It seems … reasonable to say that a contract or payment secured by duress is defective not because of some difference in the nature of the consent, but because of the impropriety of the alternative presented; that is, of the pressure used. However, not every improper pressure is duress, since our legal system provides remedies that are reasonably effective in protecting the innocent against improper pressures under ordinary circumstances, and it is better to require the use of such remedies where practicable than to resort to an indiscriminate overhauling of transactions in court. The theory underlying this article is that, to constitute duress, the following elements are both essential and sufficient: (1) The transaction must be induced by a wrongful threat, (2) for which the law offers no adequate remedy, that is, no remedy which (by practical laymen's standards, not those of the common-law nor even of equity) is really sufficient to compensate for the wrong suffered if the threat should be carried out.…

Private individuals are … aware of the effectiveness in some situations of a threat to break a contract. In some contractual dealings, the two parties cannot always keep abreast of each other in performance as the work progresses. Inequalities of investment in preparation and performance, or other inequalities between the parties, create situations where one can exert considerable pressure on the other by a threat of disregard of contract obligations.

Often it is possible for a party to make a binding promise, unsupported by any fresh consideration, to modify a term of an existing contract. For example, the payor in a construction contract might agree to pay a higher price to a builder who had encountered unexpected soil conditions. The motives for such promises are various: to gain a reputation for “fair dealing” (really risk sharing), to avoid driving the promisee into bankruptcy (which might prevent his completing performance or raise the cost of his doing so), or even to be altruistic (the contingency giving rise to modification may have dramatically altered the relative wealth position of the parties). In any event, the stakes are often substantial in such cases, while the increment in utility to the promisor may also be substantial because of the length of time over which optimal performance may extend.

Consider the example of the house purchaser who promises the builder a higher than contract price because the builder has encountered some unexpected difficulty which may make it impossible to complete the contract at the agreed price. If the purchaser merely declares his intention of paying the builder a higher price, but is free to renege, the builder may decide not to complete performance but instead to take his chances in bankruptcy court. Yet the promisor dare not pay him the extra price in advance in exchange for the builder's promise to continue, for if the contractor is financially shaky for other reasons, the prepayment may end up in the hands of a trustee in bankruptcy, with the purchaser relegated to the status of an unsecured creditor.

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.

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor-quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market. It should also be perceived that in these markets social and private returns differ, and therefore, in some cases, governmental intervention may increase the welfare of all parties. Or private institutions may arise to take advantage of the potential increases in welfare which can accrue to all parties. By nature, however, these institutions are nonatomistic, and therefore concentrations of power – with ill consequences of their own – can develop.

The automobile market is used as a finger exercise to illustrate and develop these thoughts. It should be emphasized that this market is chosen for its concreteness and ease in understanding rather than for its importance or realism.

The model with automobiles as an example

The automobiles market

The example of used cars captures the essence of the problem. From time to time one hears either mention of or surprise at the large price difference between new cars and those which have just left the showroom. The usual lunch table justification for this phenomenon is the pure joy of owning a “lnew” car. We offer a different explanation. Suppose (for the sake of clarity rather than reality) that there are just four kinds of cars.

French contract law distinguishes between contracts “to do” and contracts “to give,” with damages as the normal remedy for the former and specific performance as normal remedy for the latter. A contract to design an aircraft is a contract to do. A contract to sell an aircraft is a contract to give. A contract to build an aircraft to a certain design, and then to transfer ownership of it, is a contract both to do and to give. The distinction corresponds to the commonsense distinction between contracts for services and contracts for conveyance of land or chattels, with an intermediate area where goods are to be made in accordance with customized terms.

Steven Shavell has built a formal economic model of contract remedies that suggests that the French solution is the appropriate one, though he notes that the common law (damages as the general remedy) and German law (specific performance as the general remedy) in practice reach much the same solution by different routes, at least in the most important cases. Shavell's mathematical approach will make his paper impenetrable to most lawyers, yet its core is really fairly simple and analytically not very different from the informal models used by Kronman and Schwartz.

Shavell considers the case of a buyer who after contract must undertake some fixed reliance (to abstract from a difficult problem) and a seller who is subject to uncertainty about the cost of his contractual promise, only learning about the true cost of performance after the buyer has relied.

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.

This article proposes a new theory of the standardized warranty and of the determinants of the content of the warranties of individual products. … A warranty is viewed as a contract that optimizes the productive services of goods by allocating responsibility between a manufacturer and consumer for investments to prolong the useful life of a product and to insure against product losses. According to the theory, the terms of warranty contracts are determined solely by the relative costs to the parties of these investments. An insurance function of warranty coverage, of course, is well known. The novelty of the theory is its emphasis on the variety of allocative investments that consumers may make to extend productive capacity and its consideration of the difficulties of drafting warranty contracts to encourage such investments. …

The basic theory defined

Let us … [try] to predict the contents of warranties where the costs of extending product life and of insuring product losses are the sole determinants of their contents. Imagine that consumers are perfectly informed about the likelihood of a product defect and about the losses that will be suffered should a product become defective. Imagine also that consumers somehow make their preferences regarding warranty terms known to manufacturers and that manufacturers are responsive to those preferences. Imagine that warranty contracts are standardized only to reduce negotiation costs and thus that the standardized form itself does not affect the substantive obligations of consumers relative to manufacturers.

