Law's Order, Friedman: 6, 8, 12, 13

Ch.6: "Of burning houses and exploding coke bottles"
    "Legal rules allocate risk." (F63)
    "Insurance companies also allocate risk--to themselves, at a price.  (F63)
    why pay more for insurance than the expected loss? "If my house burns down,... dollars will be worth much more to me."  (F63)
    "Transferring risk does not eliminate it, but pooling risk does." (F64)
    "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 issue of choice under uncertainty, including risk aversion, is discussed at greater length in Chapter 13 of Price Theory. (F64)
    The term "moral hazard" is misleading to a modern reader, since it suggests that the problem has something to do with morality. It makes more sense if you read "moral" in the now nearly obsolete sense of "having to do with the mind" ... Moral hazard is a hazard that arises not from external facts of the world but from internal facts of the actor--in this case, his rational behavior in a situation where he does not bear all of the resulting costs. (F66n)
    Moral hazard: "the failure of the insured to take cost-justified precautions once he has shifted the risk the precautions protect against to the insurance company." (F66)
    "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 by increasing the incentives of the the insurance 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."..."Seen from this standpoint, coinsurance...looks...sensible." (F68)
    "extended service contract" is another example--it shifts risk to the party which can avoid it more cheaply. (F69)
    "A legal rule that makes Coca-Cola responsible if a Cole bottle blows up is, in effect, mandatory insurance...." (F69)
    "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)
    "adverse selection--an inefficient outcome due to asymmetric information." (F70)
    the problem with insurance that policies to compensate for adverse selection (a warranty on used cars) increases another (moral hazard): "Such conflicts appear with disturbing frequency when trying to design efficient legal rules: Fixing one problem often creates another." (F70-1)
    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 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.) (F72)
    Case law about landlord/tenants: "The general rule has been stated that in the absence of a lease provision to the contrary, a tenant is not relieved from the obligation to pay rent despite the total destruction of the leased premises. Magaw v. Lambert, 3 Pa. 444 (1846); Hoy v. Holt,91 Pa. 88(1879). Manderino, J. in Albert M. Greenfield & Co. V. Kolea, Supreme Court of Pennsylvania, 1976, 475 Pa. 351 , 380 A.2d 758 . (F72n)
    The judge goes on to argue that "The presumption established in Magaw and Hoy, supra, no longer has relevance to today's landlord-tenant relationships," and thus that the old common law rule should be abandoned. (F72)
    See also Crow Lumber & Bldg. Materials Co. v. Washington County Library Bd., 428 S.W.2d 759 (Mo. App. 1968), which discusses the common law rule, its exceptions, and legislative abrogation of the rule in some states. (F72)
    bona fide purchaser: Love v. Elliott, 350 So. 2d 93 (Fla. App. 1977) is a case where Russell fraudulently got Mrs. Elliott, who was illiterate, to sign by her mark a deed conveying a much larger mineral interest in her property than she had agreed to sell. Russell then recorded his deed and sold his interest. The buyer was held to have good title, the court holding that a deed procured by fraud, unlike a forged deed, could be used to pass title to a bona fide purchaser. (F72)
    On the other hand, Cumberland Capital Corp. v. Robinette, 331 So. 2d 709 (Ala. App. 1976) held that a signature procured by deceiving the grantor about what he was signing counted as a forgery. Harding v. Ja Laur Corp., 20 Md. App. 209 , 315 A. 2d 132 (1974) gives a similar result for a slightly different fraud. (F72)
    "[T]hese cases make sense in terms of one simple rule for allocating risks: Put the incentive where it does the most good." (F72)

Ch.8: Games, bargains, bluffs, and other really hard stuff
    strategic behavior: "behavior in which each person's actions are conditioned on what he expects the other person's actions to be." (F85)
    game theory "deals with such problems" (F85)
    game theory sources: There is a lengthier discussion of game theory in Price Theory, including a more detailed explanation of solution concepts. For another perspective on game theory, from a legal scholar more optimistic about its usefulness than I am, see Randal C. Picker, An Introduction to Game Theory and the Law (June 1994), webbed in pdf format. (F85n)
    transaction costs = a variation on strategic behavior (F86)
    "One reason strategic behavior is so important in the economic analysis of law is that it deals with a lot of two-party transactions: litigation, bargaining over permission to breach a contract, and the like." (F86)
    a second reasong is reliance on Coase, when "transaction costs often involve strategic behavior" (F86)
    "One [approach] ... is to bite the bullet and introduce game theory wholesale into our work. That is an approach that some people doing economic analysis of law have taken. I am not one of them." Why not? Either situation is simple enough that other approaches work, or we simplify too much to be realistic. (F86)
