1The Strategic Structure of Contract Law

Book Draft

Juanjo Ganuza

Fernando Gomez Pomar

Universitat Pompeu Fabra, Barcelona (Spain)

I) THE BASIC ECONOMICS OF COOPERATION AND CONTRACT

II) THE SOCIAL GOALS OF CONTRACT LAW: EFFICIENCY AND DISTRIBUTION

III) THE BASIC LAW AND ECONOMICS NOTIONS OF CONTRACT LAW

IV) THE LAW AND ECONOMICS OF CONTRACT FORMATION

1) Existence and Formalities in Consent

2) Tacit Consent and Timing of Consent

3) Illegal Contracts and Contracts Against Public Policy and Public Morals

4) Defects in Contractual Consent

5) Standard Terms in Contracts

6) Complex Contract Negotiations: Pre-contractual Liability

7) Complex Contract Negotiations: Representations and Warranties

V) COMPLETING THE CONTRACT: THE LAW AND ECONOMICS OF CONTRACT BREACH

1) What is a Breach and Remedies for Breach

2) Legal Remedies for Breach and their Strategic Effects

3) Impossibility and Frustration of Contract

2Chapter 1

The Basic Economics of Cooperation and Contract

1. Introduction

One of the basic questions in modern Economic Theory is how to sustain cooperation in economic

exchange. When modern economists use the expression economic exchange they are not referring

primarily to markets. The reason basically lies in the (at least among economists) success of neoclassical

general equilibrium theory. The first fundamental theorem of welfare economics confirms that if

markets are competitive, all individuals are informed, and all commodities are allocated by means of

markets, then individual interaction through a complete set of markets produces Pareto efficiency (a

social situation in which no improvement is possible without someone being worse-off). Of course,

economists know that the conditions for the theorem to hold are very strong, and that market

imperfections abound.

Modern economists think that the most interesting economic exchanges do not take place in perfect

markets, but in imperfect markets, or in situations in which markets are only of little relevance.

Contrary to intuition, this is the case, for instance, in the relationship between an employer and an

employee, or a wholesaler and a retailer, or a seller of a good of uncertain quality and the buyer. In fact,

many modern economists tend to focus attention on human interactions outside perfect markets. Given

that most legal contracts deal with interactions in this kind of settings, it is almost natural that

analysing Contract Law from an economic perspective becomes an important dimension in

understanding human cooperation.

The broad question that we could ask ourselves could be formulated as follows: What are the means to

induce the adoption of cooperative actions in human relations, countering the impulse present in

individuals to behave opportunistically and to pursue self-interest at the expense of the common

welfare of all interacting parties1?

Despite its generality, and the apparent lack of a "legal" or "institutional" component, the truth is that

the set of issues behind this question, and the set of responses to it, are also of particular interest to

Law, and Contract Law more specifically. Contract Law is the most ostensible area of the Law directed

to promote and protect cooperation and exchange between individuals and firms. This interest should

be particularly acute when the task is precisely to design legal rules and institutions that promote

cooperative behavior and, in the end, social welfare through desirable interactions by and between

members of society.

1 The fact that modern economic theory does not focus on perfect markets does not imply that the basic toolkit of

economics (rationality, consistent utility functions, maximization of preferences, equilibrium) have been abandoned.

They have simply been redirected to a new object of interest.. See, Itzhak Gilboa, Rational Choice, MIT Press (2010).

32. Basic instruments to achieve cooperation

Economists and social scientists more generally have identified several major mechanisms to achieve

cooperation among humans.2 It has to be noted, however, that some of them are not exclusive to

humans, but to a large extent are shared by humans and animals. In presenting them we will also

briefly comment on the role -if any- that the Law and, more specifically, Contract Law, may possess in

the working of the different mechanisms.

a) Kinship

Biological selection favors genes with higher survival and reproductive payoffs, and reproductive

success involves not just selfish behavior, but also cooperative, disinterested behavior, if this benefits

other individuals sharing a part of the relevant genes. This explains why in the animal and the human

world, cooperation between family members appears to be prevalent. In other words, genetic self-

interest promotes cooperation among biologically closely connected individuals. This has a downside

too, since nepotism and similar ills may be more difficult to eradicate than one may optimistically

think. It is not clear that the Law may contribute to reinforce this cooperative driver. On the other side,

the Law may be used, albeit with uneven success, to curtail some of the negative consequences of

cooperation among kin. Rules against nepotism or corruption in favor of family members exist in many

legal systems, though their level of enforcement, and the degree of deterrence that they achieve are

probably far from perfect, even in societies in which open social norms and public opinion outwardly

condemns nepotism.

b) Selfish cooperation

Although the idea of selfish cooperation may look like an oxymoron, in fact it is not. One can think of

human interactions in which it is in the best individual interest of the parties involved to choose to

cooperate with the rest, and thus, maximize the joint welfare of the group. That is, the interaction is

characterized by a structure of payoffs to participating parties by which it is in the self-interest of each

participating party to take the action that is jointly preferable (i. e. conducive to the common good) if

and only if the rest of the interacting parties do likewise. In the terminology of game theory, these

interactions are called (for reasons unknown to us) as assurance games. Here is an example of an

assurance game:

2

Avinash Dixit, Lawlessness and Economics: Alternative Modes of Governance, Princeton University Press (2007).

4As you can observe, in assurance games there is more than a single Nash equilibrium. Although

(Cooperate, Cooperate) is the pareto-optimal (i. e., preferred by both players) outcome, it is not the only

equilibrium. (Defect, Defect) is also a Nash equilibrium, because no player has an incentive to deviate if

the other does not deviate.

There are several ways to select a specific equilibrium, in particular, to select the pareto-optimal

equilibrium. A formal and legally enforceable contract imposing legal obligations on both parties to

execute the actions corresponding to the desired equilibrium (Cooperate, Cooperate) is one option,

though it may not be workable in many settings of human interaction. Creating common expectations

on the resulting equilibrium might do the trick, with less expense, and less institutional apparatus, than

formal contracting: If each player is convinced that the other will cooperate, and each is convinced that

the other is equally convinced of it, they will both choose to cooperate, and thus the pareto-optimal

equilibrium will be achieved. There are several mechanisms to coordinate expectations to obtain

cooperation in this sense.

Typically, long-term relationships, especially when they present an open-ended time horizon, can serve

to effectively coordinate expectations of behavior by all involved parties, and therefore, to induce the

desired cooperation for the common good, or maximization of overall social welfare: if one expects the

interaction to go on in the future, one would expect that the other party will choose cooperation.

The Law, in an expressive function, can also serve to coordinate expectations around a focal point. The

fact that a given conduct (defect, in our example) is labelled as illegal, or as less desirable by the legal

system, makes the other option the focal point to coordinate the expectations on behavior by the

parties3. This explains why unenforced or weakly enforced legal rules may produce positive effects in

terms on increasing the level of cooperative behavior by individuals and firms. It the legal rule,

disregarding sanctions and enforcement, affects the beliefs of the parties as to the actions of other

players, the cooperative equilibrium may ensue.

3 Richard McAdams, A Focal Point Theory of Expressive Law, 86 Va. L. Rev. (2000).

5This coordination effect of the Law is not restricted to Contract Law. For instance, smoking bans, laws

against littering or vandalism, in addition to creating enforcement dynamics through social reactions

and sanctions, are often mentioned as expressive rules fostering selfish cooperation. But this may, be

achieved through Contract Law rules as well. The fact that a given action can be described as a breach

of contract -although non-enforceable-, or an admissible behavior under some acceptable, though

selective, contract interpretation, seems to affect the way in which people judge those actions, and their

intentions to voluntarily act one way or the other.4

c) Altruism (or fairness)

Interacting agents might not only have self-regarding preferences, but other-regarding preferences as

well, based on altruism or similar notions (preference for cooperativeness, or for achieving the common

good). Although the educational function of the Law, or of Contract Law more specifically, cannot be

completely disregarded in fostering this kind of preferences, it is arguable that it is not a forceful factor

in the promotion of collective altruism or cooperativeness as a preference.

d) Reciprocity in long-term relationships

Probably the most famous application of game theory outside economics is the prisoners dilemma. The

prisoners dilemma is a strategic structure (albeit not the only one) that characterizes many interactions

involving cooperation among two parties.

