C. Various contexts: We will be encountering a number of contexts in which economic analysis of particular contract-law rules seems especially useful. Most of these contexts involve “remedies,” that is, the means by which courts attempt to protect a contracting party when the other party breaches the agreement.
1. Some examples: It is hard, at this early point in your Contracts course, to give you good examples of how economic analysis may be used in contract law. However, here are a couple of illustrations, both connected with the problem of compensating a party who has been the victim of breach.
Example 1: Treadmill Co. manufactures electric treadmills, for which it needs many component parts. Treadmill Co. gets an order for 10,000 machines from Wal-Mart stores. Treadmill Co. contracts with Component Corp. to have Component Corp. custom manufacture 100,000 precisely machined gears, 10 of which are needed for each treadmill. Component Corp. custom manufactures the first 10,000 gears, delivers them to Treadmill Co., and is paid. Wal-Mart than cancels the remainder of its contract with Treadmill. Treadmill Co. immediately tells Component Corp. to stop making any more gears. The president of Component Corp. replies, “I’ve got a contract, and I’m going to make the remaining 90,000 gears and insist that you pay for them.” Because these gears are to be custom machined, they will have no other use, and will only be saleable for their salvage value.
If the law of Contracts permits or encourages Component Corp. to insist on finishing the contract and recovering the full contract price, economic waste—inefficiency—will obviously result. (Time and materials will be spent making the 90,000 pieces, which will just end up being sold for scrap by either Component Corp. or Treadmill.) Therefore, a court will instead require that Component “mitigate its damages.” (See infra, p. 337.) That is, Component will not be permitted to recover for any of its costs incurred after receiving the stop-manufacturing notice from Treadmill. Component will instead be allowed to recover the profits it would have made from the last 90,000 pieces, and no time and materials will be wasted. See K&C, p. 1010.
Example 2: Same initial facts as Example 1. Assume that the price under the contract with Treadmill is $1 per gear. Also, assume that after Component Corp. has custom manufactured the 100,000 gears, a new customer, Bicycle Co., says to Component Corp., “We need 100,000 gears [which coincidentally require the same specs as the ones made for Treadmill] by tomorrow, and we’ll pay $3 per gear.” There’s no time for Component to make an additional 100,000 gears, so it will either have to forgo the Bicycle order or breach the Treadmill contract by giving Bicycle the gears made for Treadmill. Assume that the gears, if timely delivered, would be worth $1.50 per unit to Treadmill, so that Treadmill would suffer a “loss” of 50¢ by not getting the shipment on time.
Economic analysis says that the law of Contracts should impose a rule of damages such that the gears will end up going to Bicycle instead of to Treadmill. Indeed, that analysis says that the rules should be ones that encourage Component to break its contract with Treadmill and deliver to Bicycle. The standard “expectation” measure of damages—which gives Treadmill a damage award of 50¢ per gear, the difference between the contract price and the value of the gears to Treadmill—will do this: Component can charge Bicycle $3, pay 500 damages to Treadmill, and pocket the remaining $2.50 (which is $1.50 more than it would have gotten had it honored the contract). So each party is better off than it would have been under a system which compels or strongly encourages the parties not to breach (e.g., a scheme under which Component had to pay Treadmill 10 times its actual losses in the event of a breach).