University of Minnesota

Law School
Legal Studies Research Paper Series
Research Paper No. 09-20

The Comparative Law and Economics of

Frustration in Contracts

Marta Cenini
Barbara Luppi
Francesco Parisi

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 Marta Cenini – Barbara Luppi – Francesco Parisi

The Comparative Law and Economics of

Frustration in Contracts

Abstract: In this article we study the related doctrines of frustration of

purpose and practical and economic impossibility. Frustration of purpose is a
defense to the enforcement of a contractual obligation that becomes available
when an unforeseen event undermines the purpose for entering into a contract.
The rules governing frustration of purpose share a common logic with the
related doctrines of practical impossibility and economic impossibility. In this
paper we consider the solutions adopted by European legal systems in a
comparative law and economics perspective. From an economic point of view
the issues that acquire relevance in the face of impossibility of performance
can be grouped in three main categories, namely: (a) risk-allocation function,
(b) information harvesting function, (c) incentive function. We examine the
ability of alternative legal rules to fulfill one or more of these economic
functions. We further observe that the choice of rules in this area of the law
should be particularly attentive to the impact of transaction costs. Frustration
and impossibility in contracts are rare occurrences. It is inefficient and often
impractical to allocate the risk of unexpected contingency at the time the
contract is made, and the remedy of discharge seems to be a desirable default
allocation of the risk between the parties, where renegotiation of the contract
remains a viable ex post option to capture the benefits of the original contract.

JEL Codes: K12, K41

Keywords: frustration of purpose, practical impossibility, economic
impossibility, risk-allocation

1. Introduction

Frustration of purpose is a defense to the enforcement of a

contractual obligation. Legal systems generally provide this defense
when an unforeseen event undermines a party’s purpose for entering
into a contract. In many legal systems frustration of purpose is often
treated and discussed jointly with the related doctrine of impossibility,
which concerns situations where unforeseen events render impossible

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(practical impossibility) or far more burdensome (economical
impossibility) the performance of the obligations specified in the
contract. Although different in their substance, the economic analysis of
the doctrines of frustration and impossibility share a common logic. In
the following analysis we shall therefore treat these doctrines together.
When unexpected contingencies occur during the performance of a
contract, there may be a divergence between what parties have
expressly agreed upon in the contract and what they have implicitly
assumed was their contractual obligation in terms of assumption of risk.
In other words, when there is a period of time between the conclusion of
the contract and the performance of the parties, there may be a
fundamental change of circumstances that makes the performance of the
contract far more burdensome, or even physically impossible, for one
party, or that completely frustrates the purpose of the contract for one
party. The event that causes the change is, as said, unexpected or
unforeseen and is not explicitly referred to in the parties’ agreement. If
it were in the parties’ agreement, the general rules on breach of contract
would apply. In all of these cases, the overarching question is whether
the burdened party should be obligated to perform (or, if her
performance has become impossible, pay damages) or whether she may
be allowed to escape contractual liability by resorting to one of several
“contract defenses.” Such defenses might include the rebus sic
stantibus (“all the things thus standing” ) clause under which a party’s
obligation under the contract is required only when conditions are the
same as they were when the contract was formed.

1.1 Review of the Literature

Scholars understand that the right way to approach the problem

requires that we pay attention to the risk problem and to the allocation
of such a risk apart from parties’ intentions at the time they negotiate
the agreement1.

1
At first, courts (see Taylor v. Caldwell, 122 Eng. Rep. 309 (1863), which is generally
recognized as the first case involving impossibility as defense) framed the problem on
the basis of the parties’ will, investigating the intents of the parties at the time the
contract was made. From this point of view, the occurrence or non occurrence of the
event is, although not expressed in the contract, an “implicit condition” that was tacitly

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 Posner and Rosenfield (1977)2 tried to show that when an event that
is not chargeable to any of the two parties makes the performance of
one party impossible or more burdensome, efficiency requires to
allocate such a risk to the party who can better bear it (the so called
superior risk bearer). Several factors would determine who can bear the
risk at the least cost: first, parties can often take precautions to decrease
the probability that performance becomes impossible or to reduce the
loss from the breach. In such a case, risk should be assigned to the
party who can take precautions to reduce it at least cost. Second, even if
no one can take precautions to reduce risk, someone can usually spread
the risk by, for example taking out an insurance policy. In such a case,
the party who can spread the risk at least cost should be held liable
(Posner and Rosenfield, 1977, p. 90-92).
A person’s ability to reduce and spread risk determines his or her
cost of bearing it. Efficiency requires allocating the risk to the parties
who can bear it at least cost. In this way, the cost of remote risks would el contrato debería
be minimized while the contractual surplus would be maximized and resolverse cuando el
would be divided between the parties3. Under this point of view, if the acreedor es quién
puede asumir al
promisee is the superior risk bearer, the contract will be discharged; if it menor costo el riesgo
el deudor is the promisor the superior risk bearer, her performance failure will be
considered as a normal breach of contract and will require her to pay
expectation damages. When it is difficult to ascertain which of the two
parties is the superior risk bearer (as happens, for example, in the
famous Coronation Cases4), the authors suggest that as long as the