In a one shot interaction, the prisoners dilemma structure cannot sustain cooperation by the players, to

the detriment of the interests of each and both of them: Each player has a dominant strategy of

defecting from cooperation.

4

Yuval Feldman and Doron Teichman, "Are All Contractual Obligations Created Equal?", Geo. L. J. (forthcoming, 2012).

6If the interaction is a unique, or one-shot interaction, the unique strictly dominant strategy equilibrium

is (Defect, Defect), producing pay-offs for the parties of (1, 1), which are strictly dominated in the Pareto

sense by (4, 4).

This dismal result is not a feature of the fact that both players choose their actions simultaneously. Even

if one acts after the other and is thus able to observe the other partys move, the non-cooperation

outcome still holds. This is the case of the one-shot dynamic interaction, such as the so-called trust

game5: Here, not trust and betray are non-cooperative actions, whereas trust and honor are the

cooperative actions.

The game begins with a decision node for Player 1, who can choose either to Trust or Not Trust Player

2. If player 1 chooses Trust, then the game reaches a stage in which Player 2 can choose either to Honor

or Betray Player 1s Trust. If Player 1 chooses Not Trust, then the game ends (in fact, Player 1 chooses

not to initiate a relationship).

If Player 1 chooses not to establish a relationship, both players payoffs are zero. If Player 1 chooses to

trust Player 2, however, then both players payoffs are one if Player 2 honors 1s trust, but Player 1

receives -1 and Player 2 receives a pay-off of two if Player 2 betrays Player 1s trust.

The Trust Game can be easily solved by backwards induction or rollbackthat is, by working

backwards through the game tree, one node at a time:

If player 2 gets to move (i.e., if Player 1 has chosen Trust) then Player 2 can receive either a payoff of

one by honoring Player 1s trust, or a payoff of two by betraying Player 1s trust. Since two exceeds one,

Player 2 will betray Player 1s trust if given the opportunity to do so. Knowing this, Player 1s initial

choice amounts to either not initiating the relationship (and so receiving a payoff of zero) or trusting

Player 2 (and so receiving a payoff of -1, after Player 2 betrays Player 1s trust). Since zero exceeds -1,

Player 1 rationally prefers not to create the relationship, contractual or of other kind. Therefore, in a

5 David Kreps, Corporate Culture and Economic Theory, in Alt/Shepsle (Eds.), Perspectives in Positive Political Economy,

Cambridge University Press (1990).

7dynamic setting, cooperation in exchange cannot be sustained, even if both parties would be better-off

by trusting and honoring trust, by establishing and respecting the relationship.

Things may be different in repeated interactions, however, and hence the great importance of long term

relationships to sustain cooperation in economic exchange. But simple repetition of the game is not

enough. The economic idea of a long-term relationship goes beyond the mere repetition of a one-shot

game. The argument is as follows:

Assume that the trust game is played in exactly the same terms as shown above, with the difference

that it is played a very large number of periods, T. Lets think first, using again the perspective of

backwards induction, of the last period. In the Tth period, Player 2 has no reason to honor the

relationship, because he can obtain a higher pay-off by betraying than by honoring, given there is no

future to care about in this last period. Anticipating this, Player 1 will not enter the relationship in the

last period, T. Then, the last possible effective period of the relationship is the T-1th period. Here,

Player 2 knows it is the last period, and therefore he would behave accordingly, betraying Players 1

trust. Anticipating this, Player 1 will not play the T-1th round, making the T-2th the last plausible

period. And so the dismal logic of the trust game unravels down to period 1, and both players find

themselves exactly in the same position as in the one-shot interaction. Finite repetition does not

improve cooperation in economic exchange. Cooperation remains unachievable when the parties know

their relationship will last for a fixed and known length of time6.

But the trust game (or other games involving cooperation, such as the prisoners dilemma) can be

repeated an infinite number of periods or, more realistically, that it can be played an unknown by the

parties- number of periods, so the interaction can end at any round, with a given probability which the

parties are unable to control.

In such a scenario, it is possible to show that if the parties care enough about the future (i. e., the

discount factor at which they discount pay-offs ahead in the future is not too large), reciprocity

strategies7 in the repeated interaction can lead to cooperative outcomes8. The two reciprocity strategies

most used in the game-theoretic literature are the following:

1. The grim trigger strategy, that states for each player:

Choose a cooperative action until the other players deviates from cooperation

Once the other player has defected, play defect forever after

2. The Tit-for-tat strategy, that states for each player:

Choose a cooperative action if the other player cooperated in the previous period

6 This result is known in game theory as the chain-store paradox, and was demonstrated by Reinhard SELTEN in his

theorem on unique subgame perfect equilibria.

7 Although many economists use terms such as trust, or reputation, in fact they refer mostly to something that is best

captured by the term reciprocity. For instance, an infinitely repeated interaction, such as the one described in the text, is

equivalent to one-shot two-players interactions among all members in a given society, where each placer is perfectly

informed about the reputation (the past history of cooperation or defection), of each and every other player. This shows

that reputation is in fact nothing different from reciprocation in conceptual terms.

8 See Joel WATSON (2002), Introduction to Game Theory, Norton; Robert Gibbons (2001), Trust in Social Structure: Coase

and Hobbes Meet Repeated Games, in COOK (Ed.), Trust in Society, Russell Sage Foundation.

8 Defect if the other player defected the previous player

This powerful result that reciprocity can achieve cooperation has been crucial to the relevance of long-

term contracts in economic theory. Even in the absence of other external mechanisms to achieve

cooperation in economic exchange, most notably, even in the absence of complete, formal, and legally

enforceable contracts, in long-term relationships the parties themselves can attain satisfactory

cooperative outcomes.

If (i) parties can write complete contracts specifying the pareto-optimal actions for each of the parties

and each of the potential or imaginable contingencies that may arise, and (ii) Courts can costlessly

enforce them, of course, the short or long nature of the relationship, and the use or not of reciprocity

strategies, is of no importance: Contract Law is able to force cooperation through the use of the

appropriate legal sanction. This is why economists, when approaching long-term relationships, have

routinely assumed that contracts between the parties are incomplete, that is, they do not specify the

complete set of optimal actions by the contractual parties. This makes a contractual relationship

governed by Contract Law what is often known in the economics literature a relational contract: Many

of the relevant actions cannot be foreseen and specified when the contract is signed, and it is in the

course of the on-going relationship that the parties will adopt those actions, based upon the set of

incentives arising from factors (personal, institutional) different from the formal contract and the legal

rules in contract Law. The relational contract can be based on information that cannot be verified by a

Court of Law, or controlled by formal legal rules and procedures. The relational contract can be based

on information only at the disposal of the parties as it becomes available, maybe only as a result of a

change of circumstances.

Of course, a relational contract in this sense cannot be simply and mechanically enforced by a Court or

an arbiter. In front of relational contracts, the quest is then the design of self-enforcing agreements or

relational contracts, those in which the parties are induced to adopt the best available actions for the

joint welfare of the parties following their own strategies, which are checked by reciprocity, reputation,

or other intrinsic motivators, but not by the direct threat of external -to the relationship- enforcement

and external sanctions.

e) External enforcement mechanisms (notably legal)

It is clear that society as a whole benefits from the fact that its members interact mostly in a cooperative

way. This explains why societies have developed systems to enforce cooperative commitments by

individuals.

These enforcement systems may show a variable degree of formalization and State intervention. For

instance, take the trust game in figure 3. If we change from 2 to -1 the pay-off of Player 2 in case of

betrayal, to reflect social disapproval by third parties of the non-cooperative behavior of that Player,

then (Trust, Honor) becomes the only Nash equilibrium of the game. Social disapproval may be

expressed by a social sanction in the form of ostracism, negative gossip, etc. Many economic exchanges

have taken place historically (and even nowadays) within relatively closed social groups defined by

9ethnic origin, religious affiliation, or philosophical creed, and in those contexts social sanctions are

particularly powerful motivators towards cooperation9.

It cannot be denied that in large and open societies the most powerful external mechanism to promote

cooperation in economic exchange is the legal system. To operate as an enforcement instrument, legal

systems require a set of rules determining cooperative behavior in a given context, an external (to the

parties involved) authority to enforce the rules, and a system to produce the relevant information in

order to apply the rule of cooperation in a given situation.

