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%From: Eric Rasmusen <erasmuse@rasmusen.bus.indiana.edu>
%Date: Wed, 14 Jun 95 13:37:38 -0500

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                     \begin{center}
            \begin{large}
    {\bf  The Economics of Agency Law and Contract Formation      }\\
             \end{large}
                     \vskip 15pt
                     May 8, 1995 \\
                    \bigskip
                    Eric Rasmusen \\
                    \vskip 1in
                    {\it Abstract} 

                    \end{center}
  This article  addresses   issues that arise in agency law when 
agents make contracts on behalf of principals. The main issue is 
whether the principal should be bound when the agent makes  a 
contract  with some third party  on his behalf which the principal 
would  immediately wish  to disavow.     The resulting  tradeoffs 
resemble those in tort law,    so     the least-cost-avoider 
principle is useful for deciding when contracts are valid  and  may 
be the underlying logic behind a number of different legal doctrines 
applied to agency cases.  In particular, an efficiency explanation 
can be found for the    undisclosed principal rule, which  says that 
the principal is generally bound even when   the third party is 
unaware that the agent is acting as an agent for him. 


 

 

          \vskip .3in
\begin{small}
          \noindent 

\hspace*{20pt}	  	  Indiana University
School of Business, Rm. 456, 

  10th Street  and Fee Lane,
  Bloomington, Indiana, 47405-1701.
  Office: (812) 855-9219.   Fax: 812-855-3354. Internet: 
Erasmuse@indiana.edu.\\ 

 Formerly titled: ``The Undisclosed Principal Problem in Contract 
Law''. Indiana University Working Paper in Economics \# 95-006.
       %Draft: 0.1 (Draft 1.1, February %1991).
 

 


   I would like to thank  Edwin Greenebaum and participants in 
seminars at the Indiana University School of Business and Georgetown 
Law School for helpful comments. 


            \end{small}


%%-----------------------------%-------------------------------------- 
----

\newpage

 

\noindent
 {\bf 1. Introduction}

 Economists have long  used the   principal-agent model     to 
explain the intricacies of labor compensation,   the organization of 
hierarchies, the design of securities,      and a host of other 
problems.    In the paradigmatic model,    a principal   hires an 
agent to exert effort, which he  cannot directly observe.  The agent 
is tempted to  be slack in his effort,    and the principal tries to 
overcome this moral hazard by designing a contract under which agent 
compensation is based on output. 

 

 The terminology of ``principal'' and ``agent'' comes from the law of 
agency, which  has ancient roots   and was formerly considered one of 
the fundamental ideas  of the common law.    Although  agency 
composes a  considerable body of law,  it is now rarely taught as a 
separate course in law schools and  as an area of law it  has not 
attracted the attention of economists.  The  issues   are quite 
different from those in  the principal-agent model. Instead of the 
economist's concern that the contract will not induce appropriate 
effort  by the agent, the lawyer's concern is over what happens  when 
the agent takes   inappropriate action, action which may involve no 
less effort.   The agent places an   order with a supplier when he 
has been forbidden to do so; he  drives  the principal's delivery 
truck into a schoolbus; he   hires the wrong employee for the 
principal's business. For the economist, the  agency problem is how 
to give the agent incentives for  the right action; for the lawyer, 
it is how to mop up  the damage when the agent has taken the wrong 
action. 


           The economist's  problem involves only the principal and 
the agent. The agent's  slack effort  affects both of them: the 
principal, because the task is  done poorly, and the agent, because 
the principal, foreseeing the low effort, will not pay as high a 
salary.  The solution is also internal to the transaction:   the 
parties  voluntarily enter into a contract that ameliorates the 
moral hazard by basing the agent's pay on his output. As with 
economic transactions in general, the law is needed only to enforce 
the contract. 


  The  lawyer's problem usually   does involve a third 
party.\footnote{A prominent area     of agency law  which does not 
involve third parties is   the law  of fiduciaries: whether the agent 
has acted  properly on behalf of the principal when the contract 
between them is vague, and how much the agent must compensate the 
principal for mistakes.   See   Cooter  \&     Freedman (1991).   } 
The agent's misbehavior may not have any  direct adverse effect   on 
the principal.  The principal is not in the schoolbus that is wrecked 
by the agent, and unless the law enforces the  contract, he  is 
unhurt by the agent's foolish or unauthorized purchases.   Third 
parties are harmed, however, so     government intervention can aid 
efficiency.  When the agent   takes a mistaken action, the damage 
must be allocated to someone---principal, agent, or third party.
 


 The best-known issues   involve torts: what happens when an agent 
injures a third party? The law deals with these involuntary creditors 
according to   the doctrines of {\it vicarious liability}  or {\it 
respondeat superior}, which make  the principal   liable for   torts 
committed by his agent in the course of the agent's 
duties.\footnote{Economic analyses of vicarious liability include 
Chu \& Quian (1992), Kornhauser (1982),  and  Sykes (1984, 1988).} 


 The present article will focus on a different problem: an agent who 
makes contracts on the principal's behalf which   the principal 
himself would not have made.  Section 2    will  lay  out the 
relevant  concepts in agency law   and illustrate them with  the 
classic  case of {\it Watteau v. Fenwick}.    Section 3  will 
construct a model of mistaken contracts,  in which  the  similarities 
between tort and contract  make the least-cost-avoider principle 
useful.      Section 4  will apply the least-cost-avoider principle 
to a variety of  illustrations that show when the principal is bound 
by contracts and when he is not.  Section 5 will analyze   a special 
set of problems  involving  contracting when the third party is not 
aware that the agent is acting for a principal--- the ``undisclosed 
principal'' problem. 


 

 \bigskip
 \noindent
 {\bf  2.  The Law of Agency}
 

    The concept of agency has long been an important part of the 
common law.    When the American Law Institute began to compile the 
influential  summaries of the common law known as the 
``restatements,'' the Restatement of Agency was  important enough to 
be   second   in the series   (after contracts).  The  {\it 
Restatement }    defines agency as ``the fiduciary relation which 
results from the manifestation of
consent by one person to another that the other shall act on his 
behalf and
subject to his control, and consent by the other so to 
act.''\footnote{  American Law  Institute,  {\it   Restatement of the 
Law, Second: Agency 2d}, St. Paul, Minnesota: American Law Institute, 
1958, \S 1. All references are to this second  restatement, hereafter 
called the {\it Restatement}.  Although I will rely on  the {\it 
Restatement} as my guide to the law in this article, it should be 
kept in mind that it is not binding on judges, who  are supposed to 
follow the decisions in their particular state.   }

\newpage
   According to Roscoe Steffen, a noted authority, 

 \begin{quotation}
 \begin{small}
 The essentials of agency are few... First, the relation is a {\it 
consensual} one; an agent {\it agrees}, or at least {\it consents} to 
act under the {\it direction} or {\it control} of the principal. 
Second, the relation is a {\it fiduciary} one; an agent agrees to act 
{\it for } and {\it on behalf} of the principal. He is in no sense a 
proprietor entitled to the {\it gains}  of enterprise-- nor is he 
expected to carry the {\it risks}.\footnote{Steffen  (1977), p. 26.}
 \end{small}
 \end{quotation}

       In the present article,  we shall take   for granted that the 
agent will not assume the risks of the enterprise, either because 
the efficient contract  puts the risk there, or  because the agent 
lacks the resources to assume liability.\footnote{This limitation is 
for reasons of  length only.   Questions  involving the agent's 
liability for contracts are both important and interesting, but 
require a different approach.}  We will focus instead on  contracts 
made by the agent with a third party on behalf of the principal. The 
{\it Restatement}'s ``general principle of interpretation'' says that 

    \begin{quotation}
 \begin{small}
 ``An agent is authorized to do, and to do only, what it is 
reasonable for him to infer that the principal desires him to do in 
the light of the principal's
manifestations and the facts as he knows or should know them at the 
time he acts.''\footnote{{\it Restatement}, \S 33.}
\end{small}
 \end{quotation}
 More specifically, the  law provides at least six reasons why the 
principal may be bound by contracts made by the agent:\footnote{This 
discussion is taken from Chapter 1 of  Ramseyer \& Klein (1994), from 
Steffen  (1977), and  the  {\it Restatement}.  I have adopted the 
categories of Ramseyer  and  Klein,  and added estoppel as a separate 
category.  }

{\it 1. Actual Express Authority.} The principal has entered into an 
explicit agreement with the agent authorizing him to take particular 
action. When the board of directors of a company votes to authorize 
the president to purchase a new office building,  this is   actual 
express authority. 


