Unit- 2,

To
6th sem,B.A,LL.B
School of law
Uom ,mysore
Economic theory of contract
What Is Contract Theory?
 Contract theory is the study of how people and organizations construct and develop legal
agreements. It analyzes how parties with conflicting interests build formal and informal
contracts, even tenancy. Contract theory draws upon principles of financial and economic
behavior as different parties have different incentives to perform or not perform particular
actions.
 It is also useful for understanding forward contracts, and other legal contracts and their
provisions. It also includes an understanding of
letters of intent and memorandums of understanding.
Types of Contract Theory
 Practice divides contract theory into three models or types of frameworks. These models define
the ways for the parties to take appropriate actions under certain circumstances stated in the
contract.
[Link] Hazard
 A moral hazard model portrays a principal who has an incentive to engage in risky behaviors
because the associated costs are absorbed by the other contracting party.
 For moral hazard to be present, there must be information asymmetry and a contract that
provides an opportunity for a party to alter their behavior. To counter moral hazards, some
companies create employee performance contracts, which depend on observable and confirmable
actions to serve as incentives for parties to act according to the principal’s interest.
 [Link] Selection
 An adverse selection model portrays a principal who has more or better information than the
other contracting party and therefore distorts the market process.
 Adverse selection is common in the insurance industry. Some insurers provide coverage for
policyholders who withhold valuable information during the application process to obtain
protection. Without asymmetric information, these policyholders would likely not be insured or
would be insured at unfavorable rates.
[Link]
 The signaling model is when one party adequately conveys knowledge and characteristics about
itself to the principal. In economics, signaling includes the transfer of information from one party
to another. The purpose of this transfer is to achieve mutual satisfaction for a specific contract or
agreement.

