This article focuses on how law and economics contribute to the concept of contract theory, especially regarding bargain theory. There is an exploration of how Game Theory provides an example of cooperation within contract theory. Pertinent scholars, such as Richard Posner, are introduced. Finally, there is a review of the concept of incomplete contracts.
Keywords: Bargain Theory; Contract Theory; Economic Analysis; Game Theory; Incomplete Contracts; Moral Hazards; Pareto Efficiency; Richard Posner; Ronald Coase
Contracts entail the consideration of two main objectives. First, one must consider what types of agreements are to be made and enforced as a result of a contract. Second, one must consider what the consequences will be if any of the signing parties break the promises of the contract.
With this in mind, Cooter and Ulen (2000) created a list of purposes for contract law. Items on their list include:
- Enable people to cooperate by converting games with non-cooperative solutions into games with cooperative solutions. Cooperation is seen as the best way to be efficient. It is believed that payoffs are higher when all parties cooperate with one another.
- Encourage the efficient disclosure of information within the contractual relationship. The parties involved should create an environment where breach of contract isn't a viable option. It is in all parties' best interest if mediation isn't required to get any of the parties to adhere to their agreement and promise.
- Secure optimal commitment to performance.
- Secure optimal reliance.
Benefit-Detriment Theory vs. Bargaining Theory
The foundation upon which contract law rests can be attributed to two main theories: Benefit-Detriment Theory and Bargaining Theory. Within Benefit-Detriment Theory, it is assumed that the promisor will benefit or that the promisee will be at a loss. While the Benefit-Detriment Theory is sometimes used today, Bargaining Theory has become dominant within Contract Law.
Bargain Theory was developed in the late 1800s and early 1900s. During this period, it was believed that a promise was legally enforceable if it was a part of a bargain. In order for a bargain to be considered legal, it had to meet three conditions:
The offer and acceptance are very clear and create a reciprocal transaction (i.e. Person A approaches Person B and extends an offer for a product or service; Person B either accepts or rejects the offer). Both parties are required to give something to make the agreement a mutual transaction. Consideration refers to the actual object of the bargaining process (i.e. The payment of $100 for concert tickets would be the consideration). The promise (contract) becomes binding once the consideration has been completed.
Some have criticized bargain theory for a number of reasons. Some of the reasons include:
- Bargain Theory does not distinguish between fair and unfair bargains.
- Consideration could be absent for justifiable reasons.
Despite its criticisms, it can be said that bargaining attains economic efficiency if both the promisor and promisee agree to enforceability at the time the agreement is made. In this scenario, Pareto's efficiency is realized. Pareto's efficiency is described as a situation in which no changes can be made to improve an individual's status without harming another individual — or, the situation in which there is the most efficient use of resources.
Scholars in the Field
Contract theory is connected to the disciplines of law and economics; Richard Posner is a key pioneer of this academic combination. His contributions are based on his views of common law. "Common law is the expression of a core of common judicial principles applied to an accretion of individual cases and not simply an averaging of unrelated, empirically derived opinions" ( Lowry, 1976, p. 10). It is the responsibility of the courts to ensure that bargain and contract transactions/agreements (i.e. enforcing transfer of titles) are honored. During the 1970s, Posner (1992) claimed that common law was efficient. He believed the legal system was operating appropriately and addressed the issues that arose. Overall, he did not believe there were any flaws in the system. In addition, he was credited for the treatment of law and economics as a field of study as opposed to an opinion of individual scholars.
However, it should be noted that Posner's assertion was not entirely supported by other scholars in the field. For example, during this period of time, scholars, such as George Priest, reconsidered their position and rejected the concept of common law as efficient. "Meanwhile, most scholars who applied economic analysis confined their analysis to the effects of particular legal rules, so those scholars had no reason to express an opinion as to whether they thought an entire field of law (much less the entire common law) was efficient" (Craswell, 2003, p. 904).
Scholar S. Todd Lowry (1976) observed how many in the economic and legal fields failed to connect social arrangements and the economic and liability issues that came with them. In his work, he reflected on how there is a social and economic interaction among bargain, contract and administrative decisions. "By failing to recognize the relational threshold as a precondition for bargain, the distinction between bargain (transaction) and contract (relation) has been obscured in some discussions of legal and economic process" (Lowry, 1976, p. 9-10).
Game Theory — Cooperation
As mentioned above, one of the purposes for contract law is to enable people to cooperate by converting games with non-cooperative solutions into games with cooperative solutions. It is believed that payoffs are higher when all parties cooperate with one another. A study conducted by Sacconi and Faillo...
(The entire section is 2717 words.)