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Terms in this set (23)

People continually make promises

Contract Law concerns agreements that people make with each other privately. And the court gets involved if one of the parties seeks to have the agreement enforced by the court.

Traditionally, courts have been cautious about enforcing promises that are not given in exchange for something

In example 1, the promise of a trip is a gift to the nephew; the uncle does not receive anything in exchange. The courts should not enforce the uncle's promise.

In example 2, money exchanges for a promise, but the seller thought that he gave a different promise than the buyer thought she received. The courts would probably require the seller to return the money and the buyer to return the car keys

In example 3, we have deception, not confusion. The court ordinarily would offer a remedy to the victims of deceptive promises


If an enforceable promise was broken, what should the remedy be?

One remedy requires the promise breaker to keep the promise. For example, if the court decided that the seller in Example 2 broke his promise, then the court might order the seller to deliver the Cadillac to the buyer.

This kind of remedy is unavailable in Example 3 because the seller cannot exterminate grasshoppers as promised. Instead, the remedy in Example 3 must involve the payment of money damages as compensation for the failure to provide an effective grasshopper killer

Two Fundamental Questions in Contract Law

What promises should be enforced?

What should be the remedy for breaking enforceable promises?

You may ask: Why does the court get involved in private contract disputes?

The basic answer is that the ability to make enforceable contracts can create benefits for everyone and therefore can enhance efficiency.

Enforcement of contracts has long been one of the core functions of governments.

Look at Sara and Peter Example for and example.
Three Main Elements of Bargain Theory

What promises should be enforceable at law?
What should be the remedy for the breach of enforceable promises?
A criticism of the bargain theory

What Promises should be Enforceable at Law?

A promise is legally enforceable if it's given as part of a bargain; otherwise a promise is unenforceable.

Bargain Theory makes enforcement hinge upon classifying promises as "bargains" or "non-bargains"

Bargaining is a Dialogue on value to agree on a price. There are three elements in dialogue: Offer, Acceptance, and Consideration.

Offer and Acceptance have same meaning here: must make an offer and other must accept.

Each Bargain involves reciprocal inducement

Promisor = refers to the person who gives a promise
Promisee = refers to the person who receives a promise

Promisor gives something to promisee, and vice versa.

Common Law looks at the term consideration to describe what the promisee gives the promisor.

According to the Bargain Theory, a contract remains incomplete until the promisee gives something to the promisor to induce the promise.

So, Consideration ultimately makes the promise enforceable.

How do Bargains relate to fairness?

In the language of law, a contract is fair when the value of the promise is proportional to the value of the consideration.

According to bargain theory, a court should enforce promises induced by consideration, regardless of whether the consideration was equivalent in value to the promise. Bargain theory holds that courts should determine whether a bargain occurred, not inquire into whether the bargain was fair

What Should be the Remedy for the Breach of Enforceable Promises?

The promisee is entitled to the "benefit of the bargain": in other words, entitled to the benefit he/she would have obtained from performance of the promise.

In order to compute compensation under the bargain theory, one would need to answer the counterfactual question: how well off would the promisee have been if the promise had been kept?

Known as Expectation Damages

A Criticism of Bargain Theory

The bargain theory sometimes denies enforcement when a promise did not arise from a bargain. This is true even if both, the promisor and the promisee, want the promise to be enforceable.

Example: after a long career where you built significant wealth you plan to donate money to Texas A&M University to build a new building with your name on it. You promise the university the funds to construct the new building. The university wants to start the construction but dare not begin without an enforceable promise. Both want the promise to be enforceable but again the bargain theory withholds enforcement of this promise. Gift promises are not induced by the prospect of gain, so they always lack consideration.

Another criticism of the bargain theory is that it calls for the routine enforceability of any bargain, just if it is a bargain, and regardless of how outrageous the terms may be.

The bargain theory is not a good theory of contracting because it is both.

Over-inclusive (in arguing for the enforceability of contracts that, on most other grounds, ought not to be enforced).
Under-inclusive (in not arguing for the enforceability of promises that both parties truly want enforced).

Hence, the theory often fails to describe what courts actually do.
We replace the bargain theory with a better answer to the two fundamental questions in contract law.

Cooperation and Commitment

Many exchanges occur instantly and simultaneously.
In such instances, there is little reason to promise anything.

The making of promises, however, typically concerns deferred exchanges -transactions that involve the passage of time for their completion.

One party pays now and the other promises to deliver goods later (payment for a promise).

One party delivers goods now and the other promises to pay later (goods for a promise).

One party promises to deliver goods later, and the other promises to pay when the goods are delivered (promise for a promise).

The passage of time between the exchange of promises and their performance creates uncertainties and risks. A cautious buyer wants a legal obligation of the seller to deliver the goods, not just a moral obligation.

The buyer may be willing to pay now for an enforceable promise but not for unenforceable promise. Both parties recognize these facts and want the promise to be enforceable.

We can think of such situations through what is called an agency game.

Now, lets look at the second question in Contract Law

What should be the remedy for breaking enforceable promises?

Sharp Dealing
In some instances, parties to a contract take a short-sighted view of self-interest. This is often true in one-time transactions or in transactions with large stakes.

With sharp dealing, the promisor may not care about the harm that breach causes the promisee or his own reputation but the promisor still cares about the legal liability.

The promisor will perform if the net benefit from performing exceeds the net benefits from breaching minus the liability. Otherwise, the promisor will breach

Remedies for Breaking Enforceable Promises?

Expectation Damages

Expectation damages push people who make promises to take the efficient level of commitment to keeping them. Expectation damages also compensate fully the victims of breach.

Reliance Damages

In general, reliance is a change in the promisee's position. The change increases the benefit of performance and the cost of breach: Remember the promise of a trip around the world? Well, the trip is more valuable to the nephew if the he purchases the necessary items in advance (luggage, etc.); but he must sell them at a loss if his uncle breaches his promise.
Enforcing a contract frequently involves interpreting it, which often poses challenges.

Should the court interpret the contract according to its plain meaning or the intent behind the words?
The contract says "Two exceptions are allowed" but the parties would have allowed a third exception if they had thought of it. Should the court interpret the contract to allow a third exception?

