Skip to main content
Loading Explore guides…
Contract Law Principles · Acedra
Home
Explore
Law
Contract Law Principles
Sign in to save
Chat
If YouTube asks you to sign in, open the video on YouTube.
Watch on YouTube
Reload player
Transcript
92 segments
Copy
Hide video
0:00
Thanks for joining this episode of the No. 86 lecture series, in which Professor Richard Epstein discusses the kinds of agreements that are covered by the law of contracts. This lecture is part of a series with Professor Epstein on how simple Common Law principles give us tools we can use to deal with complex technological and social challenges. Professor Epstein is one of the most prominent legal scholars of our day.
0:24
He is the inaugural Laurence A. Tisch Professor of Law at NYU School of Law, a Senior Fellow at the Hoover Institution, and Professor of Law Emeritus and a senior lecturer at the University of Chicago. As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker. - Are all promises enforceable? What constitutes a formal contract, and why do we need to use contracts?
0:57
One of the great puzzles associated with the law of contracts asked is very simple question are all promises to be enforced. As a moral matter, many people say, you make a promise, you have to keep it and the law would certainly agree with that but it’s a very difficult proposition to say that you are on your moral obligation and to say that the entire legal machinery costly as it is should be used to enforce particular promises.
1:23
The rough social distinction that made us quite accurate, it says that promises which are essentially designed to encourage social obligations. We need people for dinner for example usually have no intention to create legal relationship so if they are in breach and somebody doesn’t show up for the dinner, it’s a set of social sanctions that are going to be applied. On the other hand, when you start having commercial transactions with deal with the transfer of
1:48
services on the one hand or the supply of goods and land on the other, legal enforcement is generally to be presumed and therefore typically after writing is done, these things will turn out to be enforceable. So, the first element that you have is one is there an intention to create legal --- relationships and people can decide whether or not they want their agreements to be subject to legal enforcement or whether they decide not.
2:15
The second issue associated with this particular problem is in the class of serious promises, evidence say in writing are all of them to be enforceable. And here the answer comes in two parts. Part number one is whenever there is a bargain between the two parties where each side agrees to surrender something to the other in exchange for what they get back. These promises supported by consideration are always enforceable and many contracts by definition falling to this class.
2:43
Or you cannot have a contract for sale unless somebody agrees to pay a price for a good so each side is supply consideration to one another. You cannot have a contract for employment unless it turns out that one guy agrees to supply services and the other party agrees to pay for them. But there are classes of promises which in fact are not in the form of quid pro quo and the question is whether these are enforceable. You owe me a thousand dollars and I tell you forget about it.
3:10
You can pay me five hundred dollars. Can I then turn around later and say look there was no consideration that supported the original forgiveness of the debt and so therefore you can now be asked to pay the whole thing. The Roman solution was, when they came to discharge of obligations. If you forgave part of an obligation, it could not be enforced. The Anglo-American law is much worst on this stuff because it says it cannot be enforced only if there’s been some kind of detrimental reliance.
3:39
But it becomes extremely difficult to figure out what that detrimental reliance is. So, if I forgive you the five hundred dollars, does that means that if I changed my mind before you could do anything or that I can get it. Suppose it turns out that you decide to buy a new car because you got that extra money, does that counts as detrimental reliance even if the car has the independent value and so far.
