Unit 4: Contract Law
Scope of Contract Law
Contract Law concerns agreements that people make with each other privately. The court gets involved if one of the parties seeks to have the agreement enforced by the court. The two basic questions in contract law are.
1. What should be the remedy for breach of contract?
2. What kinds of contracts should be enforced in the first place?
We will treat each of these questions in turn.
Basic Economics of Contract Enforcement
Why does the court get involved in private contract disputes? The basic answer is that the ability to make enforceable contracts can create benefits for everyone and therefore can enhance efficiency. Enforcement of contracts has long been one of the core functions of even minimal governments.
Here is the basic economics. Suppose Peter is considering whether to invest $500 in Sara’s company. The investment would generate $2000 in revenues. Peter and Sara sign a contract wherein they agree to split the profits from the project, with each party earning $750. The problem is that, after Peter turns over his investment, Sara could breach the contract and refuse to give Peter his share of the profits.
Let’s make a table that summarizes each outcome.
Outcome Peter’s Payoff Sara’s Payoff
No contract $0 $0
Contract – Sara satisfies $750 $750
Contract – Sara breaches −$500 $2000
The solution is contract enforcement. If the court will enforce Peter and Sara’s contract, then Peter is confident if he enters into the contract with Sara that Sara will satisfy it. Sara’s promise to give Peter his share of the profits is now a credible commitment because Sara would be required by the court to pay. Thus, Peter is confident of his $750 profit and will enter into the contract with Sara. This is an efficiency improvement since it produces a net $1500 increase in payoff.
The purpose of contract enforcement is to allow people to make mutually beneficial deals with each other. This is especially important when there is a time element – as in the example above, Peter turned over his money right away, in exchange for a promise for Sara to deliver on her part of the deal later. Without contracts, lots of mutually beneficial business would never be done at all. This is why public contract enforcement benefits society.
Efficient Breach
A key point to make up front is that contract breach can sometimes be efficient. For example, suppose a builder promises to build a house for you at a price of $300,000, and you value the house at $400,000. The builder later learns that the materials to build the house have risen in price and would actually cost $450,000. In this case, it is efficient to just ditch the initial contract since the benefit created by the house is now less than the cost of building it.
The baseline remedy for breach of contract is expectation damages, which put the promisee in exactly the same position that he would have been in if the contract had not been breached. Expectation damages create exactly the right incentives to break contracts. The promisor is paying the full cost of the breach, so he will break the contract only when this cost is less than the cost of satisfying the contract – which is exactly the condition for it to be efficient to break the contract.1
By extension, damages that are below expectation level would cause the promisor to breach the contract too often, since he would be paying less than the cost of his breach. Damages that are higher than expectation level would cause the promisor to not breach even when it might be efficient to do so.
Remedies for Breach
There are many options for courts to remedy breach of contract. In the first place, some contracts
stipulate a remedy, meaning that the contract itself specifies what will happen in the case of a breach.
1 The logic is similar to tort law. We are shifting the damage costs to the promisor, so he will only break the contract
If a remedy is not stipulated, there are two basic families of remedies.
1. Damages – Promisor pays promisee compensation for the breach.
2. Specific performance – Promisor is ordered by the court to perform the contract.
Common Law courts traditionally have had a strong preference for damage remedies, and later in this section we will try to see why that is the case.
Calculating Damages
There are three basic ways to calculate damages.
1. Expectation damages put the victim in the same position he would have been in if the contract had been fulfilled. Expectation damages leave the victim indifferent between breach and no breach.
2. Reliance damages put the victim in the position he would have been in if the contract had never been written at all. Reliance damages leave the victim indifferent between breach and no contract.
3. Opportunity-cost damages replace the value of the next-best alternative. These leave the victim indifferent between breach and the next-best option.
We will illustrate with a series of examples.
Question: A month before an opera, agent A offers opera tickets for $80 and agent B offers opera tickets for $100. Agent A promises to deliver a ticket to the customer. The day before the opera, the agent breaches and does not deliver the ticket. At that point, the cheapest available ticket is $150. Calculate all three types of damage payments.
Answer:
1. Expectation damages are $70 – The difference between the $150 ticket and the $80 ticket that the customer was promised. This fully compensates the customer for the breach.
2. Reliance damages are $0 – If the customer had not entered into any contract with anyone, he would be in the exact same position he is in now.
Question: An agent orders a ticket for $50 and Tom agrees to buy it for $80. Had he not made an agreement with Tom, the agent would have sold it to Dana for $60. Tom never comes to collect the ticket, and now the most that the agent can sell it for is $15. Calculate all three types of damage payments.
Answer:
1. Expectation damages are $65 – The difference between the $80 the agent would have made if Tom had satisfied the contract and the $15 he makes now.
2. Reliance damages are $35 –Imagine the agent had not ordered the ticket at all. Because she did, she is now stuck with a ticket she paid $50 for and can only sell for $15. The $35 puts her back in the position that she would have been in with no contract at all.
3. Opportunity-cost damages are $45. If the agent had not entered into a contract with Tom, she would have entered into a contract with Dana. Instead of getting $60 for the ticket, she only gets $15. Opportunity cost damages compensate the agent for this loss.
Question: A surgeon operates on a patient’s injured hand and promises to make it perfect. It turns out worse than it was before the surgery. How would you go about calculating the three types of damage payments?
Answer:
1. Expectation damages would represent the difference between the value of a perfect hand (what was promised) and what the patient ended up with.
2. Reliance damages would represent the difference between the value of the pre-surgery hand (what the patient would have had with no surgery) and what the patient ended up with.
3. Opportunity-cost damages would represent the difference between the value of the hand with the next-best surgery option and what the patient ended up with.
Question: Jerry pays $10,000 to David, a grain dealer, in exchange for David’s promise to deliver grain to Jerry. As a result of signing this contract, Jerry decides not to sign a similar contract with another dealer for $10,500. Jerry plans to resell the grain to Marissa for $11,000. Jerry pays $100 in nonrefundable docking fees for the ship’s projected arrival. The ship sinks en route. David notifies Jerry of the news, and Jerry buys grain for $12,000 in order to satisfy his contract to Marissa. Calculate all three types of damage payments.
