The design and interpretation of contracts: Why complexity matters

Northwestern University Law Review

Volumn 95, Issue 1, 2000, Pages 91-132

  Eggleston, Karen ^a   Posner, Eric A ^a   Zeckhauser, Richard ^a  

^a NONE

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EID: 0038564041     PISSN: 00293571     EISSN: None     Source Type: Journal    
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References (151)

1. Assistant Professor of Economics, Tufts University.
2. Professor of Law, University of Chicago.
3. Frank Plumpton Ramsey Professor of Political Economy, Kennedy School of Government, Harvard University. Thanks to Ian Ayres, Lucian Bebchuk, Virginia Coleman, Richard Craswell, Oliver Hart, Christine Jolls, Louis Kaplow, Richard Posner, Eric Rasmusen, Thomas Schelling, Alan Schwartz, Cass Sunstein, and George Triantis, and members of audiences at the University of Chicago Law School, Tufts University, and Harvard Law School, for valuable comments. Posner thanks The Sarah Scaife Foundation Fund and The Lynde and Harry Bradley Foundation Fund for generous financial support.
4. Some of these same factors (e.g., asymmetric information) can push toward complexity in some circumstances as well. See infra Part III.
5. The law and economics literature is produced mainly by law professors, including some economists who teach at law schools, and appears mainly in law reviews. The economics of contracts literature is produced mainly by economists who teach in economics departments, and appears mainly in economics journals. Citations to both literatures can be found below.
6. See, e.g., Ian Ayres & Robert Gertner, Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules, 101 YALE L.J. 729, 730-31 (1992).
7. See Avery Katz, Taking Private Ordering Seriously, 144 U. PA. L. REV. 1745 (1996).
8. Observers sometimes wonder whether courts strike down contracts with apparently one-sided terms because they do not understand the purpose of these terms. In such cases as Britton v. Turner, 6 N.H. 481 (1834) (involving an employment contract that delayed pay until the end of term) and Williams v. Walker-Thomas Furniture, 350 F.2d 445 (D.C. Cir. 1965) (involving a consumer credit contract with a cross-collateral clause), the courts might not have understood the economic purposes behind the terms that they criticized.
9. See BOSTON SOCIETY OF ARCHITECTS, OWNER, ARCHITECT, CONTRACTOR RELATIONSHIPS: A PROJECT GUIDE (1987).
10. See infra subpart II.B.
11. Interestingly, at the moment Jim is once again under the employ of the same author to remodel two bathrooms. But on this project he is working on an hourly basis. Implicitly, the parties have recognized the virtue of a simple contract.
12. Bajari & Tadelis cite numerous empirical studies that confirm that simple cost-plus or fixed price contracts are prevalent in the private sector construction industry; mixed or incentive contracts are rare. Patrick Bajari & Steven Tadelis, Incentives Versus Transaction Costs: A Theory of Procurement Contracts (1999) (unpublished manuscript, on file with authors); see also Business Roundtable, Contractual Arrangements, CICE Project A-7 (last modified Dec. 1987) 〈http://www.brtable.org/pdf/141.pdf〉.
13. For example, the FDIC and Cravath, Swain and Moore's fee arrangement in connection with the Savings and Loan affair provided for payment of $300 per hour plus an amount that was an increasing function of the damages that Cravath recovered for the FDIC. As a consequence, senior litigators could earn as much as $600 per hour if they were successful, while their ordinary hourly rate was $375 to $400. See Stephen Labaton, For F.D.I.C.'s Top Law Firm, Fees Reaching $600 an Hour, N.Y. TIMES, April 5, 1991, at A1.
14. Nonunion employment contracts are generally quite simple, often stating only that the employee "has a job at a particular (current) wage." Oliver Hart and Bengt Holmstrom, The Theory of Contracts, in ADVANCES IN ECONOMIC THEORY 5TH WORLD CONGRESS 71, 126 (T. Bewley ed., 1987). An empirical study of a single firm's wage policy over 20 years and involving more than 60,000 observations, found that it was "less sensitive to individual differences than typical incentive theories would prescribe." George Baker et al., The Wage Policy of a Firm, 109 Q.J. ECON. 921, 953 (1994).
15. Nonunion employment contracts are generally quite simple, often stating only that the employee "has a job at a particular (current) wage." Oliver Hart and Bengt Holmstrom, The Theory of Contracts, in ADVANCES IN ECONOMIC THEORY 5TH WORLD CONGRESS 71, 126 (T. Bewley ed., 1987). An empirical study of a single firm's wage policy over 20 years and involving more than 60,000 observations, found that it was "less sensitive to individual differences than typical incentive theories would prescribe." George Baker et al., The Wage Policy of a Firm, 109 Q.J. ECON. 921, 953 (1994).
16. See Joseph P. Newhouse, Reimbursing Health Plans and Health Providers: Efficiency in Production Versus Selection, 34 J. ECON. LIT. 1236 (1996).
17. Abhijit V. Banerjee & Esther Duflo, Reputation Effects and the Limits of Contracting: A Study of the Indian Software Industry, 115 Q.J. ECON. 989 (2000).
18. Franklin Allen & Douglas Gale, Measurement Distortion and Missing Contingencies in Optimal Contracts, 2 J. ECON. THEORY 1, 2 & n.2 (1992).
19. Discussion with Gretchen Court, casting director (November 25, 1998) and review of a number of contracts. The role of lawyers as specialized agents, and its relationship to the complexity of contracts, merits its own analysis. We note only a few important issues. The tendency of lawyers to imitate prior contracts increases the prevalence of boilerplate terms. Lawyers' professional training and experience will often make them more sensitive to the need to protect against breach of contract, and less sensitive to the need to signal trustworthiness and assure that the initial deal is signed, than are the principal contracting parties. Lawyers may view adding many contingencies to the contract as their professional and ethical responsibility, whereas the cost of such detail is of little concern to them. Indeed, financial incentives are often to increase complexity to justify more income. In these and in other ways, there will be a divergence between the incentives of the contracting principals and their specialized legal agents, with important implications for the complexity of resulting contracts.
