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Why Economics are Important in Contract Law: Transaction Costs

Student name: Gergana I. Damyanova Student number: 3482030 Course code: ECB1POL Supervisor: Dr. Tina van der Linden Utrecht University

(2002). Z.1. he had incurred his transaction costs TCa and has still not received any money from B. W.. At the conclusion of period 1. 477 2 Miceli. but has not yet received the goods N. on the other hand. which used to be two separate disciplines. A will have been paid the agreed price for N and B will have received N. & Sherrin. when both A and B incur certain transaction costs TC. Stanford. For example. 90 3 Hirsch. 'A' Level Law. The second period is period 1 and is the contract-formulation stage. In this paper I am going to answer the question why economics are so important in the law of contract and what influence they have on it. p. T. A has not anymore rights on N. Transaction costs Transaction costs include any costs associated with the writing and enforcing of a contract2. so the results of them can be analyzed after that. It is about the whole range of agreements which are binding – embraces simple everyday transactions like shopping or using public transport. As economics are trying to explain the result of price changes on behaviour. At the end of 2. Bermingham.. are growing surprisingly bound during the past 30 years. 2. T. A can be late to send the goods N to B.. M. or a natural disaster may happen. The economic approach to law. p. The third stage . The particular branch of the legal science that is concerned with the economic relations is contract law. The transaction goes through three stages – period 0. So far. S. it can also explain the impact that sanctions (if assumed to be prices for certain actions) have on behaviour. I am going to explain what they are and how they are influenced by the process of making up a contract and how they influence the prices of it. C. Law and Economics: An Introductory Analysis. California: Stanford University Press. On the other hand. economic transactions need law in order to take place at first instance. 120 . In the next section. V. every transaction like this has its costs.. the transaction costs. so the goods are 1 Dugdale. (2004). (1999). important family transactions like buying a house and major commercial enterprises like taking over a company1. has incurred his transaction costs TCb. p. Butterworths. all of which he is about to sell to the buyer he had found .period 2. but both would have incurred their transaction costs as well3.B. The following example illustrates this . before the contract is formed. I am going to do so by exploring the costs which negotiating parties are likely to incur during the process of drawing up an agreement – namely.assume that seller A has N goods. This will be supported by examples. Los Angeles: Academic Press. Furmston. Introduction Law and economics. B. However. Jones. However. is the time span during which the performance of the contract is completed. there often are difficulties during that process. Then A has N goods and B has no goods but has his money M. the two parties have incurred the costs of writing a contract whose clauses should now be enforced. J.

So. if the cost of allocating a risk is less than the cost of a loss multiplied by the probability of that loss incurring. The expense of negotiating a contracts leads to the fact that some kinds of transactions are „taken out of the market” and are performed only inside firms4. This results in more mergers and desirability of larger companies. and it could not be avoided5. Middlesex: Peter Collin Publishing. Law and the Economy. the parties can choose to undergo either the price of a good contract covering a lot of „ex ante risks” (risks of future losses faced by the parties when they negotiate a contract). R. This costs are connected with the process of enforcing the contract. a recent contingency showed us that there are no contracts that are perfect. Hence. but orders all the parts from different manufacturers.destroyed. This as a natural disaster is categorized in English law as an „act of God” – it was not expected to happen. airline companies lost millions due to the fact that they couldn’t carry out their flights. 5 4 . he has to have contracts with all of them and every time he receives a delivery has to make sure that every single unit is up to the standards that have been agreed in the contract. p. However. avoids all the unforeseen risks that otherwise may have been omitted in the contract and supervises the work himself. This is really expensive and time consuming. 31 Collin. After the eruption of the volcano Eyjafjallajokull in Iceland. it can be easily and cheaply enforced even if the parties go to the court. if the contract is silent about such a risk. It is economically rational to pick up the one which minimizes the costs of a contract. or the price of not covering some risks and consequently incurring the „ex post losses” (losses that actually materialize after making the contract). or A may find that he had run out of money due to the mistakes done by his/her accountant. Teddington. P. Generally. Dictionary of Law. H. now it is important what the companies decided when they were making their 4 Bowles. This can be done by using the following simple rule: If the costs of allocating a risk are larger than the cost of a loss multiplied by the probability of that loss occurring. If these situations are covered by the contract. Mentioning unforeseen risks. For instance. the high transaction costs may have influence not only on the desirability of certain contracts but on the whole economic environment as well. On the contrary. In the area of contract law. the gap should be filled. (1992). a gap in the contract should be left. (1982). it is a way more useful for a car producer to manufacture all the parts of a car himself – this way he is not paying any transaction costs. Oxford: Martin Robertson. no matter how high the transaction costs are and how secure the contract may seem. p. if a car producer only assembles the cars. Of course all of them have huge insurances covering a lot of the accidents that may occur. usually there is a trial during which the parties have to pay to their solicitors and cover the costs of the trial itself.

