
market conditions, and therefore not be entirely able to avoid the holdup
problem for the party making the investment.87
Despite the challenges presented by the contract solution to holdup
problems, it is worth noting that the transaction cost theory claims that
learning between contracting parties improves contract design and the
final outcome and performance of the parties.88 When firms learn from
and have experience of each other they are able to assess the risk of
opportunistic behavior by the other, and learn to design more complete
contracts. Hence, they do not need to anticipate and contract ex ante over
such contingencies, but may cooperate and solve the situation when it
appears. Thus, by cooperating and learning from each other, parties gain
experience to identify the risks involved in the relationship and how to
efficiently address such risks when they occur.89 This may be particularly
relevant in industries with high investment costs and high innovation
elements.
Gilson et al. summarize the evidence on vertical disintegration in
technology-based industries.90 Producers cannot innovate in cutting-edge
84
Solís-Rodríguez and González-Díaz (2009).
85
86
For evidence, see Solís-Rodríguez and González-Díaz (2009).
87
Joskow (1990).
88
Williamson (1985).
89
Solís-Rodríguez and González-Díaz (2009).
90

technology in every field required for the success of their product, and
increasingly companies choose to buy innovation from other companies
through contracts.91 But specific investments ex ante are significantly
high, and collaboration and a long-term relationship between both parties
are necessary. This environment is what Gilson et al. characterize as
contracting for innovation.
Thus, cooperation ex post is necessary in order to interpret the uncer-
tainties contained in the contract and to renegotiate contract clauses when
necessary. The long-term nature of the contract may increase associated
uncertainty and risk, albeit it will be compensated by learning about the
parties’ propensities to behave opportunistically, which will consequently
be significantly reduced and therefore the relationship between the con-
tracting parties will strengthen. Through ongoing cooperation, contract-
ing parties can design governance and dispute resolution mechanisms in
long-term contracts that will increase contract surplus.
Cooperation and learning will directly impact the contract design
through creating knowledge and routines that raise the parties’ switching
costs and through devising a dispute resolution mechanism that builds
mutual knowledge of the propensity to reciprocate while deterring oppor-
tunistic behavior that could undermine the cooperative equilibrium.92
Consequently, the collaboration process itself raises the costs of taking
advantage of the other party’s specific investments.
This account of contracting for innovation fits into the more general
hypothesis presented in the transaction cost literature concerning how
firms develop governance mechanisms in their inter-firm relationships in
order to reduce transaction costs and thus to become more efficient.93
5. Contract Drafting and Design

Truly complete contracts do not exist.94 They are ‘hypothetical contracts
that describe what action is to be taken and payments made in every pos-
sible contingency’.95 But under incomplete information conditions, it is
too costly for contracting parties to foresee and contract over all potential
outcomes or contingencies that could take place during the life of the
contract. Contracting costs take place both ex ante, when anticipating
contract contingencies and outcomes, and ex post, when the contract has
to be enforced. It is exceedingly costly to specify all potential states of
91
92
93
Williamson (1985).
94
Williamson (1985).
95
Milgrom and Roberts (1992).

the world, as well as to prove that one such state took place. Uncertainty
about the future and the cost of writing complete contracts are essential
elements when determining the contract length.96
The difficulty of drafting complete contracts does not necessarily mean
that parties have no incentives to take into account as many contingen-
cies as possible in order to minimize contract uncertainty as much as they
can. Contracts generally include the rights and obligations of each party,
the solution to potential contract contingencies, and how the relationship
between contracting parties will be structured and governed. And, as firms
gain experience, they probably learn to design more complete contracts.97
Still, long-term contracts cannot completely specify in advance all the obli-
gations of both parties over the life of the agreement, and in order to adapt
their relationship to changing circumstances they will find it necessary to
give one, or both, parties the discretion to respond as new information
becomes available.98
Increased contract completeness in long-term contracts, while having
positive properties – it may solve issues such as anticipating potential con-
tractual risks, including the risk of opportunistic behavior by parties – also
reduces contract flexibility so that the contract becomes more difficult to
adjust to risks and new contingencies, and is, thus, no panacea. The com-
mitment necessary to create incentives for parties to make specific invest-
ments and maximize the contract surplus could be seriously undermined
by the lack of flexibility that is needed in long-term transactions.99
When drafting a long-term contract, parties have to define the contract
terms either before, or after, the specific investment is made. Defining con-
tract terms before any specific investment is made requires information that
may or may not be yet available. Drafting a contract after specific invest-
ments have been made may distort the power structure of the relationship
between contracting parties because one of the parties, specifically the one
making the specific investment, will not be totally free to decide, in light
of the specific investment having already being made. Hence, when draft-
ing a long-term contract, parties have to choose between an uninformed
decision, or a subsequent potentially distorted decision.
96
The key question when analyzing the relationship between contract length
and contractual incompleteness is determining what contingencies parties should
leave out of the contract. Aghion and Bolton (1987).
97
Contracts cannot be completed without having a previous experience of
different problems and contingencies arising from former exchanges. See Solís-
Rodríguez and González-Díaz (2009).
98
Goldberg (2000).
99

Parties may respond differently to informational problems in terms of

the completeness of the contract. There is a taxonomy100 of responses that
looks at over-completeness, under-completeness and a mix between these
two. Over-completeness is one of the possible strategies for parties in a
long-term contract, because parties may want to draft an extremely detailed
contract to try to anticipate most contingencies. A possible advantage of
some over-completeness is the fact that when parties negotiate the terms,
they have not made the specific investments necessary for the performance
of their contractual obligations, and the solutions and safeguards in the
contract may improve the incentives for those investments. At the same
time, given the time frame, the specific provisions in the contract will very
likely be interpreted and enforced under different conditions and in a differ-
ent context from that in which they were drafted, and this may cause courts
to reinterpret them and often not to enforce them. Sometimes, though, in
light of the long nature of the relationship, parties may consider that leaving
some contingencies or circumstances open could be a good strategy in order
to be able to renegotiate their relationship in light of evolving contract con-
ditions, or to allow a third party, such as a court, to fill the gaps left by them.
Under-completeness presents the drawback that when parties renegotiate
or where a third party fills the gap, specific investments have already been
made, and parties are in a monopoly situation with each other.
Trade-offs of this kind have been explored in the literature. Hubbard and
Weine101 model a contract that could solve the bilateral bargaining problem
in the natural gas context where there was a high amount of transaction-
specific capital with little value outside the relationship. Once the gas well
development costs are sunk, a pipeline faces the temptation to appropriate
some of the rents from production. In light of this, the producer demands
a long-term contract with adjustment clauses beforehand.102 Many mecha-
nisms, such as flexible pricing, for example, have been created in order to
decrease the return on opportunistic behaviour by one of the contracting
parties once the specific investment has been made.103
The inequality in the parties’ position concerning the need and cost of
specific investments has also been discussed. When they are unequally
distributed between parties, each party’s negotiation position will depend
on whether the contract terms are fulfilled, or whether if the contract is
100
De Geest (2006).
101
Hubbard and Weiner (1986).
102
Generally, guaranteed supply clauses, price and take or pay provisions,
because gas well companies are best operated near full capacity. See Hubbard and
Weiner (1986).
103
Goldberg (2000).

breached, the party who invested more in the relationship will lose more
than the other party.
Some104 argue that it would be desirable for this purpose to have both
parties investing symmetrically in the contract relationship so that the
opportunistic behavior of parties trying to renegotiate would decrease105
and that if renegotiation were to take place, the party who invested more
would receive the most.
The argument, however, does not take into account that many other
factors, such as position in the market or in the industry are also relevant
factors when deciding whether to strategically renegotiate the contract
terms. Even if parties make specific investments of equal amount, if they
occupy unequal bargaining positions or have a different share of the
market or a different position in the market, so that they need to create
a reputation among others, they may still have incentives to strategically
renegotiate or oppose renegotiation.
Dailami and Hauswald106 analyze how in the face of contractual incom-
pleteness, contract risks are transmitted and allocated between different
contracts and investors, in particular in the context of the relationship
between the off-take and financial contracts because the former serves as
security for the latter, since such long-term supply contracts are necessarily
incomplete and subject to opportunistic behavior.107
6. Contract Renegotiation v. Contract Breach

As explained in the previous section, incompleteness is inherent in con-
tracts, and large degrees of incompleteness are pervasive in long-term
contracts. Hence, parties will leave out of their contract and therefore out
of their negotiations certain terms regulating certain contingencies that
may or may not take place. This uncertainty implies that, despite the com-
mitment present in long-term contracts,108 there is an element of potential
conflict and disagreement between parties when one of these unanticipated
contingencies takes place. Most contracting parties, aware that conditions
change during the life of the contract and of the extremely costly and even
impossible option of foreseeing and allocating contract risks, may prefer
to adjust the contract to the changed circumstances.109
104
De Geest (2006).
105
Becker (1962) and De Geest (2006).
106
107
108
Salanié (1997).
109
Sometimes, even when parties do not expressly state it, it is clear from the
contract terms that they intended to do so. See Goldberg (1985).

Joskow distinguishes between the voluntary and involuntary renegotia-

tion that would take place when contractual terms are left unperformed,
amounting to a breach of contract.110 In the first case, when both parties
want to renegotiate contract terms, it will not be possible to hold parties to
the contract.111 In the second case, the case of breach, the non-breaching
party may either enforce the contract whenever possible, or seek damages
depending on what remedies are available to the court and how significant
the costs of using the legal system are.112
Parties may want to renegotiate the contract and agree as to how to
resolve the contingency, or accept that there has been a breach of contract so
that it will be for courts to determine whether the contract has been breached
and what the parties will be required to do as a result. However, it should
be noted that the incentives and consequences of incomplete contracts are
different depending on whether the solution was reached by and between
contracting parties through renegotiation, or was provided by the court.
6.1. Renegotiation
If parties had perfect information, it might be possible for contracting
parties to define and determine the circumstances of renegotiation and
even to exclude it, if parties would prefer to do so.113 Hence, if parties had
complete information, they could draft contracts that could even exclude
– if at all possible – the possibility of renegotiation, and therefore would
be renegotiation-proof.114
Given that it is not possible for contracting parties to draft complete
contracts, they will enter into incomplete contracts so that renegotiation
will be necessary whenever an unforeseen contingency takes place.115
110
Joskow (1990).
111
See generally Mahoney (2000).
112
For example, if the remedy were specific performance, the contract could
only be enforced if both parties agreed on such a remedy because otherwise specific
performance will not be an available alternative. See Jolls (1997).
113
Hart and Moore show how the contract can be constructed ex ante to affect
the bargaining power of the two parties ex post. See Hart and Moore (1988).
114
Contracts which are renegotiation proof can still improve the ex ante versus
ex post problem – ex post sharing of the contract surplus may not be ex ante efficient
– presented by the possibility of renegotiation by designing the environment of the
renegotiation in the unverifiable state for a third party and where the information
between parties is symmetric. See Hart and Moore (1988) and Dewatripont (1989).
115
When information costs are high, parties may emphasize ex post efficiency
rather than ex ante efficiency and will seek to balance both elements and draft a
formal contract with vague standards so that it may be renegotiated ex post and
adjusted to the contingencies that may take place during the life of the contract.
See Gilson et al. (2009).

Based on the commitment of the parties to each other, each party makes
specific investments and relies on renegotiating the contingencies that are
not specifically addressed in the contract.116 There may be scope for rene-
gotiation when ex ante efficiency determines ex post inefficiency.117
The parties’ incentives for renegotiating the contract might not be
symmetric when the parties’ reputation is considered. So reputation
may constrain one party’s incentives to renegotiate or unilaterally adjust
contract provisions so that the likelihood of opportunistic behavior
by this party is low. As a consequence, the other contracting party,
having less reputational interests to protect, may even benefit from the
greater discretion of the more reputed party in determining the desired
performance.118
The prospect of renegotiating presents advantages and disadvantages
for parties. On the positive side, it has the clear advantage of creating flex-
ibility to achieve ex post efficiency without incurring high costs ex ante in
trying to foresee all potential contingencies between the parties.
If renegotiation is taken into account once the contract is drafted, ex
post opportunistic behavior may be either reduced or even totally elimi-
nated. Gilson et al. suggest that in order to eliminate the risk of hold-up,
renegotiation should be regulated so that parties would determine how to
share the benefits and surplus created by the contract and therefore assure
both ex ante and ex post efficiency, whenever possible.119
Once parties have renegotiated and the uncertainty is solved, they can
perform the contract, modify the terms of the contract, withdraw from
the transaction, or write a new contract. The renegotiation solution can
achieve an ex post efficient result through negotiation as the Coase theo-
rem120 predicts: if the contract were to be profitable for one of the parties,
the other party, who would not be interested in enforcing the contract,
could bribe the other contracting party in order to withdraw the contract
and therefore not to enforce it.
On the downside, renegotiation also presents serious disadvantages.
The choice of whether to renegotiate contract terms voluntarily will
depend on how likely this renegotiation is going to be. As mentioned
earlier, if there is room in the contract for renegotiation, it will most
116
Salanié (1997).
117
Bolton (1990).
118
This result was obtained by Arruñada et al. (2001) in the context of the
automobile distribution industry in contracts between manufacturers and auto
dealers.
119
120
Coase (1937).

likely take place, and hence, contract breach and related litigation will
be avoided. It is difficult to see how the legal system, under freedom of
contract, can prevent renegotiation – which is a form of contracting – to
happen if parties leave room for it in the contract. But if renegotiation
is likely and parties are aware of it, long-term contracts would be a very
inefficient instrument for parties because the value of commitment –
which is one of the good qualities of contracts in general, and especially
one of the added values of long-term contracts – will be substantially
eroded, and therefore parties would not have proper incentives to make
efficient specific investments.
First, there is the moral hazard problem arising from the level of effort
that an agent might choose. If the agent chooses first the level of effort,
the principal will not be able to make the agent choose the optimal level of
effort, and renegotiation will result in inefficiencies.121
Also, renegotiation raises the chances of holdup for the party making
the investments and undermines the incentives to make specific invest-
ments in the first place.122 This causes serious inefficiencies and undermines
the ex ante advantages presented by renegotiation. When there is uncer-
tainty, parties seek to minimize contracting costs and balance the benefits
of commitment and flexibility with the costs of uncertainty and the risk of
potential holdup.123
Further, whenever parties are aware that renegotiation will take place,
the literature124 has shown that the revelation of information between con-
tracting parties slows down because of the trade-off between incentives to
renegotiate and the incentives to reveal private information.
Finally, as can easily be foreseen, renegotiation is costly. Goldberg125
has noted that parties, aware of this, anticipate the potential costs of
renegotiation and introduce price mechanisms in long-term contracts in
order to avoid the costs of renegotiation, thereby increasing the expected
value of the long-term contract. The larger the uncertainty or the variance
of contract outcomes, the more resources would be devoted to the con-
tract drafting effort.126 Hence, anticipating future renegotiation costs may
increase the contract drafting process.127
121
Chiappori et al. (1994).
122
123
124
See in general Dewatripont (1989); Hart and Tirole (1988); Laffont and
Tirole (1990).
125
Goldberg (1995).
126
Goldberg (1995).
127
Goldberg and Erickson (1987).

6.2. Court Adjustment

Long-term contracts include a component of commitment and coopera-
tion so that often parties will settle their differences so that they can main-
tain a constructive relationship and preserve the businesses’ goodwill and
reputation.128 But reaching a renegotiated solution between themselves
sometimes will not be possible. Hence, whenever contracting parties are
not able to reach an agreement and fill the contract terms in order to
address the unforeseen contingency, a court will have to adjust, interpret
or fill the contract gaps.129
Whether and how courts should interpret incomplete contracts is a
highly debated matter. Schwartz130 suggests that any analysis of contrac-
tual interpretation should answer two questions: first, whether courts use
broad or narrow evidentiary bases in determining the meaning of the con-
tract’s language and second, whether courts should always admit the pos-
sibility that the parties wrote in a private language and therefore should be
entitled to provide an interpretation of the incomplete contract.
The first issue refers to the question of what evidence should be admit-
ted in order to interpret the incomplete contract. When courts decide con-
tract cases where contracts are incomplete, courts generally pursue three
strategies:131 protecting process values, interpreting language and filling
the contract gaps so that they supply terms when the parties’ contract fails
to provide for the dispute that divides them. The norms and language that
should be used in order to decide contract cases is not unanimous among
law and economics scholars: while some consider that courts should use
norms that transcend the relationship, such as fairness, others understand
that such norms should be provided by normative desirable terms that
parties should be free to vary.132 But it should be noted that when contracts
are incomplete as a consequence of parties’ asymmetric information, courts
should not follow the above-mentioned strategies and treat incomplete con-
tracts as if they were complete, so they interpret the contract as written.133
128
Hillman (1987).
129
It is often argued that the party making the highest specific investment faces
a higher cost the more specific is the investment because of its exposure to the risk
that the other contracting party will walk away from the contract, especially when
there are other suppliers available in the market. Therefore, one of the parties – the
one assuming a lower specific investment – has an implicit real option through
breach of contract. See Dailami and Hauswald (2000) for a discussion of this situ-
ation in the context of the Ras Gas Project.
130
Schwartz and Scott (2003).
131
Schwartz (1992).
132
Schwartz (1992).
133
Schwartz (1992).

Some authors claim that the goal of the court’s interpretation of con-
tracts should be to facilitate the efforts of contracting parties to maximize
the joint gains – the contractual surplus – from transactions. Another
theory, the negative claim theory, suggests that this is all courts should
do.134 In the US, a majority of jurisdictions applies a literal interpretation
of contract terms, mostly based on an application of the plain meaning
rule.135 In Europe, the approach suggested by the European Commission
in the Principles of European Contract Law is to give effect to the inten-
tion of the parties regardless of whether this intention is reflected by the
works used.136 Scott137 justifies formal interpretations because they offer
the best prospect of maximizing the value of contractual relationships,
especially considering that contract interpretation often finds competent
parties together with incompetent courts.138
Nevertheless, there is a general tendency in the literature to favor
restricting the evidence that courts may use to interpret a contract based
on the argument that parties should be allowed to save costs from contract
interpretations on minimal evidentiary bases even if, in any given case,
the odds of an accurate interpretation would be higher with a broader
base.139
Once a court has determined the evidence admissible to interpret the
contract terms, the second issue is whether parties’ language in the contract
134
135
Scott (2000).
136
Article 5.101(1) of the European Principles of Contract Law provides
that
(1) A contract is to be interpreted according to the common intention of

the parties even if this differs from the literal meaning of the words.
(2) If it is established that one party intended the contract to have a
particular meaning, and at the time of the conclusion of the contract the
other party could not have been unaware of the first party’s intention,
the contract is to be interpreted in the way intended by the first party.
(3) If an intention cannot be established according to (1) or (2), the
contract is to be interpreted according to the meaning that reasonable
persons of the same kind as the parties would give to it in the same cir-
cumstances.
The European Principles of Contract Law can be found at: http://frontpage.

cbs.dk/law/commission_on_european_contract_law/PECL%20engelsk/engelsk_
partI_og_II.htm.
137
Scott (2000).
138
Scott (2000).
139

before the court or the court itself should provide the interpretation.
Schwartz and Scott140 argue that the parties’ sovereignty in the contract
requires courts to delegate to them the choice of the contract’s substantive
terms and the interpretative theory that should be used to enforce those
terms.141 Firms and contracting parties are suited to creating their own
contracts, while the state is best suited to create the broad structure within
which parties’ contracts fit. Hence, their roles are different and they should
act accordingly.
In order to have a successful intervention by courts in providing a con-
tract solution that parties have not managed to attain by themselves, a
certain level of definiteness will be needed.142 Generally, when contracts
include clear terms and define parties’ obligations, parties may be able
to avoid many disputes of interpretation, for example.143 But clear provi-
sions will also be useful when courts need to act, because if courts could
not enforce the contract terms, some efficient transactions may be deterred
and inefficient ex post negotiations may take place.144 Court adjustment
may be appropriate in some circumstances that are sufficiently identifia-
ble.145 Whenever contract clauses are not definite or clear enough, some
courts will disregard them and invoke the parties’ good faith when deter-
mining the solution of the parties’ dispute.146
The contract literature disputes whether court-imposed solutions
possess advantages. Dawson147 opposes court adjustment of long-term
contracts because he understands that courts lack sufficient standards
to redesign the contract so that it reflects the parties’ ex post agreements
based on what they would have agreed ex ante. Dawson understands that
courts enjoy an excessively unlimited discretion to create a new contract
and further, that the parties’ duty to adjust can override express contract
terms.
Different factors may predispose courts to activism when adjudicating
140
141
142
Joskow (1990).
143
Hillman (1987).
144
Joskow (1990).
145
Dawson (1984).
146
See Goldberg (2000) regarding contract clauses concerning quantity bound-
aries. Goldberg claims that contract tailoring by parties may create an incentive
for them to take into account and hence internalize their reliance interests, which
could be done much more efficiently by parties than using the good faith standards
of the courts.
147
Hillman analyzed the different approaches in the literature to the court
interpretation and adjustment of incomplete contracts. See Hillman (1987).

incomplete contracts:148 process values are offended in the contract forma-

tion or in the court of performance; enforcement of the contract adversely
affects third parties; the contract directs a result that is substantially unfair
to one of the parties; and the contract is incomplete and the court can
complete it with a term that parties will accept and courts will be able to
apply. But the court’s scope of discretion is not unlimited. The parties’
bargaining over a contract term and the parties’ purpose in including a
certain provision are crucial in determining whether the court adjustment
should trump an express contract provision.149
Further, another important issue beyond the scope of this chapter is
to determine how courts should approach a contract dispute in order to
properly decide the issues at stake.
7. The Content of the Contract: Breach, Termination, Remedies, and

Non-Compete Clauses
7.1. The Problem of Verifiability of Non-performance

We have already highlighted the essential incompleteness of long-term
contracts. Even if incomplete contracts are the inescapable rule in any
ordinary setting of economic interaction, where long-term contracts are
the norm, the extent of incompleteness is even stronger and more deci-
sive. Long-term relationships have, by their very nature, a more extended
time horizon than spot or short-term contracts. The number, influence,
complexity, and difficulty and cost in anticipation, of contingencies that
can, in one way or another, have an effect on contractual outcomes, dra-
matically increases. This is why economists, when approaching long-term
contracts, have routinely assumed that contracts between the parties are
incomplete.
This makes the long-term relationship typically a relational contract:
many of the relevant actions cannot be foreseen and specified when the
contract is signed, and it is in the course of the ongoing relationship that
the parties will adopt those actions, based upon a set of incentives arising
from factors (personal, institutional) that differ from the formal contract
and legal rules in contract law.
Of course, a relational contract in this sense cannot be enforced purely
148
Schwartz (1992).
149
Courts face difficult challenges because good faith is the parameter appli-
cable to parties when they interpret a contract term and such a principle is based
on business expectations but courts face the challenge of determining the content
or interpretation of a contract term in circumstances different from the ones of the
moment when the contract was entered. See Hillman (1987).

as written150 by a court or arbiter.151 This does not mean that no contrac-

tual clause nor contractual behavior by the parties is able to be legally
enforced. Some instances of indisputable breach of contract – departures
from the cooperative equilibrium, or lack of performance – can be detected
by the contractual partner, and verified in front of a court, and thus can
be deterred by the use of legal remedies, such as specific performance and
damages.
However, there is always the possibility of a wide variety of cases of
non-cooperative behavior within the contractual relationship that pose
insurmountable measurement problems, particularly when those behav-
iors are multi-dimensional. The chances that non-complying contractual
behaviors can be shown, in a sufficiently convincing manner, to a court
or other external adjudicator, is very low. Further, the amount and scope
of unverifiable breaches of contract would tend to increase not only with
the chances that the breaching party would escape undetected or not
be subject to legal contractual remedies, but also with the chances that
consumers would not detect or punish the defecting distributor.
Parties to a long-term contract can resort to several alternatives that can
serve as – imperfect – substitutes for perfect court enforcement of contrac-
tual remedies against verifiable breach of contract.152 First, the contract
can use, instead of a non-verifiable dimension, some veriafiable proxy for
the desired contractual behavior, and thus make use of legal enforcement
of this proxy, given that courts could use legal remedies for its breach.
Second, the contract can contain clauses that tend to decrease the benefits,
and to increase the costs, of behavior of the other party deviating from
the cooperative pattern. In other words, they can try to introduce clauses
in the contract that serve as mechanisms facilitating its self-enforcing
character.
Of particular importance among the self-enforcing mechanisms that
are an alternative to legally formal enforcement, and specially relevant for
the legal treatment of termination and compensation after termination, is
150
On many occasions nothing is written, and the contractual intention has to
be inferred from the behavior of the parties, prior or posterior to the initiation of
the relationship.
151
This is the reason why the quest, in this area of relational contracts, of the
economic literature has been how to design self-enforcing relational contracts, that
is, contracts in which the parties are induced to adopt the best available actions for
the common good, based on their own strategies, but checked by reciprocity, repu-
tation, or other intrinsic motivators. This is, as well, the reason why economists
often view with mixed feelings the function of the law in this sort of setting.
152
See Mathewson and Winter (1985); Klein and Murphy (1988); Klein (1995)
and Paz-Ares (1997, 2003).

the use of future quasi-rents for the distributor linked to the continuation
of the relationship:153 if the terms of the contract are adjusted so that one
of the contracting parties expects to earn quasi-rents on its investments,
if and only if the existing relationship goes on, that party has a powerful
motive to remain into the contract, and thus to avoid the kind of negative
behavior that can trigger the end of the relationship.
It should be noted, though, that in order to make this instrument of
relation-specific quasi-rents work as an incentive mechanism to achieve
cooperation in dimensions outside what can be verified by a court, pre-
serving the effectiveness of the threat of termination is crucial, a point that
has been underlined by several commentators.154
7.2. Specific Investments and Breach Remedies

As mentioned earlier, specific investments are relationship-related invest-
ments so that their value depends on whether parties are within or outside
the contract terms. The nature of such investments, as summarized above,
poses important challenges for optimal investment decisions. The presence
of specific investments also affects decisions to perform or breach, and to
terminate or to go on with the relationship. It is easy to observe that the
holdup problem makes the party with higher specific investments more
vulnerable in all dimensions of the relationship.155 Therefore, whenever
parties make investments that are mostly relation specific, the costs of
ending the contract are high for the party making the investment and,
therefore, this party will have a much lower incentive to terminate because
this will be very costly. In contrast, if investments are not relation spe-
cific and therefore may be used outside the relationship, the incentives to
terminate the contract will increase.
The presence of specific investments also affects decisively the working
of the standard legal remedies against breach of contract, and thus,
given the pervasive presence of such investments in long-term contracts,
the effects of breach remedies in these may be quite different from what
happens in spot contracts.
For the analysis on parties’ incentives to perform and to invest, a
further distinction within specific investments is necessary. The economic
153
The pioneering analyses along this line are by Rubin (1978); Klein (1980);
and Klein and Leffler (1981).
154
Klein (1995) underlines the importance of termination-at-will for the effec-
tiveness of self-enforcing mechanisms, and how legal constraints – mandatory
severance payments or compensation, or good cause requirements – severely limit
this option. See also, Paz-Ares (1997, 2003).
155
See Williamson (1985) and Hart and Moore (1988).

theory literature dealing with incomplete contracts has distinguished two

pure types of such investments. Selfish investments are investments that
benefit the party making the investment, and not the other party: if the
buyer makes the investment, it just increases the value of performance
for the buyer, without decreasing production costs for the seller; if the
seller makes the investment, it just decreases its production costs, without
increasing the value of performance for the buyer.
Cooperative investments156 are investments that confer direct benefits on
the other contracting party, and not on the party making the investment.
If the buyer makes the investment, it just decreases the production costs
for the seller, without increasing the value of performance for the buyer; if
the seller makes it, it just increases the value of performance for the buyer,
without decreasing production costs for the seller. There are also hybrid
investments that benefit both contracting parties, the investor and his
partner, although we will disregard this complication in what follows.157
For selfish investments, the solutions explored in the economic lit-
erature have evolved in two directions. First, to design mechanisms in an
incomplete contract that can achieve an efficient outcome, both in terms
of trade and in terms of specific investment. Most contributions explore
ingenious procedures in the bargaining conditions in the renegotiation
phase of the contract, so that the party making the investment receives the
full value of the investment. Some opt to place external conditions on the
renegotiation phase,158 others for the use of options and appropriate strike
prices for their exercise.159 Other approaches rely on contracts determin-
ing intermediate quantities to trade, so after renegotiation it turns out
that the investing party receives in some cases more and in some cases less
than the marginal social value of the investment, and if the quantity is
adequately chosen in the contract, both effects may cancel out and in the
end induce efficient levels of investment. These approaches, however, have
only limited applicability to the design and operation of legal rules in the
contract setting.160
156
The first treatment of cooperative investments is that of MacLeod and
Malcomson (1993). For the standard treatment of these investments, see Che and
Chung (1999); Che and Hausch (1999). For a very interesting recent contribution
on contract remedies and specific investments, showing that the dismal result –
concerning expectation damages – of Che and Chung (1999) is but an extreme case,
see Stremitzer (2008).
157
In fact, few papers explore hybrid investments: Che and Hausch (1999);
Segal and Whinston (2000b); Göller and Stremitzer (2009).
158
Chung (1991).
159
Nöldeke and Schmidt (1995).
160
Edlin and Reichelstein (1996).

The second strand of the literature on selfish investments specifically

deals with legal remedies against breach, and with their impact on the
investment decision by the parties (also on the decision to perform or to
breach the contract, but let us leave that aside).
The pioneering contribution here is by Shavell.161 He addresses two
scenarios. The first is the one in which the investing party is the party that
may be the victim of breach. He then shows that expectation damages
induce excessive specific investment by the potential victim of breach.
The reason for this effect of over-reliance lies in the fact that expectation
damages fully insure the investing party against the possibility of losing
the return on the investment, more than is optimal from the point of view
of the joint welfare of the parties: even when there should be (and there is)
no trade, that is, when the contract should not be performed, the investing
party gets the full return from the investment. Reliance damages perform
even worse than expectation damages, that is, they induce even more over-
investment. The reason is that to the full insurance motive to over-rely
(reliance damages fully insure the investing party because in all possible
future states of the world, he obtains at least restitution of the cost of the
investment) now has to be added a performance inducement function: by
investing more in specific assets, the party directly increases the damage
award the other party has to pay in case of breach, thus increasing the
incentives of the latter to perform. These results have been to an impor-
tant degree confirmed by experimental tests of contracting behavior in a
controlled laboratory setting.162
The second scenario appears when the investing party is the one who
can take the decision to breach or to perform the contract. In this case,
expectation damages induce efficient investment: the breaching party is
the residual claimant of the value of the investment (the reduction in cost
of production, for instance), because the damage award he has to pay (the
value of performance to the other party) does not depend on the level
of investment. Reliance damages also perform worse than expectation
damages, although in a different direction than in the first scenario. Given
that reliance damages generally induce too little performance with respect
to the efficient level, the investing party will get a return on the specific
investment that is less than optimal, and therefore the incentives to invest
would be too low.163
Shavell’s analysis in the first scenario (the investing party is not the one
161
Shavell (1980).
162
Sloof et al. (2003).
163
Shavell (1980).

making the breach–perform choice) was extended along two different

lines. First, that post-breach renegotiation by the parties does not alter
the inefficient investment incentive under both expectation and reliance
damages, and also the ranking of the two remedies: reliance damages are
less attractive than expectation damages in order to provide less inefficient
investment incentives.164 Second, that with an appropriate instrument, one
can transform the first scenario into the second one, that is, that the invest-
ing party is the one that can take the decision to breach or to perform.
The instrument is a large up-front payment from the buyer to the seller
(assuming the seller is the party who can invest), which ensures that the
buyer would never want to breach – he would get performance for a price
close to zero, because the up-front payment is sunk when the perform-
ance decision arises. Then, any breach would come eventually from the
investing party, who has efficient breach and investment incentives under
the expectation damages remedy.165 It is true, though, that using up-front
payments can have problems of their own (basically liquidity problems on
the part of the prospective buyers, or the non-investing party more gener-
ally), but it clearly shows how the investment problem can be solved, for
selfish reliance expenditures, by concentrating the decision to breach, and
the decision to invest, in one and the same party.
The question is more complex still for cooperative specific investment.
It can be shown that if the parties cannot commit not to renegotiate the
contract, there is no incomplete contract, however complex, that can
induce efficient incentives.166 In fact, the dismal result is that a contract is
no better for the parties than no contract at all.167
For these cooperative investments, the role of legal remedies against
breach has also been explored, both absent renegotiation, and when ex
post renegotiation is feasible, usually considering that the investing party
is not the one that can take the breach–perform decision.168 In the first
case, with no renegotiation, expectation damages perform very poorly,
because as a remedy for breach, they induce zero cooperative invest-
ment. Reliance damages, in turn, do much better according to Che and
Chung: although at the price of some distortion – in the direction of
164
Rogerson (1984).
165
Edlin (1996).
166
Che and Hausch (1999) and Maskin and Moore (1999).
167
Stremitzer (2008) shows that if the contract can be conditioned (that is,
courts are able to verify) on whether performance is above or below a given thresh-
old – of quality, as paramount example – under certain conditions first best can
be attained.
168
Che and Chung (1999).

excessive breach – in the breach–perform decision, they provide much

better incentives for specific investments, and overall improve contractual
surplus over expectation damages. With efficient renegotiation ex post,
expectation damages continue to perform as poorly as before, but reliance
damages can now achieve efficient incentives, both to perform and to incur
cooperative specific expenditures.
There is also a defense of expectation damages in this setting, albeit not
ordinary expectation damages, but bilateral expectation damages. This
implies that the party who can breach can be subject to paying expectation
damages to the other party, the investor; but the latter can also be liable in
front of the former if the level of investment falls short of the level deter-
mined in the contract. If this is the case, bilateral expectation damages do
also induce efficient trade and efficient cooperative investments.169 For
this result to hold, it is necessary not only that the actual level of invest-
ment can be verified before the court (a condition for reliance damages to
operate as remedy against breach, to be sure), but also that the parties can
fix in the contract the efficient level of cooperative investment, which is a
much more implausible – though not impossible – assumption.
Finally, in a recent paper,170 it has been argued that the extremely poor
– zero cooperative investment – efficiency performance of expectation
damages (the preferred remedy for breach of contract in common law,
and also heavily used in civil law jurisdictions in many contexts) is due to
an implicit assumption that the contract does not contain any threshold of
performance, and that the court cannot imply one either. If, on the con-
trary, the contracting parties or the courts are able to compare performance
with a verifiable legally binding threshold (over the relevant dimension of
performance), expectation damages generally induce positive – albeit
suboptimal – levels of cooperative investments, and under certain condi-
tions (those of the so-called maximum quality or Cadillac contracts),171
they can even provide incentives for efficient investments of a cooperative
nature. This chapter also favors, when renegotiation is possible,172 the use
of an optional173 remedial regime for the non-investing party, consisting
of a choice between specific performance and termination – with restitu-
tion of payments made, if any – if performance of the investing party falls
169
Schweizer (2006).
170
Stremitzer (2008).
171
Edlin (1996).
172
It is well known that absent renegotiation, specific performance is likely to
produce inefficient trade and thus undesirable results: Shavell (2004).
173
The use of optional regimes has not often been considered in the literature,
with the exception of Avraham and Liu (2006, 2008).

below the legally enforceable threshold. Above the threshold, only specific
performance would be available for either party.
7.3. Covenants Not to Compete