{\it 2. Actual Implied Authority.} The principal has entered into an 
explicit agreement to employ the agent, and  although he  has not 
specifically authorized the particular action at issue, the agent can 
reasonably infer that     authority for that action has been 
delegated to him.  If the general manager of a department store hires 
clerks, the  store is bound by his contract even if he was not 
expressly granted that authority.\footnote{{\it Restatement}, \S 52, 
73.} 


{\it 3. Apparent Authority}.  The principal has no agreement with the 
agent authorizing the action, but a third party could reasonably 
infer that the agent was authorized.\footnote{``Apparent authority is 
the power to affect the legal relations of another person by 
transactions with third persons, professedly as agent for the other, 
arising from and in accordance with the other's manifestations to 
such third persons.'' {\it Restatement}, \S 8. } If a sales manager 
claims he has authority to sell flour  without confirmation from the 
home office, and such sales are customary in the flour business, then 
he has apparent authority even if other authority is 
lacking.\footnote{ North Alabama Grocery Co. v. J.C. Lysle Milling 
Co. (1921) 205 Ala. 484, 88 So. 590, as described in  Steffen, p. 
128). See also  {\it Restatement}, \S 49.  } Note that this differs 
from actual implied authority in that apparent authority may exist 
even if the principal has expressly forbidden the agent's action. 
Apparent authority depends on the   beliefs of the third party, not 
on the actual relation between principal and agent. 


{\it 4.  Estoppel}. The principal is ``estopped'' from objecting to 
the agreement made by the agent if the principal could have 
intervened to prevent the confusion over authority; e.g., if the 
principal overheard the    agreement being made and failed to assert 
that the agent was unauthorized.\footnote{ But see   Black (1990) , 
p. 63, which seems to conflate estoppel with apparent authority: 
``Agency by estoppel:  When the principal, by his negligence in 
supervising the agent,   leads a  third party to  reasonably believe 
that the agent has authority to act for the principal.''}


 {\it 5. Ratification}. If  no other authority exists, but the 
principal agrees to the contract once he learns about it, this 
ratification binds the principal.    If the flour salesman has no 
authority to sell wheat, but he makes a contract anyway, that 
contract is binding if the flour company agrees to it upon learning 
of the salesman's actions. 


   {\it 6. Inherent Agency Power}. This is the least well-defined 
reason for liability. \S 8a of the  {\it Restatement} says that 
``Inherent agency power is a term used in the restatement of this 
subject to
indicate the power of an agent which is derived not from authority, 
apparent
authority or estoppel, but solely from the agency relation and exists 
for the
protection of persons harmed by or dealing with a servant or other 
agent.'' The agency relationship may give  the agent the power to 
harm third parties even if  there is no manifestation by the 
principal that the agent is acting on his behalf. Vicarious liability 
is based on inherent agency power, and these powers also arise in 
contract. As an illustration,  let us consider perhaps the best-known 
case involving agency  and  contracts,   {\it Watteau v. Fenwick}.
    \begin{quotation}
 \begin{small}
 ``From the evidence it appeared that one Humble had carried on 
business at a beer-house called the Victoria Hotel, at 
Stockton-on-Tees, which business he had transferred to the 
defendants, a firm of brewers, some years before the present action. 
After the transfer of the business, Humble remained as defendants' 
manager; but the license was always  taken out in Humble's name, and 
his name was painted over the door. Under the terms of the agreement 
made between Humble and the defendants, the former had no authority 
to buy any goods for the business except bottled ales and mineral 
waters; all other goods required were to be supplied by the 
defendants themselves. The action was brought to recover the price of 
goods delivered at the Victoria Hotel over some years, for which it 
was admitted that the plaintiff gave credit to Humble only: they 
consisted of cigars, bovril, and other articles.  The learned judge 
allowed the claim for the cigars and bovril only, and gave judgement 
for the plaintiff for 22$l$. 12$s$.  6$d$. The defendants 
appealed.''\footnote{{\it   Watteau v. Fenwick},  1 Q.B. 346 (1892). 
The appeal lost.} 

 \end{small}
 \end{quotation}

 This case raises problems for both 

standard agency concepts and everyday notions of fairness.   There is 
no actual authority, either express or implicit,   for the agent to 
order the cigars, because  he was expressly  instructed not to order 
them. There is no apparent authority, because the principal did 
nothing to convey  the idea that the manager was acting as an agent. 
Estoppel and ratification do not apply.  All that remains is 
``inherent agency powers'': the ability of the manager,  based on his 
employment by the principal,   to harm third parties by making 
contracts. 


 

Everyday notions of fairness do not help   either.        Who should 
bear the cost of the mistaken order for cigars?  Not the principal, 
it seems, since he never ordered the cigars and expressly forbade 
the agent from doing so. Not the agent, it seems, since he  was  not 
buying the cigars for himself  and received no benefit from them. Not 
the third party, it seems, since  he had no way of knowing that the 
manager was an agent who lacked authority. 


   As in  other areas of the law where morality  and legal rules come 
into conflict,  efficiency may  come to our aid.   Section  3 will 
look at the implications of different legal rules on the incentives 
to avoid entering into mistaken contracts. 


\newpage
\bigskip
 \noindent
 {\bf 3. A Model  of  Contracts Made by Agents}
 

  The    principal  wishes   to  buy a   good he values at $V_p$, 
which costs   the third party  $V_t$ to produce.      The principal 
can either buy the good directly, at transaction  cost $c_{na}$, or 
hire an agent,  at the lower cost $c_a$.  With probability $f$, the 
agent   mistakenly orders the wrong good,   which the principal 
values at only $(V_p-R)$ and which cannot be resold for more than 
that amount.        The agent error has  a
probability given by the convex function $f(c_p, c_t)$   which is 
decreasing in    $c_p$ and $c_t$, the care  the principal and the 
third party  take  to prevent  the error.\footnote{ 

Convexity of $f$ implies that the  second derivatives $f_{pp}$ and 
$f_{tt}$ are positive (so  there are diminishing returns to care), 
and  $f_{pp}f_{tt} - f_{pt}^2 >0$ (so the effect of each party's care 
on the marginal benefit of the other party's care is small relative 
to the diminishing returns). } Let us assume that if     the contract 
is mistaken and the principal is liable, he   accepts delivery of the 
wrong  good, but if he is not liable, the contract is renegotiated at 
a price that is lower by amount $R$, so the third party bears the 
cost of the mistake. 


 

 Our focus will be on the choice of the  care  levels $c_p$ and 
$c_t$.  The principal's care  has a large number of interpretations. 
It is he who has made an    agreement with the agent, and at some 
cost he can incorporate  incentives  to  deter   agent error. This 
cost  includes the cost of   formulating and negotiating the 
agreement,  the cost of compensating the agent for his increased 
effort to avoid errors, and the cost of incentives under imperfect 
information (e.g., increased risk-bearing by the agent  and the  real 
costs of punishments).     The principal  can  also exert care by 
choosing agents carefully  and by monitoring them   to increase the 
agent's  incentives  to avoid error and  to catch erroneous contracts 
before any reliance costs are incurred.   The care level  $c_p$ 
incorporates all these  avenues of error avoidance. 


 The third party  has   less scope for avoiding agent error because 
he does not select or compensate the agent.  His chief advantage is 
that he is on the spot when the contract is being formed, so  he can 
detect some errors more easily.   Even if he does not know the 
principal's desire perfectly,  the third party  can detect gross 
agent errors, take care to avoid inducing agent error,       ask 
about the agent's instructions, and  contact the principal directly 
for confirmation. These comprise the care level $c_t$.
 



 The   transaction  price, $P$, is the result of bargaining between 
the buyer and the seller. We will assume   the price is   negotiated 
to split the expected surplus evenly between the principal and the 
third party given their  common  knowledge   of the  probability of 
agent error. 

 

 If no agent is used,  and the principal pays the transaction  cost, 
the 

payoffs  of the  principal and third party  are 

 $\pi_p= V_p -P -  c_{na}$ and $\pi_t=  P  - V_t$.
The  total surplus from the transaction is therefore 

 \begin{equation}  \label{e1}
Surplus (no \; agent) =  V_p -V_t - c_{na}.
 \end{equation}
     If the price splits the surplus  equally between the two 
parties, it will  yield 

  \begin{equation}  \label{e2}
 P = V_t + \frac{V_p -V_t - c_{na}}{2}.
   \end{equation}
   The price is falling in $c_{na}$, so  the principal and the third 
party share any reduction in the transaction cost.  The principal 
receives a direct benefit, paying out a smaller $c_{na}$, and the 
third party receives an  indirect benefit, a higher value for the 
price $P$. 


