• Video

What Are Limits on Freedom of Contract? Conspiracy, Force, Cartels, and Rate Regulation

What are limitations on freedom of contract? Professor Richard Epstein of NYU School of Law lays out the three main situations where negative externalities render contracts unenforceable: force, fraud and monopolies, the last of which is prohibited by antitrust law, formulated in the Sherman Act of 1890. https://youtube.com/watch?v=HSX7BtxCIck


Thus far what we’ve done is to talk about how it is that contracts produce gains from trade to the parties, positive externalities. The benefits are not just between the two parties, they also radiate out to the rest of the legal system. The more difficult case has to deal with the problem of negative externalities. If it turns out that it is wrong for A to hit B or for C to hit B or then if it turns out that A and C get together, it’s a situation in which the synergies between A and C essentially make the likelihood of force against the third person more likely, so the legal response is to render these contracts unenforceable in an effort to dissipate the gains and in fact, in many cases you not only render them unenforceable, you make them conspiracies and essentially you can then punish them under the criminal law because the gains to the two parties are inversely correlated with social welfare given the huge losses that are suffered by victims of force and fraud. In the simplest case in which multiple parties get together, they agree essentially to raise prices and to reduce assets or they decide that each of them will have a separate territory on which they sell. These are not contracts that deal with force but it’s pretty clear that if you do the standard economic analysis uh, the social welfare under a monopoly situation is always lower than that under a competitive situation, because transactions that would take place at the competitor’s price are excluded when the monopolist raises the price in question. So what the antitrust law does essentially is to make it impossible for you to enter into these contracts by treating them as illegal contracts and restraints of trade. This is a very old common law category and it receives its modern formation in the statutory law starting with the Sherman Act in 1890. And the history of rate regulation begins roughly at the same time as the Sherman act around the 1880s and in the old days of public utilities where the official form of supply requires that you have a single provider for the entire network. Ah so you could build only one railroad between two towns, ah, but once the railroad is built, ah, the owner of that particular railroad might be able to exact the monopoly price. But the customers have to pay you sufficient amount so that an aggregate you can remain in business and earn a risk-adjusted competitive return and so what you then do is develop rate of return regulation which forces the obligation and then requires you to sell these services on reasonable i.e. you get a competitive rate of return but no more, non-discriminatory, i.e. you have a situation where you can’t pick favors and so the so-called RAND obligations - reasonable and non-discriminatory - become the hallmark of rate regulation as the third major limitation on freedom of contract.

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