20. Banerjee & Duflo find that despite the simplicity of the ex ante formal contracts in the Indian software industry, as the projects unfold renegotiation results in behavior that is highly contingency-specific. Banerjee & Duflo, supra note 16. Although the party that initially is assigned all of the cost overrun risk does end up bearing the majority of that risk, there is substantial cost sharing: "when [firms] have a fixed price contract [which assigns 100% of cost overrun risk to the firm], they bear on average 66 percent of the overrun . . . when they have a time and materials contract, they bear on average 26 percent of it." Id. at 1003. Thus, relatively simple contracts may guide fairly complex transactions as the contracts are modified and renegotiated over the course of the relationship.
21. See J. Barkley Rosser, Jr., On the Complexities of Complex Economic Dynamics, 13 J. ECON. PERSP. 169, 170 (1999).
22. There have been several attempts by legal scholars to analyze the complexity of laws, as opposed to the complexity of contracts. See Eric Kades, The Laws of Complexity and the Complexity of Laws: The Implications of Computational Complexity Theory for the Law, 49 RUTGERS L. REV. 403 (1997); Louis Kaplow, A Model of the Optimal Complexity of Rules, 11 J.L. ECON. & ORG. 150 (1995); Peter H. Schuck, Legal Complexity: Some Causes, Consequences, and Cures, 42 DUKE L.J. 1 (1992). Their definitions of complexity overlap with ours, but the focus of their arguments is very different.
23. There have been several attempts by legal scholars to analyze the complexity of laws, as opposed to the complexity of contracts. See Eric Kades, The Laws of Complexity and the Complexity of Laws: The Implications of Computational Complexity Theory for the Law, 49 RUTGERS L. REV. 403 (1997); Louis Kaplow, A Model of the Optimal Complexity of Rules, 11 J.L. ECON. & ORG. 150 (1995); Peter H. Schuck, Legal Complexity: Some Causes, Consequences, and Cures, 42 DUKE L.J. 1 (1992). Their definitions of complexity overlap with ours, but the focus of their arguments is very different.
24. There have been several attempts by legal scholars to analyze the complexity of laws, as opposed to the complexity of contracts. See Eric Kades, The Laws of Complexity and the Complexity of Laws: The Implications of Computational Complexity Theory for the Law, 49 RUTGERS L. REV. 403 (1997); Louis Kaplow, A Model of the Optimal Complexity of Rules, 11 J.L. ECON. & ORG. 150 (1995); Peter H. Schuck, Legal Complexity: Some Causes, Consequences, and Cures, 42 DUKE L.J. 1 (1992). Their definitions of complexity overlap with ours, but the focus of their arguments is very different.
25. We propose the following metric for this dimension of complexity: (1) Order the future states of the world specified in the contract according to decreasing probability of occurrence, with the most likely state labeled 1, the second most likely state labeled 2, and so on; (2) multiply the numerical label for each state by the ex ante probability of that state materializing, and sum over all states. The resulting weighted sum is a useful ordinal proxy for the complexity of the contract in terms of expected number of contingencies. To illustrate, consider contracts A and B above. A's score would be 1*(0.9) + 2*(0.1) = 1.1, whereas B would score 1*(0.5) + 2*(0.5) = 1.5. Contract C, with three equally likely states would score 1*(0.33) + 2*(0.33) + 3*(0.33) = 2, and would be more complex than B. When states are equally likely to occur (as in contracts B and C), one can flip a coin to determine which is labeled "more likely"; the result will be unaffected. The complexity comparison is more challenging when the contract with more states has a less even distribution of likelihood among states. The first factor suggests it is more complex, the second factor that it is less complex. Some quantitative measure, such as our formula, must balance the two.
26. Payment variability will have a greater impact on contract complexity when contracting parties have more discretion to change or tailor behavior in response to that variability. If risk aversion is a concern, variability should be measured on some scale relative to the parties' wealth, as a gauge of their concern with it.
27. Of course, what person A finds cognitively challenging may seem straightforward to B, and vice versa. In some circumstances A and B may enter into a contract of such complexity that neither fully understands all of its details.
28. See Alan Schwartz, Incomplete Contracts, in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 277 (Peter Newman ed., 1998) [hereinafter Schwartz, Incomplete Contracts]; George G. Triantis, The Relevance of Unforeseen Contingencies in Commercial Contracting, in THE ENCYCLOPEDIA OF LAW AND ECONOMICS (Boudewijn Bouckaert & Gerrit De Geest eds., 2000).
29. See Alan Schwartz, Incomplete Contracts, in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 277 (Peter Newman ed., 1998) [hereinafter Schwartz, Incomplete Contracts]; George G. Triantis, The Relevance of Unforeseen Contingencies in Commercial Contracting, in THE ENCYCLOPEDIA OF LAW AND ECONOMICS (Boudewijn Bouckaert & Gerrit De Geest eds., 2000).
30. See Alan Schwartz, Incomplete Contracts, in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 277 (Peter Newman ed., 1998) [hereinafter Schwartz, Incomplete Contracts]; George G. Triantis, The Relevance of Unforeseen Contingencies in Commercial Contracting, in THE ENCYCLOPEDIA OF LAW AND ECONOMICS (Boudewijn Bouckaert & Gerrit De Geest eds., 2000).
31. Oliver Hart & John Moore, Foundations of Incomplete Contracts, 66 REV. ECON. STUD. 115, 134 (1999). We use the term "p-incomplete" to stress its meaning, the absence of p-completeness. The term "perfectly incomplete," which we do not use, misleadingly suggests that the contract has no terms!
32. In this paper we use "he" for party A, employers and buyers, and "she" for party B, employees and sellers.
33. If the price difference is greater than 3, she will provide the premium widget in the cheap state. If it is less than 5, she will not provide it in the expensive state. Both of these outcomes are inefficient Hence, the price must simultaneously be 3 or less and 5 or greater, which is impossible.
34. For an example of an f-incomplete contract, imagine that there is a third state, under which both normal and premium widgets are very expensive, and that this state is distinguishable from the other two (nondistinguishable) states. An f-complete contract would contain different obligations for the cheap and expensive set of states, on the one hand, and for the very expensive state, on the other; an f-incomplete contract would not distinguish the very expensive state from the other two states.
