Abstract
This article shows how contracts are the institutional foundation of a market economy. Contracts create wealth, allocate risk and are based on consent. There is no perfect competition and the markets are characterised by a number of failures; therefore, contracts are not perfect. However, the existence of these failures does not undermine the importance of contract and consent. A common critique of the market economy is that most transactions are based on some form of coercion. The authors try to address this misconception by showing that a contract is the result of coercion not in cases where a choice is hard for a party but when it offers a choice the party does not want to accept.
Keywords
The possibility of coordination through voluntary cooperation rests on the elementary–-yet frequently denied–-proposition that both parties to an economic transaction benefit from it, provided the transaction is bilaterally voluntary and informed. Milton Friedman [12, p. 13]
Introduction
A market economy creates wealth through market transactions but also through any kind of exchange based on consent. These exchanges and transactions not only help market participants realise their wishes, they also increase society's wealth through surpluses created by the mechanism of efficient resource allocation.
In a given transaction, when ex ante A values a widget at ϵ10 and B at ϵ15, if an exchange among them takes place, both will end up richer ex post. If the stipulated price is ϵ12, then A ends up with ϵ12 instead of owning a widget that he values at ϵ10; B now owns a widget that he values at ϵ15, plus ϵ3 (his consumer surplus), totalling ϵ18. They both became ϵ5 richer–-ϵ5 being the surplus created by their transaction. Society is also ϵ5 richer (society's share of the wealth before the transaction was ϵ25 and after the transaction it is ϵ30), because there is now a better allocation of resources (B had to have the widget) based on consent. 1 For this wealth-creation mechanism to function smoothly in a market economy, contracts should be encouraged and should also be enforced by law. Specifically, the law's main function in this case is to encourage contracts as a wealth-creation mechanism and also as a risk-allocation mechanism.
One could argue that since B values the widget more than A, a forced transfer would also increase efficiency; since it would lead to a better allocation of resources, consent is redundant. This is a mistake for many reasons: people express their idiosyncratic values by consenting to a transfer of a resource (revealed preferences); a forced transfer is necessarily based on an arbitrary assumption about valuations, usually an assumption by a third party which is not omniscient. In addition, a system of act utilitarianism which would justify such arbitrary transfers would undermine property rights, contracts and the rule of law in general. Such a system would collapse due to legal uncertainty and extravagant transaction costs.
However, for a contract to create wealth a condition is necessary: the wealth should be based on the consent of the parties, who are rational and informed. This paper will discuss these qualifications and also discuss what the nature of consent is in this case, trying to discern when a contract is not based on the genuine consent of the parties but on coercion. Since a common critique of the market economy is that most transactions are based on some kind of coercion, we believe that our discussion will help clarify some issues as well as help to discredit some hostile-to-the-market theories.
Contract, time and uncertainty
In a market exchange that leads to a contract, two (or more) rational actors promise to limit their future actions with the objective of deriving, from the present or future actions of the other party, a benefit that will be greater than the cost of restricting their actions. The presumption of rational choice theory is that the agents are rational, in that they always calculate the most effective way to satisfy their preferences. In other words, they are utility maximisers: they maximise an objective function subject to constraints. The parties generally know better than anyone else where their own interests lie 2 and will do whatever is necessary to satisfy their preferences by choosing the best means to their ends.
See Smith [36, p. 456]: ‘[E]very individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him’ [IV.ii.10]. See also Posner [31, p. 93].
Economic analysis is usually not interested in the quality, morality and nature of these preferences [39]. However, a relatively new branch of economics and psychology–-behavioural economics–-is. According to behavioural economics theory, the legal system helps construct preferences and values, both by creating procedures, descriptions and contexts in the courts themselves, and by creating entitlements that help shape preferences and values in domains that might appear to have nothing to do with law. 3 In a seminal paper Jolls et al. [18], after criticising the mainstream neoclassical law and economics approach to the nature of rationality and behaviour, attempt to enrich traditional economic analysis by incorporating a ‘more realistic conception of human behaviour’ based on a more complicated psychological treatment (using concepts like bounded rationality, bounded willpower, bounded self-interest, etc.). At the same time, Posner [32, p. 1575] has accused behavioural economics of treating irrationalities as unalterable constituents of human personality and picturing human beings as having unstable preferences and infinite manipulability:
For the formation of preferences, see Sunstein [40].