Perfect Contracts

f you remember, according to the Coase Theorem, given zero transaction costs, rational parties will allocate legal entitlements efficiently. The same applies to contracts: When transaction costs are zero, the contract is a perfect instrument for exchange. Every contingency is anticipated, every risk is internalized, all relevant information is communicated, no gaps remain for courts to fill, no one needs the court's protection from deceit or abuse, nothing can go wrong. Perfect contracts pose no conundrums of interpretation.

In other words, the parties need the state to enforce a perfect contract according to its plain meaning, but nothing more is required.

Real Contracts

Unlike perfect contracts, real contracts allocate risks imperfectly.

Ex: Suppose X signs a contract with a construction company to build a house for his family. Floor plan, construction materials, style of carpets, etc. is specified in the contract as well as the price to be paid and the date for completing the house. Now imagine some of the things that can go wrong. X can pass away and his family might no longer want the house. The court may make the estate of A pay for the house after his death, thus enforcing the contract as written. Or zoning officials in the local government might reject the construction plan. The court may decide that the contract is void because law forbids its construction• Here the court fills a gap in the contract by suppling terms of its own that do not contradict the contract's explicit terms.

In general, we identify three possible response of courts to contract imperfections: Enforce the explicit terms as if the contract were perfect. Fill a gap in the contract without contradicting its explicit terms. Replace the contract's explicit terms.

Enforce Explicit Terms, two instruments are available to them.

Default rules to fill gaps
Mandatory rules to replace explicit terms

Default Rules

Gaps exist in contracts
The gaps could be inadvertent: the construction may not mention the possibility of zoning officials rejecting the constructions plan because neither of the parties thought about this possibility
The gaps could be deliberate: the construction may not mention the possibility of zoning officials rejecting the construction plan because X and the construction company both believed this possibility was remote. Remote risks do not justify the cost of negotiating and drafting terms to allocate them
When a couple gets married, a deliberate gap may be left in a contract for psychological reasons: no couple wants to talk about dividing property in the event of divorce.

Default Rules:

Let us think about the calculations that might lead rational parties to leave gaps deliberately in contracts.

"ex ante risks" = risks of future losses faced by the parties when they negotiate a contract

"ex post losses" = losses that actually materialize after making the contract

In general, the parties to a contract must choose between allocating ex ante risks and allocating ex post losses.

The parties expect to save transaction costs by leaving gaps in contracts whenever the actual cost of negotiating explicit terms exceeds the expected cost of filling a gap.

The expected cost of filling a gap = the probability that the loss materializes multiplied by the subsequent cost of allocating it.

Allocating a risk > allocating a loss * its probability --> leave gap

Allocating a risk ≤allocating a loss * its probability --> fill gap

Mandatory Rules

Unlike default rules, mandatory rules cannot be waived or removed by mutual agreements of both parties.

By imposing mandatory terms, the law regulates the contract.

Just as in market regulation, the economic theory of contract regulation describes an imperfect contract that requires mandatory rules (think about a perfectly competitive market, and one that is imperfectly competitive and requires regulation).

Categories of market failure often found in microeconomics can be used to categorize legal doctrines that impose mandatory rules

Individual rationality: First, in economics, we assume that a rational decision maker can rank outcomes in order from least preferred to most preferred. In order to rank outcomes, decision makers must have stable preferences

If the promisor's preferences are sufficiently unstable or disorderly, then he/she is legally incompetent and cannot conclude an enforceable contract. For instance, children and the insane are legally incompetent.

Second, rational decision maker's opportunities are moderately constrained so that they can achieve some, but not all, of their objectives. Dire constraints destroy freedom of action. Major contract doctrines excuse promise breaking on the ground that the promisor faced dire constraints. If the beneficiary of the promise extracted it by threats, then promise breaking is excused by reason of duress

Notice that duress and necessity both apply when the promisor is in dire circumstances, but the cause is different. The cause of necessity is usually the promisor's bad judgement, bad luck, etc. The cause of duress is usually the promisee.

Sometimes a dire constraint follows the promise. For instance, a surgeon may promise to operate and then break her hand before the scheduled operation. A manufacturer may be excused from fulfilling his contracts because his factory burned down. Promise breaking in those cases may be excused by reason of impossibility.

Spillovers: Although contracts often have external effects, the legal remedy seldom involves contract law. In most cases, the plaintiff in a suit for breach of contract must be the person to whom the promise was made (the promisee) or the person to whom the promisee's rights were transferred (the transferee). People affected by a contract who are not parties to it usually seek relief under the law of torts, property, crimes, or regulations.

Asymmetric information: Sometimes, one or more of the parties to a contract lacks essential information about it. Several doctrines in contract law excuse promise breaking on the ground that the promise resulted from bad information. Hence, parties sometimes have the positive duty to disclose information. In most sales contracts, a seller must warn the buyer about hidden dangers associated with the use of the product, even though this information may cause the buyer not to buy it. In some instances, both parties are misinformed.

ex: In the early years of the twentieth century, rooms in buildings situated along certain London streets were rented in advance for the day on which the new king's coronation parade would pass by. However, the heir to the throne became ill, and the coronation was postponed. Postponing the parade made the rental agreement worthless to the renter. Some owners of the rented rooms tried to collect the rent anyway. The courts refused to enforce the contracts on the ground that the change in circumstances frustrated the purpose of the contract.

Monopoly: When trading partners are limited, bargains can be very one-sided. Under the bargain theory, the courts enforced bargained promises and did not ask if the terms are fair. Common Law historically contained weak protection against exploitation by monopolies• Instead of Common Law, statutes supply most protections against monopolies. Recently however, a new Common Law doctrine has evolved to allow judges to scrutinize the substantive terms of contracts. When a contract seems so unfair that its enforcement would violate the conscience of the judge, it may set aside according to the doctrine of unconscionability.


Individual Rationality:

Incompetence -Party not capable of entering into a contract
Duress -Party improperly coerced into entering contract
Necessity -Dire constraint imposed by outside circumstance

Spillovers: Contract terms contradict other public policy goals.