assumed by the parties. Recently, this point of view has been reproposed by Kim
(2007).
2
Related studies are also Bruce (1982) p. 311, Cooter and Ulen (2008), p. 276, Joskow
(1976).
3
Similarly, these authors also believe that when the contingency destroys the purpose
of the contract, efficiency requires allocating risk to the party who can bear it at least
cost, thus efficiency requires interpreting the doctrine of frustration of purpose as
follows: if a contingency makes performance pointless, assign liability to the party
who could bear the risk at least cost.
4
The Coronation cases were a group of appellate opinions in English law cases, all
arising out of contracts that had been made for accommodation for viewing the
celebrations surrounding the coronation of King Edward VII, originally scheduled for
June 26, 1902. The King fell ill, and the Coronation was postponed until August. In
general, the contracts were voided on the ground of frustration of purpose. Certain
contracts which did not mention that the purpose was to view the Coronation

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performer is generally the superior risk bearer, assigning the risk to him
in cases where there is doubt – that is, refusing discharge in those cases
– can be expected to yield correct results more often than the contrary
rule (Posner and Rosenfield, 1977, p. 111).
Following a similar argument, other authors pointed out that parties
may have a degree of risk aversion, which should be considered in the
decision on who should bear the risk and on the amount of damages to
be paid in case of breach of contract, an amount that may vary from full
expectation damages to zero or even negative damages5. Sykes (1990, p.
53-57) suggested, for instance, that the remedy of discharge is efficient
when the cost of performance has drastically increased and the promisor
is risk adverse.
More recently, other studies have criticized these conclusions on a
variety of grounds6. First, it has been pointed out that Posner’s and
Rosenfield’s superior risk bearer criterion, especially in its final result
Yo creo que no es una
(which, as we have said, allocates the risk on the performing party), re- carga que se le impone
proposes the pacta sunt servanda principle but in a more complex way: al juez, sino a la parte
instead of simply saying that the performer is always liable, Posner and frustrada, puesto que es
quién solicita la
Rosenfield demanded that the fact-finder undertake an articulate inquiry resolución del contrato
about who is the superior risk bearer. This results, in most cases, in the
same finding that would have been achieved under the pacta sunt
servanda principle (Ambrosoli, 2002, p. 60), but there is still
uncertainty. The uncertainty about who will be recognized as the
superior risk bearer also leaves open the possibility that each party will
rely on the other party to face the risk (or worse, that each party takes
out insurance for the same risk).
Second, and more importantly, Trimarchi (1991) has shown that
when we are dealing with an upsetting of the economical equilibrium of
the contract due to the occurrence of an extraordinary and unforeseeable
event, the superior risk insurer criterion cannot work. The principle of
insurance (in its widest sense) lies basically in aggregating a number of
homogeneous and uncorrelated risks with some statistically regularity

festivities were upheld, however. Here, it is clearly impossible to ascertain who is the
superior risk bearer.
5
White (1988) and Sykes (1990) argued that the issue of impossibility and commercial
impracticability is one aspect of the larger problem of the efficient remedies for breach
of contract.
6
See, among others, Gordley (2004).

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that makes the overall losses in a given time span predictable with a
reasonable degree of accuracy7. The extraordinary and unforeseeable
event is an absolute uncertainty rather than a calculable risk and more
importantly it is not recurring. Besides this problem of statistical
unpredictability, the fact that the risk has general consequences means
that it hits several debtors, which is in contrast with the requirement that
risks be of an independent nature before they can be insured against.
Trimarchi (1991, p. 66), therefore, argues that the legal rule must be
based on the situation resulting from the unanticipated occurrence, i.e. it
is necessary to face the losses with an ex post perspective. From this
point of view, it appears preferable to give the burdened party the
remedy of discharge. France, Belgium, the Czech Republic, Denmark,
England, Ireland, Scotland and Slovenia have chosen this way, and
Schwartz (1992, 1996) is favorable to this solution: requiring
performance at the condition of the contract or declare the contract
voided seem the only practicable alternative.
On the other hand, parties often have spent much money and time La renegociación del
in the performance of the contract, and there may have been efficient contrato puede ser útil
cuando la frustración es
allocation of resources resulting from the original contract. In order to parcial
preserve these benefits, there could be room left for re-negotiation of the
contract, in order to rebalance the economical interests upset by the
contingency (Trimarchi, 1991).
As the non-burdened party is in a more advantageous position, she
could try to exploit the situation and behave opportunistically. In such a
case, the parties will only rebalance to an equal position if the burdened
party has the ability to ask the judge to declare the contract void. For
this reason, Italian law provides that the burdened party may ask the
judge to void the contract and only after this judicial claim and within
the same trial, the other party may ask for opening the issue for
renegotiations. This situation would also involve the intervention of the
judge during the renegotiation.

