Econ 200 Foldvary, law and economics


Law's Order chapt 12 Economics of Contract.


A voluntary agreement creating mutual obligations among competent parties.


Reputation is an important element of enforcing agreements.

Reputation capital: value due to good will.


Example: the diamond industry in New York City, based on trust.


But in a more anonymous society, contracts are enforced by law.


Contracts are incomplete, resulting in disputes.


What makes a contract valid?


Need voluntary parties with knowledge of what they are doing.

Hence, contracts with children are not enforceable.


Need consideration.

Need willing parties, with equal bargaining power.

If one party exploits another, it is not a morally valid contract.


If the seller is a monopoly, the buyer or decision maker still has a choice.

Contracts are not enforced if they are for illegal or coercively harmful purposes,

such as a slave contract.


p. 151: A penalty clause:  for not fulfilling a contract, instead of actual damages.

It is not enforceable where a party specifies an amount payable on breach of contract which is out of proportion to the loss that the party would suffer.

As "unfair contract" terms can operate oppressively, the law restricts the use of such terms. The protection comes from the common law, the Unfair Contract Terms Act 1977

and the Unfair Terms in Consumer Contract Regulations 1999.


Another name for penalty clauses is “liquidated damages.”

Liquidated damages are an agreement between the parties as to what damages will be assessed for late completion, so that neither party has to prove what the actual damages are (or are not).

A typical liquidated damages clause reads something like the following: “For each calendar day beyond the scheduled date of Substantial Completion that the Project has not achieved

Substantial Completion, the Contractor shall pay to the Owner as liquidated damages the

sum of $_____.”


Note that it is usually appropriate to measure liquidated damages to the date of Substantial Completion, not Final Completion.


Liquidated damages are damages whose amount the parties designate during the formation of a contract for the injured party to collect as compensation upon a specific breach (e.g., late performance).

When damages are not predetermined or assessed in advance, then the amount recoverable is said to be 'at large' (to be agreed or determined by a court or tribunal in the event of breach).

At common law, a liquidated damages clause will not be enforced if its purpose is to punish the wrongdoer in breach rather than to compensate the injured party (in which case it is referred to as a penal or penalty clause).


California Civil Code § 1671 states, in part, that a “provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.”


Real estate contracts often contain "liquidated damages" provisions because damages for breach of contract can be difficult and costly to ascertain, and because these provisions can provide the parties added incentive to perform.

In deciding whether to use a liquidated damages provision and in drafting one, care should be taken so that a court, potentially years later, does not find that the provision is a penalty and, therefore, unenforceable

In 1977, California changed the policy of presumptive invalidity of liquidated damages provisions with a policy of presumptive validity in commercial, non-consumer contracts.


P. 152: duress

The current legal rule, holding contracts made under duress unenforceable,

is the efficient one.  It reduces duress.


Peace "treaties" are often made under duress.  Versailles.

Not a willing contract.


Tugboat that charges $9 million to rescue $10 million in ship.

It's a bilateral monopoly.

Two efficient extreme prices.

The price that gives the ship owner the right incentive to keep the ship out of trouble equals the cost of the rescue.

For the tug, the efficient price is the value of the ship.

The efficient price is in between.

An admiralty court may rewrite a contract too favorable to one side.

Insurance markets enable people to judge risks and costs in advance.


Contract of adhesion: take it or leave it.

Form contracts, offered as sign or no service.


There is nothing unenforceable or even wrong about adhesion contracts.

Most businesses would never conclude their volume of transactions if it were necessary to negotiate all the terms of every Consumer Credit contract.

Insurance contracts and residential leases are other kinds of adhesion contracts.

This does not mean, however, that all adhesion contracts are valid.

Many adhesion contracts are Unconscionable; they are so unfair to the weaker party that a court will refuse to enforce them.


he concept of the contract of adhesion originated in French civil law, but did not enter American jurisprudence until the Harvard Law Review published an influential article by Edwin W. Patterson in 1919. It was subsequently adopted by the majority of American courts, especially after the Supreme Court of California endorsed adhesion analysis in 1962. See Steven v. Fidelity & Casualty Co., 58 Cal. 2d 862, 882 n.10 (1962) (explaining history of concept).[1]

For a contract to be treated as a contract of adhesion, it must be presented on a standard form on a "take it or leave it" basis, and give one party no ability to negotiate because of their unequal bargaining position.

The special scrutiny given to contracts of adhesion can be performed in a number of ways:

If the term was outside of the reasonable expectations of the person who did not write the contract, and if the parties were contracting on an unequal basis, then it will not be enforceable.

The reasonable expectation is assessed objectively, looking at the prominence of the term, the purpose of the term and the circumstances surrounding acceptance of the contract.


As a general rule, the common law treats standard form contracts as any other contract. Signature or some other objective manifestation of intent to be legally bound will bind the signor to the contract whether or not they read or understood the terms.

The reality of standard form contracting, however, means that many common law jurisdictions have developed special rules with respect to them.


In general, in the event of an ambiguity, the courts will interpret standard form contracts contra proferentem against the party that drafted the contract, as that party (and only that party) had the ability to draft the contract to remove ambiguity.


An adhesion contract (often a signed form) can be so imbalanced in favor of one party over the other that there is a strong implication it was not freely bargained.

