CONTRACT THEORY AND THE LIMITS OF CONTRACT LAW Alan schwartz& robert e. scott LINTRODUCTION I. JUSTIFYING AN EFFICIENCY THEORY OF CONTRACTS A. What Firms maximize B Why the State Should Help Firm IIL THE ENFORCEMENT FUNCTION 1678 A Enforcement Often is Unnecessary B. Encouraging Relation-Specific Investment C Contracting to Avoid Disruption: The Case of Volatile Markets D. Enforcement and duress V THE INTERPRETATION FUNCTION A. The Relevant Interpretive Question Two Interpretive Issues: Problems of Meaning and of Language C. The Parties' Preferences Regarding Interpretive Styles 1. The Continuous Payoff Case 2. The Invariant Payoff Case D. Private Languages, Linguistic Defaults and the Parole Evidence Rule 1. The Preferred Linguistic Default 2. The parol Evidence rule 3. Course of Performance Evidence Sterling Professor of Law, Yale Law School; Professor, Yale School of Management Lewis F. Powell, Jr. Professor and William L. Matheson Robert A Morgenthau Distinguished Professor. University of Virginia School of law This paper benefitted from comments received at workshops at the Law Faculty, Cambridge, England and at the Pennsylvania, Texas, Toronto, Virginia and Yale Law Schools. We also are grateful to Bruce Ackerman, Jules Coleman, Sam Issacharoff, John Jeffries, Jason Johnston, Paul Mahoney, Tom Nachbar, Paul Stephan, William Stuntz and george Triantis for helpful comments* Sterling Professor of Law, Yale Law School; Professor, Yale School of Management. ** Lewis F. Powell, Jr. Professor and William L. Matheson & Robert A. Morgenthau Distinguished Professor, University of Virginia School of Law. This paper benefitted from comments received at workshops at the Law Faculty, Cambridge, England and at the Pennsylvania, Texas, Toronto, Virginia and Yale Law Schools. We also are grateful to Bruce Ackerman, Jules Coleman, Sam Issacharoff, John Jeffries, Jason Johnston, Paul Mahoney, Tom Nachbar, Paul Stephan, William Stuntz and George Triantis for helpful comments. 1 CONTRACT THEORY AND THE LIMITS OF CONTRACT LAW Alan Schwartz* & Robert E. Scott** I.INTRODUCTION........................................................................................................................2 II. JUSTIFYING AN EFFICIENCY THEORY OF CONTRACTS ............................................11 A. What Firms Maximize..................................................................................................11 B. Why the State Should Help Firms.................................................................................16 III. THE ENFORCEMENT FUNCTION .................................................................................... 17 A. Enforcement Often is Unnecessary ..............................................................................18 B. Encouraging Relation-Specific Investment...................................................................20 C. Contracting to Avoid Disruption: The Case of Volatile Markets .................................25 D. Enforcement and Duress ...............................................................................................28 IV. THE INTERPRETATION FUNCTION................................................................................. 31 A. The Relevant Interpretive Question ..............................................................................31 B. Two Interpretive Issues: Problems of Meaning and of Language.................................33 C. The Parties’ Preferences Regarding Interpretive Styles ...............................................37 1. The Continuous Payoff Case .................................................................................. .38 2. The Invariant Payoff Case ........................................................................................ 42 3. Summary ....................................................................................................................47 D. Private Languages, Linguistic Defaults and the Parole Evidence Rule ........................48 1. The Preferred Linguistic Default ............................................................................. 48 2. The Parol Evidence Rule ........................................................................................ 55 3. Course of Performance Evidence ..............................................................................57