4:01
So the Roman law is the more secure and essentially for the least of obligations generally speaking, we do not need to have a bargain. Under the American law and the English law, it’s much murkier with respect to this particular element and so the basic rule is that bargains are a huge portion of the landscape. All these one-sided promises are less frequent. Typically in business they respect it because people wish to keep the good word of their
4:25
trading partners but there are a constant stream of cases in which it’s unclear to whether or not they needed reliance for the enforcement of these one sided promises is in fact available. Can you tell us more about how contracts work? Why do people engage in contractual arrangements in the first place? Generally speaking we talk about the ability to have gains from trade and in simplest kind of case it means that I give you my horse and you give me your cow a contracted – but
4:55
in many cases it turns out that the key element is going to began from trade over time so that I am going to lend you money today and you are going to pay me tomorrow. It turns out that we always use self-help, self help devices in order to firm up these relationships. I may take security before I make you a loan. I may only make loans to people whom I trust, I may only make loans if somebody else is prepare to guarantee them but in the end these informal devices will come up short unless
5:24
there is the security and the knowledge that you can sue somebody in the event that breach takes place and so what the law of contract thus particularly in this protection of voluntary exchange is that allows you to explain the universe of mutual gains by harming promises at a performed in sequence rather than perform simultaneously and if one does not understand mutual gain hypothesis then many of the rules of contract law including those that govern
5:51
the law of conditions who has to perform that before somebody else has to perform and so forth. They become largely unintelligible. One of the key things that you must do in the law of contract is to figure out when you have skeletal agreement what terms you want add into them. The proper the so called employed term and you can only figure out what those terms are if you understand the mutual gain hypothesis over time as driving the way in which these
6:17
particular additional obligations are going to be confortized. Period Can you elaborate on the idea of mutual gain? How is that related to how contracts are set up? Why does it matter? When you put these contracts together, the model associated with them is essential that both parties turn out to engage in voluntary transaction. The word voluntary is notoriously slippery because it’s quite clear that it cannot
6:46
mean that a contract is voluntary if in fact you just agreed to it and what typically is understood is that the word voluntary is designed to negate in advance two ways in which agreement can be undermine. One of these is essentially through derris and what it means in effect is if I enter into a promise to convey something to you because you have put a gun on to my head even though I have agreed to the arrangement the derris will essentially negate the particular
7:13
dealing question and there is nobody in any legal system was ever just rejected that propositions because if you accepted it means nobody has to engage in thief in theft. What you do is put a gun on to somebody’s head and say please give it to me and now it’s perfectly good and we’ll always is worried about the effort of the individual that circumvent the basic obligations to respect the property rights on other and the derris rule is designed to do that.
7:38
The more difficult problem is that which is associated with mistake without the presence of co-version and this is divided into two parts. The first part involves the situation in which says misrepresentation of the material fact by one party to the other and the reason why people are very worried about this is that the misrepresentation will leave people to put the wrong value on the property that they are surrendering or the property they are requiring.
8:04
When they make that kind of mistake ah what happens is there is no reason to believe that the transaction is going to be for mutual game. So something that I am supposed to sell you ah for ten dollars – turns out that it worth fifteen dollars and I am told by the other party that is only worth five dollars, I will sell it on the grounds of the ten dollars I receive is less than the five dollars that I pay but in fact what really happened is that I sold it to somebody else and this also
8:32
that and what happens therefore is that you sell it to somebody else for the fifteen dollars price and all oh sorry I am going to finish this again and what happens is you sell it to somebody else at the ten dollar price and may will be that it’s worth more to you at fifteen dollars and his to him at twelve dollars and so what happens is that the misrepresentation induces inefficient exchanges. The second element is a simple mistake which is not induced by fraud and this is a much
8:51
more complicated system to organize. In some cases you tell people you have to bear the risk of your own mistakes because that’s the way on which you can prevent people from happening and other cases you thing that there mistake is so absolutely enormous that you are going to sati size the contract in the ground that are fundamental um, inefficiency in the over transaction so if you have something which is solid gold and somebody induces you to sell it on the
9:17
assumption that is only gold plated or there are many illegal systems that will allow you to sati-size that transaction. The basic rule is that for the misrepresentation cases are clear the mistake cases turn out to be extremely difficult. What happens in practice is people start to negotiate over the prospect of mistakes and you are going to have explicit terms when you can sati size the transaction based upon future events.