A crucial issue remains thus open concerning the role of Law and formal, enforceable contracts, in long-

term relationships. Does the use of contract Law promote or undermine cooperation in long-term

contracts? The response from economic theorists is surprisingly mixed and cautious. Although the Law,

and Contract Law in particular, is a powerful instrument to create incentives for cooperative behavior

in economic exchange, it is not certain whether contract Law generally improve or weaken the self-

enforcing nature of relational contracts. Two factors weigh opposite directions. First, in a positive way,

contract Law reduces the likelihood of breaching a relational contract, by making non-cooperative

behavior more costly and/or the gains from opportunistic behavior less important. In the latter,

unwelcome direction, it can be said that contract Law may reduce the effectiveness of the other self-

enforcing mechanisms in relational contracts, thus reducing the costs of non-cooperative behavior.

As a conclusion, it has to be acknowledged that the big questions concerning the actual effects of

Contract Law on many issues of contracting remain largely unanswered by economic theory in a fully

convincing way. It is also true, though, that from an economist perspective, the role of Contract Law

cannot be often properly understood without a joint contemplation of (at least) the legal factors, and of

the internal or self-enforcing dimensions, especially in long-term relationships. Legal rules and

institutions in isolation do not capture the full picture of cooperation in contracts. An exclusive focus on

the legal dimensions might induce a design of rules and legal instruments that interfere with the latter,

with the undesired result of reducing, rather than increasing, the level of cooperation in economic

exchange.

9 See for historical examples, Avner Greif, Cultural Beliefs and the Organization of Society: An Historical and

Theoretical Reflection on Collectivist and Individualist Societies, 102 Journal of Political Economy (1994); Lisa Bernstein,

"Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry," 21 Journal of Legal Studies

(1992).

10

Chapter 2

The Social Goals of Contract Law: Efficiency and Distribution

The long discussion in the preceding section has led the way to the design of substantive rules of

Contract Law in order to induce cooperation in those instances of interaction among economic agents

(individuals and firms) that take place outside well-performing and structured markets in perfect

markets. The recipe from Economic Theory is simple at the abstract level, corresponding to the abstract

goal of Contract Law as seen economically. Contract Law rules should be crafted as to create the

incentives for the behaviour of the contracting partners that would maximize the welfare of the parties

affected by the contract or, in more precise economic jargon, to maximize the joint surplus from the

contractual relationship.

From the perspective of normative reasoning, Economics (and Law and Economics, which essentially is

applied welfare Economics in the fields touched upon by, or that concern, the Law), as a social science,

is consequentialist and welfarist in its approach to societal problems. Welfarism in this regard allows

degrees, and some may advocate a strict version of welfarism, which condemns, in social decision-

making, any consideration that is not embodied in the well-being or welfare of individuals. 10 Others

adopt a milder or weaker version of welfarism, which notwithstanding a strong weight attached to the

individual welfare, does not rule out other social values, which may not demonstrably have entered the

well-being of an identifiable individual.11 Although the differences between strict and mild welfarism

are significant from a theoretical viewpoint, I dont think that the issue can be resolved inside economic

analysis (or Law and Economics) by itself, and, more importantly, my view is that those differences

have little bearing on issues of Contract Law (they are more relevant in Criminal or Constitutional

Law), so I will not pursue this distinction much further.

Both versions of welfarism in economic analysis (including economic analysis of Law) coincide in their

individualistic (or autonomy-based, or libertarian, if one prefers) approach to individual welfare.

Preferences held by an individual are taken essentially as given, and a matter of individual choice,

genetic predisposition or determination, or cultural influence, or peer pressure, but mainly outside the

bounds of the judgment of the analyst. It is true that economists are devoting increasing attention to the

process of preference formation (in which the Law may play a role, undoubtedly). In fact, social norms

have received in recent years a substantial degree of curiosity and analysis by economists and

10 Louis KAPLOW / Steven SHAVELL (2002), Fairness versus Welfare, Harvard University Press, cap. 1. A strict welfarist

would not allow restrictions on what individuals consider as welfare-enhancing, based on moral or other factors external

to the individual himself. A strict welfarist would not accord any value at all to those other factors in a social welfare

function.

11 Matthew ADLER / Eric POSNER (2006), New Foundations of Cost-Benefit Analysis, Harvard University Press, cap. 1. A mild

welfarist may allow restrictions on what individuals judge as their welfare or well-being, based on ethical or other

criteria, as well as credit some weight to those other factors in the social welfare function.

11

economically-oriented lawyers.12 But still the core of this literature has remained positive in analytical

terms, and the results have not entered the mainstream of economic normative reasoning.

Contrary to commonly accepted wisdom among philosophers and legal scholars critical of the

economic approach to social and legal decision-making, welfarism, either in the strict or in the milder

form, does not entail a rejection of distributive goals. Distribution might enter the welfarist picture

dominant in Economics and in Law and Economics through three different avenues.

First, individuals in society may have preferences concerning fair or just distribution of resources, and

therefore their well-being will be affected by how different options in social decision influence these

distributive issues. The impact of distribution is, however, indirect, through particular how

idiosyncratic will they be, is a different, and solvable only through empirical inquiry, matter tastes or

preferences actually present in the individual utility functions composing the social welfare aggregate.

Second, well-being depends on the level of wealth (meaning all material resources available to the

individual), and thus the distribution of wealth affects individual and, consequently, overall social

welfare. It seems a very plausible generalization about individual human welfare that wealth increases

the utility (the traditional term in economics to name individual well-being) of the individual, albeit at

a diminishing rate, that is, that each additional unit of wealth adds less utility to the total than the

preceding units. This generalization is commonly known as decreasing marginal utility of wealth. For

some, it may have important both at a theoretical and at a policy level distributive consequences. If

one thinks that interpersonal comparisons of welfare are possible,13 decreasing marginal utility of

wealth implies that if we compare two social situations that add an additional unit of wealth, one to a

rich individual and the second to a poor one, the second is preferable in terms of aggregate social

welfare, because it adds more welfare than the first. It can, thus, justify, extensive redistribution from

the better-off in favour of the worse-off.

Moreover, this redistributive bent is increased under most (non-additive) systems of aggregating the

welfare of each and every individual into a social welfare function. For instance, if individual well-

beings of the members of the relevant population are aggregated not through mere summation, but by

other operators (multiplicative, exponential, etc) distribution of welfare within the population is

relevant for overall social welfare.

Third, levels of wealth of an individual can directly affect incentives to behave in different areas subject

to legal rules. One of the clearest instances refers to the assets of the agents engaging in activities that

can cause harm to others. If an individual or a firm has limited assets, so that he may be unable to pay

for all resulting harm arising from his activity, his incentives to take care under alternative liability

12 Eric POSNER (2001), Law and Social Norms, Harvard University Press.

13 At the theoretical level, interpersonal comparisons of utility were taboo for neoclassical economic analysis [Lionel

ROBBINS (1932), An Essay on the Nature and Significance of Economic Science, MacMillan] is the canonical exposition of such

negative attitude), but nowadays some ways to circumvent the taboo have successfully been explored in the literature:

Matthew ADLER / Eric POSNER (2006), New Foundations of Cost-Benefit Analysis, Harvard University Press, cap. 3, for an

excellent reference to these issues, with an eye towards legal applications.

12

rules are distorted, and he will take less precaution than that required by social optimality.14 It can be

shown that adapting (lowering) safety standards to the levels of assets of the potential injurer, actually

improves the incentives to take safety measures, and in fact, with an adequately chosen more adaptive

and softer standard, the legal system can maximize the precautionary effort of potential injurers, thus

attaining a second-best situation.15 This means that in the presence of exogenously given and limited

levels of assets, 16 poorer potential injurers should optimally be subject to lower standards of behaviour

than richer individuals, and this result does not depend neither on a taste for redistribution, nor on

interpersonal comparisons of well-being. It is based on a pure incentive (or efficiency, if one prefers to

word it this way) effect, which is nevertheless dependent on the level and the distribution of wealth. In

fact, when determining optimal standards for an entire population, the level of wealth, but also its

distribution, are crucial factors for determining the desirable safety standards, and it can be shown that

under certain regularity conditions of the distribution of assets, the wealthier a given society becomes,

the higher the relevant standards should be.17

The initial economic position on the guiding principle for the design of the substantive content of

Contract Law rules is that the Law should create (taking in due regard the non-legal sources or

incentives for cooperation within the relationship) the incentives for the behaviour of the contracting

partners that would maximize their welfare of the parties affected by the contract or, in more precise

economic jargon, to maximize the joint surplus from the contractual relationship. Of course, this

assumes that the contract does not affect third-parties, because when this assumption is not satisfied, a

pure welfarist treatment of the contract should include also the impact of the contract on the welfare of

the non-contracting but affected parties. Thus, even if two firms are made better-off by a collusive

agreement that restricts competition, there are good reasons for the Law and for Contract Law not

to enforce such an agreement and, on the contrary, not to give effect to the parties intentions and to

subject it to sanctions, even criminal ones. The same happens to an agreement that intends or helps to

perform an intrinsically illegal action, such as murder, theft, or kidnapping. In fact, Contract Law rules

consider those agreements void, and, from an economic perspective, rightfully so, due to the important

negative external effects arising from them.

