This result is contrary to the common view. It is widely believed that parties exercise bargaining power by requiring weaker contracting partners to take unfavorable terms. Thus, $2 302(1)of the UCC authorizes a court to strike "any clause of the contract " if the clause is unconscionable, and it is common to hear apparently one-sided terms described as the product of unequal bargaining power. However, when bargaining power is determined prior to contract formation, as is common in business contexts, these views are incorrect. Bargaining power instead is exercised in the division of the surplus, which is determined by the price term. Parties choose the contract terms jointly so as to maximize the surplus that the price may then divide B Why the state Should Help firms We noted at the outset that there are four main objections to a single minded state pursuit of welfare maximization for commercial contract law. Part II(A)argued that the cognitive objection is weak, and Part V(A) will argue against the fairness objection. We discuss here the externality and distributional objections. The externality objection also is weak because it is descriptively true of most commercial contracts that they affect only the parties to them. A single ales contract that turns out badly is unlikely to put employees out of work or cause retailers in the firms locality to suffer. It is a firm's systematic decisions that may affect third parties in material ways. For example, a firm may run a factory with disregard for the environment or the rights of This conclusion applies though parties may be uncertain about the amount of bargaining power they actually have. For example, parties can use a maximin strategy when they know the set of possible disagreement points but do not know which member of the set applies to their case. A party using this strategy evaluates uncertain gains above the status quo by taking the disagreement point that implies the smallest gain. As a consequence, some efficient deals will not be made, but those that are will be pareto efficient. See Walter Bossert and Hans Peters Efficient Solutions to Bargaining Problems With Uncertain Disagreement Points, 19 Social Choice and Welfare 489 (2002). Our conclusion in the text is unaffected by this form of uncertainty because each disagreement point in the full set is exogenous. This set of models requires parties to reach agreement promptly on the basis on the possible choices available to them. When parties are optimistic about their bargaining power but can learn the truth by nference from the sequence of offers each of them makes, they will reach efficient bargains, though with delay. See Muhamet Yildiz, Waiting to Persuade, MIT Dept of Econ. Working Paper #02-38 (2002). We do not claim that parties always choose efficient contract terms. The existence of asymmetric information sometimes will cause parties to make constrained efficient contracts; these contracts are not"first best " but are efficient given the information structure facing the parties. In Part V, we argue that the state seldom can improve on constrained efficient contracts because information that is unavailable to the parties is unlikely to be available to the decision maker 15
23This conclusion applies though parties may be uncertain about the amount of bargaining power they actually have. For example, parties can use a maximin strategy when they know the set of possible disagreement points but do not know which member of the set applies to their case. A party using this strategy evaluates uncertain gains above the status quo by taking the disagreement point that implies the smallest gain. As a consequence, some efficient deals will not be made, but those that are will be pareto efficient. See Walter Bossert and Hans Peters, Efficient Solutions to Bargaining Problems With Uncertain Disagreement Points, 19 Social Choice and Welfare 489 (2002). Our conclusion in the text is unaffected by this form of uncertainty because each disagreement point in the full set is exogenous. This set of models requires parties to reach agreement promptly on the basis on the possible choices available to them. When parties are optimistic about their bargaining power but can learn the truth by inference from the sequence of offers each of them makes, they will reach efficient bargains, though with delay. See Muhamet Yildiz, Waiting to Persuade, MIT Dept. of Econ. Working Paper #02-38 (2002). We do not claim that parties always choose efficient contract terms. The existence of asymmetric information sometimes will cause parties to make constrained efficient contracts; these contracts are not “first best” but are efficient given the information structure facing the parties. In Part V, we argue that the state seldom can improve on constrained efficient contracts because information that is unavailable to the parties is unlikely to be available to the decision maker. 