Asymmetric Information:

Fraud -Promise extracted by lies
Culpa in Contrahendo -Missing information should have been provided
Frustration of Purpose -Outside factor undermines reason for contract
Mutual Mistake -Parties misunderstood what the contract was about

Monopoly Power:

Unconscionability -Contract is excessively one-sided
If you break your promise to come to family dinner on Sunday evening, your mother can punish you in a thousand small ways.

The same is true in repeated business transactions, where the preferred remedy for a broken promise is some form of retaliation, but not a lawsuit!

To secure cooperation in long run relations, the parties often rely upon informal devices, rather than enforceable rules.

Most Common Problems of Contracting: Non-Payment of Bills, Late Delivery, Poor Performance.

Retaliation for those in order: Suspension of Supply, Delayed Payment, Partial Payment

Repeated Game

In any round of the repeated game in which the principal invests, the agent enjoys an immediate advantage from appropriating. We have seen before that an enforceable promise can solve this problem. Assume now that the promise is unenforceable (for some reason), to solve this problem without law, the principal can retaliate in subsequent rounds of the game. Principal may see a breach coming and stop payment before it happens.

Long run relationships require commitment, which can facilitate economic cooperation without state protection.

Traditional forms of commitment include friendship, kinship, ethnicity, and religion.

ex: Long-run relations can arise from commitments to institutions. For example,Japanese employees show a high level of commitment to the corporation, as evidenced by low rates of labor mobility. Our theory predicts correctly that long-run relationships will cause Japanese corporations to rely less on enforceable contracts as compared toAmerican or European corporations. Long-run relations in the Japanese economy create more order and less law than in other countries

Endgame Problem

Even long run relationships end eventually. Near their end, business relationships often deteriorate. In the repeated game example, the principal has no power to retaliate on the last round of the game; hence the final round of the game has the same logic as a one-shot game.

Look at Endgame Example for more if need more.
Remedies as Incentives

When a party to a contract fails to perform as promised, the victim may ask the court for a remedy.

Remedies fall into three general types: Party-designed remedies, Court-imposed damages, Specific performance.

Party-Designed Remedies: First, the contract may stipulate a remedy. The contract will then contain explicit terms prescribing what to do if someone breaches. For instance, a construction contract may stipulate that the builder will pay $200 per day for late completion of a building.

Instead of stipulating a specific remedy, the contract may stipulate a remedial process. For instance, the contract may specify that disputes between the parties will be arbitrated by some other entity (which could have its own rules for remedies).

Court-Imposed Damages: Because negotiating and drafting are costly, an efficient contract will not explicitly cover every contingency. In fact, most contracts do not specify remedies for breach.

When the contract omits a remedy, the court must supply one. The court may supply a remedy in the form of damages.

Specific Performance: The courts may order instead the breaching party to perform the contractual promise.

Alternative Remedies

Different remedies create different incentives for the parties to a contract.

Expectation Damages: Damages for breach of contract compensate the promisee for the injury caused by the nonperforming promisor. In other terms, the courts award damages that place the victim of breach in the position he/she would have been if the other party had performed. We say that perfect expectation damages leave potential victims indifferent between performance and breach.

Reliance Damages: The promisee may invest in reliance on the promise• Breach usually diminishes or even destroys the value of the investment in reliance. So, reliance increases the loss resulting from breach. The courts may award damages that place victims of breach in the position that they would have been in if they had never contracted with another party. Reliance damages replace income that was lost. We say that perfect reliance damages leave potential victims indifferent between no contract and breach.

Opportunity Cost: Making a contract often entails the loss of an opportunity to make an alternative contract. The courts award damages that place victims of breach in the position that they would have been in if they had signed the contract that was the best alternative to the one that was breached. In other words, damages replace the value of the lost opportunity. We say that perfect opportunity cost damages leave potential victims indifferent between breach and performance of the best alternative contract.

With Regards to Example: Expectation damages would represent the difference between the value of a perfect hand (what was promised) and what the patient ended up with. Reliance damages would represent the difference between the value of the pre-surgery hand (what the patient would have had with no surgery) and what the patient ended up with. Opportunity-cost damages would represent the difference between the value of the hand with the next-best surgery option and what the patient ended up with.

Note that in both of our examples:
Expectation damages >Opportunity cost damages >Reliance damages

In General this is always true.

The promisee always goes with the best contract; therefore, the value of the best contract will always exceed the value of the next-best contract by definition. As a result, expectation damages exceed opportunity cost damages.

Furthermore, any contract that is entered into must represent an improvement over no contract. Otherwise, the parties never would have agreed to the contract in the first place. Thus, the value of any contract exceeds the value of no contract, and so expectation damages and opportunity cost damages both exceed reliance damages.

There are other methods that common law courts sometimes use to compute damages.

Restitution: In a deferred exchange, one party often gives something in exchange for the other party's promise to do something later. In these circumstances, a remedy for breach is to require the breaching party to return what was given. Restitution is a minimal remedy in contracts. It does not compensate the victim of breach for expectation, opportunity, or reliance.

Disgourgement: A way of calculating damages that takes away the injurer's profit. For example, suppose Sara agrees to sell a ring to Jenny for $1000 but breaks the agreement and sells the ring to Farah for $1500. The disgorgement remedy is $500. While other damage payments are about restoring the victim's position, disgorgement is about taking away the injurer's profit from breaching. When disgorgement is perfect, the injurer is indifferent between doing right, on one hand, or doing wrong and paying disgorgement damages on the other hand.

Specific Performance: Instead of damages, the court may order the breaching party to perform a specific act as a remedy. Specific performance usually requires the promisor to do what he / she promised in the contract. The typical case in which courts adopt specific performance as the remedy involves the sale of goods for which no close substitute exists. Land, houses, works of art, etc. In contrast, when breach involves the sale of goods for which close substitutes exist, courts typically award damages as the remedy.

Party-Designed Remedies: Liquidated Damages: contracts often specify the remedy for breaching one of their terms. The contract might stipulate a sum of money that the promise-breaker will pay the innocent party (liquidated damages). Alternatively, the parties may leave valuable assets on deposit with a 3rd party and specify that the assets should be given to the victim in the even of a breach. Or the parties may specify a process for resolving disputes between them.