Contract Law of different Member States, moreover, sometimes contain rules ancillary to the nullity

principle that try to create negative contract incentives (ie disincentives) to engage in such

14 This effect of limited assets (known as the judgment-proof problem) was first formally and generally established by

Steven SHAVELL (1986), The Judgement-Proof Problem, 292 International Review of Law and Economics, pp. 43-58.

15 Juanjo GANUZA / Fernando GOMEZ (2008), Realistic Standards: Optimal Negligence under Limited Liability, Journal

of Legal Studies.

16 When the levels of assets are endogenous, if the standard is nevertheless designed and imposed generally, the main

result still holds: Juanjo GANUZA / Fernando GOMEZ (2011), Soft Negligence and the Strategic Choice of Firm Size"

Journal of Legal Studies.

.

17 And this result does not depend on the dependence of the level of harm on the level of assets in the population, that is,

it applies as well to a wealth-independent (environmental, for instance) external harm: Juanjo GANUZA / Fernando

GOMEZ (2006), Realistic Standards: Optimal Negligence under Limited Liability, Journal of Legal Studies.

13

agreements.18In fact, such rules typically try to erode the incentives for cooperation within those

agreements, and to create incentives for opportunistic behaviour, thus discouraging the potential

contracting parties from entering into them.

The bulk of Contract Law rules, and also in present European Contract Law, do not respond to the

external effects from the contractual relationship, but are concerned with the internal to the parties

behaviours and effects. To what extent is in this context the goal of maximizing the joint welfare

contract surplus of the parties affected by the issues of distribution of wealth that economists tend to

recognise as relevant for normative reasoning?

My view is that it is mostly the third dimension of the relevance of distributive issues, which will be

effective and important for substantive Contract Law rules, also, eventually, for European Contract

Law rules. The level of wealth of an individual may, under a wide variety of circumstances, affect the

incentives to act in one way or the other, and this influence has to be recognised by legal rules striving

for social optimality. Thus, if A has to contract with B, on the one side, and with C, on the other, in

order to obtain certain desired entirely unsubstitutable, lets assume results, it is likely that if C has

assets much lower than B, the standard of performance may optimally be lower for C than for B.

The reason for this is not a desire to give C more wealth than to B at the expense of A (who may be

wealthier than both of them), but simply to maximize contractual effort by C and by B, given their

exogenously given levels of assets. In fact, an optimal contract fully specified, between A and C would

contain such a lower standard, compared with the complete, fully specified contract between A and B.

The Law, as a default, when parties may be unable to draft a complete contract may well include this

differentiated standard based on the relative level of assets of the contracting parties.19 But the

relevance of wealth and distribution in these circumstances does not respond to a redistributive policy

or desire, simply to an improvement of behavioural incentives of the parties, as it happens, influenced

here by those issues of distribution. In essence, we remain here in the safe terrain of efficiency, of

providing the incentives that the parties themselves would have provided in a fully contingent and

complete contract.

More problematic, at least with our current level of knowledge, is the first dimension, the one based on

the presence of a specific taste for distributive concerns in the utility functions of the contracting

parties. Although there seems to be evidence in experimental settings of behaviour consistent with a

strong taste not to be treated in an obviously unequal fashion,20 it seems very problematic to translate

this taste into substantive obligational content in abstract Contract Law rules, or even in factors that

may be fruitfully employed in such kind of legal rules. At the level of European Law, which would

18 For instance, Art. 1305, 1306, Spanish Civil Code and 817, German Civil Code. On such a disincentive vision of these

rules, Juanjo GANUZA / Fernando GOMEZ (2002), Civil and Criminal Sanctions Against Blackmail: An Economic

Analysis, 21 International Review of Law and Economics, p. 475; Gerhard WAGNER (2006), Prvention und

Verhaltenssteuerung durch Privatrecht- Anmassung oder legitime Aufgabe?, 206 Archiv fr die civilistische Praxis, p. 365.

19 This logic does not necessarily apply in all circumstances and contracts and, in fact, a default rule based on levels of

wealth may be counterproductive under many other circumstances.

20 See, for a theory of inequality aversion based on this evidence, Ernst FEHR / Klaus SCHMIDT (1999), A Theory of

Fairness, Competition and Cooperation, 114 Quarterly Journal of Economics, p. 817. Some think a reciprocity preference

more explanatory: Matthew RABIN, (1993) Incorporating Notions of Fairness in Game Theory and Economics, 83

American Economic Review, p. 1281.

14

apply to a more diverse set of individuals and groups than a national legal system, this note of caution

is particularly required, given that the available evidence points at large differences among cultures

and societies in the experimental results.21

Also problematic, though for different reasons, would be to pursue through general Contract Law rules

a policy of consistently redistributing welfare, or wealth more narrowly, from one contracting party in

favour of the other, even if one thinks that the gains from trade and interaction between parties are

unequally distributed (for instance, are systematically biased towards sellers and against buyers) and

that the legal system should attempt to correct the imbalance in this distribution.

The problem with the use of substantive Contract Law rules to achieve this redistributionist policy,

even accepting the premise of its overall desirability, 22 is that contracting parties, sellers and buyers,

firms and consumers, affected by those rules are, by definition, in a contractual relationship. And this

allows the parties to alter the terms of trade or the exchange. An increase in duties or rights that is not

efficient or welfare-increasing, in the sense of augmenting the surplus of the interaction, will imply a

readjustment of the terms to the detriment of buyers that cannot be compensated by the increased

welfare of buyers due to a higher level of sellers legal duties or buyers legal rights. Thus, a purely

redistributive legal intervention one that does not increase joint welfare apart from how this welfare

is shared among the parties to the interaction is very likely to become moot due to the readjustment in

price and/or other terms of the transaction, when the affected parties find themselves in a contractual

situation.23As has been noticed already,24 redistributive policies can be largely undone when the party

benefiting from redistribution party and the losing party are not into a contractual relationship.

Thus, it is easier to redistribute with tort law rules than with contract rules, and among the latter, it is

easier to redistribute through rules that allow one party not to enter into the contract, or alter the

21 Colin CAMERER (2003), Behavioral Game Theory. Experimental Studies of Strategic Interaction, Princeton University Press, p.

68 and following.

22 Many economists and economically-inclined lawyers are skeptical of the use of legal rules (outside the tax and social

transfers rules) to redistribute wealth. The best presentation of this view, in Louis KAPLOW / Steven SHAVELL (1994),

Why the Legal System is Less Efficient Than the Income Tax in Redistributing Income, 23 Journal of Legal Studies, p.

667; Louis KAPLOW / Steven SHAVELL (2000), Should Legal Rules Favor the Poor? Clarifying the Role of Legal Rules and

the Income Tax in Redistributing Income, 29 Journal of Legal Studies, p. 821. The core of the argument is as follows: The

use of taxes and transfers as redistributive mechanisms just creates one distortion, namely in the work-leisure trade-off.

Substantive legal rules generate a double distortion: One, the same we have just described for taxes, the other, the

inefficiency generated by a legal rule chosen not on its efficiency merits, but on its redistributive effectiveness. Again,

some within the Law and Economics literature disagree with this gloomy view of legal rules as redistributive

instruments: Christine JOLLS (2000), Behavioral Analysis of Redistributive Legal Rules, in Cass SUNSTEIN (ed.) (2000),

Behavioral Law and Economics, Cambridge University Press, Cambridge, p. 288; Chris William SANCHIRICO (2000), Taxes

versus Legal Rules as Instruments for Equity: A More Equitable View, 29 Journal of Legal Studies, p. 797; Chris William

SANCHIRICO (2001), Deconstructing the New Efficiency Rationale, 86 Cornell Law Review, p. 1003. I do not take sides in

this debate, because my topic here is narrower, as it refers solely to substantive Contract Law rules, and my view is that

one can confidently answer the narrower question without attempting to answer the broader one.