Long-term contracts often have effects even after the contract has ceased
to be in force and the relationship has ended. Covenants not to compete
are frequently observed as contract clauses in long-term contracts, and at
face value they serve to control the post-contract behavior of one or both
parties. From a theoretical perspective, they are typically instruments that
are related to contract investments, especially investments in training, and
know-how transfers that one party to the contract makes and the other
party enjoys.174 In this sense, covenants not to compete may be regarded
as an enforcement mechanism in the implicit agreement between parties to
pay back investments in general training and know-how.175
However, the differences highlighted earlier regarding the different kind
of investments – general or specific – are still present. So if the investment
in human capital is perfectly specific, the employee could not take with
him the increased human capital and increase his productivity in another
company. In addition, there could be a double holdup problem depending
on who funds the costs of the training.
However, regardless who makes the investment, there is always one
party – the non-investor – who would credibly threaten to breach the
implicit promise sustaining the investment in specific training.176
As explained earlier, the possibility of renegotiation also matters for
the outcome when specific and general training are at issue. For example,
when dealing with specific investments in specific training, both parties
have a clear incentive to over-invest. As long as the employee’s training
174
In this sense, they could be qualified as cooperative investments. See
Nöldeke and Schmidt (1995). The first analysis of cooperative investments is by
MacLeod and Malcomson (1993). For standard analysis of these investments,
see Che and Chung (1999); Che and Hausch (1999). For a very interesting recent
contribution on contract remedies and specific investments, showing that the result
regarding expectation damages – of Che and Chung (1999), is an extreme case, see
Stremitzer (2008).
175
And may be a better remedy than a liquidated damages clause, due to
problems of limited assets or personal bankruptcy of the employee. See Rubin and
Shedd (1981).
176
Labor economics literature characterizes this problem as the trade-off
between salary and training. The employee accepts lower wages – but not so low
as to reflect the true cost of training – for a while, and then the employer, once the
enhanced productivity is in place, pays a salary above the opportunity cost of the
employee, but below the full value of the trained employee. See Lazear (1998).

value is more valuable to a different third party, parties in the original con-
tract have an incentive to over-invest, especially considering the contract
could be renegotiated ex post, in the case of a contractual bid by a third
party, because a high level of investment increases the value from the third
party to obtain release of the employee, because the training is not worth
as much when the employee moves to another partner.177 The higher the
specific investments that the potential breaching party makes, the greater
are the switching costs to the new contracting party, because the more
valuable is the existing relationship for the parties – and not the outside
option, because the investment creating the extra value is specific. The
third party needs to compensate the terminating party for any switching
costs, in order to induce him to terminate.178 So, specific investments, even
without renegotiation, tend to be excessive when decided by the party who
can also decide on termination.179
Covenants not to compete, however, may be socially preferable to the
other options the parties may use to benefit at the expense of the entrant,
in the sense that the scope of the covenant may be adjusted (by the court,
for instance, ex post), simply to cover those outside alternatives for the
employee who really benefits from the general training, and excluding
from the enforceable scope other outside options for which such training
is worthless. Reducing the scope of the covenant not to compete to just
the industry may be efficient, because it ensures enough incentives for
investing in training, but eliminates the excessive incentives to invest that
respond to the purpose of extracting rent even from those who value the
employee but not the training.180
8. Empirical Literature
Long-term contracts have provided a fertile environment for empirically
testing hypotheses on contracting behavior. The empirical bent of the
transaction cost economics literature has provided an added impulse to
empirical studies on long-term contracts and the incentives they generate
177
Posner and Triantis (2001).
178
See Chung (1998).
179
This may be an additional reason to make the employer pay for the invest-
ment in training when it is the employee who can terminate. If it is the employer
(or, more realistically, the manufacturer in a distribution contract) who is more
likely to terminate, the opposite result would be desirable, however.
180
See Posner and Triantis (2001). Courts or external adjudicators cannot,
however, restrict their attention to covenants not to compete, and disregard the
other alternatives (liquidated damages or penalties, for instance), because the
parties would resort to them if covenants not to compete are controlled to avoid
the effect of extracting value from the third parties.

to make certain choices. Take the decision to vertically integrate as one

example. Lafontaine and Slade181 suggest that when transaction costs are
important, firms will choose governance structures to reduce the likelihood
and cost of haggling and exploitation of the other firms. It should be noted
that the importance of the different transactions costs – downstream or
upstream – does not equally affect the decision to vertically integrate. So as
the importance of local or downstream effort grows, integration becomes
less likely, whereas as the importance of company-wide or upstream effort
grows, integration becomes more likely.182 Regarding the effect of higher
monitoring costs on vertical integration, the empirical literature is not
unanimous.183 Lafontaine and Slade note the differences between trans-
action cost theories and property right theories regarding the incentives
of firms to integrate vertically. Transaction costs theories, developed by
Williamson184 and Klein, Crawford, and Alchian,185 noted that when the
problems associated with transaction costs are important, governance
structure will seek to minimize the likelihood and cost of negotiation and
exploitation.186 Transaction cost theories predict that vertical integration
will be more likely when transaction costs are complex and involve specific
investments such as durable specific assets, unverifiable quality of those
assets, uncertain environment or when the quasi-rents are generated by a
relationship. Property right theories, on the other side, were developed by
Grossman and Hart,187 Hart and Moore188 and Hart,189 and focused on
the relationship between specific assets, incomplete contracts and ex post
bargaining. Property rights literature predicts that vertical integration can
result in a reduction of incentives to make investments.190
But in light of the abundance of the literature regarding transaction costs
and vertical integration,191 and given that some of it is essentially driven by
181
Holmstrom and Roberts (1998); Gibbons (2005); Whinston (2003); and
Lafontaine and Slade (2007).
182
183
184
Williamson (1971, 1975, 1979 and 1985).
185
Klein et al. (1978).
186
187
Grossman and Hart (1986).
188
Hart and Moore (1990).
189
Hart (1995).
190
191

concerns about organizational theory, and not by an interest in the legal or

regulatory environment of long-term contracts, we will focus only on the
legal restrictions on termination of long-term distribution contracts, which
has become a highly contested legal issue in many jurisdictions (USA,
Spain, and others) and is one of the key issues in the harmonization exer-
cise of European private law dealing with long-term contracts (article IV.
E.-2:301 and following of the Draft Common Frame of Reference).192
The empirical evidence concerning the effects on the behavior of con-
tracting parties in a long-term contract of the legal rules that restrict or
impose legal conditions on terminating the contract is rich and ample.193
This evidence refers essentially to franchising,194 but there does not seem
to be a powerful reason to doubt that its main findings would not be appli-
cable to other contractual arrangements in distribution chains that share
issues of controlling opportunism by distributors (and, eventually, also by
manufacturers).
The first and best-known piece of empirical evidence concerning ter-
mination of long-term distribution contracts is Brickley et al.195 They
hypothesized that laws restricting franchisor termination rights would
lead to less franchising because this would lead to less profitable franchis-
ing, making other arrangements (such as franchisors running the units
directly) more profitable by comparison.
In turn, Beales III and Muris196 looked at whether data on franchise
terminations and non-renewals support the efficiency or the opportunistic
explanation for terminations.197 Their results neither support nor present
cause to reject the opportunism hypothesis: the estimated coefficients are
often of the wrong sign or statistically insignificant. However, they did
obtain a robust, significant, and negative coefficient on the ‘growth in
outlets’ variable. This suggests that, if opportunism or expropriation by
the franchisor is a factor, its effect is diluted by the franchisor’s interest
192
See, critically, Gomez (2009).
193
See Brickley et al. (1991); Beales III and Muris (1995); Williams (1996);
Lafontaine and Shaw (2005); Brickley et al. (2006); Klick et al. (2007).
194
The reason for this lies in the fact that the studies are based on US experi-
ence, where state legislation interfering with termination at will has concentrated
on franchise contracts. Moreover, it seems that franchise plays a somewhat larger
role in US distribution compared with the European context.
195
See Brickley et al. (1991).
196
See Beales III and Muris (1995).
197
Efficient termination would be one in which the franchisor detects a breach
of quality provision duties by a franchisee while opportunistic termination is
defined as any non-efficient termination. See Beales III and Muris (1995).

in maintaining its reputation in order to attract additional quality fran-

chisees.
Williams also examined termination rates of franchise contracts, in
a sample of over 1,000 contracts over a four-year period, and found no
evidence of termination being influenced by a franchisor appropriating for
himself those units that, whether through franchisees’ sales effort or for
other reasons, turned out to be particularly profitable.198
Klick et al.199 also used data on franchising chains to assess the relative
importance for termination of the disciplining and expropriation stories.
They examined state laws limiting franchisor termination rights to identify
the effect of termination at will on both the decision to franchise and on
franchisor expansion generally. Their results tend to support the view that
the disciplining effect of termination on a franchisee’s non-cooperative
behavior seems to outweigh opportunities for franchisor abuse and expro-
priation of value that termination at will may allow.
Lafontaine and Shaw200 have investigated whether data sustain the
proposition that franchisor opportunism is an important factor behind the
rate of termination, and found no result consistent with that prediction.
Brickley et al.201 sought to assess the ‘exploitation’ theory of fran-
chising, concentrating on clauses regulating contract duration that are
typically crucial for the chances that franchisees recover relation-specific
investments made in contemplation of the contract being in place for
some period of time. Specific investments make the franchisee vulnerable,
because the termination of the contract will not allow the franchisee to
recover the specific, and thus non-salvageable, investment. The longer the
contract term, the higher are the chances of complete recovery of invest-
ment by the franchisee.
Using a large sample of franchising firms, Brickley et al. analyzed the
effects on contract duration clauses of several factors.202 If the exploited
franchisee view were correct, we would expect that the larger and more
198
In fact, the main factors driving termination rates appeared to be a desire
to transfer the unit (frequently, by the franchisee herself) and to close units under-
performing due to poor franchisee performance or a disadvantageous location.
Williams (1996).
199
See Klick et al. (2007).
200
See Lafontaine and Shaw (2005).
201
See Brickley et al. (2006).
202
Among those factors were the number of years the franchisor has been
in operation; the number of sites the franchising network comprises (that is, the
franchisor’s size); the average total initial investment of a franchisee entering the
franchise network; the number of weeks of off-site training of a franchisee’s per-
sonnel. See Brickley et al. (2006).

sophisticated the franchisor, the more exploitative the contract terms, and
the shorter the contract duration, will be. Again, if the naïve franchisee
image were correct, the level of specific investments would not raise con-
tract duration, given that exploitative franchisors would try to appropri-
ate the value of the non-amortized specific investments incurred by the
franchisee.
Empirical results show that the four factors are positively and sig-
nificantly correlated with the length of the contract term: both the level of
the investments by the franchisee, and the size and the experience of the
franchisor tend to increase contract duration,203 contrary to the predic-
tion of the ‘exploitation’ hypothesis.204 There is thus evidence to indicate
that franchisors are responsive to the level of specific investments by
franchisees, and are more responsive as they become bigger and better
established. Such results furthermore provide indirect evidence that the
threat posed by opportunistic and exploitative behavior on the part of
franchisors is not in reality a particularly worrisome problem205 or, at
least, is sufficiently marginal so as not to show up in the data.
A final important issue discussed in the empirical literature on franchise
contracts is the relationship between the legislation restricting termination
at will and the number of terminations. Contrary to what one would intui-
tively expect, legislation restricting termination at will increases, rather
than decreases, the number of terminations.
The explanation for this finding206 advanced by some commentators
is that unconstrained termination at will induces franchisors to be more
forgiving of minor (even if verifiable) instances of breach by the franchisee.
Being forgiving at the beginning is not too costly for a franchisor, given
that she always retains the ability to terminate without any restriction
as soon as she observes that her benevolence has not been repaid with
cooperative behavior by the franchisee. On the contrary, if the deci-
sion to terminate is legally constrained, the franchisor will terminate on
the first occasion she can so that the franchisor (or the principal, more
203
See Blair and Lafontaine (2005), who also find that larger franchisors tend
to offer longer contracts, on average, than smaller ones.
204
These results hold irrespective of the fixed effects of the particular industry
in which the franchisor operates. Brickley et al. (2006).
205
It is true, however, that Brickley and his co-authors also find a positive
effect of legal restrictions on franchise termination (in the state where the fran-
chisor has its headquarters) on contract duration clauses: Brickley et al. (2006).
They hypothesize that this effect is due to the increased bargaining power such
legislation gives franchisees upon termination of the contract, thus reducing the
value of short-term contracts for the franchisor.
206
See Beales III and Muris (1995); Paz-Ares (2003).

generally) will not be inclined to act forgivingly in front of a first minor

breach if there is sufficient evidence that termination would be deemed an
acceptable punishment of a franchisee’s breach.
9. Conclusion
In light of the many different issues raised by long-term contracts, and the
multiplicity of approaches and results in the literature, drawing general
conclusions is virtually unfeasible. Long-term contracts present specific
issues such as – added – incompleteness, specific investments, and the
important difficulties arising from the difficulties in observing and verifying
non-cooperative behavior. Short-term contracts are not exempt from these
issues, but in some cases, they may appear as a useful alternative to contract-
ing parties. It does not seem possible to establish from a general perspective
whether parties should enter into short-term or long-term contracts. Which
type of contract will best fit the parties’ needs will depend on their goals,
position, information available and the time frame of their relationship.
From a general perspective, contracts require cooperation from con-
tracting parties, and usually this is not self-enforcing. However, in light
of the open-ended nature of long-term contracts, ongoing cooperation
between parties is of prime relevance. Long-term contracts involve signifi-
cant risks for parties, given that they involve a lower degree of certainty,
and they may raise added problems concerning specific investments, given
the chances for renegotiation. At the same time, they may yield higher
levels of commitment and cooperation, so that compliance with their
contractual obligations actually improves, and without the need to rely on
formal remedies for breach.
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17 Marriage contracts
Antony W. Dnes
1. Introduction
The growth of divorce, reduction in rates of marriage, growth of cohabita-
tion, delaying marriage to a later age, and similar trends in many societies
have all caused concern in recent years. Families are less stable and this
has implications for the welfare of children.
From an economic perspective, a major issue is the incentive structure
set up by the law of marriage and divorce. The dependency and vulner-
ability of one marriage partner to opportunistic behavior by the other is
foreseeable under current laws, opportunism being defined as self-seeking
with guile (definition of Williamson, 1985, p. 47). This chapter is specifi-
cally concerned with the extent to which laws may have set up incentives
encouraging divorces that would otherwise be avoided and discouraging
marriages that might otherwise have occurred.
Two adverse incentives are of particular interest. Ill-considered financial
obligations may create incentives for a high-earning partner to divorce
a low-earning, or possibly simply ageing, spouse if the law does not
require full compensation of lost benefits. Elsewhere, I have called this
the ‘greener-grass’ effect (Dnes, 1998; Dnes and Rowthorn, 2002). Under
current social conditions and present marital law in most countries, the
greener-grass effect will typically induce wealthy men to abandon poorer
wives. There could also be an incentive for a dependent spouse to divorce
if settlement payments, based on dependency, allow the serial collec-
tion of marital benefits without regard to the costs imposed on the other
party. I call the second adverse incentive the ‘Black-Widow’ effect (Dnes,
1998.). The husband need not be wealthy: under current conditions, Black
Widows could be women with relatively poor husbands in marriages
where he cannot transfer benefits to deter her exit.
2. Marriage as a Long-term Contract Controlling Opportunism

A useful starting point is to think of marriage as a standardized, state-
sanctioned, long-term contract between two parties. Divorce can then
be seen as breach of contract, although it should be noted that marriage
predated the development of contract, and that fault-based divorce
is not exactly the same as breach of contract since no-fault divorce is
consistent with legally sanctioning one spouse’s effective desertion. A
360

Marriage contracts 361
purely contractual starting point would be modern, although contrac-

tual elements are present in the case law (Lloyd Cohen, 1987, p. 270). A
contractual approach is also capable of considerable sophistication and
it is unhelpful to dismiss it out of hand, particularly where inherently eco-
nomic issues like asset division are at stake. A good collection of contract-
influenced articles on marriage and related issues is in Dnes and Rowthorn
(2002). Critiques of the law and economics approach, from the perspec-
tives of socio-legal studies and traditional family lawyers, can be found in
Probert and Miles (2009).
Becker was a pioneer among economic theorists of marriage and is often
regarded as a bête noir by writers hostile to economics-based approaches
to the family. Becker’s work is admirable, but was not focused on oppor-
tunism. It has led to more recent bargaining theories of the family. The
interested reader may see Becker (1974a) and Becker (1991) to inspect the
origins of economic analysis of the family. Becker’s theory, which is based
on specialization and the division of labor within the household, really
concerns cohabitation and does not give a clear reason for the emergence
of a state-sanctioned standardized marriage contract. One could, for
example, cohabit with a grandparent and achieve economies of specialism.
The theory is based on a neoclassical approach to rational decision making
(Dnes, 2009), and it is possible that some of the disagreement of sociologi-
cal writers might be reduced by moving to a context-dependent, ecological
view of rationality (Smith, 2008), in which individuals latch their behavior
onto socialized structures to economize on decision-making capacity.
Lloyd Cohen (2002; also 1987) describes marriage as an unusual con-
tract in which the parties exchange promises of spousal support, where
the value of the support is crucially dependent on the attitude with which
it is delivered. In a traditional marriage, many of the domestic services
provided by the wife occur early in the marriage, and permit the husband
to concentrate on employment such that the support offered by the male
will grow in value over the longer term. The opportunities of the parties
may change so that one of them has an incentive to breach the contract.
Divorce imposes costs on both parties, equal to at least the cost of finding
a replacement spouse of equivalent value (in contract terms, this cost is
technically a measure of expectation damages, that is the replacement cost
of the anticipated spousal support). Lloyd Cohen argues that the risks and
costs of being an unwilling party to divorce are asymmetrically distrib-
uted: the husband might be tempted to take the wife’s early services and
dump her to enjoy his later income without her (the ‘greener-grass’ effect),
and she will tend to be worth less on the remarriage market than a male of
similar age (Lloyd Cohen, 1987, p. 278).
Why do people marry? There are both psychic and instrumental benefits

to marriage. The willingness of someone to commit themselves to another

is evidence of worthiness of such love, and marriage gives a means of pro-
tecting long-term investments in marital assets. According to Cohen, the
spouses may be regarded as ‘unique capital inputs in the production of a
new capital asset, namely “the family”’. In particular, children are shared
marital outputs. Another instrumental gain is the provision of insurance:
parties give up their freedom to seek new partners, if their prospects
improve, for a similar commitment from a spouse, which is rational if the
gains from marriage exceed the cost of losing freedom to separate (see
Posner, 1992). The gains from marriage reflect surpluses that can be seen
as appropriable and may tempt a spouse to opportunistic behavior, com-
parable to the incentives in more regular long-term contracts (see Klein et
al., 1978).
Cohen also draws attention to the role of marriage-specific investments
like the effort expended on raising children, or the prospect of losing
association with one’s children, as ‘hostages’ that may suppress opportun-
istic exit from the marriage. Cohen favors the preservation of restraints
on opportunistic divorce, which he sees as requiring understanding that
marriage is a long-term contractual relationship. The ‘wrong’ judicial
approach to obligations like long-term support can lead to too much or
too little divorce. This observation brings in the idea of an optimal level of
divorce, which might be encapsulated in a rule like ‘let them divorce when
the breaching party (the one who wants to leave, or who has committed a
“marital offence”) can compensate the victim of breach’. (I pursue the idea
of optimal breach further below.)
A contractual focus on marriage is of value, but the underlying view of
the marriage contract needs to be sophisticated. Marriage contracts revolve
around direct and instrumental benefits, bargaining influences (Lundberg
and Pollak, 1996), shared goods, long-term marriage-specific investments,
incentives for due performance and incentives for opportunism. These
factors are of considerable consequence. If the law covering the financial
obligations attached to divorce fails to suppress opportunism, then people
will be hurt: fewer marriages will occur than otherwise and there may be
less investment in activities like child raising (Stevenson, 2007). People will
not be certain of obtaining predictable returns on marital investments.
In addition, the preservation of a very clear signal of commitment may
be particularly important in marriage (Rowthorn, 2002). If promises over
long-term support are largely illusionary, owing to legal reform that decou-
ples obligations from fault in divorce cases, economically weaker parties
would alter their behavior, for example increasing the time spent searching
for a reliable spouse. Such an effect has been observed in empirical work
(Mechoulan, 2006; Matouschek and Rasul, 2008), as introducing no-fault

divorce settlements into a jurisdiction appears to be linked to increases in

the age of first marriage. Some US states, such as Louisiana, have deliber-
ately adopted ‘covenant marriage’, in which the exit rules are tougher, to
increase the signal of commitment attached to marriage promises.
3. Efficient Marital Breach

In a commercial setting, breach of contract may be optimal, providing
compensation is paid to the breached-against party for lost expectation.
Awarding ‘expectation damages’ is indeed the standard remedy for breach
among commercial parties, and has the characteristic of requiring the
breaching party to pay compensation that places the victim of breach in
the position that would have obtained had the contract been completed
(see Dnes, 2005, p. 97). This requirement for expectations damages meets
the Kaldor-Hicks criterion for a welfare change, in that the gainer must
gain more than the loser loses because he was still willing to go ahead with
the change notwithstanding having to compensate the loser, who is as well
off as before. Subject to certain requirements concerning market struc-
tures, mitigating avoidable losses and related matters, the common law
may be considered efficient (wealth maximizing for the parties) in award-
ing expectation damages for breach of contract. Generally, we would
not insist on specific performance of a commercial contract, owing to
difficulties of supervision and constitutional issues of individual freedom.
We could impose a specific performance requirement if the parties could
bargain at low cost, as the party wishing to breach could offer to pay
expectations damages to escape the contract (using a property rule in the
terminology of Calabresi and Melamed, 1972 – one of several entitlements
options summarized in Ayres, 2005).
The argument for compensation rather than coercion is even stronger in
the case of intimate human relationships. In this sense, economists are in
favor of freedom to divorce, but are also focused on the need for compen-
sation that avoids setting up adverse incentive structures. Even Parkman’s
(1992, 2002) arguments favoring a specific-performance basis for divorce
law, seek to establish entitlements that would be a basis for bargaining to
a settlement based on expectations damages.
Later I shall examine arguments that a sophisticated view of the mar-
riage contract, drawing on modern ideas of long-term relational contract-
ing could give a useful direction to policy. For the moment, I examine a
more limited, classical form of contract in which marriage vows would be
taken quite literally and promises would be seen as binding. For example,
a traditionalist view of the marriage contract is as an exchange of lifetime
support for the wife, in which she shares the standard of living (‘output’)
of the marriage, for domestic services such as housekeeping and child

rearing. The classical-contract view could easily include less traditionalist

frameworks. Breach of contract by one party would allow the other to
reclaim lost expectation subject to an obligation to mitigate losses. All the
traditional marital offences, such as adultery, unreasonable behavior and
abandonment, would be relevant to a divorce system based on classical
breach of contract, in determining who had breached. Equally, no-fault
divorce would be consistent with the notion of efficient breach as it would
simply represent either (i) a decision by one party to breach the marital
contract and pay damages, or (ii) a mutual decision to end the contract
with a negotiated settlement.
Consider a lengthy marriage that ends in divorce. The parties met when
they left university. After working for some years, the wife gave up work
to have children and care for them. When the youngest child started
school, she returned to work, but at a lower wage than previously. After
20 years of marriage, the husband petitions for divorce on the grounds of
separation. Their housing and other assets have always been held jointly.
The husband would be expected to share property and income to main-
tain the standard of living his ex-wife would have enjoyed for the remain-
der of the marriage. Expectation damages are identical to the minimum
sum that he would have to pay to buy from her the right to divorce her, if
divorce were only available by consent. (He might have to pay up to his
net benefit from divorcing if this were higher and his ex-wife were able to
hold out.)
The court would assess what that standard of living was and determine
who had breached the contract. The breaching partner would not gener-
ally be difficult to detect if attention is focused, as is common across the
law, on proximate causes. The fact that the divorced wife gave up work for
a while or now earns less than might have been the case without child-care
responsibilities is immaterial in finding expectation damages: broadly, if it
can be judged that she would have enjoyed the use of a large house and of
other assets, she would be awarded the assets and income to support that
lifestyle. Her own income would contribute to that expectation, as would
her own share of the house and other assets. The divorcing husband would
be expected to contribute from his income and his share of the assets to
provide that support for his ex-wife, regardless of the impact on his own
lifestyle or on any subsequent marriage partner. Any common-law or
statutory requirement to maintain the standard of living of the children
of the marriage could be dealt with separately by the court, although the
requirement would be met by maintaining expectation in the example.
Following the principle of loss mitigation, if separation allows the
former wife to increase her income or assets in some way, or there are
opportunities to avoid losses (including opportunities for remarriage),

those amounts should be deducted from the settlement. In addition, if

she contrived an apparent breach, for example by pursuing oppressive
forms of behavior, the husband could excuse his breach under the doctrine
of duress (other classical contract doctrines would also be needed, for
example misrepresentation, but are not central to the issues at this point).
Without such safeguards, couples might be careless in preserving the
marriage. With these qualifications, expectation damages would ensure
that only efficient breach occurred, that is, when someone’s gain from the
divorce exceeded the compensation needed to put the other party, as far
as money could, in the same position as before. From a traditionalist per-
spective, the approach would give security to a woman contemplating an
investment in home-making rather than labor-market activities – although
it is actually supportive of a wide range of possible marriages.
Under a classical-contracting approach, the courts would recreate the
expected living standard of the victim of breach of the marital contract
by adjusting the property rights and incomes of the parties at divorce.
Fault would matter to the extent that the court would need to establish
who was the breaching party, but this would not rule out no-fault divorce
(actually, unilateral breach where one party wishes to leave the marriage
without citing marital offences and can divorce the other party against
his or her will). It would only be irrelevant in a system of mutual consent,
where both parties negotiated a settlement stating that neither was at fault;
where bargaining would safeguard expectations. The classical-contracting
approach preserves incentives for the formation of traditional families,
if that were considered important. Any costs incurred by the victim of
breach in raising children would be more than compensated since expecta-
tion normally exceeds such costs. The parties would only enter the mar-
riage and incur costs (possibly as opportunities forgone, which we discuss
further below) if they expected their personal welfare to be higher – hence,
expectation typically exceeds (reliance) costs.
Classical contracting is also consistent with the simultaneous existence
of separate legal obligations for the maintenance of children. However, it
would only be consistent with a literal interpretation of the clean-break
principle favored in much recent family law if sufficient property rights can
be transferred to avoid the need for subsequent periodical payments. A
classical-contract view would not be consistent with ultra-traditional views
emphasizing the sanctity of marriage, requiring specific performance, and
creating inalienability of rights.
No more difficulty should arise in family law than in complex commer-
cial law in carrying out calculations of expectation damages. Typically,
both parties will be at a mature stage of their lives where their lifestyles are
reasonably foreseeable. It would be harder to calculate alternatives like

reliance damages (see below). The courts might well discover they faced a
great deal of argument over who had caused the breach. There might also
be a tendency to apply rigid views of what constituted a party’s reason-
able expectation in a marriage, although, in common-law countries, there
has been more of a problem of inconsistent discretion in the case law on
long-term support of ex-wives.
Other criticisms of an expectation-damages approach tend to be based
on sectional views of social welfare. Thus, the arguments of feminists
may be used to reject the idea of divorce rules that reinforce the depend-
ency of women on men. Some liberals (for example, Kay, 1987) argue for
measures to increase equality between males and females in their social
roles. Others (for example, Gilligan, 1982) argue that men and women
are different (women’s art, women’s ways of seeing, women’s writing,
and so on). Recent moves in divorce law to compensate spousal career
sacrifice have been sympathetically received by these groups. Such moves
focus on opportunity cost and amount to using reliance standards of
compensation. Arguments recognizing the reliance interest have been
influential in case law developments and proposals for reform of the
laws governing financial settlements between ex-spouses, notably those
emanating from the UK House of Lords and the American Law Institute
(Ellman, 2007).
4. The Reliance Approach

In The Limits of Freedom of Contract, Michael Trebilcock (1993) con-
trasts an analysis of the financial consequences of divorce based on
classical-contract ideas with contemporary trends toward compensat-
ing opportunity costs. Trebilcock argues strongly for an expectation-
damages approach to marital breakdown, particularly because this will
suppress opportunistic abandonment of dependent spouses. According to
Trebilcock, the feminist dilemma is that divorce laws that are protective of
women legitimize the subordinate role of women in society, whereas treat-
ing the divorcing couple as equals ignores the labor-market disadvantages
that domestic specialization confers on many divorcing women.
What would happen if we compensated the abandoned spouse (usually
the woman) or the woman choosing to leave the marriage, for the oppor-
tunity cost of marrying? Opportunity cost comprises the value of alterna-
tive prospects she gave up. In contract terms, this amounts to awarding
reliance damages: the opportunity cost has become akin to wasted
expenditure and the suggested rule seeks to put her in the position she
would have been in had the marriage never taken place (the status quo
ante). Reliance draws attention to the loss of career opportunities for
many women either on entering marriage or in stopping work to have

children. An economically strong woman leaving a marriage might receive

nothing under this approach, if she could be shown to have lost nothing
through marriage.
This form of compensation should strictly provide the difference between
what has been obtained up to the point of divorce and what the lost oppor-
tunity might reasonably be expected to have provided over some targeted
period of time. The court would be required to examine and adjust the
property rights of the divorcing spouses to put the divorcing woman in
the financial position she could claim marriage prevented her from attain-
ing. The suggested operation of this standard is not strictly equivalent to
the use of reliance damages, either in contract (when this occurs) or in
tort, because there is no suggestion that the payment of reliance damages
should be linked to breach of contract: the adjustment is usually simply to
be made for the benefit of an economically weakened divorcing woman (or
comparable male cases if they emerged, for example where he had given
up work to carry out child care). Equally, there is no reason in principle
why reliance damages could not be linked to breach of contract, either in
the sense of marital offences (substantial breach) or simply as a decision by
one party to leave the marriage.
Trebilcock points out that the reliance approach is harsh in its treat-
ment of divorcing women with poor pre-marriage career prospects, for
example, the waitress who marries a millionaire. Such cases would receive
very little compensation for marital breakdown. Reliance calculations also
often require speculation about the position of the weaker party in the
distant past. In comparison, expectation damages require less speculation:
comparisons are not in the distant past and it is usually reasonably clear
by the time of divorce how the standard of living would have developed.
Nonetheless, reliance does have its supporters among some economics of
law practitioners, notably in the valuation of the loss of a housewife’s serv-
ices in fatal-accident cases and in establishing a bare incentive for invest-
ment in household production. (On accident valuation, see Knetsch, 1984.)
In the case of a fatal accident, the wife is lost and in some jurisdictions the
husband claims her opportunity cost of participating in the marriage as an
alternative to the replacement cost of hiring a housekeeper. The reasoning
is that the benefits to them both of her forgoing that opportunity must
have been at least equal to the opportunity cost (for example, wage in paid
employment) or she would not have given up the opportunity. The advan-
tage to the professional-class bereaved husband is that compensation will
typically be higher.
Although reliance damages would tend to be lower than expectation
damages, assuming the marriage increased each party’s expected welfare,
incentives for investments in domestic services would be preserved.

A woman contemplating marriage-specific investments in child care by

giving up labor-market opportunities (the reliance), for example, is better
off in the marriage with those investments and is at least as well off if it all
goes wrong. Therefore, the incentive remains for traditional marriages in
which the woman exchanges domestic services for long-term support. The
reliance approach could therefore easily support a public-policy objective
of preserving traditional family lifestyles, which may not be appreciated by
some of its supporters. Equally, one could support investments by males in
child care by establishing their right to reliance damages upon divorce.
Generally, reliance damages will not be associated with efficient breach.
Taking a contractual view first, if reliance damages are owed for breach
of contract, a party may breach when the net benefit to them before
damages is exceeded by the loss to the other party (opportunistic breach).
This is because they only have to pay for reliance, which is normally less
than expectation, so the socially suboptimal breach confers a private
net advantage upon the breaching party. In a system awarding reliance
damages for breach of contract, we would expect additional, opportunistic
divorces compared with an expectation standard. Women’s marriage-
specific investments tend to be made early in marriage, and their remar-
riage opportunities are poorer than men’s owing to the different operation
of ageing processes, demographic factors and the fact that the children
of an earlier marriage will be a financial burden on a new husband. Men
therefore would be more likely to divorce their wives (the ‘greener-grass
effect’) and the increase in opportunistic divorces would tend to harm the
interests of women on balance.
Under a system awarding reliance damages for breach, we could expect
a great deal of judicial effort to go into establishing fault (in the sense of
who breached the marriage contract) just as under an expectation stand-
ard. If less were at stake because reliance is normally less than expectation,
there would be a lower incentive to pursue disputes and there might be
fewer resources devoted to such conflict. However, the main driving force
is that a finding of fault will result in a large bill under both standards so
the difference is unlikely to be great.
In a system that awarded reliance damages of right to a divorcing party
regardless of the cause of breach (typically an award to a wife who has
specialized in child care), there may also be an incentive for opportunism
of a different kind. The problem is not peculiar to the reliance standard
but affects all non-fault standards. For example, consider an award from
a spouse divorced against his or her will under legal rules emphasizing
meeting needs in the majority of everyday cases. The apparently vulner-
able wife (or husband) might decide to divorce when the net gain from
divorce, including the reliance award, exceeds her (or his) expected net

benefit from the marriage continuing, which is a form of inefficient breach.

