CAE Working Paper #06-01
Coercion, Contract and the Limits of the Market
by
Kaushik Basu
January 2006
.
January 3, 2006
Coercion, Contract and the Limits of the Market
Kaushik Basu
Department of Economics
Cornell University
Ithaca, New York 14853
Email: kb40@cornell.edu
Abstract
It is a widely accepted principle of economics that if two or more adults
voluntarily agree to a contract or an exchange that has no negative fall-out on others, then
the government should not stop such a contract. This is often called the ‘principle of free
contract’ (PFC). There is a body of writing in economics which upholds the PFC. Yet,
this ubiquitous principle is ill-defined and full of ambiguities. For instance, since it refers
to voluntary choice, its proper use presumes an understanding of what is ‘voluntary’ and,
therefore, also, of what is coercive. What is ironic is that, while philosophers and legal
scholars have debated and analyzed these concepts and the validity of the principle of
free contract, there is very little discussion of these in economics, even though so much
of economics is founded on this principle. This has caused a lot of policy confusion. The
aim of this paper is to construct general rules for when we may violate the PFC. The
argument is constructed within the Paretian framework. Hence, the violation of the PFC
is not justified by appeal to deontological ethics or non-welfarist criteria. This is not an
easy task since the principle of free contract is often viewed as a rule that is a derivative
of the Pareto principle.
Key words: Coercion, voluntary choice, contracts, markets, government intervention.
Acknowledgements: This paper is based on my Colin Clark Lecture, 2004, held at the
Australasian Meetings of the Econometric Society, Melbourne, and a seminar
presentation at the Conference on the Philosophical Aspects of Social Choice Theory and
Welfare Economics, at the University of Caen, 20 June, 2005. The paper has existed in
the form of notes and sketches, but remained essentially unwritten till recently. Over this
time I have accumulated indebtedness to a large number of colleagues and friends. At the
certainty of omission, I would like to mention Geir Asheim, Abhijit Banerjee, Kuntal
Banerjee, Alaka Basu, Hyejin Ku, Wulf Gaertner, Prasanta Pattanaik, John Roemer,
Joshua Teitlebaum and Amartya Sen.
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Coercion, Contract and the Limits of the Market
1. Principle of Free Contract
In 1995, soon after I moved to the U.S., I got a letter from a lawyer in California
requesting me to write a letter to a judge of the California Supreme Court in support of
his client. Not being sure of the ethics of such matters, let me not reveal names. His
client, Mr. X, had been approached by an entrepreneur, Mr. R, for a loan of $500,000 in
order to open a restaurant. They agreed to an annual interest rate of 12% and a schedule
of repayment in installments. For some time R paid him in accordance with the
repayment schedule; but then he began to default. After waiting for a while, X decided to
take R to court for breach of contract. The case was proceeding well and seemingly in
favor of X, when R’s lawyers discovered that a 12% interest rate was a violation of the
statutory limit on interest rates prevalent in California at that time, which set an upper
bound at 11% for interest rates on loans. This was used by R’s lawyers to argue that the
entire contract was null and void and, therefore, R should pay no interest; moreover, by
this argument, he had over paid X and so in fact ought to get money back from X.
It was at this stage that X’s lawyer decided to seek the support of some
economists (knowing, I suppose, our profession’s proclivity in such matters). What I
wrote to the Judge of the California Supreme Court was, in a nutshell, this. What the law
says has to be followed, but how severely a violation of the law has to be redressed often
depends on our view of how reasonable the law happens to be. And I went on to argue
that in this case the statutory interest law in California was quite unreasonable. When an
adult, especially someone who is business savvy, agrees to take a loan with a 12%
interest rate and another person agrees to lend money at 12% interest rate, presumably
both expect to be better off through this exchange. And if there is no reason to expect
this to have negative fall-outs on others, then no one should stop such a contract. Indeed,
the ability among adults to freely sign contracts and rely on them is the bedrock of a
vibrant, modern economy. Business, enterprise and progress are made possible by such
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contracts and, equally, progress gets stymied if such contracts are disallowed. The rest of
what I wrote to the judge is not relevant here.