23 The argument is by no means a new one: Harold DEMSETZ (1972), Wealth Distribution and the Ownership of Rights,

1 Journal of Legal Studies, p. 223; Koichi HAMADA (1976), Liability Rules and Income Distribution in Product Liability, 66

American Economic Review, p. 228; Lucian BEBCHUK (1980), The Pursuit of a Bigger Pie: Can Everyone Expect a Bigger

Slice?, 8 Hofstra Law Review, p. 671.

24 CRASWELL (1991), Passsing-On the Costs of Legal Rules: Efficiency and Distribution in Buyer-Seller Relationships 43

Stanford Law Review, p. 387. Emphasizing the difference in redistributive effectiveness between rules on bargaining

starting points as opposed to rules on bargaining outcomes ie substantive rights and duties in the contract , Chris

William SANCHIRICO (2001), Deconstructing the New Efficiency Rationale, 86 Cornell Law Review, p. 1047.

15

negotiation process, than through rules that govern, as mandatory or default provisions, the content of

the relationship.

We will develop the argument with the help of figure 4 and figure 5, which provide an illustration of

redistributive legal intervention favouring buyers.25 In both, demand and supply for a given product or

service is depicted. A mandatory contract legal right for the buyer (think of a non-waivable warranty

on accompanying the product) is imposed. That the measure is pro-buyer is shown by the increase in

demand following the introduction of the warranty: D2 > D1.

Figure 4 represents a legal right favouring buyers that does not increase contract surplus, because it

costs the seller (as shown by the segment a-b, the distance between supply curve, S1, before the legal

warranty is imposed, and supply curve, S2, after its imposition) more than it benefits the buyer (as

shown by the segment c-d, the smaller distance from D1 to D2).

S2

c

P2 S1

d b

P1

D1

Q2 Q1 Quantity

Price

a

D2

Figure 4

After the pro-buyer legal measure is introduced, contract surplus, joint economic welfare, is reduced.

But not only that, notice that buyers are actually hurt by the policy intended in their benefit. Some of

them (those located between Q1 and Q2, cease to contract, because they value the contract less than the

new contract price P2. And those who contract are also worse-off, because the difference in price (P2-

P1) is more than c-d, the amount in which buyers value their new legal right. Notice that this

worsening of the buyers position is not due to excessive transfer of the costs of the new right from the

sellers to the buyers. Sellers are also worse-off here, because the price increase (P2-P1) is less than the

increased contract costs for the sellers (a-b).

Figure 5, in turn, represents a legal right favouring buyers that does increase contract surplus, because

it costs the seller (as shown by the segment c-d, the distance between supply curve, S1, before the legal

warranty is imposed, and supply curve, S2, after its imposition) less than it benefits the buyer (as

shown by the segment a-b, the larger distance from D1 to D2).

25 To represent a redistributive policy pro-seller (of services, say, like the mandatory termination compensation in favor

of the agent provided by Art 17-19 of the Commercial Agency Directive) one would only need to reverse figure 4 and figure 5

(the inefficient legal intervention pro-buyer, as shown now in figure 4 would be an efficient legal intervention pro-seller, and vice-

versa in figure 5).

16

S2

P2 S1

c

d

P1 b

D1

Q2Q1 Quantity

Price

a

D2

Figure 5

In this scenario, after the pro-buyer legal measure is introduced, contract surplus, joint economic

welfare, is increased. But not only that, both sellers and buyers actually benefit from the imposed legal

right. Of course the new buyers (those located between Q1 and Q2) are better-off compared with the

no-contract situation. Those who were buyers before the legal change also improve their welfare

because the increase in price (P2-P1) is smaller than a-b, the amount in which buyers value their new

legal right. Notice that this improvement in the buyers position occurs even if sellers are also

benefiting from the change, because they are able to pass-on the increased contract costs (c-d) more

than proportionately: (P2-P1) > (c-d). Therefore, the distributive effects of contract rules does not

depend primarily on the ability of sellers to charge higher prices corresponding more or less to the

higher costs produced by legal change.

Thus, if a pro-buyer legal rule is not joint welfare-enhancing, the readjustment of price and quantity

terms will in the end reduce the well-being of the intended beneficiaries of the distributive policy. If the

rule, on the contrary, increases contract surplus, even if sellers are benefiting, in net terms, from it, may

as well have valuable distributive consequences favouring buyers. This implies, at least presumptively,

a good case for Contract Law rules that create incentives for the behaviour of the contracting partners

that maximizes the welfare of the parties affected by the contract.

The preceding analysis summarizes the outcome of distributive legal rules when buyers are

homogeneous. When they differ in terms of the valuation of the increased duties or rights, the analysis

is more complicated, and the result ambiguous, because there may be winners and losers among the

group of buyers, thus raising distributive issues inside them. In fact, it is true, that under certain

conditions, a pro-buyer legal rule that does not increase contract surplus may overall benefit the class of

buyers. If the reduction in contracted quantity (Q1-Q2) is sufficiently small, and the valuation of the

increased duties or rights by the marginal buyer is sufficiently smaller than the corresponding

valuations of the infra-marginal buyers, 26 it is the case that even if the imposed rule is inefficient it

reduces joint surplus buyers as a group albeit not all of them will be better-off at the expense of

26 The marginal buyer is the one located along the demand curve at the equilibrium price. Infra-marginal consumers are

those located up the demand curve. Marginal buyers valuation is the one that determines the equilibrium price, which

will be paid, however, in the same amount by all buyers absent price discrimination.

17

sellers, who would not be able to recover through the increase in price the entire impact on production

or distribution costs of the pro-buyer rule.27

The qualitative implication, namely that inefficient legal intervention is not likely to be an attractive

redistributive policy, however, still holds. First, because pro-buyer rules that reduce joint welfare of the

contracting parties tend to burden more heavily the marginal buyers, and these are typically those who

are more worthy of redistribution in their favour, and in turn, tend to favour more intensely the infra-

marginal buyers, who are the ones that even before the legal change already enjoyed a higher share of

the contract surplus. In other words, inefficient legal interventions are more likely to produce

regressive internal redistribution among buyers. Second, because the requirements for effective

redistribution through non-welfare enhancing rules are restrictive and exacting. This makes hard for

the legal decision-maker in Contract Law (legislator or Court) to be in possession of the necessary

information to make the right redistributive choice. If the required information is not available, the

likelihood that with an inefficient rule we end up also with an undesirable distributive outcome is

relatively high.

All the preceding reasons cast substantial doubts on the ability of Contract Law Rules, and not the least

those in European Law, to ambitiously pursue distributive objectives. Particularly when these seem to

overtly conflict with maximizing the size of the welfare pie produced by the contract, the redistributive

bent should be considered very cautiously, as it is likely that they will be will not be distributively

appealing, in addition to being inefficient. This does not mean that wealth and its distribution should

be entirely disregarded in the design and implementation of Contract Law rules, but essentially their

role should be important when these dimensions improve the behavioural incentives that lead to

greater total contract surplus, or joint economic welfare of the contracting parties.

27 Richard CRASWELL (1991), Passing-On the Costs of Legal Rules: Efficiency and Distribution in Buyer-Seller

Relationships 43 Stanford Law Review, p. 377 and following. Even those who are more sympathetic to redistributive

policies among the economic analysts of the Law acknowledge the existence of these restrictive assumptions for an

effective redistribution pro-buyer in the contractual context: Chris William SANCHIRICO (2001), Deconstructing the New

Efficiency Rationale, 86 Cornell Law Review, p. 1046.