This problem could not happen under a more contractual approach,
because a decision to end the marriage would be breach of contract and
would attract a damages penalty rather than an award. The practical
problem here is that the woman in the example will either not care (on
financial grounds) whether the marriage survives, or may feel she will be
better off without it. The law will have effectively written an insurance con-
tract that perversely influences behavior: a case of moral hazard. This type
of opportunism (the ‘Black-Widow’ effect) would lead to the prediction
that divorces initiated by women would increase whenever such specified
damages were introduced.
The reliance approach could encourage opportunistic behavior and
would encounter problems of definition and calculation of the status quo
ante. It is not kind to divorced women who start out with poor career
prospects. Like the expectation standard, reliance implies no special status
for any particular family asset: houses, pensions, and anything else, are
all candidates for trading off with the aim of achieving the targeted level
of support for a party. Reliance could be criticized for introducing a tort
focus into the financial obligations of divorce, treating decisions to invest
in domestic services as like sustaining injury, and carrying the implication
that home building and child raising are activities with no benefits for the
domesticated provider. As with expectation damages, a reliance approach
could be operated around a separate system of child-support obligations.
5. Restitution
Carbone and Brinig (1991) identify a modern development in divorce law
that they describe as a restitution approach. In a US context, they argue
that academic analysis has been led by developments in the courts, which
have increasingly emphasized settlements that repay lost career opportuni-
ties, particularly in the context of a wife’s domestic support of her husband
and children during periods that allowed for the development of business
capital, and other contributions to a spouse’s career.1 Restitution might be
considered appropriate when a wife supports her husband through college:
if they later divorce, the question is whether it is right that he should keep
all the returns on this human-capital investment. The canonical example
would be where the wife undertakes the child care so that her husband can
develop his professional or business life. Restitution is often cited as an
1
See, for example, Jamison v. Churchill Truck Lines, 632 SW 2d. 34, 3536,
Missouri Ct. App. 1982, awarding part of a business for domestic contributions;
see also Carbone (1990); Krauskopf (1980, 1989), and O’Connell (1988).

appropriate remedy in contract law when not returning money paid out
by the victim of breach would lead to unjust enrichment of the breaching
party. Restitution is ideologically acceptable to cultural feminists who
wish to emphasize the repayment of sacrifices.
A restitution approach is distinct from a reliance approach, although
both often emphasize the same life choices, for example the opportunity
forgone for a separate career. Under a restitution approach, compensation
is in the form of a share in the market gain supported by the (typically)
wife’s supportive career choice, for example a share in the returns to a
medical degree, or a share of the business. Restitution is therefore only
possible where measurable market gains have resulted from the ‘sacrifice’.
The reliance approach, in contrast, is based on measuring the value of
the opportunity forgone, for example estimating the value of continuing
with a career instead of leaving work to raise children – an input rather
than output measure. Reliance puts the victim of breach in the same posi-
tion as if the contract had not been made, whereas restitution puts the
breaching party in the same position as if the contract had not been made
(Farnsworth, 1990, p. 947).
Restitution damages may be difficult to calculate. Who can really say
how much a wife’s contribution was to a husband’s obtaining professional
training? Under a tort-style ‘but-for’ test, perhaps a case could be made
that all of his earnings (and assets bought with income) belong to her.
Yet, the ex-wife must have got something from the marriage, that is, was
not supporting him purely for the later return on his income. How much
should we offset? Another problem might be negative restitution, where
a party can show that the other spouse held them back and was a drain
rather than an asset. In practice, interest in restitution awards arises in US
states with no-fault divorce and community-property rules, as a basis for
obtaining alimony for an abandoned wife. Restitution will probably be
kinder to divorcing women who had poor career prospects before entering
the marriage.
From an efficiency angle, restitution damages suffer from all of the prob-
lems already cited for reliance: the difficulties are logically identical. In a
contractual setting (using restitution as a remedy for breach), restitution
damages will lead to inefficient breach as liability for damages will again be
too low. There will be too much breach (divorce) compared with expecta-
tion damages as restitution will normally be less than expectation damages
(as long as the victim of breach expected more from the marriage than the
returns reflected in the victim’s investment in the breaching party’s career).
The higher level of opportunistic divorce will be to the disadvantage of
women, if earlier comments about the differential effects of age on remar-
riage prospects for males and females hold true. Outside of a contractual

setting, if support payments are set by statute for ex-spouses regardless of

fault, there will be an incentive for opportunistic breach by the party for
whom the restitution payment plus other expected benefits from divorce
exceed the expectation within the marriage (the Black-Widow effect
exactly as above, with restitution substituted for reliance).
Compared with reliance damages, the level of divorce could be higher
or lower under a restitution standard. This is because there is no necessary
connection between the value of investment in the other spouse’s career
and a person’s own alternative career prospects. Therefore, reliance can
be greater or less than restitution (measured as the market return on the
investment in the other spouse’s career).
The restitution standard will give the incentive necessary to bring forth
investments in domestic activities, particularly raising children. This
would operate a little differently from the reliance standard. A person
contemplating marriage-specific investments in child care by giving up
labor-market opportunities would be entitled to compensation for each
such investment decision. Therefore, the incentive remains for traditional
marriages. As with expectation damages, a restitution approach could be
operated around a separate system of child-support obligations.
6. Partnership, Property Rights and Rehabilitation

There is a trend toward the use of a partnership model in some jurisdic-
tions, notably where community-property is the norm in marriage. Singer
(1989) argues that post-divorce income disparity between ex-spouses is
the result of joint decisions and that the higher income is strictly joint
income (which could carry over to property bought from income). Singer
also points out that the equal division of property and income would meet
demands for compensation for lost career opportunities, and could further
the aims of ‘rehabilitating’ an abandoned spouse. According to Carbone
and Brinig (1991), Singer’s analysis uses conventional justifications for
post-divorce support without identifying the links between them, fails to
determine initial property rights and does not achieve a precise calcula-
tion. Singer actually has a spuriously precise system of sharing the joint
income for a number of years (she suggests one year of post-marriage
support for each year of marriage).
A partnership model is possibly consistent with an updated contractual
model of marriage, and anyway could be used as a basis for setting enti-
tlements to meet a mix of social-policy and bargaining objectives (Ayres,
2005). There is some evidence that divorcing couples do see themselves
as jointly owning at least their assets, that is, their expectations are built
around partnership. Weitzman (1981a) found that 68 percent of women
and 54 percent of men in her sample of divorcees in Los Angeles County,

California believed ‘a woman deserved alimony if she helped her husband

get ahead because they are really partners in his work’. This was similar to
the proportion supporting alimony on the grounds of the need to maintain
small children. Davis et al. (1994) note the prevalence of the presump-
tion of an equal split in their discussion of ‘folk myths’ associated with
divorce.
It is not necessary to repeat the detailed analysis of earlier sections to
note that, unless labor-market rehabilitation, or equal shares, are the
parties’ expectations from marriage, the model could lead to inefficient
breach. In turn, this can give rise to incentives for opportunistic behavior,
including the greener-grass and the Black-Widow effects, which reflect
the adverse incentive effects from using less-than-expectation damages.
If the true expectation of the dependent party went beyond equal shares
or temporary support plus rehabilitation, then a move from expectation
damages to rehabilitation would encourage breach of contract by the non-
dependent party.
7. Need
A focus on meeting post-divorce housing and other needs, particularly of
the spouse with childcare responsibilities, has been the dominant element
operating in several jurisdictions (for example, England and equitable-
distribution US states such as New York). With such laws, need is the
starting point, and the majority of cases do not reveal sufficient family
resources to go much beyond the allocation of housing to the spouse
with responsibility for care of the children, particularly as the clean-break
principle favors transferring assets in lieu of periodical payments.
There is no necessary inconsistency between a contractual view and
needs-based awards, as meeting the needs of the children of the marriage
and a breached-against spouse could be the remedy for breach of the mar-
riage contract. However, the welfare consequences of the standard are not
encouraging. If we assume that meeting need is a minimal expectation in
marriage, need awards for breach would be less than or equal to expec-
tation damages and excessive breach would occur: the by now familiar
greener-grass effect as (most likely) husbands find they are not expected
fully to compensate abandoned wives for removing the husband’s high,
late career earnings. Also, if, as is the case, need awards are not linked
to substantial breach, the Black-Widow effect can follow, if the value of
a need award plus the expectation from the changed situation (possibly,
remarriage, cohabitation, or single status) exceeds the expectation from
the current marriage. There is a direct analogy with the fourth condition
above.
Needs-based awards of spousal support do meet a concern that people

should not be trapped in unhappy marriages. ‘Fault served to restrain

men from leaving or flouting their marital obligations too egregiously,
but it also left women with little bargaining power within the relationship.
Women . . . could not leave . . . without facing financial ruin’ (Carbone and
Brinig, 1991, p. 997). However, on (utilitarian) welfare grounds alone, it
is impossible to justify the removal of costs for one person when this will
impose similar or greater costs upon another. Furthermore, the possibility
of inducing the Black-Widow effect might encourage some men to avoid
marriage altogether, which is generally a problem when contracts cannot
be secured against opportunism: a form of long-term, dynamic inefficiency
(see Dnes, 2005, p. 90). The argument that public policy requires men
rather than women to bear the financial costs of divorce is vulnerable
to the observation that it is difficult to distinguish between the unhappy
divorcing wife and the opportunistically divorcing wife. The weight of
the criticism in this paragraph could be undermined by finding that there
is typically a heavy spillover effect (externality) from the unhappiness of
one marriage partner to the welfare of other parties, for example onto
children.
8. Revising the Contract Approach to Marriage

The problems following from avoiding the use of expectation damages,
or of separating awards from the issue of breach of contract are that (i)
generally, breach will be inefficient, and (ii) breach may be opportunistic
(exploitative). However, the problems with expectation damages in mar-
riage contracts are that implications of lifetime support appear to militate
against a modern emphasis on independence in life, and protracted argu-
ments over the identification of breach would be costly, which is particu-
larly relevant when the court system is run largely from public funds. The
problems of identifying breach are at least as severe if non-expectation
standards (for example reliance) are used. Would a more sophisticated
view of the marriage contract resolve these issues?
The movement away from highly restrictive divorce laws coupled with
lifetime support obligations toward wives was followed by the evolution of
liberal laws characterized often by needs-based, discretionary systems of
property adjustment and spousal support. The social norms surrounding
marriage have clearly changed over time, in particular toward favoring
serial marriages and unmarried cohabitation (Almond, 2006). A number
of points stand out. One is that marriage rates are falling, cohabitation
rates are rising, and divorce rates are rising in many countries, which
suggests that the current legal view of marriage does not correspond with
the wishes of the population at large. Secondly, legal liberalization allows
people to change their minds as circumstances change and to revise the

marriage contract. Consequently, we need to explore the possible claim

that a more flexible view of marriage is useful and what the limits to flex-
ibility would be. The history of marital law, showing an evolving view
of the nature of the marriage contract that has been heavily shaped by
surrounding social norms, is consistent with modern legal scholarship
on ‘relational’ contracts that are shaped by a surrounding mini-society
of norms (Macneil, 1978; Williamson, 1985 and Macaulay, 1991). Brinig
(2000) has developed the idea of a socially wider governance of the family
into an approach emphasizing marriage as a covenant with wider society,
in which family ties do not end with events like divorce, but become
modified as an ongoing franchise.
One view of flexibility might be to encourage the use of clearer mar-
riage contracts, with the possibility of enforceable modifications that
could be substitutes for divorce. The literature on contract modifications
is extremely pessimistic over the prospect of welfare gain from enforcing
mutually agreed and compensated modifications (Jolls, 1997; Dnes, 1998;
Miceli, 2002). This is simply because of the difficulty of distinguishing
between genuinely beneficial revisions and those resulting from opportun-
istic behavior, which can amount to duress. Consider the difficulty in mar-
riage contracts in distinguishing between a genuine modification (because
a party now has improved prospects) and the case where a party threatens
to make their spouse’s life hell unless certain terms are agreed. Contract
modifications will not set up incentives for opportunism if, in the context
of unforeseen events, (i) it is not clear who is the lowest-cost bearer of the
risk, (ii) the events were judged of too low a value to be worth considering
in the contract, or (iii) it was infeasible for either party to bear the risk (as
explained fully in Dnes, 1995, p. 232). Generally, the view that support-
ing all modifications is desirable because there appears to be a short-term
gain is unsound: there may be undesirable long-term instability as a result,
since fewer people will make contracts that cannot be protected from
opportunism.
The idea that modifications can be legally supported when events unfold
for which it would not have been clear early on who should have benefit-
ted or borne a fresh cost does give a clue to a rôle for the court. It can
determine whether some change was foreseeable and whether the attend-
ant risk would have been clearly allocated: for example, one’s spouse’s
ageing is not a reason for scooting off without compensating him or her.
On the other hand, mutually tiring of each other would have been hard to
allocate to one party. Generally, the main focus of the law can be expected
to remain the division of benefits and obligations on divorce, that is, the
ending of a contract and move to new circumstances for the parties. A
more appropriate fundamental model of the marriage contract would be

as a relational contract (Scott and Scott, 1998). Macneil (1978) has sug-
gested that complex long-term contracts are best regarded ‘in terms of
the entire relation, as it has developed [over] time’. Special emphasis is
placed on the surrounding social norms rather than on the ability of even
well-informed courts to govern the relationship (Macneil calls governance
that emphasizes third-party interpretation ‘neoclassical’ contracting). An
original contract document (for example, marriage vows) is not neces-
sarily of more importance in the resolution of disputes than later events
or altered norms. Courts are likely to lag behind the parties’ practices in
trying to interpret relational contracts.
A relational contract is an excellent vehicle for thinking of the fun-
damental nature of marriage but it may be of limited help in designing
practical solutions to divorce issues unless it is possible to fashion legal
support for the relational contracting process. Crucially, though, the idea
emphasizes flexibility. It is a fascinating mental experiment to put the
idea of flexibility together with the persistent caution of this chapter over
the dangers of creating incentives for opportunistic behavior. Many of
the problems associated with the division of marital assets arise because
social norms change (for example, the wife has no entitlement to lifetime
support), but the individual marriage partners fail to match the emerging
marital norm (for example, a homely wife married in 1966 is much more
likely to have specialized in domestic activities). Therefore, a possible
approach to divorce law is to use expectation damages to guard against
opportunism but to allow the interpretation of expectation to be governed
by differing ‘vintages’ of social norms. As an example, the courts could
take a retrospective view of the expectations associated with each decade.
Consideration could also be given to making pre-nuptial, and post-
nuptial, agreements between spouses legally binding. Modern marriages
might be allowed to choose between several alternative forms of marital
contract (for example, traditional, partnership, or implying restitutionary
damages on divorce). Providing expectations are clarified, inefficient and
opportunistic breach could be broadly suppressed. Such a system could
operate around a statutory obligation to meet the needs of children, which
providing it does not overcompensate the parent with care, should be
neutral toward incentives.
9. Cohabitation and Marriage

Growth in cohabitation compared with marriage is noticeable in many
societies (Almond, 2006). It is still early days in relation to explaining this
switch, but one line of inquiry emphasizes the lower risk of heavy loss
of lifetime welfare following out-of-wedlock pregnancy from the 1950s
onwards, as birth control improved (Akerlof et al., 1996). This may have

caused dominant female behavior to have switched over to risking unmar-

ried intimate relationships with men, and life-cycle asymmetries may have
become less marked. Consistent with the possibility of life-cycle changes,
increased labor-market participation would tend to lower the benefits
from being insured within a traditional marriage. Women are possibly
better placed to self-insure through labor markets in current conditions.
We note a need to explain cohabitation trends more thoroughly, but move
on to consider contractual issues concerning cohabitation.
Cohabitation is everywhere treated quite distinctly from marriage, and
this is true even in modern proposals, for example from the American Law
Institute, to increase the protection afforded to unmarried partners. The
traditional position in the US is captured in Marvin v. Marvin,2 affirm-
ing that property settlements after cohabitation depend on discernible
contracts and explicit or implied trusts. The position is similar in England
and some Commonwealth countries, although statutory intervention in
Canada, Australia and New Zealand has edged the common-law world
toward the continental European position of extending elements of family-
law jurisdiction to the post-dissolution property settlements of unmarried
cohabitants. Such jurisdiction always has a lesser scope, in terms of assets
and income, than in the case of marriage.
A major question concerns the appropriateness of intervening in cohab-
itation arrangements that have been freely entered into by apparently
rational adults (Probert and Miles, 2009). Questions can be raised about
how informed the parties are, and there is some evidence that many cohab-
itants have an erroneous view that cohabitation over a period of time
leads to similar rights in law as those enjoyed by married couples, which
is untrue outside of US jurisdictions recognizing common-law marriage
(Brinig, 2000). Even if ignorance were the problem, rather than intervene
in arrangements, the state might reasonably limit its efforts to providing
better information flows – as in a pilot scheme operating in 2007 in the
UK. One possible argument for intervening in private arrangements might
be that, comparable to, say, banning child labor in industry, there could
be a general and widespread revulsion at the characteristics of the relation-
ship trends resulting in the growth in cohabitation. Externalities may arise.
A possibility for such a concern could be the impacts on children that
follow from less stable relationships, as cohabitation typically ends more
frequently than marriage. Suppose that cohabitation has grown because
men can be held to marriage less easily by women, given all the social
changes since the 1950s. Then choices are freely made, but subject, as ever,
2
122 Cal. Rptr. 815 [App. 1981].

to constraints that alter the results of choice. It is legitimate to ask whether

the characteristics of the resulting equilibrium are acceptable (Dnes, 2009).
Scholars such as Popenhoe (1996) and more general commentators such
as Bartholomew (2006, p. 249) argue that some of the characteristics,
particularly the results of growing fatherlessness for children, are not.
10. Same-sex Marriage

Another recent trend has been toward recognition of same-sex marriage
in many jurisdictions. In a sense, the discussion surrounding heterosexual
marriage and cohabitation can be extended to same-sex marriage and
cohabitation. One important difference is that, whereas the heterosexual
can choose to marry or cohabit, the same-sex couple has not had a choice in
the past and could only cohabit. There must be some probability that sunk
domestic investments are made asymmetrically by one partner in some
same-sex unions, just as in heterosexual union, which would suggest extend-
ing something like marriage rights to same-sex couples (Dnes, 2007).
It may be objected that there are very few same-sex couples with life-cycle
asymmetries comparable to those of heterosexual couples in traditional
marriages, which are anyway in decline. Same-sex relationships are sugges-
tive of greater equality between partners, although there is a possibility of
ones that are deliberately structured to leave one partner in the situation of a
traditional wife. In jurisprudence, an argument that few people are affected
by a condition is not persuasive. We would still wish to protect even a small
number of possible victims of opportunistic behavior, and the possibility of
opportunism sets up a need for extra search by partners or for other mecha-
nisms aimed at affording protection, which would tend to waste resources.
A strong argument for caution over extending marriage rights to same-
sex couples is given by Allen (2006), who notes the possible externalities
involved. The welfare of large sections of the heterosexual population may
be lowered by the state signaling that their marriages are comparable to
relationships practiced by minorities of whom they do not approve. There
is a genuine difficulty here if we ignore the externality across social groups,
certainly from the utilitarian perspective that most closely matches
economic analysis, although not necessarily from other jurisprudential
viewpoints such as an imperative to protect minorities. It is notable that
most jurisdictions maintain some distinctions between heterosexual and
same-sex marriages. Typically, a different terminology is used, such as
the domestic partnerships introduced in the UK, and there often remain
several differences in the grounds for dissolution. In the UK, domestic
partnerships cannot be dissolved on fault grounds on the basis of adultery,
which applies only to heterosexual marriage. It is possible that the distinc-
tions recognize the externality issues raised by Allen (2006).

11. Conclusions and Summary

Contract thinking suggests a case for seriously considering expectation
damages as a basis for post-divorce support obligations and asset divi-
sion. The foundation for this conclusion is controlling the incentive for
opportunistic behavior set up by the use of reliance, restitution, partner-
ship, rehabilitation and need approaches to post-divorce liabilities. The
current focus of marital law is vulnerable to the charge that behavior is
encouraged in both males and females that is predatory in nature. The
contractual uncertainty that follows from this may well deter some good
quality marriages that might otherwise occur.
The contractual view of marriage ultimately explored in this chapter is
different from commercial contract law, and is really a perspective that pro-
ceeds by useful analogy. Different vintages and varieties of marriage need
to be recognized. In particular, partners in traditional and non-traditional
marriages could be contractually protected against exploitation by recog-
nizing the variety of promises they received. The approach is also consistent
with a separate system of liability for support for children and with avoid-
ing having the state pick up the bill for failed marriages. Contract thinking
also illuminates recent trends toward unmarried cohabitation of all kinds.
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18 Franchise contracts
Antony W. Dnes
1. Introduction
Franchising is an organizational form lying between markets and hier-
archies, and can follow either a business format or a simpler dealership
model. It is a symbiotic relationship between businesses (Schanze, 1991),
typically requiring a contractual arrangement between legally separate
firms in which the franchisee pays the franchisor for the right to use trade
marks and a business format, selling associated products or services, in a
given location for a period of time (Blair and Lafontaine 2005, at p. 5).
Business-format franchising, in which the franchisor supplies a brand
name and also a model business for the franchisee to copy, is the growing
sector of franchising and covers businesses like vehicle rental and fast-food
restaurants. Many of the differences between business-format franchising
and dealerships (for example, cars or petroleum) are disappearing over
time as manufacturers provide a wide range of support for their dealers.
Theoretical and empirical work on franchising has developed from agency
theory and from ideas about asset specificity and opportunism associated
with transaction-cost analysis. I begin by considering some traditional
arguments about the capital-structure function of franchising. Next, I
consider agency and transaction-cost theoretical explanations of franchis-
ing. An interesting special case is where the franchisor also runs company
stores. Econometric work supports the view that franchise contracts
protect against reciprocal opportunism. I also examine several arguments
concerning the possible nature of ‘hostages’ in franchise contracts.
2. Franchising as a Method of Raising Capital

An early argument is that firms franchise to raise capital for expansion
(Caves and Murphy, 1975). Rubin (1978) argues that this makes no sense
unless we assume that the franchisor is more risk averse than the franchisee,
which is implausible. Even if franchisors could not use normal capital
markets, they could sell shares in a portfolio of all outlets. The shares
would diversify risk for the buyers but impose no costs on the franchisor.
Franchisees would pay less for undiversified investments if they are risk
averse, which implies smaller returns for franchisors. Any capital-market
advantages from franchising must come from shifting risk to the fran-
chisee, which only makes sense if the franchisor is the more risk averse.
384

Franchise contracts 385
Rubin’s argument that capital raising does not explain franchising

depends upon an assumption of zero transaction costs. Franchising can
be a capital issue under less restrictive assumptions. However, empirical
work generally supports organizational costs rather than capital-market
influences as the driving force behind franchising. Lafontaine (1992) dis-
covered that increases in the capital cost of opening stores reduced the
proportion of franchised outlets, which is contrary to the capital-raising
story.
3. Franchising as a Problem of Monitoring and Control

Rubin explains the features of franchising in terms of solving monitoring
problems. In retail networks where the satellite business is remote from
the head office, monitoring is difficult and it pays to develop an incen-
tive system that encourages the avoidance of shirking. A profit-sharing
agreement gives the franchisee sufficient residual profits to make shirking
too costly. The franchise chain will show more total profit if shirking is
controlled. Franchisors will not pay any more profit to franchisees than
is necessary to remove the incentive to shirk. A competitive supply of
prospective franchisees should be willing to pay lump sums equal to the
difference between franchise profits and what they could earn as managers
in similar occupations.
We do not usually observe franchise contracts of this kind. Instead,
franchisees pay a lump-sum initial fee, and a continuing royalty payment
related to sales, in return for residual profits. The most plausible explana-
tion is that the franchisee requires protection against poor post-contract
performance by the franchisor. The franchisor’s duties cover such things
as providing managerial support and the monitoring of standards of
operation throughout the franchise system. Monitoring of the system is
necessary to control a classic externality problem: if one franchisee allows
quality to deteriorate, he benefits by the full amount of the savings from
reduced quality but incurs only part of the costs as other franchisees will
suffer some of the loss of business. This type of externality is described by
Mathewson and Winter (1985) as horizontal free riding.
The theory generates several predictions. Increasing the geographical
density of outlets should make operating company stores more attractive.
Also, franchisors should buy back their outlets as their chains become
more mature, the density of outlets increases, and distance-related moni-
toring costs become lower per outlet. Buy-backs are observed in mature
chains. Much econometric work supports the importance of geographical
density in explaining franchising (Lafontaine, 1992; Brickley and Dark,
1987; Norton, 1988). Lafontaine also finds evidence that increases in the
importance of the franchisor’s inputs increase the royalty, which supports

the view that franchise contracts are partly constructed to control the
franchisor’s opportunism.
Laws restricting franchisor termination rights appear to increase the
franchisor’s profits, consistent with reassuring franchisees that oppor-
tunistic termination is under restraint. Brickley (2002) examines state
franchise-termination laws and shows how these affect franchise contracts,
specifically by providing evidence on the impact on royalties and upfront
fees in franchising share contracts. His results support the hypotheses
that a two-sided moral hazard model can explain the terms in franchise
contracts and that termination laws increase the relative importance of
franchisor effort in terms of controlling system quality. Franchise compa-
nies based in states with termination laws charge statistically significant
higher royalty rates compared with those in other states. Initial franchise
fees are lower in termination states. Franchisees appear to prefer states
with protective laws and pay a higher price for franchises in them. Price
adjustments appear to offset some of the transfers that would otherwise be
implied by the laws.
In a further line of statistical inquiry, Klick et al. (2006) note a possible
chilling effect following from state and federal laws aimed at controlling
franchisors’ use of termination provisions. Franchisors might oppor-
tunistically take over profitable establishments. However, regulation of
termination can reduce the total number of outlets, if franchisors are
denied a valuable mechanism for policing franchisee free riding on the
trademark and other elements of the business model. Such an effect would
not result if the only thing to be controlled were franchisor opportunism.
Klick et al. (2006) utilize panel data on fast-food establishments, taken
from franchise offerings, to show that laws restricting termination rights
do lead to reduction in franchising, not compensated by any increase in
franchisor-operated stores. They also examine the scope for Coasian bar-
gaining to mitigate the effect of regulation. Franchisees and franchisors
can in principle alter or avoid regulation through choice-of-law and
choice-of-forum clauses in their contracts. It turns out that employment
in franchised industries falls when states restrict franchisor termination
rights. The effect increases when there are further limitations on the ability
to contract around these restrictions. So, although franchisees benefit
from termination laws, according to Brickley (2002), there may well be
fewer of them as a result of a chilling effect on the franchisor’s opening of
franchised outlets.
4. Modelling Franchising as an Agency Relationship

Mathewson and Winter (1985) argue that horizontal externalities are not
necessary to explain franchise contracts. Monitoring difficulties arise for

the franchisor even when there is only one territory. However, vertical
externality (chiselling on the franchisor’s standards) is an ever-present
problem. Risk aversion on the part of the franchisee is also not a sufficient
condition for the emergence of a franchise contract. The franchisor could
impose a large penalty if the franchisee were caught cheating, making
the franchisee’s income the same across different demand conditions
and giving a pure risk-sharing contract with no profit-sharing. However,
the penalty may be infeasible owing to wealth constraints affecting the
franchisee and this gives profit sharing. In their model, local demand at
a franchised outlet is subject to uncertainty and may take a high or low
state. The franchisor cannot costlessly identify any ruling state of demand.
The franchisee has better local information and may attempt to reduce the
quality of his effort in high demand states and try to pass off the resulting
low output as due to a low demand state, reflecting a problem of franchisee
moral hazard. The franchise contract specifies the franchise fee schedule
(lump sum plus royalty) plus the quality of the franchisee’s input in good
and bad demand states.
Mathewson and Winter agree with Rubin that the first-best contract
between franchisor and franchisee would lease the brand name in return
for a lump-sum payment. The franchisor would be encouraged by the
incentive of maximizing the fee to find the joint-profit-maximizing moni-
toring arrangements. Each franchisee would pay a fee conditional on the
value of the brand name and therefore dependent on the optimal amount
of monitoring, and could enforce the contract ex post.
If it is infeasible to cover all aspects of the franchise relationship
in an explicit contract, profit-sharing emerges. In their basic model,
Mathewson and Winter attribute this to a constraint on the wealth
of franchisees that prevents them from sinking large investments into
franchises. This empirically relevant constraint makes franchisors rely
on rewards rather than the penalty of termination to maintain fran-
chisees’ standards. An incentive-compatibility constraint in their model
ensures that the profit accruing to the franchisee from correctly declar-
ing the better demand state and applying the correct effort level exceeds
the profit from wrongly declaring the poor state and adjusting effort
downward. A participation constraint ensures that the contract gives
sufficient profit for the franchisee to pay a royalty fee. Mathewson and
Winter derive the franchise fees, franchise effort in each state, the level
of brand-name investment by the franchisor (including advertising) and
the frequency of monitoring.
The removal of the wealth constraint from the model opens up the pos-
sibility that franchisees could post bonds to guarantee good performance.
Mathewson and Winter agree with Rubin that bond posting is problematic

as the franchisor might behave opportunistically. The expected value of

the lump sum must be less than the profits accruing to the franchisor from
the proper delivery of services. Otherwise, there will be an incentive for the
franchisor to abscond with the lump sum, possibly by contriving some
reason for contract termination. The royalty, or its equivalent, is always
the engine for rent extraction.
5. The Organizational Mix

‘Dual distribution’ is an important phenomenon. Gallini and Lutz’s (1992)
model shows that both dual distribution and the use of a sales royalty may
be methods by which a new franchisor signals the profitability of the fran-
chise chain by making franchisor returns dependent on the revenues of
company stores.
Consider the case where a franchisor with a fixed number of outlets
knows that demand is favourable so that stores should be unusually prof-
itable. The problem is to convey this information in a credible manner to
prospective franchisees. The high-profit franchisor chooses the proportion
of company stores, the lump sum and the royalty to establish a separating
equilibrium defining a contract that a low-profit franchisor would never
offer. A separation constraint ensures that a low-quality franchisor will
always make more profit from truthfully declaring quality and franchis-
ing all stores, compared with emulating the dual-distribution strategy
of the high-profit franchisor. A number of predictions may be made on
the basis of signalling theory, but they are not supported by empirical
work. To take one as an example, the high profitability of some fran-
chises would be recognized over time and there would be no need for
franchisors to operate company stores as a signal. We should see mature
franchise chains concentrating on franchising, rather than the operation of
company stores. Whilst there is possibly some support for this hypothesis,
for example Martin (1988) observes that older units are often franchised,
economists often observe a buy-back phenomenon (Thompson, 1994) as
the chain matures. Lafontaine (1993) reports econometric results showing
no support for a range of hypotheses suggesting that franchisors use their
organizational mix as a method of signalling.
The franchisor’s buying back of units is also consistent with merging
units strategically so as to internalize externalities over intra-network serv-
icing (Dnes and Garoupa, 2004). A systemic problem may arise for a fran-
chisor, if a network makes heavy use of inter-satellite transfers. Examples
of such transfers arise in automobile rental chains, where one-way rentals
are a big issue, along with servicing of vehicle breakdowns anywhere in
the network. Either the franchisor has to find a pricing scheme to main-
tain franchisees’ incentives to help other satellite businesses, or buying

back may be a solution to the problem. Very often, franchised businesses

reserve locations as company outlets, if they are heavily associated with
externalities between satellite businesses. In vehicle rental, airports may
well be kept as company outlets.
Lafontaine and Shaw (2005) show that franchisors own their own stores
more frequently, within the spectrum of dual distribution, whenever
the brand name takes on a higher value. The phenomenon is consistent
with the franchisors using ownership of some stores to maintain brand
value in the face of possible free riding by franchisees. However, such a
strategy can also be shown to weaken the franchisee’s incentive structure,
suggesting a precarious balance between preserving brand integrity and
motivating franchisees.
6. A Search Theory of Franchising

Minkler (1992) has suggested that franchising is a device through which
the franchisor gathers and uses local information. The theory is Austrian
in character and emphasizes the key role played by information in the
competitive process. There is a dark side to franchising in Minkler’s
approach: franchisees are useful temporary tools, rather as in some of the
small-business literature (Hoy, 1994; Bates, 1995).
According to agency-based theories of franchising, distance of the sat-
ellite business from the mother company, which makes monitoring more
difficult, should be associated with an increased reliance on franchising.
However, Minkler cites examples where franchised and company stores
operate in close proximity to each other. For example, in Sacramento,
California, 34 Taco Bell restaurants covered a 30-mile radius, of which
seven were company owned. Minkler argues that franchisors draw on the
local knowledge of franchisees, which concerns local tastes and market
conditions. The franchisor might be unable to direct the satellite business,
even if monitoring costs were zero, because of ignorance. Franchising
allows the use of the trade mark to be exchanged for the franchisee’s local
entrepreneurship, which is defined as noticing and acting upon opportuni-
ties. The franchisee’s local entrepreneurship reduces the cost of search for
new business.
How reasonable is the search-cost theory? Empirical work by Minkler
shows that older outlets are more likely to be franchised than newer ones,
which is consistent with the theory and with Martin’s (1988) results,
although it is not consistent with Thompson (1994). A problem is that the
buy-back phenomenon is consistent with many theories: for example, older
stores may be easier to monitor owing to experience effects unconnected
with distance. It is difficult to imagine an empirical test to distinguish
Minkler’s theory from others.

7. Vertical Restrictions and Franchising

Within the mainstream industrial-organization literature, there are papers
which show that a firm with monopoly power supplying an intermediate
product into a competitive industry has an incentive to exercise vertical
control if downstream input substitution is possible. Vertical restrictions
include refusal to supply, tied-in sales, and exclusive-dealing contracts.
The arguments of several economists that there are efficiency reasons for
all of these practices are reflected in the specialist economic analysis of
franchising, and in the benign view taken by European competition law
towards franchising (Dnes, 1991c). For example, against simple claims
that a monopolist could foreclose a downstream market by refusing to
supply unless buyers were tied into a restrictive contract, it may be argued
that it is profitable to allow access to inputs at monopoly prices to more
efficient downstream firms. However, to be fair, some recent analysis has
revealed conditions under which refusal to supply (Bolton and Whinston,
1993) is a credible policy committing a firm to compete aggressively in the
downstream market and deterring entry. Analyses of franchising based
on monopoly-power explanations of vertical restrictions are typically less
general than theories based on the economics of organization. As a very
simple example of lack of generality, note that monopoly-power theories
of vertical restrictions usually deal with product franchises, when most
business-format franchises are based on services, and would seem to have
relevance only for brand-and-trade-name franchising. The relevance of
the market-power approach is further questioned by a lack of supporting
empirical evidence: for example, Lafontaine (1992) found that the propor-
tion of franchised outlets decreased as franchisor input sales increased.
Blair and Kaserman (1982) formulate a two-period model that does rep-
resent the franchise contract as a mixture of vertical controls. The model
predicts use of both a lump sum and a royalty whenever the franchisor’s
and franchisee’s discount factors diverge (reflecting perceptions of uncer-
tainty). Blair and Kaserman avoid regarding individual controls like resale
price maintenance (RPM) and franchise fees as perfect substitutes for one
another. In general, franchising firms use a mix of contractual devices and
cannot be indifferent between them.
Blair and Kaserman suggest there may be complementarity between
monopoly-power and organizational explanations of common features
of franchised businesses. A franchisor with the relatively lower discount
factor would not be able to extract all the expected downstream rent from
the franchisee. Thus, post-contract tensions would arise as the franchisor
saw franchisees enjoying super-normal profits. If franchisor uncertainty
over forecasts fell over time, mature franchise chains would open more
company stores. Blair and Kaserman also suggest that the franchisor can

practise post-contract opportunism. The franchisor must promise the

franchisee a normal return on investment. Afterwards, however, the fran-
chisor may be able to increase his share of sales revenue without provoking
the franchisee to close down (if there were worse losses from closing). The
franchisor may use strategies like forcing, where quotas push sales past the
point of profit maximization for the franchisee. Blair and Kaserman share
some of the concerns over franchisor and franchisee incentive compatibil-
ity shown in the organizational literature and are not solely motivated by
traditional market-power issues.
Efficiency-based explanations of vertical restrictions are descended
from Telser’s (1960) analysis of RPM. A retailer could provide service
levels like advice and product demonstrations only to find that consum-
ers made use of these and then bought the product at a low price from a
no-frills retailer. There is a free-rider problem among retailers, implying
that no retailer would provide services. If service levels matter in promot-
ing sales for the manufacturing and retailing industries combined, and
are not separable, a means like RPM must be found to defeat free riding.
Marvel (1982) explains exclusive dealing, which is a common feature of
franchising, in a similar fashion. When a manufacturer with a valuable
brand supplies an outlet, it endorses the retailer’s business and centralized
advertising may promote the retailer’s sales more generally. Marvel argues
that exclusive dealing prevents retailers from diverting business to other
brands and wasting advertising.
Klein and Saft (1985) examine tied-in sales and argue that franchisors
use these either to control the quality of the final service, or to measure
the sales of franchisees. Where the franchisee cannot substitute away
from the input, a mark-up on a tie-in is equivalent to a fixed percentage
sales royalty if price is predictable. Tie-ins may also develop where the
franchisor wishes to ensure that franchisees use inputs of specific quality.
Rather than monitoring the required technical properties of more generic
inputs, the franchisor has the much simpler problem of ascertaining
whether anything else was used.
A switching-cost explanation of tied-in sales is explored by Iacobucci
(2008) and alerts us to substitution and complement possibilities between
vertical restrictions, which need to be examined on a case-by-case basis
in franchising, as in more general settings. His article shows that, instead
of using cash discounts, sellers can bundle a tied good that is worth most
to high-demand buyers. This bundling strategy can efficiently screen out
welfare-reducing sales to low-demand buyers that discounting could
provoke. This theory is capable of explaining why after-sales service, often
important in franchise chains, is bundled with a durable good such as an
automobile.

