Transaction costs and default terms

1. Contract LawAn Economic Theory of ContractsTransaction costs, complete contracts, default terms and perfect contracts Contract_D

2. Transaction costs and default terms Contracts generally involve risks, since all future states of the world are not known A complete contract is one that allocates all risks to either the promisor or the promisee However the value of some of these risks will be greater than others (either they are more likely to occur or they are more costly if they do occur) Will most contracts be complete? No! Most contracts have gaps – unallocated risks Contract_D

3. Parties to a contract might find themselves in the following situations: 1. A known and potentially costly risk is allocated in the contract – eg. a delivery point is agreed upon with the seller responsible for the safe arrival of the goods to that point and the buyer thereafter – an allocated risk 2. The costs of negotiating the allocation of the risk may be greater than the cost of the risk (either the risk is remote or the cost associated with the event is low), so that the risk is not allocated to either of the parties - a ‘gap’ is left in the contract – an unallocated risk 3. The risk itself may be unforeseen and hence not allocated - another gap- unallocated risk Contract_D

4. Rational gaps - cost minimizing gaps If the ‘risk’ is allocated ‘ex ante’ then the parties must incur transaction costs (to negotiate allocation of the risk) - with certainty If the ‘loss’ is allocated ‘ex post’, then the parties will incur transaction costs (to allocate the loss) only if the event actually occurs – they might or might not have to actually do this Consider the following transaction costs minimizing rule: Contract_D

5. if the cost of allocating a given risk > the expected cost of allocating the loss then leave the gap if the cost of allocating a given risk < the expected cost of allocating the loss then fill the gap This is the ‘private’ optimizing (cost minimizing) rule that agents would follow Contract_D

6. What is the cost of allocating a given risk? the up front transaction - costs of bargaining between the parties to the contract - these transaction costs will be incurred with certainty if the cost of the risk is allocated up front What is the expected cost of allocating the loss? (cost of allocating the loss) x (probability of the loss occurring) these transaction costs will be incurred only if the bad event happens So we can re-write the ‘private’ optimizing (cost minimizing) rule as: Contract_D

7. if the cost of allocating a given risk > (cost of allocating the associated loss) x (probability of the loss occurring), then leave the gap if the cost of allocating a given risk < (cost of allocating the associated loss) x (probability of the loss occurring), then fill the gap Gaps left in contracts on the basis of the above rule are termed rational gaps - they minimize transaction costs Contract_D

8. Example: Risk of patent infringement Big Firm is contracting to buy an electronic component from Small Firm. Small Firm relies on a number of patents to produce the component and any one of these patents might be challenged by a competitor at some future date. Contract_D

9. Big Firm believes that negotiating a contract clause to cover the possibility of contract failure due to patent infringement would costs $150,000. If the contract was to fail due to a patent infringement lawsuit against Small Firm then Big Firm believes that the cost of sorting out the damages would be $750,000. What must the likelihood of Small Firm being sued for patent infringement be before Big Firm would consider negotiating a ‘patent infringement claim clause’ in the contract with Small Firm? Contract_D

10. Recall: if the cost of allocating a given risk > (cost of allocating the associated loss) x (probability of the loss occurring), then the private maximizing strategy is to leave the gap We know that for Big Firm the rule becomes: $150,000 > $750,000 x (probability of the loss occurring) so that, $150,000/$750,000 > probability of the loss occurring so that, if probability of the loss occurring < 0.2 (20%), the optimizing strategy is to leave the gap Contract_D

11. What about the contract values themselves – the investment, expected gains, investment in reliance etc? Why do we not consider these costs in deciding whether or not to negotiate a clause? There will be many such risks in any given contract setting Some of these risks can be grouped under general provisions of the contract – ‘act of war or insurrection’ clause, ‘FOB’, ‘act of god’ Sometimes there are standard ‘trade clauses’ which cover known risks in a given market setting – ‘rain check’, ‘rain date’ Nonetheless, all contracts will be incomplete Contract_D

12. Gap-filling by courts What if a contract fails due to an unallocated risks and the parties cannot agree on an allocation of the loss How should the courts fill gaps left by the parties to a contract? Courts might ‘impute’ contract terms which the parties omitted - fill the gap – provide default terms An efficient default term allocates the loss to the party which could have borne the risk ex ante at least costs (This is the party that would have been responsible for the risk had it been allocated ex ante – why?) Contract_D

13. If the courts always impose efficient default terms then: - both parties are potentially better off, since efficient default terms lead to a minimization of the costs of dealing with the risk - parties to a contract can avoid (minimize ?) the transaction costs associated with negotiating these terms in every contract Contract law should minimize transaction costs of negotiating contracts by supplying efficient default terms when it becomes necessary to do so Does this mean that every time a contract fails and there is a gap in the contract, the parties will end up in court? No, recall ‘bargaining in the shadow of the law’ Contract_D

14. Hypothetical bargain How do courts arrive at efficient default terms? Two elements: 1. Courts need only impute the terms to the contract that the parties would have agreed to had they negotiated over the risk - the courts must decide who would have been the more efficient risk bearer ex ante. 2. Was the risk foreseen, or should it have been foreseen, by one of the parties – if so the costs of the risk was likely already included in the negotiated contract price. Contract_D