18

Chapter 3

The Basic Law and Economic Notions of Contract Law

In this chapter we will present some essential notions and concepts to start looking at contracts and

Contract Law rules from an economic and strategic perspective. The conceptual starting point to

analyze Contract Law is the notion of a complete contract (or completely contingent contract). When

individuals can write a contract:

(i) specifying each and every contractual action of the parties involved;

(ii) specifying the best action for the joint welfare of the parties involved;

(iii) for the full set of possible circumstances or contingencies that may possibly take place;

(iv) the factual basis and the agreed consequence for each and all contractual determinations can be

verified by the legal enforcer, typically, a Court of Law

then we have a complete contract

We do not find complete contracts, in this sense, in the real world. Contracts in reality do not fit this

exacting notion. We should bear in mind, however, that the economic notion of a complete contract is

essentially a conceptual tool to understand contractual behavior and contracting institutions (including

the legal institutions surrounding contracts) but it is by no means not a description of the real world of

contracting, not to speak of the legal rules and doctrines.

Let's start, however, one step back and consider the notion of contract in itself. The economic and legal

notions of a contract do not exactly coincide. The existence of an agreement by the parties is the basis of

a contract, from both the economic and the legal view point. The most foundational element in a

contract is that it consists of a voluntary28 agreement, together with the idea of set of future actions

which are enforceable through an external mechanism. Contrary to common belief, from an economic

perspective, the idea of exchange, of price paid in exchange of something plays a secondary role

compared to the idea of specification of future behavior.

Here are some notes of the concept of contract from an economic point of view:

The economic concept of contract is characterized by voluntariness29: parties to the contract

take part in it voluntarily, presumably because their preferences are satisfied better by the

contract than by any of the other mutually exclusive alternatives of conduct.

The contract establishes the future behavior of the contracting parties.

28 The Principles of European Contract Law (hereinafter, PECL), Article 1:102: Freedom of contract, proclaim the basic

freedom of contracting and determining contractual content. Art. 2:101 PECL foresees sufficient agreement as the basis of

contract formation. Similar provisions may be found in most Civil Codes.

29 Free and spontaneous determination of the will to enter into a contract, as is traditionally defined.

19

The aforementioned is based on an explicit or implicit characterization of circumstances or

future states of the world that can affect such behavior by contracting parties, or the outcomes

from such behavior.

In Law, typically any (or almost any) voluntary or consensual agreement with legal consequences will

be deemed a contract. It is obvious that the economic concept of contract is related to its legal concept,

but both differ along several dimensions:

The economic concept of contract is more exacting than the legal notion. It involves less

phenomena, less economic and social situations than the common legal concept: Spot market

interactions (buy the daily bread, in exchange for its market price, or buy shares in a stock

exchange for the spot market price) are only nominally contracts, but do not pose the problems

that the conceptual tools of the economic view of contracts are designed to resolve.

The economic concept of the contract stresses aspects such as future actions and circumstances

connected with the contract.

For example, most legal systems contain definitions of what is a sales contract or Purchase Agreement.

A sale of a newspaper in a news stand is a sales contract from the legal point of view. However, it is

not a contract from the economic view point, since it has no relevance for the future. On the contrary,

this temporal dimension exists, for example, if a purchaser pays with false currency, or when the a

purchaser finds a defect in the goods and thus may claim against seller for said defect.

For reasons mentioned above, contracts are economically relevant if either there are nothick markets,

or if markets work imperfectly. Thus, it is for the parties to decide, and not to the markets, what will

happen in the future, and on what terms. The transactions in organized and quasi-perfect markets (e.g.,

stock exchange) tend not to fall within this notion.

How does the notion of the complete contract fits into this. The beauty and usefulness of such notion

lies in the interesting property that a contract satisfying the tough requirements of a complete contract

defines a Pareto-optimal situation for the parties. A contract in which both parties agree to a complete

and welfare-maximizing specification of all contractual behavior by the parties in all possible and

imaginable states of the world and future circumstances, is Pareto-optimal by definition (otherwise

parties would not agree to it). A complete contract cannot be improved upon from the point of view of

the joint welfare of the contracting parties. This makes it an excellent benchmark for analysing and

evaluating policy and legal options affecting contracting and the situation of contracting partners.

In the real world, as already pointed out, contracts are not complete in this sense. Incomplete contracts

are the rule in the real world, given the extremely exacting requirements that pareto-optimality,

completeness of coverage, and verifiability of information pose on complete contracts. A number of

reasons have been identified by economic theorists supporting the proposition that contractual

incompleteness is the rule and not the exception:

The prevalence of non-verifiable information concerning many relevant contractual behaviors;

the inevitability of imperfect specification of actions that will take place in the future, and in all

possible states of the world in the future,

20

The difficulties in measuring and evaluating the cooperativeness of contractual behaviors,

given the multidimensionality of complexity of many of them;

The advantage, under certain circumstances, of internal (including reciprocity-based)

motivators for cooperation over external mechanisms such as formal and legally enforceable

contracts30;

The parties may not foresee all the circumstances which shall occur in the future and which

may in a way affect the contract;

Even when the parties could have foreseen all future circumstances influencing, however

slightly, the transaction, there exist several obstacles which may prevent them from reaching an

agreement: these are called transaction costs.

Therefore, the notion of complete contract is not descriptive, but heuristic: It is a very useful conceptual

benchmark, being, as it is, optimal for the parties. It allows us to evaluate and compare the real world

mechanisms to achieve a given contractual outcome, including legal rules and principles. The closer a

given contractual mechanism (legal or non-legal) brings us to the outcome under the complete contract,

the more desirable that mechanism is (remember that the complete contract, being Pareto-optimal,

cannot be improved for both parties simultaneously, and unbeatable contractual situation).

Legal theorists have long recognized the existence of loopholes, of incompleteness in legally

enforceable contracts. Many basic legal rules (artt. 1:102, 1:105 PECL, many provisions in Civil Codes)

intend to provide instruments to deal with those loopholes, basically through default rules, usages and

practices in trade or in a given area of economic or contracting activity, and good faith and fair dealing

requirements, at least in Civil Law countries.

However, an incomplete contract in the economic sense may appear as not having gaps in a legal sense.

If the essential obligations of the parties are defined, as well as the timing of their performance, it may

be the case -even often- that no surprising or unexpected event happens, so the contract appears to be

legally complete or gap-free, and the adjudicator thinks it is easy and straightforward to enforce as

written, if voluntary compliance with the terms of the contract does not occur. But such a contract is

surely economically incomplete, since the timing and actions of the parties have not been foreseen as

depending upon relevant factors: how costly it is for the parties, when the time comes, to perform, how

demand in the market may affect the valuation of performance by the buyer, and so on. A completely

contingent contract would dictate the best solution to each imaginable contingency that may affect

performance, but the incomplete contract -yet, from a legal viewpoint, gap-free contract- fails to have

fine grained and tailored determinations for each scenario, and mandates uniformly performance in the

same terms for every possible situation in the future state of the world.

30 See, Martin Brown / Armin Falk / Ernest Fehr, Contractual Incompleteness and the Nature of Market Interactions,

CEPR Discussion Paper (2002), for experiments showing how explicit and enforceable contractual clauses may crowd out

reciprocity and altruism in contracting. On these general issues, Colin CAMERER, Behavioral Game Theory. Experimental

Studies of Strategic Interaction, Princeton University Press (2003).

21

It is then clear that the economic point of view should be distinguished from the legal one: from the

former view point, the contracts are classified in complete and incomplete, whereas from the latter one,

the Law typically thinks in terms of contracts with and without obligational gaps in them.

We will try to show this idea with a very simple numerical example involving a contract for the

production and delivery of a good between Seller and Buyer.

S and B are thinking of entering into a contract. The cost of performance for S is uncertain: it could be 50, with

60% of probability, 70, with 20% probability, and 150, with 20% probability. The value of performance by S to B

is 100. In such a way, pursuant to the complete contract:

With a cost of the contract for S of 50, S shall perform since the purchaser values it in 100, and so a surplus

of 50 (joint interest) shall be produced (100 50). In this case, the contract produces an increase of the value

of 50.

Should the cost of production of the contract be 70, S shall perform, since there is still existing surplus, in

this case of 30 (100 70). The increase in social value which is produced as a result of the contract is 30.

