Contract theory and the limits of contract law

Yale Law Journal

Volumn 113, Issue 3, 2003, Pages 541-619

  Schwartz, Alan ^a,b   Scott, Robert E ^c,d  

^a YALE UNIVERSITY   (United States)

^b YALE SCHOOL OF MANAGEMENT   (United States)

^c UNIVERSITY OF VIRGINIA   (United States)

^d The Earth Institute at Columbia University   (United States)

Author keywords

[No Author keywords available]

Indexed keywords

EID: 4344671883     PISSN: 00440094     EISSN: 00440094     Source Type: Journal    
DOI: 10.2307/3657531     Document Type: Review

References (220)

1. For a broad discussion of this problem, see Michael J. Trebilcock, THE LIMITS OF FREEDOM OF CONTRACT 241-68 (1993). Autonomy theories require elastic notions of consent in order to regulate the full scope of contracting behavior with one norm. See, e.g.,
2. Randy E. Barnett, A Consent Theory of Contract, 86 COLUM. L. REV. 269 (1986);
3. Randy E. Barnett, The Sound of Silence: Default Rules and Contractual Consent, 78 VA. L. REV. 821 (1992);
4. Peter Benson, Abstract Right and the Possibility of a Nondistributive Conception of Contract: Hegel and Contemporary Contract Theory, 10 CARDOZO L. REV. 1077 (1989);
5. Peter Benson, Contract, in A COMPANION TO PHILOSOPHY OF LAW AND LEGAL THEORY 24, 33-43 (Dennis Patterson ed., 1996);
6. Peter Benson, The Idea of a Public Basis of Justification for Contract, 33 OSGOODE HALL L.J. 273 (1995). Efficiency theories tend to have a more limited scope. Positive articles analyze broad doctrinal patterns in an attempt to find fundamental consistency between these patterns and the efficiency norm, but the authors do not purport to provide a fully descriptive theory of contract law. See, e.g.,
7. Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 YALE L.J. 87 (1989);
8. Charles J. Goetz & Robert E. Scott, Enforcing Promises: An Examination of the Basis of Contract, 89 YALE L.J. 1261 (1980). Normative economic theories, on the other hand, typically evaluate discrete doctrines by the efficiency norm. See, e.g.,
9. Charles J. Goetz & Robert E. Scott, Liquidated Damages, Penalties and the Just Compensation Principle : Some Notes on an Enforcement Model and a Theory of Efficient Breach, 77 COLUM. L. REV. 554 (1977) [hereinafter Goetz & Scott, LiquidatedDamages];
10. Christine Jolls, Contracts as Bilateral Commitments: A New Perspective on Contract Modification, 26 J. LEGAL STUD. 203 (1997);
11. Alan Schwartz, The Casefor Specific Performance, 89 YALE L.J. 271 (1979);
12. Robert E. Scott, The Casefor Market Damages: Revisiting the Lost Profits Puzzle, 57 U. CHI.L. REV. 1155 (1990).
13. The problems that pluralist theories without meta-norms pose are nicely illustrated in Melvin Eisenberg's effort, which purports to solve the broad-scope-of-contract problem by proposing overlapping sets of norms. See Melvin Aron Eisenberg, The Bargain Principleand Its Limits, 95 HARv. L. REv. 741 (1982);
14. Melvin A. Eisenberg, The Theory of Contracts, in THE THEORY OF CONTRACT LAW: NEW ESSAYS 206 (Peter Benson ed., 2001) [hereinafter Eisenberg, Theory of Contracts]. For example, Eisenberg's schema restricts the domain of freedom of contract by norms of reciprocity, trust, and fairness. He recognizes that this multivalue approach can generate conflicting social propositions. When conflicts actually occur, "the lawmaker must make a legal rule that gives a proper weight and role to each of the conflicting values or goals in the context at hand." Eisenberg, Theory of Contracts, supra, at 244. Further, "when social propositions conflict the Legislator must exercise good judgment concerning the weight and role to be given to each proposition in the issue at hand." Id. Eisenberg recognizes that his theory lacks a metric that would tell the lawmaker just how to give the proper "weight and role" to each social proposition or value when conflicts occur. Id. Since courts or legislatures are likely to be involved when the relevant social propositions or values arguably favor more than one type of litigant or interest group, pluralist theories such as Eisenberg's tend to be least helpful when they are most needed.
15. In a thoughtful critique of autonomy and efficiency theories of contract, Michael Trebilcock concludes that both theory types are "legitimate in their own terms," but that without a "meta-theory that weighs or ranks these various values," both should be pursued in various social contexts according to the relative competence of different legal institutions to perform effectively. TREBILCOCK, supra note 1, at 248. This Article takes up Trebilcock's invitation and proposes a normative theory that fits business contracts, the subsidiary category of contractual relationships that the law most affects.
16. Legal scholars commonly refer to investment in the contract's subject matter as "reliance." We use reliance and the economist's term "investment" interchangeably.
17. As another example of the criticism that we sidestep here, Professor Eisenberg has criticized theories holding that contract law should maximize welfare alone on the ground that these theories are "impoverished… because they exclude other important policy values, such as the value of keeping intimate and other affective relationships free from the intrusion of state power." Eisenberg, Theory of Contracts, supra note 2, at 238. This objection may have force as applied to Category 2 contracts, between persons, but seems irrelevant to the Category 1 contracts we analyze. Contracts between General Electric and General Motors do not involve "intimate" or "affective" relationships.
18. A relation-specific investment is not fully "redeployable." As an example, assume that a seller purchases standard steel tubes to make a machine for the buyer. The seller's investment would be "general" if breach occurred before the seller began work on the tubes because the tubes could be resold on the market. The investment would become "relation-specific" if breach occurred after the tubes had been fabricated into shapes that only the buyer could use, for then the transmuted tubes could only be resold as scrap, probably for less than their cost.
19. A "hard" parol evidence rule treats writings that appear to be complete contracts as complete contracts. See infra text accompanying notes 96-98.
20. The decisionmaker specifies the content of a rule in advance. For example, drivers cannot exceed a speed limit of fifty-five miles per hour. In contrast, the decisionmaker specifies the content of a standard ex post. Thus, parties must drive "reasonably" under the circumstances.
21. The work of these scholars is concisely summarized in Karl-Gustaf Löfgren et al., Markets with Asymmetric Information: The Contributions of George Akerlof Michael Spence and Joseph Stiglitz, 104 SCANDINAVIAN J. ECON. 195 (2002).
22. Law-and-economics scholars such as Aaron Edlin, Ian Ayres, and Jason Johnston have used contract theory in an illuminating fashion when discussing particular legal rules. See, e.g., Ayres & Gertner, supra note 1; Aaron S. Edlin, Cadillac Contracts and Up-Front Payments: Efficient Investment Under Expectation Damages, 12 J.L. ECON. & ORG. 98 (1996);
23. Jason Scott Johnston, Strategic Bargaining and the Economic Theory of Contract Default Rules, 100 YALE L.J. 615 (1990). The genre of model that we and these scholars use has performed well in empirical tests. See
24. P.A. CHIAPPORI & B. SALANIE, TESTING CONTRACT THEORY: A SURVEY OF SOME RECENT WORK 27 (Institut National de la Statistique et des Études Économiques, Working Paper No. 2002-11, 2002), http://www.crest.fr/doctravail/document/2002-11.pdf.
25. 11.See Grant Gilmore, THE DEATH OF CONTRACT 42-53 (1974).
26. See id. at 63 ("[T]he theory of contract, as formulated by Holmes and Williston, seems to have gone into its protracted period of breakdown almost from the moment of its birth."). But see Richard E. Speidel, An Essay on the Reported Death and Continued Vitality of Contract, 27 STAN. L. REV. 1161, 1182-83 (1975) (reviewing GILMORE, supra note 11).
27. See GILMORE, supra note 11, at 67-68 ("[Consider] the Restatement's definition of consideration (§ 75) taken in connection with its most celebrated section-§ 90 [promissory estoppel]…. The one thing that is clear is that these two contradictory propositions cannot live comfortably together: in the end one must swallow the other up.").
28. See, e.g., Eric A. Posner, Economic Analysis of Contract Law After Three Decades: Success or Failure?, 112 YALE L.J. 829 (2003) (lamenting the absence of successful normative or descriptive theories of contract law).
29. Vestiges of this distinction exist in the few UCC sections that regulate deals "between merchants" differently from deals between a merchant and a person. See, e.g., U.C.C. §§ 2-104(3), 2-201(2), 2-207(2), 2-209(2), 2-603, 2-609(2) (2003).
30. Individuals are assumed to be risk-averse while firms are assumed to be risk-neutral. The utility function of a risk-neutral party is linear in money-that is, the party values each additional dollar of wealth it may receive as much as it valued all previous dollars. Because monetary gains are coextensive with utility gains for risk-neutral parties, risk-neutral firms will maximize profits, a monetary measure. The risk-aversion or profit-maximization assumption for firms follows from two facts. First, the amount at stake in any one contract commonly is small in relation to the size of the firm, so firms actually hold contract portfolios. Individual risks tend to offset one another in a portfolio, so the portfolio holder-i.e., the firm-wants only to maximize the monetary value of the portfolio as a whole, which is best done by maximizing the value of each contract in it. Second, as is considered immediately in the text above, firms are owned by shareholders who themselves hold diversified portfolios. The value of a shareholder's portfolio is maximized when each firm in it does as well financially as it can do. The first ground for supposing that firms are risk-averse sometimes does not hold. We pursue the implications of this failure in Section III.C below.
31. In addition, many corporate executives have attended business school and also attend business school executive programs for working managers. It is a function of business education to teach people to make optimizing (rather than cognitively erroneous) decisions. Studies also show that individual subjects can be trained to perform complex game-theoretic reasoning. See Miguel Costa-Gomes et al., Cognition and Behavior in Normal-Form Games: An Experimental Study, 69 ECONOMETRICA 1193 (2001);
32. Eric J. Johnson et al., Detecting Failures of Backward Induction: Monitoring Information Search in Sequential Bargaining, 104 J. ECON. THEORY 16 (2002).