Some months later I met an economist who had received the same request from
the lawyer and had also written to the judge. On comparing notes we discovered that we
had taken almost exactly the same line. On consideration, this is not so surprising. It is a
widely accepted principle of economics that if two or more sentient adults voluntarily
agree to a contract or an exchange, which has no negative fall-out on those uninvolved in
the contract, then the government should not stop such a contract. This is often called the
‘principle of free contract’ (see Basu, 2003, for discussion) – PFC, in brief.
Though this paper will be concerned with the exceptions to this principle, I want
to stress its significance in enabling a market economy to function effectively. In the US
this principle is often viewed as protected by the Fourteenth Amendment (1868) to the
Constitution. The freedom of contract was often alluded to as a “property right” and there
are celebrated cases, such as Lochner v. the New York State, 1905, where any effort to
curtail work hours or legislatively raise wages was struck down by the courts as being in
violation of the freedom of individuals to sign contracts as they wished. Indeed, it is
arguable that one critical ingredient in the outstanding performance of the American
economy since the late nineteenth century is the faith the U.S. courts evinced in the
principle of free contract, even though, as we shall presently see, this is a principle that
can be overdone. There is a body of writing in economics which upholds the PFC (see,
eg., Friedman, 1962) and, more significantly, there is widespread, unwritten acceptance
of this principle
1
.
Despite the value of this principle, what is worrying is that its terms are, on
reflection, ill-defined and has its share of ambiguities. For instance, since it refers to
voluntary choice, its proper use presumes an understanding of what is ‘voluntary’ and,
therefore, also, of what is coercive. Yet these are concepts ill-understood in economics.
What is ironic is that, while philosophers and legal scholars have debated and analyzed
these concepts and the validity of the principle of free contract, there is very little
1
While economists typically value this principle as a critical instrument for economic progress and
efficiency, one can think of other, philosophical justifications for adhering to this principle, such as
equating a contract with a promise and maintaining, a priori, that it is immoral for promises to be broken
(see Kaplow and Shavell, 2002, Chapter 4, for discussion of some of these alternative justifications.)
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discussion of these in economics, even though so much of economics is founded on this
principle.
This has caused a lot of policy confusion. On the one hand, we find wanton
violation of this principle by governments and bureaucrats. On a variety of matters
governments specify terms of contracts exogenously. In India, any firm that employs
over 50 laborers has pre-specified terms for laying-off workers spelled out in the
Industrial Dispute’s Act, 1947; and any firm employing more than 100 laborers has to
have prior permission from the government before it can lay off workers. A contract
voluntarily entered into by an entrepreneur and a worker that specifies terms of
disengagement which are different from what the law specifies (e.g. the salary will be
very high but the firm can ask the worker to quit with no prior notice and no severance
pay) will be dismissed by the courts as invalid in the same way that the loan contract in
California was considered null and void. So, if after having signed the contract, the
worker or the employer later reneges on it, the other side will not have any recourse to the
law. And knowing this, people in India do not typically sign such contracts. Many
economists have argued (and I find myself in agreement with them on this) that the
pervasive failure to respect the principle of free contract has harmed the Indian economy,
since entrepreneurs hesitate to start up businesses in which demand is volatile (for
instance, fashion garments) and require periodic hiring and laying off of workers.
There are mainstream economists and some legal scholars who take this line of
argument to an extremity, and do not recognize that the PFC can have any exceptions.
But it is not difficult to find examples where a majority would feel uncomfortable
adhering to the principle of free contract. Here are some examples.
In 1903 there was the celebrated case, The Port Caledonia and the Anna, in which
a vessel that got into a dangerous crisis at sea sought help from a tug (Wertheimer, 1996).
The master of the tug asked for £1,000 (an astronomical sum at that time) and made it a
‘take it or leave it’ offer. The master of the vessel, unsurprisingly, accepted the offer, but
later went to court. The court declared the ‘contract’ or agreement void and ruled that the
vessel master needed to pay £200. Evidently, the court’s ruling violated the PFC.
Second, suppose a firm puts up a sign outside the personnel office which makes it
clear to new workers that the firm pays its workers excellent salaries, gives generous