  If the agent is used,  an error may occur,  in which case it is 
efficient to  breach the erroneous contract and  write a new contract 
correcting the error.  The individual  payoffs depend on who pays the 
agent, and on  the legal rule.   If the legal rule is that the 
principal is bound   by an erroneous contract, the  expected  payoffs 
are 

  \begin{equation}  \label{e3}
  \pi_p=   (1-f(c_p, c_t))  (V_p-P) + f(c_p, c_t)(V_{p} -P- R) - 
c_{a}- c_p
 \end{equation}
 and 

  \begin{equation}  \label{e4}
  \pi_t=    P- V_t  - c_t,
 \end{equation}
 for an expected  social surplus of 

 \begin{equation}  \label{e5}
 Surplus (with\; agent)=   V_p- V_t - f(c_p, c_t) R  -  c_{a}  - c_p 
- c_t.
  \end{equation}
  This equation describes the social surplus regardless of   the 
legal rule.  It consists of the gains from trade,  $(V_p- V_t)$, the 
expected  loss due to error, $f(c_p, c_t) R$, the cost of the agent's 
effort,  $c_{a}$, and the care taken to avoid error, $(c_p+c_t)$. All 
these exist regardless of the legal rule,  which will only affect 
the levels of  $c_p$ and $c_t$,  unless it   completely chokes off 
use of  the agent. 


        The  socially optimal care levels,  $c_p^*$  and $c_t^*$, are 
found from the first order conditions for maximizing  the  social 
surplus in (\ref{e5}), 

 \begin{equation}  \label{e6}
    -f_p(c_p^*, c_t^*)   R  - 1 =0 

  \end{equation}
 and 

\begin{equation}  \label{e7}
   -f_t(c_p^*, c_t^*)   R  - 1 =0.\footnote{The notation ``$f_p$'' 
and  ``$f_t$''  refers to the derivatives of $f$ with respect to 
$c_p$ and $c_t$.} 

  \end{equation}
   In the first-best, the   agent is used  if he reduces expected 
transaction costs, i.e.,  if 

  \begin{equation}  \label{e8}
    f(c_p^*, c_t^*) R  +  c_{a} +  c_p^* +  c_t^*  < c_{na} .
  \end{equation}
 The equilibrium price under these care levels will be
   \begin{equation}  \label{e9}
 P = V_t + \frac{V_p -V_t -  f(c_p^*, c_t^*) R  -  c_{a}  -  c_p^*  + 
c_t^*  }{2}.
   \end{equation}
  We will  ordinarily assume   that the agent will indeed be used. 


   Because the parties split the surplus,  they split the gains from 
using an agent.   If the  probability of agent error  falls 
exogenously, the principal receives a direct gain, bearing the 
mistake cost of  $R$ less often, but the third party receives an 
indirect gain,  a higher price $P$.     The agent reduces transaction 
costs, to the benefit of both parties, and   both parties should be 
interested in a  legal rule that encourages efficient monitoring.  It 
is not true that  when the  principal hires the agent it helps the 
principal alone: a reduction in transaction costs helps both sides of 
the transaction. 


  We will consider four legal rules for dealing with mistaken 
agreements: 1. Enforce, 2. Void, 3. Split the cost,  and 4. Enforce 
unless the third party was careless. 


\noindent
{\underline {\it Rule 1: An Erroneous Agreement is Enforced.}} {\it 
(Strict Liability of the Principal).}
   Under this  legal rule,    the principal is always bound by his 
agent's contract.    The third party  does not bear any of the cost 
of error, and so will choose zero care.   Predicting this, the 
principal will choose $c_p$ to maximize his expected payoff, 

  \begin{equation}  \label{e10}
  \pi_p=   (1-f(c_p, 0))  (V_p-P) + f(c_p, 0)(V_{p}  - R - P) - 
c_{a}- c_p, 

 \end{equation}
  yielding the first order condition which characterizes his 
equilibrium care, 

$\tilde{c_p}$: 

   \begin{equation}  \label{e11}
 -f_p(\tilde{c_p}, 0) R -1= 0. 

 \end{equation}

 

 The third party's care  to avoid agent error is    inefficiently 
low: $0 < c_t^*$.  The principal's care may be either higher, lower, 
or unchanged  relative  to the first-best level, depending on how the 
care levels of the principal and the third party interact.  When they 
complement  each other, the cross-partial   $ f_{tp}$   is  positive, 
and the principal's effort will be  low: $\tilde{c_p} < c_p^*$.   If 
the third party never reads letters from the principal, the 
principal  will devote little effort to explaining  what the agent is 
to buy.  When $ f_{tp}$ is  negative, principal and third party 
effort substitute for each other, and principal effort will be 
high.   If the third party never checks dubious orders with the 
principal, the principal  will  hire more able  agents than in the 
first-best.   When  $ f_{tp}$ is  zero,   the principal's care will 
be   at the first best: $\tilde{c_p}=c_p^*$.  If the third party's 
effort  choice is   to not check  for  scrivener's errors made by the 
agent,     the principal's incentive to clearly explain his 
preferences to the agent is  close to being unaffected.

 

\noindent
\underline{ {\it  Rule 2: An  Erroneous Agreement is Void.} } {\it 
(No Liability of the Principal).}  This rule  puts the entire 
liability on the third party. If the agent makes an erroneous 
contract, the contract is rescinded and the third party bears the 
cost $R$.  The payoffs are
   \begin{equation}  \label{e12}
  \pi_p=    V_p-P  -  c_{a}- c_p
 \end{equation}
 and 

  \begin{equation}  \label{e13}
  \pi_t=     P- V_t -f(c_p, c_t)R - c_t.
 \end{equation}
 The principal would choose zero care, and the third party would 
choose care to solve 

 \begin{equation}  \label{e14}
   -f_t(0, \tilde{c_t})R - 1=0. 

 \end{equation}
  The comparison with the first-best is analogous to that under Rule 
1, but it is now the principal who chooses  zero  care and the third 
party whose care depends on the cross-partial. 

 

\noindent
 \underline{{\it  Rule 3.  The Principal and the Third Party Split 
the  Cost of  the Error.}}\footnote{The closest tort analogy to this 
is comparative negligence. Comparative negligence, however, becomes 
an issue only if both parties are negligent, whereas Rule 3 splits 
the cost of the error even if both parties have taken the efficient 
level of care.}   This rule   splits the cost of error  between the 
principal and the  third party.    Let the share of the mistake cost 
$R$  paid by the principal be some value $\theta$ between, but not 
including,  zero and one. 

  \begin{equation}  \label{e15}
  \pi_p=   (1-f(c_p, c_t))  (V_p-P) + f(c_p, c_t)(V_{p}  - \theta R - 
P) -  c_{a}- c_p
 \end{equation}
 and 

  \begin{equation}  \label{e16}
  \pi_t=    P- V_t   - f(c_p, c_t)(1-\theta) R  - c_t.
 \end{equation}
 The first order conditions for the principal and third party are
   \begin{equation}  \label{e17}
   -f_p(\hat{c_p}, \hat{c_t}) \theta R - 1=0 

 \end{equation}
and 

  \begin{equation}  \label{e18}
   -f_t(\hat{c_p}, \tilde{c_t}) (1-\theta)R - 1=0. 

 \end{equation}

 One might think that since  the two parties are each bearing only a 
fraction  of the loss from error,   each exerts less than the 
socially optimal level of care.  This is not true, because  Rules 1 
and 2 are just extreme forms of Rule 3, with $\theta=1$  and 
$\theta=0$, yet they do not always result in low care.      Consider 
the case where  the care levels of the two parties are substitutes. 
If the third party would exert very little care in the first-best, 
but  must bear most of the  cost when  an error occurs, he will 
increase his level of care, while the principal reduces his care 
because he bears so little liability. 


 Though we cannot predict its direction, choice of care is distorted 
because 

 the presence of $\theta$ makes the  first-order-conditions differ 
from  those in the social optimization problem, equations (\ref{e6}) 
and 

 (\ref{e7}). This is  a variant of the ``moral hazard in teams'' 
problem of Holmstrom (1982). His Theorem 1  implies that  any 
liability rule will be inefficient unless   it does one of two 
things:


$\bullet$ The rule  destroys value   by  imposing punishments   on 
the principal and the third party following agent error  that lead to 
a total cost to them of more than $R$.
This    is impractical in the context of contract law because the two 
parties to the contract would be unwilling to go to court if they 
anticipated being punished there.  In Holmstrom's original context of 
labor contracts, this approach    takes  the  form  of  paying the 
workers zero wages if their joint output is so low as to show that at 
least one worker shirked. Workers will agree to this in advance 
knowing that in equilibrium nobody will shirk under this threat, and 
if someone did, the employer would gladly carry out the threat. In 
the context of an erroneous contract, the   court  would impose   the 
entire  loss on  each partiy.  Each   would then   provide the 
efficient care level,   but they would have an actual disincentive to 
enforce the agreement in court. 


 $\bullet$
The rule  makes use of the care levels $c_p$ and $c_t$ in allocating 
liability.   This   is what  often  happens in tort law: liability is 
allocated depending on  which parties were negligent, and  Rule   4 
is  of this type. 

