Hofstra Law Review Volume 20 | Issue 4 Article 4 1992 The egliN gence-Opportunism Tradeoff in Contract Law George M. Cohen Follow this and additional works at: http://scholarlycommons.law.hofstra.edu/hlr Part of the Law Commons Recommended Citation Cohen, George M. (1992) "The eN gligence-Opportunism Tradeoff in onC tract Law," Hofstra Law Review: Vol. 20: Iss. 4, Article 4. Available at: http://scholarlycommons.law.hofstra.edu/hlr/vol20/iss4/4 This document is brought to you for free and open access by Scholarly Commons at Hofstra Law. It has been accepted for inclusion in Hofstra Law Review by an authorized administrator of Scholarly Commons at Hofstra Law. For more information, please contact [email protected]. Cohen: The Negligence-Opportunism Tradeoff in Contract Law THE NEGLIGENCE-OPPORTUNISM TRADEOFF IN CONTRACT LAW George M. Cohen* In this Article,' Professor Cohen discusses the relationship between two traditions of contract analysis developed in the Law and Economics literature: one which focuses on assigning the "sunk" costs of contract breach to the "least cost avoider," and one which would assign these costs to whichever of the contracting parties most likely acted opportunistically. The Article begins with a thorough description of these two analytical strands, and uses them to critique the classic "efficient breach" scenario. Professor Cohen posits a fault-based economic theory of con- tract analysis that combines the "least cost avoider" and "oppor- tunism" analytical strands. He focuses his discussion on scenarios where these two analytical strands suggest differing outcomes to the question of which party to a contract ought to absorb the "sunk" costs associated with its breach. He argues that these scenarios present a tradeoff between deterring negligent and opportunistic behavior in the marketplace: The Negligence-Opportunism Tradeoff. This tradeoff is analogous to the classic tension between individual freedom and society's interest in market regulation. Professor Cohen resolves this tension by arguing that the law should place a pre- sumptive priority on curbing potentially opportunistic behavior, at the expense of permitting-or at least not preventing-potentially negligent behavior. He argues that to give priority to deterring negligence over deterring opportunism-which many Law and Eco- nomics scholars implicitly advocate-perversely rewards deceitful * Visiting Assistant Professor of Law, University of Virginia; Assistant Professor of Law, University of Pittsburgh; J.D., Ph.D., University of Pennsylvania. I would like to thank for their helpful comments and suggestions, and absolve from my remaining errors the following: Ian Ayres, John Donohue, Harry Flechtner, Geoffrey Hazard, Susan Koniak, Eric Kramer, Seth Kreimer, Jules Lobel, Jack Ochs, Rafael Rob, Tom Ross, David Skeel, Dick Speidel, Rhonda Wasserman, and especially my thesis advisor, Michael Wachter. I would also like to thank for their helpful research assistance Albert Lee, Scott Bullock, Lisa Chiesa, Phil Abromats, and Peter Cohen. Earlier versions of this paper were presented at the University of Pittsburgh Department of Economics, the University of Pittsburgh School of Law, and the Duquesne University Law & Economics Symposium. The University of Pittsburgh School of Law provided financial support for this research. Published by Scholarly Commons at Hofstra Law, 1992 1 Hofstra Law Review, Vol. 20, Iss. 4 [1992], Art. 4 HOFSTRA LAW REVIEW [Vol. 20:941 behavior while punishing often unobservant action, and cracks the foundation of trust necessaryfor efficient contracting to occur. INTRODUCTION Over the past two decades, Law and Economics scholars have developed two different analytical approaches to contract law without examining the relationship between them: The first approach, based on the idea of the "least-cost-avoider" developed in tort law, aims to deter "negligent" contracting behavior by punishing a contracting party who fails to take cost-justified precautions. The second approach aims to deter "opportunistic" contracting behavior by punishing a contracting party who affirmatively acts contrary to some contractual expectation or social norm.' Typically, scholars focus on one ap- proach or the other in their work. Rarely do scholars combine the I 1. Professors Goetz and Scott first recognized a version of this dichotomy in 1983 when they wrote that Law and Economics scholarship in the contracts area "has developed from two distinct and largely unrelated analytic traditions." Charles J. Goetz & Robert E. Scott, The Mitigation Principle: Toward a General Theory of Contractual Obligation, 69 VA. L. REV. 967, 968 n.5 (1983) [hereinafter Mitigation Principle]. They identified these traditions as the "bargain model" and