Answer: Note before beginning that Jerry ends up losing $1100 – The difference between the $12,000 cost of the grain + the $100 shipping fees and the $11,000 Marissa pays him for the grain.
1. Expectation damages are $2000 – If David had fulfilled the bargain, Jerry would have made a $900 profit ($11,000 − $10,000 − $100). Instead, he loses $1100. The $2000 damages would restore the profit he would have earned if the contract had been satisfied.
2. Reliance damages are $1100 – If Jerry and David had never entered into a contract, Jerry would have avoided the $1100 loss.
3. Opportunity-cost damages are $1500 – If David had not shown up, Jerry would have entered into the contract with the other dealer and cleared a $400 profit ($11,000 − $10,500 − $100). Instead, he loses $1100. Opportunity-cost damages compensate Jerry for this missed opportunity.
The promisee always goes with the best contract, therefore the value of the best contract will always exceed the value of the next-best contract by definition. As a result, expectation damages exceed opportunity cost damages.
Furthermore, any contract that is entered into has to represent an improvement over no contract. Otherwise, the parties never would have agreed to the contract in the first place. Thus, the value of any contract exceeds the value of no contract, and so expectation damages and opportunity-cost damages both exceed reliance damages.
There are two other methods that Common Law courts sometimes use to compute damages.
Restitution is a way of calculating damages that requires the injurer only to give back what he took from the victim. For example, suppose a car dealer takes a $1000 down payment from a customer but never delivers a car. Restitution just forces the dealer to return the $1000. This is a very minimal remedy for breach. Even reliance damages might be higher than this. For example, the customer might have bought some car-specific accessories that he would not have purchased if he had not entered into a contract. Reliance damages would return this money but restitution does not.
Disgorgement is a way of calculating damages that takes away the injurer’s profit. For example, suppose Sara agrees to sell a ring to Jenny for $1000 but breaks the agreement and sells the ring to Farah for $1500. The disgorgement remedy is $500. While other damage payments are about restoring the victim’s position, disgorgement is about taking away the injurer’s profit from breaching.
Specific Performance versus Damages
A key question in contract law is whether courts should order contracts to be fulfilled in the case of breach or whether courts should allow breach as long as damages are paid.
Here is an initial point. If fulfillment of the contract is efficient, then the contract will be fulfilled under either remedy. For example, if the contract costs me $1000 to fulfill but you lose $5000 if I breach, then clearly it is efficient to fulfill the contract. If the legal rule is specific performance, the court orders me to fulfill it. If the legal rule is expectation damages, then I will fulfill the contract because it’s cheaper to pay the $1000 to fulfill it than to pay the $5000 damages.
The more interesting question is what happens in the case of efficient breach – a situation where it is actually inefficient to satisfy the contract. Broadly, efficient breach comes in two flavors. Consider a situation where Anna promises to deliver a widget to Bob.
1. Unfortunate contingency – Performance of the contract becomes unprofitable. Anna learns that it would cost more to make the widget than the widget is worth to Bob.
2. Fortunate contingency – Some alternative to the contract becomes more profitable. Anna discovers that the widget is worth more to someone else than it is worth to Bob.
In either case, breaching the contract is actually efficient in the sense that it increases total social welfare. Which legal rule – damages or specific performance – should we use to generate the most efficient outcome? Here are the main results, which we will illustrate by examples.
1. If the parties can easily negotiate, then the Coase Theorem applies and both remedies are equally efficient. There is a distributional difference. The promisor prefers damages while the promisee prefers specific performance.
2. If the parties cannot negotiate, then damages are the more efficient remedy because they give the promisor the option to compensate the promisee for damages or to perform the contract. The promisee is compensated either way, but the promisor has more options.2
Question: Amy wants to install a new pool at her hotel and will earn revenue of $200,000 if the pool is installed. John signs a contract with Amy to build the pool for a price of $140,000. Unfortunately, as soon as John starts to do the construction, he realizes that the plumbing is buried deep in concrete and it would cost $300,000 to do the job.
a. What are the profits for Amy and John if the contract is satisfied? b. What are the profits for Amy and John if the contract is breached? c. Is breach efficient?
d. Suppose that courts apply specific performance and order John to build the pool.
i. What are the threat value payoffs with no negotiation?
ii. What is the surplus from negotiations?
iii. Describe what happens in the reasonable solution.
iv. What is the payoff to each party in the reasonable solution?
e. Suppose instead that courts apply expectations damages.
i. Calculate the expectations damages.
ii. What are the threat value payoffs with no negotiations?
iii. What is the surplus from negotiations?
iv. Describe what happens in the reasonable solution
v. What is the payoff to each party in the reasonable solution?
f. Which solution is more efficient if there is no negotiation?
g. Which solution is more efficient if there is easy negotiation? Is there a distributional difference?
Answer:
a. Π𝐴𝐴𝐴𝐴𝐴𝐴 = 200,000 − 140,000 = $60,000 and Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛 = 140,000 − 300,000 = −$160,000 b. Π𝐴𝐴𝐴𝐴𝐴𝐴 = 0 and Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛 = 0
c. Yes – The pool is only worth $200,000 to Amy but costs $300,000 to build. Another way to see
this is that net profits are $100,000 higher when the contract is breached.
d. Specific Performance
i. Π𝐴𝐴𝐴𝐴𝐴𝐴= 200,000 − 140,000 = $60,000 and Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= 140,000 − 300,000 = −$160,000
ii. $100,000 – The pool creates benefits of $200,000 but costs $300,000 to build. Another
way to see this is that total profits are $100,000 higher when the pool is not built.
iii. John pays Amy $110,000 to let him breach the contract. This restores Amy’s $60,000
and gives her half the surplus.
iv. Π𝐴𝐴𝐴𝐴𝐴𝐴 = 110,000 and Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= −110,000. Notice that both Amy and John are $50,000 better off than they were when the contract is satisfied.
e. Damages
i. $60,000 – To restore Amy to her position if the contract had been satisfied. ii. John will just pay the damages, so Π𝐴𝐴𝐴𝐴𝐴𝐴= 60,000 and Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= −60,000 iii. $0 – This is already the efficient solution.
iv. John pays Amy’s $60,000 damages.
v. Π𝐴𝐴𝐴𝐴𝐴𝐴 = 60,000 and Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= −60,000
f. If John and Amy cannot negotiate, damages are more efficient. The specific performance remedy
actually forces John to build the pool.
g. If John and Amy can negotiate, both remedies are equally efficient and lead to the contract being breached. There is a distributional difference. Specific performance is better for Amy, while damages are better for John.