7
Moreover, Trimarchi (1991) suggests that the increase of performance costs very
often corresponds to an analogous increase in the buyer’s gain: in this case, the
payment of expectation damages does not compensate the buyer for an actual loss but
rather gives him an unexpected, extraordinary gain, which does not conform either to
the principle of insurance or the ex post allocation of risks.

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 Schwartz (1992 and 1996) suggests that, in cases of frustration, it is
preferable to induce the parties to enter into renegotiations rather than
leave courts to adapt or rebalance the contract. Courts, in fact, have
imperfect information about market price, and most importantly about
the subjective costs and benefits of the parties. Along similar lines,
Gallo (1992) has proposed that in order to facilitate this renegotiation,
parties should insert into every contract a clause of revision of the
agreement in case unexpected circumstances provoke a significant
disequilibrium of the performance of the parties (so called hardship
clauses). A default rule could impose such a clause, providing
incentives to the parties for undertaking a bargain if they want to
exclude the applicability of such a default rule. Unlike statutory
provisions, a hardship clause would not call for the intervention of the
judge, at least at the beginning.
At the European level, most contracts provide that when the
contingency occurs, parties have the duty to undergo bargaining in an
attempt to rebalance the contract. Only after a failure of this private
bargain may parties ask for judicial intervention. The risk of
opportunistic behavior of the advantaged party may be avoided by
requiring that both of the parties act in good faith. In this regard, it is
not consistent the art. III.-1:110 of the DCFR, which requires only the
debtor to behave in good faith. Along similar lines, the Association
Henri Capitant developed a model solution according to which the
parties must renegotiate the contract if it becomes deeply unbalanced
during its execution due to a change of circumstances that could not
reasonably be foreseen. Under this solution, the parties may terminate
the contract by common agreement or ask for the intervention of the
court only if the bargain fails “in spite of the good faith of the
contracting parties.”

2. The Economics of Frustration in Contracts

When circumstances frustrate the purpose of a contract or render

the performance of a contract impossible, the parties’ contractual
expectations are frustrated and a loss is incurred. In the face of such
impossibility, legal rules determine which contracting party should bear
the financial consequences of the impossibility. In the following, we
consider the issue of optimal allocation of the cost of impossibility

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through the lens of economics. There are several issues that acquire
relevance in the face of impossibility of performance. From an
economic point of view these issues can be grouped in three main
categories, namely: (a) risk-allocation function, (b) information
harvesting function, (c) incentive function.8
For each category, there are often two or more dimensions, each of
which contributes to the determination of the optimal allocation of risk
between the parties. These dimensions substantially affect the
optimality of the allocation of risk in order to determine which party
should bear the consequences of the frustration of the contract. Table 1
below shows that only for a small subset of situations does the same
allocation of risk from impossibility yield the optimal balance between
these competing normative goals. The restricted conditions under which
each alternative allocation of risk yields optimal results in each
dimension will be discussed in the remainder of Section 2.
In Table 1, we consider three alternative allocations of risk: one in
which frustration provides a full defense for the promisor, the other
where the risk of impossibility is entirely borne by the promisor, the
third where the risk is spread between the parties. Further, the
conditions under which the choice of allocation is immaterial are
specified. The optimal allocation of the risk from impossibility will be
determined by lawmakers and by the contracting parties according to
the relative weight attached to each of the three parameters of
optimization (i.e., optimal risk-allocation, information disclosure and
performance and reliance incentives). It is important to consider the
choice of equilibrium level of allocation of risk that the parties would
contractually agree upon under different conditions. As summarized in
Table 1, from an economic point of view, the optimal frustration rule
depends on (a) the risk propensities of the parties, (b) the determinants
of the probability of performance, and (c) the private information
available to the contracting parties.
From an economic incentive viewpoint, different frustration rules
should be chosen in all such cases in order to create the optimal balance
of these three factors.