33. Psychologists and economists have shown that persons make systematic cognitive mistakes in laboratory experiments when asked to solve specified individual decision problems. These experiments do not test a general theory of how people make decisions, and thus they raise an issue of external validity: When will real-world parties behave as did the experimental subjects? Two scholars recently noted a consequence of this "lack of theoretical foundations": "[T]he policy influence of BE [behavioral economics] is limited by its inability to predict circumstances in which anomalous behavior will arise (other than in those sorts of circumstances in which it has been observed before) or how it will respond to policy changes." Jessica L. Cohen & William T. Dickens, A Foundation for Behavioral Economics, 92 AM. ECON. Rev. 335, 335 (2002).
34. For a recent skeptical view of the relevance of the psychological literature to the law, see Gregory Mitchell, Taking Behavioralism Too Seriously? The Unwarranted Pessimism of the New Behavioral Analysis of Law, 43 WM. & MARY L. REV. 1907 (2002). We provisionally view the individual decision experiments as not relevant to our project for three reasons. First, as we are in a world of speculation, we speculate that individuals in laboratories may perform worse than officers of firms because experimental subjects have not been trained to make good decisions and are not subject to the pressures to maximize that are described above. Second, recent evidence suggests that behavioral anomalies can be substantially mitigated or made to disappear when individuals are asked to perform as actors in firms, see
35. Jennifer Arlen et al., Endowment Effects Within Corporate Agency Relationships, 31 J. LEGAL STUD. 1 (2002), or when the applicable institutions permit communication within a group of actors and require competition between groups, see
36. Tilman Slembeck & Jean-Robert Tyran, Do INSTITUTIONS PROMOTE RATIONALITY? AN EXPERIMENTAL STUDY OF THE THREE-DOOR ANOMALY (Universitat of St. Gallen, Working Paper No. 21, 2002), http://www.vwa.unisg.ch/RePEc/usg/dp2002/dp0221slembeckganz.pdf. The view that organizations composed of experts make better decisions than individual subjects is coming to be accepted in the psychological community as well. See
37. Jeffrey J. Rachlinski, The Uncertain Psychological Case for Paternalism, 97 Nw. U. L. REV. 1165, 1214-16 (2003). Third, experiments show that when persons are required to function in markets rather than to perform individual tasks, the persons reach equilibria that are consistent with individually optimizing behavior. See
38. Vincent P. Crawford, Introduction to Experimental Game Theory, 104 J. ECON. THEORY 1, 3 n.8 (2002) ("[R]epeated play of the same game often converges to equilibrium no matter what subjects are thinking.");
39. Dhananjay K. Gode & Shyam Sunder, Allocative Efficiency of Markets with Zero-Intelligence Traders: Market as a Partial Substitute for Individual Rationality, 101 J. POL. ECON. 119 (1993);
40. Dhananjay K. Gode & Shyam Sunder, What Makes Markets Allocationally Efficient?, 112 Q.J. ECON. 603 (1997);
41. Vernon L. Smith, Rational Choice: The Contrast Between Economics and Psychology, 99 J. POL. ECON. 877 (1991) (review article).
42. Parties need the law's help to deal with postcontractual opportunism. See infra Part III.
43. Put simply, if a party is to receive a fixed twenty percent of a joint gain, it would always prefer the joint gain to be $200 rather than $100.
44. A party's discount rate measures his patience: The higher a party's discount rate, the more highly the party values current dollars than future dollars. Parties with high discount rates thus are impatient bargainers: They want their share of the surplus now. A party for whom current dollars are relatively less important-a party with a low discount rate-suffers less from delay and, as a result, is more willing to reject low current offers. Hence, patient parties do well when bargaining with impatient parties, who will reduce their demands in order to reach agreement quickly.
45. There are two versions of the Nash bargaining game: "split the difference" and "deal me out." In split-the-difference bargaining, if a deal would be profitable, each party receives its disagreement payoff plus one-half of the remaining surplus; in deal-me-out bargaining, each party gets half the surplus (if they are equally patient) unless one party's disagreement payoff exceeds half of an equal split. To illustrate the difference, assume that the seller's disagreement point is $2; the buyer's disagreement point is $1; and the surplus from a deal between them would be $10. The parties' payoffs under the two games (with split-the-difference set out first) are (1) Seller: $2+1/2($10-$3)=$5.50 Buyer: $1 + 1/2 ($10-$3) = $4.50 (2) Seller: 1/2 ($10) = $5 Buyer: 1/2($10)= $5 Game theorists predict that deal-me-out bargaining is common because a party's threat to exit unless it receives its disagreement payoff plus one-half the remaining surplus seldom is credible. On the assumed payoffs here, the buyer thus would not believe a seller's threat to exit unless the seller received $2 plus one-half the residual surplus (the total $5.50 payoff) because the buyer would know that the seller never would reject $5 (its deal-me-out bargaining payoff) in favor of $2, its outside option. Anticipating the buyer's belief, the seller would agree to accept $5 rather than futilely attempt to get $5.50. Now let the seller's disagreement payoff increase to $6. Then the parties would switch from deal-me-out bargaining to split-the-difference bargaining: The seller would receive $6 + 1/2 ($10-$7) = $7.50 and the buyer would receive $1 + 1/2 ($10-$7) = $2.50. The switch in bargaining games is predicted to occur because when the seller would realize $6 from its outside option, its threat to exit unless it gets at least $6 in the bargain becomes credible. We use the deal-me-out bargaining game throughout this Article (except when the seller has a high outside option) because of the game theorists' logic and because experimental tests of bargaining behavior reject "split the difference" in favor of "deal me out." See Colin F. Camerer, BEHAVORIAL GAME THEORY 175-82 (2003);
46. Ken Binmore et al., An Outside Option Experiment, 104 Q.J. ECON. 753 (1989).
47. U.C.C. § 2-302(1) (2003).
48. This conclusion applies even though parties may be uncertain about the amount of bargaining power they actually have. For example, parties can use a maximin strategy when they know the set of possible disagreement points but do not know which member of the set applies to their case. Parties using this strategy will evaluate uncertain gains by comparing their no-deal result to the smallest payoff possible under the set of potential disagreement points. If this minimum potential payoff exceeds the surplus in a no-deal condition, parties will contract; otherwise, they will not. As a consequence, some efficient deals will not be made, but those that are will be Pareto efficient. See Walter Bossert & Hans Peters, Efficient Solutions to Bargaining Problems with Uncertain Disagreement Points, 19 SOC. CHOICE & WELFARE 489 (2002). Our conclusion in the text is unaffected by this form of uncertainty because neither party can affect any of the disagreement points if the full set is exogenous. This set of models requires parties to reach agreement promptly on the basis of the possible choices available to them. When parties are optimistic about their bargaining power but can learn the truth by inference from the sequence of offers each of them makes, they will reach efficient bargains, though with delay. See
49. Muhamet Yildiz, Waiting To Persuade, 119 Q.J. ECON. (forthcoming Feb. 2004). We do not claim that parties always choose efficient contract terms. The existence of asymmetric information sometimes will cause parties to make constrained efficient contracts; these contracts are not "first-best" but are efficient given the information structure facing the parties. In Part V, we argue that the state seldom can improve on constrained efficient contracts because information that is unavailable to the parties is unlikely to be available to the decisionmaker.
50. For excellent analyses of the strengths and limitations of the various autonomy-based theories of contract law, see Richard Craswell, Contract Law, Default Rules, and the Philosophy of Promising, 88 MICH. L. REV. 489, 514 (1989);
51. Jody S. Kraus, Philosophy of Contract Law, in THE OXFORD HANDBOOK OF JURISPRUDENCE AND PHILOSOPHY OF LAW 687 (Jules Coleman & Scott Shapiro eds., 2001). We also are not interested in the question of when individual persons should keep their promises, as we want to identify the cases in which the state should enforce the agreements that firms make. For an interesting analysis of the duty-to-keep-promises question as applied to persons, see
52. Niko Kolodny & R. Jay Wallace, Promises and Practices Revisited, 31 PHIL. & PUB. AFF. 119 (2003).
53. Agreements often are written even when the parties expect not to enforce them legally. A writing reduces disagreements over what the parties had actually agreed to do. Disagreements as to what the contract directs raise interpretation issues that are discussed in Part IV below.
54. For good, largely informal discussions of these issues, see Benjamin Klein, Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships, 34 ECON. INQUIRY 444 (1996);
55. Robert E. Scott, Conflict and Cooperation in Long-Term Contracts, 75 CAL. L. REV. 2005,2039-50 (1987).
56. Suppose S and B write a contract in a state that does not legally enforce contracts. B later learns that it could make $100 more by breaching the contract than by performing it. If B breaches, however, S will no longer deal with B. Let B's expected profits on these future contracts have a present value of $200. Then B will perform the contract, though it could not be sued for breach, because breach would cause it to lose $100, that is S100-$200=-$100. The contract is self-enforcing.
57. For example, suppose that S's later refusal to deal would impose only a $10 loss on the breaching buyer, but other sellers also will refuse to deal, raising the buyer's total loss from breach in present value terms to $200 ($10 plus a $190 reputational sanction). Again, B would voluntarily perform.
58. See Janet T. Landa, A Theory of the Ethnically Homogenous Middleman Group: An Institutional Alternative to Contract Law, 10 J. LEGAL STUD. 349 (1981).
59. An excellent survey of early informal enforcement mechanisms is Avner Greif, Informal Contract Enforcement: Lessons from Medieval Trade, in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 287 (Peter Newman ed., 1998).