History of Contract Theory

 Kenneth Arrow conducted the first formal research on this topic in the field of economics in the
1960s.1 Since contract theory incorporates both behavioral incentives of a principal and an
agent, it falls under a field known as law and economics. This field of study is also called the
economic analysis of law.
 In 2016, economists Oliver Hart and Bengt Holmström won the
Nobel Memorial Prize in Economic Sciences for their contributions to contract theory. 2 The two
were applauded for exploring “many of its applications” and launching “contract theory as a
fertile field of basic research."3
Formation and performance of contract
Formation[edit]
 At common law, the elements of a contract are: offer, acceptance, intention to create legal relations,
consideration, and legality of both form and content.
 Not all agreements are necessarily contractual, as the parties generally must be deemed to have an
intention to be legally bound. A so-called gentlemen's agreement is one which is not intended to be legally
enforceable, and "binding in honour only".[6][7][8]
 [Link] and acceptance[edit]
 In order for a contract to be formed, the parties must reach mutual assent (also called a
meeting of the minds). This is typically reached through offer and an acceptance which does not vary the
offer's terms, which is known as the "mirror image rule". An offer is a definite statement of the offeror's
willingness to be bound should certain conditions be met. [9] If a purported acceptance does vary the terms
of an offer, it is not an acceptance but a counteroffer and, therefore, simultaneously a rejection of the
original offer. The Uniform Commercial Code disposes of the mirror image rule in §2-207, although the UCC
only governs transactions in goods in the USA. As a court cannot read minds, the intent of the parties is
interpreted objectively from the perspective of a reasonable person,[10] as determined in the early English
case of Smith v Hughes [1871]. It is important to note that where an offer specifies a particular mode of
acceptance, only an acceptance communicated via that method will be valid. [11]
 Contracts may be bilateral or unilateral. A bilateral contract is an agreement in which each of the parties to
the contract makes a promise[12] or set of promises to each other. For example, in a contract for the sale of a
home, the buyer promises to pay the seller $200,000 in exchange for the seller's promise to deliver title to
the property. These common contracts take place in the daily flow of commerce transactions, and in cases
with sophisticated or expensive precedent requirements, which are requirements that must be met for the
contract to be fulfilled.
 [Link] to be legally bound[edit]
 In commercial agreements it is presumed that parties intend to be legally bound unless the parties
expressly state the opposite as in a heads of agreement document. For example, in
Rose & Frank Co v JR Crompton & Bros Ltd, an agreement between two business parties was not
enforced because an "honour clause" in the document stated "this is not a commercial or legal
agreement, but is only a statement of the intention of the parties".
 In contrast, domestic and social agreements such as those between children and parents are
typically unenforceable on the basis of public policy. For example, in the English case
Balfour v. Balfour a husband agreed to give his wife £30 a month while he was away from home, but
the court refused to enforce the agreement when the husband stopped paying. In contrast, in
Merritt v Merritt the court enforced an agreement between an estranged couple because the
circumstances suggested their agreement was intended to have legal consequences.
 [Link][edit]
 A concept of English common law, consideration is required for simple contracts but not for special
contracts (contracts by deed). The court in Currie v Misa [23] declared consideration to be a “Right,
Interest, Profit, Benefit, or Forbearance, Detriment, Loss, Responsibility”. Thus, consideration is a
promise of something of value given by a promissor in exchange for something of value given by a
promisee; and typically the thing of value is goods, money, or an act. Forbearance to act, such as an
adult promising to refrain from smoking, is enforceable only if one is thereby surrendering a legal
right.[24][25][26]
 In Dunlop v. Selfridge Lord Dunedin adopted Pollack's metaphor of purchase and sale [clarification needed
]
to explain consideration. He called consideration 'the price for which the promise of the other is
bought'.[27]
 In colonial times, the concept of consideration was exported to many common law countries, [which?
]
but it is unknown in Scotland and in civil law jurisdictions. [28] Roman law-based systems[29] neither
require nor recognise consideration, and some commentators have suggested that consideration be
abandoned, and estoppel be used to replace it as a basis for contracts. [30] However, legislation,
rather than judicial development, has been touted as the only way to remove this entrenched
common law doctrine. Lord Justice Denning famously stated that "The doctrine of consideration is
too firmly fixed to be overthrown by a side-wind." [31] In the United States, the emphasis has shifted
to the process of bargaining as exemplified by Hamer v. Sidway (1891).
 [Link][edit]
 Sometimes the capacity of either natural or artificial persons to either enforce
contracts, or have contracts enforced against them is restricted. For instance, very
small children may not be held to bargains they have made, on the assumption that
they lack the maturity to understand what they are doing; errant employees or
directors may be prevented from contracting for their company, because they have
acted ultra vires (beyond their power). Another example might be people who are
mentally incapacitated, either by disability or drunkenness. [39]
 Each contractual party must be a "competent person" having legal capacity. The
parties may be natural persons ("individuals") or juristic persons ("corporations"). An
agreement is formed when an "offer" is accepted. The parties must have an
intention to be legally bound ; and to be valid, the agreement must have both proper
"form" and a lawful object. In England (and in jurisdictions using English contract
principles), the parties must also exchange "consideration" to create a "mutuality of
obligation," as in Simpkins v Pays .[40]
 In the United States, persons under 18 are typically minor and their contracts are
considered voidable; however, if the minor voids the contract, benefits received by the
minor must be returned. The minor can enforce breaches of contract by an adult while
the adult's enforcement may be more limited under the bargain principle. [citation needed]
Promissory estoppel or unjust enrichment may be available, but generally are not.
Performance
 Performance varies according to the particular circumstances.
While a contract is being performed, it is called an executory
contract, and when it is completed it is an executed contract.
In some cases there may be substantial performance but not
complete performance, which allows the performing party to
be partially compensated.
 Research in business and management has also paid attention
to the influence of contracts on relationship development and
performance.[91][92]
Economic theory of tort law
Introduction: A tort suit enables the victim of a wrong to seek a remedy from
the person who injured her. Unlike a criminal case, which is initiated and managed by the
state, a tort suit is prosecuted by the victim or the victim's estate (or survivors). Moreover, a
successful tort suit results in a judgment of liability, rather than a sentence of punishment.
Such a judgment normally requires the defendant to compensate the plaintiff financially. In
principle, an award of compensatory damages shifts all of the plaintiff's legally cognizable
costs to the defendant. (It is controversial whether tort really lives up to this principle in
practice.) On rare occasions, a plaintiff may also be awarded punitive damages, which go
beyond what it necessary for compensation. In other cases, a plaintiff may obtain
an injunction: a court order preventing the defendant from injuring her or from invading her
rights (perhaps harmlessly). An example of the former would be awarding a plaintiff (or a
class of plaintiffs) an injunction against a polluting manufacturer. An example of the latter
would be awarding a plaintiff an injunction against a harmless trespass.
 “Tort” means “wrong” and it is natural to think that wrongs are the domain of tort law. But
tort law does not concern itself with all the wrongs that people do. Some wrongs are
addressed by the criminal law, not private law (some are addressed by both). And not every
wrong that falls within the province of private law falls within tort law. A breach of contract,
for example, is not traditionally regarded as a tort. More generally, tort law does not provide
a remedy for every wrong that a victim might suffer. Rather, tort law offers relief for a
canonical set of wrongs, or torts. These include assault, battery, defamation, and trespass,
among many others.
 Theories of Tort Law: Economic Analysis
 For many decades now, an economic analysis of tort law has been ascendant,
especially (but not only) in American law schools. Rather than surveying the
range of economic theories, this entry focuses in depth on what is arguably the
dominant strain of economic analysis: optimal deterrence theory. Proponents of
this approach, like economic analysts more generally, see tort liability primarily
as a mode of allocating the costs of accidents (though an economic analysis can
be extended to cover intentional torts, like assault and battery, too). Their
principal claim is that tort should be understood as aiming to minimize the sum
of the costs of accidents and the costs of avoiding them.