15 This result is contrary to the common view. It is widely believed that parties exercise bargaining power by requiring weaker contracting partners to take unfavorable terms. Thus, §2- 302(1) of the UCC authorizes a court to strike “any clause of the contract” if the clause is unconscionable, and it is common to hear apparently one-sided terms described as the product of “unequal bargaining power.” However, when bargaining power is determined prior to contract formation, as is common in business contexts, these views are incorrect. Bargaining power instead is exercised in the division of the surplus, which is determined by the price term. Parties choose the contract terms jointly so as to maximize the surplus that the price may then divide unequally.23 B. Why the State Should Help Firms We noted at the outset that there are four main objections to a single minded state pursuit of welfare maximization for commercial contract law. Part II(A) argued that the cognitive objection is weak, and Part V(A) will argue against the fairness objection. We discuss here the externality and distributional objections. The externality objection also is weak because it is descriptively true of most commercial contracts that they affect only the parties to them. A single sales contract that turns out badly is unlikely to put employees out of work or cause retailers in the firm’s locality to suffer. It is a firm’s systematic decisions that may affect third parties in material ways. For example, a firm may run a factory with disregard for the environment or the rights of
its workers. Systematically inefficient or unfair behavior of this kind is subject to legal regulation grouped under the headings of environmental and employment law. Again, we take advantage of this specialization principle to assume that the transactions that a contract law regulates do not create externalities, unless there is a particular reason to believe that they do Distributional effects are an appropriate state concern, but there are several reasons wh commercial contract rules seldom could create systematic distributional benefits for particular classes of parties. In the first place, commercial parties commonly occupy the roles both of selle and buyer(or licensor and licensee, etc. ) As a consequence, a pro-seller rule would hurt firms when they buy, and a pro-buyer rule would hurt these same firms when they sell. In addition, because most commercial contract law rules are defaults distributional benefits are hard to create even for firms that primarily buy or sell. For example, let a contract rule allocate a risk to the selling side of the market in order to create a distributional benefit for the buying side. Suppose also that contractual surplus would be maximized if buyers bore the risk at issue(because, say, they are the cheapest cost avoiders ). a contract allocating the risk to the buyer then would make both the seller and buyer better off( because they would be splitting a larger surplus) Consequently, the legal rule's allocation would be unstable. Because business firms attempt to maximize contractual surplus the default rules that constitute the bulk of commercial law thus seldom could systematically benefit either side of the market Moreover, it is difficult to create distributional benefits for particular firms because firms are owned by shareholders, and shareholders commonly hold diversified portfolios. A diversified shareholder often will own some firms that buy and sell, some firms that may primarily buy and others that may primarily sell. An attempt to benefit either side of the market distributionally is unlikely to create net gains for such a shareholder. Diversification also is normatively relevant a diversified owner wants the value of his portfolio to increase, not the value of particular firms in his portfolio at the expense of other firms. Indeed, investors diversify precisely to escape firm specific risk-the risk that a particular firm in which the investor has an interest will have unusually bad outcome. The satisfaction of this preference thus requires legal rules that maximize surplus across firms
16 its workers. Systematically inefficient or unfair behavior of this kind is subject to legal regulation grouped under the headings of environmental and employment law. Again, we take advantage of this specialization principle to assume that the transactions that a contract law regulates do not create externalities, unless there is a particular reason to believe that they do. Distributional effects are an appropriate state concern, but there are several reasons why commercial contract rules seldom could create systematic distributional benefits for particular classes of parties. In the first place, commercial parties commonly occupy the roles both of seller and buyer (or licensor and licensee, etc.). As a consequence, a pro-seller rule would hurt firms when they buy, and a pro-buyer rule would hurt these same firms when they sell. In addition, because most commercial contract law rules are defaults, distributional benefits are hard to create even for firms that primarily buy or sell. For example, let a contract rule allocate a risk to the selling side of the market in order to create a distributional benefit for the buying side. Suppose also that contractual surplus would be maximized if buyers bore the risk at issue (because, say, they are the cheapest cost avoiders). A contract allocating the risk to the buyer then would make both the seller and buyer better off (because they would be splitting a larger surplus). Consequently, the legal rule’s allocation would be unstable. Because business firms attempt to maximize contractual surplus, the default rules that constitute the bulk of commercial law thus seldom could systematically benefit either side of the market. Moreover, it is difficult to create distributional benefits for particular firms because firms are owned by shareholders, and shareholders commonly hold diversified portfolios. A diversified shareholder often will own some firms that buy and sell, some firms that may primarily buy and others that may primarily sell. An attempt to benefit either side of the market distributionally is unlikely to create net gains for such a shareholder. Diversification also is normatively relevant. A diversified owner wants the value of his portfolio to increase, not the value of particular firms in his portfolio at the expense of other firms. Indeed, investors diversify precisely to escape firm specific risk – the risk that a particular firm in which the investor has an interest will have an unusually bad outcome. The satisfaction of this preference thus requires legal rules that maximize surplus across firms
