Chapter 8

An Economic Theory of Contract Law

This may be the most challenging chapter in the text. One way of preparing the students for the material
is to review the material in Chapter 2 on game theory. Here is a very effective way to introduce that subject.
Imagine (or even play with the students) a game in which there are two players. Each player receives two
cards—one saying “Give me $1”; the other saying, “Give my opponent $5.” Tell the players not to
communicate with one another. They must choose one of the two cards and return it to you. You will then
do what the cards instruct you to do. So, if Player 1 returns “Give me $1” and Player 2 returns “Give my
opponent $5,” you will give Player 1 $6, and Player 2 will receive nothing. Let the students play the game
or have them draw up the payoff matrix for the game. They should see that this is a prisoner’s dilemma game
in which the players would do better to cooperate but are driven, by a dominant strategy, not to cooperate—
that is, to play the “Give me $1” card. You might even let the students communicate so as to show that
there may be defection (because “Give me $1” is still a dominant strategy). Finally, you might ask the
students to think how players who recognize that a game is a prisoner’s dilemma might change the payoffs
so as to induce themselves to cooperate.

Familiarity with game theory—perhaps through this introductory game—will greatly enhance the students’
understanding of the chapter. A central theme of the chapter is the extent to which the law can help to solve
the coordination problem between potential contracting parties. They may want to make mutually beneficial
promises that bind themselves to certain actions and induce reliance by the other party, but, in the absence
of an inexpensive method of allowing parties to make a credible commitment, it may not be easy to
achieve this commitment and reliance.

Another important theme of the chapter is that the law can assist parties to form these consensual agreements
by providing a set of default and mandatory rules that greatly reduce the costs of achieving an agreement.
This distinction between default rules and mandatory rules is very useful and a rich explanatory tool. When
you come to examine the set of rules that constitute contract law, be sure to ask the students if each of them
is a default rule or a mandatory rule. Note that there are two general kinds of default rules—majoritarian
and penalty. Majoritarian are the starting points that most people would want. By denominating those as
the default rules, the law saves most people the costs of changing to something more desirable. Rather,
the minority who prefers some other arrangement to that of the default rule will have to incur the costs of
contracting around the default. A penalty default is a default rule that will, unless changed, impose a penalty
on one of the parties if he withholds pertinent information.

Mandatory rules may not be changed, even by mutual consent. A principal justification for them is
paternalism. A good example of a potential problem that mandatory rules create is the mandatory rule that
(in almost all cases) minor children cannot make a binding contractual promise. (There is an exception that
we will come to in a moment.) That means that not even a competent minor child can waive this rule. Why?

The exception to the mandatory rule regarding minor children is that they can make binding promises with
respect to necessities such as food, shelter, and clothing. Why should there be this exception?

©2012 Pearson Education, Inc. Publishing as Addison Wesley

62 Cooter/Ulen • Law & Economics, Sixth Edition

One last thing to bear in mind. Efficiency in contract law requires efficiency at three different stages of
the contractual relationship: at the time the agreement is formed, during the time between formation and
performance when the parties need to rely upon one another, and, finally, at the time that the parties must
choose to perform or to breach. We find that one of the most challenging aspects of the theory presented
in this chapter is the economic theory of reliance. That is, we believe, a very subtle and powerful theory.

◼ Additional Topics
Third-party effects are sometimes at issue when a commercial contract threatens harm to a business rival
of one of the parties to the contract. Such a rival may be led to take action interfering with the performance
of the contract. Such actions are often discussed under the doctrine of “inducement to breach.” Third-party
effects of this sort also form part of what is known as an “economic tort.”

A recent example comes from the world of professional sports. The professional baseball team in San
Francisco, the Giants, plays their home games in a stadium, CandlestickPark, that is frequently cold and
rainy, which discourages paying customers from coming to the games. The City of San Francisco owns
Candlestick and has leased it to the Giants under a long-term contract. The Giants considered moving to
a different city, which would involve breaching their lease with the City of San Francisco. For the Giants
to move, three-quarters of the owners of National League baseball teams have to approve the change.
The City Attorney of San Francisco wrote to all the other owners of National League baseball teams to
tell them that if they voted to approve the Giants’ move from San Francisco, the City might sue them for
inducement to breach the Candlestick lease.

Another example comes from labor law. Unions wish to assist each other through “secondary boycotts.”
To illustrate such a contract, the teamsters might promise to boycott any steel factory struck by the steel
workers, and the steel workers might promise to boycott any trucking company struck by the teamsters.
Even before secondary boycotts were forbidden by statute, the courts were reluctant to enforce such
contracts that “derogate public policy.” Is this the right stance?