8
These functions are similar to those that determine the optimal allocation of risk of
failure through conventional and legal warranties, as discussed by Parisi (2004).

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 OPTIMAL FRUSTRATION RULE
Doesn’t No Partial Full
Matter Defense Defense Defense

Risk Both are Promisee is Both are Promisor is

ECONOMIC FUNCTION

Allocation risk-neutral risk-averse risk-averse risk-averse

Promisor Both have Promisee

Harvesting Symmetric
has private private has private
Information information
information information information
Incentives Promisee’s
Exogenous Promisor’s Bilateral
and Moral moral
risk incentives incentives
Hazard hazard

Table 1: Determinants of an Optimal Frustration Rule

In the following sections, we consider in greater detail the results

outlined in Table 1, examining the equilibrium choice of contractual
allocation of risk when the terms are negotiated by the parties in
different environments. Such an optimal frustration rule coincides with
the hypothetical bargained-for solution between parties, and may
provide some guidance for the understanding of the best legal allocation
of risk between the parties. This discussion is concerned with both
conventional allocations of risk, which are chosen and made into a
contract by the parties in a transaction, and legal allocations of risk,
which are created by operation of law in specified transactions.

2.1 Optimal Allocation of the Risk of Frustration

First we consider the simplest case in which the probability of

frustration is exogenous, in the sense that neither the promisor nor the
promisee has any control over the likelihood of the occurrence of
frustration or impossibility. Further assume that the information
available to the contracting parties when the contract has been signed is
symmetric. In this situation, the optimal frustration rule depends
exclusively on the parties’ attitude towards risk. In economic theory risk
aversion defines the reluctance of a person to accept a fair bargain with
uncertain payoffs and is captured analytically by the curvature of the

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utility function. A standard measure of risk aversion is the Arrow-Pratt

absolute risk aversion index, defined as . A person is risk

neutral if the risk aversion index is zero, i.e. when , which
corresponds to a linear utility function.
The possibility of a lost surplus from frustration of purpose or
impossibility of performance represents an economic risk. When parties
have the ability to diversify their risk by entering into a large number of
contracts with independent risks, it is likely that they will face lower
levels of risk aversion. In all these situations, the optimal allocation of
the risk is exclusively determined by the relative risk aversion of the
parties. The optimal allocation of the impossibility risk therefore
depends on the circumstances of the contracting situation, and on the
relative ability of parties to edge their risk aversion through risk
diversification or insurance. In this specific case, there are no
information or incentive effects created by the frustration rule. Hence,
we can distinguish two groups of cases.
The first group of cases includes situations of unilateral risk
aversion. This may be the case where one of the two parties is a large
contractor with a large portfolio of activities and risk or where one of
the two parties can obtain effective insurance for the risk. Consider the
case where one party, say the promisor or debtor, is risk neutral (hence
) and the other party, the promisee or creditor, is risk averse
(hence ). Promisor and promisee have symmetric information
and thus have similar expectations concerning the risk of frustration or
impossibility. Since the probability of frustration is exogenous and
cannot be influenced by either the promisor’s level of care in the
performance or the promisee’s level of precaution, in this case the
contracting parties would naturally bargain for a no defense in case of
frustration, and adopt similar safeguards to ensure alternative
performance in case of impossibility. This means that in case of failure
to perform, the debtor will have to pay full expectations damages. An
opposite bargained-for solution is to be expected in the converse case of
a risk-averse promisor and a risk-neutral promisee. Here, the promisee
would be the best risk-bearer and thus – if all other conditions apply –
the parties would naturally bargain for a contract with a full frustration
or impossibility defense. The promisee serves as the promisor’s insurer

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for these exogenous risks. Any other allocation of risk (e.g., no
frustration defense or spreading the risk between the parties) would be
Pareto inferior, since both parties could be made better off shifting the
entire risk on the risk-neutral party.
The second group of cases includes situations of bilateral risk
aversion. Unlike the case in which both parties are risk-neutral, where
alternative allocations of the risk will yield identical levels of aggregate
utility (the parties are in fact indifferent to a zero-mean risk and will
thus have no incentive to reallocate risk contractually), when both
parties have some positive level of risk aversion ( and
), the optimal frustration rule is likely to share the risk between
the parties. Since risk aversion induces increasing marginal costs (in
utility terms) with an increase in the value of the risk, parties would
naturally bargain for a risk-sharing solution, with a resulting partial
defense for frustration or impossibility.