In sum, cogent reasons exist to justify our principal normative claim: Contract Law should facilitate the ability affirms to maximize welfare when making commercial contracts. The reasons set out here also imply, for this class of contracting parties, that it is unnecessary or futile for courts or statutory drafters to pursue distributional goals. The contract law of commercial parties is about efficiency II. THE ENFORCEMENT FUNCTION A perennial question in contract law is why the state should enforce a contract against the wishes of a party to it. We exclude answers to this question that take the following form: The state should enforce a party's contractual promises the better to permit persons to enlist other persons in their projects, and thus to increase the sphere of autonomy within which pe ersons can operate. Or, the state should enforce promises to reenforce the morality of keeping them. These answers are ruled out here because the business firms that make commercial contracts are artificial persons whose autonomy the state need not respect on moral grounds, and whose morality is ordinarily required by positive law. The relevant question for a normative theory of commercial contract law is just when, if ever, does the goal of welfare maximization require legal enforcement of the contracts that business entities make A. Enforcement Often is Unnecessary a contract has an intertemporal aspect: parties agree today to do something tomorrow State enforcement of these agreements is unnecessary when the agreements fall within the self- For excellent analyses of the strengths and limitations of the various autonomy-based theories of contract law, see Richard Craswell, Contract Law, Default Rules, and the Philosophy of Promising, 88 Mich. L Rev. 395 ( 1989); Jody S Kraus, Philosophy of Contract Law in The Jurisprudence and Philosophy of Law (Jules Coleman Scott Shapiro, eds. 2001); and Jody S Kraus, Theories of Contact in The Stanford Encyclopedia of Philosophy(on- line)(Liam Murphy and Joseph Raz. Eds. 2001) Agreements often are written even when the parties expect not to enforce them legally. A writing reduces disagreements over what the parties had actually agreed to do. Disagreements as to what the contract directs raise interpretation issues that are discussed in Part IV belor 17
24For excellent analyses of the strengths and limitations of the various autonomy-based theories of contract law, see Richard Craswell, Contract Law, Default Rules, and the Philosophy of Promising, 88 Mich. L. Rev. 395 (1989); Jody S. Kraus, Philosophy of Contract Law in The Jurisprudence and Philosophy of Law (Jules Coleman & Scott Shapiro, eds. 2001); and Jody S. Kraus, Theories of Contact in The Stanford Encyclopedia of Philosophy (online) (Liam Murphy and Joseph Raz. Eds. 2001). 25Agreements often are written even when the parties expect not to enforce them legally. A writing reduces disagreements over what the parties had actually agreed to do. Disagreements as to what the contract directs raise interpretation issues that are discussed in Part IV below. 17 In sum, cogent reasons exist to justify our principal normative claim: Contract Law should facilitate the ability of firms to maximize welfare when making commercial contracts. The reasons set out here also imply, for this class of contracting parties, that it is unnecessary or futile for courts or statutory drafters to pursue distributional goals. The contract law of commercial parties is about efficiency. III. THE ENFORCEMENT FUNCTION A perennial question in contract law is why the state should enforce a contract against the wishes of a party to it. We exclude answers to this question that take the following form: The state should enforce a party’s contractual promises the better to permit persons to enlist other persons in their projects, and thus to increase the sphere of autonomy within which persons can operate.24 Or, the state should enforce promises to reenforce the morality of keeping them. These answers are ruled out here because the business firms that make commercial contracts are artificial persons whose autonomy the state need not respect on moral grounds, and whose morality is ordinarily required by positive law. The relevant question for a normative theory of commercial contract law is just when, if ever, does the goal of welfare maximization require legal enforcement of the contracts that business entities make. A. Enforcement Often is Unnecessary A contract has an intertemporal aspect: parties agree today to do something tomorrow.25 State enforcement of these agreements is unnecessary when the agreements fall within the self-