8. Hostages in Franchise Contracts

Transaction-cost analysis shows that franchise contractual provisions that
are often regarded as unfair in the law have important implications for
efficiency (Klein, 1995; Dnes, 2003). Fully contingent, costlessly enforce-
able, explicit contracts are not usually feasible. Uncertainty implies a large
number of possible contingencies and some aspects of contractual per-
formance are difficult to measure. Individuals have an incentive to renege
on agreements and hold up any contracting partner who has made specific
investments by taking advantage of unspecified or unenforceable aspects
of contracts. Full vertical integration between trading partners will not
always be observed: for example, integration of human capital is outlawed
by the prohibition of slavery.
One method of safeguarding performance is for a potential cheater to post
a bond (a ‘hostage’), possibly in an implicit form if the cheater is required
to make an investment in a highly specific form with a very low salvageable
value. In both cases, the same purpose is served. Franchise contracts typi-
cally require franchisees to pay lump-sum fees to franchisors and to make
highly specific investments in equipment. The franchisor usually takes the
right to terminate the contract at will if the franchisee is not maintaining
quality standards. For any hostage to be effective, it must set the franchisee’s
expected gain from cheating equal to zero. This implies that hostages will be
worth much more than the actual gain when monitoring costs are positive.
Cheating by the franchisor is controlled by possible increases in operating
costs. A franchisor known to appropriate hostages opportunistically would
lose franchisees and find it hard to recruit new ones, forcing him to use more
costly organizational forms. As long as the franchisee’s bond is greater than
the franchisee’s expected gain from cheating and is less than the cost penalty
imposed on the franchisor on moving to some other organizational form, a
hostage can support their relationship. The hostage is a low-cost substitute
for costly monitoring and enforcement devices.
Of particular interest is Klein’s argument that the franchisor’s con-
tractual right to terminate the contract at will (for good cause) supports
a number of hostages. Given termination at will, the common require-
ment that franchisees lease their properties from the franchisor can be
explained. The franchisee could be forced to move premises and sacrifice
valuable leasehold improvements, which would revert to the franchisor as
lessor. This gives the franchisor a hostage with which to control franchisee
behaviour and enables monitoring to be reduced with an associated cost
saving. In recent years, Klein has moved to the view that the rents attached
to the non-salvageable investment should be the focus in valuing the fran-
chisee’s potential loss, at least in cases where there are no binding legal
constraints on the franchisor’s behaviour.

It is important to recognize the rich variety of devices used to support

contracts. The use of restrictive covenants in franchise agreements can
also be explained in terms of hostages. Covenants usually prevent a fran-
chisee from competing in a market area for some period after leaving the
franchise system, implying that the non-availability of an alternative rent
stream is used to constrain the franchisee’s behaviour: that is, he cannot
cheat and leave for better pastures. A new franchisee’s future level of skill
is not known but if he becomes highly adept at his business, he might
be tempted to set up on his own. A covenant prevents the franchisee
from simply removing the franchisor’s investment in his training. Also,
termination by the franchisor can cause the loss of the hostage.
Arbitration clauses may be used to avoid costly legal disputes. Drahozal
and Hylton (2003) argue that defining the benefits from contract enforce-
ment as deterred harms net of avoidance costs leads us to expect contract-
ing parties to choose a dispute-resolution forum supporting the greatest
benefits net of the costs of dispute resolution, for all foreseeable disputes.
They apply such a general framework to franchise contracts, conduct-
ing an empirical analysis of the determinants of arbitration agreements.
Examining arbitration mechanisms, they show that benefits from deter-
ring contract breach generally outweigh litigation costs in the design of
dispute resolution agreements. The probability of arbitration is signifi-
cantly higher when the parties rely on implicit contract terms for which
compliance is difficult to enforce.
Williamson (1985) makes some suggestions concerning likely hostage
selection. Implicit hostages are less vulnerable to opportunistic appropria-
tion by trading partners compared with pecuniary hostages. A hostage can
be selected to be unattractive to its holder. An ideal hostage is like an ‘ugly
princess’: the medieval king with two equally cherished daughters would
be wiser posting the ugly one as a hostage, as she is less likely to be appro-
priated by the captor.
A number of common observations emerge from studying franchisees’
contracts (Dnes, 1993d). Franchising increases the specificity of invest-
ment for the satellite business, compared with independent operation;
for example, leasehold improvements are trademarked and hard to adapt
to other uses. Also, lump-sum fees are typically small in relation to sunk
investment for the franchisee and appear to be linked to the franchisor’s
costs of establishing the franchisee (training and launch advertising). The
implicit aspects of contracts are important and show adjustments that
favour the interests of both franchisees and franchisors.
The feasibility of placing disciplinary hostages with franchisors is quali-
fied by the explicit and implicit details of franchise contracts, which often
set out conditions under which the franchisor must buy back assets in the

event of termination. Statute law in some countries, like the USA, also
makes it difficult to call in a hostage for disciplinary reasons. Principles
of common law, such as the prohibition against penal damages for breach
of contract, may also make disciplinary hostages illegal in an Anglo-
American setting.
It is not surprising that franchisees are careful to avoid hostage penalties
in their contracts: investments in such things as leasehold improvements
are not ugly princesses but are of potential direct value to the franchisor.
There are several questions about the real-world feasibility of disciplinary
hostages, regardless of whether these are measured as rent streams or as
the book value of sunk investments. Sunk investment by the franchisee
may well have mainly a screening function, serving to demonstrate confi-
dence in his own competence. A hostage really needs to post the rents in a
contract, rather than some form of sunk cost, or it will not be effective in
governance. Equally, we need to recognize the manner in which contracts
can alter the sunk nature of expenditures.
It can be argued that non-cooperative behaviour, including franchisor
opportunism and franchisee moral hazard, is best removed from within
organizations, being more naturally a characteristic of market interac-
tions. It is not surprising that franchise chains show evidence of structures
aimed at enhancing communication and cooperation between franchisees
and the franchisor. Windsperger et al. (2007) show that franchisee councils
play an important role in relation to enhancing cooperation. The creation
of a council is more likely, as decision rights within the network become
increasingly allocated to the franchisor.
9. Conclusions
The last decade has witnessed considerable progress in the scientific under-
standing of franchising. Several theories have been constructed to explain
franchising, most of which emphasize savings of monitoring costs in an
agency framework. Details of the theories show how opportunism on the
part of both franchisors and franchisees may be controlled. In separate
developments, writers have argued that franchisors recruit franchisees to
reduce information-search costs, or that they signal franchise quality by
running company stores.
The associated empirical studies tend to support theories emphasizing
opportunism on the part of franchisors and franchisees. Thus, elements of
both agency approaches and transaction-cost analysis receive support. The
most robust finding is that franchising is encouraged by factors like geo-
graphical dispersion of units, which increases monitoring costs. Other key
findings are that small units and measures of the importance of the fran-
chisee’s input encourage franchising, whereas increasing the importance

of the franchisor’s centralized role encourages the use of company stores.

In many key respects, in result although not in principle, transaction-cost
analysis and agency analysis are just two different languages describing the
same franchising phenomena.
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PART IV
PERSPECTIVES

19 Behavioral approaches to contract law
Ann-Sophie Vandenberghe
1. Introduction
Legal scholars have increasingly used existing scholarship in both cognitive
psychology and behavioral economics, which suggests that human behav-
ior often deviates from rational choice in systematic and predictable ways,
to explain legal phenomena and to argue for legal reforms. This behavioral
approach to law has infiltrated the legal literature in such diverse areas as
tax law, administrative law, environmental law, criminal law, civil pro-
cedure, corporate securities law, tort law, and contract law (Langevoort
1998). There now exists an increasingly rich literature which attempts to
blend behavioral analysis and economic analysis of law into a ‘behavioral
economic analysis of law’. This new movement within legal scholarship is
called ‘behavioral law and economics’ (Sunstein 1997; Jolls et al. 1998) or
‘law and behavioral science’ (Korobkin and Ulen 2000) and builds on the
core insights of law-and-economics scholarship, but seriously scrutinizes
the shortcomings of rational choice theory. It asserts that legal scholars
seeking to understand the incentive effects of law in order to propose
efficacious legal policy should not be limited to rational choice theory,
since people regularly make decisions that deviate from rational choice in
predictable ways (Korobkin and Ulen 2000). Instead of a strict adherence
to rational choice theory, this new movement adopts a more subtle and
context-dependent view of how individuals behave for use in legal analy-
sis (Korobkin 2004). The ultimate goal of behavioral economic analysis
of law is to offer better predictions and prescriptions about law based on
improved accounts of how people actually behave (Jolls 1998).
This chapter is a review of the literature on the central attributes of
behavioral law and economics and its applications in the field of contract
law. Section 2 presents some of the evidence of non-rational behavior on
which scholars of behavioral law and economics have relied. Where pos-
sible, the general implications of the behavioral findings for the economic
analysis of law will be shown. Section 3 summarizes the challenges and
responses in the general debate over the role of behavioral economics in
legal policy-making. An overview of the specific applications of the behav-
ioral approach in the field of contract law is given in section 4. Conclusions
on the value of the behavioral approach for the analysis of contract law
follow in section 5.
401

2. Evidence of Non-rational Behavior and General Implications for the

Economic Analysis of Law
Conventional law and economics assumes that people exhibit rational
behavior: that people are self-interested utility maximizers with stable
preferences and the capacity to optimally accumulate and assess infor-
mation. However, a large body of social science literature, like cognitive
psychology, behavioral decision theory, and behavioral economics, dem-
onstrates that these assumptions are not always accurate and that devia-
tions from rational behavior are often systematic. Based on this evidence,
Jolls et al. (1998) claim that people exhibit bounded rationality, bounded
self-interest, and bounded willpower. The focus of this section is on the
evidence relating to bounded rationality.
The notion of ‘bounded rationality’ was introduced by Herbert Simon
(1955) and refers to the fact that there are critical psychological limits on
human cognition. In the past few decades, much has been learned about
human cognitive limitations and their implications for behavior. Only a
small part of the behavioral findings will be presented here.
First, there is evidence that cognitive limitations force actors to employ
relatively simple decision-making strategies which may cause actors to fail
to maximize their utility (see section 2.1). Second, numerous tests done by
psychologists and experimental economists have shown that people often
do not exhibit the kinds of reasoning ascribed to agents in rational choice
models. People make reasoning errors, and more importantly, these errors
are typically systematic. Psychologists hypothesize that subjects make
systematic errors by using decision ‘heuristics’, or rules of thumb, which
fail to accommodate the full logic of a decision. The systematic errors are
often referred to as ‘biases’, and this general topic often carries the label
‘heuristics and biases’ (see section 2.2). Third, evidence from social science
demonstrates that preferences are not as stable as typically assumed in
rational choice theory, but instead depend on endowment, status quo, or
default rule (see section 2.3).
2.1. The Use of Simplified Decision-making Strategies

An important early critic of the rational choice model’s descriptive
adequacy was Herbert Simon. As an alternative to utility maximization,
Simon (1955) introduced the notion of ‘bounded rationality’, which asserts
that cognitive limitations force people to construct simplified models of
the world in order to cope with it. In standard optimizing theory, agents
act as if they perform exhaustive searches over all possible decisions and
then pick the best. Simon (1955, 1987) hypothesizes that agents instead
perform limited searches, accepting the first ‘satisfactory’ decision.
The plausible assumption is that because individuals are limited in

Behavioral approaches to contract law 403
their information-processing capacity, they tend to simplify the cognitive

requirements of the decision process. This tendency will be more pro-
nounced as the decision increases in complexity. The most obvious com-
ponent of complexity – information load – has typically been defined as
m (the number of alternatives) multiplied by n (the number of attributes).
Social science research reveals that as the alternatives become more
numerous and/or vary on more attributes, people are more likely to reduce
their information search and to adopt simplifying strategies which require
less cognitive effort than a complete cost-benefit analysis of the available
alternatives (Abelson and Levi, 1985). The key characteristic of simplified
decision rules is that they ignore information that is potentially useful for
selecting the best alternative. There is ample evidence that several choice
rules, especially simple non-compensatory1 ones, can lead to suboptimal
choices.
It has been argued that bounded rationality arising from the high costs
of acquiring and processing information is entirely consistent with ration-
ality, which does not presuppose zero costs of acquiring and processing
information. Indeed, intentional ‘satisficing’ is often quite sensible in
light of both the costs of obtaining and processing the information to
make maximizing choices and the cognitive limitations on human beings.
Korobkin and Ulen (2000, p. 1076) argue that although ‘satisficing’
behavior can be rational in a ‘global’ sense, it nonetheless violates rational
choice theory because ‘satisficing’ causes actors to fail to maximize their
utility in the particular decision-making situation at hand.
This finding, that decision-makers are likely to make choices that fail
to maximize their expected utility in situations in which decisions are
complex relative to the capacities of those making the choice, challenges
the traditional law-and-economics conclusion that a well-functioning
market ensures that contractual exchanges and contract terms that exist
in the marketplace will maximize social value. The premises of economics
underlying traditional law-and-economics analysis push in the direction
of freedom of contract: if parties are rational, they will enter contracts
only when it is in their self-interest, and they will agree only to terms
that make them better off; otherwise, they would not have voluntarily
agreed to them. Korobkin and Ulen (2000, p. 1081) argue that the tradi-
tional law-and-economics theory needs to be modified for situations in
1
Non-compensatory decision rules do not allow trade-offs between alterna-
tives. The non-compensatory category includes the conjunctive decision rule, the
disjunctive decision rule, the lexicographic decision rule, and the elimination by
aspects rule. Under a compensatory decision rule, negative scores on one attribute
can be compensated by positive scores on another attribute.

which complexity and ambiguity create substantial barriers to optimizing

behavior.
2.2. Heuristics and Biases

In the past few decades, much has been learned about human cognitive
limitations and their implications for behavior, particularly with regard to
decisions made in the face of uncertainty and risk. If people are to respond
optimally to the risks they face, they must have reasonably accurate percep-
tions of the magnitude of those risks. However, numerous studies show that
people (including experts) have great difficulty judging probabilities, making
predictions and otherwise attempting to cope with uncertainty. Frequently
these difficulties can be traced to the use of judgmental heuristics, which serve
as general strategies for simplifying complex tasks. These heuristics are valid
in many circumstances, but in others they lead to large and persistent biases,
with serious implications for decision-making (Tversky and Kahneman
1974). The study of heuristics and biases tends to be dominated by attempts
to expose systematic errors in human judgment and decision-making.
One persistent source of error relevant for risk perception arises from
the availability heuristic (Tversky and Kahneman 1973). People using this
heuristic judge the probability of a future event based on the ease with
which instances can be brought to mind. Availability is a useful clue for
assessing probability, but because availability is affected by factors other
than probability, reliance on it leads to predictable biases. A pervasive fact
about human judgment is that people disproportionately weight salient,
memorable, or vivid evidence, even when they have better sources of
information. The availability heuristic contributes to many specific further
biases. One is hindsight bias (Fischhoff 1975). Because events that actually
occurred are easier to imagine than counterfactual events that did not,
people have a tendency to overestimate the probability they previously
attached to events that later happened. In hindsight, people consistently
exaggerate what could have been anticipated with foresight.
The representativeness heuristic (Tversky and Kahneman 1974) refers
to the tendency to assess the probability that some process A will bring
about some event B by the degree to which A is representative or similar
to B. This approach to the judgment of probability leads to serious errors
because similarity or representativeness is not influenced by several factors
that should affect judgments of probability.
Another source of error is anchoring and adjustment, referring to a
tendency to resist altering a probability estimate, once formed, when
pertinent new information comes to light (Slovic and Lichtenstein 1971;
Tversky and Kahneman 1974). Furthermore, even when actors know the
actual probability distribution of a particular event, their predictions as

to the likelihood that that event will happen to them are susceptible to
the overconfidence bias: the belief that good things are more likely than
average to happen to them and bad things are less likely than average to
happen to them. Overconfidence leads to over-optimism. Related to the
overconfidence bias is the confirmatory or self-serving bias, the term to
describe the observation that actors often interpret information in ways
that serve their interest or preconceived notions.
The experimental evidence and empirical analysis suggest that people
make consistent and systematic errors in risk assessment, which undermines
the standard assumption of conventional law and economics that fully
informed individuals employ expected utility analysis to accurately assess
risk (Arlen 1998). Behavioral economic analysis of law scholars generally
focus on evidence that people systematically underestimate many risks –
particularly risks to themselves. The possibility that people are systemati-
cally overly optimistic has important implications for the economic analysis
of law. It suggests that individuals operating in markets may underestimate
the risk to which they are subject, and thus take actions that do not maximize
their own utility. As a result, social welfare also will not be maximized.
2.3. The Endowment Effect, Status-quo Bias and Default Preference

The ‘endowment effect’ (Thaler 1980) stands for the principle that people
tend to value goods more when they own them than when they do not. A
consequence of the endowment effect is the ‘offer-asking gap’, which is the
empirically observed phenomenon that people will often demand a higher
price to sell a good that they possess than they would pay for the same
good if they did not possess it at present. The paradigmatic experimental
demonstration of this is the ‘mugs’ experiment of Kahneman et al. (1990).2
Another term – the ‘status-quo bias’ (Samuelson and Zeckhauser 1988)
– refers to an exaggerated preference for the status quo.3 It is often used
interchangeably with the endowment effect, but actually has a slightly
2
In their experiments, some subjects are endowed (randomly) with coffee
mugs, and others are not. Those who are given the mugs demand a price about two
to three times as large as the price that those without mugs are willing to pay, even
though in economic theory these prices should be extremely close together.
3
When Harvard University added new health-care plan options, older faculty
members who were hired previously when the new options were not available were
allowed to switch to the new options. If one assumes that new and old faculty
members have essentially the same preferences for health-care plans, then the
distribution of plans elected by new and old faculty should be the same. However,
Samuelson and Zeckhauser found that older faculty members tended to stick to
their previous plans; compared with the newer faculty members, fewer of the old
faculty elected new options.

broader connotation: individuals tend to prefer the present state of the

world to alternative states; all else equal, they prefer to leave things as they
are. Furthermore, people may have an exaggerated preference for which-
ever option is the default choice (Korobkin 1998a, 1998b).
All three phenomena (status-quo bias, default preference, and endow-
ment effects) are routinely explained as a result of ‘loss aversion’, the
element of prospect theory that losses from a reference point are valued
more highly than equivalent gains (Kahneman and Tversky 1979; Tversky
and Kahneman 1991). Making one option the status quo or default
or endowing a person with a good seems to establish a reference point
people move away from only reluctantly, or if they are paid a large sum.
Thaler (1980) explains the endowment effect as the underweighting of
opportunity costs. If out-of-pocket costs are viewed as losses and oppor-
tunity costs are viewed as foregone gains, the former will be more heavily
weighted. Thus a person would be willing to pay more in opportunity
costs to keep a good that he already possesses than he would be willing to
spend in received income (out-of-pocket money) to acquire the good. In
comparison to a world in which preferences are independent of endow-
ment, the status quo, or the default rule, the existence of loss aversion
produces an inertia in the economy because gains from trade are reduced
and potential traders are more reluctant to trade than is conventionally
assumed (Kahneman et al. 1990). This is not to say that Pareto-optimal
trade will not take place. Rather, there are simply fewer mutually advan-
tageous exchanges possible and so the volume of trade is lower than it
otherwise would be.
The endowment effect, status-quo bias, and default preference – when
they exist – undermine the central premise of conventional law and eco-
nomics that fully informed individuals allowed to exercise free choice will
maximize their own utility, and thus social welfare, when transaction costs
are low. In such a case, legal regimes will not necessarily maximize social
welfare simply by following the standard law-and-economics prescription to
minimize transaction costs and allow markets to operate whenever possible.
3. From Behavioral Findings to a Renewed Analysis of Law: Difficulties

and Opportunities
While the experimental literature presents a compelling case that people are
not necessarily rational utility maximizers, some authors have questioned
the usefulness of behavioral insights for legal analysis. Does behavioral
research offer an alternative model of human behavior suitable for nor-
mative policy analysis, and if so, what exactly are the normative implica-
tions? This section summarizes the challenges and responses in the general
debate on the role of behavioral economics in legal policy-making.

3.1. Do Individuals Act Rationally after All?

Conventional law-and-economics analysis assumes that people exhibit
rational behavior: that people are self-interested utility maximizers with
stable preferences and the capacity to optimally accumulate and assess
information. Law-and-economics scholars do not claim that this rational
choice model perfectly captures all human behavior, but they do claim
that deviations from rational choice generally are not systematic, and
thus generally will cancel each other out. These scholars thus assert that
rational choice, while not a perfect description of human behavior, is the
best workable approximation of human behavior. Spitzer and Hoffman
(1980, p. 1191) state that observations that do not conform to the assump-
tions of the rational choice model do not necessarily constitute grounds
for rejecting the model as an analytical tool:
If a model’s predictions are generally borne out in economic, political, or legal

situations, the model is a useful policy tool because it is generally correct about
outcomes, even though its behavioral assumptions are generally false. We say
in using such a model that people behave ‘as if’ they conform to the assump-
tions of the model.
According to Epstein (2006, p. 113) ‘the right way to understand the

theory of rational behavior cannot be to assume away . . . pervasive
human frailties. Rather, it is to explore how people of limited capacities
learn to cope with their own limitations and to succeed in spite of them, as
they often do’. Real-world choices often are affected by market choices,
expert advice, and individual experiences, which may alter, reduce, or
even eliminate judgment errors and biases. Education may also reduce
or eliminate some biases under certain circumstances. People operating
in certain markets, where learning is possible and errors are punished,
and people guided by experts who are repeat players, may act rationally
after all.
Behavioral economic analysis of law scholars argue instead that the
deviations from rational choice are systematic, not random. Most people
are likely to exhibit certain biases, they assert, and thus these deviations
from rational choice do not cancel each other out.
The argument that people have strong incentives to choose optimally
because actors who fail to make rational decisions cannot survive in a com-
petitive world carries lesser force for individuals than for firms. Firms may
fail for lack of profits, but people usually do not die of sub-optimization
(Conlisk 1996). Even with regard to business firms, Korobkin and Ulen
(2000, p. 1071) state that ‘if it were true that competition drives imperfectly
rational behavior out of business markets, such results would not occur
instantaneously, and at any given moment in time a substantial number

of participants in markets would likely be imperfectly rational actors who

have not yet learned their lessons’.
Moreover, some people need to make decisions in situations where
the individual decision-maker is not a repeat player who will learn from
errors. Even when people can learn from their errors, evidence suggests
that people learn to reassess risks only in certain conditions. Learning is
promoted by favorable conditions such as awards, repeated opportuni-
ties for practice, good feedback, unchanging circumstances, and a simple
context. Conversely, learning is hindered or blocked by the opposite
conditions (Conlisk 1996).
Although behavioral law and economics focuses on departures of
rational choice theory, it does not intend to suggest that standard eco-
nomic forces are unimportant or, as posited by Ulen (1998, p. 1763): ‘A
new theory of human decision making is in the offing, one that captures
the best of rational choice theory and supplements it with a subtle view of
how and why and when humans make mistakes in judgment.’
3.2. A Model of Human Behavior Suitable for Normative Policy Analysis

The experimental literature presents a compelling case that people are not
necessarily rational utility maximizers but instead may exhibit certain pre-
dictable, systematic biases. Posner (1998), however, states that describing,
specifying, and classifying the empirical failures of rational choice theory
is an important scholarly activity, but it is not an alternative theory of
human behavior. Arlen (1998) argues that behavioral economics of law
cannot serve as the basis for broad normative policy conclusions because
it cannot provide a coherent alternative model of human behavior capable
of generating testable predictions and policy conclusions in a wide range of
areas. According to Arlen (1998), laboratory and empirical results are dif-
ficult to transform into a model of human behavior suitable for normative
policy analysis. First, many biases exist in some circumstances but not in
others, with the scope of the biases often being difficult to predict. Second,
individuals making risky choices in the real world often are subject to more
than one bias and employ multiple heuristics, with sometimes conflicting
effects. Indeed, the cognitive theory seems to contain examples of all kinds
of errors: for example, while availability may account for overestimation
of a catastrophe, anchoring may explain under-reaction. According to
Issacharoff (2002, p. 39), the concern with applying behavioral economics
to law is that the empirical observations are either insufficiently robust or
amenable to conflicting interpretations, thereby limiting their ability to
offer reliable generalizations.
Korobkin and Ulen (2000, pp. 1057–58) respond to this type of critique
by arguing that ‘one can analyze the appropriate legal command in any

given circumstance without a grand, overarching theory of behavior as

long as one has a due regard for the relevant decision-making capabilities
of the actors in that specific setting’. Moreover, these authors (Korobkin
and Ulen 2000, p. 1072) state that ‘most laws are geared toward specific
portions of the population or to people who play specific roles.’ Hence,
even when behavioral economic analysis of law cannot yet provide a
general framework applicable to many areas of law, it can be used to for-
mulate specific normative policies. The project’s goal is to develop a more
nuanced understanding of behavior for use by legal policy-makers.
3.3. Normative Implications of Behavioral Findings

An important, but under-addressed, question in behavioral law and eco-
nomics is how evidence of bounded rationality is relevant to the formula-
tion of legal policy. It is somewhat unclear if and how legal intervention
can address non-rational tendencies in decision-making.
Many authors have recognized that it is difficult to formulate norma-
tive policy which takes cognitive biases into account because legal regimes
designed to address the biases and heuristics generally require the inter-
vention of judges, legislators, or bureaucrats, who are themselves subject
to various biases. Arlen (1998, p. 1769) posits that ‘interventions to “cure”
bias-induced inefficiency may ultimately produce outcomes that are worse
than the problem itself’.
One important finding of behavioral research is that values and prefer-
ences are not fixed, but depend on endowment, context, or the way in
which choice is presented. However, the normative implications of these
findings are far from clear. The behavioral research on the importance
of context predicts, for example, that altering default rules and rules of
presentation produces different outcomes, and it shows the unreliability
of perceived behavior as a gauge of actual preferences or likely future
behavior. However, according to Issacharoff (2002), behavioral research
cannot contribute to normative conclusions about which outcome is
desirable and should be pursued as a matter of public policy. This con-
clusion must be derived externally from broader economic and policy
considerations. Posner (1998) is concerned that the behavioral findings
that people’s preferences are unstable and manipulative will be used as
a pretext for the intervention of a totalitarian government charged with
determining the populace’s authentic preferences. That would clearly
be an abuse of behavioral decision theory. Korobkin and Ulen (2000)
admit that when policy-makers wish to use law as a means of promoting
efficiency, behavioral economic analysis of law’s present recognition of
the importance of context cannot yield normative implications that are
clearly superior to those of conventional law and economics. They state

that ‘if an actor selects “choice A” because the choices are presented in a
particular context, but he would have otherwise selected “choice B”’, it
is often difficult to determine whether the law will enhance efficiency by
reinforcing “choice A”, encouraging “choice B” in spite of the context, or
changing the context so that the actor will select “choice C”’ (Korobkin
and Ulen, 2000, p. 1104). However, Korobkin and Ulen (2000, p. 1104)
argue that understanding the importance of context for decision-makers
can enable policy-makers who want to use law as a means of achieving a
pre-established goal to establish a closer fit between the means and ends
than rational choice theory would permit.
The other important finding of behavioral research is that boundedly
rational actors make judgment errors. The consequence of bounded
rationality is that individuals make particular decisions in ways that are
not utility maximizing for them (even though the time and effort saved by
using simplified decision rules and heuristics might enable them to maxi-
mize their global utility). To the extent that the law can be used as a tool
to help actors make decisions that better maximize their utility in those
particular circumstances, law can improve efficiency. If cognitive illusions
do lead parties to make errors, then the law might play a role in reduc-
ing them. However, most of the suggestions made in behavioral law and
economics for legal reform are for devices of getting around rather than
dispelling non-rational tendencies. The usual approach in behavioral law
and economics work is to focus on designing legal rules and institutions
‘to curtail or even entirely block choice in the hope that legal outcomes do
not fall prey to problems of bounded rationality’ (Jolls and Sunstein 2006,
p. 200). In the existing behavioral law and economics literature, ‘bounded
rationality might be, and often is, taken to justify a strategy of insulation,
attempting to protect legal outcomes from people’s bounded rationality’
(Jolls and Sunstein, 2006, p. 200). However, Jolls and Sunstein (2006, p.
200) state that a quite different possibility is ‘that legal policy may respond
best to problems of bounded rationality not by insulating legal outcomes
from its effects, but instead by operating directly on the boundedly rational
behavior and attempting to help people either to reduce or to eliminate it.’
They describe legal policy in this category as ‘debiasing through law’.
‘Debiasing through law’ strategies can recognize human limitations, while
at the same time avoiding the step of removing choices from people.
3.4. Paternalism
The presence of systematic biases poses a particular challenge to the
strongest anti-paternalism arguments of conventional law and economics,
many of which appear to depend on the assumption that individuals make
rational choices. Sunstein (1997, p. 1178) asserts that the recent revisions

in understanding human behavior greatly unsettle certain arguments

against paternalism in law. While these revisions do not make an affirma-
tive case for paternalism, they support a form of anti-antipaternalism.
According to Issacharoff (1998), it is true that the tools of psychology
yield a richer understanding of human behavior, but this cannot possibly
translate into a justification for greater constraints on individual decision-
making through paternalistic interventions. In his view, ‘it would be ironic
if greater insight into the complexity of human decision making became
the justification for taking the freedom to decide, even if imperfectly, from
those very individuals’ (Issacharoff 1998, p. 1745).
However, scholars of the behavioral approach claim that the errors iden-
tified by behavioral research lead people to behave against their best inter-
ests, in which case paternalism may prove useful. If, for example, parties to
a contract suffer from cognitive limitations that prevent them from making
wise commitments, then there is at least a prima-facie case for more pater-
nalistic forms of judicial intervention rather than strict reliance on freedom
of contract. Generally speaking, when the behavioral analysis identifies
cognitive errors that parties are prone to making, it supports somewhat
paternalistic doctrine. If people make systematic errors in judgment, then
they will make bad choices even when they have the incentives and infor-
mation needed to make good ones, and hence, do themselves harm if left
to their own devices. This is the psychological argument for paternalism.
Recognition of the fallibility of human judgment commonly inspires calls
for imposing constraints on individual choice. Scholars of behavioral law
and economics do recognize that such restrictions on individual choice
would be costly for those individuals who are able to behave in their own
best interest. Therefore, they have sought to develop non-intrusive forms
of paternalistic intervention focusing on ways to allow individuals to make
better choices, rather than restricting choices.
Camerer et al. (2003) propose an approach to evaluating paternalistic
regulations and doctrines that they call ‘asymmetric paternalism’. A regu-
lation is asymmetrically paternalistic if it creates large benefits for those
people who make errors, while imposing little or no harm on those who
are fully rational. Such regulations are relatively harmless to those who
reliably make decisions in their best interest, while at the same time advan-
tageous to those making suboptimal choices. The authors embrace cost-
benefit analysis as a method of determining the desirability of paternalistic
regulations: are the benefits of mistake prevention larger than the harms
imposed on rational people? The authors review potential regulations such
as default rules, framing issues, cooling-off periods, and limiting consumer
choice, and describe circumstances under which each regulation may be
asymmetrically paternalistic.

