Contractual liability and economic analysis of the law

According to Trimarchi, contractual liability has three fundamental objec­tives:

1. to improve the distribution of productive resources;

2. to distribute the economic burden of losses without substantially endan­gering the financial status of the enterprise; and

3.

The threat of contractual liability induces compliance with contractual obli­gations, and thus liability should be imposed on the party who can avoid the costs of breach at least expense. If the least-cost avoider rule dictates liability, parties can be forced to adopt socially efficient precautions to avoid breach; they will thus maximize social wealth, and achieve the objective of improv­ing the distribution of productive resources. Trimarchi expresses his argument with mathematical notations, a noteworthy methodological step for tradi­tional continental scholarship.

Imagine a contractual relationship between a group of suppliers, A and their clients, B. If the supplier A breaches the contract, he will not be paid and both A and B sustain a loss. The supplier’s loss (lost profit and waste of labour, raw materials and capital spent attempting performance) is a, while the buyer’s loss (caused by the disturbance of their economic plans) is b. Assume that the supplier can eliminate all risk connected to breach of con­tract by taking better precautions, with cumulative cost of ". Meanwhile, the

buyers B can also take precautions to avoid or reduce the costs of breach by investing 3 (for example, by warehousing raw materials necessary to avoid a delay in production caused by breach). If the buyer takes precaution 3, he eliminates the cost of breach b.

Clearly, A should take precautions if the cost of doing so is less than the cost of the risk avoided. Formally: precaution ∀ can only be efficient if ∀ < a + b.

If both inequalities are true, then one must choose between precautions ∀ and 3, because taking precautions eliminates the risk of losses a and b, and therefore precaution ∀ renders precaution 3 useless. If ∀ < a, precaution ∀ should be taken, and precaution 3 would be superfluous. If, however, ∀ > a, the correct choice for maximizing social wealth depends on the relative efficiency of each precaution. The net social benefit of each precaution is the value left when one subtracts the cost of the precaution from the total risk avoided by taking the precaution. Formally, the net social benefit of precau­tion ∀ will be equal to a + b - ∀, while the net social benefit of precaution 3 will be equal to b - 3. Thus, precaution ∀ should be taken if a + b - ∀ > b - 3, while precaution 3 should be taken if b - 3 > a + b - ∀.

In all these situations, the question whether A should pay damages to B is resolved by establishing which party can take the socially efficient precau­tion. Thus, when precaution ∀ is socially efficient, A should be liable to B for the loss b, because then, as an effect of liability, A will have an incentive to take precaution ∀. (Recall that ∀ < a + b.) Meanwhile, when it is socially efficient to take precaution 3, A should not liable to B for cost b, so B will have an incentive to take the socially efficient precautions.

Trimarchi notes that some may object that A will avoid breach even with­out liability to retain the right to consideration. However, if A is not liable to B for damages, A will only take precaution ∀ when a - ∀ > 0, while economic efficiency requires that account be taken of B’s potential losses as well. Of course, if A is not liable to B, then B may choose its supplier more carefully, and thus create incentives for A’s adoption of the efficient level of care.

Trimarchi then examines the second function of contractual liability, that is, the efficient distribution of losses between the parties. Here, Trimarchi uses an example that calls to mind the efficiencies of scale, as well as a concept akin to risk aversion versus risk neutrality. His example is of deciding whether a hotel or its guest should purchase insurance against the risk of loss or theft of baggage. He believes that the economically efficient result is for the hotel to insure against the loss. The hotel can take precautions more cheaply because it need only negotiate one insurance contract, and thus it is in a better position to prevent loss and theft through monitoring, personal-insurance or third-party insurance - whichever is cheapest. Finally, the last objective of contractual liability is the reduction of the judicial costs of allocating the losses among the parties. According to Trimarchi, reduction of judicial costs may be achieved by adopting simple and certain rules and procedures.

After investigating the economics of contractual liability, Trimarchi con­siders two theories of contractual liability developed by Italian courts, and determines which one maximizes wealth. Italian courts base liability on fault, connected to the violation of rules of diligence, or according to the principle of strict liability, understood as liability for mere breach unless excused by impossibility caused by a force majeure. Trimarchi demonstrates that in situations where performance is rendered by an enterprise, wealth will be maximized by adopting a strict liability regime.

Trimarchi begins by identifying the effect of strict liability on the distribu­tion of resources. Strict liability for all breaches due to the breacher’s lack of organization or due to external causes that are not of a catastrophic nature, forces the breacher to take account of all risks under his control or ability to predict.