 

 

\underline{{\it Rule 4. An Erroneous Agreement is Enforced Unless the 
Third Party was Careless.}} {\it  (Strict Liability of the Principal, 
with  a Defense of Third Party Negligence).}
 Under this rule,  the principal is liable under the contract unless 
the third party took too little care.     In equilibrium,  the 
principal maximizes 

   \begin{equation}  \label{e19}
  \pi_p=   (1-f(c_p, c_t^*))  (V_p-P) + f(c_p, c_t^*)(V_{p}-R  -P) - 
c_{a}- c_p, 

 \end{equation}
 and the third party  maximizes 

 \begin{equation}  \label{e20}
 \begin{array}{ll}
  \pi_t &=   P- V_t  - c_t  \;\; {\rm if}\;\; c_t \geq c_t^*\\
     & =  (1-f(c_p^*, c_t )) (P- V_t) +  f(c_p^*, c_t)(P -R-V_t) - 
c_t \;\; {\rm if}\;\; c_t < c_t^*.\\
 \end{array}
 \end{equation} 

 The first order condition for the principal is 

   \begin{equation}  \label{e21}
     -f_p(c_p, c_t^*)  R -1 = 0, 

 \end{equation}
 which yields $c_p= c_p^*$.   The third party will choose either 
$c_t^*$, for a payoff of  $P- V_t  - c_t^*$, or   a lower care level 
that solves the first order condition
   \begin{equation}  \label{e22}
       -f_t(c_p^*, c_t)R -1 =0.
 \end{equation}
 This first order condition, however, also has $c_t^*$ as a solution. 
Thus,  it is an  equilibrium  for  both the principal and  the third 
party   to  choose the first-best care level. 

 

  Any rule which imposes liability on a negligent party will result 
in an equilibrium with efficient care by both parties in this model, 
regardless of how liability is apportioned when no party is 
negligent.\footnote{   A variety of other tort-like legal rules 
condition on negligence, like Rule 4,  but differ in  how they 
allocate liability due  to non-negligent error. The analog of 
``simple negligence with a defense of contributory negligence'' would 
be for the  principal to be bound by the contract only if he  failed 
to exert the efficient level of care to avoid agent error,  but even 
then to be released from the contract if the third party also failed 
to exert care.  The analog of ``comparative negligence'' would be for 
the principal to be bound by the contract only if  he  failed to 
exert the efficient level of care, but for  the  parties to share the 
costs if both failed to exert care. }
         Contract law, however,  unlike tort law, rarely looks to 
the level of care of each party, or splits damages between the 
parties.\footnote{    Posner (1986, p. 165) suggests that unlike in 
tort,  in contract it is    usually   very clear  that only one party 
could have prevented   breach. The performer failed to perform, which 
the payer could not prevent, or the payer failed to pay, which the 
performer could not prevent. An apparent exception to the 
indivisibility of liability is the rule of {\it Hadley v. Baxendale} 
under which the breacher is not liable for unforeseeable damages. 
({\it Hadley v. Baxendale}, 9 Ex. 341, 156 Eng. Rep. 145 (1854)) 
Since he does pay  compensation only for the immediate damages from 
breach, this splits total damages.  It allocates each type of damage 
completely to one party or the other, however,  and the 
unforeseeability of the uncompensated damages  from the point of view 
of the breacher means that  it would be inefficient to make him 
liable for them.   }     If   courts  are unwilling to consider  care 
levels or  split damages,   the legal rule  must be  strict 
liability, and we are     left with  a choice  between  Rules 1 and 
2.  The social surpluses  under these two rules are: 

\begin{equation}  \label{e25}
 Surplus (Rule\; 1:  Principal \; liable)=   V_p- V_t - 
f(\tilde{c_p}, 0) R  -  c_{a}  - \tilde{c_p}, 

  \end{equation}
 and 

\begin{equation}  \label{e26}
 Surplus (Rule \;2: Third\; Party \; liable)=   V_p- V_t - f(0, 
\tilde{c_t}) R  -  c_{a}   - \tilde{c_t}.
  \end{equation}
 Rule 1 is preferred if 

\begin{equation}  \label{e27}
     f(\tilde{c_p}, 0 ) R  + \tilde{c_p} <  f(0, \tilde{c_t}) R  + 
\tilde{c_t}.
  \end{equation}
   This is what I will call  the least-cost-avoider principle.   The 
easiest interpretation   is when  the equilibrium probability of 
agent error is the same under Rules  1 and   2, so  $f(0, 
\tilde{c_p}) =f(0, \tilde{c_t})$. In that case, we need only ask 
whether $\tilde{c_p} <  \tilde{c_t}$; does the principal have the 
least cost of  preventing   agent error?   More generally, if the 
equilibrium probabilities of error are different, it may be that 

 even if  $\tilde{c_p} > \tilde{c_t}$, the    principal  should be 
liable because  he will  prevent more errors.  Suppose, for example, 
that the principal's care consists of double-checking every contract 
the agent makes immediately, while the third party's care consists of 
trying to guess whether the agent  has forged his authorization 
letter. This form of third party care  may be so  costly  that the 
efficient level of it is very low, resulting in a low $\tilde{c_t}$ 
but also a low $f(0, \tilde{c_t})$. 

 

 

     Even if courts are constrained to use rules of strict liability, 
they can allow some flexibility by 

thinking   of the  error probability $f(c_p, c_t)$ as being the sum 
of the  probabilities    of $N$ different kinds of errors, each with 
their own kind of preventive care and their own choice between legal 
rules.  The transaction cost is then 

\begin{equation}  \label{e28}
     c_{a}    + \sum_{i=1}^N \left( f_i(c_{pi}, c_{ti})R + c_{pi}+ 
c_{ti} \right).
    \end{equation}
  For each of the $N$ mistakes,  the court  must determine where to 
put liability.   This is the approach that will be taken in the cases 
in the following section:  for each situation, try to determine 
whether the contract should be enforced or not depending on the 
parties' relative cost  of  and effectiveness in  preventing the 
particular type of agent error.     In accordance with inequality 
(\ref{e27}), the  agreement should be binding after error $i$ if and 
only if 

 \begin{equation}  \label{e29}
     f_i(\tilde{c_{pi}}, 0 ) R  + \tilde{c_{pi}} <  f(0, 
\tilde{c_{ti}}) R  + \tilde{c_{ti}}.
  \end{equation}

  An entirely different way to avoid harm  is  for the principal   to 
drop the agent and deal directly with  the  third party.  The social 
surplus would then be $V_p - V_t - c_{na}$, as in equation 
(\ref{e1}).  If Rule 1 is used, the principal may  decide to dispense 
with the agent altogether rather than risk  the agent making a 
mistake.   Abandoning use of the agent could even be the efficient 
outcome, if optimal care levels by both principal and third party 
still result in high agency costs.\footnote{The point that optimal 
deterrence  should  consider the activity level as well as the degree 
of the care in the activity is due to Shavell (1980), who made it in 
the context of torts.   }  The same outcome could occur under Rule 2. 
If  the third party must bear the cost of agent mistakes,  he may 
decide to refuse to deal with agents  and insist on direct 
negotiation with the principal. In looking at the illustrations in 
the next two sections, it will be seen that  refusal to deal with an 
agent in dubious circumstances  is often the most efficient means for 
the third party to prevent mistaken contracts.  For both principal 
and third party, the least-cost way of avoiding agent error  may be 
to dispense with the agent.
 

In sum,   the  legal rule   dealing with the consequences of 
agreements mistakenly entered into by agents cannot attain first-best 
levels of care by the principal and the third party unless the legal 
rules assigns liability based on those care levels.   Since contract 
law principles generally do not allow this,  some inefficiency will 
result, with too little effort by one party and perhaps too little or 
too much   by the other.  If different types of agent error are 
prevented by different kinds of care, however,  the legal rule can be 
improved by  placing the liability on  whichever party is the 
least-cost-avoider for the particular error. 


 

    \bigskip
\noindent
{\bf  4. Application of the Least-Cost-Avoider Principle }
 

 \noindent
 {\it  4.1 The Sources of Authority}

 The six sources of agent authority described in Section 2  can   be 
derived  from the least-cost-avoider principle.
  When the agent has actual express authority, as in Illustration 1, 
the principal  will usually be  the least-cost-avoider. 

      \begin{small}\begin{quotation}
{\it Illustration 1: Actual Express Authority.}  $P$  hires  $A$   to 
buy    goods from $T$.      $A$  orders  the goods  from  $T$.  Soon 
afterwards, $P$ realizes that he cannot make use of the goods. 
Must $P$ accept delivery and pay $T$? 

       \end{quotation}
 \end{small}
        The role of the agent    is trivial:  he carries out the 
wishes of the principal to the letter,  and when the principal is 
mistaken {\it ex post},  it is not because he employed an agent.  It 
is a useful starting point, however, to explain why $P$ should be 
bound by the agreement, because   both $P$ and $T$ could conceivably 
have prevented the harm. 


    $P$  is the natural least-cost-avoider because he  should know 
better than anyone   what goods he wants  and how much he is willing 
to pay for them.   Determining even  one's own tastes is costly, but 
trying to determine someone else's   is usually more difficult. This 
is particularly true when an agent is used, because $T$ does not even 
meet $P$ face to face. 