9:42
It means that you can basically increase the efficiency of the transaction of the front end and encourage and facilitate the occurrence of voluntary profit maximizing transactions. How are contracts made and what kinds of agreements do they cover? You’ve described the general structure that governs voluntary transactions, can you discuss contracts in a little more detail? One of the issues that people worry about in the law of contract is exactly what kind of agreements do they cover.
10:13
The basic definition is any agreement between two or more parties in which people either agree to perform or abstain from any act. Note that there is no requirement that a contract being writing in order to satisfy this um definition and indeed thousands of contracts that people enter into every day have to written evidence whatsoever. You buy a newspaper, you pay a dollar and you get the paper. It’s a contract. There is an offer, there is an acceptance and there is performance but as contracts
10:42
deal with more complex subject matter as the duration of their performance starts to increase as the value of the contracting stuff starts to increase, writing is almost always required and the reason is you cannot negotiate the purchase of a house with the same speed or rapidity that you can negotiate the purchase of a paper and so what you do is you get lots of formal stuff and the way in which it should work roughly speaking as follows:
11:08
You have a period of oral give and take in negotiation in which either side is bound even if they have court on court reach to an agreement and then what you do is you sign a written agreement by both parties indicating the major obligations to be discharged. That’s called the statue to false requirement. At that particular point, the property has not conveyed because after you make the agreement done, you run inspections first on the title papers and then on the condition of the promises
11:34
and only after those things are satisfied, you actually have the convince. So the thing to understand is that the formalities associated with contracts are heavily dependent on the size. Often times, people have sequential promises and essentially what they do is that they have themselves a giant this business decision tree and at every node in the tree, if you do this I can do that, if you do the other thing, I can do something else.
12:02
If you have what is known as a complete contingence state contract, there will be no surprises. Most people however when they draft an agreement simply talk about the basic elements so that is left to implication to fill in the gaps. So I agree to sell you certain goods which you agree to deliver me. The day comes for the delivery and you don’t do it. Am I still required to pay for the goods and then sue you for their non-delivery or can
12:27
I withhold the payment by virtue of the fact that you haven’t delivered? And the general answers to the law of conditions is that in order to make the exchange efficient, no person is essentially required to put himself at risk to the other party which is in breach. So, if you do not deliver me the goods on time by the law of constructive conditions, I do not pay for them um on the time. If I in fact am not prepared to pay for the goods, you in turn do not have to deliver.
12:56
So that’s the basic pattern of simultaneous conditions. Situation becomes more complicated when it turns out that the conditions are not simultaneous but they’re sequential. And so what I have to do is to pay you money and you agree to build me a house and I am going to make progress payments to you and now it turns out I can pay the money in one fell swoop but the construction will take several years to complete or several months.
13:23
Generally speaking what people do by way of business is they basically break the big contract into little contracts so that after the first month I owe you a progress payment, after the second month another progress payment and so forth. These contracts become very difficult if either the performance or the payment, say in the middle of this process is not done and it’s the same basic point that one makes everywhere in the law of contract.
13:47
If people keep the transaction on tracks, everybody knows what’s to be done. When they go off the tracks, often the agreement is not complete and so judges have to fill in the terms and the basic intermission that they have is filling that set of terms in the event of breach which reduces the likelihood of their occurrence and furthermore makes sure that the innocent party is most likely or to regain its lost ground.
14:11
And the law of conditions is a huge part of the law of contract under the doctrine of implication, the general premise of which is if the skeletal terms are given. Imply the additional terms so as to maximize the efficiency of the relationship. Okay. The law of contracts has to deal very much with the question of how transactions are made and basically speaking, there is the following distinction. Many transactions are essentially individually negotiated between two parties.
14:38
This would be true for example for a construction contract of a large building on a particular site and its one on one negotiations and generally speaking today, the parties are sufficiently aware of all of the various contingencies that they can specify and agree which will cover most of them. One of the clauses for example that is commonly in the modern contracts that were not in nineteen century contracts is a comprehensive purchase of an umbrella insurance country, contract
15:06
which will pay each party for its losses in the event that the building is destroyed or damaged and so therefore if you have a common insurance contract, you don’t have to worry about the question of how to allocate the loss as between the two parties. If you’re dealing with commercial equals, people are generally very comfortable with this situation and the document of freedom of contract in this area is exceptionally strong even today.