    "The alternative approach, and the one I prefer, is to accept the fact that arguments involving strategic behvior are going to be well short of rigorous and try to do the best one can despite that." (F87)
    his focus: bilateral monopoly and prisoner's dilemma (F87)
    just uses examples for bilateral monopoly: Joe/Mary and apple; Doomsday machine; bully strategy (F87-90)
    prisoner's dilemma: Joe and Mike: both confess: 2 yrs (leniency); one confesses: 5 yrs (burglary) / 3 mos. (trespass); neither confesses: 6 mo. (trespass, vagancy, resisting arrest). (F90)
    real-world example: plea bargains. Since each plea bargain saves DAs money, they can win more of their prosecuted cases, so average penalty may rise. If DA wins 90% of cases with plea bargains and 50% without, then defendant will accept bargain that is less attractive than a 50% chance of conviction but reject bargains that are less attractive than a 90% conviction. (F91-2)
    "Individual rationality does not always lead to group rationality." (F92)
    "Constructing efficient legal rules is largely an attempt to get out of prisoner's dilemmas.... We ... try ... to choose rules under which individual rationality leads to group rationality." (F92)
    A law to yield right of way to driver on the right is an attempt to solve a prisoner's dilemma problem--racing to an intersection. (F92)
    conclusions of chapter: (1) "increasing the cost of bargaining breakdown ... decreases ... the bully strategy." (2) prisoner's dilemma players "will betray each other." But in real world, we change game to cope with these. Exs: commitment, reputation, altruism to help promote cooperation. (F93)
    uses breach of contract example to illustrate bilateral monopoly and why "courts are reluctant to enforce specific performance of contracts, usually preferring to permit breach and award damages, calculated by the court or agreed on in advance by the parties." (ex: customized cams: MB=110K; MC=90K; MC after factory burns: $1M; contract price = 100K) (F93-4)
    Example 2: awarding damages in cases where pollution control costs much more than pollution damage. see cases on damages for pollution (F94)

Ch. 12: The Economics of Contract
    145: "Reputation may be the most important method for enforcing agreements in our society, although not the one of most interest to lawyers."   -- works well when "the amounts at stake are small, the issues simple, and the parties are engaged in repeat dealings."
    146: "Trusted private arbitrators": Diamond industry in NY, "dominated by orthodox Jews, forbidden by their religious beliefs from suing each other." The trustworthy rabbi mitigated disputes. Helps explain why "particular trades are sometimes dominated by a single close-knit ethnic group."
    147: "commercial arbitrator": each party "posts a bond with [a] third party ... we both trust." the 3rd party arbitrates.
    147: why contract law--why not enforce all contracts as written? (1) "courts may believe that they know better than the parties what the terms should have been." (2) "you still have to decide whether a contract exists and what its terms are" when parties disagree. (3) "contracts never say enough.... Contracts ... leave gaps to be filled in by the court."
    148: one reason to interfere with freedom of contract: "unequal bargaining power": Weaver v. American Oil Co., 257 Ind. 458, 276 N.E.2d 144 (1971) is a case where a contract was found unenforceable in part on the basis of unequal bargaining power.
    149: He is skeptical of unequal bargaining power. The extreme cases are very rare; generally monopolies still take account of consumer preferences. One exception--monopolies may not set efficient quality for all, but that is not the usual argument. Exception 2: if price isn't free, then other contract terms might have to be regulated.
    150: cases against freedom of contract: (1) costs imposed on 3rd parties. Example--illegal contracts (murder, restraint of trade, agreement not to testify). Sinnar v. Le Roy, 44 Wash.2d 728, 270 P.2d 800 (1954) is a case where a contract was not enforced because "the parties contemplated the use of means other than legal to accomplish the end desired."
    150: (2) incompetent parties--children and lunatics. Bowling v. Sperry, 133 Ind.App. 692, 184 N.E.2d 901 (1962) is a case where a minor was allowed not only to disaffirm a contract (for purchasing a car) but to get his money back. Heights Realty, LTD. v. Phillips, 106 N.M. 692, 749 P.2d 77 (1988) is a case where an exclusive listing contract between a mental incompetent and a broker was held invalid.
    151: Courts challenge terms as unreasonable and refuse to enforce them. Maxton Builders, Inc. v. Lo Galbo, 68 N.Y.2d 373, 502 N.E.2d 184 (1986) is a case upholding liquidated damages where the amount was held reasonable, since the amount (a 10% penalty for breach of a contract to purchase real estate) was close to the underlying economic loss. Lake River Corp v. Carborundum Co. 769 F.2d 1284 (1985) is a case where a contract provision was held unenforceable because the court viewed it as a penalty rather than reimbursement of actual damages.