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.

Terms such as “unfair” are foreign to the economic model of voluntary exchange which implies anticipated gains to all transactors. However, much recent statutory, regulatory and antitrust activity has run counter to this economic paradigm of the efficiency properties of “freedom of contract.” The growth of “dealer day in court” legislation, FTC franchise regulations, favorable judicial consideration of “unequal bargaining power,” and unconscionability arguments, are some examples of the recent legal propensity to “protect” transactors. This is done by declaring unenforceable or illegal particular contractual provisions that, although voluntarily agreed upon in the face of significant competition, appear to be one-sided or unfair. Presentation of the standard abstract economic analysis of the mutual gains from voluntary exchange is unlikely to be an effective counterweight to this recent legal movement without an explicit attempt to provide a positive rationale for the presence of the particular unfair contractual term. This paper considers some transaction costs that might explain the voluntary adoption of contractual provisions such as termination at will and long-term exclusive dealing clauses that have been under legal attack.

The “holdup” problem

Given the presence of incomplete contractual arrangements, wealth maximizing transactors have the ability and often the incentive to renege on the transaction by holding up the other party, in the sense of taking advantage of unspecified or unenforceable elements of the contractual relationship. Such behavior is, by definition, unanticipated and not a long-run equilibrium phenomenon. Oliver Williamson [1975] has identified and discussed this phenomenon of “opportunistic behavior,” and my recent paper with Robert Crawford and Armen Alchian [1978] attempted to make operational some of the conditions under which this holdup potential is likely to be large.

Contract rules policing contractual modification are another response to the heightened risk of extortion in specialized environments. For example, the common-law preexisting duty rule can be usefully contrasted with the more permissive regulation of contractual modification under the Uniform Commercial Code. The preexisting duty rule denies enforcement of a renegotiation or contractual modification where an obligor agrees merely to do that which he is already contractually obligated to do. The rule is primarily designed to reduce the incidence of extortionate modification in construction, employment, and other specialized contractual relationships. …

The preexisting duty rule, however, often fails accurately to mirror the underlying bad faith behavior. First, the rule discourages cost reducing negotiations in addition to threats. Moreover, the obligor satisfies the rule by assuming any additional obligations whether or not the “additional” duties are themselves part of the strategic maneuver. The Code [U.C.C. 2–209(1)] abandoned this ill-fitting rule of thumb and instead applies a general good faith standard. … Because this standard is substantially more difficult to enforce, however, the Code may not deter extortionate renegotiation as effectively as did the common law. Nonetheless, if parties generally execute contracts for the sale of goods in the context of a well-developed market for substitutes, the costs saved through legitimate renegotiations will exceed the increased enforcement costs of policing bad faith modification.

In contract cases – typically construction or mining cases – courts frequently measure the damages of the innocent party either by the diminution in the market value at the time of breach from less than perfect performance or by the cost of rendering performance perfect. The diminution measure is objective; that is, observers external to the contract, such as the judge or jury in a lawsuit, can ascertain its amount with reasonable accuracy at a tolerable cost. Yet this objective measure can undercompensate the aggrieved party, thereby contradicting contract law's principle that damages should place the injured party in the same position as if the contract were performed. For example, consider construction of a family dwelling that deviates from the contract specifications by changing the location and size of some of the rooms while leaving the total square footage of the house unchanged. This breach need not diminish market value: Preferences for housing style vary considerably, and the builder might simply sell the house to another buyer at the price the original purchasing party had offered. Nevertheless, the original purchaser may value the house promised more highly than the house actually delivered. Because market value did not decrease, there is no damage by the objective measure. Nevertheless, damage does exist, albeit of a nonpecuniary or subjective nature.

Any decision to ignore subjective value cannot rest on the ground that such damages are either unreal or frivolous – this argument is patently false. Instead, the decision must rest on more prudential considerations, namely, that the costs of determining subjective value exceed any allocative benefits that the determination might yield.

If we understand the immense utility of insurance, and the grounds, or, as may well be said, the indispensable conditions of this utility, we shall see that these depend upon a few simple principles; and we shall also see that merchants in their practice, and courts in their decisions of the multifarious and complicated questions presented by the law of insurance, constantly regard these principles. And it may be added, that if the sagacity of merchants, stimulated by a sense of direct interest, and gradually taught by experience, has discovered these principles and applied them to practice, it is not less true that courts have been too sagacious to disregard this practice. Since the days of Lord Mansfield, who set a wise example in this respect, the jurisprudence of England and America, in the matter of insurance, has done little else than adopt the usage of merchants, and give to it the force of authority.

