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Abstract:
This paper, which will appear as a chapter in the forthcoming Handbook of Law and Economics (A.M. Polinsky & S. Shavell, eds.), surveys major issues arising in the economic analysis of contract law. It begins with an introductory discussion of scope and methodology, and then addresses four topic areas that correspond to the major doctrinal divisions of the law of contracts. These areas include freedom of contract (i.e., the scope of private power to create binding obligations), formation of contracts (both the procedural mechanics of exchange, and rules that govern pre-contractual behavior), contract interpretation (what consequences follow when agreements are ambiguous or incomplete), and enforcement of contractual obligations. For each of these sections, we address the economic analysis of particular legal rules and institutions, and, where relevant, connections between legal arrangements and associated topics in microeconomic theory, including welfare economics and the theory of contracts.

contract law, freedom of contract, contract formation, pre-contractual liability, promissory estoppel, interpretation, incomplete contracts, default rules, form and substance, breach of contract, contract damages, private enforcement of contracts, contract theory

Abstract:
Much research in law and economics, following Coase's insight that the effects of a legal rule depend on the ability of those whom it governs to bargain around it, has undertaken to explain how substantive entitlements such as property rights influence the bargaining process. Perhaps more important than any substantive rights or duties in this regard, however, is the extensive body of contract doctrine that governs the procedural mechanics of exchange. The formal rules of contract formation, by attaching consequences to the various acts and omissions that bargainers can choose from in a negotiation, affect the parties' incentives to make and to respond to offers, to delay, to bluff, and to communicate in the first place. Similarly, the law of contract interpretation - ranging from default rules to irrebuttable presumptions - determines the costs of bargaining into and around particular contract terms. Both sets of rules thus influence which contracts get formed and the terms on which they get formed. For these reasons, contract formation and interpretation can fairly be said to be logically prior to every other issue in law and economics. This essay surveys the economic effects of the doctrinal rules of contract formation and interpretation, focusing specially on the incentives such rules provide for strategic behavior in negotiation. Each of its individual sections discusses a particular aspect of such incentives.

Abstract:
For the past 100 years or so the historical trend in the law of contracts has been to water down formal interpretive doctrines in favor of a more all-things-considered analysis of what the parties may have meant or what justice might require in the individual case. This trend away from formal and toward substantive interpretation of contracts has been alternately celebrated and criticized for over a century; and in recent years, a number of economically influenced scholars, in translating some of the classic arguments into economic language, have helped to clarify some of the traditional commentators' concerns. While this new economic analysis of formalism has been relatively successful in relating the traditional debates over formalism to specific transactional and institutional problems such as imperfect information and rent-seeking, however, it has fallen short along the dimension of advancing toward practical legal or policy recommendations. This essay, accordingly, proposes a different approach: one that focuses on private rather than public legal decisionmakers as a primary audience. In general, private lawmakers are likelier to be in a better position to make practical use of the economic analysis of contracts, in part because the detailed information that is necessary to implement such analysis intelligently is much likelier to be available at the individual level. Furthermore, there are many opportunities for contracting parties to choose between relatively formal and relatively substantive interpretive regimes. What is needed is a basic taxonomy of economic considerations that can serve as an organizing framework for parties choosing between form and substance when designing contracts; and the later part of the essay attempts to establish such a taxonomy.

Contract law, contract interpretation

Abstract:
Guaranty arrangements, in which one person stands as surety for a second person's obligation to a third, are ubiquitous in commercial transactions and in commercial law. In recent years, however, scholarly attention to the topic has been scant; and there is still no theoretical treatment of this body of law or practice from a economic policy perspective. This paper, accordingly, attempts to outline the basic economic logic underlying the guaranty relationship, and applies the results to a variety of specific issues in government policy and private planning. It poses and answers three main questions: First, why would a creditor prefer to make a guaranteed loan rather than an unguaranteed one? The answer is not as obvious as might first appear, given that market competition over credit terms tends to adjust the interest rate paid by an individual borrower to reflect the specific default risk that he presents. Second, given that they bear the residual risk of debtor default, why would guarantors prefer to guarantee loans rather than make loans directly, thus foregoing the opportunity to earn interest payments that could help to compensate for the risk they bear? Third, even if it is efficient for one creditor to provide funds and another to provide insurance against default, why would the parties prefer to implement this arrangement through the triangular form of a guaranty, instead of simply having the former creditor lend to the latter and the latter lend to the ultimate borrower?

Abstract:
The law of contracts has often treated options quite differently from other contractual transactions; for example, the characterization of a transaction as an option contract calls forth specially required formalities, but on the other hand often has the effect of releasing parties from doctrinal limitations on their contractual freedom, such as the duty to mitigate damages or the rule that holds excessively high liquidated damages void as penalties. Such differential treatment is challenging to explain from a functional viewpoint, in part because all contracts resemble options to the extent they are enforceable in terms of monetary damages, and in part because contracts that are nominally structured as explicit options can be close economic substitutes for contracts that are nominally structured as unconditional.