According to Rachlinsky (2003), the psychological case for paternalism

should not depend only upon a comparison of the costs of a regulatory
intervention with the benefits of saving people from their own choices,
but depends on demonstrating that the cost of either learning to adopt a
superior approach to a choice or relying on others to make a choice exceed
the cost of the paternalistic intervention.
Sunstein and Thaler (2003) advocate ‘libertarian paternalism’, an
approach that preserves freedom of choice, but encourages both private
and public institutions to steer people in directions that will promote their
own welfare. Libertarian paternalism is a relatively weak, soft, and non-
intrusive type of paternalism because choices are not blocked, fenced off,
or significantly burdened. The paternalistic aspect consists in the claim
that it is legitimate for private and public institutions to attempt to influ-
ence people’s behavior in directions that will make people’s lives better;
in other words, that it is legitimate to ‘nudge’ (Thaler and Sunstein 2008).
One particular form of paternalism embodied in libertarian paternalism
is ‘minimal paternalism’. It occurs whenever a planner (private or public)
constructs a default rule or starting point with the goal of influencing
behavior without forbidding any options (Sunstein and Thaler 2003,
p. 1188). Libertarian paternalists also ask the question: how much choice
should people be given? While libertarian paternalists want to promote
freedom of choice, they need not seek to provide bad options, and among
the set of reasonable ones, they need not argue that more is necessarily
better (Sunstein and Thaler 2003, p. 1196).
4. Applications of Behavioral Law and Economics to Contract Law

This section presents an overview of the applications of behavioral law
and economics in the field of contract law. The implications of the behav-
ioral approach for the general rules of contract law will be mentioned first,
followed by the implications for the specific rules governing consumer
contracts.
4.1. General Rules of Contract Law
4.1.1. Contract default rules Traditional law-and-economics analysis

of contract ‘default’ rules – that is, legal rules that govern the relation-
ship between contracting parties only if the parties do not explicitly agree
to different terms – posits that (1) unless transaction costs are unusually
high, the choice of default rules will have little effect on the contract terms
because wealth-maximizing parties will contract around inefficient default
terms, and (2) default terms should mirror the terms that the majority of
contracting parties would choose (‘majoritarian’ defaults) to minimize the

transaction costs when contracting around inefficient defaults. Evidence of

the status-quo bias suggests that revisions to both elements of the conven-
tional wisdom are appropriate (Korobkin and Ulen 2000).
Korobkin (1998a and 1998b) has shown experimentally that default
rules are more difficult to contract around than rational choice theory
explanations suggest. This is because contracting parties are likely to see
default terms as part of the status quo and, consequently, prefer them to
alternative terms, all other things equal. If this is the case, default terms
will be sticky and the choice of defaults may determine the terms that the
parties adopt in many cases (Korobkin and Ulen 2000, p. 1112). Even
if ‘majoritarian’ terms are selected as defaults, this stickiness will cause
some of the parties in the ‘minority’ not to contract around the default
rule even if it would be efficient for them to do so and transaction costs
are low. Because the status-quo bias makes default terms sticky and
reduces the number of parties expected to contract around defaults, it is
particularly important to select default terms that maximize efficiency for
most contracting parties (Korobkin 1998b). However, the status-quo bias
highlights the difficulty that policy-makers face in attempting to deter-
mine which terms the majority of contracting parties would favor. At a
minimum, the status-quo bias demands that lawmakers seeking to prom-
ulgate majoritarian default terms look for evidence other than what terms
are adopted in a market with an existent default for indications as to what
terms the majority would prefer (Korobkin and Ulen 2000). Hence, the
status quo bias provides an argument against the role of trade or standard
practices as a basis for determining the majoritarian default rule, because
the fact that trade practices are widely adopted does not prove that they
are optimal, even if transaction costs are low.
In the field of employment contract law, Millon (1998) argues that the
current prevalence of at-will employment in the US does not necessar-
ily indicate its superiority to job security when status-quo bias is taken
into account. If the efficiency of observed behavior cannot be taken for
granted, current arrangements do not deserve default-rule status simply
because people tend to choose them.
Korobkin (1998b) proposes two default-rule policies to reduce the
opportunities for parties to become biased in favor of the status-quo
terms: tailored default rules and non-enforcement defaults. The ‘non-
enforcement default’ announces that courts simply will refuse to enforce
contracts with gaps. Such a default term creates a status-quo term (non-
enforcement) which is so strongly disliked by all contracting parties that
parties will affirmatively contract for a different term. Especially for con-
tingencies that are highly salient to parties, such that they are unlikely to
forget to negotiate terms to address them, it might be preferable not to

provide a default term at all, instead denying enforcement of contracts

that fail to provide a term governing the contingency. ‘Tailored defaults’
leave the content of the default rule at the time of contracting unresolved.
Tailored default terms are given content by judges after the parties com-
plete their contract and a contingency occurs for which the contract does
not explicitly provide. When determining the content of the default rule,
judges will take into account the specific characteristics of the parties and
the circumstances of the particular transaction. Because the exact content
of tailored default terms is unknown to parties at the time of contracting,
parties are unable to clearly perceive a status-quo term. Tailored default
rules are typically formulated as a standard. Long-standing questions
about the comparative virtues of rules versus standards might well take
into account the behavioral insight that standards are likely to minimize
the status-quo bias (Korobkin 2000).
4.1.2. Liquidated damages and the penalty doctrine One of the puzzles
of conventional law and economics is the courts’ reluctance to enforce
penalty clauses. According to Eisenberg (1995), the special scrutiny of
liquidated damages is justified because such provisions are systematically
more likely to be the products of the limits of cognition than performance
terms, that is, terms that specify the performance each party has to render.
Eisenberg asserts that although parties can easily understand terms such
as subject matter, quantity, and price, they cannot comprehend all sce-
narios of breach and the application of liquidated damages provisions
to these scenarios. Because people accumulate, understand, and process
only a limited amount of information about the future, contracting parties
may fail to comprehend and focus on the prospect of breach. In addition,
parties at the bargaining stage are generally overly optimistic about their
ability to perform and will sacrifice the detailed bargaining necessary to
achieve an effective liquidated damage provision. The consequence is that
liquidated damages provisions, to the extent that parties intend them to
serve as a proxy for expected actual damages, are likely to be quite erratic.
The policy implication of this observation, according to Eisenberg, is that
it is proper for courts to scrutinize these provisions more closely.
Korobkin and Ulen (2000) are less sanguine about this conclusion,
because it implicitly assumes that parties are better served by accuracy in
damages than by ex ante certainty as to what damages will be if a breach
occurs – a position that is open to debate.
Hillman (2000) argues that behavioral decision theory cannot resolve
the puzzle of liquidated damages. Although some phenomena like over-
optimism support scrutiny of this provision, other cognitive heuristics and
biases support strict enforcement of the provision. First, assuming that

parties consider default rules – here the award of expectation damages

– as part of the status quo, contracting around this default and agreeing
to liquidated damages suggests that the term must be very important for
parties and that they bargained over the provision with care. Second,
assuming that cognitively limited parties do not like ambiguity, they may
prefer the safety of a liquidated damages provision over the uncertainty
of expectation damages. Third, judges who exhibit hindsight bias will
overestimate the parties’ ability to calculate at the time of contracting the
actual damages that would result from breach. Because judges will believe
that the parties’ remedial situation at the time of contracting was not
ambiguous, judges will undervalue the importance the parties attach to
the agreed-upon damages provision. For these behavioral reasons, courts
should presume the enforceability of such provisions rather than making
every effort to strike them.
Rachlinsky (2000) argues as a response to Hillman’s skepticism that
biases that cause over-optimism justify scrutiny of liquidated damages
provisions. The status quo bias does not justify deference because the
increased effort to bargain around the damages rule does not necessarily
eliminate the effects of over-optimism. Although aversion to ambiguity
justifies deference to liquidated damages, courts actually use this insight
under the penalty doctrine by giving more deference to liquidated damages
clauses when damages are hard to calculate (and thus ambiguous).
Eric Posner (2003) states that the behavioral account of the penalty doc-
trine cannot explain why the biases justify judicial scrutiny of liquidated
damages terms but not other terms. If parties overlook low-probability
events, then any contractual term that makes obligations conditional on
events that occur with a low probability could be defective on a behavioral
account, but because they are not liquidated damages provisions, actual
courts do not subject them to scrutiny. The behavioral approach does not
seem to explain existing contract law. It may also not provide a solid basis
for normative recommendations for reforming contract law. Monumental
floodgate problems would be created if courts were to police potentially
all contract provisions to account for parties’ irrationality in processing
information. This would undermine contract law’s goal of certainty and
predictability (Hillman 2000, p. 735).
4.1.3. Consequential damages The traditional contract default rule

protects the promisor against non-foreseeable consequential damages.
Garvin (1998) argues that the cognitive literature favors, at some level,
limits on even foreseeable consequential damages. He justifies attenuating
the promisor’s liability as a means of correcting for its systematic under-
pricing of risk. Generally, if individuals are overconfident about their own

ability to perform the terms of the contract, they would tend to under-
estimate the likelihood that they will be unable to perform. The remote
risks at play will be undervalued by contractual parties, particularly those
who seldom deal with these risks; as a result, they will make too small an
allowance for them in the contract price, and thus will not adequately
compensate the risk-bearing promisor. Garvin therefore supports a role
for a disproportionality test that focuses on the disparity between the size
of the risk and the size of the premium charged to bear it as part of the law
of consequential damages.
4.2. Consumer Contracts

A growing literature models consumer markets in which sophisticated
firms interact with boundedly rational consumers and consumers who
may have psychological biases. Absent legal intervention, the sophis-
ticated seller will often exploit the consumer’s behavioral biases. The
contract itself, commonly designed by the seller, will be shaped around
consumers’ systematic deviations from perfect rationality. Such biased
contracting is not the consequence of imperfect competition. On the con-
trary, competitive forces compel sellers to take advantage of consumers’
weaknesses (Bar-Gill 2004). Section 4.2.1 gives an overview of contractual
practices in consumer markets which are regarded in the behavioral law
and economics literature as responses to consumers’ boundedly rational
behavior, or even as conscious attempts by firms to exploit the cognitive
limitations of consumers. Section 4.2.2 lists some of the suggestions made
in the behavioral law and economics literature as strategies for improving
consumer choice.
4.2.1. Contractual exploitation of consumer biases
1. inefficient contract terms in standard form contracts

Korobkin (2003) assumes that buyers, when confronted with standard
form contracts, compare only limited numbers of product and contract
attributes when contemplating purchase because they are boundedly
rational rather than fully rational decision-makers. He claims that com-
petition between sellers will generate the efficient level of quality for the
attributes buyers consider (‘salient’ attributes), but low-quality terms
regarding ‘non-salient’ attributes (that is, attributes buyers do not con-
sider). The lynchpin of the theory is that sellers are unable to recoup the
costs of offering efficient non-salient terms and that this condition worsens
with increasing competition. Assuming that price is always a salient
product attribute for buyers, market competition actually will force sellers
to provide low-quality non-salient attributes in order to save costs that will

be passed on to buyers in the form of lower prices. According to Korobkin

(2003), the problem is most sensibly addressed through a combination
of market, ex ante legislative mandates, and judicial action, including a
modification of the unconscionability doctrine to protect behaviorally
biased consumers.
2. shrouded attributes In many businesses, it is customary to adver-

tise a base price for a product and to try to sell additional ‘add-ons’ at high
prices at the point of sale. Add-on prices are not advertised and they would
be costly or difficult to learn before one arrives at the point of sale (Ellison,
2005). Gabaix and Laibson (2006) present a model of consumer myopia
that explains why firms often shroud the negative attributes of their prod-
ucts, particularly high prices for complementary add-ons. For example,
hotels often shroud information on complementary add-ons like parking,
phone calls, in-room movies, minibar items, dry cleaning, or meals in the
hotel restaurant. In this setting, unsophisticated consumers fail to take the
add-on into account when comparing products. Hence, they only compare
the prices of base goods across firms, instead of comparing the total prices
(base goods plus add-on). A ‘sophisticated’ consumer anticipates the
marked up add-ons and avoids buying many of them (for example, she
brings a cell phone instead of relying on the hotel phone; she takes a taxi
instead of renting a car that requires parking, etc.). Gabaix and Laibson
show that competition will not induce firms to reveal information that
would improve market efficiency. Firms will not educate the public about
the add-on market, even when unshrouding is free. The reason for this is a
phenomenon which they call ‘the curse of debiasing’.
Debiasing improves consumer welfare, but no firm can capture or
even partially share these benefits. Educating a consumer about competi-
tors’ add-on schemes effectively teaches that consumer how to profitably
exploit those schemes, thereby making it impossible for the educating
firm to profitably attract the newly educated consumers. From a policy
perspective, Gabaix and Laibson argue that regulators might compel
disclosures or could warn consumers to pay attention to shrouded costs.
The imposition of markup caps on shrouded attributes is mentioned as a
possible regulatory response by the authors, but they reject it as a solution
because it would distort markets.
3. misperception-based pricing and bundling Oren Bar-Gill (2004,

2006, 2008) argues that consumers make persistent mistakes. Imperfect
information and imperfect rationality lead to misperception of benefits
and costs associated with the product. As a result, consumers might fail to
maximize their preferences in product choice or product use. According to

Bar-Gill, the misperceptions can be traced back to a particular category

of mistakes: use-pattern mistakes – mistakes about how the consumer
will use the product. Bar-Gill argues that sellers respond strategically
to use-pattern mistakes by redesigning their products, contracts, and
pricing schemes. His proposed theory of seller reactions to consumer
misperceptions builds on the multidimensionality of products and prices.
Multidimensional pricing and bundling can be seen as a strategic
response to consumer mistakes. Examples discussed by Bar-Gill are
rebates, credit card pricing, bundling of printers with ink, and inter-
temporal bundling in subscription markets like health clubs. In these
cases, consumers often misperceive their future use of the product. For
example, consumers overestimate the likelihood of redeeming their rebate,
they underestimate the likelihood of paying their credit card bills late,
underestimate the amount of printing, and overestimate the number of
times that they will visit the health club. With multidimensional pricing
and bundling, such misperceptions drive a wedge between the actual
price paid by the consumer and the perceived price, which may in turn
lead to welfare-decreasing decisions made by consumers. From a policy
perspective, focusing on disclosure regulation, Bar-Gill argues that the
importance of use-pattern mistakes requires more, and better, use-pattern
disclosure. In particular, sellers should be required to provide average or
individualized use-pattern information. For example, a consumer who
underestimates the likelihood of paying late and triggering a credit card
late fee will not make a truly informed choice, even if she has perfect
information about the magnitude of the late fee. The disclosure apparatus
should therefore include the amount that an average consumer pays in late
fees and how much the individual consumer has paid in late fees over the
last year (Bar-Gill 2008).
4. specific contract terms that exploit consumer biases Particular

contract terms could be seen as conscious attempts by sellers to take
advantage of consumer biases, such as the sunk cost fallacy, status-quo
bias, or consumer inertia.
Economic theory implies that only incremental costs and benefits
should affect decisions. Historical or sunk costs should be irrelevant.
Thaler (1980) suggests instead that consumers often do not ignore sunk
costs in their everyday decisions. This is called the ‘sunk cost effect’ or
‘sunk cost fallacy’. Sellers may design their contract in such a way as to
take advantage of consumers’ commitments to sunk costs.
Korobkin and Ulen (2000, p. 1126) give the example that sellers often
structure contracts such that the buyer is obligated to make monthly pay-
ments but can stop making payments and return the merchandise at any

time. Once the first monthly payment is made, the purchaser is unlikely to
discontinue the contract and return the merchandise, even if the marginal
cost of keeping the merchandise is higher than the marginal benefit he
receives from it. To the extent that lawmakers believe that such contracts
result in many consumers’ failing to maximize their utility, those law-
makers might consider implementing restrictions on the way consumer
contracts may be structured (Korobkin and Ulen 2000, p. 1126).
The status-quo bias implies that individuals tend to prefer the present
state of the world to alternative states; all else equal, they prefer to leave
things as they are, creating some inertia in the economy. These forces imply
that if, for a given choice, there is a default option – an option that the
chooser will obtain if he or she does nothing – then we can expect a large
number of people to end up with that option, whether or not it is good for
them. Sellers could take advantage of the status-quo bias of consumers, for
example, by adopting an automatic renewal clause in the contract. Such
clauses are part of many subscription contracts. Automatic renewal clauses
specify that the contract will be automatically renewed for a new term
unless the consumer gives notice of his intent to terminate. If the consumer
takes no action to cancel the agreement, he would be bound for another
term. It turns out that many consumers fail to cancel their agreement even
if the benefits from continuance are lower than the price that needs to be
paid. This failure might be due to high transaction costs involved in cance-
ling. In fact, sellers sometimes deliberately inflate transaction costs (Sovern
2006), but with status-quo bias, the level of cancellation is expected to be
suboptimal even when the transaction costs to cancel are low.
4.2.2. Strategies to improve consumer choice When people choose a

flavor of ice cream, they know what they will consume and what the price
will be. Choosing among ice cream flavors is an easy task for consumers.
But for many products, people may not understand all the ramifications
of their choice. Often people have a hard time predicting how their choices
will end up affecting their lives. In the words of Sunstein and Thaler (2003,
p. 1198), it may be hard ‘to map from options to preferences’.
Thaler and Sunstein (2008, pp. 92–3) give an example of the mapping
problem in choosing a digital camera: ‘Cameras advertise their megapix-
els, and the impression created is certainly that the more megapixels the
better. . . . But what is really problematic for consumers is translating
megapixels (not the most intuitive concept) into what they care about.
Is it worth paying an additional hundred dollars to go from four to five
megapixels?’
According to the authors, one way to help people to improve their
ability to map and hence to select options that will make them better off is

to make the information about various options more comprehensible by

providing information that translates more readily into actual use. As an
example, Thaler and Sunstein (2008, p. 93) suggest that manufacturers of
digital cameras could list the largest print size recommended for a given
camera. Instead of being given the options of three, five, or seven megapix-
els, consumers might be told that the camera can produce quality photos
at 4 x 6 inches, 9 x 12 inches, or ‘poster size’.
Thaler and Sunstein notice that people often have a problem in
mapping products into money, especially when products have a complex
pricing scheme, like credit cards, cell-phone calling plans, mortgages, and
car insurance policies. For these and related domains, Thaler and Sunstein
(2008, p. 93) propose a very mild form of government regulation, a species
of libertarian paternalism that they call RECAP: Record, Evaluate, and
Compare Alternative Prices. The government would not regulate how
much sellers could charge for their services, but it would regulate their
disclosure practices. RECAP regulation consists of a price disclosure part
and a usage disclosure part. An example given by Thaler and Sunstein
(2008, pp. 93–4) of usage disclosure in the cell-phone market would be
that once a year, issuers would have to send their customers a complete
listing of all the ways they had used the phone and all the fees that had
been incurred.4
Thaler and Sunstein (2008, p. 173) suggest that RECAP regulation
might also encompass ‘intelligent assignment’. An intelligent assignment
system matches consumers with the product that best fits their needs. Such
a system was, for example, used in Maine to match individuals with pre-
scription drugs plans. Maine officials evaluated several plans according to
three months of historical data on prescription use by eligible participants.
Participants in plans covering fewer than 80 percent of their required drugs
were switched automatically to better plans. Variants of this system are
also conceivable for use by professional sellers or intermediaries to match
consumers with the product or service that best suits their preferences.
5. Conclusions
The behavioral approach holds promise for analyzing contract law. If
economic models of the law are undermined by their rationality assump-
tions, then psychologically accurate models of human cognition might fill
in the gaps left by the economic analysis of law. The behavioral approach
is successfully applied in the field of consumer contract law. A growing
4
Note that the usage disclosure proposed by Thaler and Sunstein (2008) is
similar to the use-pattern disclosure recommended by Bar-Gill (2008).

literature models contractual behavior, whereby sophisticated firms inter-

act with boundedly rational consumers and consumers who may have
psychological biases. Firms design contract terms as a strategic response
to consumer biases and competitive markets do not cure the biases due
to a phenomenon called the ‘curse of debiasing’. The behavioral models
are used to justify legal reform of a non-intrusive kind, like asymmetric
paternalism or libertarian paternalism. Innovative forms of informa-
tion disclosure mandates, like use-pattern disclosure, are recommended
by behavioral law and economics scholars to help boundedly rational
consumers to make informed and better choices.
Whereas the behavioral approach provides a solid basis for explaining
and reforming specific rules governing consumer contracts, the value of
behavioral analysis for understanding the general rules of contract law
is rather limited. The behavioral approach has not produced a behav-
ioral theory of general contract law. The difficulty lies in developing a
behavioral model of general contracting behavior capable of generating
testable predictions and offering reliable generalizations. This is not to
say that the behavioral approach has not produced any wisdom; for
example, the empirical evidence that the status-quo bias makes contrac-
tual default rules sticky is valuable information for designing default-
rule policy.
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20 The civil law of contract
Ejan Mackaay*
1. Civil Law of Contract – General Observations1
1.1. General Features of Codified Law

This chapter presents a brief survey of economic analyses performed
on contractual institutions and doctrines that are specific to civil law –
as opposed to common law – systems (for more detailed analysis, see
Mackaay forthcoming). What sets civil law systems apart from common
law systems, besides differences in vocabulary, is that their core rules
are set out in codes drafted with the aim of covering in principle all rela-
tionships within the field of law they govern. All legal problems arising
within that field are deemed to be soluble by reference to, and through
interpretation of, one or more provisions of the code.
Whilst codes consolidate in their provisions the solutions found to a
great many practical problems that have arisen over time, it would be
illusory to expect them to provide ready-made solutions to all conceivable
problems. To cope with novel or imperfectly foreseen problems, whilst yet
maintaining the claim to complete coverage, the codes need to resort to a
small number of open-ended concepts that can be used to fashion appro-
priate solutions to such problems. Good faith and abuse of rights are some
of these concepts.
One of the main objectives of codification in civilian legal systems is to
make law accessible: all the law for a given field is in principle to be found
in one place – the code – rather than in a proliferation of individual judicial
* Parts of this chapter have been presented to audiences at the University

of Sao Paulo, Brazil, at the 22nd Workshop in Law & Economics, University
of Erfurt, Germany, and at the Symposium in honour of Michael Trebilcock,
University of Toronto, Canada. Kindest thanks to the participants in these events
for comments and suggestions. Particular thanks are due as well to Gerrit De
Geest for incisive comments on the full version of the chapter.
1
The following abbreviations are used in the chapter:
BGB – Bürgerliches Gesetzbuch – German Civil Code
CCF – Code civil des Français – French Civil Code
CCQ – Civil Code of Quebec
NBW – Nederlands Burgerlijk Wetboek – Netherlands Civil Code (see
Haanappel and Mackaay 1990).
424

The civil law of contract 425
decisions, so as to make it easier for citizens to know their rights and obli-
gations. To accomplish this, the codes need to be of workable dimensions.
This entails that the formulas used have to be concise and often abstract,
condensing large ranges of practical solutions, and the code’s provisions
should be interpreted so as to form a coherent and seamless whole. One
should not be misled by the abstract character of code provisions or by
the idea of the code as a system. Codes are not systems of abstract logic
unconnected with the real world; they are meant to reflect consolidated
experience. To work effectively with such tools, civil lawyers need to be
(made) aware of the gamut of actual cases each code article is meant to
capture, as much as common lawyers need to be cognizant of the relevant
judicial decisions on a particular point of law.
Once these general characteristics are taken into consideration, one
must expect the economic analysis of law to have as much to tell lawyers
in civil law systems as it has those in common law systems, and in the
American legal system in particular. The legal origins movement has
forcefully put forth the thesis that common law systems are more condu-
cive to economic growth than are civil law systems (La Porta et al. 1998,
1999, 2008), but this conclusion has been contested (Dam 2006; Roe 2006;
Roe and Siegel 2009; Milhaupt and Pistor 2008; Mackaay 2009) and a very
recent paper has highlighted how the imposition of the institutions of the
French Revolution, including its civil code, on other European nations
helped to clear rent-seeking barriers to trade (Acemoglu et al. 2009). On
the whole, the jury seems to be still out on the comparative virtues of
different legal families.
In what follows, we look at a sample of civil law institutions through the
lens of the economic analysis of law.
1.2. The Role of Contract Law

On an economic view, contract is an open-ended institution by which indi-
vidual actors can exchange resources to their mutual advantage, thereby
moving them to higher-valued uses. In the consensualist conception of
contract, parties can do this essentially for any object and in any form
they see fit. What then is the role of contract law? Parties need no encour-
agement to enter into profitable deals. But the law may be called upon to
avoid mishaps in the contracting process or reduce their seriousness: for
instance, one party being taken advantage of by the other, at the time of
contracting or later, as a result of unforeseen circumstances; or a division
of tasks or risks between the parties which experience suggests is less than
optimal.
The first line of defence against mishaps is precaution by the parties
themselves. Economic theory predicts that to avoid mishaps in the

contracting process each party, being a rational actor, will take all pre-
cautions whose cost is lower than the trouble so avoided, discounted by
the probability of its occurrence (Ben-Sharar 2009 explores what happens
if, for consumers, this is the only line of defence). This is the logic of
accident avoidance, which forms the basis of the economic analysis of
civil liability law. The idea can be expressed equivalently as each party
seeking to minimise the sum of the costs of precautions it takes to prevent
mishaps and those of the mishaps that it could not profitably prevent and
hence must simply absorb. Rational actors will only enter into a con-
tract if these transaction costs can be covered by the gains the contract
promises.
Both parties will seek the optimal set-up from their own point of view.
They will inform themselves about the prospective contracting partner,
about the product contemplated and about the terms on which it is
offered. If the information that can be collected on prospective contract-
ing partners is too sketchy for comfort, a party may limit dealings to a
smaller circle of people about which more information can be gleaned or
who particularly inspire confidence, for instance because of ethnic ties.
Where the performance of a contract looks uncertain, a party may insist
on being given security or a guarantor or again an express warranty that
the product will meet specific requirements. Providing securities or sure-
tyship of course entails a cost, which must be covered by the gains the
party providing them expects to realise by the contract. If these or similar
precautions are not viable or too costly, given what is at stake, or if they
leave too high a margin of residual risk of mishap, a party may take the
ultimate precaution of not contracting at all. This entails the opportunity
cost of forgoing the net gains of the contract, which, one may surmise, the
abstaining party considers to be negative.
During their negotiations, parties may further reduce the risk of
mishaps or non-optimal arrangements by exchanging information and
shifting burdens or risks between them, allocating these burdens to the
one who can take care of them at the lowest cost. When you order a book
at Amazon, they will look after the shipping, even though you pay for it:
Amazon has access to very considerable scale economies in these matters.
Parties arrive thus at the best arrangement they can fashion between
themselves. This may still leave a substantial margin of risks of mishaps
and a considerable level of precautions taken to avoid them. Can contract
law improve upon this, leading parties to ‘lower their guard’?
Corrective intervention through contract law would seem justified
whenever the cost of the intervention is more than offset by the savings
in transaction costs it generates compared to what the contracting parties
could themselves achieve, in other words whenever it allows parties so to

lower their guard that their savings are greater than the cost of the measure
itself. Wittman states this idea by the simple formula according to which
[i]n a nutshell, the role of contract law is to minimize the cost of the parties
writing contracts 1 the costs of the courts writing contracts 1 the cost of inef-
ficient behavior arising from poorly written or incomplete contracts. (Wittman
2006, 194)
Contract law aims at minimising the overall cost of mishaps and their
prevention in contract.
Of the three terms of the Wittman test, the first and the third have
already been highlighted in the discussion of the role of contracting
parties, with the difference that they are here to be taken not at the level of
individual contracting parties, but at the level of society as a whole, for all
contracting parties taken together. The first term refers to measures taken
by the parties themselves, individually and in negotiation, to find the best
arrangement – for instance in allocating risks or other burdens – and to
avoid bad surprises. The third term refers to mishaps that the parties are
unable to avoid, that is arrangements that looked too costly to prevent
beforehand or that, contrary to expectations, turn out to be non-optimal
or bad surprises and whose cost must be absorbed; an example would be
the opportunistic exploitation of a gap left in the contract.
The middle term implies that public intervention is worthwhile if it
reduces the sum of the three terms, that is if its own cost is lower than
the savings to which it gives rise in the other two terms. These considera-
tions apply to all contracting parties taken together, rather than at their
individual level.
Consider, by way of example, the court system allowing contracts to
be enforced. In the absence of such a system, breach of a contract can
certainly be punished or avoided up front, by a private system based on
arbitration and community sanctions such as blacklisting and exclusion.
In such a private set-up, actors only contract with persons they know or
against whom community sanctions will be effective. Putting in place a
system of public enforcement represents a gamble on the gains result-
ing from people daring to do business with a wider circle of persons: the
gains from more numerous and more widely distributed contracts plus the
savings in self-protection measures contracting parties would normally
take are sufficient to offset the fixed cost of the public enforcement system
plus the variable costs of contracting parties using its enforcement serv-
ices. Of course, the very presence of a public enforcement system, even
where people do not generally have recourse to it, casts its shadow over
the temptation for contracting parties to behave opportunistically and this
in itself represents a saving.

To take another example, by instituting a regime of mandatory war-

ranties in the sale of manufactured goods, one implicitly gambles that
the savings generated for a large proportion of consumers in lowered
self-protection and unpleasant surprises avoided will offset the losses
resulting for a smaller proportion of consumers of contracts that are no
longer allowed or, because of the inflexibility of the general rule, have to
be entered into on less advantageous terms than parties would have liked.
Empirically, it may turn out that numbers are different from what propo-
nents of the measure had in mind, as Priest discovered in early studies of
mandatory warranties (Priest 1978, 1981).
What are the costs of a legal rule? They vary depending on whether one
is dealing with a mandatory rule (public order – parties cannot opt out of
it) or with a suppletive or default rule (parties may agree otherwise). A
public order rule seeks to counter opportunism; by providing a fixed and
enforceable rule, it is designed to allow a substantial proportion of citizens
to lower the level of self-protection they consider necessary in given cir-
cumstances, but at the cost of reducing the negotiation space for all, which
will particularly hamper those who were willing to assume greater risk in
exchange for more advantageous terms, especially price.
The costs of a public order or mandatory rule (ius imperativum)
include:
1. the cost of framing the rule legislatively or judicially, including the risk
of capture by interest groups (rent-seeking) in the case of the political
process;
2. the cost for the parties of enforcing their rights using the public proce-
dures the rule points to;
3. the opportunity cost of ‘sharper deals’ forgone because they are pro-
hibited by the rule;
4. the cost of the rule turning out in practice to be ill-suited to the
problem it was designed to regulate.
Taken together, these costs must be more than offset by the gains the
rule generates in terms of people ‘lowering their guard’ (reducing self-
protection), contracting with a wider circle of persons and absorbing
residual risk.
In the case of a suppletive or default rule (ius dispositivum), the stakes
are slightly different because parties are now free to put it aside, but must
take the trouble (and expense) of doing so. Essentially, of the four factors
listed, the third factor falls away under a suppletive rule. However, this
may be illusory if the cost of opting out and framing one’s own rule is
practically prohibitive, in which case the rule has to all intents a public

order character. Since citizens are free to opt out, the fourth factor should
now be called ‘undue reliance’ on a rule that turns out to be ill suited.
Usually, default rules propose a solution that experience suggests most
parties would have chosen had they taken the time to contract about it
explicitly.
Any rule that promises gains from more ample contracting and savings in
transactions costs of private parties in excess of its own cost as just specified
– net gains, in other words – has a proper place in the law of contract; the
Wittman test implies that where several competing rules are conceivable for
the same subject matter, the one promising the highest net gain should be
preferred. One must expect such gains where public authorities have access
to greater scale economies in framing and enforcing rules than are open
to private actors. A broad principle reflected in many rules is to attribute
a burden to the party who can best or most cheaply influence the occur-
rence or cost of a mishap. Calabresi has proposed the term ‘cheapest cost
avoider’ for this principle (Calabresi 1970, 139 f.; Calabresi and Melamed
1972, 1118 f.). A good deal of civil contract law appears explicable as appli-
cations of the ‘cheapest cost avoider’ principle (De Geest et al. 2002).
The Wittman test would seem to account for the more detailed objec-
tives of contract law listed in the literature, such as preventing opportun-
ism, interpolating efficient terms either on a wholesale or a retail basis
(gap-filling versus ad hoc interpretation), punishing avoidable mistakes
in the contracting process, allocating risk to the superior risk bearer and
reducing the costs of resolving a dispute (Posner 2007, 99 (§ 4.1); similar
lists are given in Cooter and Ulen 2007, 232; Trebilcock 1993, 16–17).
1.3. Good Faith

Good faith is a key principle in civil legal systems (see Litvinoff 1997;
Hesselink 2004). It played a major role in late Roman law and in pre-
codification French law (Charpentier 1996). Within the modern civil law
family, it still plays an important role in French law (articles 1134 and
1135 (French Civil Code) CCF in particular) and a central role in German
civil law (‘Treu und Glauben’, article 242 BGB (German Civil Code)). In
Dutch law, the recodification towards the end of the 20th century recog-
nised as fundamental principles of civil law the subjective notion of good
faith as justifiable ignorance of title defects in the law of property, and the
objective notion of good faith as loyalty in contractual dealings, for which
the distinctive term ‘reasonableness and equity’ (redelijkheid en billijkheid)
was introduced (Haanappel and Mackaay 1990). The Quebec Civil Code
of 1994 has given good faith a substantially larger place than it had under
the old code of 1866. In all, 86 articles in the new code use the term good
faith. Amongst these, the following stand out:

6. Every person is bound to exercise his civil rights in good faith.

7. No right may be exercised with the intent of injuring another or in an exces-
sive and unreasonable manner which is contrary to the requirements of good
faith.
1375. The parties shall conduct themselves in good faith both at the time the
obligation is created and at the time it is performed or extinguished.
The European directive on unfair terms refers to good faith in the recit-
als and in article 3 (1) (Directive on unfair terms). The Unidroit Principles
of International Commercial Contracts of 1994 provide in article 1.7
that ‘each party must act in accordance with good faith and fair dealing
in international trade’ and that ‘the parties may not exclude or limit this
duty’ (Unidroit 1994) and the Vienna International Sales Convention
recognises it in article 7 (Vienna Sales Convention 1980). By comparison,
English and Anglo-Canadian law is still hostile to the general concept of
good faith (Goode 1992; Brownsword et al. 1998; Bridge 1984), though it
recognises specific applications of it; in the United States, the Restatement
(Second) of Contract explicitly refers to the obligation of good faith in
contractual dealings in § 205.2
In what follows we deal only with contractual good faith, leaving aside
good faith in property law (‘subjective good faith’), where it applies, for
instance, to the purchaser of stolen goods and to the possessor non-owner
of goods who acquires ownership through prescription. Good faith refers
here to justifiable ignorance of facts or legal status, in particular defects in
one’s title. This notion, too, lends itself to an economic analysis, in which
one compares the precautions that could have been taken to ascertain
the accurate state of affairs to the risk and cost of acting on an erroneous
assessment (Mackaay 2001).
To capture the meaning of good faith in contract law (‘objective good
faith’), legal scholarship resorts to terms such as ‘fairness, fair conduct,
reasonable standards of fair dealing, decency, reasonableness, decent
behavior, a common ethical sense, a spirit of solidarity, community
standards of fairness’ and ‘honesty in fact’ (Keily 1999, at 17–18) and
their French equivalents: ‘loyauté’ (Charpentier 1996, at 305), ‘honnêteté’,
‘intégrité’ (Pineau et al. 2001, at 35), ‘fidélité’, ‘droiture’, ‘véracité’ (Rolland
1996, at 381), ‘comportement loyal’, ‘souci de coopération’, ‘absence de mau-
vaise volonté’, ‘absence d’intention malveillante’ (Cornu 2000, see Bonne
foi ); the absence of good faith signals ‘unconscionable’ behaviour (Keily
2
‘Every contract imposes upon each party a duty of good faith and fair dealing
in its performance and its enforcement’. (Restatement 1979), as does the Uniform
Commercial Code, for instance in §§ 1-201, 1-304, 2-103, 2-403 (UCC).

1999, at 17), which in French is characterised as ‘blâmable’, ‘choquant’,

‘déraisonnable’ (Pineau et al. 2001, 44). In pre-revolutionary French law,
good faith was considered to require ‘that consent is valid, that parties
abstain from trickery, violence, any dishonesty or fraud; but also that it
was plausible and reasonable; and finally that the contract not be contrary
to divine law, to good morals, nor to the “common weal” (profit commun)’
(Ourliac and de Malafosse 1969, at 83 n. 67).
All these formulae, intuitively plausible though they may seem, merely
translate one general term into other general terms. A formula closer to
translation into operational tests is given by Pineau et al.: ‘one should not
profit from the inexperience or vulnerability of other persons to impose
on them draconian terms, to squeeze out advantages which do not cor-
respond to what one gives them’ (Pineau et al. 2001, at 44). This points to
the concept of opportunism, which from a law-and-economics perspective
contract law is thought to have a general mission to prevent (for instance
Posner 2007, 99). Let us take a closer look at this concept.
Opportunism is regularly mentioned in the economic literature. Specific
forms of it have attracted a good deal of attention:
● free riding – where a result can be brought about only by the contri-
bution of all but it is not feasible to supervise everyone, the free rider
abstains from contributing, yet shares in the spoils; (de Jasay 1989);
● shirking in a labour relationship, where the employee gives the
employer a lesser performance than promised (Buechtemann and
Walwei 1999, at 172);
● agency problems also reflect supervision difficulties – where one must
pursue one’s plans by relying on other persons’ good offices without
being able to fully supervise them; the other persons may pursue
their own interests at one’s expense;
● moral hazard – originally in insurance contracts, but with wider
application – is also a supervision problem – where the insured, once
the insurance contract has been written, behaves less carefully than
promised or demonstrated when the premium was set;
● holdout behaviour is a different kind of opportunism – where a col-
lective project will go forward only with everyone’s consent, the
person holding out suspends his consent in the hope of securing
more than his proportional share of the spoils. The opportunism
stems here not from an information (supervision) problem, but from
the monopoly power conferred by the veto;
● holdup situations are those in which one party is able to force the
hand of the other to get more than its promised or fair share of the
joint gains of the contract (Shavell 2007).