enforcing range or can be enforced with reputational sanctions. An agreement is said to be self- enforcing when the threat by either party no longer to deal with the other is sufficient in and of itself to induce performance. Reputation, in turn, will induce performance when a single contract partners boycott would not. For reputation to work, however, potential contracting parties must be able conveniently to learn why the parties'deal broke down. Reputations therefore, are difficult to establish in large economies in which particular contracting parties often are anonymous to most market participants. Rather, reputations work best in small trading communities, especially those with ethnically homogenous members, where everything th happens soon becomes common knowledge, and boycotts of bad actors are convenient to enforce. 29 Reputational sanctions also can be effective in industries that can establish trade associations; the associations become a form of collective memory regarding the contracting behavior of their members 30 This article. however focuses on contracts that fall outside the self- enforcing range and that cannot be enforced by reputational sanctions. We take this focus because parties often write the contracts it contemplates, and because we are interested in the role 26For good, largely informal discussions of these issues, see Benjamin Klien, Why Hold-L The Self-Enforcing Range of Contractual Relationships, 34 Econ. Inquiry 444 (1996)and robert e. Scott Cooperation in Long-Term Contracts, 75 Cal L Rev. 2005, 2039-2050(1987) ake "let s and b write a contract in a state that does not legally enforce contracts. B later learns that it could B. Let B's expected profits on these future contracts have a present value of $200. Then B will perform the contract, though it could not be sued for breach, because breach would cause it to lose $100($200-$100). The contract is self-enforcing For example, suppose that S's later refusal to deal would impose only a $10 loss on the breaching buyer. but other sellers also will refuse to deal, raising the buyers total loss from breach in present value terms to $200(S10 a $190 reputational sanction). Again, B would voluntarily perform See Janet Landa, A Theory of the Ethnically Homogenous Middleman Group: An Institutional Alternative to Contract Law, 10 J. Legal Stud. 349(1981). An excellent survey of early informal enforcement mechanisms is Avner Grief, Informal Contract Enforcement: Lessons from Medieval Trade in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND LAW 287(Peter Newman, ed 1998) BFor discussion, see Lisa Bernstein, Private Commercial Law in the Cotton Industry: Creating Cooperation through Rules, Norms and Institutions, 99 Mich. L. Rev. 1724 (2001); same author, Merchant Law in Merchant Court: Rethinking the Code's Search for Immanent Business Norms, 144 U. Pa. L. Rev. 1765(1996) 18
26For good, largely informal discussions of these issues, see Benjamin Klien, Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships, 34 Econ. Inquiry 444 (1996) and Robert E. Scott, Conflict and Cooperation in Long-Term Contracts, 75 Cal. L. Rev. 2005, 2039-2050 (1987). 27Let S and B write a contract in a state that does not legally enforce contracts. B later learns that it could make $100 more by breaching the contract than by performing it. If B breaches, however, S will no longer deal with B. Let B’s expected profits on these future contracts have a present value of $200. Then B will perform the contract, though it could not be sued for breach, because breach would cause it to lose $100 ($200 - $100). The contract is self-enforcing. 28For example, suppose that S’s later refusal to deal would impose only a $10 loss on the breaching buyer, but other sellers also will refuse to deal, raising the buyer’s total loss from breach in present value terms to $200 ($10 + a $190 reputational sanction). Again, B would voluntarily perform. 29See Janet Landa, A Theory of the Ethnically Homogenous Middleman Group: An Institutional Alternative to Contract Law, 10 J. Legal Stud. 349 (1981). An excellent survey of early informal enforcement mechanisms is Avner Grief, Informal Contract Enforcement: Lessons from Medieval Trade in 2 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND LAW 287 (Peter Newman, ed. 1998). 30For discussion, see Lisa Bernstein, Private Commercial Law in the Cotton Industry: Creating Cooperation through Rules, Norms and Institutions, 99 Mich. L. Rev. 1724 (2001); same author, Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms, 144 U. Pa. L. Rev. 1765 (1996). 18 enforcing range or can be enforced with reputational sanctions.26 An agreement is said to be selfenforcing when the threat by either party no longer to deal with the other is sufficient in and of itself to induce performance.27 Reputation, in turn, will induce performance when a single contract partner’s boycott would not.28 For reputation to work, however, potential contracting parties must be able conveniently to learn why the parties’ deal broke down. Reputations, therefore, are difficult to establish in large economies in which particular contracting parties often are anonymous to most market participants. Rather, reputations work best in small trading communities, especially those with ethnically homogenous members, where everything that happens soon becomes common knowledge, and boycotts of bad actors are convenient to enforce.29 Reputational sanctions also can be effective in industries that can establish trade associations; the associations become a form of collective memory regarding the contracting behavior of their members.30 This article, however, focuses on contracts that fall outside the selfenforcing range and that cannot be enforced by reputational sanctions. We take this focus because parties often write the contracts it contemplates, and because we are interested in the role