This essay sets out a theoretical account of the efficient design of option contracts - one that explains how contracting parties should strike the balance among option premium, option life, and exercise price, in order to maximize the expected surplus from their transaction. It shows that the tradeoffs between these various aspects of option contracts can affect the parties incentives to acquire and disclose information, to invest in relation-specific investments, and to take efficient precautions against the event of breach. It then goes on to develop an organizing framework for private parties choosing whether and how to structure their contractual arrangements as options, and for policymakers choosing whether or how to regulate such private choices. In short, the appropriate balance between option premium, option life, and exercise price will depend on the relative importance that the one attaches to these various dimensions of incentives.

Contract law, option contracts

Abstract:
Among legal commentators, standard form contracts have long been received with distrust, and the rules governing their interpretation have engendered considerable controversy. While economic analysis has little to say regarding the libertarian objection to standard form contracts or their relationship to personal autonomy, it can help evaluate their effects on efficiency and the distribution of the gains from trade. From such a perspective, standard forms should be analyzed like any other productive input, comparable to design, marketing, and technical support. Whether their use raises any special regulatory or policy concerns, therefore, depends on their implications for the standard litany of market failures: scale economies, monopoly, externalities, imperfect information, and the like. This essay surveys and discusses such implications, concluding that a measure of special legal treatment for form contracts is appropriate on economic grounds.

Abstract:
This Comment expands upon Clayton Gillette's defense of Article 8(2) of the Convention on the International Sale of Goods (CISG), which directs tribunals to incorporate international trade usage into private contracts governed by the Convention, unless the parties agree otherwise. The Comment attempts to offer a more robust and systematic account of when substantive interpretative doctrines such as trade usage might be desirable, as well as why such doctrines appear to be especially useful in the transnational setting of the CISG. It argues that Gillette's account is incomplete because he does not provide an explanation of why international tribunals have been more restrained than US domestic courts in their use of trade usage, and because he focuses primarily on the costs of interpretative uncertainty to the exclusion of a fuller list of costs and benefits relevant to the choice of interpretative regime. Taking this fuller list of considerations into account renders the widespread use of trade usage and similar contextual standards in the transnational setting more comprehensible, and reinforces Gillette's conclusions regarding trade usage's commercial functionality.

Trade usage, CISG, contract interpretation

Abstract:
This article surveys the effects of legal fee shifting on a variety of decisions arising before and during the litigation process. Section 2 provides a brief survey of the practical situations in which legal fee shifting does and does not arise. Section 3 analyzes the effects of indemnification on the incentives to expend resources in litigated cases. Section 4 examines how indemnification influences the decisions to bring and to defend against suit, and Section 5 assesses its effects on the choice between settlement and trial. Section 6 addresses the interaction between the allocation of legal fees and the parties' incentives for efficient primary behavior. Section 7 considers two important variants on simple indemnification: rules that shift costs based on the parties' settlement negotiations (such as U.S. Federal Rule 68 and the English practice of payment into court), and rules that shift costs based on the margin of victory (such as U.S. Federal Rule 11 and the common law tort of malicious prosecution). Section 8 reviews the brief but instructive empirical literature on legal cost shifting, and section 9 summarizes the discussion and offers conclusions.

Abstract:
This paper comments on Ronald Mann's article "The Role of Letters of Credit in Payment Transactions." In that article, Mann shows that beneficiaries of letters of credit routinely fail to present complying documents and that the applicants and issuing banks just as routinely waive the resulting documentary defects. Based on this finding, he argues that, contrary to traditional understandings, beneficiaries do not in practice rely on letters of credit as a guaranty of payment, but rather as a signalling device. On his view, the willingness of a bank to issue a letter of credit serves as a credible signal, enforced by an implicit reputational bond, of the issuer's private information that the applicant is a reliable creditor; and this signal is more important to the beneficiary in practical terms than is any legal right to collect directly from the bank.

In this paper, I argue that Mann's account does not explain why parties would want to use a commercial letter of credit as their mechanism for verifying creditworthiness, or why, given that the parties have chosen to use a letter of credit to signal the buyer's reliability, they would avoid the presumably stronger signal of making the letter legally binding. The reason why Mann's explanation is incomplete, I suggest, is that he focuses on only half of the incentive problems inherent in the stereotypical commercial letter of credit transaction. When the bilateral nature of the risk is taken into account, the use of letters of credit, as well as the fact that in most instances they are honored despite technical noncompliance with their documentary conditions, becomes substantially more understandable.

Abstract:
This paper comments on Daniel Keating's article "Exploring the Battle of the Forms in Action." In that article, Keating reports on a survey in which he interviewed a sample of 25 representatives of companies that buy and sell goods, and asked them a variety of questions about their form-contracting practices. On the basis of these interviews, Keating concludes that commercial actors have adjusted fairly well to the use of standard form contracts, that the battle of the forms is relatively uncommon in practice, and that significant statutory reform is not in order.

In this paper, I argue that Keating's empirical method - the free-form, oral interview conducted personally by the principal researcher - is less reliable, and more vulnerable to distortion by the biases of the interviewer and subject, than he acknowledges. While Keating is correct that this "hands-on" method can unearth information that could not be found through structured surveys or review of written company records, the information thus generated is not subject to the usual controls provided by those more conventional methods. Absent such controls, the information is much more likely to be used to confirm the researcher's or interviewee's prior beliefs than to disconfirm them, or to corroborate conventional wisdom. Thus I would take his findings with some skepticism, at least until they have been confirmed by a more traditional empirical study that makes greater use of tabulated quantitative data and that takes greater precautions to screen out interpretative bias.