It is economics minus the assumption that people are rational maximizers of their satisfactions. Its relation to standard economics is thus, a bit like the relation of non-Euclidean to Euclidean geometry, though with the important difference that non-Euclidean geometry is as theoretically rigorous as Euclidean geometry, whereas behavioral economics is […] antitheoretical. (Posner 1998, p. 1552)
In the example of a market contract, there is the initial assumption in mainstream neoclassical economic theory that the parties can efficiently regulate the contractual relationship they have engaged in and that they can solve all the potential problems stemming from the development of this relationship. As a result, their contractual relationship will bring them to a Pareto superior position compared to the one they were at prior to the contract. 4 The role of law is thus, initially to enforce people's promises, since these promises are by default (initially) value enhancing (and utility enhancing), and to encourage and facilitate the maximisation of the well-being of members of society by enforcing the wishes of contracting parties, 5 as expressed in their agreements recognised as contracts. 6
The parties will arrive at a Pareto optimal point after the performance of the contract and only then will the utility of the parties increase. However, this does not necessarily mean that the increase in utility will be distributed equally.
‘The desirable effects from exchange all derive from the fact that each person receives, by subjective valuation, goods and services that are more valuable than those which are surrendered’ [10, p. 694 and also p. 701]. See also Stephen [37, p. 157]: ‘[C]ontract law can be seen as ensuring that the optimal number of contracts is entered into.’
A contract is a peculiar form of a voluntary arrangement. Some of its terms ‘may be negotiated over a bargaining table … [s]ome may be a set of terms that are dictated … [s]ome may be fixed’ and ‘[s]ome may be implied by courts or legislatures’ [9, p. 14].
However, the fact that the parties decide for themselves what will be the benefit and what will be the cost of their future actions does not imply that they will always and necessarily make the right decisions. Even though it is widely accepted that the parties know best where their interests lie, it is also true that the parties can make mistakes, due to imperfect information and/or uncertainty about the future. There is a chance that (at least) one of them will make a miscalculation of the cost or the benefit, based on inaccurate information. Another potential and more common problem is the likelihood of a change in circumstances that will overturn the previous calculation of costs and benefits and will create a new situation which is sometimes completely different from the one the parties took as a given when constructing their relationship.
All these problems are basically the result of the passage of time (the ‘sequential character of economic activity-performance’, in the words of Posner [31, p. 90]), which is a sine qua non element in the exchange of promises, 7 and of the unavoidable lack of perfect information among market participants. The scarcity of time and money makes it virtually impossible for the parties to allocate responsibility for every possible contingency due to uncertainty in a deferred exchange.
Indeed, the temporal element is an essential part of the definition of contract. See Kronman and Posner [20, p. 3].
Yet another problem, added to those of imperfect information and ‘unforeseen contingencies’, is the opportunistic behaviour of one of the parties 8 that is also a result of the sequential character of the performance and is pertinent to the problem of unforeseen contingencies due to asymmetric information. A contractual relationship that begins as a relation of parties with roughly equal bargaining power can turn into (after the performance of one party) an extremely unequal relationship, a monopoly situation, with one party falling prey to the other (e.g., due to specific investment, asset specificity, etc.). Even in a long-term relationship between two parties, one party's threat of a unilateral violation of the initial contract may induce a renegotiation of the contract. As a renegotiation may result in one party capturing some of the return from the other's investments, this possibility may lead to underinvestment [16].