Trimarchi notes that strict liability is also efficient because it accounts for downstream losses. Suppose that A supplies the mechanical parts for the construction of machines to B, and B supplies such machines to C, who produces consumer goods. If A breaches its contract with B, then C will also suffer a loss: A will suffer the loss a, B will suffer the loss b, and C will suffer the loss c. A will take precautions against breach if a + b - ∀ > 0. This is not the socially optimal level of precaution, however, because the total loss resulting from the breach is a + b + c. Therefore, the expense ∀ should be taken if a + b + c - ∀ > 0. Therefore, it is necessary to burden A also with the loss c, by use of strict liability. Strict liability will impose liability on B for the loss c, and A, in turn, is liable to B for b + c. Trimarchi is not persuaded that this is excessive liability for A. He notes that, if B’s enterprise merged with C’s, A would then have to pay b + c damages. Therefore, there is no reason to reduce liability towards independent enterprises which would occur if there was one large, vertically integrated enterprise.

Trimarchi notes that a fault liability regime, based on due diligence, could be wealth maximizing. It is not, however, because the entrepreneur may expect that some economically beneficial precautions will be considered outside the boundaries of due diligence by the judge. Rather, unless the judge compares the costs of the precautions required by due diligence with the precautions required to avoid the total costs of breach illustrated above, wealth will not be maximized under a system of fault liability.

Having established his view on the economics of contractual liability, Trimarchi criticizes theories which suggest that the legal or conventional regime of contractual liability has no influence on the distribution of produc­tive resources. For example, Trimarchi criticizes Branca’s theory (Scialoja and Branca, 1967 at 94 et seq.), which suggests that distribution of losses caused by a breach is irrelevant, because the parties will modify the contract price depending on the contract rule. Trimarchi argues, on the contrary, that the market would fail to take account of the contract rule quickly, and would fail to supply sufficient information regarding individual suppliers’ precau­tions. Thus, suppliers would have no incentive to take socially efficient precautions.

Similarly, Ronald Coase’s article, ‘The problem of social cost’ (Coase, 1960, pp. Iff.) suggests that the legal distribution of damages resulting from breach is irrelevant for the optimal distribution of productive resources. If one party can avoid the loss more efficiently than the other, both would be better off if the least-cost avoider accepts liability and the contract price compensates him for taking the risk. As Trimarchi notes, however, the Coase theorem is valid only in perfect markets, specifically markets without trans­action costs. Additionally, psychological factors, free riding and asymmetric information may prevent the bargaining process from reaching Coase’s effic­ient outcome.

Notes

1. Unless otherwise stated, all the following quotations are taken from this book.

2. There are two exceptions for this rule contained in articles 2045 and 2047(2) of the Italian Civil Code, however. On the other hand, cases of organized and continuous activity are subject to the strict liability principles. For example, the provisions contained in articles 2049, 2050, 2053 and 2054, subsection 4 of the Italian Civil Code; articles 965 and 978 of the Italian Admiralty Code; and articles 10 subsection 2 and 3 of law No. 1433 of 29 July 1927.

3. Article 2050 of the Italian Civil Code.

4. For example, the method of retribution, the burden of the risk on whoever profits from the enterprise, the criterion of control, the technical competence of the master/servant related to the time and place of activity, the social position of the parties, the duration of the relationship between the parties, the actual continuity of the relationship, and the exclu­sivity of the relationship.

5. See article 2055 of the Italian Civil Code.

6. See article 2055, subsection 2.

References

Coase, Ronald (1960), ‘The problem of social cost’, Journal of Law and Economics, 3, 1-44. Scialoja, A. and G. Branca (1967), ‘On the breach of obligations’, Comment on the Civil Code, Bologna, Rome:

Trimarchi, Pietro (1959), ‘Il “case fortuito” quale limite della responsibility per il danno da cose’ [‘Fortuitous event’ as a limit of the liability for damage caused by things], Rivestra Trimestrale di Diritto e Procedura Civile, pp. 808-62.

Trimarchi, Pietro (1961), Rischio et Responsibilitd Uggettiva (Risk and strict liability), Milan: Giuffre.

Trimarchi, Pietro (1967), Causalitd e danno (Causality and damage), Milan: Giuffre.

Trimarchi, Pietro (1977), ‘Sul significo economico dei criteri di responsabilita contrattuale’ [On the economics of liability in contracts], Rivestra Trimestrale di Diritto e Procedura Civile, pp. 512-31.

Trimarchi Pietro (1987), ‘L’analisi economica del diritto: tendenze e prospettive’ [Economic analysis of law: tendencies and perspectives], 2 Quadrimestre, 563-82.

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