the "transaction cost" approaches. Bargain model theorists "have constructed models of contracting behavior under conditions of low transaction costs to examine the influence of different legal rules in environments where parties are able to allocate all relevant risks at the time of contracting." Id. In contrast, transaction cost theorists "have focused on methods of reducing transaction costs in complex contractual relationships. They assume that uncertainty and complexity often prevent parties from accurately allocating all relevant risks at the time of contracting. This scholarship thus examines the strategies parties devise to encourage subsequent cooperation in such relational contracts." Id Other scholars have recognized the dichotomy identified by Goetz and Scott. See Jay M. Feinman, Contract After the Fall, 39 STAN. L. REV. 1537, 1539 n.11 (1987) (reviewing HUGH COL- LINS, THE LAW OF CONTRACT (1986)); Jay M. Feinman, The Jurisprudence of Classification, 41 STAN. L. REV. 661, 670 n.35 (1989); Ian R. Macneil, Relational Contract: What We Do and Do Not Know, 1985 Wis. L. REV. 483, 495-96; see also Jason S. Johnston, Law, Economics, and Post-Realist Explanation, 24 LAW & SOC'Y REV. 1217 (1990) (distinguishing the "model of precautions" from "transaction cost economics"). If by "distinct and largely unrelated," Goetz and Scott meant that these traditions must necessarily be so, this conclusion seems highly questionable. The distinctions between the traditions that they identify are based on different assumptions about transaction costs and court competence in the two approaches and different objects of study. The bargain model assumes low transaction costs and focuses on court rules. The transaction costs model as- sumes high transaction costs and focuses on private contracting devices. But there is no necessary connection between the assumptions in these models. In particular, models of the influence of different legal rules under conditions of high transaction costs would seem to be crucial to an economic analysis of contract law. In distinguishing between the two traditions, I find more significant the type of behavior which the law seeks to deter or encourage, not assumptions about transaction costs and relative institutional competence. http://scholarlycommons.law.hofstra.edu/hlr/vol20/iss4/4 2 Cohen: The Negligence-Opportunism Tradeoff in Contract Law 1992] NEGLIGENCE-OPPORTUNISM TRADEOFF two approaches. 2 Never have scholars combined them in any system- atic way. This paper will develop a general fault-based economic theory of contract law that combines the least-cost-avoider and opportunism approaches. In many cases, these approaches point toward the same outcome, but often they conflict and present what I call the negli- gence-opportunism tradeoff: the legal rule must favor the deterrence of one type of behavior over the other. The negligence-opportunism tradeoff captures to a large degree the fundamental tension in contract law largely ignored by economists but traditionally recognized by lawyers: the tension between individual freedom of contract and social regulation of the marketplace.3 In resolving this tradeoff, I argue on efficiency grounds that the law should place a presumptive priority on deterring potentially opportunistic behavior over deterring potentially negligent behavior. To give priority to deterring negligence over de- terring opportunism-which many economists often implicitly advo- cate-perversely rewards deceitful sleaziness while often punishing hapless incompetence, and cracks the foundation of trust necessary for 2. Goetz and Scott, as well as other scholars, have started to link the two traditions. See VICTOR P. GOLDBERG, READINGS IN THE ECONOMICS OF CONTRACT LAW (1989); RICH- ARD A. POsNER, ECONOMIC ANALYSIS OF LAW (4th ed. 1992); Ian Ayres & Robert Gerlner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 YALE L.J. 87 (1989); Charles J. Goetz & Robert E. Scott, The Limits of Expanded Choice: An Analysis of the Interactions Between Express and Implied Contract Terms, 73 CAL. L. REV. 261 (1985) [hereinafter Limits of Expanded Choice]; Mitigation Principle, supra note 1; cf. Robert Cooter, The Cost of Coase, 11 J. LEGAL STUD. 1 (1982) [hereinafter Cost of Coase] (con- trasting the "Coase Theorem" with the "Hobbes Theorem"). Professor Goldberg's book in particular has greatly influenced my thinking about the problems discussed in this paper. 3. See, e.g., Robert Braucher, Freedom of Contract and the Second Restatement, 78 YALE LJ. 598, 599 (1969) (arguing that the Second Restatement "makes clearer the tension that exists between the doctrines of freedom of contract and elemental fairness of the transac- tion"); Harry W. Jones, The Jurisprudence of Contracts,