In the first post in this series, Sid DeLong gave us a version of how he presents contracts law to students on the first day.
In the second post, Sid offered a parable illustrating the economic benefits of contract.
Today, Sid asks . . .
Are you persuaded?
You shouldn’t be, at least not yet. Like most parables, this neat little explanation of contract is an over-simplified story that begins to unravel when we tinker with its assumptions. For example, a troublesome possibility arises when the trade turns out to make one party better off and the other party worse off, perhaps because the second party was mistaken about the values of the things exchanged. For example, maybe Earl wakes up with a fierce hangover, causing him to reduce his valuation of Terry’s beer below the value of the broccoli he had to give up.
Or suppose Earl loses the value of a bushel of broccoli while Terry gains the value of three. Should the law encourage this exchange, which is “Win/Lose” instead of “Win/Win”? Is the answer “No,” because it did not make each party better off ? Or is it “Yes,” because the net wealth of the community increased by two bushels? More generally, is the total social product of an exchange a value that the law should even pay attention to? This is much more controversial than the situation in the parable and the controversy is important because many exchanges produce both a winner and a loser. In technical terms, a trade that makes both parties better off exhibits “Pareto efficiency” while one that increases total utility while making one party worse off exhibits “Kaldor-Hicks efficiency.” (This won’t be on the final.)
Even when both parties gain, there is another serpent lurking in our Edenic Garden of Exchange. Ostensibly, the exchange is win/win, creating extra broccoli by reallocating each party’s contribution to the other. Viewed jointly or as “teammates,” Earl and Terry enjoy this surplus of utility or value by cooperating. But Earl and Terry are competitors as well as cooperators, each of whom typically seeks to maximize his or her share of this surplus by negotiating about price. In this sense, contractual exchange is a contest, a selfish struggle rather than an innocent, mutually beneficial transaction. Trying to win this contest can be costly, involving negotiations, bluffs, threats, lawyers, etc. These expenses are the dreaded transaction costs that can kill a good deal.
Thus, while their exchanges may create surplus value, the participants in commonplace contracts between labor and management, landlord and tenant, buyer and seller, lender and borrower, and employer and employee all try to capture as much of the exchange surplus as they can from each other. Economists refer to this as fighting for a bigger piece of the pie, rather than fighting to enlarge the pie. (For some reason, economists tend to fantasize about pie rather than soup or salad.) Fighting to maximize her individual profit, a party might sometimes find it better to take a bigger piece of a smaller pie, leading to a reduction in total exchange surplus. These struggles are indeed zero-sum affairs and their costs can reduce the total amount of surplus created by the transaction.
Even if we assume mutual gain and low transaction costs, are we justified in concluding that the law should facilitate all voluntary exchanges? Before answering that question, consider the following exchanges: A homeless person sells his blood for $15 to an inner-city blood bank. An undocumented worker babysits for $20 a day because she cannot legally obtain better employment. A woman on welfare agrees to bear a stranger’s child for $10,000 under a contract requiring her to give up custody at birth. A heroin-addicted lawyer pays most of his income for a steady supply of drugs. A farm worker agrees to work in unsafe conditions for the wage his employer offers. A wife in a divorce agrees to give up her share of the community property if her husband will not seek sole custody of their child. A corporation buys a block of its own shares at a large premium over the usual market price from a corporate raider to prevent him from taking over control of the company.
Are all these parties made better off by their contracts? An economist might say, “Yes, they must be or else they would not voluntarily make such trades.” But does that mean the law should encourage these transactions? Before we conclude that the law should enforce or even permit these exchanges, we must consider whether there is more to economic justice than the creation of economic surplus.
And contracts might make things very much worse indeed. When the parties to a contract negotiation are greatly unequal in bargaining power, the resulting contracts, by giving the powerful party potential legal remedies it did not previously have, may actually increase the imbalance by translating an economic advantage into a much greater weapon the powerful party can wield against the weaker party.