Even so simple a point, however, has its exceptions.   Although  $P$ 
knows his tastes best,  if $T$   knows the goods he is selling best, 
it may be $T$ who  can most cheaply avoid mistaken contracts.  This 
is the basis for the formation defenses   of fraud and 
misrepresentation which a defendant may use when accused of breach of 
contract.    It is also the basis for   many common business 
practices such as  warranties and explicit or implicit money-back 
guarantees.  If the legal default is that $P$ is responsible, but $T$ 
is the  least-cost-avoider  in transactions of a particular type, the 
contract can be modified to  shift the risk of mistake onto $T$. 

 

  In Illustration 1, the considerations involved are very little 
different from when a contract is  made without an agent, except 
that   $T$'s cost of discovering the tastes of the party with whom he 
is ultimately contracting are even higher.  When actual implied 
authority is involved, the situation is more special to agency, 
because it creates the possibility that the agent acts in a way that 
the principal did not intend and would repudiate immediately. 

     \begin{small}\begin{quotation}
{\it Illustration 2: Actual Implied Authority.} $P$ hires  $A$ as 
manager for his grocery store.   $A$ orders  fresh fruit  from  $T$, 
but orders a much   greater quantity than  $P$ desired.   Is  $P$ 
liable on the contract? 

       \end{quotation}
 \end{small}
   $P$ is liable on the contract because general managers have the 
implied authority to place orders for fruit.    This is a more 
difficult case than Illustration 1, however. We cannot just say that 
the buyer is responsible for his contracts, because in  Illustration 
2,  $A$ is acting contrary to $P$'s wishes.    Unlike in Illustration 
1,  if  $A$ were not employed, the mistaken  order would not have 
been made, so    $A$ is  not simply acting in place of $P$.   $P$ 
has, however, intended for $A$ to make contracts of this kind,   and 
knows there is some possibility that $A$ will place the wrong order, 
and in this sense $P$  intended that $A$  place  a certain number of 
wrong orders.    This was the tradeoff  between reducing transaction 
costs and increasing error modelled in Section  3.  Viewed this way, 
actual implied authority is close to inherent agency power: the 
principal has put the agent in a position where  the agent can 
inflict harm on third parties. 



 The least-cost-avoider principle  helps clear away some of the 
confusion over authority.  We must ask what general rule of liability 
would result in the least cost of avoiding this kind of mistake. 

 The principal has   a variety of means to reduce the risk of agent 
mistakes. He hires the agent, and so  can   select an agent with the 
appropriate talents  and negotiate a contract to give him incentive 
to use those talents properly.  He instructs the agent to a greater 
or lesser extent, choosing the level of detail   in light of the 
cost.  He  can    expressly instruct the agent not to take certain 
actions, and tell third parties about the restrictions.\footnote{ If 
not communicated to the third party, such withdrawal may not affect 
the manager's {\it power} to take such actions, because  he may still 
have apparent    authority, but  the principal can   punish the agent 
for taking forbidden actions, and this is the chief use of hidden 
instructions  of which the third party is unaware, such as those in 
{\it Watteau v. Fenwick}.} He can monitor the agent, asking for 
progress reports on  or randomly checking transactions that are in 
progress.   The principal's control over the agent, a basic feature 
of the agency relationship, gives  him many levers with which to 
reduce the probability of mistakes. 


    Analogs of some of these levers are available to the third party. 
He  can refuse to deal with  with an insufficiently talented agent, 
but this requires incurring  costs to  gauge the agent's talent. 
Although this may be no more difficult for the third party than for 
the principal,  the principal  often  will be  able to spread the 
fixed cost of testing the agent over  many transactions the agent 
will make for him.   Similarly, the  third party could  sign a 
contract with the agent, specifying that the agent will be punished 
if  the principal  disavows the contract, but  economies of scale are 
more  available to the principal  than   to the third party. Or the 
third party could monitor the agent by  checking with the principal 
to confirm the transaction.  Sometimes this may be efficient, but 
the trouble to which it puts the principal reduces the value of 
hiring an agent.    In light of this, it makes sense to have the 
principal liable as a general rule when the agent has actual implied 
authority. 

 

 

 The next category, 

apparent authority,  rests on manifestations made by the principal 
which reasonably lead  the third party to believe that the agent is 
acting on the principal's behalf. 

   \begin{small}\begin{quotation}
    {\it Illustration 3: Apparent Authority.}    ``P discharges A, 
his general selling agent, but gives no notice to others.  Shortly 
thereafter, A contracts to sell goods by separate contracts to X, Y 
and Z.  X had known of A's former employment.  A showed Y a letter 
from P to A signed by P, stating that A is employed as P's selling 
agent.  Z had not known of A's employment and relied wholly on A's 
oral statement.''\footnote{{\it Restatement}, \S 159.   } Do $X, Y,$ 
and $Z$ have valid contract claims against $P$? 

      \end{quotation}
 \end{small}
  The {\it Restatement} says that $X$ and $Y$ have valid claims, but 
$Z$ does not.  This  corresponds to   the least-cost-avoider 
principle, because  for $X$ and $Y$    to check the authority of 
every well-known or documented agent  for every transaction would be 
more  costly  than to require    $P$ to  notify his  customers   that 
$A$ has been fired and to  demand return of letters of 
authority.\footnote{This is close to the {\it former dealer}  rule in 
partnership law, that when a partnership is dissolved, an erstwhile 
partner still has the power to obligate the firm until former dealers 
on credit are notified of the dissolution. See Steffen (1977), p. 51 
or U.P.A.  \S  35.}  Furthermore, even if the cost to $P$ of 
retrieving his letter of authority is high, imposing the liability on 
$P$ discourages him from issuing such a dangerous letter in the first 
place. Some other sign of authority may be less easily abused. 
$Z$, on the other hand,  has   exerted no  care to determine that $A$ 
is $P$'s agent,  and $P$'s cost of advertising to every potential 
customer that  every potential  salesman is not his agent is 
prohibitively high. 


 The principle of estoppel is even more clearly related to the 
least-cost-avoider  principle.  Estoppel is based on the ease with 
which someone could have prevented harm to himself; having failed to 
prevent the harm, he is ``estopped'' from asserting  what would 
otherwise be a valid  claim. 

   \begin{small}\begin{quotation}
{\it Illustration 4: Estoppel.}   ``P learns that A, who has no 
authority or apparent authority to sell P's
goods, is negotiating with T as P's agent for their sale.  He does 
nothing
although he could easily notify T.  T pays A for the goods, as is 
customary in such a transaction.''\footnote{{\it Restatement}, \S 8B. 
}   Must $P$ deliver the  goods? 

      \end{quotation}
 \end{small}
     On pure agency grounds, $P$ would  be free to refuse to  deliver 
the goods, because $A$ is    not his agent and $P$'s manifestations 
did not deceive $T$.    Instead, the law requires him to deliver the 
goods on grounds of estoppel:   he could have prevented the 
misunderstanding but did not.    Even though $P$ did not hire $A$, he 
is the least-cost avoider because he can  prevent the mistake  more 
cheaply than   $T$ can.  He is therefore     liable for the resulting 
harm.

   Estoppel   has two special features in contrast to other sources 
of liability.\footnote{See Steffen (1977), p. 128.} First, the third 
party's recovery is limited to the losses caused by the principal's 
failure to prevent the mistake.  Strictly speaking, that failure does 
not make an invalid agreement into a contract; it just makes the 
principal liable for damages. Second, estoppel is a one-way street. 
The third party can obtain damages from the principal, but the 
principal cannot enforce the agreement against  the third party 
(unless  it is made valid by ratification, as discussed below). 
These features make it even clearer that the driving idea is that of 
the least-cost-avoider, rather than some  idea from contract idea. 



 

 Ratification, the fifth source of liability, occurs when the 
principal assents to an agreement after it is made by someone who 
lacks authority.  Ratification  is  similar to  actual express 
authority, because when the principal ratifies the agreement, he is 
saying that it is satisfactory to him and he sees no mistake worth 
the cost of renegotiation.  The principal will generally be the 
least-cost-avoider for the same reason as when the agent has  actual 
express authority. 


   The last source of liability, inherent agency power, is 
illustrated by {\it Watteau v. Fenwick}, here abstracted as 
Illustration 5.   \begin{small}\begin{quotation}
 {\it Illustration 5: Inherent Agency Power.} P buys A's tavern and 
hires him as manager, instructing him not to buy cigars for the 
tavern.  A orders cigars for the tavern anyway, from  T,  who 
believes A to be the owner.  Must P honor the agreement? 

      \end{quotation}
   \end{small} 

    $A$ lacks actual authority  to buy cigars,  because of $P$'s 
instructions, and lacks apparent authority because  $T$ does not 
believe $A$ to be $P$'s agent.   $P$'s liability is based on inherent 
agency power:  $A$ has been put into a situation,  where he can 
impose losses on third parties unless $P$ is made liable. 

