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Economic Analysis of Contract Law from the Internal Point of View

Economic analysis of law has traditionally assumed that legal rules are or ought to be designed to maximize social welfare taking as given that legal subjects are like Holmes’ “bad man” — rational, self-interested agents who care about complying with the law only insofar as non-compliance exposes them to the risk of sanctions. This Article challenges this motivational assumption while keeping the standard economic framework otherwise intact on the grounds that while some legal subjects are, like Holmes’ bad man, “externalizers” of legal rules, others regard the law from the “internal point of view,” that is, they are “internalizers” of legal rules who are motivated to conform to legal rules apart from the consequences of defiance on a particular occasion. The Article derives specific doctrinal implications for contract law assuming that there are internalizers as well as externalizers in the subject population. It analyzes several contract law phenomena: the expectation principle, according to which a victim of a breach of contract is entitled to his expectation, and no more than his expectation; the penalty doctrine and stipulated damages clauses; the doctrine of willful breach; and the doctrine of contract modification. The resulting analysis shows that internalizers respond to these doctrines differently from externalizers and evaluates how the prescriptive implications of economic analysis for the design of contract law doctrines changes once we recognize that there are both internalizers and externalizers in the population. For example, the presence of internalizers in the subject population provides a justification for punishing some “willful breaches” more harshly than ordinary breaches. It also helps to justify the modern doctrine of contract modification.