15:31
The second form of contract that one has to worry about are mass transactions where you are dealing with the standardized arrangements between various people and many people say ah um the moment you have a standardized transaction between a large company on the one hand and small diverse consumers on another hand, there is a risk of exploitation and advantage taking. The most famous article in support of this position was written on contracts of adhesion
15:56
by Friedrich Kessler in the Columbia law review of 1943 and he said that these adhesive contracts are such that you have to look with great suspicion on standardized terms. I think that this position is a mistake, let me give some of the explanations. First, everybody has to understand that standardized contracts are extremely efficient to negotiate or because what happens is you could use one form for thousands upon thousands of people.
16:23
The people who in fact draft these forms are aware of that and one of the things that you know as a draftsman if you make a mistake in the standard form contract, it can influence for the worst thousands upon thousands of transactions. Second point to note is that these things turn out to be efficient because unlike military constriction if somebody offers you a deal which is highly unattractive because of its
16:45
contract terms, you just turn the thing down and what you do is you then go to a competitor who may offer you a standardized contract with better terms in it. So it’s not the fact that the terms are standardized, it’s that the firms in many cases turn out to be onerous and generally speaking, if people know what the terms are and have the options to walk away, that will not happen. The third point to understand about these kinds of arrangements is that people are often
17:14
insecure in their own knowledge as to whether or not these agreements do or do not make sense. And what standardized contracts do is give them a bit of insurance. If it turns out that you know that sophisticated consumers are perfectly happy with the contracts they receive in this form, no more willing to buy on these terms even if you don’t know what they are. And so many forms of mass contracts essentially rely upon the fact that the uninformed can
17:39
take relation, rely, can rely upon the actions of the informed to protect themselves. The fourth point to note about these standardized contracts is they almost always provide some forms of remedy. But the remedy is not one which is so called expectation damages where you recover your losses if something doesn’t go wrong. What typically happens is there are either liquidated damage clauses on the one hand which give you enough money to signal that the company, if they are in breach, is actually
18:07
going to lose money on your transaction and in effect in addition to the money stuff, they will often give you repairing services of some sort or another. So the support services for example when you buy um, software on either a shrink wrap or a click wrap contract are very, very extensive, there’s no compulsion that they provide them but if you wish to have people come in and you tell them that you’re not going
18:30
to pay for their consequential damages, then you better give them this kind of protection. Armed with this form of protection, what they will do is that they will hedge their bets if information’s is really very valuable. You don’t want to bring a suit for consequential damages; you want to back up your hard drive from an independent source so if it crashes you can recover the data from somewhere else. And so this leads to the last explanation for why there are limits on consequential
18:55
damages in standard form contracts. It encourages responsive behavior by consumers which when done will minimize the total loss to the two parties, people start to understand that and so the system although it’s been widely attacked remains completely entrenched today. And if somebody wants to have the best explanation of where to look for this, there is a case called proceeding decided by Frank Easterbrook in 1996 which gives a very nice piece of economics
19:23
about the logic of standard form contracts. What kind of contract difficulties do lawyers deal with? In the previous section, you talked about how contracts work if all parties “play by the rules.” What are some ways that things can go wrong or that a contract can be faulty to begin with? Thus far what we’ve done is to talk about how it is that contracts produce gains from trade to the parties. ….Uhm, A and B enter into a contract for sale, both these parties are better off if
19:53
the contract is performed as promised. That increases their wealth and hence creates additional opportunities for third persons. These so called positive externalities do not have to be enforced; they’re just generated by the transaction. But it explains why courts still enforce promises because the benefits are not just between the two parties, they also radiate out to the rest of the legal system. The more difficult case has to deal with the problem of negative externalities and of these;
20:21
there tend to be two types. The first type is essentially contracts and conspiracy to commit actions which would be common law thoughts. So if it turns out that it is wrong for A to hit B or for C to hit B or then if it turns out that A and C get together and enter into a contract where together they’re going to hurt C, this is no longer a contract that you want to enforce because of the gains between the parties. It’s a situation in which the synergies of A and C essentially make the likelihood
20:50
of force against the third person more likely, so the legal response is to render these contracts unenforceable in an effort to dissipate the gains and in fact, in many cases you not only render them unenforceable, you make them conspiracies and essentially you can then punish them under the criminal law because the gains to the two parties are inversely correlated with social welfare given the huge losses that are suffered by victims of forcing fraud.
