IV. Contracts
    A. The economics of contracts
    2. Allocating risk (cont'd.)

    c. insurance contracts

    diminishing marginal utility => risk aversion
    => people will pay more than their expected loss for insurance
    why pay more for insurance than the expected loss? "If my house burns down,... dollars will be worth much more to me."  (F63)
    "People buy insurance even though most of them probably know that, on average, they can expect to collect less in claims than they pay out in premiums.... Diminishing marginal utility is a fact about most people's preferences, revealed by their choices." (F64)

    the extra payment makes it possible for insurance companies to exist
    "Insurance companies ... allocate risk--to themselves, at a price.  (F63)

    complications of insurance contracts
    --moral hazard
    --adverse selection

    (1) moral hazard

    insurance-induced reduction of cost-justified precautions because of shifting the risks to others
    "if an insurer is so careless as to insure a factory for 150 percent of its value, the probability of fire may become very large indeed." (F67)
    "If the insurance company is in a better position than the insured to prevent the loss, transferring it to them via insurance raises efficiency more by increasing the incentives of the insurance company than it lowers it by reducing the incentive of the owner. The right rule is to put the incentive where it will do the most good."(F68)
    partial remedy: coinsurance

    moral hazard by insurers also exists if the expected cost of claim exceeds the policy limit. (P109)
    "the law reads into the policy a fiduciary duty of insurer to insured; that is, the insurer is required to treat the insured as it would treat itself." (P110)

    (2) adverse selection

    "an inefficient outcome due to asymmetric information." (F70)
    "The fact that someone wants to buy insurance is evidence that you should not sell it to him--more precisely, that he is a worse risk than the actuarial tables imply." (F69)

    remedies: warranty (F71)
      universal coverage (P110)
    --but these increase moral hazard
    "Such conflicts appear with disturbing frequency when trying to design efficient legal rules: Fixing one problem often creates another." (F70-1)

    insurance infancy: contracts construed against the insured. any contributory act excused the insurer. to cut down on moral hazard, but some insurance is worth accepting moral hazard and insured can't efficiently control all change in risks (employee behavior, for ex.). As insurance expanded, conditions relaxed from greater risk pooling. (P109)
    Now: Insurance contracts principle: "insurance contracts are to be construed against the insurer." (P108)
    can insured recover from insurer if also paid by injurer? probably not, since that amplifies income swings due to injuries, contrary to the principle of insurance. (P108)
    you can only insure "something in which you have an insurable risk." (P109)
    avoids imposing costs on a 3rd party:

    better health tests can lower welfare by making the risk of bad outcomes uninsurable. It depends on the rule for disclosure, but if the insurance company knows that you have been tested, in advance, then it will not insure you. (the best rule is for the insurance company not to be able to require testing but to be informed about whether a test has occurred--insured can then get tested after buying insurance.) (F72)

    IV. Contracts
    B. Making contracts

    Goal of efficient contracts: to increase the size of the economic pie, giving a gain to be divided between the parties.

    Aspects of contracts that we'll cover: 
    making contracts
    enforcing contracts
    interpreting contracts
    breaking contracts

    Making contracts -- types of contracts we'll consider
    1. bilateral contracts
    2. unilateral contracts
    3. implicit contracts

    1. Bilateral contracts

    express contract

    the straightforward case -- 2 parties make an explicit agreement

    Minneapolis and St. Louis Railway v. Columbus Rolling Mill 119 U.S. 149 (1886) --  clear offer and acceptance case

1. P: What are the facts of the case?
2. P: Do you assert the existence of a contract?
3. P: What were its key terms?
4. D: Do you agree that there was a contract as described? Why or why not?
5. P: Did you, at any point, accept the original terms offered by the defendant?
6. P: Did you do so within the time frame granted by the defendant?
7. D: What decision did the court reach? Why?
8. General: Why might the defendant have decided not to honor its original offer once the plaintiff tried to revert back to it?

    --contracts require "offer and acceptance"

    Note: parties must mutually agree to identical terms
    A counteroffer => 
    (i) rejection and 
    (ii) cancellation 
    of  the original offer

    Silence can be assent if that is deemed reasonable based on previous dealings (P103)

    acceptance is when mailed not when received
    allows earlier preparatory measures. (P103)

    Sherwood v. Walker. 66 mich. 568, 33 N.W. 919 (1887)

1. P: What are the facts of the case?
2. P: What are you asking the court to do?
3. D: Why won't you comply with plaintiff's request?
4. P: Why do you expect defendant to comply despite the changed circumstances?
5. D: Did either of you know the condition of the cow at the time sale?
6. D: Why does the condition of the cow matter?
7. P: Why do you expect compliance despite the new information?
8. D: Did the court agree with you or not? Why?
9. P: What arguments in your favor were raised by the dissent in the case?

    "mutual mistake" invalidates a contract

    remains a controversial decision

    ? What possible disincentive results from the decision?

    ? Who had better access to information about the condition of the cow?

    ? How would you expect the price of the cow to be affected by the possibility that the cow might breed?
   "there was some evidence that Rose's sale price included her value if pregnant."  => should have been enforced. Possibly so even without evidence since owner is more likely to be knowledgeable. (P104)

    Other examples of mutual mistake:
    Baffles v. Wichelhaus 2 H. & C. 906, 159 End. Rep. 375 (Ex, 1864) -- two ships named Peerless (P104)
    Colfax Envelope Corp. v. Local No. 458-33m, 20 F.3d 750 (7th cir. 1994) -- printing press staffing dispute; contract found to be valid--ambiguous but not a mutual mistake; Posner opinion (P104)

    Hamer v. Sidway 124 N.Y. 538 (1891)

1. What are the facts of the case?
2. What does plaintiff request?
3. Why does defendant argue against honoring the claim?
4. What did the court decide?
5. Did the promisor receive any benefit from the promisee?
6. So why did the court feel that there had been consideration?

    binding contracts require consideration: a benefit for the promisor or a cost for the promisee

consideration moves the promisee to a lower indifference curve     detrimental reliance = consideration (F158)     courts consider existence, not adequacy of consideration (P101)     Suppose the uncle had promised $5K for turning 21. Enforceable? No     goal: to limit litigation by excluding trivial promises and phony, vague or inadvertent contracts (P99)

    "[T]he requirement of consideration does not exist in property law." (F158)
    Perhaps because of other safeguards such as "under the statute of frauds, all transfers of property must be in writing." (F159)

    alternative: base binding contracts on formality to imply that "we intend this agreement to be enforceable." (F158)
    advantage: parties sometimes want simple promises to be enforceable--ex: donors for college facilities; enforceable promise allows earlier action

    summary: a valid contract requires
    (i) offer and acceptance without mutual mistake
        -- a "meeting of the minds" and
    (ii) consideration

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