60. For discussion on this point, see Lisa Bernstein, Merchant Law in a Merchant Court: Rethinking the Code's Search for Immanent Business Norms, 144 U. PA. L. REV. 1765, 1781-82 (1996) [hereinafter Bernstein, Merchant Law];
61. Lisa Bernstein, Private Commercial Law in the Cotton Industry: Creating Cooperation Through Rules, Norms, and Institutions, 99 MICH. L. REV. 1724 (2001) [hereinafter Bernstein, Private Commercial Law].
62. For a general analysis of this issue, see, for example, Raja Kali, Endogenous Business Networks, 15 J.L. ECON. & ORG. 615 (1999).
63. Recent theoretical analyses and economic experiments suggest that the domain of self-enforcing contracts would expand beyond that set out in the text if market actors behaved fairly toward those who had behaved fairly toward them and punished actors who had behaved unfairly. In the experiments, subjects reciprocate good behavior even though they are not required to do so and punish bad behavior even though it is costly to do so. For a review of some of this evidence, see Ernst Fehr et al., Reciprocity as a Contract Enforcement Device: Experimental Evidence, 65 ECONOMETRICA 833 (1997);
64. Ernst Fehr & Klaus M. Schmidt, THEORIES OF FAIRNESS AND RECIPROCITY-EVIDENCE AND ECONOMIC APPLICATIONS 2-3 (Univ. of Zurich, Inst. for Empirical Research in Econ., Working Paper No. 75, 2001), http://www.iew.unizh.ch/wp/iewwp075.pdf. Analyses of how market contracting would improve if parties engaged in reciprocal fairness can be found in
65. Yongmin Chen, Promises, Trust and Contracts, 16 J.L. ECON. & ORG. 209 (2000);
66. Ernst Fehr & Klaus M. Schmidt, A Theory of Fairness, Competition, and Cooperation, 114 Q.J. ECON. 817 (1999). Whether this literature applies to market contracting among firms remains an open question for two reasons. First, when individuals in the experiments were put in market contexts and deprived of information about the payoffs of other actors, reciprocity tended to diminish. These results caused a leading experimenter to speculate: The effects of multiple players and limited information [in experiments] suggest a general conjecture about bargaining and markets. In two-person games with perfect information about how much each side is earning, fairness concerns loom largest…. The concern for fairness evident in two-player perfect information games… disappears in large markets. This does not mean traders in such markets do not care about fairness per se. They may care, but they behave self-interestedly because they aren't sure whether others are being fair and can't easily punish unfairness. A competitive market is simply a place in which it is hard to express your concern for fairness because buying or selling (or refusing to do so) will not generally change your inequality much. This… just means that people will then express social preferences about unfair market outcomes through "voice"…. regulation, and law. CAMERER, supra note 22, at 115. Second, the subjects in the experiments were individual persons who had not been trained in market behavior. Such subjects may respond differently from officers of firms, who commonly have market experience and who are subject to pressures to maximize profits. These two reasons suggest that it is premature to apply results in the fairness literature to an analysis of contracting among sophisticated firms. For a discussion of the relevance of the fairness literature to the enforcement of deliberately incomplete or indefinite agreements between individual actors, see
67. Robert E. Scott, A Theory of Self-Enforcing Indefinite Agreements, 103 COLUM. L. REv. 1641 (2003).
68. See supra note 22.
69. The buyer earns its valuation less the price, which must equal its payoff from bargaining. Since its valuation is $80 and its bargaining payoff is $15, the price must be $65. The seller earns the difference between the price and its cost, which must equal its bargaining payoff. Since the specialized product costs $50 to produce and the seller's bargaining payoff is $15, again the price must be $65. Notice that a buyer's threat to exit unless it receives its disagreement payoff ($10) plus one-half the surplus after this payoff is deducted would not be credible: The seller would know that the buyer would not pass up $15, its payoff from a deal, to take $10, its outside option.
70. The Nash bargaining that the text describes is ahistorical: Only the total surplus, the parties' discount rates, and (sometimes) their disagreement points determine the bargaining outcome. Hence, the parties in the examples in the text are assumed to ignore the seller's sunk $50 investment cost when renegotiating the contract. Individual persons in experiments and surveys sometimes take sunk costs into account, however, so that a party's payoff in a bargain will increase if the other party knows that its partner has spent money to prepare. This will increase the party's incentive to invest. See CAMERER, supra note 22, at 85-90; Lorne Carmichael & W. Bentley MacLeod, Caring About Sunk Costs: A Behavorial Solution to Holdup Problems with Small Stakes, 19 J.L. ECON. & ORG. 106 (2003);
71. Joep Sonnemans et al., On the Relation Between Asset Ownership and Specific Investments, III ECON. J. 791 (2001). Whether corporate entities are motivated by the fairness boncems regarding sunk costs that individual experimental subjects act upon is unknown. When parties can stage investments across periods, there is an equilibrium of the dynamic bargaining game they play in which parties invest more than the parties in the model we use, even when those parties are unable to enforce their contracts. See
72. Yeon-Koo Che & József Sákovics, A Dynamic Theory of Holdup (Apr. 25, 2003) (unpublished manuscript, on file with authors). Whether the stage-investment assumption applies in many cases is also unknown. Thus, we do not claim that the ability of a party to hold up its contract partner will always cause underinvestment-i.e., a refusal to make the specialized product-when contracts are not enforceable; rather, our claim is that underinvestment would occur often enough to make legal enforcement worthwhile.
73. See U.C.C. §§ 2-610(b), 2-703(e) (2003).
74. See id. § 2-709.
75. For a vivid example of the second-best strategies used when attempting contract enforcement in weak states, see Timothy Frye & Ekaterina Zhuravskaya, Rackets, Regulation, and the Rule of Law, 16 J.L. ECON. & ORG. 478 (2000). As the authors explain, [P]rivate protection rackets primarily provide two services. First, they provide basic protection from other rackets and from criminals. Second, and to a lesser extent, they help enforce agreements. These results suggest that private protection serves first as a substitute for the notoriously ineffective Russian police forces. To a lesser extent, it also serves as a substitute for the notoriously ineffective Russian courts. Id. at 491-92.
76. A thick market exists when there are many sellers and buyers trading a roughly homogenous product.
77. k.
78. nk) = 1/3 ($120-$120) + 1/3 ($120-$100) + 1/3 ($120-$80) = $20.
79. We have argued that contract enforcement serves an insurance function in the volatile markets case. Parties also can purchase business-interruption insurance, but the transaction costs of this alternative would ordinarily exceed the costs of the simple fixed-price contracts we consider. Companies face pressure to settle "bet the ranch" lawsuits for reasons similar to those developed here; settlement is a form of insurance against being put out of business. See J.B. Heaton, Settlement Pressure 30-36 (Feb. 2002) (unpublished manuscript, on file with authors).
80. Recall our assumption that parties to business contracts are risk-neutral. A third motive to contract is to transfer risk from more to less risk-averse parties. The legal enforcement of these contracts sometimes is necessary because the transferee of risk has an incentive to breach when large risks materialize. Risk-shifting contracts are not considered here, in part because one of the parties to them commonly is an insurer, and insurance contracts are the subject of a distinct and heavily regulated legal field. Moreover, although many contracts have an insurance component (e.g., commodities contracts, currency hedging), these contracts tend not to give rise to litigation.
81. An ex ante duress argument succeeds if the party proves that he would not have made the challenged contract absent the improperly coercive behavior of the other party. The key is the law's focus on behavior rather than circumstances. Thus, it is not duress on the part of an employer when a poor person accepts an offer to work at a low wage, nor is it duress on the part of a seller to charge a high price for gas when it is the only seller for many miles. The employer does not create the employee's low wealth, nor does the seller lure the buyer to the solitary spot. Contract law thus requires a duress claim to rest on the behavior of the promisee, not on the preexisting circumstances of the promisor. Chouinard v. Chouinard, 568 F.2d 430, 434 (5th Cir. 1978). This is because absent coercion by the promisee, the promisor does better by contracting than by not contracting. See Robert E. Scott & William J. Stuntz, Plea Bargaining as Contract, 101 YALE L.J. 1909, 1919-20 (1992) (discussing the general proposition that "the wrongful acts that constitute duress may be either physical force or an improper threat, but in any case the compulsion must be produced by the promisee and not by exigent circumstances facing the promisor").
82. See, e.g., Austin Instrument, Inc. v. Loral Corp., 272 N.E.2d 533 (N.Y. 1971).
83. RESTATEMENT (SECOND) OF CONTRACTS § 175 (1981).
84. Ex post duress cases are largely consistent with the test we propose, though the courts formally apply the Restatement's standards. See, e.g., Wolf v. Marlton Corp., 154 A.2d 625 (N.J. 1959); Austin Instrument, 272 N.E.2d 533. A more extensive analysis of the ex post duress case is in Alan Schwartz, Relational Contracts in the Courts: An Analysis of incomplete Agreements and Judicial Strategies, 21 J. LEGAL STUD. 271, 308-13 (1992).
85. As may be obvious, the doctrine is symmetrical: It also applies to protect buyers who have made relation-specific investments from overreaching sellers. The doctrine would be unnecessary if capital markets were perfect, or if damage suits were perfectly compensatory. Then parties could finance all good lawsuits or recover all losses. Capital markets, however, are imperfect and damage awards are not always fully compensatory.
86. Part IV concerns cases in which the parties have attempted to solve their problem with written words. The court, that is, is not called upon to fill gaps, but rather is asked to discover what the parties intended their written words to do. A theory of interpretation has two aspects: a set of rules for determining the semantic content of a party's utterances, and a set of rules for determining the legal significance that should attach to the semantic content. We focus on the former set of rules here because we have already developed a normative theory: Courts should enforce business contracts as the parties to them would want the contracts enforced. Our view regarding the separability of the rules determining legal significance from the rules governing interpretation is not free from difficulty, however. Courts doing interpretation may be influenced by their view of what a good substantive outcome is when the parties' meaning is not apparent. See Richard Craswell, Offer, Acceptance and Efficient Reliance, 48 STAN. L. REV. 481, 551-52 (1996). We ignore this complication on the assumption that if the semantic content rules improve, the courts' need to give legal answers to factual intent questions will lessen. A full theory of contract interpretation would explore more seriously the actual and ideal relation between a court's substantive preferences and its choice of an interpretive style.