Question: Suppose that a computer company exchanges the following letters with a potential client. On
May 10 the computer company mails a “firm offer” to sell a particular machine to the client at a specified
price. On May 11 the computer company sells the machine to someone else and mails a letter to the original
client withdrawing the firm offer. On May 12 the original client receives the firm offer, decides to accept,
and mails back his check. On May 13 the client receives the notice of withdrawal and sues the computer
company, alleging breach of contract.

Should the court interpret the “firm offer” as an enforceable promise? How would the bargain theory
answer this question? When the offer was first made, would the parties—the computer company and
the client—both want it to be enforceable?

◼ Gift Promises
To see the evidentiary argument against the enforceability of gift promises, we must return to the
issue of consideration. Why did the classical theory require consideration as a necessary condition for the
enforceability of a promise? It has been argued that consideration in and of itself is not really that important.
Rather, its principal function is to serve as a reasonably reliable signal for distinguishing those promises
that both parties want enforced from those that they do not. That is, consideration is a formal indicator of
serious intent. Presumably, some other such indicator—say, a notary public’s seal or some public ritual—
could serve the same distinguishing function just as well. How does this apply to the enforceability of gift
promises? The argument is that there is no obvious formal indicator of serious intent on the part of the

©2012 Pearson Education, Inc. Publishing as Addison Wesley

 Chapter 8 An Economic Theory of Contract Law 63

promisor who truly wants to give a gift in the future and to be bound to that promise. Thus, it is difficult
for the law to distinguish between a donor who truly desires to be held to his desire to give a gift and one
who is merely masquerading as a generous donor. We might characterize this argument in economic terms
as saying that the costs of distinguishing between serious and nonserious gifts are so high that, in general,
gift promises should not be enforceable, so as to save society the costs of drawing this distinction.
But is this argument against the enforceability of promises to give a gift persuasive? No. The argument
presumes, without proof, that the costs of drawing the distinction between gifts that the donor truly wants
to make and those that he does not really want to make (but wishes to be seen as wanting to make) are high
when, in fact, they may be trivial. Indeed, some legal systems have developed an inexpensive procedure
for making the distinction. The continental civil law countries typically allow gift promises to be enforceable
if they have been formalized by a notary public’s seal.
A second argument that is sometimes made for nonenforceability of promises to give a gift is that the losses
that result from nonenforceability are relatively slight. Because the resources of courts are scarce, they ought
to be relieved of the burden of trying to distinguish good from bad gift promises so that they can focus their
attention on more serious issues where the potential benefits are larger. Moreover, the argument continues,
those donors who truly want to be bound to their promise to give a gift will find ways to formalize their
intent—in essence, they will find a way to convert an unenforceable gift promise into an enforceable
promise. (How might that be done?)

The first part of this argument sounds a little hollow. There is no compelling reason to believe that the
benefits that parties realize or anticipate from the completion of a promise to give a gift are trivial. Indeed,
it is easy to imagine promises to give millions of dollars where the anticipated benefits to both donor and
donee are immense. Additionally, the bargain theory does not reserve enforceability to those reciprocal
promises for which the benefits are large. Rather, it argues for the routine enforcement of trivial bargains,
just so long as they are bargains. If this justification for not enforcing gift promises were to be consistent,
then we should also exclude from enforcement those bargain promises where the benefits are very small.
A third argument for the general nonenforceability of gift promises is that those who promise gifts are
frequently operating under an impulse that, upon reflection, they might wish to renounce. For example,
the uncle who promised his nephew the trip might have done so in an ebullient mood at a family gathering;
the alumna who promises to giver her alma mater a large sum of money might have done so in an emotional
and vulnerable moment at a class reunion. Later, both donors might not wish to be held to these impulsive
acts. The general nonenforceability of gift promises, the argument goes, protects parties from being held to
complete impulsive acts. But, again, this argument does not seem persuasive. Bargains can also be impulsive,
and yet we routinely enforce them whether impulsive or not.