Common and Civil Law traditions differ with respect to enforcing penalty clauses in contracts. Courts call a term a "penalty" when it stipulates damages exceeding the actual harm (or a reasonable prior estimate of that harm) caused by the breach. Courts call a term "liquidated damages" when it stipulates damages that do not exceed the actual harm (or a reasonable prior estimate of that harm) caused by the breach. Common Law tradition prevents courts from enforcing terms stipulating damages that exceed the actual harm caused by the breach. Common Law tradition enforces liquidated damages and withholds enforcement of penalties. Courts in Civil Law show more willingness to enforce contract penalties.

Stipulation of damages exceeding the requirements for compensation can serve 3 functions. The punitive element may be considered as payment on an insurance contract written in favor of the innocent party by the breaching party. Penalty clauses often convey information about the promisor's reliability. Most penalties can be restated as bonuses.

Models of Remedies

Focus on three types of behavior: The promisor's decision to breach or perform, the promisor's investment in performing, the promisee's investment in reliance on the promise.

Efficient Breach and Performance: When circumstances change, not performing a promise can be more efficient than performing.

This can happen in two ways: The promisor can breach the contract by breaking his/her promise. The parties can renegotiate and modify the contract to allow nonperformance of the original obligation

How to decide whether to breach the contract or renegotiate it? It depends on whether the transaction costs are low. The terms of the renegotiated contract will also depend on the bargaining power of the parties.

Look at Yvonne and Xavier example: Both the Unfortunate Contingency and Fortunate Contingency

Unfortunate Contingency: Efficiency requires the players to choose the actions that maximize the sum of the payoffs. For instance, breaching is more efficient that performing at high cost.

Fortunate Contingency: A fortunate contingency is typically an alternative contract that is even more profitable than the original contract. In those cases, the promisor would want to avoid performing on the original contract in order to profit more from an alternative contract. An injunctive remedy would increase the promisee's bargaining power in the ensuing negotiations to extract a larger share of the surplus created by the fortunate contingency. Look at House example for this one as well as Amy and John.

Investment and Performance and Reliance

Paradox of Compensation

Promisor: A contract imposes obligations on the promisor that are typically costly to perform. To perform or to increase the probability of performing, the promisor must invest. The promisor has an incentive to invest more on performing when liability for breach is higher.

Promisee: Conversely, the promisee can increase the value of performance by relying. But relying also increases the loss from breach. Obviously, the promisee has an incentive to rely more when liability for breach is higher.

In contract law, the paradox of compensation takes the following form. In order for the promisor to internalize the benefits of precaution, he/she must fully compensate the promisee for breach. In order for the promisee to internalize the costs of reliance, she/he must receive no compensation for breach. The compensation paid by the promisor for breach equals compensation received by the promisee. Therefore, contract law cannot internalize costs for the promisor and promisee as required for efficiency.

Generally, liability for perfect expectation damages gives efficient incentives to the promisor and inefficient incentives to the promisee.

Unverifiable Acts and Anti-Insurance

We can think of a solution to unverifiable acts. The contract should stipulate that the promisor who breaches must pay damages to a 3rd party, not the promisee. Thus, the builder promises to pay some amount for late completion so the builder is 100% liable• The promisee also bears 100% of the loss caused by the build's breach of contract. In general, the efficient supply of unverifiable inputs requires each of the two parties to be liable for 100% of the output so that their total liability adds up to 200%. This is known as anti-insurance.

Contract Solutions to the Paradox of Compensation

Hypothetical Harm

Hypothetical expectation damages equal the gain that the promisee would have obtained from performance if the promisee had relied efficiently: For instance, assume that breach causes the promisee who relies efficiently to lose $100, and breach causes the promisee who over-relies to lose $125. If the court awards hypothetical expectation damages, the promisee who over-relies bears the additional loss of $25. Thus, the promisee internalizes the marginal cost of his actual reliance, as required for efficient incentives.

Liability for hypothetical expectation damages can arise in two ways

First, the contract can stipulate damages at the level required for hypothetical expectation damages

Second, if the parties fail to stipulate hypothetical damages, the court might decide not to compensate for harm caused by over-reliance and would just deduct $25 from the actual harm of $125 causes by the breach.

Instead of approaching the problem directly and deducting damages from over-reliance, courts actually approach the problem indirectly through the doctrine of foreseeability.

Now let us consider contract doctrines that allocate information instead of goods

The difference in doctrines is caused by a difference in the goods themselves. Information is discovered and transmitted whereas most other goods are made and consumed. Unlike the makers of goods, the discovers of information have difficult appropriating its value, which creates a need for patents. Unlike consuming goods, using information does not diminish the amount that remains for others.

Economists say that public (or common) information is known to both parties in a bargain.
Private (or asymmetric) information is known to one party and unknown to the other.

Private Info often Motivate Exchange
For instance, someone might know how to get more production from a resource than does its owner. To increase production, knowledge must be united with control or in other terms, the owner of the resource must acquire the information or else, the informed person must acquire ownership of the resources.

In general, the transmission of information and the sale of goods unites knowledge and control over resources. Efficiency requires uniting knowledge and control over resources at least cost, including the transaction costs of transmitting information and selling goods.
Typically, parties can solve the problem of private information through private bargaining.
The informed party may offer to buy the resource• Or the informed party may offer to share the information with the owner of the resource in exchange for a proportion of the resulting increase in profits.

Unilateral Mistakes

When one party to a bargain knows the truth and the other party does not, the exchange is based on a unilateral mistake.
Courts usually enforce contracts based on unilateral mistakes: For instance, trades occur in the stock exchange when one party believes the price of a company's stock will rise and the other believes that the price will fall.

The question is, how to distinguish a mistake being mutual versus unilateral? A mutual mistake converts a contract into an involuntary exchange, which can destroy value• A contract based on a unilateral mistake usually promotes efficiency by rewarding discovery and uniting knowledge with control

The doctrines of unilateral and mutual mistake suggest: Withhold enforcement from contracts involving involuntary exchange, and enforce contracts that reward discovery and unite knowledge with control. In other terms, a contract should be enforced if doing so rewards discovery and unites knowledge with control.