 

 The least-cost-avoider principle reaches the same result, because 
$P$  can control $A$ more cheaply than can $T$. Not only do   the 
arguments made earlier  for $P$'s lower cost of mistake avoidance 
apply,  but  the    fact that $P$ is undisclosed strengthens the 
argument  because   $T$ does not even realize there is an agency 
problem.   Thus, every one of the six sources of liability can be 
justified by   the least-cost-avoider principle. 



 

 \bigskip
\noindent
 {\it 4.2  When Should the    Third Party Bear the Cost of Mistaken 
Contracts?} 


 As Section 3 pointed out, 

 the transaction benefits both principal and third party. Since both 
can take care to avoid agent error, 

 which party is  liable should  depend  on the type of error.  In 
almost all of the   illustrations in Section 4.1, the principal was 
the least-cost-avoider of error. Since the principal has more control 
over the identity and incentives of the agent, it is usually 
efficient that hebe liable. 

  ``Usually'' is not ``invariably,''  however,  as  the illustrations 
in this section will show.  The third party does have the advantage 
of being present at the time of contracting and he does have control 
over actions of his own which might lead the agent to make an 
inefficient contract. In Illustrations 6 through 9,   the 
least-cost-avoider principle   leaves the principal  free from 
liability for the agent's contracts. 

 

 

 Let us begin with the care to check authority, in Illustration 6. 

  \begin{small}\begin{quotation}
{\it Illustration 6: Not Checking Authority Carefully.}    ``P tells 
T that A is authorized to buy sheep for him when the market price of 
wool in another country has reached a certain point.  T sells sheep 
to A, relying upon A's untruthful statement that the price of wool 
has reached the
specified point.''\footnote{{\it Restatement}, \S  168. }   Is $P$ 
bound by the contract? 

    \end{quotation}  \end{small}
  In Illustration 6, $T$ is  the least-cost-avoider,  because his 
cost of verifying $A$'s claim is lower than the cost to $P$ of 
ensuring that $A$ does not make false claims. The {\it Restatement} 
agrees and $P$ is not bound by the contract.    $P$  does have means 
to prevent the false claims---  through threat of   discharge,   if 
nothing else--- but  the cost for $T$ to check the claims is 
lower.\footnote{A case like Illustration 6 is Mussey v.    Beecher 
(1849) 57 Mass. (3 Cush.) 511.  The defendant authorized his agent to 
buy up to \$2,000 in books for his store. The agent bought more than 
that amount, and ordered even more from the plaintiff, falsely 
telling the plaintiff that the limit was not yet exceeded. Judge Shaw 
ruled for the defendant. } 

 

  The outcome would be different if  it were more costly for $T$ to 
discover the information on which  $A$'s authority relies.  We have 
already seen in {\it Watteau v. Fenwick} that secret instructions do 
not protect $P$.  This is equally true of information known to $A$ 
but not to $P$ or $T$. If $P$ authorizes $A$ to buy one sheep, and 
tells $T$ that $A$ may be coming by to do so, then $P$ is bound by 
$A$'s purchase from $T$ even if $A$ had previously terminated his 
authority by   buying a different sheep from someone 
else.\footnote{{\it Restatement}, \S  171. }   $T$ cannot easily 
discover the information in these cases. 

 

   A second  reason why  $T$ may be the least-cost-avoider is that he 
is on the spot at the time of contracting and can observe the 
agent's behavior. 

\begin{small}\begin{quotation}
 {\it Illustration 7: Incapacity of the Agent.}    $P$  hires  $A$ 
as an agent to buy    goods from $T$.     While intoxicated,   $A$ 
orders  the wrong  goods  from  $T$, who knows that $A$  is 
intoxicated.   Must $P$ pay for the goods? 

       \end{quotation}
 \end{small}
   $P$ should  not have to pay for the goods,   because it is $T$ who 
has the lowest cost of monitoring $A$'s sobriety at the time of 
contracting.\footnote{Lack of capacity is a standard formation 
defense for  breach of contract. 

See  {\it Restatement (Second) of Contracts}, \S 18. }  If $T$  has 
no way of knowing that $A$ is intoxicated, the answer is more 
difficult.\footnote{{\it Restatement}, \S  122 seems to say that the 
contract remains invalid: the agent's authority  to contract ends 
after an event which  ``deprives  the agent of capacity to make the 
principal a party to it''.} Contract law  does not premise  lack of 
capacity on the knowledge of the other party of that lack. Here, 
however, $P$ stands behind $A$, and can take measures to prevent him 
from contracting while intoxicated.   If $P$ has hired a habitual 
drunkard as his agent,   $P$ surely should bear the loss from $A$'s 
frivolous agreements. 

 

      A  third reason to release the principal from liability is if 
the third party colludes with the agent against him. 

    \begin{small}\begin{quotation}
{\it Illustration 8: Collusion With the Agent.}   ``T sells a horse 
to A, P's authorized agent.  T represents the horse to be sound.  A 
knows the horse to be unsound.  P does not have this 
knowledge.''\footnote{{\it Restatement}, \S  144.   }   Is $P$ bound 
by the contract? 

      \end{quotation}
 \end{small}
   The {\it Restatement} bases the result in Illustration 8   on 
whether $T$ and $A$ have colluded. Note first that  $T$'s 
misrepresentation is not the cause of the erroneous purchase, which 
it would have been had he been selling directly to $P$, because $A$ 
was not fooled by it.  Therefore, if there was no collusion between 
$T$ and $A$, $P$  would be  bound by the contract; he could have 
gone to the trouble to hire  a  more responsible   agent than $A$. 
If $T$ had been colluding with $A$, on the  other hand,   the 
contract would  be invalid, because  $T$  could  have prevented the 
harm    by refraining from colluding with $A$, a very low cost to 
$T$. 


  A fourth reason   to   release the principal from liability  is 
if  the agent's malfeasance  should be  obvious to the third party. 

   \begin{small}\begin{quotation}
     {\it Illustration 9:  Obvious Agent Malfeasance.}    $P$ 
authorizes $A$ to  buy   a refrigerator for him.  $T$ has listed a 
refrigerator for sale at \$400, but $A$ offers \$700    if it can be 
delivered slightly more quickly.    $T$ knows that $A$ is  an agent 
for  $P$  and  that   $P$  would not value speed of delivery at 
\$300.   Is $P$ bound by the agreement? 

      \end{quotation}
 \end{small}
 According to the {\it Restatement},  ``Unless otherwise agreed, 
authority to buy or sell with no price specified in terms includes 
authority to buy or sell at the market price if any; otherwise at a 
reasonable price.''\footnote{{\it Restatement}, \S 61.}  This implies 
that  $P$ is not bound by the agreement in Illustration 9. 

$T$ has the least cost of controlling the agent's misbehavior because 
he is on the spot,  unlike  $P$. The price of \$700 is so excessive 
that it should be easy for $T$  to see that $A$ is misrepresenting 
his authority from $P$. 

 

If the price paid had only been \$450,   the mistake would not be so 
clear.  An extra \$50 is not an  unreasonable  premium for speed, and 
it is not easy for $T$ to tell that $A$ is misbehaving.  The cost to 
$P$ of preventing overpayment, on the other hand, is little different 
whether the amount is \$50  or   \$300.   The least-cost-avoider 
principle suggests that $P$ should be liable for small mistakes but 
not for large mistakes. 

 

 Illustration 9 also raises the  issue of      the level of damages 
that $P$ must pay to $T$ for breaching the contract. 

   The usual remedy the law provides is expectation  damages: if the 
principal breaches, he must pay enough   to make  the third party as 
well off as if the contract had not been breached.  An alternative is 
reliance damages:  if the principal breaches, he must pay enough   to 
make  the third party as well off as if the contract had never been 
written.  Expectation damages  induce efficient breach by the 
promisor, but  reliance damages   induce efficient reliance by the 
non-breaching  party.\footnote{See  chapter 5 of Polinsky (1989) for 
a   discussion of these contract remedies.}  In the model of 
Section   3, those issues did not arise, because the model was 
constructed so that   breach of contract would take place when 
efficient  and the reliance expenditure was made exogenous. 


In Illustration 9, if the contract price is \$700 and the market 
price is \$400,  the expectation damages would be \$300.  Reliance 
damages, on the other hand,  would  be zero if $T$ incurred no cost 
in making the contract, and very little more if $T$'s loss were 
limited to the transaction cost.   The  social cost of making  and 
breaching the inefficient contract is limited to the transaction 
cost,  since the \$300 is just a transfer, a windfall profit for $T$. 
Reliance damages are more efficient than expectation damages, because 
expectation damages would lead to excessive care by 
$P$.\footnote{This   point  is made in Rasmusen \&  Ayres    (1993) 
in the context of scrivener's errors.  If contracts with such errors 
are enforced to the letter,  parties making contracts will take 
overly great precautions to avoid the errors; it would be more 
efficient simply to reform the contract once the error was 
discovered. }   This suggests that even if  the court finds  $P$ 
liable for a contract made by an agent, reliance damages may be more 
appropriate, especially if $P$ announces his intention to breach 
immediately upon discovering what $A$ has done. 