35. In the example given in Table 2, the p-complete contract involves more states of the world (2) than the f-complete contract (1), but has less variable net payoffs to the players, and is simpler to specify, i.e., imposes less cognitive load at the drafting stage. Thus, p-complete contracts will often be more complex on our first dimension, number of relevant states, since more states can be distinguished. They will generally be less complex on our third dimension, since f-complete contracts involve consideration of the probabilities of alternative states that are nonverifiable both in drawing the contract and in deciding how to act under the contract. As more states are added, p-complete contracts remain conceptually simple; they merely compute what is best for each possible state. By contrast, f-complete contracts can become extremely complicated, possibly because each player has to draw inferences about the likelihood of alternative states from the actions of the other.
36. We emphasize that it is important to judge a contract relative to the contracting environment. Consider a world in which there are three Environments, 1, 2, and 3, ranked in order of increasing complexity. In Environment 1, a simple single clause in a contract will be sufficient to cover obligations efficiently 100% of the time; in Environment 2, the same contract will cover obligations 99% of the time; and in Environment 3 that contract will cover obligations only 20% of the time. A contract that includes only a single simple clause can be p-complete (and therefore f-complete) in Environment 1 - i.e., it would be a type "A" contract in Table 2. In the other two Environments, such a contract would necessarily be p-incomplete. Nevertheless, the single clause contract is closer to complete in Environment 2 than it is in Environment 3. A complex contract, which would add multiple clauses to the simple one, could be p-complete in any of the Environments, although the complexity would be useless in Environment 1. Thus, both completeness and complexity fall along a continuum, and for both concepts it is important to judge a contract in expected value terms (i.e., weighting contingencies by their ex ante probabilities).
37. See OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM (1985); Ronald H. Coase, The Nature of the Firm, 4 ECONOMICA 386-405 (1937). Transaction costs are frequently seen as the primary or even sole reason for contractual incompleteness. See Schwartz, Incomplete Contracts, supra note 25, at 280. To the extent that some terms may become verifiable at a given cost, whether a contract is functionally complete may also depend on transaction costs.
38. See OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM (1985); Ronald H. Coase, The Nature of the Firm, 4 ECONOMICA 386-405 (1937). Transaction costs are frequently seen as the primary or even sole reason for contractual incompleteness. See Schwartz, Incomplete Contracts, supra note 25, at 280. To the extent that some terms may become verifiable at a given cost, whether a contract is functionally complete may also depend on transaction costs.
39. See OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM (1985); Ronald H. Coase, The Nature of the Firm, 4 ECONOMICA 386-405 (1937). Transaction costs are frequently seen as the primary or even sole reason for contractual incompleteness. See Schwartz, Incomplete Contracts, supra note 25, at 280. To the extent that some terms may become verifiable at a given cost, whether a contract is functionally complete may also depend on transaction costs.
40. See OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE 5 (1995); JEAN-JACQUES LAFFONT & JEAN TIROLE, A THEORY OF INCENTIVES IN PROCUREMENT AND REGULATION (1993); BERNARD SALANIE, THE ECONOMICS OF CONTRACTS 128-29 (1997).
41. See OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE 5 (1995); JEAN-JACQUES LAFFONT & JEAN TIROLE, A THEORY OF INCENTIVES IN PROCUREMENT AND REGULATION (1993); BERNARD SALANIE, THE ECONOMICS OF CONTRACTS 128-29 (1997).
42. See OLIVER HART, FIRMS, CONTRACTS, AND FINANCIAL STRUCTURE 5 (1995); JEAN-JACQUES LAFFONT & JEAN TIROLE, A THEORY OF INCENTIVES IN PROCUREMENT AND REGULATION (1993); BERNARD SALANIE, THE ECONOMICS OF CONTRACTS 128-29 (1997).
43. A general discussion, with citations to the large literature, can be found in DAVID M. KREPS, A COURSE IN MICROECONOMIC THEORY ch. 16 (1990).
44. See, e.g., ANDREU MAS-COLELL ET AL., MICROECONOMIC THEORY ch. 14 (1995).
45. See id.
46. See, eg., Federal Trade Commission, 16 C.F.R. § 444 (2000) (prohibiting certain contractual provisions that facilitate collection of debts).
47. By contrast, in areas where these rules are liberally construed, parties can enter simple contracts on the assumption that courts will complete the contract by deriving optimal terms from precontractual evidence. Of course, this assumes that the parties think that courts will do a good job. If they think courts are likely to misunderstand the precontractual negotiations, they will add merger clauses, which state that no precontractual promises are enforceable.
48. The classic case is Henningsen v. Bloomfield Motors, Inc., 161 A.2d 69 (N.J. 1960) (striking down a warranty disclaimer in part because it was hard to understand).
49. See, e.g., Gianni Sport Ltd. v. Gantos, Inc., 391 N.W.2d 760 (Mich. 1986) (holding unconscionable a termination clause in a contract between two merchants).
50. An expert on doing business in Argentina advises American business that "relatively sophisticated" Argentine buyers are likely to "prefer to sign complicated documents in English rather than a simple draft," because "if a detailed and complex English contract is used for a sale, the buyer can easily claim a lack of understanding of the contract," and thus be able to escape liability for breach in Argentine courts. Lewis Flax, Handling Credit and Collection Issues When Exporting to Argentina, in MANAGING INTERNATIONAL CREDIT AND COLLECTIONS 1 (May 1999).
51. Such provisions protect the power of unions and make it difficult for employers to differentiate among employees in ways that would undermine solidarity. For example, they prevent an employer from offering the better employees a superior contract, which would reduce the bargaining power of the union for the worse employees.
52. See RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 104-05 (5th ed. 1998); Steven Shavell, Contracts, in 1 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 436, 438 (Peter Newman ed., 1998); Ronald A. Dye, Costly Contract Contingencies, 26 INT'L ECON. REV. 233, 234 (1985).
53. See RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 104-05 (5th ed. 1998); Steven Shavell, Contracts, in 1 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 436, 438 (Peter Newman ed., 1998); Ronald A. Dye, Costly Contract Contingencies, 26 INT'L ECON. REV. 233, 234 (1985).
54. See RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 104-05 (5th ed. 1998); Steven Shavell, Contracts, in 1 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 436, 438 (Peter Newman ed., 1998); Ronald A. Dye, Costly Contract Contingencies, 26 INT'L ECON. REV. 233, 234 (1985).