87. Most autonomy-based theories are premised on either a notion of "consent" or the exercise of will, such as the making of a promise. See sources cited supra note 25.
88. A recent commentator referred to the UCC's interpretation rules as "quasi-mandatory," the idea being that the rules are and should be very difficult for parties to avoid. David V. Snyder, Language and Formalities in Commercial Contracts: A Defense of Custom and Conduct, 54 SMU L. REV. 617, 648 (2001). Because contracting has positive costs, a quasi-mandatory rule will be mandatory in practice for many parties, who will be unwilling to bear the additional costs of specifying alternative regimes. Other commentators believe that the interpretation rules are mandatory. See, e.g.,
89. Omri Ben-Shahar, The Tentative Case Against Flexibility in Commercial Law, 66 U. CHI. L. REV. 781, 792 (1999).
90. See 4 SAMUEL WILLISTON, CONTRACTS § 631, at 948-49 (Walter H.E. Jaeger ed., Baker, Voorhis & Co., Inc. 3d ed. 1961) (1920) (explaining that the parol evidence rule "requires, in the absence of fraud, duress, mutual mistake, or something of the kind, the exclusion of extrinsic evidence, oral or written, where the parties have reduced their agreement to an integrated writing"). Willistonian formalism rests on two basic claims: (1) that contract terms can be interpreted according to their plain meanings, and (2) that written terms have priority over unwritten expressions of agreement. See Dennis M. Patterson, Good Faith, Lender Liability, and Discretionary Acceleration: Of Llewellyn, Wittgenstein, and the Uniform Commercial Code, 68 TEX. L. REV. 169, 187-88 (1989).
91. Our use of the word "language" is a little loose. Linguists would say that when everyone uses English words, majority talk and the various types of party talk are different dialects of the same language. We use a multilanguage descriptor because it seems to us to be a more convenient system of classification.
92. Courts seldom distinguish between "vague" and "ambiguous" terms. A typical judicial definition of ambiguity, for example, includes any term or word that "has no definite significance or… is capable of more than one sensible and reasonable interpretation." Ross Bros. Constr. Co. v. State, 650 P.2d 1080, 1082 (Or. Ct. App. 1982). More narrowly, however, a word is vague to the extent that it can apply to a wide spectrum of referents, or to referents that cluster around a modal "best instance," or to somewhat different referents in different people. See, e.g., Frigaliment Importing Co. v. B.N.S. Int'l Sales Corp., 190 F. Supp. 116 (S.D.N.Y. 1960) (analyzing whether "chicken" includes all types of chicken or only a subset); Highley v. Phillips, 5 A.2d 824, 826 (Md. 1939) (determining whether the sale of "all the dirt" from a tract refers also to subsurface sand). In contrast, "ambiguity" requires at least two distinct, usually inconsistent meanings. See, e.g., Petroleum Fin. Corp. v. Cockburn, 241 F.2d 312, 314-16 (5th Cir. 1957) (analyzing missing punctuation in a telegram that supported two different readings); Raffles v. Wichelhaus, 159 Eng. Rep. 375, 375 (Ex. 1864) (determining the seller's obligation when two ships named Peerless sailed from Bombay but the seller was referring to one of them and the buyer understood it as the other). Language commonly is vague in the sense that the set of objects to which a word applies is rarely delineated with absolute precision. True lexical ambiguity occurs infrequently.
93. In re Soper's Estate, 264 N.W. 427 (Minn. 1935).
94. For a modem example, see Columbia Nitrogen Corp. v. Royster Co., 451 F.2d 3 (4th Cir. 1971). In that case, the contract specified a "Minimum Tonnage Per Year" of 31,000 tons. The buyer took less than that amount, but the court permitted the buyer to introduce evidence that, in the parties' trade, stated minimum tonnages were "mere projections to be adjusted according to market forces." Id. at 7.
95. The distinction between party and majority talk can blur at the edges, but remains easy to draw in most cases. When party talk closely correlates with majority talk---e.g., when a contract's terms are used to convey a subset of the general meanings that can be attributed to the same terms in majority talk-then the line between majority and party talk may be difficult to draw. Consider a contract that requires the seller to deliver "red sweaters." Given the breadth of the category "red" in majority talk, evidence regarding usage of trade may be helpful in delimiting the shades of red that the parties considered permissible. It remains unclear, however, whether the parties intended to convey a more limited subset of meaning for the term "red," specific to the parties, or sought instead to convey the broader meaning associated with the majority definition: The distinction between majority and party talk can be difficult to draw in such an instance. By contrast, contractual terms that obviously contradict majority understandings provide a clear line between majority talk and party talk. For example, in Hunt Foods & Industries v. Doliner, Doliner provided Hunt Foods with an "unconditional" written option to buy all of the stock in his company at a stated price by a stated date. 270 N.Y.S.2d 937, aff'd, 272 N.Y.S.2d 686 (App. Div. 1966). The parties, however, intended "unconditional" to mean conditional. When a contract's terms so patently contradict majority meaning, the contract is clearly written in party talk. The New York court's decision to permit Doliner to testify as to the contract's actual meaning can be seen as a permission for the parties to write in their own private language. Id. We return to the two-language distinction in a moment. It is also discussed further in Section IV.D below.
96. max. It is recognized, for example, that evidence in category (3) is less reliable than evidence in category (4).
97. Extrinsic evidence refers here to evidence in the five additional evidentiary categories listed in the text.
98. A court applying the Willistonian theory will admit extrinsic evidence only when the contract's language is vague or ambiguous on its face. See Pysell v. Keck, 559 S.E.2d 677, 678-79 (Va. 2002).
99. In a well-known case, Chief Justice Traynor stated: The fact that the terms of an instrument appear clear to a judge does not preclude the possibility that the parties chose the language of the instrument to express different terms. That possibility… exists whenever the parties' understanding of the words used may have differed from the judge's understanding. Accordingly, rational interpretation requires at least a preliminary consideration of all credible evidence offered to prove the intention of the parties. Pac. Gas & Elec. Co. v. G.W. Thomas Drayage & Rigging Co., 442 P.2d 641, 645 (Cal. 1968).
100. min is composed of the written contract, a performance narrative, a dictionary, and the interpreter's experience and understanding of the world.
101. Section 1-303(e)(1) (formerly section 1-205(4)) of the UCC provides that when there is conflict, "express terms prevail over course of performance, course of dealing and usage of trade." U.C.C. § 1-303(e)(1) (2003).
102. min, its interpretation is more likely to deviate further from the correct answer.
103. There is considerable evidence that firms prefer a formalist adjudicatory style. See Bernstein, Merchant Law, supra note 31; Bernstein, Private Commercial Law, supra note 3 1, at 1735-37.
104. See U.C.C. § 2-601 ("[I]f the goods or the tender of delivery fail in any respect to conform to the contract, the buyer may… reject the whole ….").
105. b(i*) because e has mean zero: The buyer's expected payoff equals in expectation the correct payoff. When this more general formalization is used, the second term in brackets will equal the expectation interest in the continuous-payoff case, but this term can be less than the expectation in the discontinuous-payoff case, as it is in the textual treatment above. This is because when courts err in the latter case, the seller is exposed to the possible downside of receiving less than its expectation in a renegotiation, without any concomitant upside.
106. In addition to expanding the evidentiary base, the parties also could increase surplus by changing the contract's payoff structure. See infra text accompanying notes 72-77. Since the buyer would benefit through the price term from actions that increased surplus, the buyer would agree to either method when the method would be cost-justified.
107. Courts frequently consider extrinsic evidence when interpreting the written contract. A commentator recently explained: Extrinsic evidence includes both evidence about trade customs and evidence about interchanges between the parties---concerning the course of performance of the current contract, the course of dealing in prior transactions, or the bargaining history of the current contract. Very often this extrinsic evidence will not be solely documentary and will require evaluation of oral testimony about conversations between the parties. William C. Whitford, The Role of the Jury (and the Fact/Law Distinction) in the Interpretation of Written Contracts, 2001 Wis. L. REV. 931, 937. Over 50% of contract cases tried in federal courts are to juries, and between 25% and 30% are tried to juries in state courts. See
108. Marc Galanter, Contract in Court; or Almost Everything You May or May Not Want To Know About Contract Litigation, 2001 Wis. L. REv. 577, 591, 598 tbl.3, 602 tbl.5, 605 tbl.7, 625 tbl.15.
109. Richard Craswell shows, however, that courts evaluate the probativeness of customs by evaluating the purposes that the customs are meant to serve. See Richard Craswell, Do Trade Customs Exist?, in THE JURISPRUDENTIAL FOUNDATIONS OF CORPORATE AND COMMERCIAL LAW 118, 138-42 (Jody S. Kraus & Steven D. Walt eds., 2000) [hereinafter JURISPRUDENTIAL FOUNDATIONS]. This suggests that custom evidence is costly to admit and to contest.
110. See U.C.C. § 2-717.
111. See id. § 2-719.
112. Id. § 2-608(1).
113. Id. § 2-719(2).
114. Id. § 2-719 cmt. 1.
115. Id. § 2-601 (emphasis added).
116. See Peter Linzer, The Comfort of Certainty: Plain Meaning and the Parol Evidence Rule, 71 FORDHAM L. REv. 799, 805-06 (2002);
117. Robert E. Scott, The Uniformity Norm in Commercial Law: A Comparative Analysis of Common Law and Code Methodologies, in JURISPRUDENTIAL FOUNDATIONS, supra note 71, at 149, 167-69.
