Economic analysis of contract law after three decades: success or failure?

• Author: Posner, Eric A.

INTRODUCTION

Modern economic analysis of contract law began about thirty years ago and, many scholars would agree, has become the dominant academic style of contract theory. Traditional doctrinal analysis exerts less influence than it did prior to 1970 and enjoys little prestige. Philosophical work on the nature of promising has captured some attention, but petered out in the 1980s, with little to show for the effort other than arid generalizations about the nature of promising. Academic critiques from the left no longer stir up excitement as they did twenty years ago. Scholarship influenced by cognitive psychology has so far produced few insights. Only economic analysis seems to be on solid footing.

One way to validate a field's claims is to look at its history. Economically oriented scholars writing in the early 1970s had foundational insights, and then over time subsequent writers have criticized and refined them; because these refinements were derived from common premises, there has been a sense of forward movement in the subject, of the building of an increasingly sophisticated consensus. Although critics of economic analysis deride its scientific aspirations, the steady accumulation of insights over time resembles scientific progress. Doctrinal, philosophical, and critical scholarship by contrast has been static. The authors agree or disagree, and about the same things, as much today as they did twenty or thirty years ago.

Yet there are grounds for concern about the economic analysis of contract law. Careful students of its history know that the sense of convergence ended years ago; in the last ten years, theory has become divergent, and impasses have emerged. The simple models that dominated discussion prior to the 1990s do not predict observed contract doctrine. The more complex models that emerged in the 1980s and dominated discussion in the 1990s failed to predict doctrine or relied on variables that could not, as a practical matter, be measured. As a result, the predictions of these models are indeterminate, and the normative recommendations derived from them are implausible.

For these reasons, I will argue that economic analysis has failed to produce an "economic theory" of contract law, and does not seem likely to be able to do so. By this, I mean that the economic approach does not explain the current system of contract law, nor does it provide a solid basis for criticizing and reforming contract law. This is not to say that the economic approach has not produced any wisdom, but that the nature of its accomplishment turns out to be subtle and will become clear only after an extended discussion.

This Essay has two purposes: to document the failures of economic models to explain contract law or to justify reform, and to provide an explanation for these failures. The explanation centers on the difficulty of developing a model of contractual behavior that can be tested and that does not make unreasonable assumptions about the cognitive abilities of contractual parties.

At the outset, a few comments must be made in order to avoid some possible misunderstandings of the argument. First, I will not argue that some other approach to contract law is superior to the economic approach, nor that economic analysis should be abandoned. If a moral must be extracted from the discussion, it is skepticism about how much additional value economics has to offer to understanding contract law today.

Second, I do not make claims about the value of economic analysis for understanding other areas of law. Indeed, my critique rests on empirical and methodological judgments about the contracts literature, judgments that do not necessarily apply to, say, torts or property. Nor do I take a position in this Essay on controversies over the welfarist foundations of economic analysis. (1)

Third, I want to avoid making general arguments about what counts as a good theory. One might argue that any methodology that yields surprises or insights about a familiar topic is valuable, and those surprises or insights should be counted as theories. To avoid these philosophical issues, I will focus on the original aspirations of the economic analysis of contract law: to provide an explanation of existing legal rules, and to provide a basis for criticizing or defending those rules. (2)

Finally, I want to avoid debates about what counts as "economic analysis of contract law" by stipulating that it did not exist before 1970. This is, of course, artificial. Many earlier scholars, including Holmes, Llewellyn, Hale, and Fuller, used economic analysis in the sense that from time to time they would assume that contracting parties are rational and then speculate about how different legal rules would affect these parties' incentives. (3) From a modern perspective, however, their insights seem banal, and that is because post-1970 economic analysis is more systematic and careful. (4) The interesting question is whether the post-1970 commitment to methodological individualism and the other premises of the rational actor approach provide the basis for a theory that can be used to explain or criticize contract law.

My plan is as follows. Part I describes various results from the economic analysis of contract law and compares them with the legal doctrine. In virtually every case, models make either false or indeterminate predictions about the doctrines of contract law. Part II discusses the closely related literature on incomplete contracts, a literature that attempts to predict the content of contracts, as opposed to contract law. The separation of these two bodies of scholarship, now gradually disappearing, is an accident of history, but useful for seeing the general problems with the economic project. Part III speculates about what went wrong with economic analysis and argues that an ambiguity at the heart of the concept of transaction costs is to blame. Part IV looks at trends in contracts scholarship. Part V criticizes alternative approaches to contract theory.

1. THE ECONOMIC ANALYSIS OF CONTRACT LAW

   1. Premises and Basic Results

      The economic analysis of contract law is too familiar to warrant an extended discussion; there are also several excellent surveys. (5) Fundamental assumptions, common to nearly all efforts at economic analysis, are that individuals have preferences over outcomes, that these preferences obey basic consistency conditions, and that individuals satisfy these preferences subject to an exogenous budget constraint. Contracts scholars usually assume that individuals do not have preferences regarding the consumption or well-being of other individuals, nor regarding contract doctrine itself--there is no preference for expectation damages, for example. (6)

      The standard approach assumes that the parties enter a contract in order to secure investment in a jointly beneficial project. (7) The project could be as simple as the sale of a good from Seller to Buyer--with one party (or both) enhancing the gains by an investment that reduces the cost of production for Seller or increases the value of the good for Buyer--or as complex as the construction of a skyscraper. If Buyer can increase the value of the good by making investments prior to delivery, Buyer will want a guarantee that Seller will not increase the price after Seller has observed Buyer's reliance. A contract can sometimes prevent Seller from holding up the Buyer in this way, and thus permit Buyer to invest with knowledge that he will enjoy the full return of his investment.

      In their contracts, parties include terms describing performance and governing the main contingencies that affect the value of performance. Terms might describe the goods to be delivered, the date of delivery, or the identity of the party that bears the risk of an accident during the shipment. The terms might also release the seller from its obligation if a strike or similar event occurs. A theoretically complete contract would describe all the possible contingencies, but transaction costs--including the cost of negotiating and writing down the terms--and foreseeing low-probability events, render all contracts incomplete. In addition, parties might choose some terms or avoid others for strategic reasons, in order to exploit superior bargaining power or information asymmetries. Thus, contracts are usually quite incomplete. Parties rely on custom, trade usage, and, in the end, the courts to fill out the terms of the contract.

      The terms that appear in contracts, then, depend on what the parties are trying to accomplish, shared understandings about the relevant industry, transaction costs, general characteristics of their interaction such as asymmetric information and unequal bargaining power, and the background legal regime. The last factor, the legal regime, is the focus of the economic analysis of contract law. The question is, broadly speaking, what rules of contract law would best serve the interests of the parties. This question is asked in two different ways, depending on whether the scholar takes a descriptive or a normative approach.

      Descriptive analysis provides a "prediction" of contract doctrine. Built into this approach is the assumption that judges decide cases (and/or choose doctrine) in a manner that maximizes efficiency. (8) The question why judges would decide cases in this way, or whether it is necessary for them to do so in order to generate efficient law, is bracketed. (9) The author constructs a model in which parties would maximize their utility if they could enter an optimal contract. They cannot enter such a contract in the absence of legal enforcement, so the question becomes what legal rule enables the parties to enter the optimal contract. This hypothetical legal rule is then compared to actual legal rules, and, if they are the same, the descriptive hypothesis is vindicated.

      The normative position assumes that contract law should be efficient. As before, the author...