55. See, e.g., American Trading & Prod. Corp. v. Shell Int'l Marine Ltd., 453 F.2d 939 (2d Cir 1972).
56. See Alan Schwartz & Louis Wilde, Intervening in Markets on the Basis of Imperfect Information: A Legal and Economic Analysis, 127 U. PA. L. REV. 630 (1979).
57. See HART, supra note 33, at 5; Schwartz, Incomplete Contracts, supra note 25, at 280. As a result, complex contracts should be associated with thin markets. When markets are robust, (1) parties have less uncertainty about the nature of goods and services, which are standardized; and (2) parties rely less on each other because the market provides close substitutes, so they need not insert multiple terms in the contract in order to protect themselves against opportunism.
58. See HART, supra note 33, at 5; Schwartz, Incomplete Contracts, supra note 25, at 280. As a result, complex contracts should be associated with thin markets. When markets are robust, (1) parties have less uncertainty about the nature of goods and services, which are standardized; and (2) parties rely less on each other because the market provides close substitutes, so they need not insert multiple terms in the contract in order to protect themselves against opportunism.
59. 9 Exch. 341 (1854).
60. But not necessarily: an apparently simple contract, with say one term, might be complex because the environment is highly variable, so payoffs vary greatly as well. It is possible (even likely) that a contract with a second term would release one party (say, the uninformed party) when that party's payoff is extremely low. If so, the two-term contract is simpler along the payoff variability dimension even if more complex along the number of terms dimension. They are "complexity non-comparable."
61. See Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 YALE L.J. 87 (1989); Lucian Arye Bebchuk & Steven Shavell, Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v. Baxendale, 7 J.L. ECON. & ORG. 284 (1991).
62. See Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 YALE L.J. 87 (1989); Lucian Arye Bebchuk & Steven Shavell, Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v. Baxendale, 7 J.L. ECON. & ORG. 284 (1991).
63. A similar outcome results when parties are negotiating over the sale of technological information: "merely informing a potential buyer about one's product gives away a great deal of the benefit Hence, information is shared alongside sheaves of nondisclosure agreements, and, even then, there is selective hiding of critical components. Frequently prototypes are demonstrated, but inner workings may be hidden, much as magic stores demonstrate an illusion but not its working mechanism." R.J. Zeckhauser, The Challenge of Contracting for Technological Information, 93 PROC. NAT'L ACAD. SCI. U.S. 12,743, 12,744 (1996).
64. Bengt Holmstrom & Paul Milgrom, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design, 7 J.L. ECON. & ORG. 24, 26 (1991).
65. See id. Bajari and Tadelis, supra note 12, seek to explain the prevalence of simple cost-plus and fixed-price contracts, and the rarity of more complex incentive contracts, drawing on evidence from the private construction industry. They argue that a fixed-price contract offers the advantages of giving better incentives for cost control and not requiring the buyer to monitor costs, but has the disadvantage of leading to friction from renegotiation when changes are required. A cost-plus contract, by contrast, is advantaged for allowing smooth adjustment to changes, but disadvantaged by requiring that the buyer monitor costs and giving the seller little incentive for cost control. Given the "lumpiness" of fixed costs associated with any deviation from pure cost-plus or pure fixed-price contracts, simple extreme contracts are preferred, over a wide range of circumstances, to more complex, intermediate incentive contracts.
66. A university and a faculty member typically do not contract on all of the verifiable aspects of their relationship, partly to induce good behavior along nonverifiable dimensions, such as faculty effort: "the extensive degree of incompleteness in the specification of the university's obligations to the faculty member (e.g., secretarial support, office location, current and future salary) arises from the need to encourage the faculty member's effort. With a complete contract, the faculty member would have recourse to the courts if the university reneged on its contractual obligations, but the university would have no recourse if the faculty member shirked [since effort is nonverifiable]. Giving the Dean discretion helps to create appropriate incentives . . . and the overall relationship works better (joint surplus is increased)." B. Douglas Bernheim & Michael D. Whinston, Incomplete Contracts and Strategic Ambiguity, 88 AM. ECON. REV. 902, 904 (1998).
67. See David Kreps, Corporate Culture and Economic Theory, in PERSPECTIVES ON POSITIVE POLITICAL ECONOMY (J. Alt & K. Shepsle eds., 1990); for evidence, see Baker et al., supra note 14, at 953.
68. See David Kreps, Corporate Culture and Economic Theory, in PERSPECTIVES ON POSITIVE POLITICAL ECONOMY (J. Alt & K. Shepsle eds., 1990); for evidence, see Baker et al., supra note 14, at 953.
69. See Saul Levmore, Commissions and Conflicts in Agency Arrangements: Lawyers, Real Estate Brokers, Underwriters and Other Agents' Rewards, 36 J.L. & ECON. 503 (1993).
70. See J. Green & N. Stokey, A Comparison of Tournaments and Contests, 91 J. POL. ECON. 349 (1983); Bengt Holmstrom, Moral Hazard in Teams, 13 BELL J. ECON. 324 (1982); B. Nalebuff & J. Stiglitz, Prices and Incentives: Towards a General Theory of Compensation and Competition, 14 BELL J. ECON. 21 (1983);
71. See J. Green & N. Stokey, A Comparison of Tournaments and Contests, 91 J. POL. ECON. 349 (1983); Bengt Holmstrom, Moral Hazard in Teams, 13 BELL J. ECON. 324 (1982); B. Nalebuff & J. Stiglitz, Prices and Incentives: Towards a General Theory of Compensation and Competition, 14 BELL J. ECON. 21 (1983);
72. See J. Green & N. Stokey, A Comparison of Tournaments and Contests, 91 J. POL. ECON. 349 (1983); Bengt Holmstrom, Moral Hazard in Teams, 13 BELL J. ECON. 324 (1982); B. Nalebuff & J. Stiglitz, Prices and Incentives: Towards a General Theory of Compensation and Competition, 14 BELL J. ECON. 21 (1983);
73. Mary O'Keeffe et al., Economic Contests: Comparative Reward Schemes, 2 J. LAB. ECON. 27 (1984).
74. Edward P. Lazear, Pay Equality and Industrial Politics, 97 J. POL. ECON. 561, 579 (1989).
75. Thus, we do not assume that the payoffs are necessarily symmetrical. For a discussion of the Battle of the Sexes, see ROBERT GIBBONS, GAME THEORY FOR APPLIED ECONOMICS 11-12(1992).