118. See § 1-205 cmt. 1 ("This Act rejects both the 'lay-dictionary' and the 'conveyancer's' reading of a commercial agreement. Instead the meaning of the agreement of the parties is to be determined by the language used by them and by their action, read and interpreted in the light of commercial practices and other surrounding circumstances.").
119. If parties preferred courts to use evidentiary bases that were so broad as to foreclose judicial time for deciding other categories of cases, then courts should override the parties' preference. Such a danger of conforming to parties' interpretive preferences would seem unlikely, however, given that modem-day parties generally seem to want adjudications to be briefer than they now are. As a result, so long as there are no other negative third-party effects from judicial deference to the parties regarding interpretive styles, deferring to parties' interpretive preferences would be efficient in the majority of modem contract cases.
120. The position that a party always should be able to show that its contract was written in party talk sometimes is justified on autonomy grounds. Thus, Chief Justice Traynor explained in Pacific Gas & Electric Co. v. G.W. Thomas Drayage & Rigging Co.: "In this state…. the intention of the parties as expressed in the contract is the source of contractual rights and duties. A court must ascertain and give effect to this intention by determining what the parties meant by the words they used." 442 P.2d 641, 644 (Cal. 1968). This argument is a non sequitur as stated. No one would claim that the Statute of Frauds interferes with party autonomy in a normatively serious way, though the Statute sometimes requires parties to cast their agreements in written form. See U.C.C. § 2-201. It would not be a serious interference with autonomy for courts also to assume that parties cast their agreements in majority talk if good reasons exist to create the incentives that this assumption implies. Thus, it takes more argument than now exists to show that an autonomy-based view of interpretation would justify the rule Chief Justice Traynor stated, even if such a view were appropriately applied to firms.
121. § 2-202 cmt. 2 (emphasis added).
122. Some scholars argue that if courts are Willistonian, and thus implicitly adopt majority talk as the linguistic default, parties will incur additional drafting costs translating their private language into the majority language in order to make their intentions clear to judicial interpreters. See Jody S. Kraus & Steven D. Walt, In Defense of the Incorporation Strategy, in JURISPRUDENTIAL FOUNDATIONS, supra note 71, at 193, 197-200. This argument assumes that parties can only opt out of the plain-meaning linguistic default with costly translations. But as the discussion in the text has shown, parties can cheaply opt into a private language by agreeing in their contract that, should a dispute arise, evidence should be admitted regarding that language. Further, even when contracts contain technical party talk, most of their words will be written in the majority language. For example, parties may attribute a private meaning to the phrase "two-by-four" (wood supports so described in construction contracts are usually meant to state dimensions of 1 5/8 by 3 3/8 inches), but such parties seldom would use a private language to describe the delivery date, the place of delivery, the price, and so forth. These parties would want words with trade-language meanings to be read with trade understanding, but would not want words written in the majority language to be read as if they were special. Thus, if the linguistic default is party talk, then parties who wish to exclude party-talk interpretations of majority talk would be required to identify all of the majority terms and explicitly negate the use of extrinsic evidence for interpreting them. On the other hand, by opting into only the technical party talk they wish to incorporate, parties can more readily unbundle the two types of language--e.g., "All measures and specifications in this contract are to be interpreted in light of the customs of the construction industry." Hence, if courts are Willistonian just when parties want them to be, parties will not incur unnecessary writing costs.
123. The current interpretive rules are mandatory (or "quasi-mandatory"). For the purpose of our discussion here, which focuses on party preferences, it is clarifying to treat the rules as defaults.
124. In one case, a contract required the buyer to take "'approximately 70,000 cubic yards' of concrete" and also recited that ‘”[n]o conditions which are not incorporated in this contract will be recognized.”’ S. Concrete Servs., Inc. v. Mableton Contractors, Inc., 407 F. Supp. 581, 582 (N.D. Ga. 1975). The buyer took a little over 12,500 yards in a falling market. Id. In the litigation, his claim that parties in the trade understood explicitly specified quantities to be estimates was rejected. See id. at 585-86. On the other hand, in Columbia Nitrogen Corp. v. Royster Co., 451 F.2d 3 (4th Cir. 1971), course-of-dealing and usage-of-trade evidence was admitted to demonstrate that express price and quantity terms were only "fair estimate[s]." Id. at 7 n.3.
125. See Pac. Gas & Elec., 442 P.2d 641.
126. See Columbia Nitrogen Corp., 451 F.2d 3.
127. See Hunt Foods & Indus., Inc. v. Doliner, 270 N.Y.S.2d 937, aff'd, 272 N.Y.S.2d 686 (App. Div. 1966).
128. A formal treatment of the relation between contracting and enforcement costs and the parties' choice of contractual form will appear in Alan Schwartz & Joel Watson, The Law and Economics of Costly Contracting, 20 J.L. ECON. & ORG. (forthcoming Apr. 2004).
129. The expected return from a complex contract given the likelihood of dispute is 7($15) + .3($15-t)-$5, where the first term is the expected gain when there is no dispute, the second term is the expected gain from a trial (t is the trial cost), and the third term is the cost of creating the deal. The net expected return from the simple contract is $7. This will exceed the return from the complex contract when t exceeds $10.
130. In this example, when t = $12, 1/2 t equals $6, and the expected return from using the complex contract rises to $8.20, which exceeds the gain of $7 from the simple contract.
131. This conclusion may be thought to raise a regress problem. If parties can give interpretive instructions, then those instructions will themselves have to be interpreted, as would instructions regarding how to interpret the instructions and so forth. This problem does not appear to be serious. The default we advocate would require parties to tell courts to widen the evidentiary base. For example, the contract would recite: "Use custom." There seems little reason for parties to say "Use custom sympathetically." Courts seldom would need instructions as to how to interpret simple directives that refer the courts to evidentiary categories now in use.
132. A merger clause recites that the written agreement is the parties' final expression of their intentions. A common example states: "This contract contains the final understanding between the parties and represents the final agreement on all terms. There are no verbal agreements or representations in connection therewith. The writing is a merger of all proposals, negotiations, and representations with reference to the subject matter and provisions." For examples of similar clauses, see Luther Williams, Jr., Inc. v. Johnson, 229 A.2d 163, 165 (D.C. 1967); and UAW-GM Human Res. Ctr. v. KSL Recreation Corp., 579 N.W.2d 411, 412 (Mich. Ct. App. 1998).
133. See Franklin v. White, 493 N.E.2d 161, 166 (Ind. 1986) ("An integration clause is only some evidence of the parties' intentions. The trial court should consider an integration clause along with all other relevant evidence on the question of integration."); Sutton v. Stacey's Food Mart, Inc., 431 A.2d 1319, 1322 n.3 (Me. 1981) ("A merger clause does not control the question of whether a writing was intended to be a completely integrated agreement." (citing RESTATEMENT (SECOND) OF CONTRACTS § 242 cmt. e (Tentative Draft Nos. 1-7, 1973))); see also RESTATEMENT (SECOND) OF CONTRACTS § 209 cmt. b (1981) ("Written contracts… may include an explicit declaration that there are no other agreements between the parties, but such a declaration may not be conclusive."). Professor Corbin is regarded as the most persuasive advocate of this position: "[I]t can never be determined by mere interpretation of the words of a writing whether it is an integration of anything, whether it is the final and complete expression of the agreement or is a mere partial expression of the agreement." 3 ARTHUR LINTON CORBIN, CONTRACTS § 581, at 442 (1960) (internal quotation marks omitted).
134. We argue that courts should adopt a Willistonian linguistic default because parties prefer it and because there are "external" efficiency reasons to justify the default. First, the state subsidizes the judicial system and thus has an independent reason to reduce the likelihood of disputes. For the reasons given above, our default would reduce this likelihood further than current law. Second, if contracts are written in majority talk, courts can create standard vocabularies in which commercial transactions can be conducted. When a phrase has a set, easily discoverable meaning, parties who use it will know what the phrase requires of them and what courts will say the phrase requires. Courts that insulate the meaning of terms in the majority language from deviant interpretations by interpreting the same words in the same ways across cases thus create a collective good: a set of terms with meanings that are already understood by a large majority of potential contracting parties. It follows that courts should encourage parties to use majority talk. See Alan Schwartz, Contract Theory and Theories of Contract Regulation, 92 REVUE D'ÉCONOMIE INDUSTRIELLE 101, 102-03 (2000);
135. Robert E. Scott, The Case for Formalism in Relational Contract, 94 Nw. U. L. REV. 847, 853-56 (2000); Scott, supra note 78, at 157. Another way to put this second point is that similar contracting problems recur in varying contexts. Efficiency is enhanced if parties can adopt prior solutions, and adoption is facilitated when parties know that if they use the language in which a prior solution was cast, they will be taken by courts and contract partners to have adopted that solution. Henry Smith has shown that courts are more hospitable to a contextual interpretation when they recognize that contract language is intended for third parties, as with deeds or third-party beneficiary contracts. See
136. Henry E. Smith, The Language of Property: Form, Context, and Audience, 55 STAN. L. REV. 1105, 1177-90 (2003). Courts should recognize that the set of third parties who would benefit from a contextual interpretation is wider than is conventionally believed. This set includes parties who could profitably use the contracting solutions that prior parties had developed.
137. U.C.C. § 2-202 (2003).
138. See Eric Posner, The Parol Evidence Rule, the Plain Meaning Rule, and the Principles of Contractual Interpretation, 146 U. PA. L. REV. 533, 534 (1998); Whitford, supra note 70, at 939.
139. See, e.g., Ben-Shahar, supra note 52, at 790; Snyder, supra note 52, at 624-25.
140. This proposed interpretation of section 2-202 actually was made in Southern Concrete Services, Inc. v. Mableton Contractors, Inc., 407 F. Supp. 581 (N.D. Ga. 1975). The contract there required the defendant to take “approximately 70,000 cubic yards' of concrete." Id. at 582. The defendant purchased 12,542 cubic yards. It defended the subsequent lawsuit with the claim that trade custom and supplementary agreements between the parties would show "that the quantity stipulated in the contract was not mandatory… and that both quantity and price were understood to be subject to renegotiation." Id. The court excluded the evidence because it believed that an explicit quantity requirement would be contradicted by an understanding that the requirement was not mandatory. It explained: "To admit evidence of an agreement which would contradict the express terms of the contract would clearly eviscerate the purpose of § 2-202." Id. at 585.
