Contracts
I. Fundamentals and Necessity of Contract Law
Contract Definition: A contract is a mutual, voluntary agreement between two or more persons.
If an agreement is truly voluntary, it implies that both parties anticipate deriving a benefit.
A contract requires that the parties have the intention to create legally binding relationships (a legal bond).
Informal promises, jokes, or statements made in a non-serious context do not qualify as legally binding contracts.
The Need for Contract Law: Simple transactions (like buying an apple) do not require formal contract law, but complex, long-term transactions (like building a house) do.
Contract law is necessary because contracts never say enough; there is not enough detail to cover every possible contingency, requiring courts to fill in gaps.
It helps address situations where parties disagree on whether a contract exists or what its terms entail.
Essential Elements for Enforcement (Suits Example): For a contract to be legally viable, it must typically include an offer (offer), acceptance, and consideration (contraprestación), where each party gives something of value in exchange.
II. Contract Enforcement Mechanisms Beyond the Courts
Reputation: This is often the most important method for enforcing agreements, especially in industries involving repeat dealings.
A store guarantees a refund even if the cost of suing for a return is low because they do not want a reputation for cheating their customers.
Private Arbitration (Diamond Industry Example): In trust-intensive industries like the New York diamond market, where members may avoid the legal system, disputes are settled by respected local arbitrators (e.g., rabbis).
If a party refuses to abide by the arbitrator’s ruling, they face economic and social sanctions and are essentially forced out of the industry, thus reinforcing the agreement.
Contractual Law Base: Arbitrators must base their decisions on the rules of contractual law (derecho contractual), which can derive from common custom and what is normally understood, rather than only centralized state legislation.
A contractual law base is needed because no contract can cover all nuances, providing a foundation for determining what constitutes a contract in complex cases.
III. Freedom of Contract and Its Limits
Freedom of Contract (Efficiency Argument): The assumption is that rational bargainers will negotiate terms that maximize the net gain (economic efficiency) for both parties, supporting the enforcement of contracts as written (Coase Theorem).
If a contract term is inefficient, the parties should be able to renegotiate the terms and adjust the price so that both benefit from the change.
Challenging "Unequal Bargaining Power": The idea that a monopolist will impose inefficient terms is largely incorrect.
A monopolist (like the seller of a book or car rental agency) still has the incentive to make improvements—either to the product or the contract terms—if the value of the improvement to the customer is greater than the cost to the seller, allowing the seller to charge a higher price.
Contracts of Adhesion ("Bogus Duress"): Form contracts (e.g., car rentals) that are offered on a "take it or leave it" basis are generally legally valid and not considered duress.
This is justified because competition exists (substitutes like other rental agencies or Uber), giving the customer an option to walk away.
Companies use form contracts to reduce the high cost of drafting individual contracts and to mitigate the risk of employees cheating the company on pricing.
Limits on Contractual Freedom (Illegality and Third Parties): Contracts are typically unenforceable if they violate the law or impose substantial net costs on third parties without their consent.
Examples include murder-for-hire contracts or illegal clauses (e.g., saying one party becomes the owner of the other).
Coercion and Capacity: Agreements are invalid if made under coercion (coerción), such as duress by an assailant.
Contracts are also not enforced for individuals lacking capacity, such as children or those who are cognitively compromised.
IV. Duress and Implied Consent Scenarios
Real Duress (Mugger): A contract made under the threat of violence (e.g., giving a check to an assailant instead of being shot) is unenforceable because the threat (coercion) eliminates voluntariness.
The current legal rule of non-enforceability is efficient because making such contracts binding would increase the profitability of mugging and therefore increase the probability of people being mugged.
Semi-Real Duress (Sinking Ship/Tugboat Salvage): When a tugboat rescues a sinking ship and charges an extremely high price, this situation is different from real duress because the tug captain did not cause the danger.
Admiralty courts often rewrite the agreement to a reasonable price (e.g., $1 million instead of $9 million for a $10 million ship).
The high price incentivizes tugboat owners to invest in being available for rescues, but the low price incentivizes ship owners to take due precautions.
Implied Acceptance (Services Rendered): Determining whether an agreement exists based on implicit actions is difficult and subjective.
Windshield Washing Example: If a driver does not move or reject the service, there is an argument for implicit acceptance and an obligation to pay.
Emergency Medical Services (Good Samaritan): A doctor treating an unconscious accident victim may legally bill the victim. This acts as a Pigouvian bounty (negative liability rule) for conferring an unasked benefit, as the victim could not contract for the necessary service.
V. Contract Formation and Reliance
Detrimental Reliance: A promise can become enforceable if the promisee assumed some cost or effort based on the promise (reliance).
Lost Dog Rewards: If a neighbor returns a lost cat and then discovers a reward sign, enforcing the reward ("contract") depends on whether doing so increases the overall efficiency (net gain) of finding lost articles.
An argument against enforcing the reward if the finder didn't know about it is that the finder acted based on the information available (good will), and subsequent discovery of more favorable terms should not invalidate the original voluntary act.
VI. Damages, Breach, and Risk Allocation
Efficient Breach: A breach is efficient (good) when the cost of performing the contract exceeds the benefits it generates, leading to a net loss for society.
A liability rule that makes the breaching party liable for damages is often preferred to specific performance, especially when transaction costs are high.
Expectation Damages: The legal rule requires the breaching party to pay the victim enough to put them in the position they expected to be in had the contract been fulfilled.
This rule promotes efficient breach (the breacher internalizes the victim's loss when deciding whether to break the contract) but encourages inefficient reliance (the victim relies too much, knowing they will be fully compensated).
Reliance Damages: The breaching party must compensate the victim only for expenditures made in reliance on the contract (to make them whole as if the contract had never been signed).
This rule promotes efficient signing (each party only needs to assess their own probability of breaching) but results in inefficient breach (the breacher ignores the victim's lost profits).
Liquidated Damages: Damages are stipulated in the contract beforehand.
Liquidated damages are a private property rule where the breacher must pay a pre-determined amount to "buy permission" to breach.
They are superior because they incentivize efficient reliance (the victim's compensation is fixed regardless of their spending), and if set correctly, they can lead to efficient breach or efficient signing.
Courts often invalidate clauses deemed "penalty clauses" (too high a compensation), assuming they know the real cost better than the parties, which may be inefficient.
Risk Allocation: Efficient contracts allocate losses associated with something going wrong to the party best positioned to manage that risk.
Spreading Losses: Risk should be assigned to the party that can spread the loss across multiple transactions (e.g., a large home builder versus an individual owner).
Moral Hazard: The party in the best position to prevent the loss should bear the liability (e.g., the photographer who knows his film is valuable, not the low-cost lab, is liable if the film is lost – Hadley v. Baxendale rule).
VII. Information, Pricing, and Fraud
Speculation and Information (Laidlaw v. Organ): Courts typically allow profit from superior market knowledge (speculation) to be enforced because it incentivizes the production of valuable information (e.g., news of a peace treaty or future scarcity) that stabilizes prices.
Fraudulent Concealment: A seller cannot withhold highly relevant information about the item being sold (e.g., disease, or a house's notorious reputation for being haunted) to secure a sale, as this may result in a net loss for the purchaser and is considered fraudulent.
Price Discrimination: Companies sometimes charge different prices based on the buyer's perceived willingness to pay (e.g., charging a foreigner more than a local).
While technically legal and often a functional business strategy, this practice can lead to customer feelings of being "ripped off" and create distrust, potentially driving customers toward competitors who offer clear, transparent pricing.