A legally binding agreement between two parties to do a certain thing, in which one side has all the bargaining power and uses it to write the contract primarily to his or her advantage.


An example: a rich landlord dealing with a poor tenant who has no choice and must accept all terms of a lease, no matter how restrictive or burdensome, since the tenant cannot afford to move.

An adhesion contract can give the little guy the opportunity to claim in court that the contract with the big shot is invalid.


Another example of an adhesion contract is a standardized contract form that offers goods or services to consumers on essentially a "take it or leave it" basis without giving consumers realistic opportunities to negotiate terms that would benefit their interests.

When this occurs, the consumer cannot obtain the desired product or service unless he or she acquiesces to the form contract.


Shrink wrap contracts


Shrink wrap contracts are license agreements or other terms and conditions of a (putatively) contractual nature which can be read and accepted by the consumer only after the consumer opens the product.

The term refers to the shrinkwrap plastic wrapping used to coat software boxes, because such packaging makes it impossible for the buyer to have read the contract before completing the purchase.

These contracts are not, however, limited to the software industry.


Courts in the United States have faced the issue of shrink wrap contracts in two ways.

One line of cases follows ProCD v. Zeidenberg which held such contracts enforceable (e.g. Brower v Gateway), and the other follows Klocek v. Gateway, Inc, which found them unenforceable.

These decisions are split on the question of assent, with the former holding that only objective manifestation of assent is required while the latter require at least the possibility of subjective assent.


In general, a user is not legally obligated to read, let alone consent to any literature or envelope packaging that may be contained inside a product; otherwise such transactions would unduly burden users who have no notice of the terms and conditions of their possession of the object purchased, or the blind, or those unfamiliar with the language in which such terms are provided, etc.


At the very least, the fair trade laws of most U.S. states would grant a buyer the right to cancel the purchase of a product where an enclosed contract provides terms of which purchaser can not be aware at the time the product is purchased.


The doctrine of consideration.

A contract must have a gain for each party to be enfoceable.


The doctor who saves a person and then bills him.

The saved person must pay the bill.

However, someone who imposes a benefit on another is only rarely permitted

to use the law to force the beneficiary to pay for it.

Otherwise there would be strategic behavior.


Again moral hazard, adverse selection

Photo developer loses valuable photos.

Developer can better afford to take the risk.

But moral hazard implies the photographer should take the risk.

The developer processes many rolls of film,

so they have an efficiently low level of care.

That is, in fact, the law.

Moral hazard and adverse selection work in the same direction.

An efficient contract assigns the loss to the the party with greater control.


Efficient breach


Breach can be efficient as the cost may be lower than fulfillment.

Without breach, the party is entitled to demand specific performance,

with high penalties for refusal.


The Coase theorem could induce the least costly option.

Contracts are breached if performance results in a net loss.

The Pigovian solution: when there is a breach,

pay expecation damages, enough to make the other as well off as fulfillment.


The doctrine of detrimental reliance.

A party had costs in expecation of fulfillment of the contract.


Reliance damages: If the contract is broken by X, X owes Y compensation for expenses made in reliance of fulfilling a contract.


Liquidated damages: the parties agree in advance on how much each will owe the other if he breaches the contract.


The basic arguments regarding contract are the same as with optimal insurance.

Exectation damages are a solution for moral hazard, or inefficient breach.

Reliance damages are a solution to adverse selection, or inefficient signing.


Reducing the moral hazard of one party can increase it to the other.


P. 168: The boundaries of fraud.


It benefits society to let people profit from obtaining information,

including information used in speculation.

It is not desirable for persons with private information about a good for sale,

to withhold it.


Holder in due course


A Holder in Due Course is anyone who accepts a check for payment.

On the face of the check there cannot be any evidence of fraud, nor can the person accepting the check have knowledge of any fraud related to it.

The recipient of the check is an HIDC and is entitled to be paid for the check.

The statute of limitations for an HIDC to sue the check’s maker for its face value is 10 years from the issue date, or three years from the date the check was deposited and returned unpaid, whichever comes first.

A HIDC can assign, sell, give, or otherwise transfer its rights to another party, who becomes the new HIDC with the same legal rights as the original Holder.


Suppose A promised to pay money to B in exchange for services. B then transferred the right to payment to C. C is then insulated from any consequence arising from a conflict between A and B.


Suppose A sues B for non-performance of service. C is insulated from any remedy A receives against B. A is still obligated to pay the original obligation to C.


Make a check “expire” before replacing it, or you can be held liable for both checks.

Print an expiration statement on the face of checks such as, “THIS CHECK EXPIRES AND IS


If a check is then lost, wait 20 + 2 days from the initial issue date before reissuing.

Many companies print “Void After 90 Days” or longer.

A party that accepts an expired check has no HIDC basis if the check is returned unpaid.


Suppose there is a sale of a good for credit.

By contract, the seller of the good may sell the promissory note.

Under the “holder in due course,” the finance company holding the note

may compel the purchaser to pay the full price even if the product is defective.

The buyer may still have a claim against the seller.


The rule can be considered inequitable to consumers.

The United States Federal Trade Commission promulgated Rule 433, which "effectively abolished the [holder in due course] doctrine in consumer credit transactions.


But the doctrine benefits the buyer by making a promise to pay more credible.

The doctrine reduces the cost of financing installment sales.


Assignment: Discuss the efficiency of the holder in due course doctrine.