141. § 2-202(a).
142. U.C.C. § 2-208 cmt. 2 (1989) (providing that "a course of performance is always relevant to determine the meaning of the agreement"). Revised Article 1, approved in 2001, substantially preserves the section 2-208 definition of "course of performance" in new section 1-303(a) but deletes the comments to former section 2-208. See U.C.C. §§ 1-303, 2-208 (2003). To date, revised Article 1 has been adopted only in a few states. Section 2-208 and its comments thus remain as part of the enacted UCC in the large majority of jurisdictions.
143. See, e.g., U.C.C. § 2-208 cmt. 1 (1989) ("The parties themselves know best what they have meant by their words of agreement and their action under that agreement is the best indication of what that meaning was."). On the current legal status of section 2-208, see supra note 101.
144. See U.C.C. § 2-209(4) (2003) ("Although an attempt at modification or rescission does not satisfy the requirements of subsection (2) [excluding modifications except by a signed writing]… it can operate as a waiver."). Comment 4 explains that "[s]ubsection (4) is intended, despite the provisions of subsection[] (2) …. to prevent contractual provisions excluding modification except by a signed writing from limiting in other respects the legal effect of the parties' actual later conduct." Id. § 2-209 cmt. 4.
145. This example was stimulated by Ben-Shahar's model, but he apparently assumes that deviations impose the same loss in each period rather than the same loss on average. Ben-Shahar, supra note 52, at 796-800. On his assumption, parties are indifferent to whether courts admit course-of-performance evidence to show a change in meaning. Ben-Shahar later relaxes the same-loss assumption, however, and then concludes, as we do, that the soft version of the parol evidence rule will disadvantage typical parties.
146. Our argument here is similar to Karl Llewellyn's view of custom. He believed that customs govern ordinary cases but seldom are relevant to the unusual cases that cause parties to litigate. See Alan Schwartz, Karl Llewellyn and the Origins of Contract Theory, in JURISPRUDENTIAL FOUNDATIONS, supra note 71, at 12, 16.
147. Arbitrators obey the parties' interpretive instructions, but courts do not. Our analysis thus identifies a reason for parties to use arbitration, but it cannot support the inference that parties use courts because they prefer the interpretive styles in current use. There are other reasons for using courts, such as the ability to get discovery, to have appeals, to have the substantive law applied by experts in it, to create effective precedents, and the like. See Kenneth S. Abraham & J.W. Montgomery, III, The Lawlessness of Arbitration, 9 CONN. INS. L.J. 355 (2003);
148. Charles L. Knapp, Taking Contracts Private: The Quiet Revolution in Contract Law, 71 FORDHAM L. REV. 761 (2002). The widespread use of merger and no-oral-modification terms in contracts intended for courts also suggests, in line with our views, that parties who prefer judicial enforcement also prefer enforcement under a different interpretive style.
149. Parties tend to omit low-probability states. For example, if very low demand is thought quite unlikely, parties will not incur the contracting cost to specify their obligations in the very low-demand state. A lawsuit could arise if this state materializes and the parties cannot agree on a new price.
150. Since these rules are facilitative, courts should permit future parties to vary them. Judicial creation of such gap-filling defaults is not inevitable. A court instead can refuse enforcement when gaps cause a contract to be obligationally incomplete-that is, when the terms the contract does contain provide an insufficient basis on which to ground a remedy. The common law rule is that contracts leaving material terms incomplete or indefinite are not legally binding. It may be paradoxical that the indefiniteness rule is itself a default. Parties can opt out of it by more completely specifying their obligations in the contract.
151. The Restatement defaults differ from statutory defaults because a restatement is not self-executing. A restatement provision cannot become a legal default until it is both promulgated by the American Law Institute (ALl) and then adopted by a court when resolving a dispute. Thus, our analysis here applies both to the private legislatures that promulgate defaults and to the courts that adopt them.
152. For analyses of how contractual innovations spread, see Gerald F. Davis, Agents Without Principles? The Spread of the Poison Pill Through the Intercorporate Network, 36 ADMTN. SCI. Q. 583 (1991);
153. Gerald F. Davis & Henrich R. Greve, Corporate Elite Networks and Governance Changes in the 1980s, 103 AM. J. Soc. 1 (1997).
154. See Charles J. Goetz & Robert E. Scott, The Limits of Expanded Choice: An Analysis of the Interactions Between Express and Implied Contract Terms, 73 CAL. L. REV. 261, 291-93 (1985).
155. See id. at 284-85. The courts' behavior explains the intensive lobbying by firms regarding the proposed revisions to Article 2, especially the warranty terms. See Robert E. Scott, The Rise and Fall of Article 2, 62 LA. L. REV. 1009, 1049-53 (2002). Firms know that judicial action can make a UCC default sticky in practice.
156. Russel Korobkin has argued that the "endowment effect" makes defaults hard to change. Individual subjects in experiments manifest the endowment effect when they demand much more to sell an item-for example, a coffee mug-than they would bid to purchase the item. Put another way, persons' preferences are in part a function of the legal assignment of property rights; they are not independent of that assignment, as the Coase Theorem supposes. In the realm of contract law, a party subject to the endowment effect would ask much more to give up a default that is favorable to it than the party would bid to obtain from its contract partner a clause that is identical to the default. As a consequence, for such parties defaults are more like mandatory rules; the endowment effect would prevent parties from conveniently altering the allocations that the defaults create. Korobkin conducted experiments casting first-year law students in the role of attorneys, and found that they advised clients in a manner that manifested endowment effects. See Russell Korobkin, The Status Quo Bias and Contract Default Rules, 83 CORNELL L. REV. 608 (1998). A more recent treatment is
157. Russell Korobkin, The Endowment Effect and Legal Analysis, 97 Nw. U. L. REV. 1227 (2003). Professor Korobkin's experiments are not relevant to the types of transactions we consider. Recent theory attributes the endowment effect to the existence of a real option on the subject of sale. A party uncertain about the value of a good to her can delay a purchase or sale while gathering more information. To buy or to sell thus exercises the option because information is no longer relevant after the transaction. As a consequence, the seller's price is the sum of the good's cost and the (positive) value of the option to delay sale; the buyer's bid is the sum of the value of the good to him and the (negative) value of the option to delay purchase. Adding option values to an ask price and subtracting them from a bid price produces differences between them that are of the same order of magnitude as are manifested in the psychological experiments. See
158. Massimo Paradiso & Antonella Trisorio, The Effect of Knowledge on the Disparity Between Hypothetical and Real Willingness To Pay, 33 APPLIED ECON. 1359 (2001);
159. Eric van Dijk & Daan van Knippenberg, Buying and Selling Exchange Goods: Loss Aversion and the Endowment Effect, 17 J. ECON. PSYCHOL. 517 (1996);
160. Jinhua Zhao & Catherine L. King, A New Explanationfor the WTP/WTA Disparity, 73 ECON. LETTERS 293 (2001). An implication of these articles is that the endowment effect should be small or absent when sophisticated parties who know what they are doing trade goods for money. Daniel Kahneman thus remarked: "Loss aversion plays little role in routine economic transactions, in which a seller and a buyer exchange a good and money, both of which were held for that purpose."
161. Daniel Kahneman, Reference Points, Anchors, Norms, and Mixed Feelings, 51 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 296, 301 (1992). Consistent with this view, sophisticated actors trading in real markets have been shown not to manifest endowment effects; their preferences are independent of the initial location of property rights to traded objects. See
162. John A. List, Does Market Experience Eliminate Market Anomalies?, 118 Q.J. ECON. 41, 42-43 (2003) ("[M]arket experience matters: across all consumer types, marketlike experience and the endowment effect are inversely related. In addition, within the group of subjects who have intense trading experience (dealers and experienced nondealers), I find that the endowment effect becomes negligible."). Our analysis assumes away endowment effects because we study transactions between firms with "intense trading experience" who "trade goods for money."
163. If the state wants a particular rule actually to control behavior, it should make the rule mandatory. Currently, parties are permitted to create their own contracts, but sometimes only at the cost of contracting out of state-created defaults. The costs of contracting out will exceed the gains for some firms but not others. As a consequence, a fair but inefficient default disadvantages firms with relatively high contracting costs, but cannot fully realize the state's fairness concern because other firms will create their own deals.
164. Section V.C below argues that the UCC's implied warranty term is inefficient because it provides a seller with too little guidance regarding the performance obligation and also creates moral hazard.
165. Scholars have identified a set of default rules that are termed "information-forcing" because the rules create an incentive for a party to disclose relevant information to its contract partner. See Ayres & Gertner, supra note 1. Information-forcing rules include those providing that damages cannot be recovered unless they are foreseeable and reasonably certain; the rules create an incentive for a promisee who fears breach to disclose in advance to the promisor the loss the promisee would suffer. The promisor then will be able to price more accurately and to take optimal precautions against breach. Information-forcing rules fall within the analysis here because parties can create them on their own. For example, sellers routinely propose contracts that disclaim liability for consequential damages. This creates an incentive for buyers who may suffer these damages to disclose them to the seller and then to purchase insurance by bargaining away the disclaimer. An information-forcing default thus will be popular if parties would agree to disclose in the circumstances in which the rule applies. It has been shown that the foreseeability default may not always be popular in this sense. See Johnston, supra note 10, at 626-38 (stating that parties facing a monopolist may not want to disclose the profits they would earn from successful transactions because the monopolist then may price discriminate against them).
166. See Alan Schwartz & Robert E. Scott, The Political Economy of Private Legislatures, 143 U. PA. L. REV. 595, 607-37 (1995).
