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responses to the great categories of known coordination problems: agents' limited
rationality, opportunism, and risk" (Brousseau 1993, p.74).
In the first instance, contracts limit the consequences of the limited rationality of
economic agents by implementing "procedures and rules of conduct that free them from
the need to calculate or imagine what they need to do at each point in time." However,
transactions costs involved in writing and executing complete contracts covering all
foreseeable contingencies may prove insurmountable. Furthermore, in situations of
farreaching uncertainty, when it is no longer possible to even imagine all possible states
of the world, "completeness becomes impossible." Then it becomes necessary to resort
to authority, that is to contractually entrench a right, normally residual, of one of the
parties to "decide on the effective usage of the factors contributed by each" (Brousseau
1993, p.75).
To discourage opportunism when the future is foreseeable, the signatories will attempt to
deter it with specific incentives, such as the chosen modes of remuneration, so that each
party will have an interest in honoring his word. This is the spirit in which economic
theories of incentives and agency were developed. When uncertainty is far-reaching, it
becomes necessary to resort to two types of measures to complete these incentive
structures and render them useful under all assumptions. First, surveillance and
appropriate penalties are applied to discourage manifestations of opportunism. Second,
efficient procedures for negotiation and mediation, even arbitrage, are implemented to
settle disputes relative to the allocation of the organization's quasi-rent (Brousseau 1993,
p.75).

In concrete terms, corporate schedules of conditions illustrate these types of antagonistic
cooperation quite well. In matters of deadlines and costs, premiums are paid to, and
penalties imposed on, the business person. Additionally, a principal contractor, an expert
chosen by the principal but exercising a certain independence, will oversee the execution
of the contract and censure any failure to comply, whereby recourse to an ad hoc joint
committee or to an independent arbitrator remains possible. Finally, a contractually
defined procedure allows for constant adjustment of the contract to changing conditions,
especially the addition of supplementary tasks and the consequential revision of
deadlines and prices.
Finally, as to risk, many contracts, especially those governing labor relations, are
characterized by a division of losses and gains that account for the relative level of risk
aversion of one of the parties: for example, the employee vis-à-vis the employer.

These various mechanisms are both supplementary, as in the case of incentives and
insurance, and complementary, as with routines and authority "The complexity of
contracts springs from the formulation of these various types of solutions to coordination
problems" (Brousseau 1993, p.75). It thus becomes necessary to distinguish between
types of contractual relations.
First, memoranda of association or operation of what Hauriou once called institutions,
and what economists still call "institutions" (Williamson 1985) or "organizations" (M©nard
1995), such as firms, are treated separately. As demonstrated by the theory of
transaction costs - founded by Coase (1960) and developed into an entire school of
economic thought, notably represented by Williamson (1985) - while trade takes place in
markets, institutions strive to shield their internal dealings from market forces (Coase
1937, 1988; M©nard 1995). Nonetheless, the birth and even the operation of these
institutions is based on the meeting of wills: contracts of partnership, shareholder
agreements, even labor contracts. The forms assumed by cooperation and opportunism
differ here from those of their counterparts in contracts subject to the market, and also
from those between shareholders or between employers and employees. The system of
[16]
law for organization-contracts is necessarily affected (Didier 1999).

Second, and even for contracts set in the market, it has become conventional, following
[17]
Ian Macneil, to distinguish between transactional contracts and relational contracts.
The latter assume a contractual relationship of a fixed duration, and may consist of a
single long-term contract or a cooperation based on repeated contracts (Brownsword
1996, p.14). The phenomenon is all the more important because many transactional-type
contracts, such as sales contracts, acquire a relational dimension by their integration into
blanket contracts.

According to the economist Eric Brousseau, relational contracts require that future
economic uncertainty be accounted for, leading to an incompleteness in their content
that facilitates dynamic adjustment later. This incompleteness tends to reflect, on one
hand, the objective commonality of interests that are at least partly and durably shared
and, on the other hand, the distinctive confidence linked to habituation and the
participants' knowledge of each other (Brousseau 1996). The sociologist Siegwart
Lindenberg (1988) has demonstrated that solidarity resulting from the permanence and
the strength of the bonds between the parties tends to curtail the pursuit of maximum
benefits, creating a distinction between contractual relationships according to the degree
of solidarity.
Finally, the concept of antagonistic cooperation, and the view that the contract is a
means of organizing it, contrasts with the idyllic conception of a conflict-free world, in
which no party is able to impose on the other choices that are counter to its interests and
in which all trade necessarily benefits everyone. It also differs from the view of the
contract as a means of hostile domination and exploitation of one party by the other
(Brousseau 1996, p.340).

With regard to the law, we see that the modern idea of cooperation within the contract
lies somewhere between the classical model of entirely self-interested utility
maximization and pure altruism. Cooperation is not limited to honoring one's own part of
the bargain, or enabling the other party to do likewise (or obtaining the benefits of the
contract), nor does it imply accommodating every demand made by the other party.
Cooperation falls between the unconstrained pursuit of self-interest and the unqualified
subordination of said interest.
It is the essence of cooperation to give rise to a community of interests between the
parties. As already observed by Durkheim (1933), trade cannot be reduced to that brief
moment in time during which an object changes hands, it creates important relationships
between the parties within which their solidarity must not be disrupted. This community
of interest does not eliminate each individual's self-interest, but rather restricts its,
normally dominant, scope. In concrete terms, cooperation means that each party's
selfish behavior must be compatible with the interests of the contracting community. This
requirement, while congruent with a purely utilitarian view of the contract - at least for
contractual relations characterized by long duration and having a personal-relationship
aspect - also appears to have a certain inextricable moral side (Brownsword 1996, p.18),
as the interests of others are taken into consideration (Mazeaud 1999). It is also morality
that makes contractual justice the other final aim of the contract.

3.2 The contract is binding only if it is just

Alongside social-utility considerations, the requirement for justice and reliability (Trigeaud
1983) gives rise to a moral and legal obligation to honor the given word. Similarly,
considerations of justice and solidarity provide underpinnings for the need to cooperate,
which can also be linked to the contract's social utility.
We are speaking of contractual justice in a very specific sense, that of commutative
justice - borrowed from the classical distinction made by Aristotle and Saint Thomas
Aquinas between distributive and commutative justice. Application of commutative justice
leads to the pursuit of equality of benefits. Need we also seek equality of the parties
(Thibierge Gelfucci, 1997)?
3.2.1 The pursuit of equality of benefits
From a moral perspective, each party to trade must receive the equivalent of what she
surrenders. This is the essence of how contractual justice is understood today.
Considered in light of its principal function as an instrument for exchanging goods and
services, the contract, like liabilities in general, is subject to the principle of commutative
justice. It must not undermine the pre-existing equilibrium of endowments, implying that
each party must receive the objective equivalent of what he has ceded (Gounot 1912;
Gomaa 1968).
Georges Rouhette has further observed that, from a sociological perspective, the
contract is deemed a commutative act, "normally establishing reciprocal obligations" that
"must be equal for both sides" (Rouhette 1965, §85: 331 and the authors cited there).
Historically, James Gordley (1991, 1995) has shown how the moral philosophy of
Aristotle and Saint Thomas Aquinas, being founded on the principle of commutative
justice, was transmitted by the teachings of the late scholastics, especially Molina (1614),
Soto (1553), and Lessius (1608), who elaborated a doctrinal construction of the contract.
Despite a decline in the seventeenth and eighteenth centuries, these teachings inspired
the work of Grotius, Pufendorf (Laurent), Barbeyrac, and then it influenced the authors of
the Code Civil through Domat and Pothier.
On the moral, and especially the legal, level, commutative justice is reducible to the
relative equivalence of the benefits exchanged.
[18]
Regarding commutative justice, writers as early as Saint Thomas Aquinas emphasize
the subjective nature of the value of trade and the difficulty of assigning an objective
value to each benefit. We also find there the idea that, to establish strictly legal rules
governing contracts, the importance of the security of the contract agreement must be
unassailable on the basis of commutative justice, unless an imbalance is deemed to
surpass a certain threshold or there is fraud.

