Freeman

ARTICLE

Economics, Law, and Personal Relationships

Contract Law Provides Logical Examples for Personal Relationship Law

JANUARY 01, 1998 by DAVID LABAND, JOHN SOPHOCLEUS

David Laband is a professor of economics at Auburn University, Auburn, Alabama. John Sophocleus is an instructor in Auburn’s economics department.

Two recent, headline-making judicial decisions in civil cases offer striking reminders about why judges, juries, and legislators would benefit from instruction in basic economic principles. The decisions rendered in these cases involving personal relationship law turn economic (that is, common) sense on its head and are inconsistent with legal treatment of virtually identical circumstances under contract law.

In the first case, a young Texas man broke off his engagement to his fiancée, demanding that she return the engagement ring he had given her. When she refused, he sued. The judge ordered that she return the ring. It’s possible that the judge’s ruling in this case was colored by a personal engagement experience that went awry. Nonetheless, we cannot help wondering whether the judge who issued this ruling has ever sold a house.

The deposit, or earnest money, that the prospective home buyer offers to the seller when a contract is written serves as the buyer’s pledge of good faith. Earnest money is the would-be buyer’s pledge (in this case a formal contractual obligation) that he will work actively to fulfill the terms of the contract and bring the proposed sale to a successful conclusion. If the putative buyer backs out of the contract for reasons that are not within the control of the seller, the seller can legally claim the earnest money. We all know and appreciate the reason why this is so: unless specific provisions of the agreed-upon contract permit the seller to continue to market the property, it is understood by both parties that the seller will suspend such efforts and also work actively to conclude the sale.

In the absence of this legally binding pledge, moral hazard problems would make it much more difficult to buy and sell real estate. The person who had contracted to purchase a house would have no financial incentive to honor the contract, other than the fact that he hadn’t found another property more to his liking. Indeed, the hope of finding such a property might induce the prospective buyer to continue searching. If he found a property he liked more, he could walk away from the contract without penalty at any time prior to formal execution of the contract.

By the same token, the behavior of sellers also would be different. Knowing that the putative buyer might not honor the contract, the seller would have every incentive to continue to show the property to other prospective buyers. In the (normally unlikely) event that he could find another buyer willing to pay more than the first one, he would break the contract with the first and write one with the second. To forestall this possibility, which might indeed be damaging to the first buyer (who may have valued the property more than the contracted-for price), he induces the seller to stop looking for other buyers, by compensating him (via earnest money) for the implied costs that result from removing the house from the market. The seller, in turn, is protected from buyer opportunism by demanding sufficient earnest money to satisfy him, at the margin, in the event the buyer finds something better. Earnest money does not insure that real estate contracts are never broken. But it does imply that such contracts are only broken on good cause—that is, when the value to the prospective buyer of breaking the contract exceeds the lost earnest money. This market mechanism provides a remedy for contracts broken through bad faith, without the parties seeking resolution through the courts.

The Marriage Market

Earnest money contributes to efficient transacting in real estate markets. Engagement rings contribute to efficient relationship formation in what Nobel laureate Gary Becker refers to as the marriage market. The giver of such a ring pledges, explicitly or implicitly, to work toward achievement of a marriage between himself and his fiancée. By taking herself out of the general marriage market, the recipient of the ring puts herself at risk. Specifically, she risks that while she is off the market, so to speak, she will miss meeting someone else with whom she might have enjoyed a happy and fulfilling relationship. By accepting her fiancé’s ring, she gives up valuable opportunity, secure in the knowledge that if her fiancé dumps her, the value of the ring will compensate her for the costs implied by those lost opportunities.

Analytically, the fiancé’s pledge of good faith (purpose, incentives, and impact on behavior) is identical to that of a prospective house buyer. The judge’s recent decision with regard to the former is not only inconsistent with well-established contract law governing the latter, but also raises the costs of contracting between young people interested in developing long-term relationships with one another. We can only assume that if the prospective buyer of the judge’s house had backed out at the last minute, he would have been happy to return all of the earnest money pledged when the contract of sale first was written. It is precisely because individuals are not happy about returning earnest money that such money typically is held by a neutral third party.