2.2 Allocating Risk to Harvest Information

Let’s consider the different group of cases in which the risk is still
exogenous but where the parties have different knowledge about the risk
of frustration or impossibility and/or where they have different
information about the financial consequences of non-performance. In
this case, the person with better information has a higher accuracy in the
estimate of the probability or the financial consequences of frustration.
For the sake of expositional clarity, let’s further assume that both parties
are risk-neutral so that alternative allocations of risk are equally
desirable from the risk-allocation point of view, discussed in Section
2.1. When operating under such an assumption, the only relevant
criterion for choosing among different allocations of risk from
impossibility is the effect that alternative rules may have on the parties’
incentives and ability to reveal information. In the law and economics
literature, this function of conventional allocations of risk is known as
signaling: the choice of frustration rule reveals truthful and credible
information to the other party. This information-harvesting function
materializes in different ways according to which of the two contracting
parties has private information which is not known to the other. In the
following, we consider the three possible combinations of asymmetric
information and the role played by allocations of risk in each situation.

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2.2.1 Frustration Rule as Signal of Promisor’s Confidence

Even though both contracting parties are aware that the probability
of frustration is exogenous and is not influenced by their behavior, they
may have asymmetric information concerning the likelihood of
frustration or impossibility. A promisor may have informational
advantages due to economies of scale in the acquisition of information,
or due to other natural advantages in forming an accurate estimate on
the likelihood of frustration or impossibility of performance as specified
in the contract. For the purpose of our analysis, imagine the simple case
in which different producers are faced with a varying probability of
frustration. In this case, the promisor has better information than the
promisee concerning the realization of conditions of impossibility.
The promisee expects the frustration rate to be equal to the market
average, while the promisor has a more accurate expectation of the
frustration rate for the specific contract. Analytically let us denote with
the average rate of frustration in the market. In presence of
asymmetric information on the promisor’s side, the promisor has a more
accurate knowledge of the probability of frustration in the specific
contract. Let us denote with the probability of frustration of the
contract as estimated by promisor . Promisors may face different
exogenous frustration rates for a number of possible reasons. A
promisor that expects to offer greater reliability compared to the average
market expectation will have ; likewise, a promisor that
estimates a greater risk of frustration compared to the market average
will have . Such asymmetric information creates a problem
that is similar in nature to the lemons problem first considered by
Akerlof (1970). In the presence of asymmetric information, the
promisor’s willingness to be liable (and to add the price of the allocation
of risk to the sale price) is a credible signal of the information available
to the promisor. Through the mechanism of contractual allocations of
risk, individual promisors that face different exogenous probabilities of
frustration will be able to offer observable and credible information to
their promisees. Allocations of risk are a costly and thus credible signal
which creates a separating equilibrium and can thus be seen as valuable
tools to harvest information.

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 From a practical standpoint, the signaling mechanism works
because promisors know (or can more accurately estimate) the actual
probability of defects of their products and can compute the expected
cost of frustration risk. Promisors who face a higher risk of frustration,
, face higher costs for waiving a defense. Assuming
enforceable allocation of risk contracts and assuming away situations of
truncated liability (e.g., bankruptcy or dissolution of the manufacturer’s
company, etc.), each promisor is able to undertake the risk only if he or
she can receive a price at least equal to the expected cost of future
liability claims. This price mechanism will yield a separating
equilibrium such that different types of promisors will be able to offer
different types of coverage for the case of frustration or impossibility
(hence they will choose different frustration rules or similar rules, but
only at different prices). In turn, promisees will be able to infer the
actual type of promisor from the observation of the allocation of risk
that they offer, thus correcting the asymmetric information problem
faced by the contracting parties. In this way, the choice of frustration
rule serves a valuable information-harvesting function in the course of a
transaction. As for the general case, this signaling allows for the
transmission of credible information and it plays the general role of
correcting information asymmetry between parties and facilitating trust.

2.2.2 Frustration Rule as Signal of Promisee’s Sensitivity to Risk

While it is reasonable to assume that the promisor may have an

informational advantage concerning the likelihood of frustration and
events that may cause the impossibility of the contract, it may be natural
to assume that the promisee may have private information concerning
his or her ability to cope with non-performance and the potential harm
that he or she would suffer in case of frustration of the contract.
From an economic point of view, interesting results can be
obtained if the promisee possesses private information that is not
available to the promisor. Following this line of thought, the choice of
allocation of risk will not signal the promisor’s private estimation of the
risk, but rather the content of the private information of the promisee,
namely the expected level of harm that he or she faces in case of
contract frustration. Let’s consider the case in which individual
promisees face different levels of loss in the event of contract