The difficulty associated with establishing a just price leads to acceptance of a certain
objective equivalence of benefits. The natural operation of the market does not allow a
"just" price for fungible goods to be spontaneously determined, as even Friedrich Hayek
(1976), a guru of liberalism, has recognized. Given the impossibility of objectively
determining a just price, only when a marked injustice is clearly proven will it be directly
addressed in order to reestablish the contractual balance.
What we must generally strive for is that each party find an interest in contracting. As we
have seen, this interest, this specific utility, is the very motor of the will. A priori, it is
necessary and sufficient that each party rationally believe that he is receiving more, or at
least something of greater value to him, than that which he is surrendering. Thus the
contract allows everyone to obtain more value, enriching everyone in the community. It
remains true, however, that the subjective appreciation of the values must not be
distorted. Therefore, emphasis must be placed on the role of the contractual procedure.
John Rawls has demonstrated that an equitable procedure transmits this quality to its
result, but only on condition of being rigorously implemented (Rawls 1999). He
vociferously argues the need for an effectively fair and equitable procedure (Audard
1988). To the extent that it is possible and necessary, commutative justice will be upheld
by ensuring the effective rectitude of the contractual procedure. This rectitude can be
realized only with true consent, the protection of which is thus the cornerstone of
procedural justice.
The rectitude of the contractual procedure thus assumes the absence of coerced
consent, but also extends to controlling behavior.
In France (Lyon-Caen 1946; Desgorces 1992; Tallon 1994; Le Tourneau 1995) as in
most countries (Deschenaux 1969; Loussouarn 1992; Romain 1998), the essential
instrument of control in positive law is good faith, in the sense of Treu und Glauben -
deriving from our Roman-Christian heritage (Ranieri 1998; Gauthier 1999) - and, to a
lesser extent, its converse, the abuse of right (Josserand 1939; Stijns 1990; Stoffel-
Munck 1999). Good faith is required first and foremost during the elaboration of the
contract (Jourdain 1992; Philippe 1992; Sacco 1992; Van Ommeslaghe 1992), to impose
fairness in the negotiation, before and after the tender is issued, for confidentiality, for
the obligation to neither deceive the other party nor take advantage of his relative
weakness, and, most of all, for honest disclosure. It is also required by article 1134,
paragraph 2, of the Code Civil, at the stage of performance of the contract (B©nabent
1992). This ensures that in its interpretation the spirit has precedence over the letter. It
completes the contractual obligations by referring to the legitimate expectations of the
signatories, revises these obligations even when the contract makes no such allowance,
and assumes the good faith of both the promissor and the promissee when
circumscribing its reach. Good faith is thus instrumental to the economic utility of the
contract (Jamet-le Gac, 1998).
Finally, when the conditions under which a contract are concluded suggest a failure of
the contractual procedure, especially in the case of adhesion contracts, the law will
intervene directly to eliminate clauses that were abusively imposed by one party on the
other.
Acceptance of an adhesion contract usually confirms the adherent's subordinate position.
Must we look past the equivalence of benefits to the equality of the parties?
3.2.2 The pursuit of equality of the parties
Inequality between the parties may result from a given signatory's consent being
compromised owing to error or fear, even to inexact or insufficient information. It may
also be ascertained by taking into consideration the inherent inequality of entire groups
of contracting parties, usually at a relative disadvantage because of constraints or
ignorance. These groups may include consumers or employees, for example. In this
situation it is legitimate to ensure special protection of the consent of these groups. Here
inequality of the parties is not distinct from inequality of the benefits, of which it is the
source.

In matters of distributive justice the issue is quite different. It consists of giving each their
due, in accordance with nature as some would have it, in accordance with sociological or
economic imperatives or the will of the government, others maintain. The goal here is no
longer to ensure a fair and equitable contractual procedure, but rather a result deemed
objectively just.
The evaluations required for distributive justice fall to positive law, in concrete terms to
authorities competent to judge these matters. The danger is that these authorities will
distort the natural unfolding of the contractual procedure in order to advance interests
they deem, more or less arbitrarily, more worthy of protection. This statist form of
distributive justice has been severely criticized, notably by Friedrich Hayek. In France,
[19]
the statut du fermage or, more recently, acts governing excessive indebtedness,
provide good examples.
At this point in our reflection we may consider that, in our current system of private right,
the contract governing the trade of onerous goods or services can be characterized as a
category in law, as a meeting of minds (which constitutes its essential subjective aspect),
and from the perspective of utility and justice (its objective goals). It thus remains a
meeting of minds destined to produce effects in law, the binding force of which depend
upon it conforming to objective law. On these grounds it must remain true to its objective
goal: utility and justice. The goal of social utility gives rise to the subordinate principles of
legal security and cooperation. The goal of contractual justice gives rise to the search for
equality of benefits by the respect of a contractual procedure that is effectively fair and
equitable.

[13]
Cf., for a rational conception of the relationship between utility and justice, Perelmann
(1968). On utility and justice for social cohesion, see Baranès and Frison-Roche, (1994).

[14]
Cf., for Japanese law, Jun Sunaga (1985), which presents the importance to Japanese law
of both the general theory of the contract and of nullities.

[15]
Le respect dÛ aux anticipations l©gitimes d'autrui, Pans, Bruylant and LGDJ, (1995).

[16]
Cf. Didier (1999), who defines the organization-contract as "a contract that, explicitly or
implicitly, defines a task, divides it into constituent parts and allocates them in one way or
another to the signatories."

[17]
Macneil (1974).

[18]
Aquinus, Somme th©ologique, qu.77, art.1, sol.
[19]
The statut du fermage is a law governing the relationship between farmers or
sharecroppers and landowners (trans.).
Notes
Chapter 6 was originally published as "Le contrat en tant qu'©change ©conomique," in
Revue d'Economie Industrielle (92, 2000).
1. It is also possible to contrast, on one hand, the genotype, a historical
construct based on the idea of free will that is rooted in the general
theory of the contract and of jurisprudence and, on the other hand, the
phenotype, a concrete actualization of contracts, i.e. the various
categories of actions recognized as contracts by substantive law, arising
from legal practice. For more on the application of these terms to
contracts, see Sacco (1999).
2. The word "cause" here is taken directly from the French, where it carries
the meaning of a necessary condition for a contract to be valid. It
pertains to the "why" of the obligation, i.e. in trade it accounts for the
agreed consideration, the existence and lawfulness of which must be
verified (trans.).
3. The heritage of statist positivism officially affirms the principle of
obedience to rules, especially to the law. It is also acknowledged,
however, that legal scholars, and particularly judges passing verdicts,
must concretely search for solutions that are just. Reconciling these two
principles is the goal of an intellectual process characteristic of judicial
thinking. Objective law is the upshot of that concrete quest for a solution
consonant with justice and social utility.(Cf. Ghestin 2002.)
4. Ancel objects to the traditional representation of contracts that
emphasize the binding force and the creation of obligations. To him,
beyond the creation of obligations, the contract has an essentially
normative effect.
5. Cf. Demogue (1934), according to whom agreement "between people
with conflicting interests is always of great significance." We prefer the
term "self-interest," since the interests are not necessarily opposed and,
as we shall see, a certain level of cooperation is always necessary.
6. Cf. Portalis (1844). Also, with respect to consumers, cf. Cornu (1973).
7. Cf. Ghestin (1982, pp. 4-5) for developments along the following lines,
"The contract is only an instrument sanctioned by the law because it
provides for socially useful operations"; "The contract is foremost an
indispensable instrument for individual projections"; and "The contract is
also the preferred instrument of individual freedom and responsibility."
8. Cf., especially, Mazeaud (1998); Flour and Aubert (1998).
9. For works previous to 1965, see Rouhette (1965, pp. 1-66). Cf. Coipel
(1999), who observes that, "while avoiding the excesses of the theory of
free will, traditional civil law doctrine continues to consider that the
meeting of minds is the reason why objective law recognizes the binding
force of the contract."
10. Even those who continue to see free will as the "principle," or the "rule,"
admit that "the will does not, as maintained by tenants of the pure theory
of free will, create rights that are simultaneously autonomous and prior,"
but that it "is only a delegated, and as such, regulated, authority," and
that "the law defines, in light of the social interest (which surely includes
the useful and the just) the extent and the specifics of the authority it
cedes to individuals." This is combined with the uncontested observation
that "the will remains an authority proper to each individual subject to the
law, and which he may use autonomously within in the framework laid
out by the law" (Flour and Aubert 1998, 128, p.77).
11. We first presented this analysis in two articles on "la notion de contrat," in
Revue Droits (1990, p.7) and D 1990, Chroniques p.147.Cf. a related
concept presented later in Terr©, Simler and Lequette (1993, 1999), in
these terms: "The contract derives its binding force, not from itself, but
from an external norm. The authority imputed to individual wills is not
inherent, but derived" (emphasis in the original).
12. Cf., for another illustration from the area of moral law, the necessary
distinction between freedom of the will or of reason and absolute
sovereignty, John Paul II (1993).
13. Cf., for a rational conception of the relationship between utility and justice,
Perelmann (1968). On utility and justice for social cohesion, see Baranès
and Frison-Roche, (1994).
14. Cf., for Japanese law, Jun Sunaga (1985), which presents the
importance to Japanese law of both the general theory of the contract
and of nullities.
15. Le respect dÛ aux anticipations l©gitimes d'autrui, Pans, Bruylant and
LGDJ, (1995).
16. Cf. Didier (1999), who defines the organization-contract as "a contract
that, explicitly or implicitly, defines a task, divides it into constituent parts
and allocates them in one way or another to the signatories."
17. Macneil (1974).
18. Aquinus, Somme th©ologique, qu.77, art.1, sol.
19. The statut du fermage is a law governing the relationship between
farmers or sharecroppers and landowners (trans.).
Contract Theory and Theories of
Chapter 7:

Contract Regulation
Alan Schwartz
1 Introduction
Discussions of regulation commonly focus on regulating particular industries, such as the
airline industry, or regulating types of firms, such as natural monopolies. These
discussions often concern the substance of the transactions that regulated firms make.
Few regulatory discussions focus on regulating contracts as such. As an example of the
distinction just drawn, a regulation discussion may ask what terms a regulated firm can
include in its contracts with customers; a discussion of contract regulation may ask what
terms the state should supply to firms to use in transactions with each other. In recent
years, law and economics scholars have begun to add to the question which contract
rule would be appropriate in particular cases the more abstract question regarding how
the state should regulate contracts between business firms as a general matter. Contract
regulation as a distinct area for scholarly inquiry is in its infancy, however.[1] This
chapter's goal is to introduce the subject and to indicate its importance in the hope that
[2]
more detailed treatments will follow.
An economic theory of contract regulation will have a substantive and an institutional
aspect.[3] The substantive aspect asks what the state should do. The institutional aspect
asks which legal institutions should perform the needed regulatory tasks. Given the
complexity of the subject and the necessary brevity of this chapter, any conclusions
respecting these aspects must be tentatively held. With this disclaimer and beginning
with substance, the state appears to do four things well: enforce contracts; police the
contracting process for fraud and duress; supply parties with common vocabularies to
use when writing contracts; and supply parties with governance modes for the conduct of
transactions or the resolution of disputes. It should do only these things, and not the
additional things that it sometimes attempts. An example of such an additional thing is
the attempt to implement an ex post fair solution in a particular case when both contract
and renegotiation have failed. Regarding the institutional aspect of the theory, only
courts can perform the first two tasks just listed; only legislatures can do the last; and the
third task commonly is and should be shared between the legislative and adjudicatory
[4]
institutions.

