Introduction

I have been teaching the basic Contract Law course for a few years now, and have been struck by the courts' frequent indifference to economic context. It is not so much a matter of the court arriving at the wrong answer as it is the court's asking the wrong questions. In too many instances the court frames the problem in away which obscures the essential features of the transaction. A little – very little – sensitivity to some elementary economic concepts can go a long way toward illuminating a number of problem areas.

In this chapter, I want to illustrate this proposition by engaging in a close analysis of two American court decisions often featured in contracts casebooks: Mattei v. Hopper and Bloor v. Falstaff Brewing Corp. This is a piece of a larger project (Goldberg 2002). The other chapters in Part III have emphasized the manner in which contracting parties allocate to one party the discretion to respond to changed circumstances, but constrain that flexibility by conveying the counterparty's reliance interest. These decisions raise a different problem: production and transfer of information regarding the sale of an asset of uncertain value. Had the courts chosen to frame the problems this way, disposition of both cases would have been straightforward. The court's decision in the former case remains unaffected, but the implications for similar cases would be quite different. The decision in the latter case is simply wrong.

There are a large number of institutional responses to the information problem. I will focus on two which explain nicely the structure of the contracts in controversy.

Many aspects of relational contract law can be illuminated by examination of a well-known case from outside the realm of contract law: Boomer v. Atlantic Cement. The facts of Boomer are simple. Atlantic Cement built a large cement plant which produced some pollutants creating a nuisance for some neighboring residents and businesses. The victims sought an injunction to prevent the nuisance. However, the court took into account that the magnitude of damages to the victims was only about $183,000 while if the victims received an injunction, they could conceivably force the cement plant, valued at over $40 million, to shut down.

Shutting down the plant would entail a great social cost and this could be avoided by denying the injunction. Of course, it is highly unlikely that the plant would be closed down even if the injunction were granted. For, if the plant were to close, the victims would receive only a modest benefit: the clean air that removing the nuisance would provide. The clean air might well be worth more to Boomer and friends than the $183,000 price tag assigned it by the court. Nevertheless, the victims could almost certainly do much better if they bargained with Atlantic, selling it the right to continue in business with the same level of pollution. If the plant has no other uses and little scrap value, the victims could conceivably obtain something close to the $40 million that the plant was valued at. The magnitude of the payment would de end upon the bargaining skill and the amount of resources devoted to the bargaining by the two sides.

Suppose that none of the work performed for a large firm required firmor job-specific skills. Further, assume that all the paperwork costs associated with labor turnover were nil. Even in these extreme circumstances there would still be good reason for the large firm to establish an elaborate governance structure for employees and for the employees to achieve considerable de facto job security.

To direct workers to perform certain tasks and to discourage behavior that impairs performance, the firm requires devices which impose costs on the worker for noncompliance. The ability to impose costs is enhanced by making quitting expensive for the worker. If the worker could simply walk away without cost, any particular punishment (say a suspension or fine) could be ignored; if, however, quitting imposed a substantial loss on the worker, he would be vulnerable to the threat of punishment and thus the deterrents become credible. Further, a high exit cost can be a powerful deterrent in its own right. The firm can use the threat of termination to influence the worker's behavior.

The firm has available a number of devices with which to penalize exit, or what amounts to the same thing, reward continuation. One device is to pay a premium wage (like Ford's five-dollar day), the sacrifice of that premium being a cost of leaving borne by the worker. Note that the premium is not paid “up front”; it is deferred so that the payment is contingent upon the worker's continued satisfactory (from the employer's viewpoint) performance. Deferral enables the firm to enforce the agreement without recourse to the expensive judicial system; if legal enforcement were free, then up-front payment would suffice.

In a discrete transaction, the parties need not rely upon performance by a particular trading partner. For many exchange relationships, however, that is not the case. Having entered into a contract with a particular supplier, a buyer will find that the costs of leaving this contract and dealing with an alternative supplier are high. The buyer's dependence on continued dealing with this supplier gives the supplier power over the buyer in the sense that the seller can threaten to impose costs on the buyer unless it acted in a certain way.