    151: this presumes that (1) court can figure out a penalty clause, and (2) a penalty clause is never efficient. "A penalty clause is a private version of a property rule." It gives promisee a right that must be bought back. A property rule may be better than a liability rule--avoids courts, expresses confidence in renegotiation options. "Yet the same legal system that routinely enforces property rules created by judges and legislatures refuses to enforce property rules privately created by the people they will bind."
    152: contracts under "duress" are unenforceable. Probably "the efficient one" since we gain less by the enforceability of mugging contracts than we lose by increasing the profitability of mugging. But not always the case (ex: peace treaties are signed under duress)
    154-5: considers duress during a rescue (tug saving a ship). Incompatibility: price to tug should be value of ship; price to ship should be cost of rescue. Need to figure out which side is most responsive and set a least bad price in between. The situation is a bilateral monopoly. 156: the present legal rule "permits an admiralty court to rewrite a contract that is too favorable to one side." Lowers chance of sinking while bargaining. Austin Instrument Inc. v. Loral Corp., 29 N.Y.2d 124, 272 N.E.2d 253 (1971) is a case where a firm obtained refund of a price increase, which it had agreed to pay under pressure, on grounds of economic duress. The case does not fit our analysis of the sinking ship, since the "emergency" was the result, not of an external emergency, but of the supplier threatening to breach its contract if it did not get the higher price. Arguably this is closer to the case of the mugger.
    156: bogus duress: "contracts of adhesion"--take it or leave it. Henningsen v. Bloomfield Motors, Inc., 32 N.J. 368 368, 161 A.2d 69 (1959) is an example of a contract invalidated by the court because "From the standpoint of the purchaser, there can be no arms length negotiating on the subject. ... He must take or leave the automobile on the warranty terms dictated by the maker." It is not duress, since the seller (Avis in Friedman) must persuade you to sign. Why common form contracts? (1) "to reduce the costs of drawing up contracts." 157: (2) "reduces the risk that their employees will cheat them."
    157: form contracts may be suspect "for instance, when the contract is so complicated that the customer does not know what he is signing." [In Cutler Corp. v. Latshaw, 374 Pa. 1, 97 A.2d 234 (1953), the court held unenforceable a warrant of attorney with confession of judgement, which was buried in fine print on the back of the agreement. The court dictated that "when a party to a contract seeks to bind the other with ... a device not ordinarily expected...the inclusion of such a...provision must appear in the body of the contract and cannot be incorporated by a casual reference with a designation not its own."]
    157: contracts may be elaborate and one-sided to reduce court interpretation, with reputation at stake as a check on enforcement.
    158: what makes a contract binding? (1) formality to imply that "'we intend this agreement to be enforceable.'" (2) doctrine of consideration. Detrimental reliance is consideration. [Ricketts v. Scothorn, 57 Neb. 51, 77 N.W. 365 (1898) provides an example of a contract without consideration, enforced on grounds of reliance. "Having intentionally influenced the plaintiff to alter her position for the worse on the faith of the note being paid when due, it would be grossly inequitable to permit the maker, or his executor, to resist payment on the ground that the promise was given without consideration." Feinberg v. Pfeiffer Co., 322 S.W.2d 163 (Mo. App. 1959) and Ricketts v. Scothorn are detrimental reliance cases. The latter is closer to the example in the book. The plaintiff's grandfather had made a promise to her but, after his death, his executor refused to honor it; the court held for the plaintiff.] Tort law or refusing to honor informal contracts might be more efficient, the latter inducing more formality.
    158: "[T]he requirement of consideration does not exist in property law."
    159: Perhaps because of other safeguards such as "under the statute of frauds, all transfers of property must be in writing."
    159: contracts with unknown party (rescue with unknown reward offered) [For a real case on whether someone is entitled to a reward if he did not know it had been offered, see Broadnax v. Ledbetter, 99 S.W. 1111 (Tex. 1907), which found the offer unenforceable. Another example is Glover v. Jewish War Veterans of US 68 A.2d 233 (1949). The parents of the girlfriend of a murder suspect gave information about the suspect's whereabouts which lead to his arrest. The court found that the parents were not entitled to the reward that had been offered because it is "impossible for an offeree actually to assent to an offer unless he knows of its existence."] We don't know the net result of making reward offers enforceable to those who searched without knowing will yield net benefits. More will search but fewer rewards will be posted. He shows an example where marginal benefit from extra searcher is less than marginal cost. A lost cat is a common-property resource and causes rent seeking.