[1]
Early treatments of the topic are in Schwartz (1992a) and Tirole (1992). Citations to more
recent work will appear below.

[2]
Courts will not enforce contracts that create externalities, such as agreements to fix prices.
There also is considerable regulation of contracts between firms and consumers, commonly
rested on the ground of an imbalance in sophistication and resources between these parties.
Contracts that create externalities and consumer contracts are beyond the scope of this
chapter.

[3]
A competing theory of contract regulation that is pursued largely by legal scholars holds that
the state should enact contract rules that are fair and that promote community among
contracting parties. An extensive treatment of this theory is in Collins (1999). Implementing a
fairness theory is difficult when parties have the freedom to alter fair legal rules that do not
maximize their expected gains. This point is developed in a little more depth on p. 120 below.

[4]
Private associations often create rules to regulate transactions among the members and
between members and outside parties. These rules have the legal status of contracts made
among an association's membership. The question whether courts should treat these
contracts as they do ordinary market contracts is unsettled in the law and among
commentators, but there is a tendency for courts to enforce the contracts as written when the
rules are clear. An interesting study of the contrast between the adjudicatory practices of
courts and the adjudicatory practices of the institutions that private associations create is
Bernstein (1996).
2 The substantive function
Law and economics scholars have proposed five regulatory functions for inter-firm
contracts:
1. Enforcing a contract's verifiable terms: Enforcement is specific when the
state orders a party to perform the task or to make the transfer that the
contract directs. Enforcement also can be by a damage sanction, as
when the breaching party is required to pay to its contract partner the
profit that the partner would have earned had the contract been
performed.
2. Supplying contracting vocabularies: The state cannot enforce a contract
unless it knows what the contract says. A way to know this is to supply
parties with a stock of common meanings, and this is done in three ways.
First, the state can restrict parties to the dictionary meanings of the
words they use, unless a contract at issue explicitly defines a commonly
used word in an idiosyncratic manner. Second, a court when deciding
cases or a statute can define commonly used words or phrases in the
customary way. For example, the phrase "FOB Seller's place of
business" has long meant that the buyer is to bear the expense and risk
of transporting the goods once the seller delivers them to the carrier.
Commercial statutes now define the FOB phrase in this way. As a
consequence, if a contract uses the FOB phrase and the goods are
damaged or destroyed while in transit, the seller is entitled to the price
and the buyer bears the loss. Third, the state can adopt for purposes of
adjudication the meanings that private trade associations have
developed.[5]
3. Interpreting agreements: The adjudicator asks what the parties to the
contract before it meant by the words they used. It is the particular
meaning that controls. If particular parties meant by the phrase "FOB
Seller's place of business" that the buyer was to bear the expense of
shipping the goods, but not the risk of their damage in transit, then on
this interpretative theory if the goods were damaged, the seller could not
recover the price unless it shipped new goods.
4. Supplying default rules: The three principal types of default rules are[6]:
A. "Problem solving" default rules: The state supplies parties with
rules that maximize expected surplus. Awarding a party the gain
it would have made under the contract had the other party
performed is efficient with respect to the decision whether to
breach the contract or to perform it. Hence, a legal rule that
awards the gain if the contract is silent maximizes expected
surplus, at least with respect to the breach decision.
B. Information forcing default rules: The state supplies rules that
seldom would be optimal for the party with private information.
The effort of this party to contract out, it is hoped, will reveal
information that is needed for efficient trade or investment. For
example, suppose that one party can increase the probability of a
successful performance by increasing the amount of effort it
commits. This party could not choose the optimal effort level if it
is uninformed as to the value that a successful performance
would have. In this circumstance, a legal rule that would award
the passive but informed party no remedy if performance turned
out to be unsuccessful may induce this party to disclose its
valuation, thereby facilitating the taking of efficient precautions by
the uninformed performing party. (See Bebchuk and Shavell
1991, 1999.)
C. Fair default rules: The state supplies parties with rules that are
fair according to some normative conception. To illustrate, courts
and commentators often think that it is fair for the seller to supply
conforming goods when the buyer has paid a nontrivial price. The
law generally implies a warranty “ the seller must compensate
the buyer if the goods are defective “ and this is sometimes said
to follow from the law's commitment to fairness.
5. Regulating the contracting process: This function has several aspects:
A. Not enforcing contracts that were procured by fraud, such as
misrepresenting the quality of a performance that is to be
rendered.
B. Not enforcing modifications to contracts that were procured by
exploiting sunk cost investment.
C. Implementing the ex post efficient solution. As an example, when
circumstances have materially changed between the time the
contract was made and is to be performed, such that
enforcement would benefit one of the parties but make society
worse off on net, commentators urge courts not to enforce, and
some courts heed this advice.
D. Implementing the ex post fair solution. Continuing with the
example, if performance would give one party a windfall gain,
commentators urge courts to reduce the gain to a fair level, and
courts occasionally attempt to do this.

[5]
There are fewer such generally accepted, privately created meanings than had been
supposed. See Bernstein (1999).

[6]
A complete taxonomy of default rule types is found in Schwartz (1994).
3 The institutional aspect of contract regulation
3.1 What is possible?

In common law countries, courts today perform all five regulatory functions. The contract
parts of Civil Law Codes tend to be written on a fairly high level of abstraction because
the Codes regulate many different transaction types. This confers considerable
discretion on courts, and it would be interesting to test the hypothesis that courts in Civil
Law countries also perform these five functions. In any event, legislatures cannot
perform functions (1) enforcement, (3) interpreting agreements, and much of (5)
regulating the contracting process “ because these are adjudicatory functions. To
enforce a contract (function (1)) or to find what particular parties meant by the words they
used (function (3)) requires case-by-case inquiries. Legislatures supply rules. Function
(2), the supplying of contracting vocabularies, is shared between courts and legislatures.
A statute cannot define every word or phrase that parties into the indefinite future may
use in the contracts they will write. Courts, on the other hand, must give legal effect to
the words in a contract; and the definitions they develop in the course of doing this often
are held to specify the legally operative meanings when the same words appear in later
contracts. Hence, courts necessarily play a residual role in supplying contracting
vocabularies, even when the legislature has enacted a vocabulary itself.[7] The policing
function (function (5)) also can be shared. For example, the legislature can direct courts
to ignore windfalls when deciding cases or it can create standards by which courts must
assess whether fraud has been committed. Legislatures seldom seem to perform these
tasks, so the policing function (5) is today performed exclusively by courts.
This is not to say that courts can perform every aspect of this function well. Thus, a court
seldom would have the information to implement the ex post efficient solution (function
(5C)). This is because courts receive information only from the parties. If parties are
symmetrically informed ex post, however, they will bargain to the efficient solution, so
that courts will not see the case. If courts see only cases in which information is
asymmetric, then they will lack the information to implement the efficient solution. As an
illustration, let it be efficient to breach a particular contract because the seller's cost to
perform would exceed the buyer's valuation, but suppose that the seller's cost is neither
observable nor verifiable. The parties, suppose, cannot agree on a price for breach, the
seller refuses to perform and the buyer sues. The court cannot know whether breach
would be efficient or not; and since the seller's refusal to perform is itself verifiable, the
court can only enforce the contract.[8]
A court also could not perform function (5D), implementing the ex post fair solution,
because courts act subject to the institutional constraint that they decide according to
either pre-existing legal or moral principles. Any division of ex post gains between two
business firms would be arbitrary; that is, there is no legal or distributional principle that
would permit a court to decide whether it is fair to give the plaintiff or the defendant
particular shares. Since legislatures cannot perform functions (5C) and (5D) “
implementing ex post efficient or fair solutions “ these functions should not be performed
for institutional reasons; that is, the limited competencies of legal institutions imply that
the state should not alter the performances that contracts require to achieve either ex
post efficiency or ex post fairness.

Before asking which of the remaining regulatory functions should be performed and by
whom, it is worth noting that the two interpretative functions sometimes will be
inconsistent. Parties will be less inclined to use judicially or statutorily defined phrases if
courts will permit a party who turns out to suffer from a rigid application of a definition to
introduce evidence that in pre-contract conversations the parties indicated that a rigid
application was not their intention. Rather, parties will more frequently themselves define
the words they use in the contracts they write, an effort that is more costly but more
predictable than relying on pre-existing but malleable definitions. On the other hand, a
rigid application of pre-existing definitions may impose obligations that some parties did
not intend to assume. Thus, there is a tension between the "vocabulary-supplying" (2)
and the "meaning-finding" (3) contract interpretation functions. (See Scott 2000.)