Although these specific forms of opportunism have attracted a good deal

of attention, one would be hard put to find a proper definition of opportun-
ism in general (Cohen 1992, at 954). Classical economic theory paid little
attention to the notions of transaction costs and opportunism, preferring
to study markets as if transactions occurred in principle without friction.
In contrast, for so-called ‘institutionalist’ economists, these notions play a
central role, often in specific reference to the Coase Theorem. Williamson,
who has done much to clarify the concept in economic thought, defines it
as ‘self-interest seeking with guile’ (Williamson 1975, 26; and later works,
1985 and 1996). He contrasts opportunism with trust and associates it with
selective or partial disclosure of information and with ‘self-disbelieved
promises’ about one’s own future conduct. Dixit adds that it refers to a
class of actions that may look tempting to individuals but will harm the
group as a whole (Dixit 2004, 1). George Cohen defines opportunistic
behaviour in general as ‘any contractual conduct by one party contrary to
the other party’s reasonable expectations based on the parties’ agreement,
contractual norms, or conventional morality’ (Cohen 1992, at 957).
To sum up, a party to a contract may be said to act opportunistically
where it seeks, by stealth or by force, to change to its advantage and to the
detriment of the other party or parties the division of the contract’s joint
gains that each party could normally look forward to at the time of con-
tracting. It tries, in other words, to get ‘more than its share’. Opportunism
may involve getting a party to enter an agreement it would not willingly
have signed if it had been fully informed (ex-ante opportunism); it may
also involve later exploiting unforeseen circumstances the contract does
not provide for in order to change the division of gains implicitly agreed
upon when the contract was entered into (ex-post opportunism). In acting
opportunistically, one party significantly exploits an asymmetry in the
relationship amongst the parties to the detriment of the other party or
parties. In a prisoner’s dilemma game, this would correspond to defection
where the other party or parties would choose cooperation.
For opportunism to arise, there must be an asymmetry between
the parties, of which one takes advantage at the expense of the other.
Asymmetry itself does not signal opportunism: you rely on profession-
als of various kinds for services they specialise in; life would be difficult
without it. Opportunism corresponds to the legal concept of bad faith; it is
the exact opposite of good faith, which we can now define as not turning
to one’s advantage the vulnerability of the other person in circumstances
that might lend themselves to it.
Not all forms of opportunism call for public corrective intervention.
According to the Wittman test, intervention would not be worthwhile
for minor forms of opportunism, which are best dealt with by persons

being normally on their guard: here self-protection is cheaper than the

constraints a public mandatory rule inevitably imposes on all actors. The
law makes opportunism actionable only where one party takes advan-
tage of an asymmetry to a significant degree, that is, beyond a certain
threshold of seriousness. This explains why puffing and minor exaggera-
tions (bonus dolus) are not actionable. The impediments to the function-
ing of markets would seem here to exceed the savings in self-protection.
In a very general sense, one might say that the core of contract law is
that all contracts must be performed in good faith and that the task of the
courts is to sanction the absence of it. But this would leave far too much
discretion to the courts and too much uncertainty for citizens. Hence good
faith has had to be particularised in civil codes into a number of more
specific concepts, each with its own legal tests. Whittaker and Zimmerman
provide the following list for civilian systems: culpa in contrahendo; obliga-
tions d’information; laesio enormis; the abuse of rights; personal bar; inter-
pretation of the parties’ intentions (whether standard or ‘supplementary’);
the doctrine of ‘lawful contact’; laches; unconscionability; Verwirkung;
purgatio morae and purgatio poenae; doctrines of change of circumstances
or ‘erroneous presuppositions’; the notion of a ‘burden’ (Obliegenheit);
force majeure; exceptio doli; mutual mistake; liability for latent defects; the
legal consequences associated with the maxims nemo auditor turpitudinem
suam allegans and dolo agit qui petit quod statim redditurus est; and venire
contra factum proprium. (Whittaker and Zimmerman 2000, at 676; also
Zimmerman 2001, 172). Since all these concepts are derivative of good
faith, one would expect the three general features – asymmetry; exploita-
tion; beyond a certain threshold – identified above to shine through all
particularisations (Mackaay and Leblanc 2003). Good faith remains as a
residual concept with which to fashion new remedies where no existing one
is appropriate (as one may expect for some cyberspace contracts).
2. Formation
Under the heading of the formation of contract, civil law doctrine tradition-
ally deals not only with the modalities of consent through offer and accept-
ance, and other basic requirements of contract such as a legitimate cause
and object, but also with defects of consent – error, fraud (dolus), violence or
threat, as well as lesion – whose presence is analysed as having undermined
the contract from the outset and hence requiring the parties to put each
other back in the situation they were in before entering into the agreement.
2.1. Offer of Reward

You offer a reward for the return of your cat. Should you be bound to pay
the reward even if the person returning the cat did not know of the offer?

Some persons – active searchers – may be induced to search by the prospect

of the reward; casual finders may return the property if they happen upon it,
on the off chance of a reward. The relevant question is how a rule requiring
knowledge will affect the two groups: it will encourage active searchers, but
may discourage casual finders; one may expect the latter group to be more
numerous than the former; but the former group may react more strongly to
the incentive of reward than the latter. A priori the net effect of a rule requir-
ing knowledge is not obvious; it may be a wash. Given the uncertainty, a
rule requiring knowledge reduces the number of claims that could reach
the courts, but knowledge may be difficult to prove. By contrast, a public
offer of reward may be easier to prove, which would militate in favour of a
rule making the reward due once it was publicly offered, whether or not the
finder had knowledge of it. The German Civil Code adopts the latter rule in
article 657, as does the Quebec Civil Code in article 1395:
The offer of a reward made to anyone who performs a particular act is deemed
to be accepted and is binding on the offeror when the act is performed, even if
the person who performs the act does not know of the offer, unless, in cases
which admit of it, the offer was previously revoked expressly and adequately
by the offeror.
The Dutch Civil Code provides in article 5:10 that the finder is entitled
to a reasonable reward.
2.2. Defects of Consent

In a strictly formalist system, such as Roman law was (but see Del
Granado 2008), there would be little need to correct regretted decisions.
The formalities would ensure well-considered decisions and exclude ill-
advised ones as well as subtle fraud and violence. Prospectively all parties
expect to benefit by the projected transaction. Criminal law would take
care of cases of outright fraud and violence.
Why abandon formalism? Because it also entails important costs: it
increases transaction costs; it limits the range of acceptable contracts. This
would slow down markets and may deprive us of innovations, the gains
from which, taken over all contracts, will surely suffice to offset a few
regretted decisions. Modern legal systems rather bet on innovation and
hence go by the principle of consensualism, both as to the variety of con-
tracts that can validly be entered into – an open set – and as to the absence
of formalism for doing so.
Within the consensualist conception of contract, one needs correctives
for cases where consent is obviously not enlightened (error and fraud)
or free (threat of violence). The correctives one finds in the codes of
civil law systems plausibly pass the Wittman test, in that they reduce the

precautions the majority of contracting parties might otherwise feel com-

pelled to adopt, whilst not unduly restricting the range of sharp deals some
parties might contemplate.
2.2.1. Error For a contract to produce a Pareto gain, each of the

parties must, at least prospectively, expect to benefit by it. This expecta-
tion can only be realistic if the parties are abreast of the essential stakes of
the projected contract. Should they be mistaken about them, the contract
may not lead to a Pareto gain.
Civil law systems deal with this matter under the heading of error.
Where the error is the result of information having been trafficked by the
other party or under its control, the special rules of fraud apply because of
the opportunism that is clearly involved here.
In setting up rules dealing with mere mistakes, two pitfalls are to be
avoided. In refusing to recognise an error, one would sanctify a relation-
ship that does not create a Pareto gain and one needs to consider the
incentive effect that will have on the errans: lots of precaution next time
round; this is costly and slows down markets. If the law is to pursue
welfare enhancements in private relationships, the contract better be
redone. Conversely, were undoing a contract for alleged error to become
too easy, legal certainty would be undermined: a purchaser will hesitate to
undertake further transactions with the merchandise just bought if it may
have to be returned to the seller; third persons may hesitate to buy it for
the same reason. A seller cannot count on the profit made in a sale that the
purchaser could easily undo. All of this slows down market operations.
The law draws the line between these opposite forces by providing that
only an error concerning the essentials is a cause for the contract to be
called into question (1400 CCQ (Civil Code of Quebec)). Essentials are
considerations such that had a party been properly informed of them, it
would not have contracted at all or only on different terms. That party
does not stand to benefit from the contract as it is.
The essentials cover first of all the very nature of the operation (sale or
lease) and the object (the house with or without its furnishings). Where
one or both parties are mistaken about these elements, the contract is
deemed not even to have come into existence. Parties are thus deprived
of their preferred option and given an incentive to complete their
negotiations.
A party may demand the nullity of the contract on the ground of error,
where it is unilaterally mistaken about an essential element of the con-
tract, which was decisive for its consent (1110 CCF). This may concern
the object (could the horse purchased be used for horse races?) or the
person performing the contract. In either case, the other party must have

been apprised of the importance of these factors in the course of the

negotiations leading up to the agreement. Where the other party was not
made aware, the contract goes forward. This gives the mistaken party
an incentive to be quite clear about the features of the object it considers
essential.
Where the essential nature of the factor about which one party is mis-
taken is not in question, that party is given the option of demanding the
nullity of the contract or going through with it anyway (relative nullity).
By its decision, the party signals whether or not it expects to gain by the
contract as is. The other party, running the risk of being deprived of its
preferred option (that is, the contract does not go forward as it is), has
an interest in making sure that its opposite number is properly informed
about any feature flagged as essential.
Other mistakes – about the profitability of the object or minor features,
for instance – are deemed inexcusable and do not call into question the
validity of the contract. The mistaken party, being deprived of its preferred
option, is given an incentive to look after these itself. It is the cheapest cost
avoider for them. This also holds for inexcusable errors, that is, those over
which the mistaken party has been negligent in not taking cost-justified
precautions of checking, considering what was at stake. The opposite rule
would invite moral hazard on its part.
2.2.2. Fraud Fraud or dolus consists in one party’s manipulating by

trickery or by lies the information on which the other bases its consent.
It is an example of opportunistic behaviour. Any error based on fraud is
deemed excusable and it is open to the mistaken party to call for the nullity
of the contract, even where it concerns the profitability of the object sold
or the reason for contracting. Economically, the opportunist is deemed
always to be the cheapest cost avoider.
Classical examples of fraud are the used car seller turning back the
odometer of cars to give the false impression that they have been used less
than they really have; a seller of immoveable property hiding the fact that
the projected enlargement of an existing road will eat away part of the land
to be sold, the fact that a well on the property does not provide drinkable
water or that an order prohibiting habitation has been issued against the
property.3 Fraud is also considered to be present when one party gives
misleading answers or outright lies to specific questions from the other.
3
All real French cases: Civ. 19 January 1977, Bull. civ., I, no. 40, p. 30; Civ. 13
February 1967, Bull. civ. I, no. 58; Civ. 10 February 1999, Contrats Conc. Consom.
1999, no. 90; Civ. 29 November. 2000, Bull. civ. III, no. 182, p. 127.

Until recently, the accepted wisdom was that only active behaviour
or misrepresentation could constitute fraud; simply keeping silent could
not. It would fall to each party to inform itself about all factors it deemed
important and about which the other had not provided information. Over
the past half century, French law and other civil law systems have moved
to the position that it may be fraudulent even to keep silent about an
element which is clearly of interest to the other party and about which it
appears to be ill-informed. The new rule has initially found acceptance in
the context of a relationship of trust between the parties. It was then gen-
eralised to réticence dolosive, consciously keeping silent, thereby failing to
correct the other party’s misapprehensions.
This extension appears to be a remedy complementary to the duty to
inform the other party about the essential elements of the projected con-
tract. A recent paper boldly argues that the duty to inform encompasses
and can usefully replace the defects of consent of error and dolus, as well
as the latent defects doctrine in sales.4 Whether this general doctrine has
the required precision in practical applications to provide the certainty
law demands, or whether particularisations into specific doctrines remain
useful, as we argued as regards good faith, is a point that warrants
further discussion, given the level of detail the scholars drafting the Draft
Common Frame of Reference needed to go into in order to spell it out.
Art work raises the trickiest problems. It may be interesting to examine,
by way of illustration, a few key cases the French courts have had to deal
with.
the poussin case This lengthy saga stretches over the period from 1968
till the final decision in 1983.5 In 1968, a couple decides to sell a painting
they own and to this end have it examined by an expert, who attributes
it to the Carrache School (end of the 16th century), but not to its most
famous representative, Nicolas Poussin. Armed with this assessment,
they hand over the painting to be auctioned and it fetches 2,200 francs
on 21 February 1968. At the end of the auction, the National Museum
Association exercises its right to pre-empt the designated buyer and take
possession of the painting – presumably in the national interest – at the
price agreed to by the buyer. The painting resurfaces after restoration at
the Louvre as a true Poussin, worth several million francs.
4
De Geest and Kovac (2009, §§ 2.8 and 2.14), examining in this light articles II-
3:101–106, II-7: 204, 201, 205 and 207 and II-9: 402 of the Draft Common Frame
of Reference (DCFR 2008, 101).
5
Civ. 1er, 13 December 1983, Bull. civ. I, no. 293, and comments by Fabre-
Magnan (2004, nos. 108 f., p. 273 f.).

The frustrated couple sue to have the initial sale annulled on the ground
of error about an essential quality of the object sold. The courts of first
instance and of appeal dismiss the case, but the highest jurisdiction in
France, the Cour de cassation, found in favour of the couple, sending the
case back to a different court of appeal for the purpose of determining
whether the couple’s consent might have been vitiated by the conviction
that the painting could not possibly be a Poussin. Unfounded certainty can
be a ground for error. It should be added that there had been numerous
instances of counterfeit paintings attributed to Poussin, so the question
was of considerable practical importance.
The second court of appeal found that error needed to be gauged
according to the information available at the time it was made; yet here
all relevant information came to light after the couple made their mistake.
This new decision was once more taken up to the Cour de cassation and
once more reversed, with the court ruling that subsequent information
could be used to establish the true state of affairs at the time of sale and to
reach a finding of error.
The rule that flows from this saga appears to fly in the face of the incen-
tive logic holding that experts should be able to capitalise on their special-
ised knowledge by benefiting from the increased value that results from the
true nature of the object becoming known. The rule would discourage the
discovery and bringing to market of hidden treasures.
One may wonder, however, whether the quality of the buyer implicitly
played a role in the decisions of the Cour de cassation. Where a public
agency exercises its right to pre-empt in the national interest, one may
surmise that it suspects an undervalued treasure. Had this hunch been made
public beforehand, the painting would have been sold – and hence would
have had to be pre-empted – at a much higher price, even if doubt sub-
sisted about the true nature of the painting. Surely the couple would have
benefited from part of that increase, and the ultimate buyer, from the rest.
As the case initially unfolded, all of the value increase benefited the State –
hence the community at large. Does the State need special encouragement
to make money out of the expertise of its servants in the matter of under-
valued paintings? The Cour de cassation’s decision implicitly answered that
question in the negative. One may wonder whether the court would have
reached the same decision with respect to a private buyer. At all events,
owners of ‘old’ paintings are alerted to the spectacular gains that may await
them if they have the paintings evaluated. This may help bring hidden treas-
ures to light. Small consolation. One may wonder whether a better incentive
effect would not have been achieved by having the frustrated couple seek
recourse against the expert whose expertise turned out to be deficient and, if
no recourse would lie, to look out for a better expert next time.

the fragonard case6 Most fortunately, the Cour de cassation had

occasion a few years later to revisit the matter, but now with respect to
a private buyer in otherwise similar circumstances. Here a private owner
sold to an expert for 55,000 francs a painting called Le Verrou, which an
expert opinion had attributed to the School of Jean-Honoré Fragonard.
The expert purchaser, having restored the painting, recognised it as a true
Fragonard and sold it to the Louvre for 5,150,000 francs. Once more, the
original seller sued for annulment of the original sale on the ground of
error regarding an essential quality of the object of sale. The lower courts
declared the nullity of the contract on the basis of the rule established by
the Cour de cassation in Poussin, but the court itself reversed that decision
on the ground that the expert’s work had conferred upon the original seller
an unjustified enrichment, which should be taken into account. Upon
referral, 1,500,000 francs were awarded to the expert and the Cour de
cassation left that decision undisturbed.
Are the incentives better aligned this time? Some commentators
observed that the new rule discourages risk-taking by experts and indeed
investment in acquiring expert knowledge in the first place. Hidden treas-
ures would remain hidden. Need one be that pessimistic? After all, the
decision confers a substantial fraction of the value increase to the expert
as well as to the initial owner. It appears to give signals to both of them,
to the owners to have their art work evaluated and (perhaps) brought to
market; to the expert to spot undervalued treasures, since they would be
rewarded with a fraction of the value they unearth. It would have been
disastrous indeed to reward the expert according to the time spent examin-
ing and restoring the painting. Altogether it would seem that the rule gives
incentives for entrepreneurial behaviour to both parties involved, rather as
the code does in the case of the discovery of buried treasures on someone
else’s land: splitting the gains half-in-half.7
the baldus photographs case8 The rules developed by the French

supreme jurisdiction do not mean that sellers can in all circumstances
recover part of the value increase occurring after the sale as a result of cir-
cumstances of which they were unaware at the time of sale. This is nicely
illustrated by the Baldus photographs case. In 1986, a woman entrusts
50 photographs of Baldus – one of the earliest photographers to make
6
Civ. 1er, 25 May 1992, Bull. civ. I, no. 165, JCP G 1992. I. 3608, 370.
7
716 CCF; 938 CCQ; 5:13 NBW (Netherlands Civil Code).
8
Civ. 1e, 3 May 2000, Bull. Civ. I, no. 131, D. 2000. IR. 169, JCP G 2001. II.
10510, note C. Jamin.

a name for himself in the mid-19th century – to an auction house to be

sold by public auction, for 1,000 francs per photograph. They are bought
by an expert, who succeeds in reselling them for a multiple of that price.
In 1989, the woman contacts the purchaser directly to offer him a second
series of Baldus photographs for which she sets the price again at 1,000
francs per photograph. The purchaser accepts, realising full well that he
can resell them for several times that price. Subsequently, the seller learns
(finally!) that Baldus was a famous photographer and seeks to have the
sale annulled on the ground of fraud – here fraudulently keeping silent –
alleging that she would never have sold the photographs for that price had
she been apprised of their true value. The courts, this time with approval
of the Cour de cassation, dismiss the case, observing that the purchaser was
under no duty to inform the seller, given that it was the seller who took the
initiative of contacting the buyer and of setting the price.
The decision has the effect of protecting experts seeking to capitalise on
their knowledge, where they have done nothing to mislead the seller and
the latter sought them out and set the price at which the merchandise was
offered, without first ascertaining market value. The decision gives sellers
an interest in having their property appraised by an expert before offering
it for sale. The amount obtained in the first public auction – 50,000 francs
– suggests that this was not an extravagant precaution to take.
Altogether, economic analysis of law suggests a reading of these three
seminal cases that makes sense in terms of apportioning the various
burdens and prospects of gain so as to give the right signals to the parties
involved.
2.2.3. Threat of violence or fear Threats of violence or fear refer to situ-

ations of disequilibrium of force between the parties, in which the stronger
one opportunistically abuses its own advantage by ‘twisting the arm’ of
the other party or threatening to do so. It corresponds more or less to the
common law concept of duress. A contract entered into as a result of fear
is unlikely to lead to a Pareto gain. Whilst there is an obvious danger in
letting contracts entered into under such circumstances go forward, the
opposite danger should also be stressed: if it is too easy to get out of a deal
on the ground of threat of violence or fear, one may discourage all forms
of pressure, even those that break a deadlock and lead to agreement, con-
ferring a gain on all parties. The code provisions should reflect a concern
to skirt both of these dangers.
To be actionable, the fear brought to bear on a contracting party may
stem from the other party or from a third person, and it should threaten
a harm to the person or property of that contracting party or to that
of a third person, providing that the seriousness of the threat would be

sufficient to impress a reasonable person, to use the formula of the French

code (1111–15 CCF; 1402 CCQ). Mere respect for or awe of the other
person is not sufficient to have the contract annulled. Moreover, annul-
ment is refused if the victim of the threat subsequently approved the
contract, after the threat had ceased, or has let the period provided for
restitution lapse without acting.
Article 1404 of the Quebec code deserves to be noted. A person who,
whilst aware of the state of necessity of another, in good faith helps the
latter to get out of that state need not fear that the contract by which the
assistance is provided will be annulled on the ground of fear or violence.
The opposite rule would of course discourage persons from providing
assistance to persons in danger or distress. Yet it is important to prevent
persons providing assistance from opportunistically exploiting the situ-
ation to their – excessive – advantage, since this would lead to excessive
precautions on the part of potential victims. The use of the term ‘good
faith’ appears designed to prevent this form of opportunism.
2.2.4. Lesion Lesion is usually presented in civil law scholarship under

the heading of defects of consent, although its nature does not perhaps
quite comport with that qualification. Since 1994, the Quebec code
provides a definition:
1406. Lesion results from the exploitation of one of the parties by the other,
which creates a serious disproportion between the prestations of the parties; the
fact that there is a serious disproportion creates a presumption of exploitation.
[Prestation is civil law English for the object or service each party must render
onto the other]
In cases involving a minor or a protected person of full age, lesion may also
result from an obligation that is considered to be excessive in view of the patri-
monial situation of the person, the advantages he gains from the contract and
the general circumstances.
The difficulty, from an economic point of view, is that things have no

‘natural’ price. Values are essentially subjective. The very fact that some-
thing is sold means that it is worth more to the buyer than to the seller.
Value depends on circumstances of time and place. The bottle of water I
drink when quite thirsty during a hot summer day is worth much more to
me than the one I drink routinely in the winter. The second-hand book
that completes my collection of a little-known author is worth a lot to me,
but little to the average buyer. When unfortunate circumstances cause me
to have an urgent and unforeseen need for cash, I may have to let the col-
lection go for far less than it might fetch under normal circumstances.
These examples illustrate the difficulty of determining what would be
a disproportion, serious or not, between the prestations of the parties to

a contract. This is true also of the test of seven-twelfths of the sale price
of an immoveable, which the French code, in articles 1674 and following,
indicates as the threshold beyond which a contract is deemed lesionary.
In the absence of objective criteria, could one get a grasp of lesion by
looking at the subjective side, that is, factors that relate to the situation
of the victim of lesion or the circumstances under which it is supposed to
have occurred? This is no doubt the purpose of the term ‘exploitation’,
which points to opportunism, discussed above. But beyond the cases of
defects of consent and the general concept of good faith, it is difficult to see
how this concept advances the determination of what lesion is.
The codifiers appear to have been aware of the problem and for this
reason have provided that as between capable adults lesion is no ground
for annulment of a contract (1118 CCF; 1405 CCQ). Each party is con-
sidered the cheapest cost avoider when it comes to looking after its own
interest. Lesion is recognised for minors and for incapable grown-ups,
in which case it reflects soft paternalism (on paternalism, see Buckley
2005). In recent consumer legislation, consumers appear to be treated as
incapable adults. In the Quebec Consumer Protection Act, the legislature
has deemed it wise to further clarify the concept of lesion, applicable to
all consumer contracts, by providing that the consumer’s obligation must
be ‘excessive, harsh or unconscionable’.9 French consumer legislation
uses the qualification that the act must have amounted to an abuse of the
weakness or ignorance of the person; this appears to refer to the circum-
stances in which the contract was entered into and implicitly to extend the
scope of the concepts of fraud and threat of violence. It is obvious that one
attempts here to capture practical applications of the idea of opportunism.
These terms do not really resolve the problem, but they do indicate the
need to use the concept of lesion sparingly.
Are solutions to these problems to be found in the consideration, put
forth by researchers in the behavioural law-and-economics tradition, that
the average observer would find unfair an agreement that significantly
differs from the idea that that person has formed of the reference transac-
tion under similar circumstances (Jolls 2007)? Only further research on the
interface of law, economics and cognitive psychology will tell.
2.3. Cause
In canon law, a contract could not be valid unless the prestation of either
party constituted a valid reason for the other to enter into the contract,
9
Quebec Consumer Protection Act, LRQ P-40.1, articles 8 and 9, available at
http://www.canlii.org/en/qc/laws/stat/rsq-c-p-40.1/latest/rsq-c-p-40.1.html.

in other words if there was a fair ‘counterpart’ to one’s own prestation.

If from the outset this cause was an illusion, the contract would be null.
In common law, consideration appears still to play a similar role: a con-
tract will not be formed without valid consideration. The common law
judge does not inquire into the actual equivalence of the prestations on
both sides; the original canon law concept, however, invited precisely this
inquiry. If one of the prestations became impossible, the contract would
perforce be void.
Some modern civil law systems maintain the concept of cause, but
without mandating an inquiry into the actual equivalence of the presta-
tions, save in special circumstances such as lesion. Cause now refers to the
existence of a standardised or stylised reason for a party to undertake a
contractual obligation: the counterpart in the case of bilateral contracts;
liberal intention in the case of gratuitous contracts. Whether the concept
still serves a useful function is a moot point. At all events, the French,
Belgian, Spanish, Italian and Quebec codes still maintain it (1131 CCF;
1371, 1411 CCQ; Kötz and Flessner 1997, 54 f.). The new Dutch law has
abandoned it. German law and the laws of the Scandinavian countries
have no causa requirement.
3. Contents
3.1. Limitation or Exclusion of Liability Clauses

Clauses limiting or even excluding liability raise more clearly perhaps than
others the spectre of opportunism: to limit liability for the consequences of
one’s own actions opens the door to moral hazard. Of course, the market
itself provides a first range of sanctions: loss of clientele, bad reputation,
black listing, boycott. Nonetheless such clauses may not attract the atten-
tion of consumers at the time of contracting and may badly hurt some of
them in individual cases. In the literature, the matter has been discussed
under the heading of signing-without-reading (see De Geest 2002, who
examines in some detail whether the Directive on unfair terms of 1993
adequately deals with the matter).
The codes handle the problem by providing that such clauses are in prin-
ciple valid, so as to allow parties to allocate risks in the best way they can
come up with. But their validity is subject to severe restrictions reflecting
the danger of opportunism. By way of example, the Quebec code provides
in article 1474 that one cannot exclude liability for physical damage done
to another intentionally or through gross recklessness, gross carelessness
or gross negligence. For bodily or moral injury, no exclusion at all is per-
mitted. In the particular context of sale, article 1732 provides that sellers
may not limit warranties to exempt themselves of the consequences of

their personal fault. To this, article 1733 adds that no exclusion is allowed
where sellers have not disclosed defects of which they were aware or could
not have been unaware (professionals and specialised sellers or manufac-
turers). All in all, if these and similar provisions are looked at as remedies
against opportunism, it is striking that they are all the more severe as the
risk of damage and of opportunism is greater.
Traditionally, civil law doctrine held that parties could not contract out
of their essential obligations under a given contract. The idea is reminis-
cent of the doctrine of fundamental breach in common law. In a recent case,
the French Cour de cassation arrived at a similar result in the Chronopost
case,10 invoking the absence of cause. Once more, an economic reading of
the decision would point to an apparent attempt to curtail opportunism.
3.2. Penalty Clauses

A penalty clause allows parties to spell out at the time of contracting the
amount of damages that will be due in case of non-performance or late
performance of obligations arising under the contract. The interest of such
a clause is to set the amount of damages without the need to prove preju-
dice in court and the risk of arbitrariness or misperception by the court
assessing the damage. Penalty clauses should allow parties to better plan
their affairs, in the full knowledge of their rights and obligations should
they be unable to perform the contract as initially agreed.
The amount the penalty clause stipulates may be an estimate of the
anticipated damage, but may also stray away from it, either upwards or
downwards, in the latter case amounting to a clause limiting liability for
damages. Where the clause sets a penalty well above the actual anticipated
prejudice, it has a signalling function: it signals the debtor’s confidence in
being able to perform without a hitch. In the ‘market for lemons’ story,
generous warranties offered in sales signal higher quality wares (Akerlof
1970). For the beneficiary, it represents a sure way of forcing the actual
performance of the contract should the debtor prove reluctant. For these
reasons, penalty clauses have a useful economic purpose.
Yet penalty clauses are open to abuse: a consumer may underwrite them
without giving them due attention and live to regret it; conversely, the
obligation of one party may be shrunk to virtually nothing. In either case,
there is a risk of opportunism.
10
Chronopost, Com. 22 October 1996, Bull. 1996 IV no. 26; JCP G 1997. I.
4002, obs. Fabre-Magnan; D. 1997. Jur. 121, obs. Sériaux; JCP G 1997. II. 22881,
note D. Cohen; Gaz. Pal. 1997-08-16, no. 238, p. 12, note R. Martin; Répertoire du
notariat Defrénois, 1997-03-15, no. 5, p. 333, note D. Mazeaud; JCP G 1997. 924,
note J.K. Adom; van Schaik (2004).

Common law traditionally distinguishes between liquidated damage

clauses and penalty clauses. It admits the former, as a reasonable estimate
of actual damage and saving transaction costs, but refuses the latter where
the amount set is very different. The reasons given for the distinction should
not detain us here; what is of interest is that the civil law traditionally did
not make the distinction (see Mattei 1995; Hatzis 2003). From a law-and-
economics point of view, the civil law rule allows for the signalling effect,
which common law excludes. But what of opportunism? It is interesting to
note that the matter has been amply discussed in the law-and-economics
literature. The upshot of the debate is that those who would allow penalty
clauses see the need for means to control opportunism through such
concepts as unconscionability.
Whilst generally in civil law systems penalty clauses are valid, the courts
are more and more inclined to moderate their severity. The French code,
as well as the Quebec code and the new Dutch code, for instance, allow
the courts to reduce the penalty where the obligation has been partially
performed (1231 CCF; 1623 (2) CCQ; 6:94 Netherlands Civil Code).
Moreover the French code, in article 1152, allows the court, even ex
officio, to reduce or increase the penalty where it appears manifestly exces-
sive or pathetic, stipulations to the contrary being void. The European
Directive on unfair terms, in article 3 (3), sub e, generalises these principles
by prohibiting the imposition of a ‘disproportionately high sum in com-
pensation’ on consumers who fail to fulfil their obligations (Directive on
unfair terms 1993).
The Quebec code, in article 1623, provides for the reduction of an
‘abusive’ penalty, using the same term as in article 1437, where it applies
only to consumer contracts, a restriction not applicable to article 1623. No
explicit provision is to be found in the Quebec code for increasing penalties
that are manifestly insignificant. At most, one may surmise that the courts
might arrive at that result by interpreting such a clause as an implicit
limitation of liability clause to which article 1474, prohibiting exclusion of
gross negligence, is applicable.
All in all, these provisions seem designed first and foremost to control
opportunism in the use of penalty clauses, even if that may reduce their
signalling function.
4. Performance
4.1. Excusable Non-performance: Force Majeure

Force majeure refers to an event making performance impossible, which
in terms of article 1470 of the Quebec code is both unforeseeable and irre-
sistible, and lies outside the sphere of events for which the party invoking

it is accountable (see also 1152 CCF). Where any of these characteristics

is absent, the party in default is liable, which should give it an incentive to
take precautions or to underwrite insurance; any other rule would create
moral hazard. Where all three factors are present, we face an event over
which the non-performing party cannot exert any influence and hence
which it would be futile to encourage it to prevent.
In the case of non-performance due to force majeure, civil law provides
that the party prevented from performing is liberated from its obligation
and does not owe damages. What happens then to the performance of the
other party, if that has not become impossible? Civil law doctrine analy-
ses the problem under the heading of the theory of risks. In principle, the
party prevented from performing assumes the risk: it will be excused from
performing itself, but cannot ask the other party to perform. The opposite
rule would create moral hazard.
In contracts that entail the transfer of ownership, the rule is different:
the risk falls to the owner, even before delivery. In article 1456 of the new
Quebec Civil Code that rule has been changed so as to transfer risk to the
new owner only upon delivery; possession now carries with it the burden
of the risks. From the viewpoint of the economic analysis of law, the
burden seems thus to have been placed in each circumstance on the party
that is the cheapest cost avoider.
All of this is suppletive law – parties may contract around it. An
example of such contracting is the clause often encountered in commercial
contracts labelled hardship. It provides that where an important change
of circumstances of an economic or technological nature occurs that seri-
ously disturbs the balance of obligations under the contract, each party
may ask that the contract be renegotiated. The hardship clause reflects the
idea of unforeseeability, which in most civil law systems is not recognised
as a ground for the courts to modify the parties’ obligations (implicitly,
1439 CCQ).
The problem for the courts is nicely illustrated by a 19th-century
American case, Goebel v. Linn.11 Before electricity was commonly avail-
able, cooling was provided by means of large blocks of ice, delivered
by specialised suppliers who cut the ice at the end of winter and stored
them in specially insulated warehouses for use during the summer. In
November 1879, a brewer in the State of Michigan had contracted with
such a supplier for the regular delivery of ice blocks for the summer of
1880. The ice was sold at $1.75 a ton, or $2.00 a ton should a shortage
develop. The winter was unusually mild and the brewer, while there was
11
Goebel v. Linn, 47 Mich. 489, 11 NW 284, 41 Am. Rep. 723 (1882).

still time to contract with others, took the precaution of contacting its sup-
plier to make sure that the contract would be performed as agreed. The
supplier confirmed that it did not foresee difficulties and fully expected to
live up to its obligations. But the spring turned out to be even milder than
expected, so that far less ice could be cut than was usual. A severe short-
age developed.
The supplier contacted the brewer in May 1880, explaining that it
could only guarantee delivery of the ice at a price of $5 a ton. The brewer,
fearing interruption of the ice supply with loss of a great supply of beer it
had on hand, gave in and the parties settled on $3.50 over an eight-month
period. At the end of that period, the supplier demanded payment under
the contract; the brewer refused to pay the supplement, invoking duress.
The court granted the action for payment of the full amount, ruling
that the price was reasonable under the circumstances; that the supplier
had not taken advantage of unforeseen circumstances to drive an unfair
bargain; and that the mere threat of not standing by one’s initially agreed
obligations did not amount to duress.
The case has provoked a wide range of comments, stretching from
straightforward support to disapproval, as undermining business moral-
ity. Posner opines that if the court had heeded the brewer’s insistence
on getting the ice at the originally agreed price, the supplier would have
gone bankrupt and the brewer would still have had to find ice at the even
higher market price. Nothing indicates that the supplier had opportunisti-
cally taken advantage of changed circumstances. He approves the result
(Posner 2007, 100–101).
Against this, others have argued that the courts should not allow con-
tracts to be reopened where changed circumstances give one of the parties
a temporary monopoly with which to twist the other party’s arm. This
does not mean that reopening a contract should never be allowed. In the
Goebel case, one would have to know the frequency of mild winters. If
they occur with some regularity, the supplier is best placed to assume the
risk (perhaps spreading it through subcontracts), in which case, the court
should refuse retroactively to reopen the contract. On this view, only if
mild winters were extremely rare and totally unforeseeable would the
court’s decision be justified (Aivazian et al. 1984).
In French civil law, some authors have detected a tendency to allow
court revision of contract for imprevision in very exceptional circum-
stances. The ground the courts have used is that to insist in such a case on
the original terms would go against the duty of dealing in good faith that
parties owe each other. It will be interesting to see whether this tendency
persists and whether it draws the line as suggested above on the basis of
economic considerations.

