Chapter 4

The Economics of Contract Law I: The Elements of a Valid Contract

Key Points

•        Contract law provides the legal background for economic exchange by enforcing voluntary agreements.

•        Contracts cannot always provide for contingencies that might arise between the formation of the contract and the performance date. The economic theory of contract law says that courts should supply the missing terms in these incomplete contracts so as to maximize the gains from trade.

•        From a legal perspective, a valid contract includes three elements: offer, acceptance, and consideration. When offer and acceptance are present, the parties are said to have achieved a “meeting of the minds.”

•        Consideration is the return promise that makes a contract mutual. Consideration need not be a monetary payment; it can also be a voluntary surrender of a legal right. Under traditional contact law, courts only inquire into the presence of consideration, not its form or adequacy.

•        A contract is invalid if one or both of the parties is mentally incompetent, if one of the parties entered the contract under coercion or duress, if the contract involves a mutual mistake, or if the terms of the contract are unconscionable. These excuses are referred to as formation defenses.

•        The proper economic interpretation of coercion or duress is that it is about prevention of monopoly.

•        The doctrine of mistake concerns the rules for disclosure of private information prior to contracting. Economic theory shows that the court should not require disclosure of information that is socially valuable and was deliberately acquired. In contrast, the disclosure rule is irrelevant for efficiency when the information is purely distributive, or when it was casually acquired (regardless of its type).

•        The doctrine of unconscionability invalidates contracts whose terms appear to be grossly unfair at the time of performance. This rule is economically justifiable if the unfairness reflects a true defect in the formation of the contract (for example, fraud, coercion, or incompetence), but not if it merely reflects an unfavorable outcome for one of the parties. The problem is that it is not generally possible to distinguish these two types of situations after the fact.