21:17
The second situation which is more common today is also contracts in re-strengthened trade and typically these are cartel type arrangements in the simplest case in which multiple parties get together, they agree essentially to raise prices and to reduce assets, to reduce they agree ah for example at least to, to either raise prices or reduce output or some combination of the above or they decide that each of them will have a separate territory on which they sell.
21:41
These are not contracts that deal with force but it’s pretty clear that if you do the standard economic analysis uh, the social welfare under a monopoly situation is always lower than that under a competitive situation because transactions that would take place at the competitor’s price are excluded when the monopolist raises the price in question. So what the anti- trust law does essentially is to make it impossible for you to enter
22:05
into these contracts by treating them as illegal contracts and restraints of trade. This is a very old common law category and it receives its modern formation in the statutory law starting with the Sherman act in 1890. The third situation where you have to deal with ah essentially the limitations on freedom of contract has to do with monopolies that are what we call natural monopolies. Those situations like with common … on the one hand in the old days of public utilities
22:35
where the official form of supply requires that you have a single provider for the entire network. Ah so you could build only one railroad between two towns, ah, but once the railroad is built, ah, the owner of that particular railroad might be able to exact the monopoly price. And the history of rate regulation begins roughly at the same time as the Sherman act around the 1880’s and 1890’s says that yes you are under duty to serve, there’s no freedom of contract to stay out.
23:02
But the customers have to pay you a sufficient amount so that an aggregate you can remain in business and earn a risk adjusted competitive return and so what you then do is develop rate of return regulations which forces the obligation and then requires you to sell these services on reasonable i.e. you get a competitive rate of return but no more, non-discriminatory i.e. you have a situation where you can’t pick favors and so the so-called RAND obligations
23:29
- reasonable and non-discriminatory - become the hallmark of rate regulation as the third major limitation on freedom of contract. Working this out is a hugely complicated exercise and there’re entire courses that deal with ah, that particular subject and as you would expect the rules differ as a function of technology and time but this would cover for example railroad transactions in the period from 1880 say going on forward, public utility regulation and in modern areas the whole question of
24:00
how you deal with access to the internet and other forms of um, communication that may or not be subject to monopoly, um, influences. The traditional rules with respect to contracts on the enforcement side have to do with the relationship of the two parties who make the contract. But in fact, the law is much more complicated than that because we have issues dealing with assignment, delegation and third party beneficiaries. Let’s take them up in order.
24:28
Ah, if you’re dealing with a situation of delegation it is a case in which A has an obligation to perform to B and A decides that he doesn’t wish to perform it and wishes to get C in substitution. The question is, is A required to accept that particular substitution and the answer depends upon the question as to whether or not the substitution reduces the value of the performance to A that he expected to receive from B. So in the simplest case, if what C does is simply
24:58
to pay the cash that B owed since cash is fundable everything is fine. But if you change it a little bit and as a future obligation where credit worthiness matters, then B cannot delegate a future obligation to C because C could easily be worthless and so essentially the rule is generally speaking, if you wish to delegate an obligation where there’s a risk to the promisee, ah, they can veto the transaction and unless you get the consent for the delegation, the original party will be liable.