Question: Silicon Inc. is a manufacturer of computer chips. Peachware Inc. manufactures desktop computers. Peachware and Silicon enter into a contract in which Silicon agrees to deliver a box of computer chips to Peachware for $200,000, to be paid upon delivery. Silicon’s cost of manufacturing and shipping these chips is $150,000. If Peachware gets the chips from Silicon, it will bear a cost of $150,000 to manufacture computers (this is in addition to the $200,000 it paid for the chips). It will then be able to sell the finished desktop computers for $900,000. If Silicon does not deliver the chips as promised, Peachware has to get the chips from an outside supplier at a cost of $300,000. Just before delivering the chips to Peachware, Silicon receives a frantic call from Waygate Inc. that offers to pay them $600,000 for the box of chips. Silicon cannot produce additional chips in time and can only satisfy one of the orders.
a. What are the profits for Peachware and Silicon if the contract is satisfied? b. What are the profits for Peachware and Silicon if the contract is breached? c. Is breach efficient?
d. Suppose that the court uses expectation damages. What will happen? Is the outcome efficient,
even without negotiation?
e. Suppose that the court orders specific performance.
i. What are the threat value payoffs with no negotiation?
ii. What is the surplus from cooperative negotiations?
iii. Describe what happens in the reasonable solution.
iv. What are the profits for Peachware and Silicon in the reasonable solution?
v. Can you think of a different solution if Peachware can negotiate directly with Waygate?
f. Which remedy is more efficient if there is no negotiation – damages or specific performance?
Answer:
a. Π𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑤𝑤𝑃𝑃𝑤𝑤𝑃𝑃 = 900,000 − 200,000 − 150,000 = 550,000 and
Π𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑃𝑃𝐽𝐽𝑛𝑛= 200,000 − 150,000 = 50,000.
b. Silicon will breach and sell the chips to Waygate, forcing Peachware to get the chips from its
outside supplier:
Π𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑤𝑤𝑃𝑃𝑤𝑤𝑃𝑃 = 900,000 − 300,000 − 150,000 = 450,000 and
Π𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑃𝑃𝐽𝐽𝑛𝑛= 600,000 − 150,000 = 450,000.
c. Yes – Breaching the contract benefits Silicon more than it hurts Peachware. Another way to see
this is that total profits are higher when Silicon can breach.
d. Silicon will simply pay Peachware’s $100,000 damages and proceed to beach the contract. This
is the efficient outcome, with no negotiation necessary.
e. Specific performance.
i. Π𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑤𝑤𝑃𝑃𝑤𝑤𝑃𝑃 = 900,000 − 200,000 − 150,000 = 550,000 and
Π𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑃𝑃𝐽𝐽𝑛𝑛= 200,000 − 150,000 = 50,000.
ii. $300,000 – Peachware gains $400,000 by breaching the contract, but Silicon loses only
$100,000 as a result of the contract breach. Another way to see this is that total profits are $300,000 higher when the contract is breached.
iii. Silicon pays Peachware $250,000 for Peachware to allow breach. This restores
Peachware’s $100,000 lost profit and provides half the surplus from the breach. iv. Π𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑤𝑤𝑃𝑃𝑤𝑤𝑃𝑃 = 900,000 − 300,000 − 150,000 + 250,000 = 700,000 and
Π𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑃𝑃𝐽𝐽𝑛𝑛= 600,000 − 150,000 − 250,000 = 200,000.
Notice that both Peachware and Silicon earn $150,000 more in profit than they did when the contract was satisfied.
v. Peachware might nevertheless demand that Silicon deliver the chips so that Peachware
can sell the chips to Waygate themselves. This is actually just as efficient. The surplus just goes into Peachware’s pocket rather than being split with Silicon.
f. If there is no negotiation, damages are more efficient. With a damages remedy, Silicon will breach its contract upon payment of damages. With specific performance, Silicon is forced to inefficiently satisfy the contract if it cannot negotiate with Peachware.
g. If there is easy negotiation, both remedies are equally efficient. Both lead to Silicon breaching its contract.
To summarize, breaching contracts can sometimes be efficient. This can be either because the contract becomes unprofitable to fulfill (unfortunate contingency) or because an alternative becomes even more profitable than the original contract (fortunate contingency).
Stipulated Remedies
Contracts may contain a stipulated remedy if the contract is breached. Liquidated damages are stipulated damages that compensate for actual harm caused by the contract breach. Penalties are contract-specified damages that exceed the actual level of harm.
In a basic sense, enforcement of penalties in excess of liquidated damages is inefficient because the threat of a high penalty might force a promisee to go through with a contract even if it is inefficient to do so. Here is a continuation of our previous example.
Question: Amy wants to install a new pool at her hotel and will earn revenue of $200,000 if the pool is installed. John signs a contract with Amy to build the pool for a price of $140,000. Unfortunately, as soon as John starts to do the construction, he realizes that the plumbing is buried deep in concrete and it would cost $300,000 to do the job. The contract has a clause requiring John to pay $500,000 to Amy if he breaches.
a. Suppose that courts enforce the full stipulated damages of $500,000, including the penalty.
i. What is the outcome if there is no negotiation? What are the profits for each party? ii. What is the outcome if there is easy negotiation? What are the profits for each party?
b. Suppose instead that courts only enforce liquidated (expectation) damages.
i. How much are the expectation damages?
ii. What is the outcome if there is no negotiation? What are the profits for each party? iii. What is the outcome if there is easy negotiation? What are the profits for each party?
c. Which remedy is more efficient if negotiation is not possible?
d. Which remedy is more efficient if negotiation is easy? Is there a distributional difference?
Answer:
a. Stipulated damages
i. John will build the pool rather than breach. It’s cheaper to lose $160,000 by breaching than it is to pay a $500,000 penalty.
Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= 140,000 − 300,000 = −160,000 and Π𝐴𝐴𝐴𝐴𝐴𝐴= 200,000 − 140,000 = 60,000
ii. There is a $100,000 surplus from the breach. Thus, John will pay Amy $110,000 to let
him breach the contract. This restores Amy’s lost profit and gives her half the surplus. Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= −110,000 and Π𝐴𝐴𝐴𝐴𝐴𝐴= 110,000. Notice that both parties are $50,000 better off.
b. Liquidated damages.
i. $60,000 – Amy’s lost profit.
ii. John will simply pay Amy’s damages Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= −60,000 and Π𝐴𝐴𝐴𝐴𝐴𝐴= 60,000.
iii. No additional negotiations – This is already the efficient outcome, where John breaches the contract, so Π𝐽𝐽𝐽𝐽ℎ𝑛𝑛= −60,000 and Π𝐴𝐴𝐴𝐴𝐴𝐴= 60,000.
c. If there is no negotiation, liquidated damages are more efficient. The extremely high stipulated damages force John to inefficiently build the pool to avoid the $500,000 damages.
You might mistakenly think that enforcement of large penalties is purely distributional and has no efficiency consequences, but the example above shows why this is wrong. Enforcement of penalties in excess of liquidated damages might force inefficient performance of the contract if the parties are unable to negotiate it away on their own. This probably explains the long-standing preference in Common Law for awarding only liquidated damages.
Nevertheless, are there any benefits of enforcing penalties in excess of liquidated damages? If we add some twists to the model, then the answer can be yes.
• Insurance – If the customer’s subjective value on contract performance is higher than market value, then the customer might avoid entering into a contract at all if he knows the court will award only market-based liquidated damages. That is, the promise of enforcement of fully stipulated damages might be the only way that the parties will be able to form a contract at all.
• Signaling – A firm (e.g. a builder) might agree to a high penalty as a way to send a signal to customers that it is more reliable than other firms in the market. If courts refuse to enforce penalties, then the signal is worthless and the firm loses its ability to distinguish itself in this way.
• Penalties can be tautologically restated as “bonuses” anyway. For example, instead of a $30 “penalty” for late delivery, the seller could reduce the price by $30 and insert a clause in the contract where the buyer pays a $30 “bonus” for on-time delivery. It’s strange that courts are willing to enforce the “bonus” clause, but not the “penalty” clause, since the two are actually equivalent in a basic accounting sense.
Paradox of Compensation
The promisor can make investments to ensure that the contract is fulfilled. These are called
investments in performance. For example, a builder might pay workers overtime to make sure that a building is completed on time.
At the same time, the promisee can make investments to increase the value of the contract if it is completed. These are called investments in reliance because these investments rely on the contract being fulfilled to produce value. For example, a restaurant owner might buy a lot of food for a grand opening ceremony for a building that the contractor promises to complete. A customer might purchase accessories specific to a car that a seller promises to deliver.
exactly right because the promisor is responsible for paying full damages for a breach. However, the promisee has no incentive to be careful about investments in reliance because she will be fully compensated for damages if the contract is breached. For example, if the promisee knows that a restaurant building might not be completed on time, she might want to be careful about ordering too much expensive food for the grand opening. But if the promisee is guaranteed full expectation damages, she has no incentive to be careful about ordering food because she will be fully compensated in case the builder is unable to complete the building on time.
Do you see the analogy to tort law? This is exactly the same as the problem with strict liability. It provides an incentive for injurers to take efficient precautions to avoid injuries, but it provides no incentives for victims to invest one little bit in undertaking any precautions because they are fully compensated for any losses that occur.
What if we instead switch to not awarding any damages for breach of contract? Now the promisee has an incentive to undertake the efficient level of investment in reliance, because she will not receive any damages if the contract is breached. But the promisor of course has no incentive to undertake any investments in performance since he is not paying any damages. This is analogous to the “no liability” rule in tort law.
In order for the promisor to make efficient investments in performance, he must pay full expectation damages. But in order for the promisee to make efficient investments in reliance, she must not receive any damages. Therein lies the paradox of compensation. Compensation paid by the promisor is equal to compensation received by the promisee, so contract law can never create efficient incentives for both the promisor and the promisee.
Seems pretty grim. Are there any solutions? Here are a few ideas.
• Liquidated damages fixed in contract – The promisee might agree to some level of compensation in advance with no compensation for additional over-reliance. For example, a contractor might agree to pay for the unused telephone service in a building if the building is not done in time but not for crates of lobster for the grand opening party.
• Negligence-type rules – The court might try to determine whether the promisor and/or promisee invested efficiently and assign damages accordingly (like negligence rules in tort law). The problem is that it is almost impossible for any court to determine this.
damages. At the same time, the promisee has incentives for efficient investment in reliance since she actually receives nothing. In this scheme, both parties are paying the full cost of contract breach, which creates efficient incentives for both. One might even imagine a market forming where anti-insurance firms bought from private parties the right to collect this compensation in the event of a contract breach.
How has Common Law evolved to deal with this issue? There is a long-standing doctrine known as foreseeability, which is clearly designed to address precisely this problem. According to the principle of foreseeability, a promisor should only be held liable for damages related to reliance costs that he could have reasonably expected. For example, if you order some dog food and the pet store fails to deliver it, they might be liable for your costs to obtain it from elsewhere but not for the cost of your dogs’ dying from starvation because you didn’t feed them.
Enforceable Contracts
Having covered the first central issue of contract law – how to penalize breaches of contract – we now turn to the second central issue. What kinds of contract should be enforced in the first place?
There are two basic types of defenses for breach of contract in Common Law.
1. Formation defense – The contract was never valid
2. Performance excuse – The contract was valid but the breach is excusable.
Historically, there are a few Common Law principles that govern which contracts are enforceable. First is consideration – both sides have to get something. Contracts to give a gift are not generally enforceable. There should also be a meeting of the minds – both sides have to understand the contract. Importantly, there is not generally a requirement that contracts be fair, although Common Law is becoming increasingly hostile towards contracts that are excessively one-sided, which is an issue that we will deal with later in this section.
Incomplete Contracts
Let’s first deal with the issue of contracts that contain holes.
In fact, it can sometimes make sense to leave gaps in contracts if the cost of filling them exceeds the expected cost of fixing the problem later. If a risk is very remote and the transaction cost of negotiating out a written solution in the contract is high, then it can be efficient to leave gaps in contracts.
In Common Law, there are two kinds of rules that impose judgments on parties that are not written into the contract.