76. For a discussion of evolutionary arguments, see H. Peyton Young, The Economics of Convention, 10 J. ECON. PERSP. 105 (1996). Young argues that 50-50 division (for example, its prevalence in sharecropping contracts) can be explained by the fact that this rule is the unique stochastically stable convention (i.e., convention that is robust under small, persistent random shocks) under certain plausible circumstances.
77. See Lisa Bernstein, The Questionable Empirical Basis of Article 2's Incorporation Strategy: A Preliminary Study, 66 U. CHI. L. REV. 710 (1999); Stewart Macaulay, Non-Contractual Relations in Business, 28 AM. SOC. REV. 55 (1963).
78. See Lisa Bernstein, The Questionable Empirical Basis of Article 2's Incorporation Strategy: A Preliminary Study, 66 U. CHI. L. REV. 710 (1999); Stewart Macaulay, Non-Contractual Relations in Business, 28 AM. SOC. REV. 55 (1963).
79. We are grateful to Malcolm Brachman, President, Northwest Oil Company, for this example.
80. See, e.g., Langellier v. Schaefer, 36 Minn. 361 (1887).
81. U.C.C. § 2-207 (1998).
82. See E. ALLAN FARNSWORTH, CONTRACTS 295-310 (1982).
83. Another possibility is that courts do not deny formation under the mirror image rule, but instead assume that delivery is acceptance of the buyer's form, if the buyer's form differs from the seller's initial form. In this case, the choice between the rules probably does not matter at all, except that the complexity of 2-207 creates needless uncertainty.
84. See THOMAS C. SCHELLING, THE STRATEGY OF CONFLICT 57 (1960) (defining focal point).
85. See Young, supra note 59.
86. Recall also our earlier point that fairness norms or industry conventions will resolve conflicts over the distribution of surpluses as they are generated, obviating the need for complex terms that specify distributions in advance.
87. Early work by Rubinstein and others on the simple principal-agent model showed that in the absence of discounting and with an infinite horizon to the agency relationship, a first-best solution (i.e., simultaneously providing correct incentives and involving completely efficient risk sharing) is possible. Ariel Rubinstein, An Optimal Conviction Policy for Offenses that May Have Been Committed by Accident, in APPLIED GAME THEORY 406 (S. Brams et al. eds., 1979). The key insight is that with repeated outcomes, the principal can eventually infer the agent's hidden action (effort level) very closely from the average of past observations; with an infinite horizon, agent shirking will eventually be detected. Anticipating punishment when or if discovered engaging in moral hazard, the agent performs optimally from the beginning. This incentive would be lost if the relationship were based on a series of short-term contracts (for example, with different principals in each period), unless reputation effects are strong enough for the different principals all to become aware of the agent's previous behavior.
88. For example, Director Steven Spielberg paid Tom Stoppard $120,000 for helping to edit the screenplay for "Indiana Jones and the Last Crusade." When the film became a huge success, Spielberg sent Stoppard a $1 million thank-you bonus. See Stephen Dubner, Steven the Good, N.Y. TIMES MAG., February 14, 1999, at 38. Spielberg may have made the noncontracted additional payment simply because he is an honorable person, or because Stoppard is a friend; but in any case such payment helps to maintain a reputation for trustworthiness that encourages mutually beneficial long-term relationships. (Indeed, when questioned about the nature of his character, Spielberg responded by starting to recite the Boy Scout moral code: "I'm trustworthy, I'm loyal . . ." Id.).
89. Allen & Gale, supra note 17; see also Kathryn E. Spier, Incomplete Contracts and Signaling, 23 RAND J. ECON. 432 (1992); discussions in Bernheim & Whinston, supra note 53, and Schwartz, Incomplete Contracts, supra note 25.
90. Allen & Gale, supra note 17; see also Kathryn E. Spier, Incomplete Contracts and Signaling, 23 RAND J. ECON. 432 (1992); discussions in Bernheim & Whinston, supra note 53, and Schwartz, Incomplete Contracts, supra note 25.
91. Allen & Gale, supra note 17; see also Kathryn E. Spier, Incomplete Contracts and Signaling, 23 RAND J. ECON. 432 (1992); discussions in Bernheim & Whinston, supra note 53, and Schwartz, Incomplete Contracts, supra note 25.
92. Allen & Gale, supra note 17; see also Kathryn E. Spier, Incomplete Contracts and Signaling, 23 RAND J. ECON. 432 (1992); discussions in Bernheim & Whinston, supra note 53, and Schwartz, Incomplete Contracts, supra note 25.
93. This argument that simple rules help in detecting self-serving behavior of others is reinforced by the results of Allison and Messick that "divisibility of a resource by six tended to make equality [of division among six people] more salient and hence acted as a restraint against taking more than an equal share." Scott T. Allison & David M. Messick, Social Decision Heuristics in the Use of Shared Resources, 3 J. BEHAV. DECISION MAKING 195, 210 (1990).
94. Macaulay, supra note 60, at 64.
95. Bengt Holmstrom & John Roberts, The Boundaries of the Firm Revisited, 12 J. ECON. PERSP. 73, 81 (1998).
96. Ching-to Albert Ma & T. G. McGuire, Cost and Incentives in a Behavioral Health Carve Out, 17 HEALTH AFF. 53 (1998).
97. A "carve out" is a contractual arrangement in health care under which a particular set of services (such as mental health and substance abuse treatment) are "carved out" from the total health insurance premium and contracted out separately to a provider distinct from that insuring and providing the rest of the health services to a beneficiary population.
98. See PAUL MILGROM & JOHN ROBERTS, ECONOMICS, ORGANIZATION AND MANAGEMENT 266 (1992).
99. See also Keith J. Crocker & Kenneth J. Reynolds, The Efficiency of Incomplete Contracts: An Empirical Analysis of Air Force Engine Procurement, 24 RAND J. ECON. 126 (1993) (finding that contractors with better reputations are less likely to have a fixed-cost contract and more likely to have a cost-reimbursement contract). According to Bajari and Tadelis, supra note 12, at 30, "fixed price contracts feature high levels of design, high cost reducing incentives, and possibly large amounts of friction when changes are required. Cost plus contracts feature low levels of design, fast tracking [shorter completion time], low cost reduction incentives, and low friction for changes." And see Banerjee and Duflo, supra note 16 (finding that in the Indian software industry more established firms have simpler time- and-material contracts, while young firms have complex fixed-price contracts).