bringing up an action is not rational from an economic point of view. the party that was more likely to foresee that a war may break out is the party that should bear the loss. In other words. Law & Economics. or chose not to cover it and incur the ex post losses of not being able to perform their flights. p. & Ulen. A baseline for such a hypothetical case is provided by the case example used by Robert Cooter and Thomas Ulen in their „Law and Economics” (2008): An oil company signs a contract to deliver oil by a certain date from the Middle East to a European manufacturer. It is important to notice that whatever the decision is. they should have put more effort in their insurance contracts. In this case it is more likely that the oil company that is operating in the Middle East should have better knowledge of the political circumstances there and should be more aware that in this area of the world it is likely that wars will happen. However.. Nevertheless. the court simultaneously accomplishes two things which are referred to as „dispute resolution” and „rule creation”. (2008). the manufacturer has to reduce production and lose profits.contracts . but want not to be included in the contract in order to try to escape liability. „Assuming that the oil company is better able to bear the risk of war. T. than the European manufacturer who if not interested has no knowledge at all of the situation there6. the court should assign the loss of not delivering the oil in a way to make future contracts more efficient. Pearson. In comparison with the volcano case. therefore. so the manufacturer files a lawsuit against the oil company. So. airliners may file lawsuits against insurers. R. In other words. Such a decision would also make negotiating parties less eager to remain silent about risks that they are aware of. The contract remains silent about the risk of a war breaking. but for the single consumer stands the dilemma whether the transaction cost of enforcing the contract through the legal system are going to outweigh the compensation he/she might receive.whether to undergo the ex ante risk of a volcano erupting and closing the airspace. 2008). before the oil is delivered a war breaks in that country and the company is prevented from delivering. economic efficiency requires the court to hold the oil company liable for breach of contract and. 6 . there is the individual who is also insured. which would have led to higher transaction costs. the airline companies probably should have thought that a natural disaster may prevent them from executing their flights. Looking from the micro side of this story. From an economic point of view. 6 Cooter. and who also hopes that her/his losses will be covered. If not.” (Cooter & Ulen. the court will not only resolve the dispute between those litigants but will as well create a direction for future parties in similar circumstances. because it would not make the consumer better off. airliners and passangers may bring action against their insurance companies in search for some compensation. As most likely companies are going to try to use the defence of „the act of God” and escape liability in this situation. make it responsible for paying for the European manufacturer’s lost profits due to non-performance. Due to that.

these responses to the costs are studied by economists. help the legal system in calculating a baseline for damages. a baseline that will make other negotiating parties work more efficiently while drawing up a contract. They are also necessary for the negotiating parties to consider whether it is economically efficient to cover certain risks or to leave them out of the contract. This helps them to minimize their costs and to operate in the most optimal way. to search for their rights through the legal system. However. Results from such research. . or not to do so. Conclusion Transaction costs are used not only to show the costs that a contract involves.3. because a trial would make them only worse off.