We are led to conclude that the rule proposed in §90 of the Restatement is a sound one. That is, the
economic theory of contracts argues for the general enforceability of promises to give a gift where
the donee reasonably relied to her detriment on the donor’s intention to fulfill the promise.
Let us make one last economic argument for the enforceability of gift promises according to the rules of §90
of the Restatement. (See box below.) The argument is that enforceability according to those terms encourages
efficient behavior by both donor and donee. Suppose, first, that gift promises are not, as under the bargain
theory, enforceable. A donor who really wants to be taken seriously by a donee must incur extraordinary
costs of convincing the donee of his intent to be bound so that the donee may rely upon his fulfilling the
promise. For example, she might put the money she intends to give to the donee in the hands of a third party
with irrevocable instructions to give it to the donee at some future date. These extra costs of giving a gift
would not be necessary if the promise were enforceable. For his part, a donee who cannot be certain that a
promise to give a gift is enforceable may not be able to take action in reliance upon the gift. The direct
and indirect costs of this inability to rely may be substantial and constitute a further inefficiency of the
nonenforceability of gift promises.

©2012 Pearson Education, Inc. Publishing as Addison Wesley

64 Cooter/Ulen • Law & Economics, Sixth Edition

Now suppose that all gift promises are enforceable. This, too, would be inefficient. Donors would be
excessively careful about what they say—perhaps ending each statement with a disclaimer that they
make no promise, express or implied. Donees might over-rely—that is, undertake too many or too
expensive decisions in reliance upon the promise’s being performed.

Neither of these extremes—never enforce or always enforce a gift promise—is efficient; each involves
inefficiencies by donors or donees. The virtue of the enforceability criteria of § 90 of the Restatement is
that they create efficient incentives for promising by donors and for reliance by donees. Those donors
who would like to be taken seriously can do so without incurring extraordinary costs, and frivolous donors
are discouraged. Those donees who would like to rely are encouraged to do so but only up to a reasonable
amount, thus discouraging overreliance.

Question: Can you argue that the §90 rule for the enforceability of gift promises efficiently allocates the
risk of performance and nonperformance between the donor and the donee? What might be the effect of
proposing general enforceability but not requiring that the donee detrimentally rely? Would you expect
donees to over-rely on a gift promise, relative to what a donor wishes?

The following problem and solutions are used with the permission of Professor Gillian Hadfield, now of
the University of Southern California Gould School of Law.

Efficient Breach Example

Spud Co. is a dealer in potatoes. Chip Co. makes potato chips. On Monday, Spud and Chip enter into a
contract in which Spud agrees to deliver 100 bushels of potatoes to Chip on Friday; Chip agrees to pay
Spud $2.00 per bushel.

Spud’s cost of growing and delivering potatoes = $100.

Chip’s cost of converting potatoes into chips = $100, $25 of which must be spent on Friday morning before
the potatoes are delivered and which cannot be recovered if no potatoes arrive.

If no potatoes arrive on Friday, Chip must wait until Monday to call around to alternative suppliers to
purchase potatoes. The price of potatoes on this “spot” market is $3.00 per bushel. The price of potato
chips is $4.00 per bushel.

Variation 1: Assume for this variation that Chip paid for the potatoes at the time the contract was signed.
Just before delivering the potatoes to Chip at noon on Friday, Spud receives a frantic phone call from
Babette, the chef at Chez Babette. She has discovered that the potatoes she bought from someone else are
rotten and she needs 100 bushels immediately to make her famous vichyssoise (a fancy name for cold potato
soup) that weekend. She is willing to pay $5.00 per bushel as she cannot wait till Monday to buy potatoes
on the spot market.

Is breach efficient? Under what measures of damages will efficient breach be achieved?

Variation 1A: Same as 1 but Babette offers $3.00/bushel.

©2012 Pearson Education, Inc. Publishing as Addison Wesley

 Chapter 8 An Economic Theory of Contract Law 65

Variation 2: Assume for this variation that Chip agreed to pay for the potatoes C.O.D. On Thursday, Chip
is shut down for health code violations and will not be able to reopen for two months while it renovates its
production facilities to bring them up to code. It therefore has no use for the potatoes to be delivered on
Friday. If Chip performs by taking delivery of the potatoes, they will go to waste. If Chip breaches, it will
refuse to accept delivery. Spud, as dealer, can sell the potatoes to someone else for $1.50 a bushel.

Is breach efficient? Under what measures of damages will efficient breach be achieved?

Efficient Precaution/Efficient Reliance Example

Spud Co. v. Chip Co. continued

Variation 3: This variation is the same as Variation (2), in which Chip Co. is shut down for health violations
but now Spud Co. spends money in reliance on the contract. Suppose that Chip Co. is in a location that is
hard to find. Of Spud’s delivery costs, $10 is spent getting precise directions over the phone from Spud and
communicating these to the delivery person. The remaining costs of production and delivery are $90. The
total cost of production and delivery is therefore $100.