1. Default rules fill in gaps in contracts.
2. Mandatory rules replace explicit contract terms.
Default rules apply when a contract is silent about something that becomes important. For example, suppose a building cannot be completed because of issues getting permits from the state, but the contract says nothing about permits. A couple getting married might not say anything about what is going to happen in the event of a divorce.
In Common Law, default rules are standard principles that apply in the absence of explicit contract language. Efficient default rules save parties the costs and trouble of negotiating in advance.
Even if language is not strictly missing from a contract, Common Law often sets aside contract terms that are too vague. For example, imagine a contract that requires a seller to “put his best effort” into satisfying some condition. When courts do try to resolve vague issues like this, the burden of proof is typically very high. The point is to incentivize parties to write their contracts more clearly.
By contrast, mandatory rules actually replace clear, explicit language in the contract. These are the subject of the balance of this section.
Mandatory Rules in Common Law
Mandatory rules disregard or replace explicit contract terms. There is a similarity here to basic welfare economics. If markets worked perfectly, then private markets and private contract terms would always be efficient. By definition, the only possible impact of government interference with private contracts (i.e. mandatory rules) would be to reduce efficiency. This is just like the argument we give in basic microeconomics that private market outcomes are efficient and that government interference in private markets (e.g. price controls) can only reduce efficiency.
can lead to inefficient outcomes if bargaining breaks down or does not work well. Some kind of market failure is typically offered as the justification for mandatory rules that interfere with private contracting.
Economists usually sort market failure into three categories.
1. Spillovers – Private transactions that involve costs and benefits external to the parties involved. This covers the well-known cases of externalities and public goods.
2. Asymmetric information – Actions or information are hidden from one side. 3. Monopoly power – Lack of competitive market forces.
We will add individual rationality, which is more controversial, but basically applies if private parties are unable to make rational decisions.
Standard mandatory rules in Common Law are outlined below, and classified as to the type of market failure they address. The important point is that scholars of Law and Economics aren’t satisfied to justify mandatory rules on the basis of “fairness” or because it seems like the right thing to do. It is basic economics that government interference in private agreements reduces efficiency unless there is a market failure. Thus, in justifying mandatory rules, economists have to appeal to some kind of market failure in order to argue that such interference has any potential to create benefits for society.
Individual Rationality
• Incompetence – Party not capable of entering into a contract
• Duress – Party improperly coerced into entering contract
• Necessity – Dire constraint imposed by outside circumstance
Spillovers • Contract terms contradict other public policy goals
Asymmetric Information
• Fraud – Promise extracted by lies
• Culpa in Contrahendo – Missing information should have been provided
• Frustration of Purpose – Outside factor undermines reason for contract
• Mutual Mistake – Parties misunderstood what the contract was about
Monopoly
Power • Unconscionability – Contract is excessively one-sided
Incompetence
Common Law does not recognize contracts with a party who is legally incompetent to enter into a contract. For example, contracts with children or with mentally disabled individuals are not valid. Another reason is transactional incapacity, which occurs when something specific about the circumstance prevented the party from acting competently, like high-pressure sales tactics.
There is a good efficiency rationale for this principle. Competent contractual partners can protect the interests of incompetent partners at a lower cost than anyone else can. The way to encourage them to do so is to hold competent people liable for failing to protect the interests of incompetent contract partners.
Duress
A contract is formed under duress when a party enters into it because of unlawful threats or coercion. Importantly, Common Law makes a distinction between legitimate bargaining demands and improper coercion. “I’ll only sign the contract if you agree to pay me more money” is a perfectly valid bargaining demand. “Sign this contract or I’ll kidnap your sister” is not.
How can we distinguish between the two? There is a simple test. Legitimate bargaining creates a surplus, and a failed bargain results in zero surplus. By contrast, coerced threats create no surplus; they just redistribute surplus via a threat. A failed bargain in this case destroys surplus.
Common Law enforces promises that are extracted to create a surplus cooperatively, but does not enforce promises that are extracted by a threat to destroy value. This is an efficiency improvement. People would waste resources protecting themselves against duress if the state enforced contracts made under duress. The state is well-positioned to protect people against being coerced by refusing to enforce contracts that were made under duress.
The two examples below help to illustrate the distinction.
Question: A captain hires a crew for a fishing expedition. One day before the end of the job, the crew demands that the captain agree to pay them more money or they will all quit immediately and the fish catch will rot. The captain signs the contract. Is this a valid contract?
Answer: No. The contract would not be enforced under Common Law. The crew is just trying to redistribute wealth to themselves by threatening to destroy value. There is no creation of any new surplus.
Question: In the scenario above, the crew – one day before the trip begins – receives a call about a better paying job. They demand more money from the captain to work with him, and he agrees. Is this a valid contract?
Necessity
While duress involves coercion created by the other party, necessity involves a constraint imposed by some outside circumstance. For example, suppose a person gets sick on a boat. The only doctor available offers to treat him, but forces him to sign a contract agreeing to pay an exorbitant price. One way to see the distinction is that, with duress, the promisee threatens to destroy value by acting. With necessity, the promisee threatens to destroy value by not acting.
Common Law generally allows for reasonable compensation for services contracted in the event of necessity, but not an excessive award. For example, the doctor in the situation above would be able to recover the market value of his services, possibly with some premium for his inconvenience, but the court will not enforce the contracted price if it is exorbitant.
How much of a premium should courts award to rescuers who contract out their services in the case of a necessity? If we turn to efficiency, economics would suggest that the reward should be set so that rescuers are willing to act under circumstances of necessity. As such, the reward necessary to incentivize these rescues depends on the circumstances.
• Fortuitous rescues happen by chance and do not require any resources in advance. For example, a passerby in the desert happens to have some extra gas and runs across someone who is stranded.
• Anticipated rescues use resources set aside for this purpose. For example, people driving through the desert regularly carry extra gas in case they run into someone stranded.
• Planned rescued involve active search. For example, a patrol roams the desert to see if anyone is stranded.
If the intention is to incentivize rescues, then among the three the largest award should be for planned rescues, followed by anticipated and fortuitous rescues.
Question: A doctor stops by the side of the road to treat an accident victim.
a. Under what circumstances is it efficient for the doctor to treat the victim?
Two weeks later, the victim receives a bill for the doctor’s services. Consider three legal rules.