Note to distinguish between productive information and redistributive information: Productive information can be used to produce more wealth -it is information that allows existing resources to be moved to more productive uses. Redistributive information creates a bargaining advantage that can be used to redistribute wealth in favor of the informed party (knowing before anyone where the state will locate a highway --> benefit from real estate prices)

Further, one can acquire information actively -that is by investing resources in the acquisition of information -or fortuitously, that is by chance.


Nature of Info: Productive; if acquired by investment then it is enforceable. If it is acquired by fortuity then there is no enforcement. Redistributive; if acquired by investment there is no enforcement, same if it is acquired fortuitously.

Three Economic Principles to Remember:
1. Enforce contracts based on differences in productive information, especially if that information was acquired by investment
2. Enforce most contracts based on differences in mixed information (productive and redistributive).
3. Set aside contracts based on differences in purely redistributive information or if the information was acquired fortuitously

Duty to Disclose: Safety information helps people to avoid harm. The law does not generally require an informed person to disclose productive or redistributive information to uninformed people. However, the law typically requires informed people to disclose safety information to uninformed people. Ex: when buying a home that is infested with termites. A contract separates knowledge from control when the seller fails to disclose information needed by the buyer to prevent the good's destruction. When bargaining to a contract, the parties should divulge safety information.

Fraud and Misrepresentation: Fraud at common law requires a lie -a false assertion made with the intention to deceive. Under common law, the victim of fraud is entitled to damages for harm caused by fraud. The idea is, if parties to a contract know that fraud is ground for voiding the agreement, then they can rely on the truthfulness of the information developed in negotiations for the contract.

Indefinite or Vague Promises: When a contract is formed, parties often want vague terms to be enforceable as best the courts can do. The parties often cannot foresee future contingencies well enough to describe them explicitly in the contract. While the parties cannot be precise ex ante, they find themselves wanting courts to apply vague principles ex post. Ex: say the contract describes "best efforts"; a court perhaps cannot distinguish "best efforts" from "second-best efforts" but it can probably distinguish "best efforts" from "minimal efforts".

Making good decisions in such cases requires the courts to understand thoroughly the purpose of the contract. This typically requires time, effort, experts, etc.
In Common Law, crimes are distinguished by the following elements: Intent, Public Harm, Burden of Proof, and Punishment.

Intent -A criminal deliberately does something wrong

Public harm -Crimes harm the community at large, not just the victim

Burden of proof -Is higher than for monetary judgments

Punishment -Guilty defendants are punished, not simply ordered to pay compensation


Intent is not an easy question: We might think of injury-causing behavior on a continuum from careful to negligent to reckless to intentional.

The line for tort law falls somewhere in between careful and negligent behavior. This is called fault. By contrast, the line for criminal law falls somewhere in between reckless behavior and intentional harm. This is called guilt.

In Common Law, the standard for criminal behavior is known as mensrea ("guilty mind") -the criminal must know that he was doing something wrong.

Intent can be interpreted broadly, though. A drunk driver probably did not intend to kill someone in an accident, although there was some level of intent in choosing to drive drunk.

Public Harm

Property law, contract law and tort law mostly deal with private disputes. By contrast, a murder or robbery scares everyone in the community and creates a public harm over and above the private harm to the victim. The public harm aspect makes criminal law different.

Public harm justifies the prosecution of criminal cases by the state instead of by victims. Indeed, the state can press criminal charges even if the victim has no interest in doing so.

Public harm justifies the prosecution of "victimless" crimes. Drug use or prostitution might not involve a victim in the usual sense, but they harm the community.

Public harm justifies the prosecution of attempts to commit crime. You cannot bring an attempted tort to court if there is no actual damage. But an attempted murder causes harm to the public because of the fear and alarm it raises.

Burden of Proof

Criminal cases must be proved in court beyond a reasonable doubt -no reasonable person could conclude that the defendant is not guilty.

What aspects of criminal law might explain this difference? The state is the plaintiff, so it has a built-in resource advantage over most defendants. Citizens need protection against prosecutors who want to look tough for political reasons. Convicting an innocent person seems morally worse than freeing a guilty person. An incorrect monetary judgment is just a transfer. An incorrect criminal judgment produces a net loss for society -the direct cost of imprisonment as well as the opportunity cost of the prisoner's time. Jail costs on average $62 per day in Texas. The opportunity cost of the prisoner includes• Loss of family time -often families of jailed defendants break up. Loss of income due to job loss. Weaker legal preparation due to incarceration. Higher likelihood of offending due to incarceration.


In property, tort and contract law, the typical remedy is compensation, designed to restore the victim's welfare. By contrast, the remedy in criminal cases is punishment, designed specifically to harm the injurer.

Punishment includes things like imprisonment, fines paid to the state, the death penalty, etc.... all of which have no compensatory function for the victim. The goal of punishment is to leave the criminal worse off
The choice to commit crimes in rational terms as simple cost-benefit analysis. Becker's model asserts that it is useful to think about the choice to commit a crime just like any other rational choice: The criminal will commit a crime when the marginal benefit exceeds the marginal cost.

In a policy sense, what we learn from rational crime model is that the state can reduce the number of crimes by changing incentives. Namely, increasing the marginal cost of committing crimes reduces the number of crimes that satisfy the cost/benefit criterion for the criminal.

Two Basic Techniques to Raise Marginal Cost of Committing Crime: Increase the probability that the criminal is caught, and increase the severity of the punishment for criminals who are caught.

In this model, to deter crime, the state can either catch more criminals or punish criminals who are caught more severely.

The next natural question is whether there are any limitations on the sorts of crimes for which the rational crime model makes sense. Perhaps at first glance, but economics has always put a lot of stock in people making rational choices even when they do not realize they are being rational. Another important point is that the goals of the criminal law system lie in its aggregate effects, not in each specific case. In other words, just because we can identify some criminals who might not respond to strengthening punishments, such a policy change still produces aggregate benefits on the whole as long as there are some criminals who do respond.

ex: How does a high wage impact the propensity to commit crimes in the Becker rational crime model? Someone who earns a high wage has a high opportunity cost associated with going to jail, and so is less likely to commit crimes.
Despite the faith that economists place in rational choice, it does seem like there are some kinds of crimes for which impulse or diminished rationality plays an important role.