In this variation, Chip Co. can take the following steps to minimize or eliminate the risk of being shut down
for health code violations.

Level of Precaution Prob. of Shut Down Cost of Precaution

1 50% $ 0
2 10% $50
3 0% $75

If Chip gets shut down by the health officials, Chip will breach the contract, in which case Chip’s cost will
equal expenditure on precaution plus damages to Spud. If Chip breaches, Spud will lose the $10 invested
in specific directions to reach Chip and then Spud will pay $100 in production and delivery costs for potatoes
selling for $150. Under which measure of damages (restitution, reliance, expectation) will Chip Co. engage
in efficient precaution?

Variation 4: This variation is the same as Variation (3) except now Spud Co. has a choice about how much
money to spend in reliance on the contract. To guarantee that the driver doesn’t get lost, Spud Co. can
send someone out to test the directions taken down over the phone and to make additional notes about the
landmarks, confusing parts of the route, etc. This person’s time costs Spud an additional $20, so that the total
amount invested in finding the route to Chip Co. is $30. However, since this person’s time is less expensive
than the driver’s time plus the truck rental time, eliminating any risk the driver will get lost reduces the
remaining costs of delivery to $60. Total delivery cost is therefore $90.

Is it efficient for Spud Co. to invest the additional $20 in reliance?

Under which measures of damages (if any) will Spud Co. engage in efficient reliance?

©2012 Pearson Education, Inc. Publishing as Addison Wesley

66 Cooter/Ulen • Law & Economics, Sixth Edition

Answers to Spud v. Chip

Variation 1: Perform: Spud profit = 200 − 100

Chip = 400 − 200 − 100 = 100
Joint = 200

Breach: Spud: 500 − 100 + 200 = 600

Chip: 400 − 300 − 100 − 25 − 200 = −225
Joint: 375
Breach is efficient

Damages: Restitution = $200

Reliance = $225
Expectation = $325

Spud’s breach decision: Perform profit = 100

Breach profit = 600 − D
Breach under all measures—efficient

Variation 1A: Perform: Joint Profit = $200

Breach: Spud profit = $400
Chip profit = −$225
Joint = $175
Breach not efficient

Damages as in 1
Spud’s breach decision: Perform profit = $100
Breach profit = $400 − D
Efficient breach only under expectation damages

Variation 2: Perform: Spud profit = $100 = [−100 + 200]

Chip profit = $−200
Joint = $−100
Breach: Spud profit = $50 = [−100 + 150]
Chip profit = $0
Joint = $50
Breach efficient

Damages: Restitution = 0
Reliance = 0
Expectation = $50
Chip’s breach decision: Perform profit = −$200
Breach profit = −$D
Efficient breach under all measures

©2012 Pearson Education, Inc. Publishing as Addison Wesley

 Chapter 8 An Economic Theory of Contract Law 67

Variation 3:

Perform (no shutdown) Breach Expected Profit

Spud −100 + 200 = 100 −10 − 10 + 150 = 40
Chip 1 −100 − 200 − 0 + 400 = 100 0 120 = 0.5(200) + 0.5(40)
2 −100 − 200 −50 + 400 = 50 −50 134 = 0.9(150) = 0.1(−10)
3 −100 − 200 −75 + 400 = 25 125 = 100 + 25

Expected joint profit Level 1 = 120 1/2(200) + 1/2 (40)

Level 2 = 139 0.9(150) + 0.1(4) = 139
Level 3 = 125

Level 2 is optimal level of precaution

Chip’s precaution decision: Level 1 profit = 50 − D/2

Level 2 profit = 40 − D/10
Level 3 profit = 25
Damages: Restitution = $0; Level 1 (also excuse result)
Reliance = $10; Level 1
Expectation = $60; Level 2—efficiency

Variation 4: Discretionary reliance investment = $20

Suppose Level 1 precaution taken, expected return
from increased investment = 0.5  $30 (savings)
= $15
increased investment inefficient

Spud’s reliance decision:

Invest profit = 0.5(110) + 0.5(20 + DI)
= 65 + DI/2
Don’t invest = 0.5(110) + 0.5(40 + DDI)
= 75 + DDI/2

Damages: Restitution = 0; Don’t invest; efficient

Any fixed DI = DDI efficient
Reliance: DI = $30
DDI = $10
Invest inefficiently (guaranteed I)
Expectation: DI = $90
DDI = $60
Invest inefficiently (guaranteed I)

©2012 Pearson Education, Inc. Publishing as Addison Wesley