I. The patient is not required to pay anything.
II. The patient is required to pay whatever the doctor asks.
III. The patient is required to pay the going market rate for comparable services.
b. Describe the efficiency loss that might be created by (I). c. Describe the efficiency loss that might be created by (II).
Answer:
a. It is efficient for the doctor to treat the patient as long as the benefits to the patient are greater than the cost to the doctor of treating her.
b. Doctors might be unwilling to lend assistance even when it would be efficient to do so.
c. Doctors might be over-eager to provide treatment even when it is not efficient to do so. On the other side of the transaction, patients might avoid accepting emergency treatment even if it would be efficient for them to do so if they are scared of being required to pay an exorbitant bill.
d. It might be worth providing a bit of an extra reward over and above market value to encourage
doctors to make their services available in these emergency cases. For example, we might want to incentivize doctors to carry some basic tools with them.
Spillovers
Common Law courts may refuse to enforce contracts that derogate public policy – with spillovers that go against public policy interests somehow. For example, the court would not enforce a contract wherein a theft victim promises to pay a police officer to solve his case, because this creates a public harm in the operation of the police department. As another example, you don’t see a lot of cocaine manufacturers who sue their dealers for contract breach.
Impossibility
In Common Law, impossibility refers to a constraint that arises after the contract is signed that prevents it from being fulfilled. For example, consider a surgeon who breaks his hand after agreeing to perform a surgery or a driller who promises to drill a well for a homeowner but runs into impenetrable rock. Most contracts have gaps relating to remote, low-probability risks.
What should courts do? Excuse the breach or require the person who breaches to pay damages anyway? Economically, how should we decide who is responsible for these risks? Under Common Law, breaches are excused when some outside circumstance destroys a basic premise on which the contract was made. Examples are physical impossibility, acts of God, or if performance of the contract becomes illegal or economically impractical.
But how would we design a rule with an eye to efficiency? For purposes of economic efficiency, the general principle is that the risk should be allocated to the least-cost risk bearer – the contract party who can bear the risk at lowest cost.
can probably buy insurance against his factory burning down more easily than a customer can buy insurance against a part not being delivered.
Frustration of Purpose
Closely related to impossibility, frustration of purpose occurs when some unforeseen even undermines a party’s reason for entering into a contract, and both parties understood that this was the reason when the contract was signed. A classic case in Common Law occurred when owners of hotels along a parade route had rented out rooms to customers, specifically for the purpose of watching a coronation parade. But there was rain and the coronation had to be rescheduled. Should the renters be forced to pay for the rooms anyway?
Again, we invoke the principle of the least-cost risk bearer. The court ruled for the case above that the owners could easily eliminate potential losses simply by rescheduling the rentals for parade day. But customers risked being forced to pay twice. Thus, the court ruled in favor of the renters and did not require them to pay for the rooms.
Mutual Mistake about Facts
A mutual mistake about facts occurs when both parties misunderstand some key element of the contract. For example, suppose a buyer agrees to buy land from a seller specifically for the purpose of harvesting timber, but unbeknownst to either of them the land is barren because a fire burned down the all of the trees a week earlier.
Resolving such cases in an efficient way again involves the principle of the least-cost risk bearer. For example, if the seller could have easily prevented the fire or held insurance, then he is the least-cost risk bearer and so the court should not enforce the contract. In general, for contracts involving property transfer, the owner of the property at the time is usually the least-cost risk bearer for problems involving the property.
Mutual Mistake about Identity
A mutual mistake about identity occurs when the two parties had different things in mind when the contract was written. For example, suppose a buyer and seller were thinking of two different cars when they made an agreement for a car sale.
surplus in the first place, and so there is no efficiency rationale for enforcing contracts based on mutual mistake about identity.
Unilateral Mistake
A more interesting case is unilateral mistake, which occurs when only one party to the contract is mistaken as to the circumstances or some key element. For example, consider a buyer who buys an old car from a seller. The buyer knows that the car is an antique classic and very valuable. The seller thinks it’s a piece of junk.
While Common Law tends to void contracts based on mutual mistakes, courts will usually enforce contracts that involve unilateral mistake.
Is there an efficiency rationale? The fundamental difference is that a contract involving a mutual mistake can destroy surplus by forcing an inefficient transaction. By contrast, an agreement based on a unilateral mistake can reward discovery and investment. For our example above, if the buyer knows that the car is rare and valuable, it makes good sense in terms of efficiency that the buyer should control the car, even if it seems distasteful that he got it because he didn’t tell the seller how valuable it is.
Economically, there are two pieces.
1. It makes sense to reward information that is productive, not simply information that is
redistributive.
For example, the buyer of the antique car will probably make better use of it than a seller who lets it rust in his garage, so the buyer’s information in this case is actually productive. By contrast, consider a rancher who buys a pregnant cow from a farmer when the farmer does not know the cow is pregnant. Well, the farmer is going to figure out eventually that the cow is pregnant, so there is no particular efficiency reason for the cow to go to one party or the other. The rancher’s early purchase in this case is purely redistributive
2. It makes sense to reward information that is obtained actively, not simply information that is obtained fortuitously.
Overall, the key for efficiency is to enforce contracts that are based on differences in productive information, especially if the information was obtained through costly investment. People sometimes state the maxim as: “Unite knowledge and control.” The most efficient way to allocate resources is for the person who can make the most productive use of them to retain control.
Question: The War of 1812 significantly reduced the price of tobacco in the US because exports were banned during the war. Thomas received private information that the war had ended. He immediately wrote a futures contract with John, who was not yet aware that the war had ended, to buy tobacco from him at the low price. Would efficiency suggest enforcing the contract or rescinding it?
Answer: Thomas’ information is purely redistributive. The contract does not contribute in any way to an increase in productivity, so there is no efficiency rationale for enforcing the contract. (There’s no efficiency rationale for rescinding it, either. The resolution is just a matter of distribution).
Question: A geologist studies an area and surmises that there are minerals under his neighbor’s property that the neighbor would be unlikely to discover on his own. He buys the property from his neighbor, but doesn’t tell him about the minerals. The neighbor is furious when he hears about all the mineral wealth. Would efficiency suggest enforcing this contract or rescinding it?