167. i) is more likely to be close to one than close to a large number. A more extensive analysis of the heterogeneity point is in Alan Schwartz, The Normative Implications of Transaction Cost Economics, 152 J. INSTITUTIONAL & THEORETICAL ECON. 287 (1996).
168. Recall that a rule specifies the relevant conduct in advance--e.g., no driving above fifty-five miles per hour.
169. The buyer's expectation interest would be its valuation less the price, which was $15 in the example.
170. See, e.g., Taylor v. Caldwell, 122 Eng. Rep. 309 (Q.B. 1863); RESTATEMENT (SECOND) OF CONTRACTS § 263 (1981).
171. U.C.C. § 2-615(a) (2003). Section 261 of the Restatement contains the same rule in almost the same language. RESTATEMENT (SECOND) OF CONTRACTS § 261 (1981).
172. U.C.C. § 2-314(2).
173. See id. §§ 2-205 to-209, 2-302, 2-305 to-307, 2-309, 2-311 to-312, 2-314 to-315, 2-317, 2-503 to-504, 2-508, 2-511, 2-513, 2-602 to-610, 2-612, 2-614 to-615, 2-704 to-706, 2-709 to-710, 2-712, 2-714 to-716, 2-718 to-719, 2-723. The UCC also adopts standards in order to avoid resolving controversial issues. See Schwartz & Scott, supra note 117. Our analysis here is meant to show that even if the ALI and NCCUSL were bolder, the cost concern would generate many standards.
174. An index clause links the transaction price between the parties to verifiable external indices, such as the Consumer Price Index (CPI), that correlate with the economic conditions facing the parties. The degree of correlation is a function of the type of party (some firms' costs will move more closely with the CPI than other firms' costs will, for example), so that index clauses vary with particular parties or party types.
175. Force majeure clauses apparently have a long pedigree. Consider, as an example, the following clause in a contract between Michelangelo and the heirs of Pope Pius III requiring Michelangelo to produce fifteen marble statues for the cathedral in Siena within a specified time: Item, whereas the said Michelangelo, by virtue of the said agreement, has bound himself to cause marble to be brought to Florence from the mountains of Carrara for the making of the said statues; and whereas, by reason of the besieging of the Pisans within the territory of Pisa, war has once more broken out; and whereas the Florentine Republic may endeavour to divert the course of the River Amo in such wise that the transport of the said marble from the mountains of Carrara to the city of Florence may therefore be hindered; and whereas also the said Michelangelo may fall ill, which God avert… then… the said [new contractual period] shall be suspended during the time of the said hindrance. ANTON GILL, IL GIGANTE: FLORENCE, MICHELANGELO, AND THE DAVID, 1492-1504, at 215-16 (2002).
176. See, e.g., T.W. Oil, Inc. v. Consol. Edison Co., 443 N.E.2d 932 (N.Y. 1982).
177. See, e.g., Aluminum Co. of Am. v. Essex Group, Inc., 499 F. Supp. 53 (W.D. Pa. 1980).
178. This test sometimes can be met. For example, the standard merger agreement contains a term permitting the buyer to exit without penalty if a "material adverse change" occurs in the interim between signing the contract and concluding the merger. This term does not specify the events that could constitute a material adverse change because there can be many such events whose effects will vary with the ex post state of the world. A standard nevertheless is efficient here because the buyer will exit only if the seller's value has fallen materially. The threat of exit creates an incentive for the seller to take synergy-increasing actions that lower the probability that its value to the buyer will fall materially. See Ronald Gilson & Alan Schwartz, Understanding MACs and MAEs (2003) (unpublished manuscript, on file with authors), available at http://islandia.law.yale.edu/ccl/papers/mergerl5.pdf. This example is offered to suggest that some statutory standards may be efficient, but it may also support the inference that parties will write a standard in their contracts when a standard would maximize surplus.
179. See, e.g., Victor P. Goldberg, Discretion in Long-Term Open Quantity Contracts: Reining in Good Faith, 35 U.C. DAVIS L. REV. 319 (2002) (analyzing in detail the ways in which courts have used the good faith standard that regulates discretion in output and requirements contracts under section 2-306(1) to undermine the controls on discretion that the parties had set for themselves).
180. See Alan Schwartz & Robert E. Scott, COMMERCIAL TRANSACTIONS: PRINCIPLES AND POLICIES 204-24 (2d ed. 1991).
181. Before 1978, parties routinely contracted out of section 2-609 with ipso facto clauses, which stated precisely when a party could cancel the agreement in consequence of its partner's financial difficulty. The current Bankruptcy Code outlaws these clauses on the (erroneous) ground that they permit solvent parties to deplete the bankruptcy estate. See 11 U.S.C. § 365(e)(1) (2000). For an analysis, see Yeon-Koo Che & Alan Schwartz, Section 365, Mandatory Bankruptcy Rules and Inefficient Continuance, 15 J.L. ECON. & ORG. 441 (1999). A concrete example of contracting out occurs in Northwest Lumber Sales, Inc. v. Continental Forest Products, Inc., 495 P.2d 744, 748-50 (Or. 1972).
182. Ian Ayres has suggested that standards may be good defaults because precedent can crystallize around them, thereby providing parties with guidance. See Ian Ayres, Making a Difference: The Contractual Contributions of Easterbrook and Fischel, 59 U. CHI. L. REV. 1391, 1415-16 (1992). This argument assumes that legal standards will become operative implied terms in parties' contracts, thereby giving courts the opportunity to apply them. The premise generally fails because parties contract out of the standards.
183. The last danger is said to have occurred in England when the courts adopted an excuse standard. As English lawyer Andrew Rogers, Q.C., wrote in his introduction to a book on the excuse doctrine: It is only in relatively recent times that the English courts relented in their demand that the strict words of the contract be adhered to, notwithstanding changes in circumstance. The resulting doctrine of frustration has not worked satisfactorily. The courts found it difficult to determine… the limits for its application…. …[F]rustration under the general law brings in its train automatic discharge. To avoid such results, the parties to the contract are required to draft their own particular code. That in turn means a substantial increase in transaction costs. Notwithstanding the costs involved, in an effort to meet the difficulty many contractors have undertaken fairly detailed contractual risk allocation. Andrew Rogers, Foreword to FORCE MAiEURE AND FRUSTRATION OF CONTRACT, at v, v-vi (Ewan McKendrick ed., 2d ed. 1995).
184. A rare example of a successful default rule is the requirement that a breacher pay the other party the difference between the contract and market prices. The rule applies in only one state of the world: when there is breach. It is simple to apply because the court only compares the contract and market prices, and it is efficient for many parties because the rule protects the expectation interest. Other good default rules are hard to find.
185. The problem was identified in Steven Shavell, Damage Measures for Breach of Contract, 11 BELL J. ECON. 466 (1980), and elaborated on in
186. William P. Rogerson, Efficient Reliance and Damage Measures for Breach of Contract, 15 RAND J. ECON. 39 (1984).
187. Courts cannot prevent this practice because a court can observe only what the parties can observe. If the court does not know the value that optimal investment would have generated, it cannot award that value to the buyer. It must instead award the value the buyer actually lost. A nice, though technical, discussion of the impossibility of writing first-best efficient contracts when both the seller's costs and the buyer's valuation are unobservable is Patrick W. Schmitz, On the Interplay of Hidden Action and Hidden Information in Simple Bilateral Trading Problems, 103 J. ECON. THEORY 444 (2002).
188. Concise but moderately technical discussions of these contracts are Patrick W. Schmitz, The Hold-Up Problem and Incomplete Contracts: A Survey of Recent Topics in Contract Theory, 53 BULL. ECON. RES. 1 (2001);
189. Alan Schwartz, Incomplete Contracts, in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW, supra note 30, at 277. A nice-though also technical-example is
190. Benjamin E. Hermalin & Michael L. Katz, Judicial Modification of Contracts Between Sophisticated Parties: A More Complete View of Incomplete Contracts and Their Breach, 9 J.L. ECON. & ORG. 230 (1993).
191. Asymmetric information also can create "ambiguity aversion," and when it exists an attempt by the state to fill contractual gaps would usually be futile. To see why, assume that n > 1 probability distributions may characterize the occurrence of a possible event or state of affairs. A party behaves in an ambiguity-averse fashion when it calculates its expected payoffs by using the lowest probability in any of the n possible distributions. Suppose, then, that party F would be better off if state ? materializes than party G would be, while party G may be better off if state ? materializes than party F would be. When F is calculating its expected payoffs, it will use the probability distribution that puts a relatively higher weight on state ? obtaining, in which it is worse off, than it would put on state ? obtaining, in which it is better off. For similar reasons, G will put a relatively greater weight on state ? obtaining. When the parties act in this fashion, they calculate their expected payoffs differently even though they agree on the monetary payoffs; the parties estimate differently, because they are estimating with different probability distributions. This behavior can create an inefficiency. The sum of the payoffs that ambiguity-averse parties expect to occur will be less than the true expected surplus (since each party is calculating with the most unfavorable probability). As a consequence, the parties may perceive an efficient deal, which in fact would create gains in excess of costs, as creating costs in excess of gains. A response to this problem is to use an incomplete contract and to rely on renegotiation to determine the terms of trade in some possible future states. This can be more efficient than writing a more complete ex ante contract because when a state of the world materializes, the parties will know what their actual gains from trading in that state would be. They will then trade when trade is efficient and otherwise will not. Ambiguity aversion is more likely to occur when parties face high uncertainty (so that it can be hard to know just which probability distribution is the correct one to use). And when uncertainty is great, the parties' preference for contractual incompleteness suggests that filling gaps with state-created rules or standards would not advance the parties' objectives. A recent discussion thus stated: "The argument … suggests why incomplete contracts may not be a paradox in a world with ambiguity aversion since their inefficiency will not be 'readily fixable'-complete contracts do not help very much." Sujoy Mukerji, Ambiguity Aversion and Incompleteness of Contractual Form, 88 AM. ECON. REV. 1207, 1218 (1998).
