Inertia and Preference in Contract Negotiation: The Psychological Power of Default Rules and Form Terms

Abstract

I. INTRODUCTION In The Problem of Social Cost,1 the foundational article of the and movement, Ronald Coase suggested that when transaction costs are zero, the initial allocation of a legal entitlement is irrelevant to its eventual ownership.2 Assuming no transaction costs, the Coase Theorem predicts that if party A values an entitlement more than does party B, A will keep the entitlement if it is initially allocated to him, and he will buy it if it is originally allocated to B.s This powerful insight depends on the assumption that an individual's valuation of entitlements does not depend on ownership; that is, A values an entitlement neither more nor less if he is initially allocated that entitlement than if it is initially given to B.4 The assumption that preferences are exogenous to entitlement allocations is empirically testable, however, and has been demonstrated to be false, at least under some conditions. The empirical evidence, labeled alternatively the quo bias,5 the endowment effect,,6 or the offer/asking price gap,7 instead suggests that the initial allocation of legal entitlements can affect preferences for those entitlements. The consequence is that completely alienable legal entitlements will be sticky-that is, tend not to be traded-even when such stickiness cannot be explained by transaction costs. The evidence thus describes an important flaw in the Coase Theorem's mighty armor. The principle goal of one branch of the discipline of behavioral and economics or law and science8 is to explore the legal implications of this flaw.9 In a previous article, I argued that contracting parties are less likely to bargain around background-or default-contract terms established by the than the Coase Theorem would predict because the parties are likely to view default terms as a constituent part of the status quo, much like an entitlement.10 The claim, if correct, has both positive and normative implications for the analysis of default rules. On the positive side, it leads to predictions that differ from traditional and analysis regarding what circumstances are necessary for contracting parties to bargain around default rules.11 On the normative side, it suggests somewhat different strategies (again, compared to traditional and analysis) for lawmakers interested in selecting default rules that will enable private bargainers to maximize allocative efficiency.12 This Article advances two primary claims in an attempt to broaden and deepen the scope of previous analysis. The first claim is that the status quo bias has broader ramifications for negotiations than causing parties to prefer terms identified as legal defaults to those that are not legal defaults. There is likely to be a bias in negotiations in favor of any term that serves as a reference point-or point of departure-for bargaining. Legal default rules may serve as such reference points, but so may terms in form contracts used as the basis for negotiations, or terms embodied in preliminary drafts prepared by one party. I assert that the operative dichotomy for negotiators is not between default terms and non-default terms, but rather between inaction (which parties generally prefer) and action (which parties prefer to avoid). Parties are likely to favor default terms, in many instances, because these terms are often correlated with inaction (i.e., the default terms will be operative if the parties do nothing). But contracting parties will tend to favor any terms that will operate in the absence of a specific agreement to the contrary. I call this the inertia theory of negotiation. If this claim is correct, its positive implications are similar to, although broader than, those suggested in my previous article: terms contained in an initial draft contract will have far more staying power than the transaction costs associated with changing the terms, standing alone, would suggest. …