Answer: It is efficient in this case to enforce the contract. The information is productive. The geologist can make better use of the land than the farmer can, and it took some work for him to realize that the minerals were located under the farmer’s property.
Question: Consider the two scenarios below.
I. A geologist buys land from a farmer that he knows to contain gold deposits. He does not tell the farmer about the gold before he buys the land.
II. A painting in a gallery appears to be a valuable painting by Picasso. The buyer buys it, but the painting turns out to be a worthless forgery.
A lawyer representing the seller in (II) argues that the case is really no different from (I). According to him, the sale of the painting is a valid contract based on a unilateral mistake, and a unilateral mistake is not a valid reason to void a contract in Common Law. Do you see any important difference between (I) and (II)?
Answer: The information in (I) is productive. The geologist is the efficient owner of the land. By contrast, the information in (II) is purely redistributive. There is no efficiency rationale to enforce the contract.
Fraud
In Common Law, fraud requires a lie, not merely the omission of information.
Economic efficiency obviously requires that contracts based on fraud not be enforced. The purpose of a contract is to allow the creation of a surplus, but the presence of fraud means that there may never have been a surplus in the first place.
Question: A seller is very attached to her home and wishes to sell it only to someone who will maintain the property as a house. A prospective buyer promises that he will use the property as a house. The sale is completed, and the seller moves out. However, several days later she learns that the buyer intended all along to demolish the house in order to build a parking lot. Does efficiency suggest enforcing the contract or rescinding it?
Answer: The buyer’s promise constitutes fraud, and so efficiency would suggest rescinding the contract. The trading surplus was based on the seller’s understanding that the property would be maintained as a house. If this is not true, the trade may not have been efficient in the first place.
Duty to Disclose
Duty to disclose means that sellers are required to disclose certain information (e.g. safety information) to buyers. Failure to disclose information does not rise to the level of fraud, but nevertheless duty to disclose is becoming increasingly standard in Common Law.
Your initial thought might be that these are transfers, just like a unilateral mistake. But there is typically an efficiency improvement associated with duty to disclose requirements. For example, suppose Melissa buys a house from Sara. Sara knows that the house is infested with bugs but doesn’t tell Melissa about the bugs before she buys the house. Under duty to disclose, Sara is required to tell Melissa about the bugs before the buys the house. Importantly, there’s something beyond a unilateral mistake here. If Melissa had known about the bugs, she might have been able to get them exterminated, but because she doesn’t know, the bugs do a bunch of costly damage. Thus, there is a tangible efficiency reason to require such disclosures – not simply a moralistic view that it’s the right thing to do. Duty to disclose for safety concerns is obviously efficient for the same reason. The buyer can avoid costly damages.
Contracts of Adhesion
Having covered limited rationality, spillovers and imperfect information, we turn now to our final market failure justification for mandatory rules that overturn explicit contract terms – monopoly power.
It is standard microeconomics that monopolies can charge inefficiently high prices because of their market power. In exactly the same way, monopolies can demand unreasonable and inefficient contract terms because of lack of competition – a competitive market would open the door for another seller to enter the market and offer more favorable terms.
A contract of adhesion is a set of take-it-or-leave-it contract terms that arises because of monopoly power.
are identical, then there must be either monopoly power or some kind of cartel among firms that amounts to monopoly power. Economists would emphasize that the market failure present in contract of adhesion only exists when there is demonstrably some kind of market power. The existence of a standard-form contract is not sufficient to prove monopoly power, as there are benefits to standard-form contracts and other reasons that they might arise. Examples include:
• Standard-form contracts can enhance price competition by standardizing other parts of a transaction.
• Standard-form contracts reduce transaction costs for consumers by imposing homogeneity on other parts of the deal besides price. There is no need for buyers to bargain over every single aspect of the transaction.
• Standard-form contracts can arise because ignorant buyers sign them without reading them.
The point is that contracts of adhesion based on monopoly power can be inefficient, but merely the existence of a standard-form contract is not sufficient to prove that there is monopoly power.
Another interesting aspect of Common Law on contracts of adhesion is that courts are much more willing to adjust non-price terms in contracts than they are to adjust the price. Does this make any economic sense?
It is basic economics that a monopolist who can extract all the surplus from a market through price (i.e. perfect price discrimination) will design other contract terms efficiently in order to maximize market surplus. The outcome will be efficient, with all the surplus going to the monopolist. However, if the monopolist cannot extract all the surplus out of a market, then he might distort other contract terms in order to increase his own surplus, even if they reduce efficiency. A concrete example is that monopolies often try to prevent resales.
Thus, it might make sense to let a firm do whatever it wants with price as a way to encourage it to set other contract terms efficiently. The court can then adjust these non-price terms if they seem unreasonable or inefficient.
Unsconscionability
Finally, we turn to contracts that just seem unfair. According to the Common Law doctrine of
unconscionability, the court can set aside a contract if it is so one-sided as to “violate the conscience of the court.”3
Of course, this standard is vague and there are differences across judges in how unconscionability is applied to any specific set of circumstances.
What would economics say? Economists are very reluctant to set aside valid contracts on fairness grounds as long as both parties clearly understood the contract terms at the time. The problem economists would cite is that it leads to serious unintended consequences. A long-standing public policy controversy is extremely high interest rates charged to poor borrowers in payday lending facilities. The problem is that, if courts refused to allow these high interest rates, there is ample evidence that the poor would have no access to credit at all.
Outside of an appeal to some kind of limited rationality, it is hard to justify an efficiency improvement from outlawing mutually agreeable contracts if both parties are informed. The farthest economists might go is an extra layer of scrutiny to make sure that there is solid proof that both sides understand contracts that seem very one-sided.
Case Study
The following pages contain two opinions in the case Jacobs & Young Inc. vs. Kent. The basic facts are as follows. George Kent paid the contractor Jacobs & Young to build a house for him. Although the contract specified that Reading brand pipe should be used for the plumbing in the house, the contractor installed Cohoes brand pipe instead. After the house was already built, Kent discovered that the wrong brand of piping had been used and he refused payment on the contract until Jacobs & Young corrected the problem. Jacobs & Young sued Kent. The initial court ruled in favor of Kent, but the majority appellate opinion finds in favor of Jacobs & Young.
a. The discrepancy between the two opinions amounts to a disagreement about how damages should be calculated. Summarize this disagreement.
b. Briefly describe the disagreement about which evidence should be admitted. c. Summarize the economics of the argument given in the majority opinion. d. Summarize the economics of the argument given in the dissenting opinion. e. On efficiency grounds, which argument do you think is stronger on balance?