25:29
Now when you start to work on the other side of the transaction, there are two ways in which you can create third party interest. One is by assignment and one is by third party beneficiaries. Starting with the assignment situation, suppose it turns out that, um, A owes B a thousand dollars, but it turns out that B needs the cash right now and A’s promised only to be paid at a future time. It is perfectly respectable in those situations ah, for B to take the particular right to
26:00
receive the money, sell it to C and receive in exchange eight hundred dollars today. He’s better off because he gets the money when he needs it and C is better off because he gets a better loan. Do you think in effect under these circumstances that the debtor is allowed to veto the transaction? And the answer generally speaking is no because what happens is the obligation you’re talking about is no more onerous if paid to one party than the other.
26:28
But if you want to reassign only some part of this particular debt, then the debtor has a legitimate beef because he doesn’t want to have to do business with two creditors, it’s much more difficult to renegotiate a loan for extensions and you have to deal with two enforcement actions. So the usual rule is given the surcharges is called the extra burden are from a partial assignment, those things are prohibited.
26:51
And then there are also cases where it may, will be complicated because it’s a service obligation. I may agree to be your man servant and now you want to reassign the obligation to somebody else, to whom I don’t wish to work and so the usual rule when you’re dealing with personal services, a free assignment is not going to be allowed because of that surplus interest. The last form of situation is what the third party beneficiary contract in which what A
27:18
and B do is enter into a contract where it is understood that B can destroy, discharge the obligation to A by making a certain payment to C. Under the early common law rules of brevity of contract, it was generally thought to be impossible to have an obligation that was enforced by a third party. So going back to the Roman rule on this point, it turned out that B as the promise or could discharge that obligation by making the payment to C but that C could not enforce that right if B did not pay.
27:50
Starting with the great case of Lawrence and Fox in 1859, the rule was that the third party beneficiary could sue in order to collect the debt. Ah, that rule turns out to be exceptionally important not so much in the creditor situation but where they’re postmortem promises because if it turns out I make a promise to A, who’s about to die to pay money to C and it turns out that when A dies the air will not pay
28:14
the money over to C. Generally speaking, allowing the third party to sue is extremely important. The key case of that is where these are insurance contracts and insurance companies actually lobbied for legislation that allowed them to have enforceable obligations to the named beneficiary under an insurance policy even if they were not party to do it. The key thing to understand about these promises is there are a very narrow scope.
28:42
Most times if you look at modern agreements, people do not want rights to be vested in third parties except under narrow circumstances like the insurance case just mentioned and so the standard contract today will often have the following clause in it; this agreement does not create any rights in any third parties, the doctrine of third party beneficiary is excluded. The explanation for this is that most people wish to have the right to modify contracts
29:08
freely and if in fact you interpose a protected right to a third party, it upsets the modification process. Modification is of course extremely important with respect to long term contracts because circumstances may well change and as to the mutual benefit of two parties that an agreement be adjusted in one way or another and given that particular practice as a general matter, it is widely understood today that third party beneficiary rights are generally inefficient.
29:36
It’s not that you have to ban them as a matter of law, it’s that these obligations tend to be excluded as a matter of explicit agreement. What happens when there’s an issue with a contract that’s not due to coercion, force or fraud? What if a mistake is made or there is an honest misunderstanding? Or if the contract becomes impossible to fulfill due to something that’s the fault of neither party? Under the law of mistake, the problems that we’re talking about happen prior to the
30:05
formation of the contract. The most famous illustration is A and B agreed for the sale of goods and the goods are destroyed prior to the time than the contract is made to the ignorance of both parties. And the general rule in that case is since there is no abuse by either side; it’s usually cheaper to say that the entire contract is going to be called off rather than to try to figure out who was going to get what kind of remedy.