Who’s Responsible for Seduction?

The second case, which was covered in major newspapers and several network television talk shows, centered on a married couple and the “other woman.” The husband’s affair led him to divorce his wife of 17 years and marry that other woman, who now, of course, is “the” woman. The other woman did not fall in love with the husband with specific intent to injure his wife. Nonetheless, the wife sued the interloper under a North Carolina law that can hold outsiders responsible for breaking up marriages. (The statute in question, which deals with alienation of affection, was abolished by the North Carolina Court of Appeals in 1985, but the state Supreme Court overturned that ruling.) A jury found that the other woman had seduced the husband away from his wife, and it awarded the jilted spouse $500,000 in compensatory damages and $500,000 in punitive damages.

This situation also has a marketplace analogy with well-developed contract law that makes economic sense. By way of illustration, consider what happens when Wal-Mart opens a new store. Via the heady allure of lower prices and a wide array of merchandise, Wal-Mart “seduces” customers away from the local Sears, which has been in operation for 30 years. The competition provided by Wal-Mart is welcomed by all of the local shoppers because they know that their lives will improve through lower prices, enhanced operating hours by both stores, a wider selection of merchandise, and so on. The owners of Sears likely will be unhappy at the prospect of losing customers, but they do not have legal recourse to collect damages from the “other company.”

In the language of legal and economics scholars, Wal-Mart has imposed a “negative externality” on Sears. That is, actions undertaken by Wal-Mart have made Sears worse off, even though there may have been no specific intent on the part of Wal-Mart management to do so. Their aim was to provide products that the public at large finds desirable, at prices that induce prospective customers to become paying customers. Legally, the fact that Sears is injured in this process is incidental, not deliberate. Negligence law does not apply either. Firms are not required to consider the possible adverse consequences of their actions for their competitors when setting prices or determining operating hours, the friendliness and appearance of their sales staff, the types and quality of merchandise carried, and so on.

There are hundreds of thousands of “other companies” in the business world. They “seduce” customers away from their competitors. It is this continuous process of widespread, intense seduction of consumers that forces firms that want to survive (either by forming long-term relationships with specific customers or by continuously attracting new customers) to constantly improve the quality of the goods and services they offer. The well-being of hundreds of millions of individuals, both in the United States and elsewhere in the world, is enhanced by these competitive seductions. Whether they actually induce individuals to walk away from a longstanding relationship or not is immaterial in this regard because consumers will benefit from improved quality and service from all firms, including ones they have patronized for years. Thankfully, these ubiquitous tempters and temptresses cannot be sued for building better mousetraps. If they could be, the capitalistic system that has made America the economic juggernaut of the twentieth century would collapse. The law in this regard has got it right in terms of making economic sense.

However, if a customer is obligated under the terms of a contract to purchase items from Sears and breaks that contract when Wal-Mart comes to town, Sears can collect damages for breach of contract. Note that Sears’s legal remedy is tied to the contractual breach—it can collect from the customers, not from Wal-Mart. If the courts did not enforce such a contract, it is uncertain whether Sears would have agreed even to locate in the town, as its financial well-being may hinge on fulfillment of long-term sales agreements with customers.

Similarly, the jilted wife in North Carolina should have been able to sue her ex-husband for breach of their marital contract. If the courts did not recognize and enforce the husband’s obligations to his wife, she arguably would be much less likely to have agreed to marry him in the first place. Fortunately, the adultery laws on the books in most states have this one right too. If the courts are not willing to support market mechanisms that facilitate development of long-term personal relationships, individuals will change their behavior, entering such relationships with greater trepidation and, accordingly, with increased use of formal legal provisions to hedge against entering a bad relationship. Such contracts would, for a variety of reasons, be very costly to write and enforce (not to mention unromantic), thereby increasing business for North Carolina lawyers and judges. This incentive notwithstanding, the people of North Carolina would be better served by having their state legislators and Supreme Court justices take a refresher course (or two) in economics, if not common sense.

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January 1998

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