15. A rule of common law: the promisor must bear the costs of `reasonably expected costs of breach’, while the promisee must bear the costs of ‘unforeseeable costs of breach’, unless the promisor is notified of such costs I If a risk is known to the promisor, then the promisor is responsible for that risk – otherwise the promisee is responsible Contract_D

16. Does this make sense? - It provides a clear rule for the courts and the parties to a contract - If the risk is known then the promisor can ‘price it into’ the contract, or explicitly negotiate for the promisee to assume the risk - If there is some unusual risk (unforeseen to the promisor) but known to the promisee, then the burden is on the promisee to make the promisor aware of this risk Note that all of this might be difficult in practice Often thecourt must rely on the ‘customs of the trade’ in order to determine what each party knew or should have known about the facts involved Contract_D

17. Example - Who should be responsible for the weather? – see note package A-I Power Company in New York State has a contract to provide power to Major Manufacturer Power Company buys its power from Quebec Hydro A bad winter storm interrupts the Quebec Hydro power supply Major Manufacturer loses power and $1,000,000 in profits Major Manufacturer sues Power Company for breach of contract Contract_D

18. It is known that: - Major Manufacturer could have built a back-up gas fired power plant for use in emergencies at a cost of $500,000 annually - Power Company could have made a risk sharing agreement with Southern Power Company to supply each other with extra power in case of emergency at a cost of $100,000 annually (i.e. share a grid). Efficient default term: Power Company could have borne the risk at a lower cost than can Major Manufacturer, therefore it should be forced to compensate Major Manufacturer for its loss of profits Contract_D

19. What if Major Manufacturer only lost $50,000 in profits? Then the loss does not justify compensation, since it would be more expensive to avoid the loss ($100,000) than the loss suffered It would be inefficient to force the Power Company to incur $100,000 in cost to avoid a $50,000 loss What if another customer, Minor Manufacturer who lost $150,000 in profits could have supplied back-up power by buying a portable generator at an annual cost of $2,500? Should Minor Manufacturer be compensated by the Power Company? Contract_D

20. Example – foreseeability In 1990 Grain Transport contracts with Farm Co-op to transport 1,000 tons of grain per week from point A to point B at a cost of $10,000 per year, for a three year period After two years Grain Transport begins billing Farm Co-op at the rate of $12,000 per year, citing increases in the cost of fuel as the reason Farm Co-op refuses to pay the additional $2,000 per year and Grain Transport sues Contract_D

21. Suppose that: - Grain Transport knew, or should have known, that there was a 50% chance that the cost of fuel might increase by $2,000 per year during the third year of the contract, implying that the expected increase in fuel costs was $1,000 (0.5 x $2,000) - further, at the time the contract was made, Grain Transport could have contracted to buy fuel for the third year of the contract, at the 1990 price, for an additional charge of $500 - Farm Co-op had no special knowledge of the market for fuel and could not have foreseen the possible increase in fuel prices Contract_D

22. The court is likely to decide that: 1. The hypothetical bargain which Grain Transport and Farm Co-op would have made, would have allocated the risk of increased fuel prices to Grain Transport - it was the most efficient bearer of that risk 2. Who pays the $2,000 loss due to increased fuel costs? Grain Transport. 3. But who pays the ‘hypothetical’ hedging costs of $500? (The amount Grain Transport could legitimately charge as the costs of dealing with the risk) Contract_D

23. Can Grain Transport, at least, charge Farm Co-op an amount equal to the costs of doing what the court found it should have done? No, Grain Transport knew, or should have known, that the price of fuel might go up. Therefore, whatever price it agreed to in the original contract should have ‘priced in’ the risk of fuel price increases. If Grain Transport did not include such a risk premium in its contract price, then that is its own fault and there is no reason to make Farm Co-op pay after the fact. It cannot charge its customer ‘after the fact’ for the cost of a bad event the risk of which its customer was unaware. Contract_D

24. Example – foreseeability again Martha leases a condo from Rentcorp as of January 1st Rentcorp contacts her on December 25th to inform her that the condo will not be available until February 1st Martha is required to move into a local hotel for the month of January at a cost of $2,000 Rentcorp agrees to pay the $2,000 in hotel costs - this is less than the additional $4,000 it would have cost Rentcorp to make the condo available by January 1st Martha informs Rentcorp that she had intended to run her consulting business from her condo and that she must now rent office space, install telephones, etc. and the cost of disruption to her business will be an additional $5,000 Rentcorp tells her that it will not pay for the business interruption costs – Martha sues for breach of contract Contract_D

25. What would Rentcorp have done if they had all of the information? Rentcorp knew, or should have known, that Martha might be required to live in a hotel for a month at a cost of $2,000 - since it would have cost Rentcorp $4,000 to complete the condo on time, Rentcorp would have selected the ‘efficient’ option of delaying the completion of the condo and paying Martha the $2,000 in alternative living costs Contract_D