People always weigh the present more heavily than the future in making decisions.

The degree to which future costs and benefits are of diminished importance relative to the present is known in economics and finance as discounting. Low discounting means that decision-makers care almost as much about the future as they care about the present. High discounting means that decision-makers care very little about future outcomes.

People make bad decisions in the present because they are not really weighing the future consequences of their actions. With respect to criminal activity, we might say that people commit some crimes because they enjoy a present benefit but are ignoring a large future cost (the punishment).

This is fundamentally no different from smoking, over-eating or not saving money, all of which economists struggle to explain as a product of rational choice.

In this model, irrational crimes occur when the criminal experiences a lapse in judgment that makes his discounting extremely high. A rational, planned crime like embezzlement occurs when the criminal methodically compares costs and benefits. But an irrational crime occurs when the criminal unreasonably discounts future consequences in making his choices. Diminished rationality crimes are more likely to occur when people have volatile mood swings and are more likely to slip into this "high discounting" mode.

Few Observations to keep in mind: Young people have more variable moods than older people. The diminished rationality model justifies discouraging drug and alcohol use, which contributes to erratic moods and high discounting. The diminished rationality model justifies subsidies for mental health support.

The key policy implication to take away from the diminished rationality model is that: Increasing the severity of punishments is of very limited use in deterring limited rationality crimes and, making punishment more immediate and more certain is more important.

If someone is committing a crime precisely because he does not care what happens in the future, then making a jail sentence 35 years versus 30 years is unlikely to change his behavior. But knowing that he will be caught immediately and with certainty may have an impact.

This model suggests the use of certain and quick, but less severe, punishments for juveniles -spend more on police enforcement and less on incarceration. Indeed, evidence suggests that children do not respond at all to more severe punishments, but they do respond to swiftness and certainty. By contrast, harsh punishments make more sense for adults who commit crimes involving extensive pre-planning.
The optimal level of criminal punishment balances out the marginal benefit and the marginal cost of additional deterrence. The marginal benefit of deterrence is the social benefit associated with crime reduction. The marginal cost of deterrence includes the explicit and the implicit costs associated with catching and punishing criminals -enforcement costs, punishment costs, and the opportunity cost of the lost productivity of prisoners.

Importantly, the benefit associated with crime reduction features diminishing marginal returns.

The resources required to deter the most serious crimes (e.g. murders) produce a much larger benefit for society than resources expended to deter more marginal crimes (e.g. petty thefts). By comparing the marginal cost and the marginal benefit of additional crimes deterred, society can set the efficient level of punishment and deterrence

There are a few important insights of the optimal deterrence model: The optimal level of crime is never zero unless deterrence costs are zero -Any time there is a positive cost associated with enforcement and punishment, there will always be some crimes that are so low-impact that they are not worth deterring. And a decline in enforcement costs makes it more efficient to eliminate more crimes.

Look at Police Hiring Example with Muggings.

One persistent controversy associated with the optimal deterrence model is whether to include the criminal's benefit in our calculations.

For a concrete example, suppose that Jasmine steals a $200 purse from Tali. An economist would say that the $200 is just a transfer from Tali to Jasmine and is not really a "cost" associated with the crime per se.

Rather, the social cost associated with the crime is potential victims' wasted resources protecting themselves, the criminals' wasted time committing crimes instead of doing something productive, and any residual property damage caused by the theft. By contrast, a moralist would say that the social cost of Jasmine's crime does include the $200 because her benefit is not legitimate and should not be regarded as offsetting Tali's loss.

Another complication is that severe penalties for small crimes -even if they appear to be efficient for the specific crime in question -can create a problem because using such penalties for smaller crimes makes them unavailable for larger crimes.

For example, if we execute house burglars, then once a criminal has already broken into someone's home there is no additional penalty for killing the residents. Such a law might reduce burglaries, but it would surely increase the level of violence associated with burglaries that do occur.

Finally, the rational crime model suggests that crimes can be deterred either by raising the probability of detection (enforcement) or by strengthening penalties. Simple reasoning would suggest that there should be substantial savings from shifting more weight to the latter.

In other words, we could catch half the number of criminals, but just punish them twice as severely -same deterrence value but with lower enforcement costs. The problem is that, in addition to the specter of making errors, such a scheme violates many people's moral consciences -in essence, punishing offenders who are caught over-severely because not many actually get caught.
In theory, monetary fines can be calibrated to be equally unpleasant and create the same deterrence as jail sentences.

Thus, the optimal deterrence model would suggest more intensive use of financial penalties and less use of imprisonment because they are much cheaper.

Indeed, fines generate a profit for the state, even taking into account collection costs, while imprisoning someone in a Western country costs a lot of money (not to mention the opportunity cost of lost productivity)

Indeed, the optimal deterrence model suggests that it makes little sense to jail anyone until the ability to punish him financially has been completely exhausted -we might even consider taking away future income. Furthermore, long jail sentences are practically useless for diminished rationality crimes.

European countries use fines much more intensively than the US, which relies heavily on incarceration. Why?
For one thing, crimes in the US are more violent, involve weapons and involve repeat offenders, which tends to make people think that monetary punishments are insufficient. Another difference is that US fines tend to be fixed based on the offense. By contrast, the European system tends to set fines as a percentage of the offender's income. Here, the European system makes more sense. The incentive effects are better -a modest fine might not mean much to a wealthy offender.

We argued that monetary fines can create deterrence for crimes just as well as jail time can, but is deterrence for future criminals the only reason to imprison people? Maybe the purpose of jail is not so much to deter crimes as it is to keep dangerous people off the street.
We argued that monetary fines can create deterrence for crimes just as well as jail time can, but is deterrence for future criminals the only reason to imprison people? Maybe the purpose of jail is not so much to deter crimes as it is to keep dangerous people off the street.