4.2. Contractual Remedies: Specific Performance

Where one party does not receive the performance to which it is entitled
under the contract, while itself performing correctly or offering to do so,
it can call on the full might of the law to force the hand of the recalcitrant
debtor. What should the frustrated creditor be able to demand? At first
blush, it would seem normal to allow it to demand the prestation it was
entitled to under the contract: specific performance. This would give it the
gains it counted on in entering into the contract. In common law systems,
however, specific performance is considered the exceptional remedy,
the normal one being damages. This rule has an effect similar to that of
prohibiting penalty clauses, whilst allowing liquidated damage clauses.
In civil law systems, by contrast, specific performance is considered the
first choice at the disposal of the creditor victim of non-performance (1590
and 1601 CCQ; article 3:296 NBW). Article 1142 of the French code,
providing that non-performed obligations to do or not to do dissolve into
damages, is considered no longer to reflect current law: French courts
accept to order the debtor to perform, and to set a penalty (astreinte) for
every period of time or occasion the debtor does not comply. The obliga-
tion to give, which means to transfer ownership, lends itself quite naturally
to specific performance, in the sense that the judgment can provide the
title of transfer; in the case of immoveables, judgment rendered upon an
action in execution of title (en passation de titre) can be entered into the
registers of real rights (3:300 NBW). The Quebec code explicitly recognises
the sanction of specific performance, in cases which admit of it (1590 and
1601 CCQ).
Since American law – the starting place for law and economics – admits
specific performance only sparingly, a lively debate developed to determine
when it actually does so and whether law and economics can offer a plau-
sible explanation for it. An initial article by Kronman (1978) suggested
the matter turned on the distinction between unique goods and those for
which ready substitutes are available in the market. For the former, spe-
cific performance would normally be granted, not least because the damage
would be particularly hard to assess; for the latter, market prices would be
available and damages would routinely be granted. For services, specific
performance risks violating the personal freedom of the debtor, and for
this reason only damages would be available for non-performance.
The upshot of the debate that followed is usefully summarised in a
paper by Eisenberg (Eisenberg 2005). Two fundamental principles should
in his view govern the matter, namely the bargain principle and the indif-
ference principle. According to the first principle, parties are normally
the best judges of their own interests and hence their contract should
be enforced as agreed, save in special circumstances such as defects of

consent. The second principle holds that remedies should be chosen and
applied so as to render the victim of non-performance indifferent between
regular performance and the situation that obtains upon the granting of
the remedy.
Specific performance normally accords with both principles. Should it
be granted in all circumstances? Some arguments tell against that view.
The common law remedy of the injunction is a court order backed by the
sanction of contempt of court, which is a criminal offence. Yet here it is
applied to a private dispute, which seems awkward. Moreover, injunctions
violate individual freedoms.
A second reason for not granting specific performance in all circum-
stances is conflict with another common law principle, that of mitigation
of damages by the victim of non-performance. Eisenberg gives the example
of a municipality contracting for the construction of a bridge. Once the
construction is under way, it realises that it will be unable to fund the road
leading up to the bridge and advises the builder of its desire to cancel the
project. The builder ignores the notice, completes the bridge and sues for
payment. The municipality has no use for the bridge – a social waste. It
would have been better to halt the project and indemnify the builder for
costs already incurred. Completing the bridge needlessly aggravates the
waste. The court dismisses the action for payment.
A third reason militating against granting specific performance across
the board is that it opens the door to opportunism by the victims of non-
performance, which is particularly obvious in the case of wares whose
value fluctuates. If the value increases, the frustrated creditor of the
prestation might sue for specific performance; should it go down, the
creditor might sue for damages as these would be measured at the time of
non-performance.
Eisenberg’s recommendation is to accept specific performance as the
regular sanction save in cases where it would be inappropriate. In the case
of moveables readily available in the market, specific performance should
not be granted since frustrated buyers can easily procure the objects else-
where and claim the price difference as damages. Conversely, Eisenberg
would not grant specific performance against the buyer of such goods,
since the vendor should be satisfied selling to a third person and claiming
the price difference, if any, from the initial buyer. For unique goods, for
long-term contracts and for purchase and sale of immoveables, specific
performance would be apposite in his view. In service contracts, one may
hesitate about granting specific performance where it interferes with indi-
vidual freedom, such as cases where one would force the hand of a famous
artist or athlete. By contrast, there is no reason not to grant it against an
organisation, forcing it, for instance, to reinstate a person who has been

unjustly dismissed. These rules seem close to the practices followed in

many civil law jurisdictions.
What do we know about how actors in the field actually choose amongst
the various remedies? A Danish study (Lando and Rose 2004) finds that
businesspersons rarely ask for specific performance, preferring damages
instead. This seems to confirm the intuition that once a relationship is
spoilt, there is little point in forcing the unwilling debtor to perform;
better to claim damages, cut the ties and start again with different persons.
Civil legal systems leave this choice with the victims of non-performance
and it will be interesting to see further fieldwork on how they exercise the
choice.
5. Conclusion
The general thesis put forward in this chapter is that there is no reason
to expect the economic analysis of law to be any less applicable to civil
law systems than it is to common law systems, once structural differ-
ences between the two families are taken into account. Civil law systems
aim at bringing together all rules pertaining to a given field in a law
code; to keep the code workable, its provisions have to be concise, often
using rather abstract language to summarise a broad range of situa-
tions encountered in practice. Since codes must in principle cover all
legal problems within their purview, they carry an implicit ambition to
be complete. As a result, unlike common law systems, they have to rely
on some broad and open-ended concepts such as good faith or abuse
of rights to fill the gaps and ‘close’ the system. The contents of good
faith can be clarified usefully by linking it to the economic concept of
opportunism.
In looking more closely at some civil law concepts, one discovers that
matters having triggered discussion in common law systems, such as the
desirability of limiting penalty clauses or specific performance, are also
cause for reflection in civil law systems. Examination of civil law defects
of consent shows developments and arguments that are reminiscent of
common law discussions, with a different vocabulary. This similarity had
already been highlighted in an Anglo-French comparative exercise (Harris
and Tallon 1991).
All in all, law and economics provides a useful tool for lawyers in civil
law systems at a time when Europe is looking for common principles of
contract and delictual responsibility. When one is comparing national
legal systems in search of communalities, it offers a functional analysis
in terms of which different national systems can, as it were, be put on a
common denominator. That is an important asset for doctrinal analy-
sis.

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21 Unjust enrichment and quasi-contracts
Christopher T. Wonnell
1. Scope of the Chapter

This chapter presents an economic analysis of some of the most typical
cases involving the law of restitution, which is generally defined as the
class of all claims grounded in the unjust enrichment of the defendant
(Goff and Jones 1993, p. 3). Actions that seek damages based upon restitu-
tionary principles at law are frequently characterized as quasi-contractual
in nature. However, restitutionary remedies are also available in equity,
as with the constructive trust that a court can impose on property to
avoid the defendant’s unjust enrichment. This chapter will question the
economic utility of a generalized theory of unjust enrichment, but defends
the economic wisdom of three of the most common categories of relief that
have gone under that umbrella term.
The first of these sources of restitutionary or quasi-contractual relief
involves plaintiffs who did something that purposely but unofficiously
benefited defendants, such as a physician who provided emergency
medical services to an unconscious patient.1 An economic rationale could
be that the law is seeking to provide an incentive for providers to render
services that the recipients value more than their cost but that cannot be
negotiated contractually by virtue of high transaction costs.
If the rescue is indeed efficient, one question is whether the potential
rescuer should be under an affirmative duty to provide the service (Epstein
1973, p. 190). Thus, this chapter will explore both restitutionary ‘carrots’
for rescuers and potential tort or criminal ‘sticks’ that might be imposed
on nonrescuers.
The rescue situation, however, is by no means the only scenario in which
restitutionary relief is available. This chapter will discuss two other broad
patterns of cases. One pattern concerns transfers that were not fully vol-
untary or informed, as with payments of money by mistake or pursuant
to a contract that has become impossible to perform. In such situations,
plaintiffs can often recover restitutionary recoveries from defendants,
although defendants may be able to interpose defenses such as changed
1
Cotnam v. Wisdom, 104 S.W. 164 (Ark. 1907); In re Crisan Estate, 107
N.W.2d 907 (Mich. 1961).
454

Unjust enrichment and quasi-contracts 455
circumstances in reliance on the payments made. The economic theory

here is that full divestiture of the plaintiff’s property as a consequence of
mistake would encourage excessive care in the avoidance of mistakes or in
the contractual transfer of possession. If the social cost of a mistaken or
contractual transfer is small, it would not be wise to allow the private cost
of the transfer to be large.
A third common restitutionary pattern is the benefit-based remedies
for wrongs committed. For example, if the defendant converts property
belonging to the plaintiff and uses the property to make some profit, the
plaintiff may be able to ‘waive the tort and sue in assumpsit’ to recover
the gain the defendant has made. The economic theory here is essentially
one of deterring a defendant from bypassing market transactions where
transaction costs are low enough to make such transactions feasible.
2. The Anomaly of Benefit-based Liability

The essence of restitutionary claims is often said to be the focus on the
defendant’s gain as opposed to the plaintiff’s loss (Dobbs 1993, section
4.1). From an economic perspective, this is immediately anomalous.
Economic analysis generally sees legal intervention as a response to
conduct that imposes harm, seeking to sanction or ‘price’ that behavior so
as to reduce its incidence to more optimal levels. Barring some argument
based upon envy or spite, the presence of a gain as such is not a reason for
the law to become concerned (Wonnell 1996, pp. 177–90). To the contrary,
the defendant’s gain is normally a factor that cuts against the wisdom of
trying to impose sanctions on the defendant for harms that the defendant
may have caused.
For example, one imposes sanctions on a contract breacher because of
the harm that breach inflicts on the promisee, but one might worry about
excessively large sanctions that would deter even efficient breaches where
the defendant’s gain from breach exceeded any harm caused (Posner 2007,
pp. 119–20). Similarly, one imposes tort liability on an ultra-hazardous
activity because of its predictable harms or costs, but one is not led to
embrace criminal sanctions, injunctions, or benefit-based liability against
the blaster precisely because of the gains that the defendants (and their
contractual partners) are making from their blasting activity. And, of
course, under Learned Hand’s famous test of negligence in the Carroll
Towing case, an action can be considered non-negligent and therefore
escape liability precisely when the benefits from not taking care were
larger than the expected harm.2 Finally, the paradigm case of damnum
2
United States v. Carroll Towing Co., 159 F.2d 169, 173 (2d Cir. 1947).

absque injuria is the losses caused by fair competition, losses which are not
compensable precisely because the gains made by defendants and their
contracting partners from the ability to compete freely are so large.
These facts strongly suggest that ‘unjust enrichment’ is never going to
have the unity as a field that might be possessed by other great categories
of the law such as tort and contract (Wonnell 1996). The conclusory label
‘unjust’ hides the nature of the harm that warrants legal intervention. And
there must be some special, rather than general, reason to regard ‘enrich-
ment’ as an integral part of the wrong rather than as a factor in complete
or partial mitigation of the wrong.
This chapter suggests that ‘unjust enrichment’ is really a shorthand for
three essentially different concepts. The first is the theory of rewarding
those who intentionally confer positive externalities on others with the
fruits that could have been earned by contract had transaction costs been
lower. The second is the idea of incomplete divestiture of property. The
third is the notion of deterring the conscious bypassing of available market
options.
3. Hypothetical Contracts for Rescuers; Duty to Rescue

One situation in which the law has awarded ‘restitutionary’ remedies
involves the plaintiff who rescued the defendant’s person or property and
seeks compensation for costs incurred in the rescue. Physicians are fre-
quently awarded their reasonable fee when they render emergency medical
services to unconscious patients. Other situational rescuers are sometimes
given compensation for their out-of-pocket costs, although many provid-
ers of services are denied compensation for having acting ‘officiously’
(Dawson 1961). If tort law penalizes the imposition of negative exter-
nalities, this branch of restitution law rewards the creation of positive
externalities (Epstein 1994, p. 1377).
Dramatic rescues from death or serious bodily injury are not the only
example of this class of remedies. In Continental countries, a party can
recover in negotiorum gestio for costs incurred in repairing storm damage
to the house of a neighbor who was out of the country. Co-owners of
property are often allowed to make necessary repairs or maintenance
expenses on the common property and to bring actions against their co-
owners for compensation. A party who creates a common fund, such as a
class-action plaintiff or her attorney, can often recover in restitution from
others benefited by the plaintiff’s action (Silver 1991, p. 656). Although
less dramatic than the rescue cases, the essential principles of these cases
are the same. The transaction costs of a voluntary transaction are high,
whether because of unavailability of a party, bilateral monopoly condi-
tions, or free rider effects, and the Kaldor-Hicks efficiency of the service

is sufficiently obvious that the risk of judicial error appears tolerably low
(Bouckaert and De Geest 1995, p. 485).
It is certainly true that not all providers of valued services are entitled
to compensation from the enriched recipients. Courts tend to deny recov-
ery to those who ‘intermeddle’ or provide services ‘officiously’. When
transaction costs are low enough to enable a voluntary transaction, there
is no efficiency advantage to allowing parties to provide services without
consent and then to demand compensation after the fact.
It is somewhat doubtful that the principle involved in the rescue cases
is one of benefit-based liability at all (Levmore 1994, p. 1427). The physi-
cian who performs emergency medical services is not really asking for a
benefit-based remedy (Saiman 2007, p. 13). If the service was ineffective,
the plaintiff can recover although the defendant derived no benefit. And if
the service was effective, the benefit derived is the value of the defendant’s
extended life, which is not awarded. Nor should it be, from the stand-
point of efficiency, for such a ‘rescue’ which provided no benefit to the
defendant would encourage the defendant, who controls the regular use of
herself and her property, to exercise excessive care to avoid the need to be
‘rescued’ (Wittman 1985, p. 182). The plaintiff’s regular fee is normally a
good measure of the defendant’s benefit because it is a reflection of alter-
natives available to the defendant; if many people are willing to perform
a service for a particular fee, any one service provider cannot benefit the
defendant by more than the fee she could have paid instead. However,
in the rescue context, there may have been no other service providers, so
the plaintiff’s regular fee is no longer an indication of the extent of the
defendant’s benefit (Wonnell 1996, pp. 169–71).
Instead, the principle of the rescue cases is essentially one of hypotheti-
cal contract, imposing on the defendant the contract which would have
been consented to had the transaction costs been lower (Long 1984, pp.
415–16). It is properly denied when the plaintiff had no contractual intent,
as when the services were offered with the intention of extending them as a
gift. The label ‘quasi-contract’ has a bad reputation with restitution schol-
ars, because the notion of ‘contract’ is so misleading in describing why the
defendant is liable in the case of mistaken transfers or in the case of willful
conversions (Goff and Jones 1993, p. 6). In the rescue setting, however, the
contract analogy seems apt, as long as one remembers that the consent is
hypothetical and indicative only of how the parties would have contracted
had the opportunity been available.
Rescuers are not always treated well by the courts (Dagan 1999, p.
1152). Courts may dismiss rescuers as intermeddlers too frequently,
leading to an inefficiently low number of rescue attempts (Wade 1966,
p. 1212). One situation in which rescuers fare somewhat better is in

admiralty, where successful rescuers are often awarded a considerable fee

for their efforts (Albert 1986, pp. 111–15). The need for professional res-
cuers to engage in investments in rescue-related equipment may partially
explain the sympathy accorded to such rescuers in admiralty. It has been
argued that the structure of compensation for rescuers in admiralty closely
approximates the terms of a transaction that the parties would have made
with the rescuer had a transaction been possible (Landes and Posner 1978,
pp. 103–04).
Are there good economic reasons for the law to take a different attitude
toward sanctioning inflictors of negative externalities as opposed to subsi-
dizing generators of positive externalities? It has been questioned whether
there are sound economic distinctions, and that the law’s asymmetry in
this regard is better understood in non-economic terms about responding
to ‘harms’ or ‘rights violations’ rather than all costs (Hershovitz 2006, p.
1152). On the other hand, liability for harm and lack of awards for benefits
both put the onus for negotiating a change in legal status on the active
party who might be better situated to undertake that function (Levmore
1985, p. 70). In some circumstances, a reasonable level of efficiency can be
obtained by the party who wants to create positive externalities obtain-
ing the consent of one or a few beneficiaries. The others can free ride but,
unlike parties protected by property rules against harms, cannot hold out
in such a way as to block settlements altogether (Porat 2009, p. 205).
An interesting question is whether rescues, if they are clearly efficient,
should be required rather than left to the law of quasi-contract. An award
that was substantial enough to clearly exceed the plaintiff’s costs should be
sufficient to inspire rescue. If restitutionary awards are generous, a duty to
rescue could be superfluous, but by the same token it would appear to be
a harmless supplemental incentive.
The most serious problem with penalties (especially when pursued to
the exclusion of liberal restitutionary awards) is their indirect effects on
incentives. A person who realizes that her talents and properties can be
conscripted to help others will not have as much incentive to develop
those talents and properties in the first place or have them in a place where
they could be useful to others, although the empirical significance of this
problem will vary with the circumstances (Levmore 1986, pp. 889–92).
This problem might be quite unimportant where the cost of the rescue was
trivial, as with the paradigm case of the person who refused to throw a
rope to a drowning swimmer.
The incentive problem with mandatory rescue as opposed to restitu-
tionary regimes is essentially a problem of governmental knowledge. To
impose an efficient duty to help, one would need to know about the previ-
ous choices available to potential rescuers and what effect the prospect of

liability might have on those choices. To create a hypothetical contract,

one can instead ignore past choices, as a mutually beneficial transaction
should not deter others similarly situated from making the choices which
would place them in a position to be of service to others.
This is not to say that a duty to rescue would always be inefficient.
Where one party is both a better avoider of the loss and a better insurer
against uncertain outcomes, it may be an express or implied part of a
contract that one will provide rescue services when needed by the other.
This may explain why the law sometimes imposes a duty to rescue between
parties in a ‘special relationship’ with each other, such as common carri-
ers or innkeepers and their guests (Prosser and Keeton 1984, section 56,
pp. 376–7). Another possible case for an efficient rescue duty would be a
setting in which one was equally likely to be a rescuer or a rescuee. In that
case, a party may actually be encouraged to be in a position where she can
be of service, as an unintended byproduct of wanting to be somewhere that
others would have a duty to rescue if one got into trouble (Hasen 1995, p.
141).
Another potential problem with a duty to rescue is that the would-be
rescuee loses some of her incentive not to be in a position that would require
rescue (Wittman 1981, p. 89). In principle, this should be accounted for in
saying that the duty is truly an efficient one, for if the rescuee is a cheaper
cost-avoider, the would-be rescuer’s duty would not be efficient (Calabresi
and Hirschoff 1972, pp. 1060–61). However, this would once again require
considerable knowledge on the part of the state as to the steps that could
have been taken by would-be rescuers and rescuees.
If knowledge of decisions available in prior periods is unavailable, the
safer course may be to try to construct mutually beneficial bargains by gen-
erous rewards extended to rescuers, at least where there is no reason to fear
that a plaintiff may have induced the demand for her own rescue services
(Levmore 1986, p. 886). It is true that a restitutionary award, by making
rescues more likely, will increase the incentive of potential rescuees to act
in ways that will require their rescue, but because rescuees will be forced to
pay for the service rendered to them, the effect will be considerably smaller
than that generated by a duty to rescue.
Still another potential problem with the duty to rescue concerns admin-
istrative costs. Parallels can be drawn with the great costs of trying to
enforce against consensual or victimless crimes, where lack of evidence
is a serious problem unless one resorts to very aggressive law enforce-
ment techniques. The person who was not rescued may be deceased and
unavailable as a witness, while other witnesses to the nonrescue may
be equally culpable as nonrescuers and thus unwilling to bring forward
their information (Rubin 1986, p. 274). And if multiple nonrescuers were

involved, there will be difficulties in assessing relative responsibility. There

may be some incentive gain from the purely symbolic effect of creating a
largely unenforceable legal duty to rescue, although this would have to be
traded off against any losses that might occur in the feelings of altruism
or heroism that might result from the perception that one was performing
only a legal duty (Rubin 1986, p. 275).
The economic argument for a duty to rescue – somewhat uncertain, as
noted above, at least for rescues of nontrivial cost – should be distinguished
from the broader social or utilitarian argument for redistribution from
those with surplus resources to those with greater need for the resources.
The economic argument asserts that each rescue is a Kaldor-Hicks effi-
cient transaction, and can add that rescue situations are sufficiently unpre-
dictable that a general duty of rescue might well be in everyone’s ex ante
interest to accept. The redistributive argument would assert that people
have a duty to do their part for others in dire need even if the economic
value of their resources (as contrasted with their utility) is not higher in the
rescuee’s hands, and despite the fact that the rescuer may have no reason-
able expectation of receiving reciprocal benefits. In normal circumstances,
a welfare state would be the sensible mechanism for coordinating such
a duty, but in rare emergency cases the person who should act might be
sufficiently individuated that a private law rescue duty could supplement
the system of taxation and public protection. At least some commentators
appear to make both the economic and the redistributive arguments for a
duty to rescue (Weinrib 1980, pp. 272, 292). The redistributive argument
of course suffers from the more general moral hazard problems of welfare
states in altering behavior by shielding people from the consequences of
their choices.
4. Incomplete Divestiture
Suppose that the plaintiff pays money to the defendant by mistake,
perhaps having miscounted the money or misidentified the defendant’s
account number. It has been argued that these cases raise purely distribu-
tional concerns and do not create social costs that would require economic
analysis (Gergen 2001, p. 1929). But in fact there is an economic rationale
for requiring the defendant to return the money.
The essential idea is that the plaintiff is in a position to make decisions
over her own property, and the law should create an incentive to optimize
these decisions. There may be a modest social cost created if the plaintiff
is careless in directing her money, as the mistake must then be identified
and corrected at some administrative effort. Ideally, the property holder
should be liable for these costs in order to ensure that she takes proper care
to avoid mistakes. However, it would not be efficient to punish mistakes

with full divestiture of the plaintiff’s rights to the value of the money. Such
a rule would impose a private cost on the plaintiff much larger than the
social cost of correcting a mistake. The plaintiff would be induced to exer-
cise too much care to avoid her mistake (Huber 1988, p. 99). Moreover,
the defendant would have a perverse incentive not to correct, or even
potentially to cause, the plaintiff’s mistake.
It should be noted that restitution claims do not always involve a literal
transfer of property from the plaintiff to the defendant. The plaintiff may
have provided services, or discharged the defendant’s debt, but there has
been a transfer of wealth from the plaintiff to the defendant, measured
abstractly (Lionel Smith 2001, p. 2142). And ‘property’ can be a contest-
able basis for defining appropriate enrichments (Dagan 2004, pp. 21–2).
On the other hand, it has been argued that restitution is a field potentially
allowing excessive judicial discretion, and that the primary cases for
relief should be those where harm and enrichment are clearly defined by
property entitlements previously established (Sherwin 2005, p. 1182).
In the case of money, the social cost of the mistake is usually small,
although it may be large if the defendant took actions in detrimental reli-
ance on what reasonably appeared to be new wealth. In other situations,
the social cost of mistake may be quite substantial. A common pattern
involves a plaintiff who constructs a building by mistake on the defend-
ant’s land.3 As the defendant did not ask for the building, it may be worth
considerably less than the value of the plaintiff’s labor and materials
invested in the project (Dickinson 1985, pp. 62–3).
Older cases tended to deny recovery to the plaintiff builder on the theory
that the defendant should not be made worse off by being required to pay
for an improvement she did not want.4 This approach, however, does
create an incentive for the plaintiff to exercise excessive care in avoiding
mistakes, and for the defendant to exercise insufficient care to avoid such
mistakes by the plaintiff.
Many recent cases have granted a restitutionary recovery for the
plaintiff who constructs a building on the defendant’s land by mistake.
The Betterment Acts enacted in most US jurisdictions give an owner the
choice between paying the value of the improvement or selling the land
to the improver at its unimproved value (Dagan 2001, pp. 1128–9). The
problem with this approach is that the social cost of the mistake is difficult
3
Madrid v. Spears, 250 F.2d 51, 54 (10th Cir. 1957); Rzeppa v. Seymour, 203
N.W. 62, 63 (Mich. 1925).
4
Producers Lumber & Supply Co. v. Olney Bldg. Co., 333 S.W.2d 619 (Tex.
Civ. App. 1960).

to measure. The illiquidity of the newfound wealth imposes different costs

on different types of parties, depending upon their overall preferences and
financial situation (Kull 1997). Perhaps the best approach would be for the
courts to make generous assumptions about the amount of harm that will
be caused by the illiquidity, and to award the plaintiff an amount that one
can assert with considerable confidence will not make the defendant worse
off from the overall transaction.
The essence of the plaintiff’s claim is not that the defendant has been
enriched. If for some reason the plaintiff’s building looked particularly
good on the defendant’s land, there is no reason to require the defendant
to disgorge the gains received in excess of the costs plaintiff has incurred.5
Rather, the plaintiff’s essential claim is harm caused by the incomplete
divestiture of property.
It would clearly be undesirable to allow the plaintiff to retain formal
title to the building while the defendant retained formal title to the under-
lying land. This would create serious problems of bilateral monopoly and
accompanying high transaction costs of breaking the compulsory relation-
ship (Wonnell 1996, p. 197). Property, however, is a bundle of severable
sticks, and the fact that necessity compels the divestiture of the plaintiff’s
physical rights to the property does not mean that the plaintiff must also
lose her rights to the value of that property.
Incomplete divestiture is the counterpart to the more familiar idea of
incomplete privilege (Bohlen 1925). A defendant who is caught in a storm
and needs to use the plaintiff’s docking facilities is not confronted with
legal rules designed to prevent use of the plaintiff’s property, such as crimi-
nal sanctions, injunctions, or benefit-based liability. However, the defend-
ant remains liable for the costs imposed, as an incentive for the defendant
to take the potential for such emergencies into account in evaluating
how to make use of her own property.6 Necessity compels the yielding of
exclusive physical rights to the property (and the right to charge any price
made possible by free contract), but it does not compel the yielding of the
plaintiff’s rights to the value of the property. ‘Restitution’ in these cases
is essentially the same principle, but where the plaintiff rather than the
defendant is the active party, and accordingly where the law must remain
alert to the possible harms caused by the activity in question.
Contracts provide the backdrop for many restitutionary remedies. In
some circumstances, especially important in losing contracts, the courts
5
Madrid v. Spears, 250 F.2d 51, 54 (10th Cir. 1957); Rzeppa v. Seymour, 203
N.W. 62, 63 (Mich. 1925).
6
Vincent v. Lake Erie Transportation Co., 124 N.W. 221, 222 (Minn. 1910).

may allow a restitutionary recovery as an alternative to standard expecta-

tion principles of damages. This is quite a problematic idea, as it allows
the plaintiff to escape the allocation of a risk that the contract may have
efficiently placed (Kull 1994, pp. 1465–70). It also gives the plaintiff a per-
verse incentive to induce the defendant to breach a contract, or to jump
on breaches of uncertain materiality as excuses for rescission. However,
in some situations it seems likely that the parties would have wanted a
restitutionary recovery, especially where the defendant completely failed
to perform and the plaintiff’s restitutionary interest is much easier to
calculate than her expectation (Kull 1994).
Restitution is also granted in many cases to the breaching party to
a contract.7 As a general idea, this is simply a way of ensuring that
the nonbreaching party receives her expectation interest, but only her
expectation interest, upon breach. It is therefore justified by the general
economic argument that favors expectation damages and disfavors puni-
tive damages, involving the principle of efficient breach and the desire to
avoid high-transaction-cost bargaining over the surpluses from breach
between bilateral monopolists (Posner 2007, p. 119). On the other hand,
in some circumstances it may be difficult to calculate the expectation
interest, with the result that a restitutionary recovery for the breach-
ing party threatens to undercompensate the nonbreacher and thereby
underdeter breach.
Parties sometimes provide for forfeitures of downpayments without
regard to actual damages as an implicit recognition of this phenomenon
of restitutionary awards leading to undercompensation of the nonbreach-
ing party. The general argument that contracts are presumed efficient (at
least between informed parties) would argue for the enforcement of such
bargained-for forfeitures.
Finally, restitution is often granted in the case of broken contracts, such
as those held to be unenforceable under the Statute of Frauds,8 or those
that become impossible to perform through some intervening condition
or statute. Again, we face a case of incomplete divestiture of property.
The parties parted with their goods or services on assumptions that have
proved to be invalid. If the court were to simply leave the parties where it
finds them, the parties would have incentives to strategically and uneco-
nomically delay the transfer of physical possession of resources involved in
the contracting process (Bouckaert and De Geest 1995, p. 475). To induce
parties to use optimal timing in contracts, transfers should be undone if
7
Restatement of Restitution (1937, section 108(b)).
8
Boone v. Coe, 153 Ky. 233, 154 S.W. 900 (1913).

no social harm has been caused (by, for example, affixing resources to
projects that no longer have value).
If a net social harm has been caused by contractual activity, the problem
is more complex. Indeed, there is a terminological issue of whether ‘restitu-
tion’ is really involved when the plaintiff’s work caused loss to the plain-
tiff but did not actually enhance the defendant’s wealth (Petty 2008, pp.
371–5). Clearly, there are many such cases in which a remedy called ‘res-
titution’ has been allowed (Dawson 1961, p. 577), but it has been argued
that this use of the restitution (or ‘restoration’) concept without unjust
enrichment is productive of confusion (Kull 1995, p. 1193). From an eco-
nomic point of view, when there is a net social loss one might ask which of
the parties is more efficiently situated to have prevented or insured against
that loss (Posner and Rosenfield 1977, p. 83). In this sense, the problem is
analogous to the economics of accidents (Dagan 2001, p. 1795).
5. Disgorgement for Bypassing Viable Market Options

Another use of the restitutionary idea is as an alternative remedy for
wrongs. It should be noted that not all commentators are comfortable that
the concept of ‘restitution’ governing disgorgement remedies is the same
unjust enrichment concept creating substantive liability in other settings
(Edelman 2001, p. 1869). In a somewhat similar vein, others have argued
that ‘restitution’, with its connotation of ‘giving back’, can be a misleading
label for such a disgorgement approach (McInnes 1999, pp. 24–5; Stephen
Smith 2003, pp. 1042–3).
Terminological issues aside, a person who intentionally converts prop-
erty belonging to another is liable in tort for the harm caused, but may
also be liable in restitution for the benefit received from her own use of
the ill-gotten property. It is said that the plaintiff can ‘waive the tort and
sue in assumpsit’ to recover gains larger than the plaintiff’s loss (Palmer
1978, Section 2.10). Restitution can be awarded against those who pro-
cured the plaintiff’s property ‘through imposition (express or implied), or
extortion; or oppression; or an undue advantage taken of the plaintiff’s
situation, contrary to laws made for the protection of persons under
those circumstances’.9 Willful takers of intellectual property belonging
to the plaintiff have often found themselves affected by this principle
(Gordon 1992).
Is this remedy an exemplar of the broader principle that a person should
not ‘profit from a wrong’?10 From an economic perspective, this depends
9
Moses v. Macferlan, 2 Burr. 1005, 97 Eng. Rep. 676 (1760).
10
Restatement of Restitution (1937, section 3).

greatly on how ‘wrong’ is defined. If ‘wrong’ is confined to well-defined,

easily avoidable conduct that unambiguously imposes more harm than
benefit, it would certainly be true that efficiency would require that the
defendant not be permitted to profit from the wrong. The law needs to
deter such conduct, and disgorgement is the minimum sanction sufficient
in principle to effectuate such deterrence. Of course, in this case, economic
analysis would see no reason for trying to put the defendant on her own
indifference curve between right and wrong conduct (Wittman 1985, p.
182). If the behavior is clearly defined and unambiguously inefficient,
punitive damages or criminal sanctions may be in order, or certainly liabil-
ity for harm caused (by definition, larger than the benefit received). Thus
the disgorgement principle, while valid, would be properly submerged in
the law beneath more severe penalties.
On the other hand, if ‘wrong’ is defined as conduct that the law ought
to sanction, it is no longer true that we would want a rule that a person
should not ‘profit from a wrong’. In economic theory, sanctions are
imposed because the behavior in question might be inefficient, or because
the precise behavior involved is inefficient but is difficult to distinguish
before the defendant’s action is taken from other behavior, the inefficiency
of which is less clear. In such cases, the liability needs to be measured by
harm caused rather than benefit derived. Harm-based liability gives the
defendant an incentive to undertake the activity if and only if her benefits
truly exceed the harm caused. Benefit-based liability would make the
defendant indifferent to the costs imposed on the plaintiff (as these did not
affect remedies) and to the benefits she herself derived (as these would be
taken away in any event).11
One should not expect, therefore, any robust general principle of law
that involves disgorgement of gains received. Gains in themselves are
not objectionable; they serve to mitigate wrongdoing. Gains should be
disgorged in cases where the actual remedies are likely to be considerably
more severe, so that the disgorgement idea is unnoticed. When other pen-
alties are inappropriate, this is usually because of factors that make the
disgorgement idea inappropriate as well.
There is one situation, however, where disgorgement is a sensible
remedial approach, namely, the conscious bypassing of readily available
market alternatives. This behavior is clearly inefficient, because even if
the defendant had more valuable uses for the property in question than
the plaintiff, she could, by definition, have obtained those efficiencies by
consensual means. Many takings are inefficient, and the litigation costs of
11
Wittman (1985, p. 173).

distinguishing those that are from those that are not are likely to dwarf the
transaction costs of a voluntary move of the property.
An interesting question is whether this principle should result in
a defendant’s duty to disgorge gains made by a breach of contract
(Farnsworth 1985, p. 1369). The theory would be that a promise consti-
tutes property of the plaintiff, and that the defendant has converted that
property by retaining the benefits of refusing to perform. On the other
hand, the contract breach setting is one of bilateral monopoly, and the
parties might have considerable difficulty agreeing on a voluntary distri-
bution of the gains from breach. Where that situation obtains, a disgorge-
ment rule might threaten to undermine the gains from breach entirely, or
result in their dissipation through haggling over their distribution (Posner
2007, pp. 119–20). The traditional rule disfavoring disgorgement remedies
for breach of contract may well be efficient for that reason (Campbell
and Harris 2002, p. 236), although it should certainly yield in the face of
evidence that the contracting parties intended a disgorgement remedy to
apply.
The disgorgement remedy has gained strength in recent years. The
House of Lords embraced the concept in Attorney General v. Blake.12
The tentative draft of the new Restatement (Third) of Restitution pro-
vides for disgorgement as a contract remedy when the breach is ‘profit-
able’ and ‘opportunistic’.13 According to Andrew Kull, Reporter for
the new Restatement, ‘profitable’ does not mean that the breach itself
makes money for the defendant (or is rational), but that it continues
to make money despite the duty to pay damages (Kull 2001, p. 2057).
‘Opportunistic’ is designed to exclude a breach in which the defendant
renders a substitute performance that fulfills the plaintiff’s expectation
interest. The former concept seems in direct tension with the idea of effi-
cient breach, but the latter appears to leave room for a breach motivated
by changes in circumstances if the defendant exhibits a good faith willing-
ness to acknowledge responsibility for her contractual obligations and the
harm she has caused.
The concept of “efficient breach” has its critics. The difficulty of measur-
ing the loss to the plaintiff, and the existence of unrecoverable costs such
as attorney’s fees, emotional distress, and subjective harms not provable
with reasonable certainty, have suggested to some that stronger remedies
based upon pacta sunt servanda notions are needed. (Eisenberg, 2006, pp.
570-578). A disgorgement remedy in this sense is rather similar to specific
12
4 All E.R. 385 (H.L.) (Eng.) (2000).
13
Restatement (Third) (2005, section 39).

performance, and counts on private bargaining in the shadow of strong

remedies as a Coasian solution to whatever inefficiencies might arise when
circumstances change after contracts are entered.
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McInnes, Mitchell (1999), ‘The Canadian Principle of Unjust Enrichment’, Alberta Law
Review, 37, 1.
Palmer, George E. (1978), The Law of Restitution, New York: Aspen Publishers.
Petty, Aaron R. (2008), ‘The Reliance Interest in Restitution’, Southern Illinois University
Law Journal, 32, 365.
Porat, Ariel (2009), ‘Private Production of Public Goods: Liability for Unrequested Benefits’,
Michigan Law Review, 108, 189.
Posner, Richard A. (2007), Economic Analysis of Law, 7th edition, New York: Aspen
Publishers.
Posner, Richard A. and Rosenfield, Andrew M. (1977), ‘Impossibility and Related Doctrines
in Contract Law: An Economic Analysis’, Journal of Legal Studies, 6, 83.
Prosser, William and Keeton, W. (1984), The Law of Torts, 5th edition, St Paul, MN: West
Publishing.
Rubin, Paul H. (1986), ‘Costs and Benefits of a Duty to Rescue’, International Review of Law
and Economics, 6, 273.
Saiman, Chaim (2007), ‘Restating Restitution: A Case of Contemporary Common Law
Conceptualism’, Villanova Law Review, 52, 487.
Sherwin, Emily (2005), ‘2005 Survey of Books Related to the Law: Rule-Oriented Realism’,
Michigan Law Review, 103, 1578.
Silver, Charles (1991), ‘A Restitutionary Theory of Attorney’s Fees in Class Actions’, Cornell
Law Review, 76, 656.
Smith, Lionel (2001), ‘Restitution: The Heart of Corrective Justice’, Texas Law Review, 79,
2115.
Smith, Stephen (2003), ‘The Structure of Unjust Enrichment Law: Is Restitution a Right or
a Remedy?’, Loyola of Los Angeles Law Review, 36, 1037.
Wade, John W. (1966), ‘Restitution for Benefits Conferred without Request’, Vanderbilt Law
Review, 19, 1183.
Weinrib, Ernest J. (1980), ‘The Case for a Duty to Rescue’, Yale Law Journal, 90, 247.
Wittman, Donald (1981), ‘Optimal Pricing of Sequential Inputs: Last Clear Chance,
Mitigation of Damages, and Related Doctrines in the Law’, Journal of Legal Studies, 10,
65.
Wittman, Donald (1984), ‘Liability for Harm or Restitution for Benefit?’, Journal of Legal
Studies, 13, 57.
Wittman, Donald (1985), ‘Should Compensation be Based on Costs or Benefits?’, International
Review of Law and Economics, 5, 173.
Wonnell, Christopher T. (1996), ‘Replacing the Unitary Principle of Unjust Enrichment’,
Emory Law Journal, 45, 153.
Cases
Attorney General v. Blake, 4 All E.R. 385 (H.L.) (Eng.) (2000).
Boone v. Coe, 153 Ky. 233, 154 S.W. 900 (1913).
Cotnam v. Wisdom, 104 S.W. 164 (Ark. 1907).
In re Crisan Estate, 107 N.W.2d 907 (Mich. 1961).
Madrid v. Spears, 250 F.2d 51 (10th Cir. 1957).
Moses v. Macferlan, 2 Burr. 1005, 97 Eng. Rep. 676 (1760).

