Posted by: captainfalcon | September 20, 2010

Law and Economics: A Case Study

The parts of the Internet in which I marinate have a fair degree of contempt for the basic assumptions of law and economics. A good test of whether this contempt is justified is to read a rudimentary (but intelligent) law and economics critique, and see whether it (a) has the ridiculed assumptions and (b) fails to defend them, or give them plausible characterizations. (This is a good test because a tradition’s rudimentary critiques tend to point to what animates the tradition. More sophisticated work typically obscures with jargon the tradition’s animating presuppositions.)

Note 7 on page 61 of Contract Law and Theory is a basic, but intelligent, law and economics critique of a 1965 decision by the DC Circuit of the United States Court of Appeals, Williams v. Walker-Thomas Furniture Co. The decision played a major role in fleshing out, and establishing in general common law, the “unconscionability exception” to the enforceability of a contract.* I will review the facts of the case, and then explain and evaluate what law and economics has to say about it. (Walker Thomas Furniture is no more, but the interwebs tell me its dilapidated sign is on a dilapidated building across from the Convention Center on 7th Street NW.)

WTF was a DC retailer serving the poor inner-city. It permitted buyers to pay the price of their purchases in monthly installments. Williams was a mother of seven on welfare who made fourteen significant purchases on the installment plan. With each installment-purchase she had to sign a contract including a so-called “cross collateral clause.” In WTF’s case the clause read “the amount of each periodical installment payment to be made by (purchaser) to the Company under this present lease shall be inclusive of and not in addition to the amount of each installment payment to be made by (purchaser) under such prior leases, bills or accounts; and all payments now and hereafter made by (purchaser) shall be credited pro rata on all outstanding leases…due the Company by (purchaser) at the time each such payment is made.” This means, in effect, that payments are credited to all outstanding purchases in parallel, as opposed to in series. WTF retains title in everything Williams has purchased on the installment plan until all her outstanding debts are paid down. If Williams defaults then WTF replevins everything she bought since she last paid down her debt. Williams defaulted. WTF tried to replevin all her stuff. Williams said she had assumed title reverted to her as soon as she paid the full price of a particular good, and that it was unconscionable that she should lose her all on the basis of an obscure contractual clause. (The Court agreed with her.)

The law and economics analysis says that the cross-collateral clause is desirable because it “makes possible transactions that would otherwise be unavailable or at least more costly.” Eliminate the clause and WTF will either eliminate the option to pay in installments or increase its prices; the clause’s point is to protect WTF against the (high) risk of its (poor) customers defaulting.

What would be most desirable for WTF, of course, is for the cross-collateral clause to have a discountable effect on its customers’ behavior. Then WTF could charge the same price it would charge absent the cross-collateral clause and protect itself against the risk of customer default. If WTF is doing this – if its pricing scheme is precisely what it would be absent the cross-collateral clause – then the law and economics analysis is flawed.

There are two conceivable scenarios under which the cross-collateral cause could have a discountable effect on WTF’s customers’ behavior. First, its customers could be systematically ignorant of the cross-collateral clause. Second, its customers could “systematically underrate the costs to them of agreeing to such a clause, perhaps to the extent of discounting the cost of the clause to zero.” (Other scenarios – e.g. that its customers systematically aim to pay more – are also conceivable, but I won’t focus on them here. They seem to me off-the-wall. I wonder whether the sort of mind that would be attracted to law and economics finds the two conceivable scenarios I contemplate similarly grotesque.) These conceivable scenarios, obviously, violate two simplifying assumptions of law and economics: (a) the assumption of perfect knowledge and (b) the assumption of perfect rationality. The law and economics theorist therefore denies that they are meaningful possibilities. It is this denial that forms the basis of his opponent’s contempt. To see whether the contempt is justified, it is worth examining the grounds of an intelligent law and economics analysis of the questions.

An intelligent reply to the first conceivable scenario is this:

Gullible or careless people certainly are taken advantage of, but why are they not bilked more often? One answer is that competition in the marketplace sometimes takes care of them. First, if Ms. Williams was unaware of the clause in the Walker-Thomas sales agreement, and had she stopped elsewhere…another store (out of self-interest, in order to make the sale) might have told her of the “bad clause” in the Walker-Thomas agreement. Second, assume that 10% of…shoppers in are gullible and the other 90% are not. If the store wants to print up its sales agreement in advance, it has to decide whether to include the ‘bad clause.’ If it does, it loses 90% of its potential customers…Most stores will find it not to be in their profit-making interest to lose the many in order to bilk the few (n. 7, p. 61).

Here, a mechanism (competing firms, presumably supplemented by word-of-mouth) by which the majority (the non-gullible) attain perfect knowledge is hypothesized.

The second conceivable possibility – of systematic cognitive bias – has received substantial attention from behavioral economists. Contract Law and Theory has this to say about it: “A [behavioral economist] might be inclined to support the use of unconscionability when the probability of consumers suffering from systematic cognitive error seems high while [a law and] economic analyst might be inclined to argue that the assumptions supporting the case for intervention on the grounds of systematic cognitive errors are ‘strong,’ and probably not very amenable to empirical verification.”

I find each response seriously unpersuasive. The first, I intuit, simultaneously underestimates the percentage of gullible and overestimates the efficacy of the market-mechanism for disseminating knowledge. (Or, perhaps more to the point, gives no reason to think it doesn’t suffer both these, at least psychologically possible, failings.) The second reply, meanwhile, is simply bizarre. It may well be that the attribution of systematic irrationality is resistant to empirical verification (both because designing the tests – in light of the complexity and variability of human behavior – is a challenge and because a wide range of behaviors is compatible both with systematic irrationality, and with the attribution of rationality plus a suitable set of goals). But surely these same problems also afflict the case for attributing systematic rationality. In the face of this evidentiary equivalence, what, other than Platonic complacency, could justify a theoretical (as opposed to ethical, or aesthetic) preference for the one over the other?

Assuming I’m right, and the rudimentary law and economics analysis in Contract Law and Theory points to what animates its entire tradition, it seems to me the tradition is contemptible.

* While the Uniform Commercial Code, which antedated the decision, established that “If the court as a matter of law finds the contract or any clause of the contract to have been unconscionable at the time it was made the court may refuse to enforce the contract,” the UCC only applies to sale-of-goods contracts. (It also post-dated the contracts in question in Williams.) Williams discovers a general unconscionability exception in the common law. Additionally, while the UCC articulates a similar test to Williams’s – a contract is unconscionable if, “in light of the general commercial background and the commercial needs of the particular trade or case,” it is excessively one-sided – the test is comparatively gnomic.



  1. Strange this post is totaly unrelated to what I was searching google for, but it was listed on the first page. I guess your doing something right if Google likes you enough to put you on the first page of a non related search.

    • What were you searching for?

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