3.2 What is desirable?
The virtues of contract enforcement need not be stressed but there is a point to be made
about enforcement modes. A contract can be "enforced" by awarding damages to the
injured party or by specifically enforcing the actions that the contract requires. Solutions
to the problem of inducing efficient relation-specific investment commonly involve the use
of contracts that condition on verifiable sub-sets of information, and that require specific
[9]
enforcement of the transfers that the contracts direct. A practical objection to these
solutions is that contract enforcement takes time, but subject to this difficulty European
laws that make specific performance relatively easy to get are preferable to common law
rules that make it difficult. Also, the desirability of preventing fraud and exploitation
(functions (5A) and (5B)) is obvious.
Turning to functions (2) and (3), the vocabulary supplying function is non-controversial
when it is stated in isolation, but becomes controversial when the tension between it and
the interpreting agreements function of (3) is made explicit. This is because the two
functions partly derive from distinct normative goals. The vocabulary-supplying function
is efficient. Providing a contractual vocabulary is a public good. When parties have a
common vocabulary, they can know what they are agreeing to and what will be enforced.
The costs of supplying standardized contract terms will often exceed the gains for
particular contracting parties. Also, a party who would be disappointed in the deal if it
were enforced has an incentive to cheat ex post, by claiming that the parties made a
different deal “ that they intended the words they used to have a meaning particular to
them. In sum, private parties will create sub-optimal sets of vocabularies, and a common
contractual vocabulary could not survive unless it was made mandatory by judicial
enforcement of the statutory or case-created meanings.
The meaning-finding function of interpretation follows from autonomy norms. Under
these norms, a person cannot be made to take, or to be prevented from taking, lawful
actions without his informed, voluntary consent. Hence, when a contract is sought to be
enforced against a person, that person must be permitted to offer evidence as to the
actual meaning that the parties intended the contract's words to have. Evidence relevant
to this question can be found in what was said and done before the contract was made,
from the customs of the industry or trade in which the parties exist, and from any conduct
ex post that can shed light on what the written words meant to the people who actually
used them. When a court permits such evidence to be introduced, it is said to engage in
contextual interpretation, and when a court refuses to consider such evidence in favor of
applying standard meanings in standard ways, it is said to engage in acontextual
interpretation. Courts in the United States vacillate between these two modes of
interpretation, but it is difficult to discern a principle underlying the decisions.[10]

Resolving the conflict between the vocabulary-supplying function (2) and the interpreting-
agreements function (3) is beyond the scope of a short chapter such as this, but a
remark is in order. Autonomy norms are strongest when a contract is sought to be
enforced against an individual, and lose force as the defendants become companies.
Hence, a normative theory of contract regulation whose subject is transactions among
firms should prefer courts to abandon function (3) in favor of function (2). A less definitive
solution is to let adjudicatory methods be default rules, so that courts which are using
acontextual interpretation would switch to a more literal enforcement mode when the
parties' contract so requested.[11] It is unclear how this suggestion would work in practice.

Function (3C) “ supplying fair default rules “ arguably should not be performed by any
state institution. This is because the set of surplus maximizing rules and the set of fair
rules, by any normative criterion, likely are disjoint. Business parties will contract out of
"fair but inefficient" default rules. As a consequence, while a decision-maker may want to
resolve choices among legal rules by fairness norms when all of the feasible rules are on
the Pareto frontier, the supplying of fair default rules independently of their efficiency can
be wasted effort for the rule creators and will impose unnecessary contracting costs on
parties.

The remaining functions to consider are (5B) and (5C), supplying parties with problem-
solving and information-forcing default rules. The problem-solving task can be divided
into two sub-functions: (a) Providing modes of governance, such as a corporate form or
a bankruptcy scheme; (b) Solving particular problems, such as the scope of the seller's
obligation to supply product quality. The rationale for providing both functions is the
same: supplying a governance mode or a solution to a complex but commonly recurring
problem will often cost particular parties more than the gains that the mode or form could
yield to them. A court could not supply a governance mode because courts exist to
decide disputes, not create business-regulating codes. In addition, parties to a litigation
will supply courts with information that may help to win a case, but will not supply
information necessary to create an entire governance mode. Courts sometimes can
supply rules to solve more particular problems. Thus, courts never but legislatures can
and sometimes do supply parties with default governance modes, and both institutions
sometimes attempt to solve particular problems.

The public goods aspect of supplying solutions to problems implies that problem-solving
default rules should be created, but there is a distinction between supplying governance
modes or dispute resolution schemes and the solving of particular problems. The former
sets of solutions can be highly general, and applicable to a wide range of commercial
behaviors. Thus, many different types of business activity can be conducted in the
corporate form. In contrast, attempting to solve particular problems will often founder on
the heterogeneity of large, modern economies. The state creates rules either through
adjudication, which is expensive and time consuming, or by legislation, which also is
costly and takes time. Consequently, state solutions to problems will not be cost justified
unless the problems can be approached in a general way. Though commercial problems
often are general “ how to induce efficient sunk cost investment, for example “ the
solutions to these problems usually are specific. Contracts that may induce efficient
investment thus condition on verifiable sets of information related to the costs and
valuations of the parties to these contracts, and require transfers that are efficacious only
in connection with these particular costs and valuations. (See, e.g., Hermalin and Katz
1993; Edlin and Reichelstein 1996; Maskin and Tirole 1999.) Hence, a set of state
supplied default rules that attempted to induce efficient investment likely would approach
in size the set of private contracts. This would not reduce social costs.
The disjunction between the need for state-supplied default rules to be general in form
and the need for particularist solutions to commercial problems has led to dramatic
legislative failures. As an example, the Uniform Commercial Code provides that, when
the contract is silent, sellers assume all risks associated with product quality, as a
consequence of which the sellers must pay compensation for any loss a buyer suffers
from a non-compliant product. Sellers of products that may cause substantial losses,
especially when the products are complex, always contract out of this default rule. The
sellers then specify the precise quality obligation and damage risk they are willing to
assume, and these specifications differ across products. Thus, the Code warranty
sections impose contracting costs that are large in the aggregate but create no offsetting
benefits. This story can be retold for other rules, and its lesson is that there are few
commercial problems whose solutions are sufficiently general to justify the supply of
problem-solving default rules by the state.

To the difficulty of heterogeneity must be added the related difficulty of asymmetric
information. Parties will contract out of default rules that condition on unverifiable
information because such rules would produce moral hazard. The pervasiveness of the
verifiability problem thus seriously constrains the regulatory function of supplying default
rules to commercial parties. And in sum, the related difficulties of heterogeneity and
asymmetric information suggest that legislatures seldom should attempt to create
contract law rules that have the purpose of maximizing surplus for parties who accept
[12]
those rules. These two difficulties do not plague to the same degree the function of
creating default modes of economic organization, such as the standard partnership or
business corporation.

The function of supplying information-forcing default rules (4C) also suffers from the
difficulties of heterogeneity and asymmetric information. The goal here is to supply rules
that will induce separating equilibria, but it will be difficult for courts or legislatures to
obtain the knowledge needed for inducing separation when the economic actors function
in highly heterogenous economies, and there is considerable private information. (See
Adler 1999.) Analyses of third-degree price discrimination also suggest that separating
agents is a context-specific task. While the issue is still under debate, one conclusion is
clear: writing useful problem-solving or information-forcing default rules is a harder task
than was originally thought.

[7]
As an illustration, the American Uniform Commercial Code creates a set of default rules to
regulate sales transactions. These rules use terms that are derived from commercial practice,
but the Code defines them explicitly. Hence, parties who today use a statutorily defined term
are held to intend the statutory meaning. The original Code's list of terms is not exhaustive,
however, so courts are continually defining new terms, some of which have been incorporated
into Code revisions. This process continues.

[8]
In addition to this theoretical difficulty, parties seldom would want a court to implement an ex
post efficient solution in the rare cases when it could because commercial agents need
prompt answers. Litigations take a long time, so that any otherwise efficient solution usually
would be outmoded before it could be devised. Perhaps for the reasons given in the text and
in this note, courts seldom attempt to implement ex post efficient outcomes. There are
examples of these attempts in connection with long-term contracts.

[9]
For a review, see Schwartz (1998).

[10]
For a discussion, see Posner (1998).

[11]
This is suggested in Bernstein (1996).

[12]
Courts recognize these difficulties implicitly, and tend in asymmetric information
environments to enforce only those terms that condition on verifiable information; they do not
try to create new rules. (See Schwartz 1992b.)
4 Conclusion
Jean Tirole has written: "The challenge for the economist is to develop a theory of the
optimal judiciary scope of intervention (the class of problems over which the courts have
discretion) and instruments (the menu of choices they face)." The need actually is
broader than this - to develop a theory of what the state in general should do regarding
contracts and then to specify which legal institutions should perform which substantively
desirable functions. This chapter has sketched the possible functions the state can
perform and made a few preliminary remarks about which of these functions are possible
and desirable to perform. Courts can and should enforce the verifiable terms of contracts,
police the contracting process to deter fraud and duress, and help to supply firms with a
common vocabulary to use when making contracts. Legislatures should also supply
vocabularies and create default modes of economic organization. At this early stage in
our understanding of these issues, these are the most defensible tasks and institutional
roles that it is possible to do and to play.