100. See Alan Schwartz, Relational Contracts and the Courts: An Analysis of Incomplete Contracts and Judicial Strategies, 21 J. LEGAL STUD. 271 (1992) [hereinafter Schwartz, Relational Contracts].
101. See Alan Schwartz, Relational Contracts and the Courts: An Analysis of Incomplete Contracts and Judicial Strategies, 21 J. LEGAL STUD. 271 (1992) [hereinafter Schwartz, Relational Contracts].
102. An arbitrator says, "It's good for my business that things are becoming more complex." Gail Diane Cox, Arbitration Is No Simple Matter, NAT'L L.J., June 28, 1999, at A1.
103. Arbitration clauses are becoming increasingly complex because judges enforce them narrowly. For example, after a New York court held that an arbitration clause in an employment contract that applied to "all differences . . . over the application or performance of any part" of the contract did not apply to age discrimination claims, parties added age bias claims to the clause. As a result of arbitration litigation, "[a]rbitration clauses are becoming paragraphs, and paragraphs are becoming pages." Id.
104. See OLIVER E. WILLIAMSON, MARKETS AND HIERARCHIES: ANALYSIS AND ANTITRUST IMPLICATIONS (1975); OLIVER E. WILLIAMSON, THE MECHANISMS OF GOVERNANCE (1996); Coase, supra note 32, at 386.
105. See OLIVER E. WILLIAMSON, MARKETS AND HIERARCHIES: ANALYSIS AND ANTITRUST IMPLICATIONS (1975); OLIVER E. WILLIAMSON, THE MECHANISMS OF GOVERNANCE (1996); Coase, supra note 32, at 386.
106. See OLIVER E. WILLIAMSON, MARKETS AND HIERARCHIES: ANALYSIS AND ANTITRUST IMPLICATIONS (1975); OLIVER E. WILLIAMSON, THE MECHANISMS OF GOVERNANCE (1996); Coase, supra note 32, at 386.
107. Paul L. Joskow, Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets, 77 AM. ECON. REV. 168 (1987) [hereinafter Joskow, Contract Duration], reprinted in CASE STUDIES IN CONTRACTING AND ORGANIZATION 104 (Scott E. Masten ed., 1996); Paul L. Joskow, The Performance of Long-Term Contracts: Further Evidence from Coal Markets, 21 RAND J. ECON. 251 (1990); Paul L. Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants, 1 J.L. ECON. & ORG. 33 (1985) [hereinafter Joskow, Vertical Integration].
108. Paul L. Joskow, Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets, 77 AM. ECON. REV. 168 (1987) [hereinafter Joskow, Contract Duration], reprinted in CASE STUDIES IN CONTRACTING AND ORGANIZATION 104 (Scott E. Masten ed., 1996); Paul L. Joskow, The Performance of Long-Term Contracts: Further Evidence from Coal Markets, 21 RAND J. ECON. 251 (1990); Paul L. Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants, 1 J.L. ECON. & ORG. 33 (1985) [hereinafter Joskow, Vertical Integration].
109. Paul L. Joskow, Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets, 77 AM. ECON. REV. 168 (1987) [hereinafter Joskow, Contract Duration], reprinted in CASE STUDIES IN CONTRACTING AND ORGANIZATION 104 (Scott E. Masten ed., 1996); Paul L. Joskow, The Performance of Long-Term Contracts: Further Evidence from Coal Markets, 21 RAND J. ECON. 251 (1990); Paul L. Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants, 1 J.L. ECON. & ORG. 33 (1985) [hereinafter Joskow, Vertical Integration].
110. Paul L. Joskow, Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets, 77 AM. ECON. REV. 168 (1987) [hereinafter Joskow, Contract Duration], reprinted in CASE STUDIES IN CONTRACTING AND ORGANIZATION 104 (Scott E. Masten ed., 1996); Paul L. Joskow, The Performance of Long-Term Contracts: Further Evidence from Coal Markets, 21 RAND J. ECON. 251 (1990); Paul L. Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants, 1 J.L. ECON. & ORG. 33 (1985) [hereinafter Joskow, Vertical Integration].
111. Paul L. Joskow, Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets, 77 AM. ECON. REV. 168 (1987) [hereinafter Joskow, Contract Duration], reprinted in CASE STUDIES IN CONTRACTING AND ORGANIZATION 104 (Scott E. Masten ed., 1996); Paul L. Joskow, The Performance of Long-Term Contracts: Further Evidence from Coal Markets, 21 RAND J. ECON. 251 (1990); Paul L. Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants, 1 J.L. ECON. & ORG. 33 (1985) [hereinafter Joskow, Vertical Integration].
112. See Joskow, Vertical Integration, supra note 83, at 55.
113. See generally Joskow, Contract Duration, supra note 84.
114. HERBERT SIMON, ADMINISTRATIVE BEHAVIOR (2d ed. 1961) quoted in WILLIAMSON, THE MECHANISMS OF GOVERNANCE, supra note 82, at 6. For an overview of this concept, see John Conlisk, Why Bounded Rationality? 34 J. ECON. LITERATURE 669 (1996).
115. HERBERT SIMON, ADMINISTRATIVE BEHAVIOR (2d ed. 1961) quoted in WILLIAMSON, THE MECHANISMS OF GOVERNANCE, supra note 82, at 6. For an overview of this concept, see John Conlisk, Why Bounded Rationality? 34 J. ECON. LITERATURE 669 (1996).
116. HERBERT SIMON, ADMINISTRATIVE BEHAVIOR (2d ed. 1961) quoted in WILLIAMSON, THE MECHANISMS OF GOVERNANCE, supra note 82, at 6. For an overview of this concept, see John Conlisk, Why Bounded Rationality? 34 J. ECON. LITERATURE 669 (1996).
117. See HART, supra note 33.
118. S.E. Taylor, The Interface of Cognitive and Social Psychology, in COGNITION, SOCIAL BEHAVIOR, AND THE ENVIRONMENT (J.H. Harvey ed., 1981).