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frustration. Let us denote with the (high) level of loss experienced
by a loss-sensitive promisee in case of frustration, and with the
(low) level of loss faced by a promise with lower sensitivity to
frustration. Let us assume that . If promisors cannot
differentiate a high loss promisee from a low-loss promisee due to
asymmetric information, a single allocation of risk will be offered to all
promisees, based on the average expected loss. However, if frustration
rules are derogable and alternative allocations of risk can be bargained
for, the promisee’s willingness to forego liability coverage in exchange
for a discount can signal the actual level of risk that he or she faces.
Promisees facing a higher risk, i.e. characterized by a loss level equal to
, will bargain for a rule that shields them from the risk of frustration,
while low loss promisees, i.e. characterized by a loss level equal to ,
will prefer to obtain a discount, forgoing full coverage. Also in this
case, the contractual choice of a frustration rule may serve a socially
valuable information-harvesting function.

2.2.3 Frustration Rules as Matching Devices

When both the promisor and the promisee have private information
which is not known by the other contracting party, a bilateral
asymmetric information problem arises. Consider a case where both
information problems illustrated above are present, such that only the
promisor knows the actual probability of frustration, and only the
promisee knows the actual loss faced in case of frustration. Together,
the combined presence of the two asymmetric information problems
poses an interesting coordination problem. As generally shown by
Spence (1977, p. 570) and as discussed by Wehrt (2000, p. 184) for the
case of warranties, the solution of this problem is characterized by the
Pareto optimal matching of different promisors and promises. Promisors
will choose different frustration rules, signaling their private
information concerning the rate of frustration. Promisees will demand
varying frustration rules, signaling their individual risk levels. In
equilibrium, promisors with a higher expectation of frustration (i.e.
) will enter into contracts with promisees who face smaller
individual losses (i.e. facing a loss equal to in case of frustration),
whereas more confident promisors (i.e. ) will enter into
contracts with more sensitive promisees (i.e. characterized by a loss

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equal to ). If a continuous level of signaling is possible, the outcome
will be Pareto-optimal, coinciding with the efficient matching of
individual promisors and promisees that would occur in an ideal world
of truthful disclosure and symmetric or observable information.
It is important to note that when the rules governing the effects of
impossibility or frustration are not derogable by the parties, the
signaling and matching functions discussed above cannot effectively be
fulfilled, since all parties will be subject to such rules and no separating
equilibria could be observed under such regimes.

2.3 Incentives and Moral Hazard

In real life, the probability and financial consequences of frustration

can often be influenced by the behavior of the parties. Promisors can
edge against contingencies that may affect their ability to perform in the
face of unforeseen events through inventory and futures markets.
Promisees can plan ahead to minimize the financial consequences of
frustration. In this setting, we can distinguish three different scenarios:
(a) situations of unilateral incentives where only the promisor influences
the probability of frustration; (b) situations of unilateral incentives
where only the promisee influences the probability of frustration; and
(c) situations of bilateral incentives where both the promisor and the
promisee influence the probability of such event. In all cases of
endogenous risk, allocations of risk operate as incentives for the parties
to invest in order to reduce the risk from impossibility. Allocation of
risk may be seen as an instrument with which the parties control the
efforts of the promisor and promisee to provide all the necessary
conditions for the realization of the contract. Similar to the previous
cases, we will assume in the following analysis that the only
consideration for the choice of a frustration rule given by the effects of
the rule on the incentives of the parties (i.e., we assume away the risk-
allocation and information-harvesting functions of the rule).
The first and most natural case is the case in which only the
promisor can effectively influence the probability of a frustration. In a
unilateral promisor’s incentive case, the only relevant variable is the
effort of such party to reduce the likelihood of negative conditions that
may cause the impossibility of the contract. Analytically, promisor