of the law; legal rules matter when private enforcement mechanisms fail. 3 Even so, the efficiency gains from enforcing contractual promises presuppose the existence of contracts and commercial transactions often are conducted without them firms often make simultaneous exchanges of cash for goods or services rather than exchange promises for the later trade of these goods or services. In this world, property law is a sufficient encouragement to commerce because a party will only part with goods or money if the party values more highly what is offered in exchange. Thus, protecting property supports efficiency But in contrast to simultaneous exchanges, a contract is a set of promises regarding future behavior. Such promises are costly to make and to memorialize. In order to understand the role of the state in relation to contracting behavior, it thus is necessary to explain why parties will incur these costs when contracts are legally enforceable but not otherwise State enforcement is helpful to contracting parties in a number of contexts but particularly important in the two cases that Parts Ill(B )and C next discuss-when investment is relation specific and when a bad state realization can create serious disruption costs. We analyze these cases both because of their intrinsic economic significance and because of their relation to other aspects of contract law. For example, the need to cushion an adverse state realization and the need to avoid an adverse contract interpretation that would create similar disruption costs can cause risk neutral parties to act as if they are risk averse. The recognition of this should influence legal doctrine. The next two subparts thus treat paradigmatic cases Recent theoretical and empirical work shows that when a nontrivial portion of actors in a market will act fairly toward contract partners, fairness can substitute for reputation. For example, party a will deal with party b not because party B has a reputation for fairness but because party B is likely just to be a fair person. For a review, see individuals act in experiments as if they have a taste for farmes .sity of Zurich (2001). In this literature, somes hile other individuals behave only out of self interest. Similarly, when a nontrivial portion of actors in a market will behave honestly toward contract partners, certain efficiencies can be achieved in high transaction cost environments that would otherwise be unattainable. See reputational considerations aside, firms have tastes for fairness or honesty. We assume they do not for purposesor Yongmin Chen, Promises, Trust and Contracts, 16J Law, Econ. Org 209(2000). It is an open question wheth this article in order to focus on the role of the law
31Recent theoretical and empirical work shows that when a nontrivial portion of actors in a market will act fairly toward contract partners, fairness can substitute for reputation. For example, party A will deal with party B not because party B has a reputation for fairness but because party B is likely just to be a fair person. For a review, see Ernst Fehr, Alexander Klien and Klaus M. Schmidt, Fairness, Incentives and Contractual Incompleteness, Working Paper #72, Institute for Empirical Research in Economics, University of Zurich (2001). In this literature, some individuals act in experiments as if they have a taste for fairness, while other individuals behave only out of self interest. Similarly, when a nontrivial portion of actors in a market will behave honestly toward contract partners, certain efficiencies can be achieved in high transaction cost environments that would otherwise be unattainable. See Yongmin Chen, Promises, Trust and Contracts, 16 J. Law, Econ. & Org. 209 (2000). It is an open question whether, reputational considerations aside, firms have tastes for fairness or honesty. We assume they do not for purposes of this article in order to focus on the role of the law. 19 of the law; legal rules matter when private enforcement mechanisms fail.31 Even so, the efficiency gains from enforcing contractual promises presuppose the existence of contracts, and commercial transactions often are conducted without them. Firms often make simultaneous exchanges of cash for goods or services rather than exchange promises for the later trade of these goods or services. In this world, property law is a sufficient encouragement to commerce because a party will only part with goods or money if the party values more highly what is offered in exchange. Thus, protecting property supports efficiency. But in contrast to simultaneous exchanges, a contract is a set of promises regarding future behavior. Such promises are costly to make and to memorialize. In order to understand the role of the state in relation to contracting behavior, it thus is necessary to explain why parties will incur these costs when contracts are legally enforceable but not otherwise. State enforcement is helpful to contracting parties in a number of contexts but is particularly important in the two cases that Parts III(B) and C next discuss – when investment is relation specific and when a bad state realization can create serious disruption costs. We analyze these cases both because of their intrinsic economic significance and because of their relation to other aspects of contract law. For example, the need to cushion an adverse state realization and the need to avoid an adverse contract interpretation that would create similar disruption costs can cause risk neutral parties to act as if they are risk averse. The recognition of this should influence legal doctrine. The next two subparts thus treat paradigmatic cases