Majority Opinion (excerpts)
The defendant learned in March, 1915, that some of the pipe, instead of being made in Reading, was the product of other factories. The plaintiff was accordingly directed by the architect to do the work anew. The plumbing was then encased within the walls except in a few places where it had to be exposed. Obedience to the order meant more than the substitution of other pipe. It meant the demolition at great expense of substantial parts of the completed structure.
The plaintiff left the work untouched, and asked for a certificate that the final payment was due. Refusal of the certificate was followed by this suit.
The evidence sustains a finding that the omission of the prescribed brand of pipe was neither fraudulent nor willful. It was the result of the oversight and inattention of the plaintiff’s subcontractor.
Reading pipe is distinguished from Cohoes pipe and other brands only by the name of the manufacturer stamped upon it at intervals of between six and seven feet. Even the defendant’s architect, though he inspected the pipe upon arrival, failed to notice the discrepancy.
The plaintiff tried to show that the brands installed, though made by other manufacturers, were the same in quality, in appearance, in market value, and in cost as the brand stated in the contract-that they were, indeed, the same thing, though manufactured in another place. The evidence was excluded, and a verdict directed for the defendant.
We think the evidence, if admitted, would have supplied some basis for the inference that the defect was insignificant in its relation to the project. The courts never say that one who makes a contract fills the measure of his duty by less than full performance. They do say, however, that an omission, both trivial and innocent, will sometimes be atoned for by allowance of the resulting damage, and will not always be the breach of a condition to be followed by a forfeiture.
The decisions in this state commit us to the liberal view, which is making its way, nowadays, in jurisdictions slow to welcome it. Where the line is to be drawn between the important and the trivial cannot be settled by a formula. ‘In the nature of the case precise boundaries are impossible.’ The same omission may take on one aspect or another according to its setting. Substitution of equivalents may not have the same significance in fields of art on the one side and in those of mere utility on the other. Nowhere will change be tolerated, however, if it is so dominant or pervasive as in any real or substantial measure to frustrate the purpose of the contract.
The question is one of degree, to be answered, if there is doubt, by the triers of the facts, and, if the inferences are certain, by the judges of the law. We must weigh the purpose to be served, the desire to be gratified, the excuse for deviation from the letter, the cruelty of enforced adherence. Then only can we tell whether literal fulfillment is to be implied by law as a condition. This is not to say that the parties are not free by apt and certain words to effectuate a purpose that performance of every term shall be a condition of recovery. That question is not here. This is merely to say that the law will be slow to impute the purpose, in the silence of the parties, where the significance of the default is grievously out of proportion to the oppression of the forfeiture. In the circumstances of this case, we think the measure of the allowance is not the cost of replacement, which would be great, but the difference in value, which would be either nominal or nothing. Some of the exposed sections might perhaps have been replaced at moderate expense. The defendant did not limit his demand to them, but treated the plumbing as a unit to be corrected from cellar to roof. In point of fact, the plaintiff never reached the stage at which evidence of the extent of the allowance became necessary. The trial court had excluded evidence that the defect was unsubstantial, and in view of that ruling there was no occasion for the plaintiff to go farther with an offer of proof. We think, however, that the offer, if it had been made, would not of necessity have been defective because directed to difference in value. It is true that in most cases the cost of replacement is the measure. The owner is entitled to the money which will permit him to complete, unless the cost of completion is grossly and unfairly out of proportion to the good to be attained. When that is true, the measure is the difference in value. Specifications call, let us say, for a foundation built of granite quarried in Vermont. On the completion of the building, the owner learns that through the blunder of a subcontractor part of the foundation has been built of granite of the same quality quarried in New Hampshire. The measure of allowance is not the cost of reconstruction.
Dissenting Opinion (excerpts)
I dissent. The plaintiff did not perform its contract. Its failure to do so was either intentional or due to gross neglect which, under the uncontradicted facts, amounted to the same thing, nor did it make any proof of the cost of compliance, where compliance was possible. Under its contract it obligated itself to use in the plumbing only pipe (between 2000 and 2500 feet) made by the Reading Manufacturing Company. No examination, so far as appears, was made by the plaintiff, the subcontractor, defendant’s architect, or anyone else, of any of the pipe except the first delivery, until after the building had been completed. Plaintiff’s architect then refused to give the certificate of completion, upon which the final payment depended, because all of the pipe used in the plumbing was not of the kind called for by the contract. After such refusal, the subcontractor removed the covering or insulation from about 900 feet of pipe which was exposed in the basement, cellar, and attic, and all but 70 feet was found to have been manufactured, not by the Reading Company, but by other manufacturers, some by the Cohoes Rolling Mill Company, some by the National Steel Works, some by the South Chester Tubing Company, and some which bore no manufacturer’s mark at all. The balance of the pipe had been so installed in the building that an inspection of it could not be had without demolishing, in part at least, the building itself.
were made by that company and he ought not to be compelled to pay unless that condition be performed.
The rule, therefore, of substantial performance, with damages for unsubstantial omissions, has no application. What was said by this court in an earlier case is quite applicable here:
‘I suppose it will be conceded that everyone has a right to build his house, his cottage or his store after such a model and in such style as shall best accord with his notions of utility or be most agreeable to his fancy. The specifications of the contract become the law between the parties until voluntarily changed. If the owner prefers a plain and simple Doric column, and has so provided in the agreement, the contractor has no right to put in its place the more costly and elegant Corinthian. If the owner, having regard to strength and durability, has contracted for walls of specified materials to be laid in a particular manner, or for a given number of joists and beams, the builder has no right to substitute his own judgment or that of others. Having departed from the agreement, if performance has not been waived by the other party, the law will not allow him to allege that he has made as good a building as the one he engaged to erect. He can demand payment only upon and according to the terms of his contract, and if the conditions on which payment is due have not been performed, then the right to demand it does not exist. To hold a different doctrine would be simply to make another contract, and would be giving to parties an encouragement to violate their engagements, which the just policy of the law does not permit.’