The first two selections are concerned with some issues regarding power within the contractual relationship. While Klein [6.1] focuses primarily on franchise contracts and I [6.2] focus on the employment relationship, much of the analysis is relevant to a broader class of contracts. The crucial point is that the power is not necessarily bad; rational parties often want to set up their relationship so that one party will be able to exercise power over the other. At the same time, they often want to utilize some devices for governing the exercise of that power. This might entail reliance on reputation with the trade, public enforcement, explicit contract terms, establishment of a private dispute resolution apparatus, or some combination of these.

Klein's central point is that it will often be the case that the most efficient arrangement will entail apparently unfair contracts. One party will be able to impose a substantial penalty on the other.

The lost-volume seller problem is a very confusing one that has been incorrectly analyzed by numerous commentators and has been a constant source of confusion to the courts. The issue is this: If a buyer breaches a purchase contract for a manufactured item and the seller subsequently resells the product at the same price, has the seller suffered any damage, and if so, should he be compensated for it? In cases in which the seller is a retailer, the conclusion is (a) yes, the seller does suffer damages, (b) the damages are the market price of the service of selling the goods, (c) the market price of selling is approximately the gross margin, (d) even though the damages are incurred, full compensation would probably be inefficient, and (e) the law ought to encourage the parties to use nonrefundable deposits as liquidated damages. This argument is developed in Selection [4.1], one of the few papers in this book that considers contracts between businessmen and consumers.

While that argument is of interest in its own right, it serves as a useful introduction to the lost-volume problem that arises in contracts between business firms. The line of argument is somewhat different, but the basic conclusion remains the same: Although the damages are real, the law should deny recovery and facilitate customized remedies via liquidated damages clauses. The treatment of the lost-volume problem in the nonretail case is explored in the notes and questions at the end of Part IV.

1. On May 15 shares of Acme Industries are selling at $16 per share. Smith agrees to deliver 1,000 shares to Jones on June 1 at $20. On June 1 Acme is selling at $30 per share and Smith reneges. By June 5 Acme is selling at $12. Jones sues for breach of contract asking for $10,000 – the difference between the contract price and the market price at the time of the breach. Smith argues that Jones might have held the shares rather than selling them immediately and that the market price of $12 should be used in determining damages; consequently, Smith argues, he should not have to pay anything. What is the appropriate measure of damage?

2. In the summer of 1973 X chartered Y's ship for seven years beginning in 1974 at a rental of $1 million per year. After the Yom Kippur War, the demand for shipping soared and Y refused to deliver the ship, renting the ship to someone else for a six-month charter at $3 million. X sued for breach of contract. Justice moves slowly, and by the time the matter reached trial, shipping was in the doldrums. Multiyear charters that were going for $4 million per year in 1974 were available for $200,000 in 1977 when the case finally came to trial. The defendant argued that it did the plaintiff a favor by breaching; since the plaintiff was better off following the breach, Y argued, there were no damages.

The first paper in this book appeared over two decades ago in a sociology journal. Nevertheless, Stewart Macaulay's paper on the use (and nonuse) of contracts by businessmen has had a considerable influence on economic scholarship. The paper provides a good picture of how businessmen view contracts and why contract language is often of little relevance in describing the behavior of contracting parties and influencing the resolution of disputes. It provides a commonsense backdrop for much of what comes later.

A distinguishing feature of this collection of readings is the focus on “relational exchange” as opposed to “discrete transactions.” These are analytical constructs, not categories for classifying existing contractual arrangements. The former concerns arrangements in which contracting parties are isolated, to some degree, from alternative trading partners and the outcomes depend in part upon the behavior of the parties during the life of the contract. The latter concerns exchange of commodities in thick markets (a lot of buyers and sellers); the fact that a buyer enters into a contract with a particular seller today does not give that seller any advantage or disadvantage vis à vis other sellers in subsequent dealings with that buyer. As we shall see, most of the interesting, and difficult, questions of contract law disappear in a world of discrete transactions. In Selection [1.2], I provide a brief introduction to the concept of relational exchange. This is followed by a discussion of “transactions costs,” a term I am somewhat uncomfortable with. The reasons for that discomfort are spelled out in [1.3].

1. Goebel v. Linn is discussed in three of the selections. Which do you find most persuasive?

1. 1.1 Suppose that Goebel accepted the modified contract until the end of the season. Instead of defaulting on the note, Goebel then sued the ice company for damages for breach of contract and argued that the second contract was simply the “cover” contract. Should it be able to recover the difference between the original contract price ($2.00) and the modified contract price ($3.50)? See Endiss v. Belle Isle Ice Co.