See Posner [31, p. 89-92], Muris [25] and Trebilcock [41, p. 16]. In conditions of perfect competition, opportunism would be extremely expensive given the full information and the consequent effects in reputation: ‘[b]ecause [market transactions] are repetitive, they usually make deceit and nonfulfilment of promises unprofitable’ [38, p. 22].
The role of contract law is to provide parties with the background legal rules (optional and mandatory default rules) that will help them, to the greatest extent possible, overcome the aforementioned problems. Contract law supports (by the force of the state and the legal system in general) 9 and at the same time regulates the exchange of promises. Its principal function is to help the parties realise their wishes. Therefore, it has to deal satisfactorily with the problems of imperfect information, opportunism and the risk of contingencies that the parties did not or could not predict. 10
The enforcement of promises is the primary (and almost undisputed) function of contract law. This role of contract law in a market economy (a basic prerequisite for the coordination of economic activities, especially investment) will not be discussed further in this paper, since it is considered a resolved issue. See Cooter and Ulen [6, p. 168-170] and Shavell [35]. The problem that remains is the facilitation of private purposes by the law and the creation of the necessary incentives for the reliance of people on promises, which is again the outcome of the appropriate legal rules.
The perfect contract
In a perfect world of perfect competition, a market exchange could lead to a perfect contract. 11 A perfect contract is ‘a promise that, if enforceable, is ideally suited to achieving the ends of the promisor and the promise’ [5, p. 230]. 12 In such a ‘complete contingent contract’, every possible contingency would be foreseen and regulated by the parties [35]. In this world of perfect information and competition, opportunism would wane, given the existence of reputational effects (since information is costless) and the possibility of private sanctions. In such a world, the only function of law would be the enforcement of contracts–-but even this would be redundant since market forces would assure contractual performance 13 –-and any intervention by the state (through contract law or through other forms of regulation) would be inefficient.
See especially Craswell [8, p. 85] for a description of such an environment and a non-technical explanation of why, in a perfect market, only the efficient clauses survive. See also Milgrom and Roberts [22, p. 24-25, p. 126-128].
‘A contract … is called Pareto efficient if the contract is impossible to modify … so as to raise the expected utility of both of the parties to it’ [35, p. 436, author's italics].
See, e.g. the famous remarks by Sir George Jessel in Printing and Numerical Registering Co. v. Sampson, L. R. 19 Eq. 462, 465 (1875). See also Klein and Leffler [19].
However, given that actual markets are merely the ‘reflection’ of the idea of a perfect market with perfect competition and perfect (and thus symmetric) information, we must cope with the fact that imperfect information entails imperfect contracts. Nevertheless, in a basically free market economy, where the distance between the theoretical concept of perfect competition and the reality of real markets is not so great, there is a good chance that many of the contracts will be nearly perfect (i.e., that they will serve the intentions of the parties adequately). 14 The fact that the great majority of contracts are performed without any (or many) problems constitutes empirical proof of this hypothesis.
Or rather, slightly imperfect (or imperfect in respects of slight significance): ‘No system has to be perfect to survive’ [11, p. 3].
Nevertheless, there are a number of ‘incomplete’ contracts [33, p. 175-189]. Apparently, these are the contracts that heavily suffer from the ‘imperfection’ of the market.
15
The gravest circumstances of a ‘malfunctioning’ market are ‘market failures’ [28, p. 588-590], where the distance between imperfect and perfect competition is so great as to create serious problems in many aspects of economic life
16
and, in our case, in the formation (or performance) of contracts [
We consider a contract clause as imperfect, i.e., inefficient, when ‘the harm it inflicts on buyers is greater than the savings it creates for sellers’ [8, p. 82].
This qualification is not common to all discussions of market failures. See also Posner [31, p. 93].