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can choose an effort level that influences the probability of
frustration The higher is the effort exerted by promisor , the less
likely the frustration of the contract will be. In analytical terms this is
equivalent to assume . In different contexts, the law and
economics literature terms this criterion of allocation of risk as the
“cheapest risk avoider” criterion. The intuition behind this concept is
straightforward. Since the promisor is in the best position to minimize
the risk from impossibility, it is desirable to shift on such party the
financial consequences associated with such event. Any mitigation or
waiver of the promisor’s liability for frustration or impossibility would
undermine the optimal incentives to minimize this endogenous risk.
Situations of unilateral incentives where only the promisee
influences the probability of frustration are probably less frequent but
not impossible occurrences. This situation is modeled analytically as
before, with the only difference that the effort level is chosen by the
promisee. With respect to the choice of frustration the considerations
above apply in the converse. When only the promisee can affect the
probability of a contract’s impossibility or frustration, the rule should be
chosen to create incentives on the promisee to minimize the likelihood
or the economic harm that would follow from frustration. Predictably,
the “cheapest risk avoider” criterion in this case yields the converse
optimal allocation of risk, rendering it desirable to shift on such party
the financial consequences associated with the event of contract
frustration or impossibility. Any alternative rule would reduce or
eliminate the promisee’s incentives with an increase in the endogenous
probability of impossibility or frustration.
It may occur that both the promisor and the promisee are in a
position to influence the probability of contract impossibility or
frustration. Situations of bilateral incentives are the result of a
combination of the two unilateral problems considered above.
Whenever the two incentive problems can be separated, the bilateral
problem can be dealt with as a mere sum of two unilateral problems.
This approach presupposes that it is possible to ascertain ex post
whether a certain condition that materializes and causes the frustration
of the contract is attributable to one or the other party. In this case, the
optimal frustration rule would provide no defense and full promisee’s
coverage for all those risks which are under the control of the promisor

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and would instead provide a full defense for those risks which are
affected by the behavior of the promisee. In the market as we know it,
however, a bilateral precaution problem cannot be easily reduced to the
mere sum of the two elementary unilateral incentive problems. This is
borne out in cases where both parties can influence the frustration or
impossibility of the contract, with no opportunity to establish ex post the
cause of such event. In all such cases where the causal contribution to
the frustration cannot be ascertained ex post, the decoupling solution
considered by Priest (1981) is not viable. In these cases, no first best
outcome can be created by a single frustration rule. A second best
outcome can be pursued through partial allocations of risk and a partial
defense which would leave the parties’ incentives only partially aligned.

3. Legal Solutions from an Economic Perspective

The member countries of the European Union, as is well known,

overcome the problems caused by the occurrence of an unexpected
circumstances by providing several remedies varying from those of
physical or practical impossibility,9 to those of frustration of contract:
Zweckvereitelung, presupposizione, doctrine of assumptions, and so
on,10 to those of economical impossibility: Äquivalenzstörung,11
eccessiva onerosità sopravvenuta, imprévision, etc.
In all of these remedies, it is always necessary that:

9
Impossibility can be divided in three categories: practical impossibility, which is
considered in Austria, Germany, Lithuania, Spain, Italy; legal impossibility, which is
considered in Austria, Germany and Italy; and economic impossibility or commercial
impracticability.
10
Frustration of contract has been codified in several jurisdictions: Greece, Hungary,
Lithuania, the Netherlands, Portugal. In the other jurisdictions, it is recognized at
judicial level (for example, in Italy).
11
The doctrine of Zweckvereitelung and Äquivalenzstörung are part of the general
concept of objektive Geschäftsgrundlage which was first elaborated by Larenz (K.
Larenz, Geschäftsgrundlage und Vertragserfüllung, München-Berlin, 1963; K.
Larenz, Lehrbuch des Schuldrechts, I, München-Berlin, 1962, 230 ss.). This concept
was at first acknowledged by Courts and then by legislator himself, who in 2002
codified it in the German Civil Code. In Austria also, it has been applied but not
codified yet.

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 1) there is an event, subsequent to contract formation12, that
drastically changes the proportion of the performances of the two
parties, making the performance of one party far more burdensome than
it was at the time of contract formation or at worst impossible; This
may happen, for example, when the costs of the performance becomes
extraordinary high, or inflation makes the cost of the labor and materials
far higher;
2) the contingency that causes the alteration is not chargeable to
any of the parties and is extraordinary, exceptional, unforeseeable,
unexpected, etc.; for some Members (especially Italy), it must be
generally true that the event hits all the debtors and is able to affect the
market price of the performance. Examples of extraordinary situations
include high inflation, war, the opening or closing of a market, etc.;
3) finally, it is necessary that the contract is not aleatory and that
the occurrence materializes a risk that parties have not referred to in the
contract, or that one party has to bear; this criterion takes into account
the “normal risk” of a contract, which can be determined by taking into
account what kind of contract parties have entered into (for instance, a
sell between consumers; a sell between professionals; a contract
between a contractor and a contracting firm in order to built a new
house, an oil well, etc.; a contract between a supplier and a client; etc.)
and in what kind of market. For example, in the market of some raw
materials, a fluctuation in price equal to 200% in a very brief period of
time is a frequently recurring situation.13
It is clear that the set of situations considered by the member states
of European Union encompass only cases in which the risk of
frustration or impossibility is exogenous and cannot be influenced,
reduced or minimized by the behavior of the parties. This means that the
allocation of the risk on one or the other party cannot operate as
incentives for the party to invest in order to reduce such a risk.
Furthermore, the scenarios considered generally involve parties with
symmetric information, where neither party has private information
about the probability or the financial consequences of the event.