30:29
It is always understood in these mistake cases ah, that the parties can stipulate one way or another as to who takes the risk of the non-existence of the goods. The second form of difficulty associated with the law of contract has to do with the doctrine of impossibility or frustration. What happens is you have an agreement which is entered into Time 1 which calls for a future performance and then before the performance becomes due, but after the contract is formed,
30:57
something happens which makes it impossible for performance to take place. The first case on this is a famous case called Tyron Caudwell, where there was a situation where there was a license to use a certain hall for the performance of some great gala and between the time of the formation of the contract and the time of the gala, the entire place burnt down. So in part, performance was impossible. In the famous opinion of Lord Blackburn said both sides are discharged under this agreement
31:28
and his basic intuition in this particular case is since the fire was the fault of no one and each side is going to bear his loss, the question he had to ask is if you give yourself a remedy, is it going to improve the overall situation? And the answer is it’s not going to prevent the occurrence of the event because that was beyond the control of either party. And then in addition to that trying to pay, figure out who pays what to whom is a hugely expensive situation.
31:55
So then on average the people buy agreement would rather for the losses to lay where they fell, rather than to try and shift them. So the position was unless the agreement provides otherwise, or when there is impossibility of performance because of the destruction of a thing in question, all future obligations are discharged. The doctrine of impossibility sometimes applies to cases where performance is possible but
32:15
none the less pointless and the famous English case on this is Crow v Henry where the second situation that you deal with is not one of impossibility but one where the agreement becomes pointless over time. I agree to let you rooms um, on a certain day, the purpose for the arrangements so that you could watch the coronation parade of King Edward and in the case of Crow v Henry, what happened was that the coronation parade was cancelled by virtue of the fact that the King
32:36
was sick and now in effect if somebody has to pay the particular money in question, he is just going to get a room to look out over an ordinary street. It’s not worth the huge premium that you pay. Question is, is this particular transaction frustrated or is it not? And this is a very difficult question and essentially what the judges decided is that since the object of the transaction could not possibly be performed, what they did is
33:04
they discharged the obligation to make future payments but they did not allow the refund of the payment that was already made. Here, it’s extremely tricky because it turns out that if in fact the coronation was rescheduled for another day, that is the parade was rescheduled for another day, what do you want to do under these circumstances? And the whole problem therefore is one of incomplete contracting. If the parties had made an agreement of what is to happen in the event of cancellation
33:31
that would be respected. Trying to fill in the gaps is a somewhat artificial venture and the effort to save money is paid or kept money is not paid or not owed is a crude first approximation. It isn’t perfect. It’s less confident in this case than it is in the case of the burning pen. But nonetheless, the law on this particular point has shown some considerable degree of premises and so what we do in effect is that we have these frustrations and impossibility
33:58
cases, we try to develop default rules that minimize the dislocation and urge parties to enter into private agreements so as to minimize the loss in light of their particular knowledge of the circumstances of the ah dispute or the incident in question. What happens when there’s an assumption of risk made in the agreement (as can happen in insurance contracts for instance)? How do we deal with people who engage in more risky behavior because they’re insured?
34:27
One of the other difficulties associated with the contracts is the problem with the adverse selection in which people will enter into a contract having information that they are likely to get their benefits from that. So think of the situation currently with respect to Obama care or where an insurance company is required to offer the same policy to outcome is regardless of their age or condition of health but the doctor of adverse selection says is those people who know they have the
34:54
highest risk would be the one who buy the policy. Those people who know that they are relatively healthy will not. If in fact you charge and average premium for the entire class, it means that you will end up losing large amounts of money which is exactly what has happened to many of the parties who have in fact are been required to sell things under the Obama care exchanges. Traditionally particularly with respect to marine insurance, the rule was um you always
35:21
could inspect and ask questions before you issue the property and indeed if somebody misrepresented either the likelihood of a risk or the severity of the risk, you can set the contract beside. Traditional contract law always allowed and ensures to have protection against adverse selection, a modern law tends to deny those things, it’s a very powerful break and the common law rules with superior. The second major issue associated with respect to insurance is called the problem of moral hazard.