There are six conditions 17 that must be met in order for the market (and consequently for the contract) to be perfect 18 :
See Cooter and Ulen [5, p. 234-235 and also
This does not mean that there will always be a problem when one of the conditions does not apply in a particular situation. In many cases, either the ‘failure’ is not so critical as to justify an intervention by the state, or the parties do not deem it so important as to initiate legal action or as to destroy a precious longterm relationship, or ‘government failure’ is worse than market failure. See Buchanan et al. [3].
Individual rationality. Decision-makers must have stable rational preferences. This means that their preference ordering must be complete, transitive and reflexive. Their behaviour must be rational 19 and not random or irrational, and they must try to maximise their utility, given the constraints, by finding the best feasible outcome.
Constrained choice. The parties must be constrained only by the factor of scarcity (in their income, time, energy, consumer demand, technology, etc.) in the materialisation of their preferences (but see [41, p. 79-84]). Their choice must be free and not subject to any other kind of restriction by private parties (e.g., threat) or by the state (e.g., regulation). Such restrictions would result in a distortion of choice–-and consequently the distortion of price mechanism. Any constraint on choice would destroy the value of price as a signal to a competitive market, 20 and its only effect would be redistribution of wealth from one party to another without the creation of value [6, p. 235-239].
Transaction costs. The cost of engaging in any transaction should be minor for the parties. Problems arise from an absence or an inefficiently low amount of bargaining because of high transaction costs (see [6, p. 240-242]; and [2]. From an economist's point of view, the primary role of contract law is to reduce transaction costs for agents through dispute resolution processes that obviate the need to fully specify contracts. That is, contract law serves as a substitute for the need to contract for every possible contingency as a transaction cost-minimising (economising) mechanism and/or a substitute for a dispute resolution process (prior to engaging in a transaction). For many, this is the basic prerequisite that includes, in one way or another, all the rest.
Externalities. The contract must not have negative third party effects (externalities). The cost of the transaction in its entirety must be borne by the parties and not by any other third party that has nothing to do with the contract. 21
Imperfect information. The parties must be fully informed as to the nature and consequences of their choices.
22
This does not mean that there should be no (primary) uncertainty as to future events, but that there should be no severe informational asymmetries or symmetric informational imperfections, distorting the choice of either party (see [
Monopoly. There must be enough potential contractors, for example, many buyers and many sellers (i.e., no monopolies, 23 monopsonies or oligopolies). None of the parties should have great market power in the particular market and use it to extract monopoly rents [4, p. 801-807, also p. 376-379]. More accurately, the party that has the market power should not exploit it to his favour, thus, making the bargain extremely one-sided. 24
See Williamson [42, p. 398] for the three versions of rationality: strong form (hyper-rationality maximisation-comprehensive contracting), semi-strong (bounded rationality-farsighted contracting), and weak (bounded rationality-myopic contracting). Although these distinctions are relevant, they have the defect of not being continuous (a defect shared by many types of categorisation). We would choose ‘rational spirit’, a term Williamson himself uses and prefers.
See Gensler [13, p. 387] and generally the seminal article on this problem by Hayek [15]. See also the inter-war Mises and Hayek versus Lange controversy. See Mises [
See generally Papandreou [27]. But see also Epstein [10, p. 700]: ‘Seeking to respect all (but only) negative externalities by the legal system leads to a place where there is no decision for individual choice or personal self-control, a result that is wholly inconsistent with our ordinary intuitions about autonomy and self-control. So to avoid that situation we run to a world in which autonomy allows us to impose negative externalities on those with whom we refuse to deal but not on those upon whom we inflict force.’
See especially Craswell [7, p. 9-18], but also see on the contrary Note [26, p. 988-994], arguing that the economic solutions to the problems created by imperfect information are ultimately controversial normative and empirical judgments.
Monopoly could also be the result of opportunism in cases of contract modification, a phenomenon due to the sequential character of performance; see Posner [31, p. 92]. See also Craswell [7, p. 5-9], who does not consider monopoly as ‘a likely source of inefficient contract terms’ (the essence of his writing is that monopoly is a problem which must be dealt with not by contract law but by antitrust law). For Craswell, the basic problem and the main source of inefficient contract terms is imperfect information. See also Schwartz for similar views [34, p. 114].