12
In Sweden, the doctrine of assumptions includes both mistakes on conclusion and
changes in circumstances after the conclusion of the contract.
13
Other requirements may be demanded: for instance, Spain requires that at least one
party has not performed yet.

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 This scenario is similar to what we consider in paragraph 2.1. and
the solution of the risk-allocation problem seems to be found
exclusively on the basis of parties’ attitude towards risk. In case a
contingency occurs, the risk aversion of the promisee calls for full
liability of the promisor; on the other hand, the risk aversion of the
promisor requires that she may be allowed to escape contractual
liability, as discussed in Table 1.
With regards to the set of situations considered by the doctrines of
frustration and impossibility, it is not correct to assume that consumers
are risk-averse, while firms and professionals, who are contractors with
large portfolio of activities and risk, are risk-neutral. As we have seen,
these doctrines requires for their applicability that the unforeseenable
event causes a drastical change of the proportion of the performances of
the two parties, making for instance the performance of one party far
more burdensome than it was at the time of the contract. This means
that if a firm or a professional is held liable and forced to perform or
pay full expectation damages, this loss (which creates a windfall gain
for the other party) would disrupt their economic and financial planning.
This in turn would generate a net welfare loss. In other words, toward
the kind of risk that causes the so called distruption cost (Trimarchi,
2003, 52, 54), neither firms nor professional may be considered risk
neutral.
In Section 2.1, we have further noted that when both parties have
some positive level of risk aversion, the optimal frustration rule is likely
to share the risk between the parties.Yet, it is inefficient and often
impractical to allocate the risk of unexpected contingency at the time
the contract is made. Cooter and Ulen (2008) and Pardolesi (1996, p.
456) have shown that the parties are rational in not discussing and
allocating such remote and improbable risks and so it is efficient for the
parties to ignore them, since the transaction costs involved would not be
justified from an economic point of view, given the low probability of
these events. This idea is related to the necessary incompleteness of
contracts: negotiating the allocation of risks imposes transaction costs
with certainty while the occurrence of the risk is, in our case, remote
and improbable. Parties will leave a gap in their contract if the cost of
allocation of a risk is more than the cost of allocating a loss multiplied
by the probability of a loss, which is the case with highly-improbable
post-contract contingencies. If the probability that the event occurs is

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low, it is less costly for parties to allocate the loss when it occurs than
bear transaction costs with certainty in order to allocate the risk in the
contract. (Shavell, 1980)
For this reason, the remedy of discharge seems to be the only viable
default allocation of the risk between the parties to prevent the net
welfare loss. Both the parties will not be held to perform their obligation
and they shall forgo their right to counter-performance. Many of the
European Countries choose this solution, although by following
different legal constructs or procedure14.
Renegotiation of the contract remains a viable ex post option to
capture the benefits of the original contract whenever appropriate.15
This would allow parties to face the transaction costs of renegotiation to
reallocate the loss only when it materializes.
On the contrary, when the probability and financial consequences
of frustration can be influenced by the behavior of the parties or one or
both of them have information that can affect the accurate estimation of
the probability and financial consequences of the event, the economic
functions of the frustration rules cannot be simultaneously fulfilled and
often hinge upon the use of legal remedies as default rules that are
freely derogable by the parties. When the rules governing the effects of
impossibility or frustration are not derogable by the parties, several of
the functions are compromised for the benefit of other functions (e.g.,
the tradeoff we observed when discussing the risk-allocation and
incentive functions) or entirely lost (e.g., the loss of the signaling and
matching functions observed when the applicable frustration remedies
are made mandatory).

14
France, Belgium, the Czech Republic, Denmark, England, Ireland, Scotland and
Slovenia are inclined to give the burdened party only the remedy of discharge.
15
Austria, Germany, Greece, Hungary, Italy, Lithuania, the Nederland, Portugal, Spain
and Sweden leave a room for the renegotiation or adjustment of the contract. In Italy,
first the burdened party asks for the termination of the contract, and then the other
party may offer an adjustment of the contract; under Austrian law, Wehfall/Fehlen der
der Geschäftsgrundlage entitles the disadvantaged party to either terminate the
contract or to claim adjustment, in this case only if both parties would have concluded
the contract with this different content had they anticipated the change of
circumstances; etc.

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