35:53
Traditionally and narrowly the doctor in moral hazard is means as follows: I know one fact that I have insurance so therefore I engage in the liberate actions which work to my benefit and then also give me insurance kinds of coverage ah that turns out to be the paradigmatic case but not the only case and today moral hazard means that if you are insured for example for against accident what you will do is engage in behavior that is
36:18
more risky than you would do if you are not covered by ah an insurance policy and the reason is that insurance policy means that you should slip not all but at least part of your losses on to somebody else and so if the total losses are a thousand and it turns out that your share is only five hundred, you will respond to this if there was a five hundred dollar risk, even though the insurance company is going to have to pay the four thousand.
36:44
So again what typically happens in private insurance contract is that you limit the kinds of activities people can engage in, in order to minimize the moral hazard risk. So, if you get health insurance, it may will be that you are denied coverage if you decide to go sky diving or scuba diving or something of this sort, you cut out the high risk activities so that the insurance company can now control against its losses which mean that it can offer an affordable premier.
37:12
Adverse selection and moral hazard essentially drive the organization of the insurance contracts and more than that even ordinary business contracts often have risk elements in them so that insurance is not just a discrete line of business but it’s part of every business you have whether it’s employment on the one hand or contract or sale on the other. Why do contracts matter? The system of contracts sounds extremely complex.
37:39
Can you give a simple explanation of why contracts are not only important, but necessary? If one wants to think about why contracts are so important and you look at it in terms of the mutual benefits of the party, it turns out that contracts allow you to make improvements on public space when the government enters into various kinds of agreements with various contractors to pave the roads or to repair. If you look at the private space generally speaking, no individual can build all the
38:07
things that are necessary and the law of contracts allows you to specialize and essentially to take people with different sets of skills and to combine them in optimal fashion. The thing to understand about contracts is that litigation looks at a particular contract and talks about what should be done in the event of breach. Somebody who’s thinking about contracts as a social institution has to look at a network of contracts and see how one contract builds and depends upon another.
38:35
And in this particular framework, what is key is to make sure that each of the contracts is performed in the correct sequence so that if nothing goes off the rails, you can coordinate the activities of large numbers of people and modern management techniques were designed to achieve exactly that particular result. To make sure that the systems are in place, the backups are in order ah, so that you don’t get a disruption in production, because it’s not just the individual dispute that takes
39:01
place with difficulty, it’s that all people are going to be engaged in work after this contract will now been slowed up. So if the people don’t put the foundations in correctly, the guys who are responsible for building the walls will not be able to do their work and if the guys who put the walls in are not able to do their work, the painters will not be able to do theirs and so on down the line. So the system of contract requires high levels performance from suit to nest and there are
39:27
oversight situations. There are architects who review these things; there are owners, supervisors of one sort or another. So that contracting becomes this very complicated set of relationships and often that’s lost sight of if you just look at litigation because those are concerned with breaches between A and B and what we need to do is put that A, B contract into its larger social and business context. Thank you for listening to this episode in the Common Law unit of the No. 86 lecture
39:58
series, where Professor Richard Epstein looks at long-established common law and regulatory patterns, and lays out six core principles as building blocks. His approach has roots in Roman Law, Anglo-American Common Law, and early Constitutional practice. These rules regulate human interactions in ordinary social life, and deal with individual autonomy, property and first possession, freedom of contract, and tort.
40:26
The spirit of debate of our Founding Fathers animates all of the No. 86 content, encouraging discussion and critical reflection relative to how each subject is widely understood and taught in law schools and among law students. Subscribe to the No. 86 Lecture series on your favorite podcast platform to have each episode delivered the moment it’s released. You can also go to fedsoc.org/no86 for more lectures and videos on Property, Contracts, and the Common Law. Thanks for listening.
41:11
See you in class!
Here to help you learn
Sign in to keep a private conversation with your course tutor.
Ask me anything about the material…
Sign in to chat