\bigskip

 

  What this variety of illustrations has shown is that the 
least-cost-avoider principle can be   useful  in guiding   agency 
law.   The next section will continue to use the principle, but in a 
special context--- the undisclosed principal problem. 

 

\pagebreak
\bigskip
  \noindent
 {\bf 5. The Undisclosed Principal Problem and Other Issues} 


  This section will address the basic problem of the undisclosed 
principal and use that context to address a number of other issues in 
agency law. 


\bigskip
  \noindent
 {\it  5.1 The Undisclosed Principal Problem} 

 

       The undisclosed principal problem arises when an agent makes 
an agreement with a third party who does not realize that the agent 
is acting as an agent    rather than on his own behalf. The question 
then arises of whether the third party has a legal claim against the 
principal as well as against the agent.  {\it Watteau v. Fenwick} is 
a particularly dramatic  example   because the agent acted against 
the express wishes of the principal, but the problem exists even if 
the agent is obedient, as     in Illustration 10. 

  \begin{small}\begin{quotation}
 {\it Illustration 10: The Undisclosed Principal Problem.}   A agrees 
to buy goods from T.  A represents P, unknown to  T.    Is   P 
bound by the contract? 

 \end{quotation}  \end{small}
  Conventional contract law says that $A$ and $T$ are bound by the 
contract. Agency law says that $P$ is also bound, but this  is   s 
difficult to justify under the usual jurisprudential theories of 
contract law.\footnote{This discussion is drawn from Barnett (1987), 
who provides   references to the case law and evidence of  the 
discomfort of common law scholars with the undisclosed principal 
rule. Barnett briefly  discusses efficiency theories of contract, but 
objects to them as not providing a normative theory of contractual 
obligation.}   The rule seems to violate the standard will theory of 
contract. As    the {\it Restatement} says, 

   \begin{small}\begin{quotation}
 The  undisclosed principal  rule  appears to violate   basic 
principles of  contract law. The relation between principal and a 
person with whom the agent has made an authorized contract is spoken 
of as contractual, although by definition there has been no 
manifestation of consent by the third person to the principal or by 
the principal to him.\footnote{ {\it Restatement}, \S  186.}
 \end{quotation}  \end{small}
   The rule is no better explained by  the bargain theory  or 
reliance theories of contract. The bargain theory looks to  whether 
the two parties bargained with each other.   $T$  did not knowingly 
bargain with $P$, and making  $P$ liable   provides $T$ with a 
benefit for which he did not bargain. 

The reliance theory looks to whether the two parties reasonably rely 
on each other's promises. $T$ does not rely on $P$'s promises, 
because he does not know that $P$ exists.\footnote{Barnett (1987) 
shows that his own ``consent theory'' of contract does explain the 
common law rules of the undisclosed principal problem.  This theory 
looks to whether (a) the subject of the contract is a morally 
cognizable and alienable right owned by the transferor and (b) the 
transferor manifests his consent to transfer the right.}

    An efficiency theory of contract law has an easier time 
explaining the undisclosed principal rule.  The least-cost-avoider 
principle says that $P$ should be bound because $T$'s  cost of 
preventing  $A$ from making an inefficient contract is   greater than 
$P$'s.  $T$,  who does not even know  that $A$ is an agent,  should 
be allowed to take  even less care  than  if he knew $A$ were an 
agent. Consider  again Illustration 9, in which $A$ pays \$700 for a 
refrigerator that normally costs \$400.  The {\it Restatement} seems 
to indicate that $P$ is released from obligation regardless of 
whether he is disclosed or undisclosed. The least-cost-avoider 
principle suggests that  the court should think harder about 
releasing $P$ if he is undisclosed, because $T$ has less reason to be 
suspicious and to investigate.  Without knowing that $A$ is an agent, 
$T$  has no reason to doubt that $A$ has   some  personal reason for 
paying   a large premium for speedy delivery. 



The rule that undisclosed principals are bound  by their agents' 
contracts is also useful because it encompasses  situations  in which 
the agent has used the resources of the principal to appear wealthier 
or more dependable.      {\it Watteau v. Fenwick} is  one such case: 
the manager seemed  more creditworthy because he appeared to own the 
tavern.  Indeed, the very act of placing an order may make an agent 
seem more dependable. If  an individual orders ten thousand dollars 
worth of replacement parts for  a nuclear reactor, it is natural  to 
suppose that he is acting on behalf  of a larger business. 



    The main  objection to making $P$ liable is that  it  provides a 
windfall to $T$,  because $T$ did not rely on $P$'s credit  when 
entering into the contract. If $T$ has the option of enforcing the 
contract against either $A$ or $P$, he has gained an advantage for 
which he had not bargained with $A$: if $A$ is insolvent,  $T$ can 
sue $P$ instead.   This windfall matters not only for fairness  but 
efficiency, as  Illustration 11  shows. 

      \begin{small}\begin{quotation}
 {\it Illustration 11$'$: Windfalls$'$.}    $A$, who owns no assets, 
orders   goods  on credit from $T$ which cost   \$90 to produce.  If 
there is no recession, $A$ can resell the goods for \$105, while if 
there is a recession, which occurs with a 10 percent probability, the 
goods are worth \$0.  The contract takes the form of a contract price 
of \$101, and $A$ breaches if a recession occurs. 

 \end{quotation}  \end{small}
  \begin{small}\begin{quotation}
 {\it Illustration 11$''$: Windfalls$''$I.} The same as 11$'$, 
except: 

  $A$ is backed by undisclosed principal $P$, who must honor the 
contract and will not become insolvent in doing so.    $T$ believes 
the probability that $A$ is backed by an undisclosed principal is 
negligible and so   still insists on a  contract price of \$101.  A 
contract price of \$101,  would yield negative profits for $P$,   so 
no agreement  is reached. 

 \end{quotation}  \end{small}
  \begin{small}\begin{quotation}
 {\it Illustration 11$'''$: Windfalls$'''$.} The same as 11$''$, 
except:  The legal rule is that $P$ is not a party to the contract, 
and so need not pay damages if $A$ breaches.  A contract price of 
\$101 would yield positive  profits for $P$, and so agreement is 
reached. 

   \end{quotation}  \end{small}
   In each of the variants of Illustration 11, it is efficient for 
$T$ to sell the goods to $A$, but in 11$''$, in which the undisclosed 
principal  is bound, agreement is not reached. Thus, there is indeed 
a potential efficiency loss associated with   making undisclosed 
principals liable on contracts. Some mutually beneficial contracts 
will not be made because $T$ does not know the value of  the contract 
being offered to him. 

 


  Whether because of the windfall problem or for some other reason, 
there is one class of undisclosed principal  cases where American 
courts have usually exempted the principal from liability.  This 
class is described in   Illustration 12. 

    \begin{small}\begin{quotation}
{\it Illustration 12: Principal Pays  but Agent Breaches.}  $A$ 
agrees to buy goods from $T$, and $T$ delivers the goods.  Unknown to 
$T$, $A$ is an agent for $P$. $P$ pays $A$ the money for the goods, 
but $A$ becomes insolvent before paying $T$. Can $T$ sue $P$ for 
payment? 

    \end{quotation}  \end{small}
  Most American courts would deny $T$ the right to sue $P$, on the 
grounds that $T$ relied only on $A$'s credit, but English courts, and 
the {\it Restatement},  would give $T$ the right to sue.\footnote{See 
Barnett (1987), pp. 1973, 1984   and the {\it Restatement} \S 208.} 
The least-cost-avoider principle  leads  to   the English rule. $P$ 
has the least cost of inducing $A$ to make an efficient contract, and 
also has the least cost of preventing $A$ from losing the payment 
money before transferring it to $T$. 


 \bigskip
  \noindent
 {\it  5.2  Special Contract  Terms} 


   One of the maxims of the      law and economics of contract  is 
that if  transaction costs are low, the parties will customize their 
contract regardless of the legal default rule, so an inefficient 
default rule can cause only a limited amount of harm. This might seem 
to be a way out of the undisclosed principal problem, as in 
Illustration 13. 

    \begin{small}\begin{quotation}
{\it Illustration 13: Special Contract Terms.}  $A$ agrees to buy 
goods from $T$, but the contract specifically excludes any liability 
on the part of anyone but $A$ and $T$.  $A$ represents $P$, unknown 
to  $T$.    Is $P$ bound by the contract? 