On the other hand, if the cost of production is of 150, according to the complete contract, S should not

perform, since a cost of 150 is incurred in order to obtain a benefit of 100 (100 150 = -50). The contractual

surplus is negative. Therefore, it is in the best for the common good of both parties that the contract is not

performed. This type of situation has been traditionally labelled as a case of EFFICIENT BREACH, since

according to the complete contract it would be desirable for S not to perform, which would look like a

"breach of contract" if the parties, as is usually the case, had simply written a contract stipulating that S, at

a given time, should perform and B at that time should pay the price.31

In the example it should be noted -a point of general validity- how the role of the contract price is essentially

distribute between the parties the surplus or increase in value produced by the actions contemplated in the

contract. The higher the price, the bigger the sellers share of the surplus. At a lower price, it is the purchaser

who benefits from most of the value.

The price also is the inducement to contract, that is, it may not be inferior to the one which makes S or P enter

into the Contract within said interval (minimum price in order that S enter into the contract and maximum price

in order to B to do the same). In our case, many prices within a range could be part of a complete contract since,

in any case, the complete contract shall be performed whenever it is desirable for both ex ante that it is

performed. Of course, B could obviously prefer the lowest possible price, and S the highest possible one. S shall

not accept a price of 30 as he will prefer not to enter into the contract (since the cost of production of the good is,

at least, 50).

From the economic point of view, what is crucial is that value is created, not the fact that any party may obtain

more or less from the contractual surplus, the cooperation pie (typically that issue depends on the negotiation

abilities of each contracting party, and therefore, usually outside the boundaries of Law and Economics).

What is a conclusive issue in order that a complete contract exists is that a surplus is created (a situation that

cannot be improved upon for both parties at the same time). If, e.g. a price of 60 is agreed (within the

contracting interval), which places the parties in a better position than one not to enter into the contract. (If for

any reason whatsoever, the cost of production is 70, according to the concept of complete contract, S shall enter

into the contract although he will only obtain a price of 60 since 70 is lower than 100 (70 < 100) (100 = estimation

31

A critique of this notion in Daniel Markovits and Alan Schwartz, "The Myth of Efficient Breach: New Defenses of

the Expectation Interest", 97 Virginia Law Review (2011), p. 1939.

22

of the consideration for B): the concept of complete contract looks at the joint interest and not the interest of only

one of the parties: the optimal thing is that contract is entered into because a value of 30 is created ,

notwithstanding the fact that, later on, S looses 10 (price - cost of production = 60 70 = -10).

With this example we can observe the relevance of informational problems for the actual existence of complete

contracts: There exist certain circumstances which, even though they could be contractually foreseen and solved

by both parties in an optimal way, they may not be verified by a third party who shall have to find a solution in

respect of said contract.

E. g. a Court or an arbitrator may not be able to determine, in the prior example, when the cost of production is

actually 150 or a lower amount. Lets think that the actual cost, ex post, is 60. We know that when cost is 150, the

optimal solution would be not to perform. Thus, if in a contract which provides for the non-performance of S in

case the cost is 150, S does not comply with it being the actual cost of 60, it may try to cheat the arbitrator or

Court by saying that the cost has been of 150. In that case, S may benefit from a more complete contract, in order

to manipulate the lack of verifiability by the external enforcer. For said reason, it may be better to use a more

coarser information set, a contract with lees fine information, but which may be verified by an external observer

and not subject to manipulation by the parties according to their ex post private interest (e.g., audited figures,

instead of demand conditions). In that case, although the contract is not complete, the circumstance shall be

more secure and less subject to interested modifications and strategic use by the parties before an arbitrator or a

Court.

Let's now turn to another foundational issue, namely the roles and tasks that Contract Law can be

entrusted with in this framework, beyond the simple one of enforcing the terms of a contract in a sort of

purely mechanistic way. These tasks indeed result from the basic notions of contract and complete

contract that we have previously examined.

We emphasized above the importance of voluntariness, of consent -a more common and dear legal

concept. Voluntariness ensures, at least presumptively, that the interaction improves the lot of the

parties compared to the situation prior to the contract. Contracts are indeed enforced -and encouraged-

legally, because the social effects of contracting are judged to be positive and praiseworthy. A key

requirement for this attitude in legal systems is the existence of consent. Without consent, nothing

typically guarantees that the contract makes both parties better-off. Thus, it makes sense for the legal

system to devote energy and resources to try to make sure that consent is indeed genuine, not merely

cosmetic. Genuine consent, of course, depends on the knowledge and information that parties have

over a long range of relevant variables, at the time of entering into the contract. Moreover, the social

desirability of contract not only depends on the interaction being consensual, but also on the outcome -

or perhaps the mere existence- of the contract not affecting negatively non-contracting parties. Think of

a price fixing agreement among competitors and the negative effects over consumers. Thus, the legal

system is also concerned with the third-party dimension of how and what contracts are entered into.

These tasks form the first pillar of Contract Law rules, namely those related to contract formation. Here,

issues of voluntariness and information loom large, as will become apparent in the following chapters.

The legal rules on contract formation affect a wide variety of decisions by potential contract parties, and

not just narrowly those that take place in the contract negotiation and agreement phase (how to

negotiate, how to respond to offers by the other side, whether and how much to invest prior to the

contract) but also previous actions, such as acquiring information about the future contract, or how to

look for adequate contract partners. We also find rules -not always inside Contract Law as it is

23

traditionally understood- that police the contract in order to reduce or eliminate negative externalities

or third-party effects. It is in the area of contract formation where we tend to find mandatory rules, that

is, legal propositions whose application does not depend on the intention of the people involved, so

that they will be forced onto the parties even if they do not like them or prefer to be free from them, or

governed by other rules.

The second fundamental role is directly linked to the idea of completing the incomplete agreement

made by the parties. Many factors explain why contracting parties fail to make complete contracts in

the economic sense of the term, and thus fail to realize the full gains from the interaction by setting the

best action rules for every possible contingency. But the parties, although not having signed a complete

contract, have signed a contract nonetheless, and thus circumstances will take place where their failure

to specifically provide for an optimal response will become relevant, and often, this will even lead to a

dispute. Contract Law rules will be then used to determine which actions parties will need to take in

those contingencies not explicitly provided for by the contract agreed by the parties or, less frequently,

to override the actions that the parties themselves had foreseen. This is a task of completion of the

contract.

Completing the contract may involve different legal tasks. Interpreting and construing the agreement is

one of them, since they imply the determination of a contractual outcome when the text of the contract

is not sufficiently clear and unambiguous. It also includes the fundamental function of providing

remedies for breach, that is, for situations where one of the parties feels aggrieved because the other has

failed to act according to what the terms of the contract provided for as obligations. Interpretive rules

and default rules on breach of contract, applied by external adjudicators such as Courts or arbiters

constitute the bulk of the tools through which Contract Law discharges this function. As already

mentioned, the complete contract notion is very useful to think of this completion endeavor, since it

provides the optimal benchmark against which to assess how well or how badly the different

alternative solutions offered by interpretive or breach rules fare with respect to the pareto-optimal

allocation. Also it is importance to notice that these legal rules will affect a wide range of actions by the

parties, from drafting behaviour, to performance and breach decisions, to decisions of whether to

invest,, how much to invest, and what type of investments linked to the contract to make, to risk

allocation of the consequences of probabilistic developments and contingencies.

It is important to notice, however, that the task of completion is not the sole responsibility of these rules

for the entire realm of contracting. The Law often relies on other mechanisms different from default

rules designed and/or enforced by Courts. For certain types of important areas of contracting, the legal

system, although not fully renouncing to use default rules, prefers to entrust completion to other

means, of a diverse nature. Sometimes, the incomplete contract has to be completed by subsequent

negotiation by the parties (renegotiation is term usually chosen by economists) in order to determine

how parties will act in the contingencies that arise after the formation of the contract. The Law

substantially does not provide default rules to cover future contingencies and outcomes, besides very

broad and undetailed provisions, and simply is concerned about the break-up of the contractual

relationship and its aftermath. Thus, if parties fail to satisfactorily renegotiate their agreement along the

way to respond to every contingency, the only option is to bring the contract to an end, under the rules

about break-up set up by the legal system. Many contracts are handled according essentially to this

model. Paramount among those is marriage, but also in the business context this model is easy to find:

24

joint ventures and other similar types of business agreements are completed essentially relying on a

continuous process of renegotiation in the shadow of the legal rules about break-up.