2. 1.2 The fact that the size of the ice crop would depend upon the weather is obvious and one would expect that ice contracts would reflect this. The twenty-five cent premium in the event of a small ice crop in Goebel's contract is one way to deal with this contingency. A second device would be to include a prorationing arrangement. Such a clause was used by at least one other seller of ice in that era. See Kemp v. The Knickerbocker Ice Co.

3. 1.3 Suppose that Goebel's contract did call for prorationing and that some buyers used their quotas to resell to those who were desperate for ice at prices in the $10- to $15-per-ton range.

4. […]

1. As Bishop notes, the foreseeability doctrine in contracts has little to do with the possible occurrence of low-probability events. It concerns the ability of the parties to control the magnitude of the damages that actually occur. Bishop emphasizes one device for doing so: providing notice of the special circumstances. An alternative, which he does not consider, is for the parties to arrange their affairs so that the magnitude of the damages would not be so great if the other party failed to perform. That is, in Hadley v. Baxendale the shipper could have reduced the expected cost of a breach by informing the carrier of the consequences of a failure to deliver or by carrying a greater inventory of shafts so that the plant would not have to remain idle in the event of a delay (breach) by the carrier.

The possibility that Hadley could have held a larger inventory of shafts (an input) has been widely recognized. Less attention has been given to other ways in which the costs of the failure could have been limited by timely effort on the part of Hadley. Hadley could have held a larger inventory of flour (the output). After the shaft was delivered and the mill again operating, Hadley could have made up for some of the lost output by running at a higher level of output than he otherwise would have. (In effect, that entails having a larger inventory of productive capacity – another input – than Hadley might otherwise carry.)

The Law and Economics revolution is proceeding in these days apace. Economic analysis is being applied by scholars to a wide range of legal problems. Scholars identified with the use of economic analysis – Richard Posner, Frank Easterbrook, Robert Bork, Douglas Ginsburg and Stephen Williams – have been named to the federal bench (although not all have remained on the bench). First-year law students in most law schools are confronted with the intricacies and paradoxes of the Coase Theorem in at least one of their classes.

Economic analysis has probably had its greatest impact in its traditional stronghold of antitrust and in the tort/nuisance area. There has been a reasonable amount of work on the economics of contracts and contract law, and this too is beginning to have an impact. This book represents a sampling of that literature, supplemented by a few pieces from the more distant past. I do not want to oversell the virtues of the economic approach – overselling is one of the vices economists have been accused of in their forays into legal issues. Economics does not provide all the answers. And some that it does provide are wrong, as we shall see. Nonetheless, it does provide a powerful analytical framework that can both enhance our understanding of how parties structure their contractual relationships and illuminate many areas of contract law.

The scope of these readings is deliberately circumscribed. My primary interest is in commercial transactions between modern, Western business firms.

1. Consider again Cooter's hypothetical agreement between Xavier and Yvonne. As Yvonne's lawyer, how would you draft the contract to protect against the possibility that the store would not be ready on September 1? Remember that the greater Xavier's potential liability, the higher the original contract price must be to compensate him for bearing that risk. If your contract includes a liquidated damages clause, as Cooter suggests, what sort of damage formula would you include? Would you be willing to accept a disclaimer against consequential damages? Should Xavier's failure to perform be excused if the breach was not his fault (or for any other reasons)?

2. Suppose that one of the items Xavier needs to complete his building is the industrial air-conditioning compressor mentioned by Goetz and Scott. If the compressor is delivered late, Xavier will breach his contract with Yvonne and be liable for damages as specified in the contract you have helped draft. Should Xavier's contract with the supplier shift any or all of these damages to the supplier?

3. Suppose that the compressor manufacturer misfiled Xavier's order. As a result, he ends up installing the compressor six months late and Xavier cannot convey the shop to Yvonne until March 1.