Many additional topics remain to be explored. These include whether parties should be
permitted to choose the interpretative practices that courts will apply to their agreements;
whether courts should emulate the contracting practices of private associations; whether
contextual interpretation helps parties to solve their own problems or hinders parties; and
the appropriate level of generality that legal default rules should take. Contract theory
regulation thus has an interesting research program.
Notes
Chapter 7 was originally published as "Contract Theory and Theories of Contract
Regulation," in Revue d'Economie Industrielle (92, 2000).
1. Early treatments of the topic are in Schwartz (1992a) and Tirole (1992).
Citations to more recent work will appear below.
2. Courts will not enforce contracts that create externalities, such as
agreements to fix prices. There also is considerable regulation of
contracts between firms and consumers, commonly rested on the ground
of an imbalance in sophistication and resources between these parties.
Contracts that create externalities and consumer contracts are beyond
the scope of this chapter.
3. A competing theory of contract regulation that is pursued largely by legal
scholars holds that the state should enact contract rules that are fair and
that promote community among contracting parties. An extensive
treatment of this theory is in Collins (1999). Implementing a fairness
theory is difficult when parties have the freedom to alter fair legal rules
that do not maximize their expected gains. This point is developed in a
little more depth on p. 120 below.
4. Private associations often create rules to regulate transactions among
the members and between members and outside parties. These rules
have the legal status of contracts made among an association's
membership. The question whether courts should treat these contracts
as they do ordinary market contracts is unsettled in the law and among
commentators, but there is a tendency for courts to enforce the contracts
as written when the rules are clear. An interesting study of the contrast
between the adjudicatory practices of courts and the adjudicatory
practices of the institutions that private associations create is Bernstein
(1996).
5. There are fewer such generally accepted, privately created meanings
than had been supposed. See Bernstein (1999).
6. A complete taxonomy of default rule types is found in Schwartz (1994).
7. As an illustration, the American Uniform Commercial Code creates a set
of default rules to regulate sales transactions. These rules use terms that
are derived from commercial practice, but the Code defines them
explicitly. Hence, parties who today use a statutorily defined term are
held to intend the statutory meaning. The original Code's list of terms is
not exhaustive, however, so courts are continually defining new terms,
some of which have been incorporated into Code revisions. This process
continues.
8. In addition to this theoretical difficulty, parties seldom would want a court
to implement an ex post efficient solution in the rare cases when it could
because commercial agents need prompt answers. Litigations take a
long time, so that any otherwise efficient solution usually would be
outmoded before it could be devised. Perhaps for the reasons given in
the text and in this note, courts seldom attempt to implement ex post
efficient outcomes. There are examples of these attempts in connection
with long-term contracts.
9. For a review, see Schwartz (1998).
10. For a discussion, see Posner (1998).
11. This is suggested in Bernstein (1996).
12. Courts recognize these difficulties implicitly, and tend in asymmetric
information environments to enforce only those terms that condition on
verifiable information; they do not try to create new rules. (See Schwartz
1992b.)
Economic Reasoning and The Framing
Chapter 8:

of Contract Law-Sale of an Asset of Uncertain
Value
Victor P. Goldberg
1 Introduction
I have been teaching the basic Contract Law course for a few years now, and have been
struck by the courts' frequent indifference to economic context. It is not so much a matter
of the court arriving at the wrong answer as it is the court's asking the wrong questions.
In too many instances the court frames the problem in a way which obscures the
essential features of the transaction. A little - very little - sensitivity to some elementary
economic concepts can go a long way toward illuminating a number of problem areas.
In this chapter, I want to illustrate this proposition by engaging in a close analysis of two
American court decisions often featured in contracts casebooks: Mattei v. Hopper[1] and
[2]
Bloor v. Falstaff Brewing Corp. This is a piece of a larger project (Goldberg 2002).The
other chapters in Part III have emphasized the manner in which contracting parties
allocate to one party the discretion to respond to changed circumstances, but constrain
that flexibility by conveying the counterparty's reliance interest. These decisions raise a
different problem: production and transfer of information regarding the sale of an asset of
uncertain value. Had the courts chosen to frame the problems this way, disposition of
both cases would have been straightforward. The court's decision in the former case
remains unaffected, but the implications for similar cases would be quite different. The
decision in the latter case is simply wrong.
There are a large number of institutional responses to the information problem. I will
focus on two which explain nicely the structure of the contracts in controversy. If, for
example, the buyer is the most efficient provider of certain pre-sale information, then the
parties might agree to give the buyer the option to buy while it collects further information.
Such a lock-up provision was at the core of Mattei v. Hopper. Or, if the buyer fears that it
is buying a "lemon," the seller could alleviate that fear by making some of the
compensation contingent upon the future performance of the asset. Such was the case
in Bloor v. Falstaff, although neither the court nor the litigators figured it out.

[1]
51 Cal.2d 119; 330 P.2d 625; 1958 Cal.LEXIS 213.

[2]
601 F.2d 609 (2d Cir.1979).
2 Mattei v. Hopper
Peter Mattei, a real-estate developer, entered into an agreement with Amelia Hopper to
purchase a tract of land so that he might construct a shopping center on a tract adjacent
[3]
to her land. The purchase price was $57,500 and Mattei was given 120 days to
"examine the title and consummate the purchase." He gave a $1,000 deposit to the real-
estate agent. The agreement was evidenced on a form supplied by the real-estate agent,
commonly known as a deposit receipt. The concluding paragraph of the deposit receipt
provided: "Subject to Coldwell Banker & Company obtaining leases satisfactory to the
purchaser." Before the 120-day period had run, Ms Hopper notified him that she would
not sell her land under the agreed-upon terms. He then informed her that satisfactory
leases had been obtained and tendered the balance of the purchase price. She refused;
he sued.

Her defense was that the satisfaction clause rendered the promise illusory. He had
promised to purchase only if he were satisfied, which, she argued, committed him to
nothing at all. There was no consideration and, therefore, no contract. The trial court
agreed. On appeal, the California Supreme Court reversed. If there were no limits on
Mattei's right to claim dissatisfaction, then there would be no contract. However, the
court held, Mattei was not so free. His invocation of the clause was subject to a good-
faith limitation.[4] By binding himself to go forward unless he could in good faith claim
dissatisfaction with the leases, Mattei provided the requisite consideration.
Real-estate transactions routinely make the transaction contingent upon information that
would be developed after the contract has been entered into. For example, in Omni
Group, Inc.v. Seattle-First National Bank,[5] another casebook favorite, the purchaser's
obligation depended on its satisfaction with an engineer's and architect's feasibility
[6]
report. In a number of disputes, the seller has argued that the conditions rendered the
promise illusory. And, as in Mattei, the courts have often rescued the deal by reading a
good-faith requirement into the promisor's satisfaction condition. Indeed, in some
instances they have done so in the face of contract language making the satisfaction a
[7]
matter of the buyer's "sole judgment and discretion."

Had the deal been structured a bit differently, there would have been no question of
consideration or good faith. The transaction could have been conditional on the
satisfaction of some independent third party, perhaps a lender or appraiser.[8] Mattei
could have taken an option on Hopper's land, for, say $1,000.The $1,000 would provide
consideration, hence there would be a contract, and Mattei could choose not to exercise
[9]
the option for any reason at all. Or Mattei could have made the $1,000 deposit non-
refundable. If that were an exclusive remedy, then the situation would be identical to the
option. There are two differences between the actual transaction and the $1,000 option.
One is the language describing the conditions that would influence Mattei's decision to
exercise the option. The other is the price. Hopper granted Mattei a four-month option
with an exercise price of $57,500 and a price of $0.Is this by itself sufficient to find
consideration, without resort to an implied duty to exercise his discretion in good faith?

The answer should be "Yes". Properly understood, the buyer's promise is valuable to the
seller, even if the buyer reserved the right not to go through with the deal if he so chose.
The agreement facilitates the production of information which can result in an enhanced
price for the seller's asset (Goldberg 1997).The apparent paradox of the sale of a
valuable option at a price of zero disappears upon recognition that the agreement is in
reality two intertwined transactions. In the first, the buyer purchases an option: he pays a
positive price to induce the seller to take the property off the market for a period of time.
In the second, the seller pays the buyer to develop some information about the
commercial prospects of the property. The seller believes that if the buyer had better
information, the sales price would be higher and that the buyer is the most cost effective
producer of that information. The netting of these two transactions could easily result in
the buyer paying nothing. Indeed, we need not stop at nothing. The seller could agree to
a negative price - the seller could pay the potential buyer up front or could agree to pay if
the deal falls through, either because it or the buyer decided not to consummate the
transaction.
The first half of the transaction - the option - is straightforward. The second - the lock-up
- is less so. The seller faces two information problems. First, there is a possible
information asymmetry with potential buyers fearing that the seller might take advantage
of the information she developed while the property was in her possession. Potential
buyers might discount their bid because of their fear that they might be buying a lemon
(Akerlof 1970).The seller has a number of devices, none of them free, for providing
quality assurance to purchasers. She might collect and publish information; she might
provide specific representations and warranties; she might make some of the sale price
contingent on the future earnings from the property (Gilson 1984).Or she might choose
to subsidize the production of information by one (or possibly more) potential buyer(s).
Straight cash payments would not be the best way of accomplishing this, but let us put
that aside for the moment. The simple point is that if the new information sufficiently
enhanced the seller's credibility, the seller could receive more from the enhanced sale
price of the land than it would lose from the payment to the prospective buyer. That is,
the exercise price of the option is higher because the buyer and seller both know that if
the property turns out to be less desirable, the buyer can walk away.

Second, given that the value of the land is uncertain and information about the value is
costly to produce, the owner might not be in the best position to develop the information.
The information might be on general matters of interest to most potential buyers, for
example, soil conditions, traffic patterns, or the availability of potential anchor tenants. Or
the information might be more specific to particular potential purchasers, for example,
financing conditions or the availability of particular anchor tenants closely linked with a
specific potential purchaser. If the buyer is the most efficient producer of this information,
then, again, the seller might be willing to pay some of the buyer's expenses if doing so
would increase the sale price by enough.

Why might sellers choose to make the payment indirectly, linking it to the option to buy,
rather than simply paying cash? If the buyer's information costs are high, then the buyer
must consider the real possibility that the expenditures would be for nought if the seller
subsequently refused to sell. Even if the information were valuable only to the first buyer
(say, the architectural plans and economic feasibility study for a unique structure), the
buyer might be reluctant to incur the costs if the seller could sell to someone else or
could take advantage of the buyer's sunk cost when negotiating the sale price. Potential
buyers will balance the expected costs of additional information production against the
expected benefits. If the seller can subsidize information production by certain buyers or
otherwise increase the likelihood that the buyer would reap the rewards of its investment,
it can influence the quantity and quality of the information produced. In particular, the
seller must decide whether it prefers a large number of potential buyers each spending a
small amount on information or a small number (perhaps one) studying the asset more
intensively.

