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Contract Law: Enforcement, Bargain Theory, and Formation Defenses, Study notes of Economics and Law

Alliance UniversityEconomics and Law

An overview of contract law, focusing on the enforcement of contracts, the bargain theory, and formation defenses. It covers topics such as offer, acceptance, consideration, enforceability, formation defenses, and performance excuses. The document also discusses default rules, reliance, investment in performance, damages, and various court-imposed and party-designed remedies.

Typology: Study notes

2012/2013

Uploaded on 05/15/2013

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Econ 522 Review 2: Contract Law
Fall 2012
This document is by no means comprehensive, but instead serves as a rough guide to the
material we have discussed on contract law. I would suggest that you use other study aids
as well (such as the lecture slides, discussion handouts, textbook, and exams from previous
semesters) in your study for the midterm.
1 Contracts
In class we said a contract is a legally binding promise. Contracts exist in order to facilitate
trade when transactions don’t happen simultaneously. Contract law mainly deals with two
questions:
•Which contracts should we enforce?
•What should we do if a contract is breached? There must be some adverse consequence
to breaching a contract, or contracts are unenforceable.
1.1 Bargain Theory
The bargain theory of contracts is an early legal theory which says that a contract should
be enforced if three things are present:
•Offer: One side offers the contract.
•Acceptance: The other side accepts the contract.
•Consideration: Each side gives up something of value.
However, modern courts do not always behave according to bargain theory. For efficiency,
we generally want to enforce those contracts that both parties wanted to be enforceable
when they signed the contract.
1.2 Enforceability
•Contracts designed to get around a law are unenforceable: this is called derogation of
public policy
•Contracts that cannot be performed without breaking the law are unenforceable
•Exception: if the promisor knew the contract violated (or tried to get around) the
law, but the promisee didn’t
1
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Econ 522 Review 2: Contract Law

Fall 2012

This document is by no means comprehensive, but instead serves as a rough guide to the material we have discussed on contract law. I would suggest that you use other study aids as well (such as the lecture slides, discussion handouts, textbook, and exams from previous semesters) in your study for the midterm.

1 Contracts

In class we said a contract is a legally binding promise. Contracts exist in order to facilitate trade when transactions don’t happen simultaneously. Contract law mainly deals with two questions:

  • Which contracts should we enforce?
  • What should we do if a contract is breached? There must be some adverse consequence to breaching a contract, or contracts are unenforceable.

1.1 Bargain Theory

The bargain theory of contracts is an early legal theory which says that a contract should be enforced if three things are present:

  • Offer: One side offers the contract.
  • Acceptance: The other side accepts the contract.
  • Consideration: Each side gives up something of value.

However, modern courts do not always behave according to bargain theory. For efficiency, we generally want to enforce those contracts that both parties wanted to be enforceable when they signed the contract.

1.2 Enforceability

  • Contracts designed to get around a law are unenforceable: this is called derogation of public policy
  • Contracts that cannot be performed without breaking the law are unenforceable
  • Exception: if the promisor knew the contract violated (or tried to get around) the law, but the promisee didn’t
  • Contracts made by incompetent individuals (i.e. children or mentally ill people) are unenforceable.
  • Contracts made under dire constraints are unenforceable:
    • Necessity: There was no meaningful choice by the promisee, perhaps because of an emergency
    • Duress: Not only was there no meaningful choice by the promisee, but this situation was caused by the promisor

Courts may also refuse to enforce contracts that are overly vague, are standardized take-it- or-leave-it contracts (adhesion), or are dramatically unfair (unconscionability).

1.3 Formation Defenses and Performance Excuses

  • A formation defense asserts that a party should not be liable for breach, since there was no valid contract, perhaps for one of the reasons discussed above.
  • A performance excuse asserts that a party should not be liable for breach, even though there was a valid contract, because circumstances have changed. We discussed several of these in class: - Impossibility: It is impossible for the party to perform the contract. - Fraud : One party deliberately tricked the other. - Failure to Disclose: One party failed to disclose critical information to the other. ∗ Under civil law, parties have a duty to disclose important information. ∗ Under common law, generally only dangers to safety need be disclosed. The exception is new products, which come with an “implied warranty of fitness.” - Frustration of Purpose: A change in circumstances made the contract pointless. - Mutual mistake: Both parties made a mistake, without which the contract would not have been signed.

1.4 Default Rules

A default rule tells the court what to do when a contract fails to specify what should happen in some contingency. Such an omission is called a gap, and they are inevitable; it’s not feasible to include every possible contingency in a contract. We’ve considered two types of default rules, as well as regulations:

  • A efficient default rule is an attempt to fill a gap with the rule the parties would have wanted, had they thought to specify it. Such rules work well when gaps exist due to a high transaction cost of filling them, and not due to strategic omission.
  • A penalty default rule is an attempt to fill a gap with a rule the parties would not have wanted in order to encourage the parties to disclose information and fill the gap with something efficient. Such rules may work well when gaps are left for strategic reasons.
  • Regulations are like default rules, but can’t be negotiated around.

1.9 Party-Designed Remedies

Party-Designed Remedies are those that are explicitly written into a contract:

  • Liquidated damages reasonably approximate the harm done.
  • Penalty damages are greater than the actual harm done. Common law courts often do not enforce penalty damages, whereas civil law courts generally do. However, whatever you can accomplish with penalty damages can also be accomplished with a performance bonus, which common law courts generally enforce.