This is basically a problem of antitrust law and economics, where there are widely contradicting views. See generally Cooter and Ulen [6, p. 250-255] and Posner [30].
We repeat that these conditions are not as absolute as they seem. For example, the total absence of transaction costs is impossible, but this does not signify that all contracts will be imperfect by default. The concepts are relative (or better, we are using them relatively), especially in real world situations such as commercial transactions in a given modern capitalist economy.
If all the aforementioned requirements are met, 25 then the contract is perfect and it must be enforced by the courts. But if one of them is not, then the contract is imperfect and there is a good chance that the parties will end up in court or that one party will be burdened by this imperfection so severely as to make future contracting parties inefficiently cautious. Contract law can provide solutions to this problem by creating doctrines that are suitable for correcting the defects of the market. These doctrines will provide a ‘perfect-contract environment’ for the parties by reducing the probability of problematic situations. At the same time, parties will save time and money, that is, economise on transaction costs, and they will have a better chance of elaborating on more intricate aspects of their relationship, thus, further reducing the likelihood of problems, since the cost of bargaining will be lower [41, p. 16-17].
A note on coercion
We emphasised above that the parties must be constrained only by the factor of scarcity and that their choice must be free of coercion. However, one could wonder if the Marxist argument that every transaction in a capitalist economy is the result of coercion is in fact justified. One does not have to be a Marxist to acknowledge that parties often feel ‘forced’ to enter into a transaction, especially when they do not have any alternatives. Is that coercion? Is there a criterion to determine when consent is not genuine but the result of coercion?
We propose a very simple, easy-to-use criterion: the ‘disappear button’. This is based on a thought experiment we will briefly present here. In three extreme cases:
A robber points a gun at you, demanding ‘your money or your life’.
You are in a desert, dehydrated, and you happen to have on you €1,000. Out of the blue you find an oasis with a merchant selling bottled water for (surprisingly!) €1,000 a bottle.
You need money urgently, you are not creditworthy and you borrow money from a loan shark at a 500% interest rate.
According to many authors, all three cases are instances where there is no consent. You have a choice (even in the first example) but your choice is the result of coercion, not of consent. We beg to differ for cases (b) and (c). The difference between these two cases and case (a) is that these are choices that are very hard but which you would nevertheless prefer to have than to not have. If you could press a button which would make the thief in case (a) disappear you would certainly do it. Obviously, you would not press the button in the other two cases:
You would prefer to have the hard choice in the desert. If the seller was a mirage, that would be very disappointing to you.
You would prefer to have the hard choice in the loan shark's office. If the police were to enter the room suddenly and arrest him for usury, you would very be disappointed if he had not lent you the money before they took him.
In neither of these cases would you press the ‘disappear button’ because these are choices you want to have. They are hard choices, but the hardship was not caused by the people trying to exploit your dreadful situation. However, there is a difference between case (b) and case (c). The choice in (b) is constrained by the existence of a monopoly. It's a problematic choice and the court should not enforce a contract that is the result of a monopoly situation. In the third scenario there is no monopoly and there is no coercion. You are a bad risk and that is why only the loan shark is willing to ‘help’ you. If the law ‘protects’ you from his ‘help’, your situation will be much worse and this would be a result of coercion by the state, the worst kind of coercion.
Conclusion
This brief paper has discussed contracts as the institutional foundation of a market economy. Contracts create wealth, allocate risk and are based on consent. However, contracts are not perfect because markets are not perfect. There is no perfect competition and the markets are characterised by a number of failures. However, the existence of these failures does not undermine the importance of contracts. Contract law should be constructed in such a way as to correct these failures. Finally, we tried to show that a contract is a result of coercion not in cases where a choice is hard for a party but when it offers a choice the party does not want to have.
Footnotes