 1 The Economic Interpretation of Fault Liability

 Taking the relevant social problem to be the problem of costly accidents,
economic analysts deem the paradigmatic tort to be that of negligence. The law
holds a person to be negligent when she imposes an unreasonable risk of injury
on another. Imposing an unreasonable risk of injury is in turn a matter of failing
to take precautions that a reasonable person would take. But which precautions
would a reasonable person take?
2 The Economic Interpretation of Strict Liability
 If fault liability is efficient, what are we to make of strict liability? Can it be
efficient as well? Since someone facing strict liability will bear the costs of his
conduct whether or not he is at fault, one might think that a potential
defendant under a regime of strict liability will have no incentive to invest in
precautions. This is wrong. Suppose that I am strictly liable for some costs that
I impose on you—costs of $100. Suppose further that by taking $90 worth of
precautions I can eliminate the chance of my imposing these costs on you.
What is it rational for me to do? The answer is obvious. It is rational for me to
invest in $90 worth of precautions, since I come out $10 ahead if I prevent the
injury and thereby avoid liability for it. So even under a regime of strict
liability, potential defendants have an incentive to take cost-justified
precautions. And they won’t take any precautions that are not cost-justified. If
it would cost $110 to take a precaution that would eliminate the chance that
you would suffer an injury with an expected cost of $100, I would prefer to pay
for your injury than take the precaution. So strict liability does not induce extra
care. Under a regime of strict liability, potential defendants have an incentive
to take all cost-justified precautions—just as they do under fault liability.
 Objections to Economic Analysis
 There is no doubt that economic analysis offers valuable insight into tort law's
capacity to increase overall safety and reduce the costs of misfortune or bad luck.
For all its insight, however, economic analysis is vulnerable to difficult objections.
These objections speak both to tort's substantive norms and to its structural
features. We discuss some of the most significant objections here.
 3.1 Substance
 Many theorists believe that economic analysis offers a questionable interpretation
of the legal duty to behave reasonably. In characterizing negligence as the failure
to take cost-justified precautions, economic analysis identifies reasonable risk-
taking with rational risk taking. Economic analysis effectively invites us to
determine what risks it would be acceptable for a potential defendant to take on
the assumption that he owns both the resultant benefits and the resultant
injuries. This way of articulating the fault standard treats an activity's costs and
benefits as being of the same importance regardless of where they fall. But what I
owe you may not be the same as what I owe myself. Indeed, it might be
reasonable for me to be more solicitous of your well-being than my own, since we
might think me entitled to make tradeoffs with respect to my own well-being that
I am not entitled to make with respect to yours.
 2 Structure
 Economic analysis cares about the relationship between a particular
injurer and victim only to the extent that the nature of this
relationship provides evidence of the ability of either party to reduce
accident costs. As far as economic analysis is concerned, there is no
intrinsic reason why a victim should sue the person who injured him.
Nor is there any intrinsic reason why a plaintiff should argue in court
that the defendant wronged him, rather than that the defendant was
in a better position to reduce overall costs.
 The most basic relationship in our actual institution of tort law is the
relationship between an injurer and his victim—not the relationship
between each litigant, taken separately, and the goal of minimizing
the sum of the costs of accidents and the costs of avoiding them. If
the victim of another's mischief brings an action in tort, he brings it
against the person he believes has injured him, not against the
person best situated to reduce overall costs.