We begin with an obvious empirical fact. Much economic activity takes place within long-term, complex, perhaps multiparty contractual (or contract-like) relationships; behavior is, in varying degrees, sheltered from market forces. The implicit contract of utility regulation, the contractual network that constitutes a firm, franchise agreements, pensions, and collective bargaining agreements are examples. Granted this, we can then proceed along two different lines. First, we can attempt to explain why relationships take the form that they do; why does a particular firm own its retail outlets rather than selling through franchised outlets or discount stores? Second, what impact does the relationship's structure have beyond the relationship? Do the price adjustment rules used in employment contracts or in regulated industries give the wrong short-run signals, thereby exacerbating unemployment? Since economists attempt both to explain and prescribe, these questions can also be recast in normative terms: How should parties structure their relationships (from the point of view of the parties or other groups – perhaps society as a whole)?

To make headway in understanding the essential features of relational exchange it is convenient to set up a stylized problem. Consider two parties contemplating entering into a contract who must establish rules to structure their future relationship. The parties can have competing alternatives both at the formation stage and within the relationship. The choice of rules will depend upon the anticipated outcomes. The choice will also reflect three significant facts about the world that are so obvious that only an economist would feel compelled to recognize them explicitly.

The economics of price adjustment

The benefits of price adjustment

Business firms have ample incentives to include some form of price adjustment mechanism in their contracts even if both parties are risk neutral. Firms do not generally enter into multiyear contracts because of their concern for the future course of prices. Rather, they enter into the agreements to achieve the benefits of cooperation. Having entered into such an agreement, the parties have to make some decision regarding the course of prices during the life of the agreement. That is, price adjustment will probably be ancillary to the main purposes of the agreement.

Price adjustment can be difficult and costly. Why then bother? Why not simply establish a price or a schedule of prices for the duration of the agreement? I will suggest four reasons that might lead business firms to consider using some form of price adjustment. First, if the contract concerns a complex product that will be continuously redefined during the life of the contract, a price adjustment mechanism can price the “amendments” to the original agreement. Examples include cost-plus pricing of sophisticated defense hardware and complex construction projects. Second, to properly coordinate their behavior, the parties want correct price signals. If the price of an input were below the market price (and if the buyer could not resell at a price greater than the contract price) the buyer would have an incentive to use “too much” of the input.

Suppose that on April 1, Able enters into a contract to sell a commodity to Baker at a price of $2.00 per bushel for delivery at Baker's plant on June 1. Five days later, Able changes his mind and says he wants to withdraw the promise. Baker, meanwhile, has done nothing in reliance upon the existence of this particular contract. What functions are served by enforcing this purely executory agreement in the absence of any evidence that Baker has relied upon the existence of the contract? This is the question posed by Fuller and Perdue. The answers to this question can be divided into two categories: practical and conceptual. The former are less interesting and I will get them out of the way quickly.

Three practical reasons for not requiring evidence that the promisee relied in any way on the contract are (a) it would complicate the litigation with a messy fact question of whether the promisee had indeed relied; (b) the promisee might be encouraged to act in a manner that established his reliance to lock in a good deal, even if this action would be inefficient; for example, he might enter into a resale contract specifying delivery of the goods associated with this particular contract rather than promising to sell goods that met certain specifications; (c) requiring reliance might induce the promisor to expend resources to determine whether or not particular promisees did rely, an inquiry that would serve no useful purpose.

With an executory commodity contract, the promisee can avoid the costs arising from untimely contracting. Entering into a contract too close to the performance date can raise costs.

One of the benefits of editing a collection is that one can clarify, reinterpret, or recant one's own earlier writings. I shall take advantage of that opportunity here with regard to Selection [7.1]. The basic point is still correct. Rational buyer ignorance and adverse selection create the possibility that standard form contract terms will be inefficient; it is possible that judicial supervision or legislative intervention would improve the situation. Moreover, my argument was sufficiently qualified so that a sympathetic reader could conclude that I was only stating a possible case for overriding the terms included in the standard forms. Nonetheless, the tone suggests (and that coincides with my beliefs when the paper was written) that courts and legislatures should take a rather aggressive stance with regard to the secondary terms of standard form contracts. I am much less sanguine about the possible utility of such intervention today.

The roots of this change in opinion are both a decreased faith in the ability of courts and legislatures to do the job well and an increased faith in the ability of private parties to cope with, if not fully resolve, the problems associated with standard form contracts. Courts and legislatures have learned how to justify intervention. But they have not seemed to learn how to intervene. They have not come to appreciate the subtleties in designing efficient contract terms. It is not enough to say that a disclaimer of consequential damages was not understood or consented to by the buyer. One must also understand the possible rationale for such a disclaimer.