The seller might be able to use some of the information developed by the prospective
buyer to its advantage in dealing with subsequent potential purchasers - in effect free-
riding on the first prospective buyer's efforts. If, for example, Mattei had identified some
retailers with a strong interest in being anchor tenants, Ms Hopper or a third party could
approach those retailers directly. Later buyers could either use the information or draw
some inferences about the content of the information from the first party's behavior. The
potential purchaser must fear that others would free ride upon the information it
produced, and without assurances or subsidies would likely produce too little information.
Again, by providing those assurances or subsidies, the seller can influence the buyer's
production of information.

Direct cash payments to the buyer would, in general, not work. Such payments would
create two obvious moral-hazard problems. If the seller pays for information while buyers
determine how much to produce, the buyers will not bear the financial responsibility for
their investment decisions; they will have an incentive to over-spend. Moreover, the
buyers would be reluctant to share the information with others; they would also be more
inclined to tilt their information production toward information that would be of more value
to them than to other possible buyers. A seller might be able to police this behavior by
monitoring or by separating the production of information from the use of it (perhaps by
insisting upon fire walls or by hiring information specialists who cannot benefit directly
from the information generated).But if the potential buyers are indeed the best producers
of information, the separation of ownership from use can be costly.

The lock-up provides an opportunity for a buyer to develop the information secure in the
knowledge that if the information is positive, he will be able to reap the rewards. Mattei is
free to explore the matter for 120 days and, if satisfied, he can buy Hopper's property for
$57,500.The option means that if the value exceeds the strike price, all the benefits go to
the buyer. If the information is negative, the buyer can refuse to exercise the option. It
will, however, be out of pocket the information costs. Thus, the first moral-hazard
problem is resolved. The seller bears some of the information cost in the negotiated
exercise price, but the buyer bears all the direct costs of information production and,
therefore, has the incentive to economize.[10] The cost of the option to the buyer is its
expected expenditure on information. True, he does not promise to spend a dime on
information production or to act upon any information produced. The seller's reward
comes not from the buyer's explicit promise to produce information, but from the reward
structure established by the bargain. This moral-hazard problem explains why the net
price of the two transactions often ends up being zero. Sellers do not want to over-pay
for the information. In effect, the net price of zero sets a limit on the amount of effort the
buyer should put into the search.

The satisfaction clause suggests an all-or-nothing outcome. Either the buyer is satisfied
and the option exercised, or he is not and the option expires. Good faith is obviously
irrelevant in the former case; what about the latter? If we unpack that, it becomes clear
that good faith adds almost nothing. Suppose that in the 120-day period after Mattei's
deposit, the real estate market crashed and Mattei then chose not to exercise his option.
One could argue that the non-exercise of the option because of adverse market
conditions was bad faith, but that is a flimsy argument. After all, if the value of the
property falls, the quality of the leases (that is, their economic value) falls too. Unless we
insist that the contract meant that Mattei must be satisfied with the leases with rents
determined on the date he and Hopper entered into their agreement, Mattei should be
able to take into account changed market conditions when deciding whether or not to go
forward with the sale.

If the information were only moderately disappointing, the buyer could make an
alternative offer (perhaps waiting for the official expiration of the option).Nothing in the
nature of the option precludes a subsequent sale to Mattei (or another buyer) at a new
price below the exercise price. Of course, if Mattei's research gives him an informational
advantage, he could exploit this advantage by acting strategically. Suppose that he finds
the property worth a bit more than the exercise price. He could feign disappointment,
telling Hopper that he cannot exercise his option, but that he would be willing to
purchase the property at a new, lower price. Such strategic behavior might be less than
admirable, but it is hard to imagine that it could trigger good-faith concerns. The
questionable behavior occurs only in the renegotiation of the contract and the seller is
hardly without recourse. If the seller were suspicious, after all, she maintains the right to
refuse to sell to this buyer at any price below the initial contract price; she could shop the
second offer to other potential buyers who might be able to draw some inferences from
the original buyer's behavior.

In both cases, Mattei's decision not to go forward with the purchase would be the result
of his having already performed his part of the agreement; that is, he would have
acquired information on the value of the leases and acted upon the information by
choosing not to exercise his option. What if Mattei had produced no information at all? If
a better offer came along, the fact that Mattei had not yet spent anything searching for
information about the parcel should not destroy Mattei's option. Surely, the buyer had
bought the option to act on good news and the external offer is simply a manifestation of
that good news. The only concern would be that Mattei for some reason wanted the
property off the market and had no intention to either acquire information or consummate
the deal. Perhaps Mattei entered into similar agreements on a number of parcels but
intended to purchase only one. Even then, there was some likelihood that he would
choose this particular parcel, so it would be unreasonable to characterize this as merely
an attempt to put a parcel off the market for a period of time. It is difficult to imagine a
plausible scenario in which a buyer would simply tie up a property with no intention of
moving forward.[11] Yet that class of cases is the only one in which even a plausible case
can be made for holding that the buyer's discretion undercut consideration. And then the
legal response should not be "no contract"; rather, if anything, there should be a claim by
the seller for fraud.

The foregoing is a somewhat convoluted path to a simple point. The seller and buyer
both benefitted from the agreement, regardless of whether the buyer's discretion was
limited by good faith. It was limited by a more significant, practical constraint, self-interest.
The lock-up benefitted Hopper by increasing both the probability that the land would be
sold by a certain date and the expected price of the asset. It benefitted Mattei by giving
him a pure option and by giving him assurance that if he chose to expend resources on
evaluating the property (as he most likely would, else why bother?), then he could
purchase the land at the pre-set price if the information turned out positive. There is a
bargain; both sides benefit and the seller suffers a detriment (her property is temporarily
tied up).The buyer does not directly suffer a detriment, since he has the discretion to do
nothing, even though exercising that discretion would almost certainly not be in the
buyer's interest.

The contract could have left Mattei's decision, to his sole discretion, thereby making it a
pure option. What purpose could be served by adding the satisfactory-lease clause (or
satisfaction with engineering studies, approval of sub-division maps, etc.)? Such clauses
can be viewed as a device for conveying information to the seller about the buyer's
intentions. If the seller knows that the buyer's intended use is a shopping center, that
information will affect the strike price of the option. The clause's effect is similar to a
buyer's representation. Suppose, however, that Mattei had no intention of building a
shopping center and that his real intent was to drill for oil (and that the land was much
more valuable in that use). It could be argued that this deception should be actionable,
perhaps as fraud, misrepresentation, or a breach of the implied covenant of good faith.
But that is a far cry from concluding that there was no contract.

The option terminology suggests that the discretion be unbounded, but that need not be
the case. The parties can, if they so choose, limit that discretion in various dimensions.
They could even contract into a good-faith standard, however nebulous that might be.
Indeed, the default rule could be that the discretion is constrained by good faith so that
the parties would have to contract around it. My concern is twofold: (a) by making the
buyer's good faith a necessary element of the contract (else no consideration), the
doctrine needlessly raises good faith from a default rule to a mandatory rule, waivable
only by concocting an alternative basis for enforceability (cash consideration or, that
great wild card, reliance); and (b) absent an understanding of the context, good faith
does not provide a coherent constraint on the buyer's discretion.

[3]
Mattei v. Hopper, 51 Cal.2d 119; 330 P.2d 625; 1958 Cal.LEXIS 213.

[4]
Mattei could have been held to an objective (reasonable person) standard or a subjective
(good faith) standard; the court chose the latter because of the difficulties in determining
objectively the qualities of a satisfactory lease.

[5]
32 Wash.App.22; 645 P.2d 727; 1982 Wash.App.LEXIS 2819.

[6]
"This transaction is subject to purchaser receiving an engineer's and architect's feasibility
report prepared by an engineer and architect of the purchaser's choice. Purchaser agrees to
pay all costs of said report. If said report is satisfactory to purchaser, purchaser shall so notify
seller in writing within fifteen (15) days of seller's acceptance of this offer. If no such notice is
sent to seller, this transaction shall be considered null and void" at 3-4.See also Horizon
Corporation v. Westcor, Inc., 142 Ariz. 129; 688 P.2d 1021; 1984 Ariz. App.LEXIS 461
(approval of zoning, leases of major retail tenants, and financing); Rodriguez v. Barnett, 52
Cal.2d 154, 338 P.2d 907 (1959) (satisfaction with and approval of a subdivision map);
Larwin-Southern Cal, Inc. v. J.G.B. Investment Company, Inc., et al., 101 Cal. App.3d 626,
162 Cal. Rptr. 52 (1979) (buyer's approval of a preliminary title report, its approval of its
engineering report as to soil conditions, dirt balance, drainage, utility requirements and its
economic feasibility study, and the approval of a tentative map).

[7]
Horizon Corporation v. Westcor, Inc., at 134. See also Resource Management Company v.
Weston Ranch and Livestock Company Inc., 706 P.2d 1028. 1034; 1985 Utah LEXIS 884; 86
Oil & Gas Rep.631.

[8]
The only good-faith issue would be whether the third party's independence had been
compromised by a side deal with the buyer.

[9]
If the contract gives a false recital of the payment of nominal consideration ("in
consideration of buyer's payment of $20, "), the majority position in the United States is that
there is no contract. See Lewis v. Fletcher, 101 Idaho 530 for majority position and Smith v.
Wheeler, 210 S.E.2d 702 for the minority position.

[10]
One line of argument, developed in French and McCormick (1984), suggests that sellers
invariably bear all the costs of pre-sale information production. As I show elsewhere
(Goldberg 1997, pp.475-81), they over-state the case. Nonetheless, it is correct to say that
sellers will often find it in their interest to help potential buyers economize on their pre-sale
information expenditures.