119. Even though p-incompleteness stemming directly from bounded rationality of the contracting parties has not been successfully modeled, "there is another sense in which one can say that a contract is incomplete: it is incomplete if the parties would like to add contingent clauses, but are prevented from doing so by the fact that the state of nature cannot be verified (or because states are too expensive to describe ex ante). . . . It is true that the parties' obligations are fully specified and that renegotiation at date 1 always 'completes' the contract (i.e., makes it contingent). However, the way the contract is completed is not optimal from an ex ante perspective." Hart & Moore, supra note 26, at 134-35.
120. See, e.g., Schwartz, Incomplete Contracts, supra note 25.
121. But only as long as their rationality is not too bounded. They must be sufficiently rational to realize that they cannot anticipate and understand all events.
122. MILGROM & ROBERTS, supra note 77, at 127.
123. For a critique of judicial refusal to enforce no-renegotiation clauses, see Christine Jolls, Contracts as Bilateral Commitments: A New Perspective on Contract Modification, 26 J. LEGAL STUD. 203 (1997).
124. Consider a contract to paint a person's portrait. The painter may fear that once the portrait is complete, the buyer can offer to pay a much lower price than originally agreed upon, knowing that few if any others will be willing to pay for a portrait of someone else. (The law allows the buyer to refuse in good faith, but lack of good faith is hard to prove.) To avoid having the painting effort held up in this way, the painter may insist upon a more complicated contract that features installment payments as the portrait progresses. Alternatively, suppose a portrait of a leader will be needed, but it is unclear at the time of contracting who the leader will be (e.g., because elections may be called to select a new leader). In this case the contract may be simple, with both parties agreeing to wait until the future is revealed to specify the portrait rather than write a complex contingent contract anticipating and describing the many possible future scenarios.
125. See Hart & Moore, supra note 26, at 128-29.
126. Id.
127. For a critique of the Hart and Moore view, see Eric Maskin & Jean Tirole, Unforeseen Contingencies and Incomplete Contracts, 66 REV. ECON. STUD. 83 (1999) (arguing that people would prefer a world in which they could enter renegotiation-proof contracts).
128. See Jolls, supra note 93, at 208-09 (and citations therein).
129. See ILYA SEGAL, COMPLEXITY AND RENEGOTIATION: A FOUNDATION FOR INCOMPLETE CONTRACTS (1996); Hart & Moore, supra note 26.
130. See ILYA SEGAL, COMPLEXITY AND RENEGOTIATION: A FOUNDATION FOR INCOMPLETE CONTRACTS (1996); Hart & Moore, supra note 26.
131. For example, one could compare the very simple contracts governing diamond sales in the ethnically homogenous communities described in Lisa Bernstein, Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry, 21 J. LEGAL STUD. 115 (1992), with those used in other areas of the country or in other countries where sales occur among people who are not members of such a homogenous community.
132. Using the contracts database available at 〈http://crcse.business.pitt.edu/〉, we conducted very preliminary empirical work to establish some stylized facts and test the plausibility of some of our hypotheses about the relationships among economic stake in the contract, duration, and complexity. We had 2 samples, each with 32 contracts. One sample involved land contracts; the other involved leases. In our sample of land contracts, we found that the number of lines in the contract - a crude proxy for complexity - was positively associated with the contract price (p < 0.05). In our sample of leases, contract duration (in years) was far more powerful than price in explaining the number of lines in the contract. This is not surprising, since as a lease stretches over many years, uncertainty - the driver of complexity - plays an increasingly important role. Considerations such as general escalation in rents, required repairs to the building, and the economic success of the lessor, all uncertain ex ante, will affect the contract. The positive correlation between contract length and price became statistically insignificant when controlling for contract duration. Price per year, years, and years-squared could jointly explain about one-third of the variation in "complexity" (proxied by lines) for the sample. There was also some evidence of diminishing returns to complexity as duration increased. (The estimated coefficient for years-squared was negative and statistically significant at the 5% level, controlling for price per year and years.) Unfortunately these empirical results are no more than suggestive: the proxy for complexity is crude; the samples are small; many potentially relevant independent variables were not available, etc. For example, we know nothing of the contracting environment for each contract. Nevertheless, these preliminary findings, along with other studies cited herein, indicate that the factors we discuss are of some empirical relevance. Much more work remains to be done in quantifying and explaining the simplicity and complexity of contracts.
133. The tension between lawyers and business people is part of the folklore. Lawyers complain that business people do not plan carefully enough against future contingencies; business people complain that lawyers' caution interferes with valuable deals. See, e.g., Macaulay, supra note 60.
134. Schwartz, Relational Contracts, supra note 79, at 282-83.
135. Liberal interpretation is associated with Llewellyn, Corbin, and Traynor. See Pacific Gas & Elec. Co. v. G.W. Thomas Drayage & Rigging Co., 442 P.2d 641 (1968) (Traynor, J.) (criticizing formalistic contractual interpretation); Arthur L. Corbin, Mr. Justice Cardozo and the Law of Contracts, 48 YALE L.J. 426 (1939) (praising Cardozo for seeing through form and enforcing the parties' intentions).
136. If courts are limited in their self-control, or hindered in their decision making, aggressive interpretation can have grave negative consequences, both on the contracts that are interpreted, and through a feedback effect on the contracts that are negotiated initially. Liberal interpretation is generally less predictable than literal enforcement, encouraging attempts to renegotiate for a greater share of a surplus (or a smaller share of a loss), and rewarding socially unproductive investment in ability to predict court behavior. If these constraints are serious, literal enforcement of a contract's verifiable terms would be preferable to aggressive interpretation.
137. See Eric A. Posner, The Parol Evidence Rule, the Plain Meaning Rule, and the Principles of Contractual Interpretation, 146 U. PA. L. REV. 533, 540-47 (1998).
138. For example, many will quarrel with our treatment of conventions. There are many complications; at least, (1) the conventions should arise under conditions where they are likely to be efficient, see Robert D. Cooter, Structural Adjudication and the New Law Merchant: A Model of Decentralized Law, 14 INT'L REV. L. & ECON. 215 (1994); the conventions must be verifiable by courts rather than optimal only given nonlegal enforcement by private adjudicators, see Eric A. Posner, The Regulation of Groups: The Influence of Legal and Nonlegal Sanctions on Collective Action, 63 U. CHI. L. REV. 133, 158 (1996); and (3) they must be coherent and meaningful (for skepticism, see Bernstein, supra note 60, at 710).