What are these principles? They are few and easily stated. And indeed they all rest on one principle. It is, that if insurance be made too costly to the insured, and if it be too difficult for them to obtain indemnity for loss by reason of the narrow construction of the law, or the severe application of technical requirements, the practice of insurance would be checked, and it would be left very much to the wealthiest and the most careful merchants, who are those that need it least, and who would be most disposed – to use a common phrase – to “stand as their own insurers.”

… The individual who has insurance which covers all costs demands medical care as though it had a zero price, but when he purchases insurance, he must take account of the positive cost of that care, as “translated” to him through the actuarially necessary premium. Hence, he may well not wish to purchase such insurance at the premium his behavior as a purchaser of insurance and as a demander of medical care under insurance makes necessary.

The presence of a “prisoners' dilemma” motivation makes this inconsistency inevitable. Each individual may well recognize that “excess” use of medical care makes the premium he must pay rise. No individual will be motivated to restrain his own use, however, since the incremental benefit to him for excess use is great, while the additional cost of his use is largely spread over other insurance holders, and so he bears only a tiny fraction of the cost of his use. It would be better for all insurance beneficiaries to restrain their use, but such a result is not forthcoming because the strategy of “restrain use” is dominated by that of “use excess care.”

It has been recognized in the insurance literature that medical insurance, by lowering the marginal cost of care to the individual, may increase usage; this characteristic has been termed “moral hazard.” Moral hazard is defined as “the intangible loss-producing propensities of the individual assured” [Dickerson, 1963, p. 463].

1. Posner and Kronman (1979, p. 225) criticize Clarkson et al. (1978) by noting that the danger of the promisee's trying to provoke a breach should be reflected in the initial negotiations over the price and other terms of the contract. The parties could determine whether such external supervision was necessary. Hence, a refusal to enforce a clause on this ground presumes that the parties were incapable of weighing the merits of supervision on their own. A response to this is that since parties would want courts to fine-tune penalty clauses by selective enforcement, it is reasonable to incorporate such enforcement as an implied term. Do you think that parties would generally accept such a term? Should they be allowed to disclaim the implied term?

2. Ronko is a newspaper columnist whose contract provides him with a salary of $200,000 per year for five years. If he quits before the contract expires he is required to pay a penalty of $50,000 per year for each year he has worked. If he were to quit after the third year, therefore, he would owe his ex-employer $150,000. Should such a penalty be enforced? Compare this to the contract of Banks, a columnist at another paper. Banks's contract provides him with a salary of $150,000 per year plus $50,000 per year deferred income, which is paid only if he works all five years. Banks quits at the end of the third year and sues for his deferred compensation. Should he recover?

If conditions change after parties enter into a contract, one of them might want to be excused from performance or at least have its obligations revised. Under certain circumstances courts have excused performance invoking the doctrines of impossibility, frustration, impracticability, or mutual mistake. Courts will sometimes keep the contract alive, but rewrite it. It is not uncommon for German courts to revise the price term in a long-term contract; see Dawson (1983). While that is rarely done in American courts, it is not unheard of.

Richard Posner and Andrew Rosenfield [9.1] attempt to provide an economic explanation of the impossibility doctrine. They emphasize the importance of putting liability on the party that is the superior risk bearer. In part, this means the party that is in the best position to avoid costs. But they also place great emphasis on the risk aversion of the parties and the relative costs of insuring against risk. I am, it should be recalled, generally hostile to explanations centering on attitudes toward risk. In the following selection, I present an alternative explanation that does not require explicit assumptions as to the risk preferences of the parties. The explanation hinges on an understanding of why contracts will often include force majeure clauses, which state that in the event of certain “acts of God” – fire, breakage of machinery, strikes, and so forth – performance will be excused.

Contracting parties can anticipate the need for change by including in their initial agreement some mechanisms for adjusting the contract price – for example, a price index.

Because conditions will change after parties enter into a contract, there are tremendous advantages to maintaining flexibility to adjust the arrangement in the light of changed circumstances. There will also, however, be opportunities for one party to take advantage of the other's isolation from market alternatives and insist that an existing contract be modified in its favor. Contract law faces the difficult task of facilitating the former while attempting to restrict the latter. The common law utilized the preexisting duty concept to police attempts to modify contracts while the Code has utilized the notion of good faith modification.

The four selections in Part VIII are all concerned with this problem. It should be clear to the reader that the problem is another variation on the Boomer problem. The party requesting the modification is in the same position as the party that might get the injunction. The more it appears that this party is simply taking advantage of the other's vulnerability, the more likely it is that the court will intervene (providing only damages in the case of the cement company and invoking some variant of the preexisting duty doctrine in the contract case). On the other hand, the more the opposite party was responsible for its own plight, the less willing a court will be to bail it out. One can perhaps read Hackley et al. v. Headley (discussed by Dalzell [8.1]) as holding that if a party is vulnerable to a request to modify because it is on the verge of bankruptcy, this condition is entirely of its own making; its “fault” makes it extremely unlikely that the opposite party's behavior would be found unlawful.