4 - Behavioral Economics, Contract Formation, and Contract Law

Summary

The Coase Theorem, on which much of the edifice of “law and economics” is built, posits that when transaction costs are zero the initial allocation of a legal entitlement is irrelevant to its eventual ownership. If an entitlement is first granted to Amy, she will keep the entitlement if she values it more than does Beth, but Amy will sell the entitlement to Beth if it is Beth who values it more. If the entitlement is originally granted to Beth, on the other hand, she will sell it to Amy if Amy places a higher value on it. The power of the Coase Theorem, and indeed its veracity in the real world, depends on its underlying behavioral assumption that an individual's valuation of entitlements does not depend on ownership; that is, Amy values an entitlement neither more nor less if she is initially allocated that entitlement than if it is initially given to Beth.

The assumption that preferences are exogenous to entitlement allocations is testable, and it has been demonstrated to be false, at least under some conditions. The contrary evidence, often labeled the “status quo bias” or the “endowment effect,” instead suggests that the initial allocation of legal entitlements can affect preferences for those entitlements. The consequence is that completely alienable legal entitlements will be “sticky” – that is, tend not to be traded – even when such stickiness cannot be explained by transaction costs. The evidence thus describes a substantial weakness in the edifice of traditional law and economics.