192. Under section 2-715(2)(a), the buyer can recover (in addition to direct damages under sections 2-712, 2-713, or 2-714) "any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know." U.C.C. § 2-715(2)(a) (2003).
193. The prospect of inefficient performances also would induce excessive precautions against breach.
194. These clauses disclaim the seller's liability for consequential damages and restrict the buyer's right to reject, but obligate the seller to repair or replace defective tenders. See SCHWARTZ & SCOTT, supra note 131, at 204-09.
195. Karen Eggleston, Eric Posner, and Richard Zeckhauser recognize that parties may write simple contracts as a consequence of asymmetric information, but they urge courts to interpret these contracts liberally. That is, courts should "freely" insert terms in a way that "(roughly speaking) maximizes the ex ante joint surplus of the contract." Karen Eggleston et al., The Design and Interpretation of Contracts: Why Complexity Matters, 95 Nw. U. L. REV. 91, 127 (2000). These authors do not show how courts could create efficient terms when sophisticated parties with money at stake could not, nor do they consider the possibility that sophisticated parties would contract out of unhelpful judicial efforts.
196. This claim may appear vulnerable to the objection that inefficient defaults are "harmless bromides" because parties are already writing the contract; their marginal cost of avoiding a bad legal rule, thus, is slight. This objection is mistaken on two levels. First, the total social cost of avoiding an inefficient legal rule is not slight. The small cost of changing the rule for a particular contract must be summed over all of the transactions that the rule affects in the decades that the rule will exist. Second, it is actually costly to change a bad rule when writing a particular contract because courts tend to regard state-created defaults as presumptively fair or efficient. This institutional bias raises the cost of contracting out. See, e.g., Hayward v. Postma, 188 N.W.2d 31, 33 (Mich. Ct. App. 1971) (holding that parties must use clear and unequivocal language to shift liability for the risk of loss from seller to buyer); Davis v. Small Bus. Inv. Co. of Houston, 535 S.W.2d 740, 744 (Tex. Civ. App. 1976) (holding that a contractual provision purporting to allocate to the debtor the burden of "all" expenses incurred in preserving collateral was insufficient to trigger the "unless otherwise agreed" provision of Texas's equivalent of former section 9-207(2)(a) of the UCC, which required that "reasonable expenses" be chargeable to the debtor); Caudle v. Sherrard Motor Co., 525 S.W.2d 238, 240 (Tex. Civ. App. 1975) (taking a similar approach with respect to Texas's equivalent of section 2-509 of the UCC). Moreover, judicial interpreters may be reluctant to give the express language of the contract a meaning that conflicts with the relevant default. See, e.g., Nanakuli Paving & Rock Co. v. Shell Oil Co., 664 F.2d 772, 794-805 (9th Cir. 1981) (holding that a merger clause that excludes evidence of prior dealings does not bar evidence of usage of trade to alter the price term in the contract); Legnos v. United States, 535 F.2d 857, 858 (5th Cir. 1976) (holding that despite the express term "F.O.B. vessel" in a contract, international context requires that "the intention of the contracting nations, rather than definitional niceties, must be given controlling weight").
197. It is widely believed that contemporary courts ignore the indefiniteness doctrine. Conventional wisdom holds that courts should (and do) fill contractual gaps with general standards of reasonableness and good faith. See, e.g., 1 CORBIN, supra note 94, § 95, at 400. This conventional wisdom is misleading. In a recent article, one of us shows that the indefiniteness doctrine has survived the influence of the UCC and the widespread academic support for filling gaps with standards. See Scott, supra note 33. In dozens of cases, American courts dismiss claims for breach of contract on the grounds of indefiniteness, often without granting any relief to the disappointed promisee. Scott argues that parties write incomplete contracts in the face of a rigorous indefiniteness doctrine when they can create efficient extralegal mechanisms for coping with problems of hidden information and hidden action. Using the language of this Article, his claim is that parties sometimes can solve moral hazard problems when courts cannot.
198. The rules prohibiting fraud and duress also function to prevent a party from externalizing costs. Fraud and duress do not create social wealth but rather redistribute it (unfairly) between the parties. Were these practices permitted, the costs of enforcing the redistributions would be externalized to society. Thus, fraud and duress are grounds for declining to enforce a contract, because the resulting deal does not maximize joint welfare.
199. Traditional accounts of paternalism require the paternalist-here a judge-to aim at improving the agent's welfare. For a discussion, see Richard J. Arneson, Mill Versus Paternalism, 90 ETHICS 470 (1981);
200. Seana Valentine Shiffrin, Paternalism, Unconscionability Doctrine, and Accommodation, 29 PHIL. & PUB. AFF. 205 (2000).
201. See RESTATEMENT (SECOND) OF CONTRACTS § 311 cmt. a (1979); see also Zumwinkel v. Leggett, 345 S.W.2d 89 (Mo. 1961) (holding unenforceable a no-oral-modification clause); Beatty v. Guggenheim Exploration Co., 122 N.E. 378, 381 (N.Y. 1919) (Cardozo, J.) ("Those who make a contract may unmake it. The clause which forbids a change may be changed like any other…. Whenever two men contract, no limitation self-imposed can destroy their power to contract again."); Jolls, supra note 1 (discussing reasons why parties might want to ban modifications). Civil law codes, on the other hand, discourage renegotiation; these codes thus are more consistent with the argument in the text than with the common law. See Eric Brousseau, Did the Common Law Biased [sic] the Economics of Contract… and May It Change?, in 6 LAW AND ECONOMICS IN CIVIL LAW COUNTRIES 79, 83-85 (Bruno Deffains & Thierry Kirat eds., 2001).
202. A more extensive formal discussion of the parties' preferences regarding modifications is in Schwartz & Watson, supra note 89.
203. See supra Section III.B.
204. The seller in this example could not sue for the $40 price because we assume that product values are not verifiable. Thus, the seller could not prove that the value was high.
205. The investment in this example is termed "cooperative" because the seller invests to increase the buyer's value. When renegotiation is permitted, cooperative investment can be impossible to motivate by contract. See Yeon-Koo Che & Donald B. Hausch, Cooperative Investments and the Value of Contracting, 89 AM. ECON. REV. 125 (1999);
206. Ilya Segal, Complexity and Renegotiation: A Foundation for Incomplete Contracts, 66 REV. ECON. STUD. 57 (1999). Our earlier examples involved self-investment (the seller invests to lower her costs; the buyer invests to increase his value). Efficient self-investment is easier to motivate with appropriate contracts. Both kinds of investment are common.
207. Modification bans also can be efficient when one of the parties is risk-averse. To see why, consider a possible contract between a risk-neutral principal and a risk-averse agent who is supposed to do a task. The principal, it is commonly assumed, cannot verify the agent's behavior to a court, so the contract must motivate the agent. This will require the agent to bear risk; that is, her pay must be contingent on the outcome, so she will try to produce a good result. The agent bears risk because the outcome is a function both of her efforts, which increase the likelihood of a good result, and chance. After the agent acts, but before the result is known, a Pareto-superior deal between the parties becomes possible: Since the agent has acted, she no longer needs to be motivated, but she still bears risk because nature has yet to act. The deal will transfer risk from her to the risk-neutral principal by paying the agent a fixed fee that will lie somewhere between the contract's good-and bad-state payoffs to her. If the parties anticipate this renegotiation, however, they will know that the agent's payoff will not be a function of the outcome; rather, it will be the fixed fee the agent expects to get in the renegotiation. Thus, the agent cannot be motivated to try hard because her payoff actually is noncontingent. When trying hard is efficient, permitting renegotiation thus is inefficient. The parties, ex ante, again have good reasons to prevent themselves from changing their minds. See Jolls, supra note 1, at 209-24.
208. See RESTATEMENT (SECOND) OF CONTRACTS §§ 237, 241 (1981). If the performance is substantial, the default rule is that the promisee must transfer the price less a sum that would compensate it for the deviation from full performance. As we will see below, when the promisee's valuation is not verifiable the right to deduct damages is hollow.
209. See id. § 227 cmt. b ("The policy favoring freedom of contract requires that, within broad limits… the agreement of the parties should be honored even though forfeiture results. When, however, it is doubtful whether or not the agreement makes an event a condition of an obligor's duty, an interpretation is preferred that will reduce the risk of forfeiture."); see also Robert E. Scott & Jody S. Kraus, CONTRACT LAW AND THEORY 718-20 (3d ed. 2002).
210. N.E. 889 (N.Y. 1921).
211. See id. at 890.
212. See id.
213. See id. at 890-91.
214. See id.
215. See U.C.C. § 2-718(1) (2003) ("Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach …. A term fixing unreasonably large liquidated damages-is void as a penalty.").
216. See Goetz & Scott, Liquidated Damages, supra note 1, at 568-76.
217. See Alan Schwartz, The Myth That Promisees Prefer Supracompensatory Remedies: An Analysis of Contracting for Damage Measures, 100 YALE L.J. 369, 383-87 (1990).
218. For a review of the various ways, including the one above, that enforcing penalties can enhance efficiency, see Aaron S. Edlin & Alan Schwartz, Optimal Penalties in Contracts, 78 CHi.-KENT L. REv. 33 (2003).
219. See id. When the seller has market power, parties may use penalties to deter the entry of competitors into the seller's market. See id. at 40-42. Under current law, however, courts strike what they perceive to be penalty terns whether those terms were used to increase investment or to impede entry. We argue here that courts should only ban inefficient penalties; to ban other penalties is only misplaced paternalism. Another way to put this claim is that a party should always be free to argue that a damages term would create a negative externality or perpetuate a market failure-grounds that we maintain would still be sufficient reason for courts to strike such a term. But it is a mistake to treat as a sufficient proxy for these inefficiencies a liquidated damages clause that would overcompensate a party in expectation.