26. However, at the time it decided to delay completion of the condo, Rentcorp had no reason to know that Martha was going to operate a business from the condo – they could not have known about the additional $5,000 in business interruption cost – had Rentcorp known it could have spent the extra $4,000 to complete the condo by January 1st – this would have been the efficient option Contract_D

27. But since Martha did not inform Rentcorp of these ‘unusual’ (unexpected to Rentcorp) costs, Martha is liable for the business interruption expenses of $5,000 This is a case of ‘over-reliance’ on the part of Martha. Rentcorp should not be required to pay for losses it caused, but had no reason to know might occur Not knowing the possibility of the business losses, Rentcorp could not account for them in its decision making. Again, the court must take account of the ‘customs of the trade’ and what each party knew or should reasonably have known about the facts involved Contract_D

28. Perfect contracts and market failures Will a court ever set aside (negate) explicit terms in a contract? Yes. When courts alter the terms of a contract they are said to be regulating the contract - completely analogous to ‘regulation’ of markets – government is interfering with what would otherwise be a voluntary private transaction Governments regulate markets towards ‘efficiency’ when there is a ‘market failure’ of some sort Courts regulate contracts toward ‘efficiency’ in order to correct the effects of market failures when they arise in a given contract Contract_D

29. To begin with, consider the notion of a perfect contract perfect contract in a contract which is: - ‘complete’ - all relevant information has been exchanged between the parties - every possible future state of the world has been considered and all resulting risks have been allocated to the party who can bear them most efficiently - since all risks have been allocated to the party which can bear them most efficiently (at least costs) a perfect contract is ‘efficient’ - all possible gains from bargaining have been exhausted - there are no unexploited cooperative surpluses remaining Contract_D

30. There are no ‘gaps’ or ‘market failures’ in a perfect contract There is no need for the courts to ‘regulate’ the contract (overturn explicit terms of the contract) due to market failures The parties only need the courts to enforce the contract When will the parties negotiate such a ‘perfect contract’? Recall the Coase theorem, rational (maximizing) parties will negotiate a perfect contract when transaction costs are zero Contract_D

31. If transaction costs are zero, it is costless to develop information and allocate risks - all risks will be allocated to the party which can bear them most efficiently and each benefit is allocated to the party which values it most Any contract negotiate between rational individuals, under zero transaction costs, will be complete Will this ever actually happen? NO! Transaction costs are never zero. Contract_D

32. How and why do contracts deviate from ‘perfection’? 1.Individual rationality 2.Transaction costs 3. Spill-overs (externalities) 4. Information deficiencies 5. Monopoly Contract_D

33. Individual rationality • a rational individual is one who has complete and stable preferences - individuals such as children or the insane are ‘legally incompetent’ and cannot commit to an enforceable contract - individuals who make contracts under ‘duress’, some external threat not accounted for in the terms of the contract, are not acting in their own rational self-interest - contracts made by a desperate promisor, in ‘necessity’ - duress and necessity are situations in which a promisor faces a ‘dire’ constraint prior to making the promise - if the dire constraint follows the promise and results in the inability of the promisor to fulfil the promise, then this is termed ‘impossibility’ (firm’s plant burns down) Contract_D

34. Transaction costs Successful contract negotiation involves: searching negotiating drafting enforcing If these transaction costs are greater than the available social surplus, successful contract negotiation is precluded This results in the loss of the available social surplus Contract_D

35. Spill-overs (externalities) Third parties suffer, or benefit, from contracts which they are not directly involved in - externalities Private contracts will be inefficient since they will not account for third party costs or benefits Third parties cannot enter into the bargaining because of transaction costs Corrective action by the courts usually occurs under property, tort, crimes or regulation and not contract law per se. The exception is when a court refuses to enforce a contract when it derogates public policy – anti-combines agreements, contracts which ‘tie the hands’ of one party to a negotiation (bargaining in good faith), contracts to carry out some illegal activity (supply illicit drugs, etc.) Contract_D

36. Information deficiencies At times one or more parties to a negotiation lacks essential information relevant to the contract negotiations - someone lied, withheld information, mistakenly failed to transmit, or saved money by not transmitting, an interpretation error Ignorance is rational if the cost of acquiring the information exceeds the expected benefit of having it - not bothering to read the fine print when you buy a TV set Ignorance is irrational when you stand to gain more from having the information, than it cost to acquire - finding out which is the ‘best’ professor offering a first year course Contract_D

37. Information deficiencies which can void a contract: Fraud - lying by omission or by misinforming – if one party has more, or more accurate information information then that party has a duty to share the information Frustration of purpose - occurs when both parties lack important information, so that both parties premise the contract on misinformation Mutual mistake - each party acts on different but incorrect information Contract_D

38. Monopoly Potential buyers have only one (or a few oligopoly) potential sellers with which to negotiate This imbalance of market power is usually dealt with through regulation and not contract law Exception - doctrine of unconscionability which some courts have used to overturn ‘unfair’ contracts Contract_D

39. Next section We will the economics of long-run relationships Are contracts necessary? Why is it that you accept many promises without the protection of contract law? Contract_D