139. For example, many will quarrel with our treatment of conventions. There are many complications; at least, (1) the conventions should arise under conditions where they are likely to be efficient, see Robert D. Cooter, Structural Adjudication and the New Law Merchant: A Model of Decentralized Law, 14 INT'L REV. L. & ECON. 215 (1994); the conventions must be verifiable by courts rather than optimal only given nonlegal enforcement by private adjudicators, see Eric A. Posner, The Regulation of Groups: The Influence of Legal and Nonlegal Sanctions on Collective Action, 63 U. CHI. L. REV. 133, 158 (1996); and (3) they must be coherent and meaningful (for skepticism, see Bernstein, supra note 60, at 710).
140. For example, many will quarrel with our treatment of conventions. There are many complications; at least, (1) the conventions should arise under conditions where they are likely to be efficient, see Robert D. Cooter, Structural Adjudication and the New Law Merchant: A Model of Decentralized Law, 14 INT'L REV. L. & ECON. 215 (1994); the conventions must be verifiable by courts rather than optimal only given nonlegal enforcement by private adjudicators, see Eric A. Posner, The Regulation of Groups: The Influence of Legal and Nonlegal Sanctions on Collective Action, 63 U. CHI. L. REV. 133, 158 (1996); and (3) they must be coherent and meaningful (for skepticism, see Bernstein, supra note 60, at 710).
141. The specific recommendations are based on the positive analysis, including prior literature cited in the earlier discussions.
142. See, e.g., Ian Ayres, Default Rules for Incomplete Contracts, in 1 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW, supra note 43, at 586-88.
143. See Frigaliment Importing Co. v. B.N.S. Int'l Sales Corp., 190 F. Supp. 116 (S.D.N.Y. 1960).
144. Schwartz offers this argument in the spirit of conjecture; in addition, he excludes from his analysis many of the factors on which we focus. See Schwartz, Incomplete Contracts, supra note 25; Schwartz, Relational Contracts, supra note 79. For other views of this subject, see Charles Goetz & Robert Scott, Principles of Relational Contracts, 67 VA. L. REV. 1089 (1981); Robert E. Scott, A Relational Theory of Default Rules for Commercial Contracts, 19 J. LEGAL STUD. 597 (1990).
145. Schwartz offers this argument in the spirit of conjecture; in addition, he excludes from his analysis many of the factors on which we focus. See Schwartz, Incomplete Contracts, supra note 25; Schwartz, Relational Contracts, supra note 79. For other views of this subject, see Charles Goetz & Robert Scott, Principles of Relational Contracts, 67 VA. L. REV. 1089 (1981); Robert E. Scott, A Relational Theory of Default Rules for Commercial Contracts, 19 J. LEGAL STUD. 597 (1990).
146. Schwartz offers this argument in the spirit of conjecture; in addition, he excludes from his analysis many of the factors on which we focus. See Schwartz, Incomplete Contracts, supra note 25; Schwartz, Relational Contracts, supra note 79. For other views of this subject, see Charles Goetz & Robert Scott, Principles of Relational Contracts, 67 VA. L. REV. 1089 (1981); Robert E. Scott, A Relational Theory of Default Rules for Commercial Contracts, 19 J. LEGAL STUD. 597 (1990).
147. Schwartz offers this argument in the spirit of conjecture; in addition, he excludes from his analysis many of the factors on which we focus. See Schwartz, Incomplete Contracts, supra note 25; Schwartz, Relational Contracts, supra note 79. For other views of this subject, see Charles Goetz & Robert Scott, Principles of Relational Contracts, 67 VA. L. REV. 1089 (1981); Robert E. Scott, A Relational Theory of Default Rules for Commercial Contracts, 19 J. LEGAL STUD. 597 (1990).
148. Schwartz's view itself depends on courts having a minimum level of competence. If they are too incompetent, then no information is verifiable, in which case discussion of the optimal judicial strategy is idle. See generally Eric A. Posner, A Theory of Contract Law Under Conditions of Radical Judicial Error, 94 Nw. U. L. REV. 749 (2000). For other discussions of contract law and judicial competence, see Richard Craswell, Property Rules and Liability Rules in Unconscionability and Related Doctrines, 60 U. CHI. L. REV. 1, 38-41 (1993); Gillian Hadfield, Judicial Competence and the Interpretation of Incomplete Contracts, 23 J. LEGAL STUD. 159 (1994).
149. Schwartz's view itself depends on courts having a minimum level of competence. If they are too incompetent, then no information is verifiable, in which case discussion of the optimal judicial strategy is idle. See generally Eric A. Posner, A Theory of Contract Law Under Conditions of Radical Judicial Error, 94 Nw. U. L. REV. 749 (2000). For other discussions of contract law and judicial competence, see Richard Craswell, Property Rules and Liability Rules in Unconscionability and Related Doctrines, 60 U. CHI. L. REV. 1, 38-41 (1993); Gillian Hadfield, Judicial Competence and the Interpretation of Incomplete Contracts, 23 J. LEGAL STUD. 159 (1994).
150. Schwartz's view itself depends on courts having a minimum level of competence. If they are too incompetent, then no information is verifiable, in which case discussion of the optimal judicial strategy is idle. See generally Eric A. Posner, A Theory of Contract Law Under Conditions of Radical Judicial Error, 94 Nw. U. L. REV. 749 (2000). For other discussions of contract law and judicial competence, see Richard Craswell, Property Rules and Liability Rules in Unconscionability and Related Doctrines, 60 U. CHI. L. REV. 1, 38-41 (1993); Gillian Hadfield, Judicial Competence and the Interpretation of Incomplete Contracts, 23 J. LEGAL STUD. 159 (1994).
151. Parties that fear liberal interpretation can (1 ) include a merger clause, which directs courts not to rely on evidence of precontractual negotiations when interpreting contracts; (2) include a clause asking the court to ignore extra-contractual evidence such as course of dealing; (3) avoid clauses that invite judicial scrutiny of the contractual relationship, such as "best efforts" and "good faith" clauses; and (4) include a choice of law term that directs the adjudicating court to apply the law of a state that has strict interpretive rules. Indeed, parties routinely follow the first two strategies, and we suspect that they follow the third and fourth as well. However, there is a danger that liberal courts will interpret any of these clauses liberally, which will tend to muddy the outcome.