For other relationships, the legal system provides that a permanent or stable organization will be

created by the parties, and the organization will be entrusted with completing the contract. The legal

system does not have a hands-off approach, since it contains default rules for some specially important

or frequent contingencies, and also provides safeguards against malfunctioning of the organization set

up by the parties through the contract. But the detailed and daily completion is left to the organization

governing the contract. This is what we observe in companies and corporations, where the company

and corporate relevant bodies take the decisions about course of action and contract completion along

the way -and often it is a long way, since the contracts are in principle of indefinite duration- within the

boundaries set by mandatory company law rules.

Default rules of Contract Law, renegotiation and organization do not exhaust the contract completion

mechanisms that legal systems actually use. An important one is authority: one of the parties is

entrusted with the power to complete the contract and provide rules of action for the contingencies

affecting the life of the contract. This authority is not without bounds or limits, often strict ones. In fact,

the Law gives especial weight to such constraints, in order to reduce arbitrariness, and even discretion,

in the exercise of the authority to complete the contract. The employment contract is probably the

clearest example of this completion model, where the employer is empowered to determine most of the

content of the contract, albeit subject to important constraints imposed by employment laws and

collective agreements, setting limits to working conditions and often establishing as well compensation

schemes following termination of the relationship. Also outside the labor contract one may observe this

completion mechanism at work. In distribution contracts (franchise, selective distribution, etc.) the

franchisor or supplier enjoys significant authority to complete the contract, again subject to certain

limits on the exercise of authority, and sometimes under the shadow of compensation provisions for

termination. Again, it is no surprise than in most legal systems, legal density and emphasis concerning

those contracts, both quantitatively and qualitatively, is concentrated on limiting discretion and

regulating the consequences of termination.

In the following chapters we will not deal with this set of alternative contract completion mechanisms.

Not because we believe they are, theoretically or practically, unimportant. It is merely that our focus is

on the core of Contract Law, or if one prefers, the traditional area of this field of the Law. Thus, the

discussion in the remainder of this book will be organized around the two main tasks of Contract Law

in the narrow sense of the word: rules on contract formation and rules on contract completion. Again,

the division is not intended as metaphysically essential, since it is clear that both are mutually

dependent. Parties would obviously decide to enter into a contract having regard of how the Law will

complete their agreements: contracting parties weigh the legal remedies in case of breach by the other

party before they jump into the agreement. And the contract formation process will influence how a

contract will be interpreted, gaps will be filled, and remedies will be enforced. For expositional

purposes, we will deal with the issues arising from the two fundamental tasks of Contract Law in a

separate fashion.

25

Activities and Readings

1. S and P are considering entering into a contract. The cost of production of the consideration for S

is uncertain: it could be 30, with 60% probability (1), 70 with a probability of 20% (2) and 150 with a

probability of 20% (3). The value estimation of the consideration on the part of P is of 100, and the

price would be paid on completion and delivery of the consideration.

a) Let us suppose that the parties enter into a contract which will be called A1, whereby S will

perform the consideration for P at any case and that the latter shall pay the price of 75. Which is

the surplus of this contract for P and for S? Show why both will prefer another contract to be

called A2, pursuant to which S will perform the consideration only when the cost is 30 or 70,

and calculate a satisfactory price for both to prefer entering the A1 contract to A2.

A1)

1. 60% (75 30) = 60% X 45 = 27

2. 20% (75 70) = 20% X 5 = 1

3. 20% (75 150) = 20% X (-75) = -15

V32s = 27 + 1 15 = 13

Vp= 100 75 = 25

A2) in order to persuade P of complying with his consideration, the price must be lowered as

follows, if p = 60:

Vs = 60% (60-30) + 20% (60-70) = 60% (30) + 20% (-10) = 18 2 = 16

Vp =80% (100-60) + 20% (0)33 = 32

According to the aforementioned calculations, we can notice that S y P prefer to enter into a

contract under the form of A2. Thus, A1 is not a complete contract (either S or P shall not

comply with it in some circumstances): They may always find a price (p) which either could

make the contract more attractive for both parties (however, the that in each occasion there may

exist a different possible price, it does not mean that it is not a complete contract).

b) Let us suppose that the initial contract (called A3) provides for compliance solely when the cost

of compliance is 30, establishing a price of 50. Show why both contracting parties prefer

contract A2 to contract A3.

A3) The cost of the consideration for the Seller (S) is 30 in 60% of the cases, so:

Vs = 60% (50 30) = 12

Vp = 60% (100 50) = 30

32 V = estimation of the contract for (S) and (P) respectively.

33 Pursuant to contract A2, S shall only perform his consideration when the cost is of 30 or of 70 (that is to say, in 80% of

the cases), so in the other 20% of the cases he shall not enter into the contract.

26

S and P prefer A2 to A3 as both maximize their benefits under this contract: under A2, S

obtained 16 y P obtained 32.

Conclusion: If we initially consider a situation which differs from the best possible contract for

the benefit of both parties (the complete contract) it will be possible to find a case in which if the

price is modified conveniently, the benefit of all contracting parties shall improve.

2. STS, 1, 11.2.1999 (RJ 1999\652). MP: Alfonso Barcal y Trillo- Figueroa

FUNDAMENTOS DE DERECHO

PRIMERO.- Doa Mara del Carmen H. P. y doa Estrella A. A. promovieron juicio declarativo de

menor cuanta contra doa Encarnacin P. G., en reclamacin de pago de la cantidad de 16.666.666

pesetas, importe de su participacin en el premio correspondiente al boleto propiedad de las tres, as

como los intereses legales hasta el total pago de la suma reclamada, y, subsidiariamente, para el

supuesto de que no se estime procedente la pretensin deducida, que se determine por el Juzgador cual

es la participacin personal de las demandantes en el premio obtenido, declarando la obligacin de la

demandada al pago a las actoras de la cantidad procedente. Las pretensiones as ejercitadas fueron

desestimadas por el Juzgado de Primera Instancia Nmero Dos de Legans en Sentencia de 16 de

marzo de 1993, pero fue revocada por la dictada, en 21 de junio de 1994, por la Seccin Vigsimo

Primera de la Ilma. Audiencia Provincial de Madrid, y en su lugar, estimando totalmente la demanda,

conden a doa Encarnacin P. G. a pagar a favor de doa Mara del Carmen H. P. y de doa Estrella

A. A. la cantidad de 16.666.666 pesetas, importe de su participacin en el premio correspondiente al

boleto propiedad de las tres, as como a abonarles el inters anual de 16.666.666 pesetas, incrementado

en dos puntos, desde la fecha de esta sentencia hasta el completo pago de la suma de 16.666.666

pesetas. Y en esta sentencia se relatan una serie de hechos, que atendiendo al modo y forma en que

figuran redactados, bien pueden ser conceptuados como probados, y que concuerdan,

substancialmente, con los estimados acreditados en la recada en primera instancia, as: A doa Mara

del Carmen H. P. (demandante), doa Mara Estrella A. (demandante) y doa Encarnacin P. G.

(demandada), les una una fuerte amistad, y, durante el ao 1989, acordaron jugar, conjunta y de forma

continua y habitual, a la Lotera Primitiva, para lo cual se realizaba una aportacin semanal de 235

pesetas cada una, que, en un principio, era recogida por la seora H., y, posteriormente, por la seora P.

la cual se encargaba de presentar el boleto de siete apuestas para ser visado, previo pago de su importe,

quedndose con el resguardo, con el compromiso que, de obtener un premio, se partira su importe

entre las tres por partes iguales. Y as lo vinieron haciendo, hasta el da 8 de enero de 1992. Tras recibir

las aportaciones dinerarias de las seoras H. y A., la seora P. vis el boleto mltiple de 7 apuestas,

nmero 365-07420810-076 (con la siguiente combinacin: 2-7-12-27-32-34-41 y reintegro el 2) para

participar en el primer sorteo del ao 1992 de la Lotera Primitiva, a celebrar el da 2 de enero de 1992,

quedndose con el resguardo del boleto, el cual no result premiado. Exista en esas fechas un concurso

denominado "Primi-Juego II" que se rega por unas normas publicadas por el Organismo Nacional de

Loteras y Apuestas del Estado (Ministerio de Economa y Hacienda), figurando un extracto de las

27

mismas en los establecimientos autorizados. Siendo una de las formas en las que se puede participar,

atendiendo a las llamadas telefnicas que se efecten en directo desde el programa de televisin en el

que previamente se retransmite el sorteo de la Lotera Primitiva. Para lo cual se tiene en cuenta la Gua