Indeed, in criminal justice there are at least four major purposes of imprisonment.

The four major purposes of imprisonment: Deterrence, Incapacitation, Rehabilitation, Retribution.

Deterrence -The threat of imprisonment deters people from committing crimes.

Incapacitation -Keeping criminals away from everyone else.

Rehabilitation -Counseling, job training or education that encourages people not to commit additional crimes after they are released.

Retribution -Moralist theory on making people suffer for committing crimes.

Incapacitation: It is unquestionable that there is a small group of habitual criminals. About 2/3 of all current prisoners have prior criminal records, and as many as half of prisoners who are released end up in jail again within one year of their release. Most disturbingly, violent criminals who are released commit an average of 12 serious crimes every year until they are rearrested. Maybe the point of imprisonment is just to keep these people away from society.

Two conditions for Incapacitation to be Successful

1. The imprisoned criminal cannot simply be replaced by another criminal. For example, there is probably very little incapacitation value to imprisoning a street drug dealer who can be easily replaced by another dealer. By contrast, a drug cartel leader might have some specialized knowledge that nobody else can replicate, so incapacitating him could be worthwhile.

2. Imprisonment must reduce the total number of crimes, not just delay them. This probably holds generally since the propensity to commit crimes falls as criminals age.

Can we measure the incapacitation value of imprisonment?
Statistically, it is hard to separate out the incapacitation value of imprisonment from the deterrence value. One way to do it is to observe what happens when sentencing laws change quickly. If there is an immediate drop in crime rates, it must be due to deterrence rather than to incapacitation because there is not enough time for any new incapacitation to kick in.

Sentencing Laws: Common Law traditionally gave judges wide latitude and significant discretion in sentencing. But a wave of violent crime in the 1970's and large disparities in sentencing across judges has led to a legislative scheme that increasingly requires judges to follow rigid sentencing guidelines based on the offense and on the offender's previous record.

The cost of maintaining the US prison system has risen astronomically as a consequence of these new sentencing laws, and very recently there has been a push towards rolling back some of these mandatory sentencing guidelines, especially for nonviolent offenses, because they have become too expensive to enforce.

Some states require a life sentence for a 3rd felony regardless of whether it is violent or serious. One concern is that such laws create an increase in the level of violence among crimes committed by third-time offenders -if the result is a life sentence for any crime, then there is no incentive to scale back the level of violence. A second consequence is that prosecutors are less likely to charge people with felonies and juries are less likely to convict on felony charges if they think that the punishment is disproportionate. More generally, harsh sentencing laws might not have as much impact as it would seem because juries are less likely to convict criminals as the penalties become more and more severe. There is quite a bit of research substantiating this point, especially with respect to the death penalty.
Individuals can do things on their own to prevent crime

Private deterrence benefits only the individual who engages in the deterrence. For example, installing a lock on your house prevents your house from being burglarized.

One effect of private deterrence activities may be simply to redistribute crime to another victim. A burglar encountering a locked door may simply move on to another house.

By contrast, public deterrence benefits everyone. For example, a few people carrying concealed guns raises the risk of mugging people and make it less likely that muggers will attack anyone, even people who do not happen to be carrying a gun.

The implication for public policy is that public deterrence creates a positive externality. Specifically, ex ante observable precautions, obvious to the criminal before the crime is committed, mostly just redistribute crime. But ex post observable precautions, which are not obvious before the crime is committed, create large public benefits by raising the expected cost of committing a crime. This public goods effect provides a rationale for the government to subsidize public deterrence activities.

Intervention by Private Citizens

Private citizens can always do things to help law enforcement. We might call this "doing your civic duty". For example, private citizens can report crimes, try to dissuade offenders or help the police if they are in trouble. Different people have varying levels of willingness to engage in these activities. Some people will bear a high cost to act responsibly. Other people will never lift a finger to be a civic-minded person. Typically, the cost of doing one's civic duty typically falls as the number of responsible people rises.

This is a consequence of herd effects -it is easier to conform when more people are doing something. When most people help the police, it is easier for you to intervene. When there is a social expectation and most employees report corruption, there is less fear of retaliation if you do. If most people follow public smoking rules, it is easier to confront people who are not.

What is the equilibrium in a model like this? How many people become socially responsible? It turns out that there are two cases. The diagrams in the following slide show the willingness to pay to be socially responsible and the cost of being socially responsible, as a function of the proportion of citizens who are socially responsible.

Look at Diagram

Both are decreasing functions -some citizens are willing to invest a lot to be responsible; others are not. And the cost of being responsible falls as more and more citizens are responsible because of herd effects. The equilibrium structure depends on whether the willingness to pay curve is steeper than the cost curve.

The second case is the most tantalizing. If others are not being responsible, then it is costly to go at it alone and thus nobody starts. But if enough people are being responsible, then it is easier to jump on board and be responsible yourself.
Crime rates in cities are at least twice as high, and as much as 7 times higher than crime rates in rural areas. However, evidence suggests that urbanization does not "cause" crime per se.

However, evidence suggests that urbanization does not "cause" crime per se. As a matter of pure statistics, both violent criminals and victims of violent crime in the US are disproportionately African American. Furthermore, changes in the crime rate have tended to follow the same pattern as these demographic changes. The crime wave from 1960-1980 is, at least in part, attributable to baby boomers (born between 1945-1965) reaching young adulthood.

The reason for this pattern is a source of intense debate among social scientists. Explanations proposed by various researchers include demographic characteristics in the African American community (single motherhood), sociological and cultural issues, and persistent discrimination and lack of opportunity.

A small number of people commit a very large proportion of violent crimes. Just 6% of young adult males commit 50% of all violent crimes and almost 70% of released offenders go on to commit more crimes.

What about the connection between low income and crime? The association is actually weaker than many people initially think. More inequality in recent decades has actually corresponded to lower crime rates. Additionally, there does not appear to be any convincing association between unemployment rates and crime rates. For example: 2008 recession didn't see a huge crime spike due to the huge increase in unemployment.