Finally, even if the exchange is not problematic in any of these ways, contract law may be unnecessary to the success of non-simultaneous exchanges. Society has developed many other institutions that encourage or even coerce the performance of commercial promises. A promisor who is contemplating breach of his promise must, for example, consider his religious or ethical beliefs, his personal sense of duty, his “good name” in his social circle, and his prospects of future business with the promisee or other trading partners. Both common sense and empirical research suggest that these social norms and other constraints are far more important than contract law in facilitating trade within established social groups.
But perhaps contract law increases in importance when the trading partners are strangers who are not likely to deal with each other in the future or when the amounts in question are so large that informal sanctions for misbehavior become inadequate to assure performance.
Yet even between strangers, legal enforceability may not mean very much. You will discover (if you do not already know) that a lawsuit is a very expensive and uncertain way of obtaining compensation for harm. Depending on how much money is at stake, it will usually cost more than it is worth to sue a person who breaches a contract. Nevertheless, the fear that a victim of a contract breach may expose the breacher to the costs of litigation (maybe just to establish her own reputation for toughness in future deals) may be enough to discourage opportunistic breaches and thus to facilitate trade.
THE FOUR ASSUMPTIONS: Our concerns about voluntariness, knowledge, mental capacity, and public policy lead to potential limitations on the scope of contract law, which will be significant in several of the doctrines you will learn about. To be more precise, the hypothesis that all voluntary exchange is mutually beneficial, and therefore worthy of legal enforceability, is premised on four major conditions or assumptions:
1. CAPACITY: Both parties are rational and have the mental and emotional capacity to act on their desire and reason.
2. KNOWLEDGE: Both parties have complete and accurate knowledge of themselves, the subject of the exchange, and the surrounding circumstances, insofar as such knowledge affects the desirability of the exchange to them. (A weaker version of this condition assumes only that each party is aware of any limitation on her knowledge about the exchange and can take such limitations into account.)
3. VOLUNTARINESS: Both parties are free from improper threats or other forms of coercive pressure to enter the exchange. Instead, the parties are motivated solely by their desire for the exchange.
4. EXTERNALITIES: The exchange does not harm or impose costs on any third party. The judicial system itself is a “third party” for purposes of this assumption.
If any of these conditions is not satisfied, we can no longer assume that an exchange is beneficial and we might have reason not to enforce it.
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The little parable illustrates long-standing theoretical ideas about economics. The centrality of voluntary exchange to the coordination of a free-market system was described in a famous passage written by Adam Smith in 1776:
In civilized society, [man] stands at all times in need of the cooperation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons. In almost every other race of animals each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likley to prevail if he can interest their self-love in his favor and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. “Give me that which I want, and you shall have this which you want,” is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations 26-27 (R.H. Campbell and A.S. Skinner, gen. eds. 1976).
The basis of modern economics is the cognition that it is precisely the disparity in the value attached to the objects exchanged that results in their being exchanged. People buy and sell only because they appraise the things given up less than those received. Thus the notion of a measurement of value is vain. . . . If a man exchanges two pounds of butter for a shirt, all that we can assert with regard to this transaction is that he — at the instant of the transaction and under the conditions which this instant offers to him — prefers one shirt to two pounds of butter.
Von Mises, Human Action: A Treatise on Economics 204 (1949 3d ed. 1966).
Neo-classical economists in general attach strong normative value to regimes of private exchange and private ordering and often bring some degree of skepticism to bear on the capacity of collective decision-makers, including legislatures, regulators, bureaucrats, or indeed courts, to adopt policies or laws that will unambiguously increase net social welfare. This 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. Thus, in most exchanges, the economic presumption is that they make all the parties thereto better off, that is, they are Pareto superior. This presumption is rebuttable by reference to a fairly conventional list of forms of market failure or, in a transaction-specific context, contracting failure, which neo-classical economists recognize as inconsistent with this presumption, for example, monopoly, externalities, information failures. Or, as Milton Friedman puts the presumption in Capitalism and Freedom: “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 bilaterally voluntary and informed.
Collective decisions which are not the result of voluntary agreement among all affected parties may technically be able to satisfy the Pareto criterion (making some better off and none worse off), but typically such decisions will generate both winners and losers.
Michael J. Trebilcock, The Limits of Freedom of Contract 7 (1993)
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