Chapter 2 - Economic Analysis of Contract and Contract Law

Summary

In voluntary transactions, efficiency is enhanced because goods and services will be allocated to the best user and surpluses will be created. But the time lapse between the formation of a contract and its performance creates risks and uncertainties. This problem will be increased by the problems of opportunism, distrust and incomplete contracts. Thus the efficiency of transactions can be endangered. Since the market cannot always work efficiently, it is required that contract law is introduced as a supplementary mechanism for transactions. Economists assume that there is a close relationship between the structure of contract damage rules, people's behaviour and social efficiency. An efficient law is able to facilitate people's capacity for welfare maximization in the transactions, and to promote social efficiency. This chapter will first indicate the economic reasons why people make contracts and what would happen if there were no contract law. Afterwards, the economic functions of contract law will be provided in section 2. Section 3 will further provide the economic theory of the binding effect of a contract. One important result of the binding effect is that if one party to a contract breaches, the non-breaching party will be entitled to contract remedies. A basic economic theory of contract remedies will be included in section 4. Section 5 will conclude.

Economic Analysis of Contracts

Voluntary Transactions and Efficiency

Voluntary transactions are justified both in the traditional legal theory and from an economic perspective. Lawyers relate them to the principle of freedom of contract. But economists pay more attention to the welfare that can be created through transactions. Suppose there are two parties Y and X. Yhas a machine that is worth 50 euros to him but is worth 150 euros to X. According to economists, a rational person is assumed to be interested in welfare maximization and he will take actions which make him better off.

In this case, X might obtain this machine either through producing a similar one for himself or buying it from Y at a price lower than 150 euros. But Y would be willing to give up the machine only if he could acquire more than 50 euros.