[11]
For a case in which the plaintiff alleged that the defendant entered into an option-like
agreement with no intention of going forward, see Locke v. Warner Bros., 57 Cal.App.4th 354,
66 Cal.Rptr.2d 921 (1997).
3 Bloor v. Falstaff[12]
The owners of Ballantine beer (IFC) sold Ballantine's brand name and distribution
network (but not the brewery) to Falstaff, another brewer, for $4 million plus a 50 per
barrel royalty for beer sold with the Ballantine brand name for a six-year period. Had
Falstaff maintained Ballantine's sales volume the royalty payment would have been over
$1,000,000 per year. Falstaff agreed to use "best efforts" to promote and maintain a high
volume of sales and further agreed to pay liquidated damages in the event of a
substantial discontinuance of distribution under the Ballantine brand name. The seller
subsequently went bankrupt and the bankruptcy trustee sued Falstaff under the contract
claiming that Falstaff had not used "best efforts" in promoting Ballantine and that it had
substantially discontinued production, thereby triggering the liquidated damages clause.
The court found for the plaintiff on the first point, but not the second. The opinion has
been well received, with commentators generally agreeing that Falstaff's breach was so
egregious as to not provide much of a test of the boundaries of "best efforts." Farnsworth,
for example, says: "Unfortunately, its decision did relatively little to add precision to the
meaning of ˜best efforts,' since Kalmanovitz [of Falstaff ] fell so far short of the mark"
(Farnsworth 1984).

Judge Friendly held that the "best efforts" clause required Falstaff to generate sales of
Ballantine beer even if that came at the expense of Falstaff's profits:
While [the best efforts] clause clearly required Falstaff to treat the Ballantine brands as
well as its own, it does not follow that it required no more. With respect to its own brands,
management was entirely free to exercise its business judgment as to how to maximize
profit even if this meant serious loss in volume. Because of the obligation it had assumed
under the sales contract, its situation with respect to the Ballantine brands was quite
different Clause 8 imposed an added obligation to use "best efforts to promote and
maintain a high volume of sales " Although we agree that even this did not require
Falstaff to spend itself into bankruptcy to promote the sales of Ballantine products, it did
prevent the application to them of Kalmanovitz' philosophy of emphasizing profit über
alles without fair consideration of the effect on Ballantine volume. Plaintiff was not
obliged to show just what steps Falstaff could reasonably have taken to maintain a high
volume for Ballantine products. It was sufficient to show that Falstaff simply didn't care
about Ballantine's volume and was content to allow this to plummet so long as that
course was best for Falstaff's overall profit picture, an inference which the judge
permissibly drew. The burden then shifted to Falstaff to prove there was nothing
significant it could have done to promote Ballantine sales that would not have been
financially disastrous.[13]

The evidence was sufficient to convince the court that Falstaff had not tried hard enough
to generate sales of Ballantine beer.

Judge Friendly takes it as axiomatic that the contract required Falstaff to trade off its
profits for Ballantine's sales. Conspicuous by its absence in the decision is any analysis
of why the contract included the royalty arrangement and the best efforts covenant. That
is not entirely his fault, as the record was completely silent on this point. So, we are left
with the somewhat peculiar spectacle of a court giving meaning to a context-sensitive
phrase with no guidance as to the context. Had the court recognized that the royalty was,
in effect, an "earnout," ancillary to the one-shot sale of some of Ballantine's assets to
Falstaff, the outcome would have (or, at least, should have) been different.

An earnout makes part of the payment for an asset contingent upon some measure of
future performance. Often it is a function of profits; here it is a function of sales. Most
corporate acquisitions do not involve earnouts. In 1998, of the over 9,000 acquisitions
only 153 included an earnout.[14] Earnouts rarely show up in appellate litigation -a LEXIS
[15]
search found only 42 cases. That might not adequately indicate the frequency with
which they generate disputes. I suspect, based in part on my consulting experience, that
the disputes are far more common, but that they arise in arbitrations, not litigation.[16]
IFC was, essentially, selling two assets - Ballantine's brand name and its distribution
network. Its purpose was simple. It wanted to sell at the highest price. Other things equal,
the fewer post-sale restrictions on Falstaff's exploitation of the assets, the more Falstaff
would be willing to pay. That should be obvious, but the court's failure to recognize this
basic point is the core of the problem. Falstaff's pursuit of "profit über alles," ex post,
redounds to IFC's benefit, ex ante.So, any restriction, like the best efforts clause,
immediately raises a red flag: how might the particular restriction raise the value of the
Ballantine assets, ex ante?

The earnout was a response to the problem of asymmetric information. In some earnouts,
the managers of the seller are expected to provide services to the buyer - the earnout
serves a role similar to a covenant not to compete. That was not the case here, as the
IFC managers were real-estate people with no useful knowledge about the beer industry
and no intent to stay in the business. IFC was certifying the quality of the Ballantine
assets. In sales of complex assets the seller typically has more information than the
prospective buyer. If buyers cannot distinguish good assets from bad, then they are likely
to be suspicious of any particular asset and to reduce their offer price accordingly.
Sellers can get a better price if they can convince buyers of the quality of the asset.
[17]
There are myriad ways of providing assurance. The seller can provide extensive
representations and warranties; the buyer can engage in extensive due diligence
investigation. The parties have an incentive to economize on the joint production of
information. By accepting some of its compensation in a contingent form, the seller
provides some assurance to the buyer of the quality of the asset.
The parties want an arrangement which maximizes the value to the buyer ex-ante.But
producing information and assurance is not costless. The process of maximizing the
value of the asset can reduce the size of the joint pie. That would obviously be true if the
parties had spent months negotiating elaborate representations and warranties and/or
engaging in a due diligence investigation. In this instance the parties avoided all these
costs using the royalty payment instead. It, too, is not costless. Earnouts in general have
a number of value-reducing features. They do not track value perfectly; they can distort
incentives; and they are not strategy-proof - that is, the buyer can operate the business
in a way which exploits the mechanism. For example, if an earnout based on profits in
the first three years, the buyer can make investment decisions which shift profits from the
third to the fourth year. Anticipation of these costs will influence the final price of the
asset.
The Ballantine royalty had the potential to alter Falstaff's incentives in two ways. First,
the royalty acts as a tax (roughly 2 percent) [18] on sales which could induce Falstaff to
market a somewhat smaller amount of Ballantine product than it would have, but for the
royalty. So "best efforts" might possibly mean that Falstaff should push its sales effort a
bit beyond the point that would otherwise be optimal, ex post.The distortion of incentives
(which in this instance is quite minor) is a common problem in contingent compensation
arrangements (franchise fees, percentage leases, oil and gas royalties, and so forth) and
"best efforts" is just one of the devices for dealing with the problem.
The relatively low "tax" suggests that this was not the concern of the parties. The more
likely concern was diversion: there were two assets being sold and the earnout tracked
only one of them. If Falstaff could use the distribution network to sell Falstaff rather than
Ballantine, the royalty would not track the value of the asset. The "best efforts"
requirement could be viewed as one contractual device for protecting against this sort of
diversion. But the context suggests how the clause should be read."Best efforts" in this
context means that Falstaff agreed that in its pursuit of "profit über alles" it would not
opportunistically divert sales from Ballantine (the sales of which were to track asset
quality) to Falstaff. And that poses the central question: did Falstaff use the network to
divert more sales than the parties should reasonably have expected? That might be a
difficult question to answer for some fact patterns, but for the facts of this case the
answer is easy and negative. When Kalmanovitz took charge he dismantled the
distribution system. Falstaff did not divert resources to the more profitable brand, it
simply terminated (or at least drastically pared) a project that did not work.
So, we are left with two plausible meanings of "best efforts" in the context of this
transaction. First, it could be aimed at correcting Falstaff's incentives which were a bit
distorted by the royalty "tax." Second, and more plausible, it could have been an attempt
to limit diversion of revenue away from the device chosen to provide assurance of that
value. Neither of these provides a basis for concluding that Falstaff's pursuit of profit
über alles by revising its Ballantine marketing strategy and dismantling much of the
Ballantine distribution network violated its obligation to Ballantine.

How to explain the liquidated damages of $1.1 million per year in the event of Falstaff's
substantial discontinuance of Ballantine? If this proviso was included as part of the
quality assurance mechanism, as I first thought, it makes no sense. In effect, it says: if
the assets are really terrible so that they are unusable, then Falstaff pays Ballantine $1.1
million per year for the duration; if on the other hand, they are only pretty bad, Falstaff
pays less. That is a perverse result, which I thought, could be explained only by poor
drafting.
However, the clause makes more sense if it is viewed as being independent of the
quality of the brand name and instead concerns diversion of revenues from the
exploitation of Ballantine's distribution network. With this reading Falstaff says, in effect:
we agree that we will not cheat you by diverting receipts from the metering device
(Ballantine sales) and profiting by the use of the other valuable asset we have purchased,
your distribution network; if we have done too much diversion, we agree to pay a penalty
(although the law does not permit us to call it that).The trigger for the penalty would not
be the quantity of Ballantine sold nationally, which is what the court focused on in ruling
that there has not been a substantial discontinuance. Rather, it would be the percentage
of Ballantine being sold through the old Ballantine network.
But this mechanism had one big hole. What if the network itself turned out to be of little
or no value, as was in fact the case? Falstaff essentially abandoned the network, but
continued to exploit the brand name as best it could. If the proviso's purpose was to
thwart massive diversion of revenues, there was no diversion. Falstaff bore the direct risk
of the distribution network being a lemon; it seems unlikely that ex ante the parties would
have wanted Falstaff to post an additional bond against that prospect. But, and this must
be emphasized, it is most likely that neither party expected the distribution network to be
worth so little, and the contract reflected their failure to anticipate this possibility.

