06 March 2012 Written by  Mesganaw Kifelew and Demelash Shiferaw

Historical development and Economic Analysis of contract law


Historical development of contract law

This section provides a very brief account of the historical development of contract law. The historical development of contract law can be under stood in terms of the conceptual foundations of obligations, which was traced back to ancient and classical Roman law.  However the foundations of the present day law of contract were laid in the 19th century. This period in history saw the rapid expansion of trade and industry inevitable resulting in the increments in the volume of commercial disputes as a result people turned to the court of law for solutions. Gradually, there developed a body of settled rules which reflected and of the disputes from which they arose and the prevailing belief of the time.  However, this rules and belief are affected by the dominant economic philosophy, the so called the laissez-faire individualism-the view that the state should not meddle in the affairs of business and that individuals should be free to determine their own destinies. This philosophy was mirrored in the law of contract by two assumptions-freedom of contract and equality of bargaining power. According to freedom of contract theory it is assumed that everyone is free to choose which contracts they entered into and the terms on which they wish to do so. According to equality of bargaining power theory, the parties were deemed to have equal power to bargain on their business and deemed to be of equal bargaining strength.

These theoretical foundations of contract law produced an acceptable legal framework for the regulation of business transaction that resulted in the crystallization or codifications of contract laws across the world. The two theories did also define the role of the courts. Courts were required to enforce the agreement of the parties, as it was without questions its fairness etc. Over years the freedom of contract theory though maintained at present is subjected to different limitations. The theory of equality of bargaining power had brought certain unnecessary results because parties to a contract do not necessarily have equality. For example, employers and employees, producers and consumers, lenders and borrowers do not have equal power in the negotiations. Employees, for example, did not have equal bargaining power with employers, and as a result entered in to contracts the terms of which were more favorable to the employers (employees were supposed to work for as long as 16 hours per day & more, less wages etc). Courts were simply required to enforce such terms. This led to dissatisfaction, riots, unrest etc calling for government intervention. Thus, governments do lay down the minimum conditions for enforceable employment contracts. Today, we find the law of contract providing the conditions for the making and enforcement of contract. However, we should note that the theory of freedom of contract and equality of bargaining power are still the foundations of contract law in many legal systems.

The Economic Analysis of Contract Law

This section is intended to introduce an emerging discipline of law and economics as applied in contracts. The economic analysis of contract law provides a new paradigm into contract law in terms of both defining the concept and the economic function of contract & contract law. As the subject is vast to cover in this material, we have opted to consider some of the concepts and assumptions suggested by leading scholars (Look ‘Economics of Contract Law’ by Kronman and Posner (1979) for further understanding).

One fundamental economic principle is that if voluntary exchanges are permitted-if, in other words, a market is allowed to operate-resources will gravitate towards their most valuable uses. The exchange will make not only the parties better off but will also increases the wealth of the society, assuming that the exchange does not reduce the welfare of nonparties more than it increases the welfare of the parties. The existence of the market-locus of opportunities for mutually advantageous exchanges-facilitates the allocation of the good or service in question to the use in which it is most valuable, thereby maximizing the wealth of society.

It is assumed that individuals are rational maximizes of their own self-interests. That is, they will respond to other people and to events in a way that increases their own utility. It is this, which lies behind the notion that individuals will trade resources until the resources reach the people who value them most highly. Economists express the idea that something may be worth more to one person than to another by saying the first will be prepared to pay more for it than the second. However, they use the word “utility’ rather than ‘wealth’ because the theory does not assume that everyone is selfishly pursuing greater personal wealth. Individuals may well like to see other individuals made better off and be prepared to give some of their own wealth to achieve that. An economist fits this into his general theory by saying the donor’s ‘utility’ is increased by seeing the donee made better off.

The basic economic function of contract law is to provide sanction for reneging, which, is in the absence of sanctions, sometimes tempting where the parties’ performance is not simultaneous. During the process of an extended exchange, a point may be reached where it is in the interest (though perhaps short-run interest) of one of the parties to terminate performance. If A agrees to build a house for B and B pays him in advance, A can make himself better off, at least if loss of reputation (which, depending on A’s particular situation, may be unimportant to him) is ignored, by pocketing B’s money and not building the house. The problem arises because the non-simultaneous character of the exchange offers one of the parties a strategic advantage, which he can use to obtain a transfer payment that utterly vitiates the advantages of the contract to the other party. Clearly, if such conduct were permitted, people would be reluctant to enter into contracts and the process of economic exchange would be retarded. Hence, the basic function of contract law to provide a sanction for breach of promises.

A non instantaneous or extended exchange creates not only strategic opportunities that parties might try to exploit in the absence of legal sanction, but also uncertainty with regard to the conditions under which performance will occur. This uncertainty exposes the parties to the risk that the costs and benefits of their exchange will turn out to be different from what they expected. An important function of contract law in this regard is to enforce the parties’ agreed upon allocation of risk.

A related function is to reduce the costs of the exchange process by supplying a standard set of risk allocation terms for use by contracting parties. Many substantive rules of contract law are simply specifications of the consequences of some contingency for which the contract makes an express provision. If the parties are satisfied with the way in which the rules allocate the risk of that contingency, they have no need to incur the expense of writing their own risk allocation rule in to the contract.

Last modified on Wednesday, 02 May 2012 13:05