Producers Lumber & Supply Co. v. Olney Bldg. Co., 333 S.W.2d 619 (Tex. Civ. App. 1960).
Rzeppo v. Seymour, 203 N.W. 62 (Mich. 1925).
United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947).
Vincent v. Lake Erie Transportation Co., 124 N.W. 221 (Minn. 1910).
Legislation
Restatement of Restitution (1937).
Restatement (Third) of Restitution and Unjust Enrichment (Tentative Draft No. 4) (April
8, 2005).

Index
accident avoidance 426 arbitration in franchise agreements

Acemoglu, D. 425 393
action-directing action 62 Arlen, Jennifer 405, 408
adaptation Arrondel, L. and A. Lafferère 108
autonomous 285–6, 288 assets
coordinated 285–6, 288 complementary 287
add-ons 417 specificity 282
adhesion contracts see standard form substitute 287
contracts assumpsit 455
Adler, Barry E. 231–2, 236 asymmetric paternalism 411
administrative control 285 Attorney General v. Blake 466
adverse selection 226 at-will termination 353
agency costs and third-party interests at-will, franchise 392
148–9 autonomous adaptation 285–6, 288
agency problems 431 Axiom of Unilateral Action 245–8
Aghion, Phillipe, Mathias Dewatripont Ayres, I. 197, 363, 371 see Rasmusen,
and Patrick Rey 291, 293, 295 E. and I. Ayres; Ayres, I. and
Aghion, Phillipe and Benjamin G. Klass
Hermalin 196–7 Ayres, I. and G. Klass 46
Aghion, Phillipe and Patrick Bolton Ayres, Ian and Robert Gertner 226–8,
193–5, 324–5 232, 235–6
Aivazian, Varouj A. 447
Aivazian, Varouj A. et al. 73 bailout 296–7
Akerlof, George A. 444 Baldus photographs case 439
Albert, Ross A. 458 bargaining 249–50, 448
aleatory view of negotiations 9, 12, bargaining power 16, 115–16
24 bargaining, revolving-offer 292–3
Allen, D.W. 377 Bar-Gill, Oren 120, 230–31, 416–18
allocative efficiency 32, 34, 36, 42, 105, Bar-Gill, Oren and Omri Ben-Shahar
156 63–4, 69, 71
Almond 373 barriers to efficient contracts 156–7
alternative governance mechanisms Bartholomew, J. 377
129, 146 Barton, John H. 158
altruism see bequests, altruistic Basu, Kaushik 65
bequests Bates, T. 389
ambiguity aversion 200 Baumol, W.J. 302
anchoring 404 Beales, H. 36
Anglo-American theory of contract Beales, J. and T. Muris 351
law 9, 80 Bebchuk, L.A. and Omri Ben-Shahar
Anglo-Canadian law 80, 89, 91, 430 10, 12, 17, 19–20, 25, 27
Anglo-Saxon inheritance 106–7 Bebchuk, L.A. and R.A. Posner 120
annulment of contract 440 Bebchuk, Lucian Ayre and Steven
anticipatory repudiation 171 Shavell 226–8, 232
arbitration 129, 146 Becher, Shmuel I. 122
471

Becker, Gary S. 361 Bracewell-Milnes, Barry 104–5

Becker, Gerry 41 see legal deterrence, breach 315–16, 327, 335–6, 341–8,
theory of 455–67
Becker–Barro model 103 efficient breach 455, 466
behavioral approaches to contract law Brenner, Gabrielle 108
401–21 Brickley, J.A. 385
behavioral economics 401–21 Brickley, J.A. and F.N. Dark 385
benefit-based liability 465 Brickley, J.A., F.H. Dark, and M.S.
Ben-Shahar, Omri 10, 18–19, 25, 40, Weisbach 351
131, 144, 426 Brickley, J.A., S. Misra and L. Van
see Bebchuck and Omri Ben-Shahar; Horn 352
Bar-Gill, Oren and Omri Ben- Bridge, M.G. 430
Shahar Brinig, M.F. 374, 376
Ben-Shahar, Omri and J.J. White 121 Brown, J. 52
bequests Brownsword, R. 430
accidental or unplanned bequests Bruce, Christopher 212
97–8, 106 Buchanan, James and Gordon Tullock
altruistic bequests 99–100, 106 104–5
bequests based on pure exchange Buckley, F.H. 64, 66, 72–3, 442
101–2 bundling 417
capitalist or entrepreneurial bequests Burrows, Andrew 225
103–4 buy-backs, for franchise 385, 388–9
paternalistic bequests 100–101
retrospective bequests 101 Calabresi, G. 429
strategic bequests 102–3 Calabresi, G. and J.T. Hirschoff 459
voluntary or planned bequests Calabresi, G. and D. Melamed 363,
98–103 429
Berglöf, E. and G. Roland 297 Calabresi, Guido and Douglas A.
Bergstrom, T.C. 108 Melamed 68, 70
Bernheim, B. Douglas et al. 109 calculating damages
Bernstein, Lisa 146 diminished value 170
best-efforts clause 125, 128, 184 lost surplus 169–70
Betterment Acts 461 opportunity cost 170
bias 402, 404–6, 408, 410, 413, 416–19 out-of-pocket cost 170
status-quo bias 405–6, 413, 419 substitute price 169
Bigelow, J. 266 see also reliance; restitution;
bilateral warranty problems 265–6, expectation
268, 273 Camerer, C. 411
Bishop, William 47, 165–6, 168 Campbell, D. and D. Harris 466
Black-Widow effect 360, 369, 371–3 capital-market 384–5
Blair, R.D. and D.L. Kaserman 390 Carbone, J.R. and M.F. Brinig 371,
Bohlen, F.H. 462 373
boilerplate see standard form contracts Carroll Towing 455
Bolton, P. and M. Whinston 390 catchalls 127–8, 131
Bolton, Patrick and Mathias cause for entering contract 442
Dewatripont 158 Caves, R.E. and W.F. Murphy 384
bond, for franchise 392–4 Chandler v. Webster 219
Bouckaert, B. and G. De Geest 67, characteristics of contracting parties
457, 463 143–4
bounded rationality 64, 402–3, 409–10 charity 89–90

Index 473
Charpentier, E.M. 429–30 cause for entering 442

Che, Y.-K. and D.B. Hausch 244–6, error 435–7
248 excusable non-performance 445–6
Che, Yeun-Chu and Chung, Tai- franchise 384–95
Yeong 189 hardship clause 446
Chiappori, P. 322 holdup problem 239–53, 282, 290,
Chronopost case 444 298
Chu, Cyrus 108 incomplete 241, 281, 288–89, 295,
Chung, Tai-Yeong 189, 193 298–300, 314–15, 317, 323,
civil law of contract 424–50 334–5, 338, 341, 344
civil liability 426 interpretation 228–41
classic bargain theory 9 marriage 360–78
classic economic theory 432 mistake 435–7, 460
classical theory of contract 61 modification 73
clean break principle 365 option 239–53, 291–4
Coase, R.H. 283–4, 328, 336 performance 445–50
Coase Theorem 161, 432 principal-agent 322
Coasian bargaining 386 public enforcement of 427
Coasian solution 466 quasi-contracts 454–67
cognitive error 198–201 short-term 316–23
cognitive psychology 401–21 contractual discharge 209, 212–14,
cohabitation 360–61, 375–7 216–19
Cohen, George M. 10, 22, 125–51, contractual mistake and
432 misrepresentation 31–52
Cohen, Lloyd 361–2 Cooper, R. and T.W. Ross 266–7
commitment 320–22, 337–8 cooperation 300, 314–15, 330–31, 338,
common-law marriage 376 354
Commons, John R. 282 cooperative equilibrium 331, 342
comparative institutional analysis 284 cooperative investment models of
competition 288, 297–8 holdup problem 243–7, 315
competitive equilibrium 258, 261 cooperative investments 189–90, 344,
complementary assets 287 346–7
completeness of contracts 126–30, cooperative specific investment 346
331–3 cooperativeness 221–2
Conlisk, J. 407–8 coordinated adaptation 285–6, 288
consensualism 434 Cooter, R. and T. Ulen 34–5, 57–8,
consent, defects of 434 64–5, 71–2, 429
consequential damages 415 Cooter, Robert D. and Melvin Aron
consideration 80–83, 85–6, 90–94, 443 Eisenberg 169–71, 173
constrained choice 62, 64 Cornu, G. 430
consumer biases 416–17 cost-benefit analysis
exploitation of 418–19 precontractual investment 12–13,
consumer choice, improvement 419 19
consumer contracts 416 Cour de cassation 438–40, 444
consumer mistakes 417–18 court competence and error 145–8
contextualism 131, 133–4, 136, 141–8 covenant marriage 363
contra proferentem 122, 138 Craswell, Richard 10, 12–16, 23, 26–7,
contracts 41, 44–5, 63–4, 69–71, 159, 166
annulment 440 credence properties 256
breach 455–63 credibility 69

Cserne, Péter 57–79 Dnes, A. 363, 374, 377, 390, 392–3

see Cserne, Péter and Szalai, Akos Dnes, A. and N. Garoupa 388
Cserne, Peter and Szalai, Akos 72–3 Dnes, A. and R. Rowthorn 360–61
Dobbs, D.B. 455
Dagan, H., 457, 461 double bind effect 76
Dailami, M. and R. Hauswald 334 downstream markets 326
Dam, K.W. 425 Draft Common Frame of Reference
damage provisions 180, 182 437
damages limitations 216–17 Drahozal, C.R. and K.N. Hylton 393
damnum absque injuria 455–6 dual distribution 388–9
Darby, M. and E. Karny 256 duress 57–79
Davis, G., S. Cretney and J. Collins contract modification 73
372 economic duress 66, 75–6
Davis, Kevin E. 117 engineered vs. non-engineered 66,
Dawson, John P. 60, 340, 456, 464 68, 71
De Geest, Gerrit 109, 429, 443 necessity 71–2
see Bouckaert, Boudewijn and Dutch Civil Code 434, 443, 445
Gerrit De Geest; De Geest, Dutta, S. and S. Reichelstein 318, 321
Gerrit and Roger Van den duty to inform 437, 440
Bergh duty to rescue 456–60
De Geest, Gerrit and Roger Van den dynamic commitment 295–8
Bergh 58
debiasing 417 EC Directive 274
decision-making strategies 402–4 economics of governance 281
default preference 405–6, 419 Edelman, J.J. 464
default rules 428 Edlin, A. and B. Hermalin 251
default versus mandatory rules Edlin, Aaron S. and Alan Schwartz
135–7 162, 179, 188
majoritarian 412–13 Edlin, Aaron S. and Reichelstein,
non-enforcement 413–14 Stephen 188
tailored 413–14 efficient breaches 455, 466
defects of consent 434, 441 efficient contracts and efficient
deferred reciprocity 101 nonperformance 155–6, 185
definiteness 316–17, 340 efficient information exchange 11,
Del Granado, J.J. 434 23–4
Deutch, Sinai 122 efficient rate of precaution 235
Dewatripont, M. and E. Maskin Eidenmuller, Horst 59, 62
296–7 Eisenberg, M. 35, 199, 234–5, 414,
Dewatripont, Mathias see Bolton, 448–9, 466
Patrick and Mathias Dewatripont Ellison, G. 417
Dickinson, K. 461 Emons, W. 266, 268
Directive on unfair terms 430, 443, endowment effect 405–6, 409
445 English law 430
discount rate 272–3 Epstein, Richard A. 74, 407, 454, 456
disgorgement remedies 464–6 equal division inheritance 106–10
diversified investments 384 equilibrium 248–50, 253, 267, 299–300
divorce 360–78 strategies 249
fault 360 cooperative 331
no-fault 360, 362–4 perfect 292–3
Dixit, A.K. 432 error in contract 435–7

Index 475
Esposto, Alfredo G. 64, 66 French inheritance law 107–8

estate tax 104–6 French law 107–8, 429, 431, 435,
European Commission 339 441–3, 445–8
Evans, R.B. 248–50, 253 Friedman, David D. 164
excusable non-performance of contract Friedman, Milton 64
445–6 Friedmann, Daniel 161, 163
expectation 92, 158–9, 186–7, 347 frustration of purpose 219
experience properties 256 Fudenberg, D. 299, 317
exploitation of nonreaders 119–20 Fudenberg, D., B. Holstrom, P.
ex post mechanisms 287–9, 291, Milgrom 317–18
294–5, 301 Fuller, Lon 81–2
express invocation 220–21 Fuller, Lon and William Perdue 159,
170
failure to read 118 Fumagalli, C. and M. Motta 326
Farnsworth, E.A. 9–10, 12–13, 24, 26,
370, 466 Gabaix, Xavier and D. Laibson 121,
fault divorce 360 417
fiduciary contracts 133, 140 Gallin, N.T. and N.A. Lutz 388
Fischhoff, B. 404 Gal-Or, E. 262
force majeure 445–6 Garvin, L.T. 415–16
foreseeability 225–38 Geis, George S. 132, 229, 233–4
formalism see textualism Gergen, M. 460
formation defences 61, 74–5 German Civil Code 429, 434, 443
formulation error 129 Giesel, Grace M. 75
Fragonard case 439 gifts, wills, and inheritance law 94–114
franchise Gillette, Clayton P. 118–24
arbitration 393 Gilson, R.J. 330–31, 336
at-will 392 Goebel v. Linn 446–7
bond 392–4 Goetz, C.J. and Scott, R.E. 13, 117,
buy-backs 385 155, 172–3, 182–3, 226
contracts 384–95 Goff, Lord R. and G.H. Jones 457
franchising 351–3 Goldberg, Victor P. 140, 145, 218–19,
free riding 391 337
hostages 392–4 Golden Rule 101
inter-satellite transfers 388 good faith 14, 22, 60, 125, 128, 132,
monitoring 386–7 135, 140, 143, 145, 184, 429–33
resale price maintenance 390–91 Goode, R. 430
restrictive covenants 393 Gordon, W. 464
royalties 385 governance mechanisms 283–6
search-cost theory 389 governance structure 222
sunk investments 394 Graham, Daniel A. and Ellen R. Pierce
switching-cost 391 73
termination provisions 386, 392 gratuitous promises 80–94
tie-ins 391 greener grass effect 360, 368, 372
vertical restrictions 390–91 Grosskopf, O. and B. Medina 10,
fraud 436–7 27–8, 37
free riding 431, 391 Grossman, S.J. 259, 262
free riding, franchise 391 Grossman, S.J. and O. Hart 350
French Civil Code 429, 435, 441–3, Grossman, Hart and Moore 290
445–6 Guthrie et al. 200

Haanappel, P.P.C. and E. Mackaay disclosure and information

429 acquisition 32–4
Hadfield, Gillian K. 145 formation 163–4
Hadley v. Baxendale 225–38 holdup 68
Hale, Robert L. 75 incentive-based theories of duress
Hand, Learned 455 65–7
hardship clause 446 incentives to bequests 99–100
harm-based liability 465 negotiating 12, 24–6
Harris, D. and D. Tallon 450 performance 155
Hart, O. and J. Moore 241–8, 289–91, incentives and contract length 322
299, 350 incomplete contracts 130–32, 216–17,
Hasen, R.L. 459 241, 281, 288–9, 295, 298–300,
Hatzis, A.N. 445 314–15, 317, 323, 334–5, 338, 341,
Hatzis, Aristides N. and Eleni 344
Zervogianni 74 incomplete divesture 460–64
Havighurst, Harold C. 81–2 incomplete information 319
Henningsen 115 indifference curve 258, 260, 264, 465
Hermalin, Benjamin E. et al. 65–6, indifference principle 448–9
73–4, 128, 289 information
Hershovitz, S. 458 acquisition 33–4, 37
Hesselink, M.W. 429 asymmetric information 129,
heuristics 402, 404–6 408 117–18, 122, 135, 140, 143–4,
hidden actions 298–9, 301 197–9, 212, 228, 298, 318–19,
hierarchical governance 284–6, 297 325, 338
Hill v. Gateway 2000 118 disclosure, voluntary 36–8
Hillman, R.A. 414–15 incentives to acquire information
Hirshleifer, H. 34–5 32–4, 226
Hochster v. De La Tour 171 productive and redistributive
holdout problem 431 information 34–5
holdup problem 239–53, 282, 290, renegotiation 220
298, 315, 318, 327, 329–30, 336–7, transfer 259
348, 431 information-forcing default 228–9
Holström, B. and J. Roberts 328 institutional competence 69–70
horizontal free riding 385 institutional economics 297, 432
hostages, in franchising 392–4 intentional ambiguity 129, 226–7
Hoy, F. 389 inter vivos transfers 97, 99, 105
Huber, P.K. 461 interpretation and implied terms in
human capital 301, 327, 348 contract law 125–51
Hviid, Morton 227 interpretation of contracts 338–41
hybrid governance 284–9, 295, 297–9, inter-satellite transfers, of franchises
301–2 388
hybrid investments 344 investment 240–45, 248–52, 262, 265,
282, 290–91, 293–4, 296–7, 314,
Iacobucci, E. 391 318, 323, 326–34, 336–7, 343–9,
imperfect information 64, 67 384
impossibility and impracticability cooperative 344, 346–7
207–24 diversified 384
incentive intensity 285, 299 hybrid 344
incentives selfish 344–5
communication 227–9 sequential 250–51

Index 477
simultaneous 250 La Porta, R. 425

specific 314, 318, 326–33, 336–7, Laffont, Jean-Jacques and David
343–8 Martimort 158
Issacharaoff, S. 408–9, 411 Lafontaine, F. 385, 388–90
Lafontaine, F. and K. Shaw 352, 389
Jackson, Thomas H. 171 Lafontaine, F. and M. Slade 350
Johnston, J.S. 10, 19, 24, 119, 227, Landes, W. and R. Posner 45–6, 458
232 Lando, H. and C. Rose 450
joint fault and multiple contingencies Langevoort, D.C. 401
142–3 least-cost-avoider 15–16, 22
Jolls, Christine 37, 374, 442 Leff, Arthur A. 122
Jolls, C. and C.R. Sunstein 410 legal deterrence, theory of 41–2
Jolls, C., C.R. Sunstein and R. Thaler lésion 64, 440–42
401–2 Levmore, S. 457–9
Joskow, Paul 210–12, 292, 328, 330, liability, benefit-based 465
335 liability, harm-based 465
liability, limitation clauses 443
Kahneman, D., J.L. Knetsch and R. libertarian paternalism 412, 420
Thaler 405 limitation clause on liability 443
Kaldor-Hicks efficiency 363, 456, linguistic over-determination 289
460 Lipshaw, Jeffrey 130, 139
Kaldor-Hicks test see allocative liquidated damages 166–7, 178,
efficiency 414–15, 445
Kambhu, J. 266, 268 literalism see texualism
Kaplow, L. and S. Shavell 289 Litvinoff, S. 429
Katz, A. 13, 15–16, 26, 117, 141, 143 Loasby, B. 287
see Hermalin, Benjamin E. et al. Long, R.A. 457
Keily, T. 430 long-term contracts 208, 210, 217–19,
Kennedy, Duncan 61, 64 221, 223, 281–302, 314–54
Klass, G. see Ayres, I. and G. Klass Lyon, T.P. and E. Rasmusen 245–8
Klausner, Michael 117
Klein, B. 119, 282, 362, 392 Macaulay, Stewart 218, 374
Klein, B. and L.F. Saft 391 Mackaay, E. 425, 430
Klein, B., R.G. Crawford, and A.A. Mackaay, E. and V. Leblanc 433
Alchain 350 Macneil, Ian R. 163, 374–5
Klick, J., B. Kobayashi and L. Mahoney, Paul G. 41, 155–77, 166
Ribstein 352, 386 majoritarian default rule 228–30,
Knetsch, J. 367 412–13
Knight, F.H. 282, 301 mandatory rescue 458
Kornhauser, Lewis 117 mandatory rule 428
Korobkin, R. 120, 406, 413–14, mandatory warranties 428
416–17 Mann, D.P. and J.P. Wissink 266, 268
Korobkin, R. and T. Ulen 401, 403, Mann, R.J. 19, 120
407–10, 413–14, 418–19 marital
Kostritsky, J.P. 10, 14, 22–3, 142 assets 362
Kötz, Hein 58–60, 443 breach 363–78
Krell v. Henry 207–8, 213, 219 breach remedies 366–71
Kronman, Anthony T. 33–4, 64, 66, market
165, 448 downstream markets 326
Kull, Andrew 82–3, 168, 462–4, 466 equilibrium 260

failure 117–18, 122 mitigation of damages 449

governance 284–6, 297 modification of contracts 59, 93
Marotta-Wurgler, Florencia 121–2 modification of marriage contracts
marriage 374
contracts 360–78 money damages 239
modification of contract 374 money-back warranties 256
partnership model 371 monitoring, of franchise 386–7
post-nuptial agreements 375 monopoly 64, 71, 73, 116–17
pre-nuptial agreements 375 Moore, J. and R. Repullo 289
same-sex 377 moral consideration 94
Martimort, David see Laffont, Jean- moral hazard 289, 295, 298, 301,
Jacques and David Martimort 321–2, 337, 386, 394, 431, 436, 446
Martin, R.E. 388–9 multidimensional pricing 418
Marvel, H. 391 Muris, Timothy J. 73, 140
Maskin, E. and J. Moore 289 Muthoo, A. 292
Maskin, Eric and Jean Tirole 191 mutual assent, mutual consent 18–19,
material adverse change 184 61, 122
Mathewson, G.F. and R.A. Winter
385–7 Napoleonic inheritance 106–7
Matouschek, N. and I. Rasul 362 Nash 267, 289, 299
Mattei, U. 445 need-based remedy for marital breach
Maxcy, J.G., R.D. Fort and A.C. 372–3
Krautmann 324 negative externalities 64
McInnes, M. 464 negotiorum gestio 456
Mechoulan, S. 362 neoclassical economics 282, 284, 287
Medina, B. see Grosskopf, O. and Netherlands Civil Code 445
B. Medina no-fault divorce 360, 362–4
Melamed, Douglas A. see Calabresi, Nöldeke, G. and K.M. Schmidt
Guido, and Dougas A. Melamed 241–3, 250–51, 294
Ménard, C. 283, 286–7 Noll, J. 266
Miceli, T.J. 374 nominal consideration 91
Milhaupt, C.J. and K. Pistor 425 non-compete 341, 348–9
Millon, D. 413 non-cooperative game 288
Mineral Park 208 non-enforcement default rules 413–14
Minkler, A. 389 non-performance 341–3, 445–6
minoritarian default rule 229 non-rational behavior 402, 410
misperception-based pricing 417 Norton, S.W. 385
misrepresentation 437 no-trade penalty or outcome 191
fraudulent misrepresentation 31, Nozick, Robert 62
41–6
innocent misrepresentation 31, 50–52 objective good faith 430
masqueraders 87 OECD 106, 110
negligent misrepresentation 31, offer of reward 433
47–50 Ogus, Anthony 32
optimal level of care 47–8 old-age security 101–2
promissory representations 46 opportunistic behavior 11, 20–23,
Missouri Furnace v. Cochran 171 40–41, 73–4, 139–42, 159, 166,
mistake 31, 37–9, 61, 64, 460–61, 435–7 168–9, 174, 221–2, 431–3, 436,
cross-purpose mistakes 40 442, 449
consumer 417–18 optimal damage measure 26–7, 163

Index 479
optimal default cap 230–31 Priest, George L. 168, 265, 428

optimal precision 234 primogeniture 108
option contracts 239–53, 291–4 principal-agent contracts 322
organizational costs 385 prisoner’s dilemma 220, 299–300
Ourliac, P. and J. de Malafosse 431 private ordering paradigm 63–5
outside option model 293 Probert, R. and J. Miles 361, 376
over-investment 11–12, 18, 27–8, Probst, Thomas 58
322–3, 348–9 product complexity models of holdup
problem 243–7
Palmer, G.E. 464 profit-sharing agreements 385, 387
Pareto principle 67, 76, 101, 156 promissory estoppel
Parkman, A. 363 bargaining power 16
parol evidence rule 126, 134, 137, 141 classic bargain theory 9–10
partial performance 167, 170 opportunism deterrence 23
partnership model of marriage 371 optimal damage measure 26
paternalism 410–12, 420 protection during negotiations 13,
asymmetric 411 20
libertarian 412, 420 trust protection 21
penalties for failure to rescue 458 Prosser, W. and W. Keeton 459
penalty public enforcement of contracts 427
clauses 187, 190, 193–5, 293, 444–5 public order 428
doctrine 414–15
defaults 226–30, 232, 235–6 quality premiums 273
perfect equilibrium game 292 quasi-contracts 167, 454–67
perfect tender rule 168–9 quasi-rents 323, 327, 343
performance of contract 445–50 Quebec Civil Code 429, 434–5, 441–3,
Perloff, Jeffrey M. 212 445–6, 448
Petty, A.R. 464 Quebec Consumer Protection Act 442
Pierce, Ellen R. see Graham, Daniel A.
and Ellen R. Pierce Rachlinsky, J.J. 412, 415
Pineau, J. 430–31 Radin, Margaret 76
plain meaning rule 134, 138 Rasmusen, E. and I. Ayres 38–9
Poitevin, M. 325 Rasmusen, E. see Rasmusen, E. and I.
pooling resources 287, 297 Ayres
Popenhoe, D. 377 Rasmusen, E.B., J.M. Ramseyer and
Porat, A. 458 J.S. Wiley Jr. 325
Posner, Eric 228–9, 233, 415 rational choice theory 401–2, 407–8
Posner, Richard A. 65, 74, 133–4, 140, redistributive equity 105
209–12, 362, 408–9, 429, 447, 455, refinance 296–8
463, 466 regret contingency 155–6
see Landes, W. and R. Posner relational contracting 289, 295, 299–
post-nuptial agreements 375 300, 314
Poussin case 437–9 relation-specific investments 12, 14,
precontractual liability 9–28 20, 22
preliminary agreement 13–14 reliance 10, 156–7, 159–64, 168–70, 455
Prentice, Robert A. 80–95 bargaining power and timing 15
pre-nuptial agreements 375 bilateral reliance 17
price adjustments 216–17 fraudulent misrepresentation 44–5
price reduction warranties 256, 274 gift promises inducing reliance 89
pricing, multidimensional 418 liability regimes 17–18

optimal investments 13 Samuelson, W. and R. Zeckerhauser

precontractual reliance 11–13 405
unilateral reliance 14–16 sanctions 155
see optimal damage measure satisficing 403
reliance damages 345–6 Savage, L.J. 282, 301
reliance damages for marital breach Schmitz, Patrick W. 190–91
366–9 Schwartz, A. and R.E. Scott 10, 13,
remedies 155–77, 315–16, 335, 341–8, 14, 25, 27, 128, 134, 136, 142–5,
345–6, 437, 454 340
remedies for marital breach 366–73 Schwartz, Alan 74, 184–5
renegotiation 156, 161, 163–6, 188–90, see Schwartz, A. and R.E. Scott;
240–53, 291–5, 298–9, 316, Edlin, Aaron S. and Alan
318–22, 327, 333–8, 344, 346–9 Schwartz
Renner, Shirley 217 Schwartz, Alan and Louis L. Wilde
repeat players 115–16 118–19
repeated hidden action 281 Schweizer, Urs 162–3
replacement warranties 256 Scott, E.S. and R.E. Scott 375
reputation 129–30, 220, 269–72 Scott, R.E. 10, 219–20, 339
reputational equilibrium 270 see Schwartz, A. and R.E. Scott;
resale price maintenance, franchise Goetz, C.J. and R.E Scott.
390–91 Scott, Robert E. and George G.
rescission 35–6, 167–9 Triantis 159–60
rescue 454, 456–7 screening mechanisms 297
Restatement (Second) of Contracts seal 91
208, 430 search properties 256
175(1) 58 search-cost theory, of franchise
Restatement (Third) of Restitution 466 389
restitution 57, 67, 159–60, 167–9, 174, Segal, I. 244–5, 247–8
347, 454–8, 461–3 Segal, I. and M.D. Whinston 325
restitution damages for marital breach selfish investments 344–5
369–71 Selten, R. 292
restrictive covenants in franchise sequential contracting behavior 121
agreements 393 sequential investment 250–51
revolving-offer bargaining 292–3 Shaked, A. and J. Sutton 246–8, 250,
reward, offer of 433 252
risk and contract length 322 Shavell, Steven 49, 65–6, 68–9, 71–2,
Roe, M.J. 425 127, 156, 158, 162, 175, 345
Roe, M.J. and J.I. Siegel 425 Shell, R.G. 10, 21–2
Rolland, L. 430 Sherwin, E. 461
Rosenfield, Andrew 209–12 shirking 385, 431
Rosental, P.A. 108 short-term contracts 316–23
Rowthorn, R. 362 shrouded attributes 417
royalties, of franchise 385 signaling equilibrium 197–8
Rubin, P.H. 384–5, 387, 459–60 Silver, C. 456
Rubinstein equilibrium 249 Simon, Herbert 217, 402
Rubinstein-Stahl 292 simultaneous investment 250
rule of absolute liability 207 Singer, J. 371
Slovic and Lichtenstein 404
Saiman, C. 457 Smith, V. 361
same-sex marriage 377 Smith, J. and R. Smith 39

Index 481
Smith, Lionel 461 textualism 128, 131, 133, 136, 142–9,

Smythe, Donald J. 207–24 434
social welfare 290–91, 294, 299–300 Thaler, R. 405–6, 418
soft-budget constraint syndrome 289, Thompson, R.S. 388–9
295–8 threat of violence or fear 440
Sovern, J. 419 tie-ins, franchise 391
specific investments 314, 318, 326–33, timing of foreseeability determination
336–7, 343–8 234–5
specific performance 164–6, 239, 294, Tirole, J. 295
342, 348, 448–50 Tomes, Nigel 107–8
Spence, M. 259, 262 total and partial breach 167
Spitzer, M. and E. Hoffman 407 trading opportunity 246–9, 252–3
standard form contracts 115–24 transaction cost theory 115–16, 282,
status-quo bias 405–6, 413, 419 287, 330–31, 350, 384–5, 392
Statute of Frauds 463 transferable control 295
Step-Saver Data Systems, Inc. v. Wyse Trebilcock, Michael 366, 429
Technology 118 Trebilcock, Michael J. 63–4, 67, 76
Stewart, Hamish 61, 63, 67 see Aivazian, Varouj A. et al. 73
stickiness 232–3 Triantis, George G. 73, 214–16 see also
Stigler, G. 42 Scott, Robert E. and George G.
stipulated damages 180, 182–4, 186, Triantis
189, 194–5, 198–202 Trimarchi, Pietro 216–17
stochastic damages 231–2 Tullock, Gordon see Buchanan, James
Stole, Lars A. 184–5 and Gordon Tullock
Stolle, Dennis P. and A.J. Slain 118 Tversky, A. and D. Kahneman 404,
subjective good faith 430 406
subsequent improvement warranties typology of default rules 229
256, 274
substitute assets 287 UCC Article 2 93, 179–80, 208
Suez Canal cases 213, 219 Ulen, T. 408 see also Cooter, R. and
sunk cost effect 418 T. Ulen
sunk investments, of franchise 394 unconscionability 60, 64, 74, 417, 430
Sunstein, C.R. 401, 410 underinvestment 294–5, 323
Sunstein, C.R. and R.H. Thaler 412, undue influence 58–61
419–20 unforeseeability 446–7
superior risk bearer 131, 137–9, 142 Unidroit Principles of International
suppletive law 428, 446 Commercial Contracts 430
switching-cost, of franchise 391 Uniform Written Obligations Act 91
Sykes, Alan O. 213–14 unjust enrichment 439, 454–67
Szalai, Akos see Cserne, Péter and unverifiable information 181–4, 186–8,
Szalai, Akos 190, 192
use-pattern mistakes 418
tailored default rules 226, 413–14
taxing bequests see estate tax valuation 290
Taylor v. Caldwell 207 van Wijck, Peter 225–38
Taylor, James Stacey 63 verifiability of non-performance 341–3
termination at will 353 vertical disintegration 330
termination provisions, of franchise vertical integration 328–9, 350
386, 392 vertical restrictions to franchising
Tesler, L. 391 390–91

Vienna Sales Convention 430 White, Michelle 213

volition, theory of 57 Wickelgren, A.L. 246–8
voluntariness 57–8, 61–2, 64, 67, will theory see classical theory of
70–71, 74–5 contract
Von Neumann, J. and O. Morgenstern Williams, D. 352
282 Williamson, O.E. 217–18, 283–6, 321,
von Thadden, E. 298 327, 350, 374, 393, 432
Wils, W. 19–20
Wade, J.W. 457 Windsperger, Cochet and Ehrmann
Walt, Steven 178–206, 216 394
warranties 256–74 Wittman, D. 427, 429, 432–4, 457,
mandatory 428 459, 465
money-back 256 Wonnell, Christopher T. 36, 38, 67,
price reduction 256, 274 455–7, 462
replacement 256
subsequent improvement 256, 274 Zervogianni, Eleni see Hatzis, Aristides
Wehrt, K. 269 N. and Eleni Zervogianni
Weinrib, E.J. 460 Zhou, Q. 32–3, 36, 38, 41, 43–6,
Weitzman, L.J. 371 31–52
Westinghouse case 210–11 Zimmerman, R. 433


Contract Law and Economics - de Geest - 2011 (LIBRO COMPLETO)

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General Editor: Gerrit De Geest

1. Tort Law and Economics

Future titles will include:

Procedural Law and Economics

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ENCYCLOPEDIA OF LAW AND ECONOMICS, SECOND EDITION

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All rights reserved. No part of this publication may be reproduced, stored

Edward Elgar Publishing, Inc.

A catalogue record for this book is

Library of Congress Control Number: 2009943918

ISBN 978 1 84720 600 8

Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

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List of contributors vii

PART I FORMATION AND INTERPRETATION

9. Contract remedies: general 155

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PART III LONG-TERM CONTRACTS

15. Long-term contracts and relational contracts 281

19. Behavioral approaches to contract law 401

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Mireia Artigot i Golobardes, Professor of Law, Universitat Pompeu

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Peter van Wijck, Assistant Professor of Economics, Leiden University and

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This volume provides an overview of the economic literature on contract

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information exchange and strategic interaction. Litigation is not only a

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inheritance law. Common law contract doctrine traditionally refuses to

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impracticability. Should parties be excused from their contractual obli-

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law countries. Law and economics is a scholarly product developed in

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‘promissory estoppel’ in the Restatement (First) of Contracts dates back to

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Since the confusion surrounding the problem of precontractual liability

2. Protecting Precontractual Reliance

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the parties to begin to rely on the expectation of the successful formation

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Briefly, investing is efficient whenever the potential benefit (weighted by

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and raised a certain amount of capital, he would be granted a franchise.

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on a party that bargains in an ex post opportunistic manner (that is, by

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the retracting party. Following the economic analysis developed in his

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superior information should be deterred by the prospect of liability. Wils

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which both have incentives to appropriate the gains from contracting.

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explores possible alternatives. He concludes that imposition of a general