Contracts and Choice Theory, Part 1 – Choice Theory and the Economic Analysis of Contracts

In ‘Choice Theory and the Economic Analysis of Contracts’ I offer an economist’s reaction to Hanoch Dagan and Michael Heller’s important book, ‘The Choice Theory of Contracts.’ In this post, I summarize the two main arguments from that short review essay.

The first has to do with nomenclature. When referring to the economic analysis of contract law, Dagan and Heller use terms such as ‘wealth maximization’, ‘efficiency’, ‘utility’, ‘utilitarianism’ and ‘social-welfare maximization’. But Dagan and Heller do not adopt the standard economic definitions of these terms. Their idiosyncratic definitions risk confusion, at least among economists. More importantly, they lead to a mischaracterization of the economist’s position.

Consider Dagan and Heller’s frequent use of the term ‘utility.’ Indeed, the two main contract goods in Choice Theory are utility and community. For Dagan and Heller, ‘utility’ refers to material, economic benefits. This is quite different from how the economist understands ‘utility’. For the economist, ‘utility’ means anything that enters into an individual’s utility function, anything that represents the individual’s preferences, including many non-material benefits. Dagan and Heller’s narrow definition of utility underlies their claim about conflict between utility and community (which I discuss in the review essay, but not here).

The second argument responds to Dagan and Heller’s claim about the relationship between Welfare Economics and Choice Theory. For the economist, the importance of Choice Theory depends on the different predictions and prescriptions that it generates. I am not convinced that these differences are significant.

Here I focus on one set of examples, offered by Dagan and Heller: refusing enforcement of non-compete agreements, limiting advance sale of future wages, and upholding the semi-inalienable unilateral right of termination of certain long-term contracts. The argument is that Choice Theory supports these limits on freedom of contract, whereas Welfare Economics rejects them. But, of course, the economic analysis of contract law has recognized the need to limit freedom of contract in certain cases, where externalities, market power, imperfect information and imperfect rationality prevent the parties from entering a welfare-maximizing contract. And Dagan and Heller’s examples can be explained within the standard economic framework, specifically based on imperfect information and imperfect rationality.

Dagan and Heller, in their response to my review essay (Dagan and Heller, ‘Why Autonomy Must be Contract’s Ultimate Value’), argue that the economist’s endorsement of limits to freedom of contract is contingent. Autonomy, Dagan and Heller argue, has a more principled position, based on the need to promote self-authorship, understood as the ‘right to write and re-write the story of our life.’ The right to re-write explains the need for limiting freedom of contract. But this right to re-write will often conflict with the right to write – to make a credible long-term plan and engage others to participate in this plan. This means that autonomy explains the limits on freedom of contract only if the right to re-write dominates the right to write. Dagan and Heller, however, do not tell us when the right to re-write dominates the right to write. They don’t tell us what factors guide the resolution of this conflict – what the resolution in favor of limiting freedom of contract is contingent upon. Therefore, they do not show that the difference between Choice Theory and Welfare Economics is significant in practice.

Oren Bar-Gill is the William J. Friedman and Alicia Townsend Friedman Professor of Law and Economics at Harvard University.