[12]
This discussion summarizes (and simplifies) a more complete analysis of the case
presented in Goldberg (2000).

[13]
At 614-15.

[14]
For the number of deals, see "1998 M&A Profile," 33 Mergers & Acquisitions (March-April
1999, p.42).For the number including earnouts, see "Deal Structuring: Earn-Outs Get Into
More Deals," 33 Mergers & Acquisitions (March-April 1999, p.35).

[15]
LEXIS search, 10 January 2000.

[16]
In 1999 I was involved, briefly, as a potential expert witness in two arbitrations concerning
the interpretation of an earnout clause.

[17]
See Gilson (1984), note, pp.262-4.

[18]
Ballantine's 1970 price was $26.60 per barrel (PX 9 at 1618) and the royalty rate was 50
per barrel.
4 Concluding remarks
Two anecdotes do not a theory make. The analysis of these cases is meant only to
illustrate the value of adopting a more transactionally sensitive perspective in contract
litigation. I am not advocating that we try to ascertain the parties' true intent, a process
Judge Easterbrook once characterized as inviting "a tour through Walters' cranium with
[19]
Walters as the guide." Certainly, in Mattei the parties were using forms and were
largely unaware of the implications. And the lawyers drafting the Ballantine contract no
doubt gave little attention to the possible meaning of "best efforts," a phrase they threw
around liberally, using it six other times in the agreement.[20] The point is that the context
of the transactions should constrain the court in interpreting what reasonable parties
could (and should) have meant. An interpretation of a contract which begins with the
presumption that the seller intended to restrict the buyer's subsequent use of the asset is
bound to fail unless there is an understanding of the possible gains from tying the
buyer's hands. Had Judge Friendly understood that - and I must emphasize that the
litigators gave him no help whatsoever - then Falstaff would have been an easy case, but
for the other side.

The case law is American, but the problem is universal. And the solutions - the
option/lock-up and the earnout/royalty - are sufficiently obvious that I would be most
surprised if they were not in common use outside the United States. I would speculate
that the fit between what the parties do and the legal system's accommodation of their
needs would be no better in the non-American legal systems; Falstaff would probably
have fared no better elsewhere. I hope that this brief chapter will encourage a
comparative analysis confirming my expectations on both fronts, and that such research
might help nudge the doctrine in the proper direction.

[19]
Skycom Corp.v. Telstar Corp., 813 F.2d 810, 814 (7th Cir. 1987).

[20]
See Goldberg (2000) p.1471.
Notes
Chapter 8 was originally published as "Economic Reasoning and the Framing of
Contract Law: Sale of an Asset of Uncertain Value," in Revue d'Economie Industrielle
(92, 2000).
1. 51 Cal.2d 119; 330 P.2d 625; 1958 Cal.LEXIS 213.
2. 601 F.2d 609 (2d Cir.1979).
3. Mattei v. Hopper, 51 Cal.2d 119; 330 P.2d 625; 1958 Cal.LEXIS 213.
4. Mattei could have been held to an objective (reasonable person)
standard or a subjective (good faith) standard; the court chose the latter
because of the difficulties in determining objectively the qualities of a
satisfactory lease.
5. 32 Wash.App.22; 645 P.2d 727; 1982 Wash.App.LEXIS 2819.
6. "This transaction is subject to purchaser receiving an engineer's and
architect's feasibility report prepared by an engineer and architect of the
purchaser's choice. Purchaser agrees to pay all costs of said report. If
said report is satisfactory to purchaser, purchaser shall so notify seller in
writing within fifteen (15) days of seller's acceptance of this offer. If no
such notice is sent to seller, this transaction shall be considered null and
void" at 3-4.See also Horizon Corporation v. Westcor, Inc., 142 Ariz. 129;
688 P.2d 1021; 1984 Ariz. App.LEXIS 461 (approval of zoning, leases of
major retail tenants, and financing); Rodriguez v. Barnett, 52 Cal.2d 154,
338 P.2d 907 (1959) (satisfaction with and approval of a subdivision
map); Larwin-Southern Cal, Inc. v. J.G.B. Investment Company, Inc., et
al., 101 Cal. App.3d 626, 162 Cal. Rptr. 52 (1979) (buyer's approval of a
preliminary title report, its approval of its engineering report as to soil
conditions, dirt balance, drainage, utility requirements and its economic
feasibility study, and the approval of a tentative map).
7. Horizon Corporation v. Westcor, Inc., at 134. See also Resource
Management Company v. Weston Ranch and Livestock Company Inc.,
706 P.2d 1028. 1034; 1985 Utah LEXIS 884; 86 Oil & Gas Rep.631.
8. The only good-faith issue would be whether the third party's
independence had been compromised by a side deal with the buyer.
9. If the contract gives a false recital of the payment of nominal
consideration ("in consideration of buyer's payment of $20, "), the
majority position in the United States is that there is no contract. See
Lewis v. Fletcher, 101 Idaho 530 for majority position and Smith v.
Wheeler, 210 S.E.2d 702 for the minority position.
10. One line of argument, developed in French and McCormick (1984),
suggests that sellers invariably bear all the costs of pre-sale information
production. As I show elsewhere (Goldberg 1997, pp.475-81), they over-
state the case. Nonetheless, it is correct to say that sellers will often find
it in their interest to help potential buyers economize on their pre-sale
information expenditures.
11. For a case in which the plaintiff alleged that the defendant entered into
an option-like agreement with no intention of going forward, see Locke v.
Warner Bros., 57 Cal.App.4th 354, 66 Cal.Rptr.2d 921 (1997).
12. This discussion summarizes (and simplifies) a more complete analysis of
the case presented in Goldberg (2000).
13. At 614-15.
14. For the number of deals, see "1998 M&A Profile," 33 Mergers &
Acquisitions (March-April 1999, p.42).For the number including earnouts,
see "Deal Structuring: Earn-Outs Get Into More Deals," 33 Mergers &
Acquisitions (March-April 1999, p.35).
15. LEXIS search, 10 January 2000.
16. In 1999 I was involved, briefly, as a potential expert witness in two
arbitrations concerning the interpretation of an earnout clause.
17. See Gilson (1984), note, pp.262-4.
18. Ballantine's 1970 price was $26.60 per barrel (PX 9 at 1618) and the
royalty rate was 50 per barrel.
19. Skycom Corp.v. Telstar Corp., 813 F.2d 810, 814 (7th Cir. 1987).
20. See Goldberg (2000) p.1471.
A Transactions-Costs Approach to the
Chapter 9:

Analysis of Property Rights
Gary D. Libecap
1 Introduction
Property rights have been receiving considerable press from both policy-makers and
academic scholars. As well they should. They are among the most critical social
institutions, providing the basis for resource-use decisions and for the assignment of
wealth and political power. As such, the property regime profoundly influences both
economic performance and income distribution in all economies. Property rights define
the accepted array of resource uses, determine who has decision-making authority, and
describe who will receive the associated rewards and costs of those decisions.
Accordingly, the prevailing system of property rights establishes incentives and time
horizons for investment in physical and human capital, production, and exchange. Cross-
country differences in property rights result in important differences in economic
development and growth (Barro 1997; De Soto 2000).[1]

The property-rights structure also is critical for the environment and natural resource use.
Complete and well-defined individual or group property rights internalize externalities and,
thereby, guide decision-makers to consider the social consequences of their actions. In
this manner, property rights minimize the losses associated with the tragedy of the
commons or open-access resources (Hardin 1968; Johnson and Libecap 1982; Ostrom
1990; Deacon 1999; Brown 2000; Rose 2000). Finally, Pipes (1999) argues that private
property rights are essential, not only for economic performance, but also for establishing
and protecting individual social and political rights within a society.

Despite all of these advantages, property rights are controversial; often are very
incomplete; and vary widely across societies in structure and scope. Recent experiences
in transitional economies shows that property-rights regimes for valuable assets such as
farm land and industrial enterprises cannot be transferred readily from one society to
another, regardless of the anticipated benefits of doing so. The change in property rights
redistributes wealth and political power and shifts the nature of production, which is often
the motivating factor. But there is uncertainty as to the outcome; there are measurement
[2]
problems; and there are winners and losers from property-rights changes. Uncertainty
and measurement issues make it difficult to determine what the gains from a new rights
arrangement might be. Further, since property rights involve exclusion, some parties will
be denied access to resources or revenues under the new system. Those that anticipate
being harmed by the institutional adjustment mobilize to resist or modify the process.
Those that expect to benefit are proponents, but under these circumstances, institutional
change requires complex negotiation and compromise.

Even in more localized natural resource settings, it can be difficult to define a property-
rights solution to mitigate the losses of competitive common-pool extraction. Except in
cases where there are relatively small numbers of homogeneous parties using a
resource in a limited area, agreements to control access and use typically occur late,
after the costs of an inappropriate rights arrangement have been borne (Brown 2000).

Unfortunately, neoclassical theory offers little guidance as to why property institutions
that otherwise would seem to improve economic welfare and performance are not
quickly adopted or are openly resisted. The New Institutional Economics (NIE) with its
emphasis on transactions costs (Williamson 1979; Eggertsson 1990; Furubotn and
Richter 1997), however, offers important insights. A transactions-costs approach
illuminates why the development of well-defined property rights in response to changing
economic conditions will be more difficult than much of the traditional, neoclassical
literature suggested (Demsetz1967). Indeed, without consideration of transactions costs,
it is hard to explain North's (1990) observation that property-rights institutions that

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