    160: Zero party contracts--a doctor who aids an unconscious victim [Cotnam v. Wisdom, 104 S.W. 164 (Ark. 1907) is a case where a doctor rendered emergency services to an unconscious payment, who died without recovering consciousness. In re Crisan Estate, 107 N. W.2d 907 (Mich. 1961) is a similar case involving a hospital. Farnsworth, in whose Contracts I found these examples, comments that "The reader who wonders what effect the patient's religious scruples regarding medical treatment might have will have to be content with the Michigan court's comment that "there is surprisingly little case authority to be found" in this area. (p. 104 fn 27)] Currently, doctor can bill. (see Friedman footnote on suing for benefits. Ordinarily must get permission, since "a property rule usualy moves services to their highest-valued use more cheaply and reliably than a liability rule." With an unconscious party, courts use a "negative liability rule" (a Pigouvian subsidy).
    160: gap-filling: the Uniform Commercial Code is available online. 160-1: goal of courts is try to fill in terms the parties would have come up with: (1) that's efficient; (2) cuts contract costs since parties know that court will promote mutually beneficial back-up role.
    161: risk bearing: contractors building houses: assigning risk to supplier is logical since supplier can spread risk more easily and prevent fires
    161: film developing: should developer pay trip costs? No due to moral hazard. 162: Hadley v Baxendale , 1. 9 Ex. 341, 156 Eng. Rep. 145 (1854). Moral hazard pulls in opposite direction of risk spreading.
    162: Moral hazard and adverse selection generally argue in same direction: the promisor usually knows risks and can prefent them better, so "an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particulary something."
    Efficient breach: 162-63: clearing land during the Great Depression. 163: The land clearing (actually, levelling) case is Groves v John Wunder Co. 205 Minn. 163 , 286 N.W. 235 (1939). The cost of the levelling would have been $60,000, the value of the land after leveling only $12,000. The court awarded damages of $60,000, thus giving the plaintiff the upper limit of the bargaining range (assuming he had bargained with the threat of insisting on specific performance of the contract), and making the defendant (assuming he had anticipated the result) indifferent between breaching and (inefficiently) performing. The case is discussed in Richard Posner, Economc Analysis of Law, 5th edn., p. 134.
    163: no penalty for breach --> opportunistic breach. But under Coase theorem, efficient contracts are not breached even without enforcement. "As long as transaction costs are sufficiently low, contracts worth fulfilling will be fulfilled." 163-4: Regardless of whether contracts are unenforceable or if specific performance is required.
    164: unenforceability and specific performance are property rules.
    164: "Specific performance is an uncommon rule except in contracts for the sale of real property." [An example of a case where specific performance was granted for a contract not involving real estate (involving, in fact, the supplying of tomatoes, which were in short supply) is Curtice Borthers Co. v. Catts, 72 N.J. Eq. 831, 66 A. 935 (1907).]
    164: liability rule. obvious answer is "the Pigouvian solution to the problem of externalities." 165: Result: expectation damages.
    165: problem. expectation damages could reduce incentive to sign contracts. "[W]hat we want is a rule under which each party has to know only the risk of his breaching in order to decide whether or not a contract is worth signing." [the text is wrong on this point: The problem arises if firm A does not know what P is--how much money B expects to make. Now firm A knows what it will owe under reliance damages but not under expectation damages, creating a problem of adverse selection for firm A in deciding whether to sign the contract.]
    166: reliance damages --> "efficient outcome on the sign/don't sign margin." "The expectation rule...produces effieicnt breach but inefficient signing."
    167: "Both expectation damages and reliance damages result in an inefficiently high level of reliance.
    "There is a third alternative that solves that problem: liquidated damages."
    167-8: "Expectation damages are a solution to a problem of moral hazard, alias inefficient breach. Reliance damages are a solution to a problem of adverse selection, alias inefficient signing." Reducing moral hazard for one party raises it for the other.
    168: the boundaries of fraud: [Laidlaw v Organ, 15 U.S. 178 (1817). See also the discussion of the case in Anthony T. Kronman, "Mistake, Disclosure, Information, and the Law of Contracts, 7 J. Leg. Stud. 1, 9-18 (1978).] Organ's victory induces rent seeking. 169: But it encourages the quick spread of information. "If the Louisiana Supreme Court had ruled in favor of Laidlaw rather than Organ, and consistently followed the same rule in other cases, the result would have been less speculation and more unstable prices for agricultural commodities."
    170: so speculators produce valuable information, but the value does not correspond to the size of the profit.
    170: Stambovsky v. ackely: "We do not want a system in which people who happen to have information highly relevant to the value of what they are selling... have an incentive to withhold it...."

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Posner:
    31: Contract law: "concerned with facilitating the voluntary movement of property rights into the hands of those who value them most"