Economic theory would actually tell us that the relationship between crime and income is uncertain. On one hand, lower income may induce people to turn to criminal activity for money, and low income also reduces the opportunity cost of committing crimes and going to jail. On the other hand, good economic conditions offer more opportunities for crimes. Overall, the relationship between economic conditions and crime is weak, at best, and there is no consensus on an answer.
There was a huge drop in US crime rates between 1991 and 2001, and across basically all kinds of crimes.

Violent crimes in general fell 37%; Murder fell 43%; Rape fell 25%; Robberies fell by 46%; Motor vehicle thefts fell by 35%

The decline was shared across all demographic groups and geographic areas, but was especially pronounced in large cities. Crime rates continue to fall presently, but the decline is not anywhere near as sharp as it was between 1991 and 2001. The fundamental causes of this decline are a major research question. Here are six factors that do not seem to be reasons for the decline.

1. The strong economy: At most, the 2% decline in unemployment over the period may have been responsible for a 2% drop in crime rates, and there is not even consensus about this. Massive unemployment and 2008 recession didn't see a raise in crime at all. Overall, the connection between the economy and crime rates is weak at best.

2. Changing demographics: The percentage of the US population made up of 15 to 24 year old males actually rose over the period in question.

3. Gun Control Laws: There is no consensus that stricter gun control reduces crime rates and no consensus on the impact of gun availability on crime generally.

4. Aggressive Policing: Some cities, New York being the most famous example, started policing much more aggressively in the 1990's, including the controversial "stop-and-frisk" and "broken window" policing that focused on punishing even minor offenses. The impact of this aggressive policing seems to be nil. Cities that did not adopt these policing tactics enjoyed the same decline in crime rates as cities that adopted them. Even within the cities that adopted aggressive policing tactics, there was no discernable acceleration in the decline of the crime rate when the tactics were adopted.

5. Laws allowing the carrying of concealed weapons: The converse of the above point is also true. There is also no evidence that increased proliferation of guns reduces crime.

6. Increased use of the death penalty: There were four times as many executions in the US in the 1990's than in the 1980's. Nevertheless, there is no consensus in the literature that the death penalty deters crime. Even if we accept the most generous estimate of the impact of the death penalty on crime, the increased use of executions accounts for only 1.5% of the reduction in crime rates.

Let us turn now to 4 factors that do appear to be important causative factors underlying the decline in crime rates.

1. Increase in the number of police: While aggressive policing tactics appear to have no impact on crime, the number of police matters. The elasticity of crime to the number of police suggests that about 5-6% of the decline in crime rates is a consequence of the 14% increase in the number of police over this period.

2. Rising Prison Population: Increases in punishment appear to account for about 12% of the reduction in violent crimes and for about 8% of the reduction in property crimes. This could be a result of deterrence or incapacitation.

3. Reductions in crack cocaine usage: The 1980's saw an epidemic of very violent gang wars over crack cocaine, which was particularly associated with many of the homicides among young, black males

4. Legalized Abortion: At least half of the decline in crime rates is a direct consequence of legalized abortion. The argument is that abortion both reduced the number of young people and changed the demographic mix in a way that reduced the number of likely criminals. Specifically, they argue that abortion rates are much higher among women who are statistically more likely to have children who go on to commit crimes. This argument is not universally accepted, but is well-known among economists.
Death Penalty

Almost no developed countries use the death penalty. The US is a notable exception, although the number of executions is low and falling.

Whether or not the death penalty deters crime is a subject of intense debate. The seminal study is Sellin (1980) who found that the death penalty has no impact on crime rates. Ehrlich (1977) found that the death penalty does induce a deterrence effect, but the effect is minimal compared to increases in the probability of arrest and conviction generally. Katz, Levitt and Shustorovich (2003) find no evidence of any deterrence effect. Donohue and Wolfers (2005) come to the same conclusion. By contrast, Dezhbakhsh, Rubin and Shepherd (2006) find that each execution deters between 18 and 150 murders.

Overall, statistical analysis is tricky because execution is limited to such a small and specific group of criminals, and so it is difficult to tease its effect out of the data. Furthermore, even if there is deterrence, the social cost of the death penalty is large. The trial and appeals process is extensive, and costs easily run into millions of dollars, particularly as a result of due process rights specific to death penalty cases.

Finally, there is strong evidence of racial bias. Blacks are 7 times more likely than whites to be executed for the same crime. Black men who rape white women are 18 times more likely to be executed than white men who rape black women. The overrepresentation of African Americans in the number of executions makes even many advocates of the death penalty uncomfortable.


Does drug abuse lead to other crimes? Maybe. Drug addicts might need to commit crimes to generate income to buy drugs. Drug addicts have problems holding on to legitimate jobs. Some drugs lead to extreme mood volatility, contributing to high-discounting limited rationality crimes. Finally, drug dealing is a profitable business, so many crimes result from competition among drug dealers.

Typically, policymakers cite the existence of these social costs as rationale for outlawing drugs. The net effect of drug laws is to reduce their supply and raise their price. This is the central public policy dilemma surrounding drugs. Among addicts, drug laws are practically worthless. Limiting only supply benefits the drug dealers. So instead need to go after both the supply and demand.

Turning to data, the war on drugs has been a total failure. Given that the war on drugs has been completely unsuccessful, should we just legalize them? Even if drug use increases slightly as a result, a bit more use in a regulated environment might be preferable to slightly less use in a criminal and unregulated environment.


It is easy to observe that the US has higher rates of violent crime than other developed countries and also allows much easier access to guns. There is no doubt that having a firearm deters crime.

More broadly, the answer is not obvious. Can access to guns increase crime? Sure. Access to guns makes crime easier and makes it more difficult for the police to pursue criminals.

But can access to guns reduce crime? Sure. Criminals are less likely to commit crimes if victims have guns.

At first glance, the statistical correlation between gun ownership and violent crime appears to be very strong. There are more guns than people in the United States, with at least half of all households owning a gun.

There is some evidence of a deterrence effect associated with gun ownership.

There is a substantial likelihood that a house burglar in the US will encounter a homeowner with a gun. Furthermore, there is a positive externality even for households without a gun because the burglar does not know in advance which homeowners own guns.

But there is no consensus that having more or less guns deters crime.