    \end{quotation}  \end{small}
  $P$ has no obligation to  $T$ here,\footnote{    {\it Restatement}, 
\S 189.    }   but it may be difficult to write a contract of this 
kind because  asymmetric information creates serious trouble for this 
contract maxim.\footnote{A number of articles have appeared in recent 
years showing how parties may be reluctant to propose special 
contractual terms, or to object to adding terms, because such actions 
would reveal their private information. See    Ayres \& Gertner 
(1989)  and Spier   (1992).} 

 If $A$ proposes a term exempting other parties from liability, $T$ 
can deduce that $A$ is backed by a principal, which is information 
that $A$ may not wish to disclose. Hence, if most agents wished to 
exempt their principals,  it would be important to make this 
exemption  the default  rule, or perhaps even to make it mandatory. 


 


\bigskip
  \noindent
 {\it  5.3  An Agent Acting Outside of His Authority} 


     Section 4.1 discussed  why the principal should be liable when 
the agent has various categories of authority. Why   should the 
principal   not  be liable  when the agent acts without   authority? 
The question may seem  vacuous, but     the principal might have  the 
least cost of preventing     mistakes by the agent  even when the 
mistakes are unconnected with the principal's purpose in hiring him. 
Illustration 14   is  an example. 

       \begin{small}\begin{quotation} 

  {\it Illustration 14:  An Agent Acting on his Own Behalf.  } 
``$P$ authorizes $A$ to purchase a particular horse in $A$'s name and 
gives $A$ the money to do so.  $A$ purchases the horse on his own 
credit, without disclosing $P$'s existence, intending to abscond with 
horse and money, which he subsequently does.''\footnote{{\it 
Restatement}, \S   199.}  Is $P$   liable to $T$, the seller of the 
horse? 

           \end{quotation}
 \end{small}
  According to the {\it Restatement}, $P$ is not liable, because $A$ 
is not acting as his agent.  If  $P$ were a disclosed principal and 
$A$ bought the horse  on $P$'s credit, $A$'s motivation would not 
matter and  $P$ would be liable.  This  makes sense because  $P$ can 
control $A$ at lower cost than $T$. 


 Since $P$ is undisclosed, Illustration 14 seems hard to  distinguish 
from the ordinary   undisclosed principal  problem in Illustration 
10.   In both, the issue is whether $P$ should be liable for the 
mistaken contract  when $T$ does not know of $P$'s existence.  Why 
should $A$'s motivation matter? 



The answer may lie in providing efficient incentives for $P$ to 
decide whether to hire $A$. 

 In Illustration 10,   where $A$ is acting on behalf of  $P$,    the 
contract would not have been made had $P$ not  set the process in 
motion. If   contracting  by means of an  agent sometimes leads to 
harm, $P$ ought to bear the cost,  or he will be too willing  to use 
an agent.      Illustration  14  is different because    $P$'s hiring 
of $A$ in no way caused the  harm.    If $P$ had never hired $A$, $A$ 
could still  have  done   the same thing, agreeing to buy the horse 
from $T$ and absconding. That $A$'s action   is to  abscond with  a 
horse  is irrelevant; if $A$ had chosen to abscond with $T$'s bicycle 
instead, the problem would be essentially the same. Since the harm 
does not result from $P$'s desire to buy a horse using  an agent, it 
would be  inefficient to  impose an extra cost on that activity by 
making $P$ liable for  $A$'s misdeeds. 


    The point that the principal should not  be liable for harm 
caused by  an agent acting  without authority can be applied more 
generally. An argument could be made using the least-cost-avoider 
principle. Perhaps the principal should be liable for harm caused by 
the agent even if all of Section 3's six sources of liability  are 
lacking, because the principal can still control the agent by means 
of his contract.  This may be  easier to see in the context of tort. 
The  legal  rule of vicarious liability is that the principal is 
liable  only for torts that the agent commits in the course of 
employment.\footnote{{\it Restatement},  \S 219.}  Imagine  going a 
step further by making the principal liable even for the agent's 
holiday torts. The justification would be that   the principal can 
control even those torts,  by   threatening to fire  the agent if 
they occur.  Making the principal liable would be distortionary, 
however,  because it would  tend to deter the hiring of agents.  The 
extra liability on the principal is like a tax on hiring agents. 
Thus,  it is not enough to discover that the principal is the 
least-cost-avoider in controlling agents; one must also decide 
whether  imposing the cost of avoiding the harm might overly deter 
principals from hiring agents in the first place. 


 


 

\bigskip
  \noindent
 {\it  5.4  Negotiable Instruments} 

 

 A negotiable instrument is  a transferrable written promise     to 
pay  money.  Whether an undisclosed principal is bound by a note 
signed by his agent depends on whether it is negotiable. Consider 
Illustrations  15 and 16. 

 \begin{small}\begin{quotation}
    {\it Illustration 15: A Negotiable Instrument.}    ``Chicago, 
June 1, 1928.  On demand I promise to pay to bearer \$100.''
(Signed) ``A.''\footnote{{\it Restatement}, \S  152.} 

  \end{quotation}  \end{small}

    \begin{small}\begin{quotation}
   {\it Illustration 16: A Nonnegotiable Note.}    ``Chicago, June 1, 
1928.  On demand I promise to  pay John Smith \$100.''(Signed) 
``A.''\footnote{{\it Restatement}, \S  152.} 

 \end{quotation}  \end{small}
 According to the {\it Restatement},  $A$'s undisclosed principal may 
be found liable in Illustration 16, but not in Illustration 15. 

     It is easiest to explain why the principal could be  liable in 
Illustration 16. This  may just be   the payment part of the earlier 
Illustration 10: the third party, John Smith, has    done something 
for the principal,   and the agent pays Smith with the note. 

 

 The only difference in Illustration 15 is that the promise is to 
``the bearer,'' yet the undisclosed principal is not liable. 

This might be due to  the need for transferrability.  By asking for a 
note made out   to ``bearer,''  $T$  is showing that he may wish to 
transfer the note to a fourth party, $F$. The value of the note 
depends on the creditworthiness of $A$, which may make it difficult 
for $T$ to receive the full value of the note from $F$.  This is a 
problem of adverse selection; if $T$ tries to resell the note to $F$, 
$F$ will  suspect from  that very act that $T$  has heard something 
unfavorable about $A$'s credit. Anything that increases the 
possibility that $T$ is better informed than $F$ about the value of 
the note will make it more difficult for $T$ to transfer the note. If 
the rule is that $P$ is liable on $A$'s note, the asymmetry of 
information between $T$ and $F$ will most likely  increase.  Not only 
will $F$ fear that   $T$ has superior information on $A$'s credit, 
but  also on $P$'s existence and $P$'s credit.   Thus, $T$ should 
prefer to receive a note from $A$ relying only on $A$'s credit (but 
for a slightly larger face value) instead of a note from $A$ relying 
on the credit of  both   $A$ and a possible undisclosed principal. 

 



\bigskip
\noindent
 {\it  5.5 Liability of the Third Party to the Principal }

A different part of the undisclosed principal problem is  the 
obligation of the third party to the principal.   Should $T$ be bound 
contractually to a party he did not know existed? Illustrations 17 
and  18  contrast two situations in which this might arise. 

       \begin{small}\begin{quotation}
   {\it Illustration 17:  Inadvertent Sale to an Enemy.}   $T$ agrees 
to sell goods to $A$, who, unknown to $T$, is an agent for $P$. $T$ 
and $P$ are bitter enemies, and $T$ would never willingly sell goods 
to $P$, as $A$ and $P$ know.    $T$ later  discovers that $A$ is 
acting for $P$.    Is  $T$ bound  by the agreement? 

      \end{quotation}  \end{small}
    \begin{small}\begin{quotation}
 {\it Illustration 18:  Inadvertent Sale to a Rich Buyer.}   $T$ 
agrees to sell  goods   to $A$, who, unknown to $T$, is an agent for 
$P$.   $P$ is very rich, and $T$ would have held out for a higher 
price if he had known $P$ was interested in the goods.  $T$ later 
discovers that $A$ is acting for $P$.    Is  $T$ bound  by the 
agreement? 

      \end{quotation}
 \end{small}
      In both of these illustrations, $T$ would have been willing to 
sell to $A$ at the specified price, but not to $P$.  Where they 
differ is in $T$'s motivation.  In Illustration 17,  $T$'s  motive is 
real,  rather than redistributive.  $T$'s utility from holding the 
goods himself is greater than  the sum of his utility from  the sale 
price to $P$ plus the disutility of knowing that $P$ has bought the 
goods.  The result is analogous to when a purchaser buys a defective 
product:   the utility he expects from the transaction is less than 
the utility he receives. Thus, there is a strong case for 
invalidating the sale.\footnote{Steffen (1977), p. 188 says that   if 
the third party has once refused to deal with the principal, the 
principal may not circumvent the refusal by using a secret agent, 
according to most courts.  When the third party's desires are less 
objectively manifested, courts are less likely to  intervene. An 
example is Kelly Asphalt Block Co. v. Barber Asphalt Paving Co. 
(1914) 211 N.Y. 68, 105 N.E. 88, in which Judge Cardozo held for an 
buyer who  had remained an undisclosed principal because he 
suspected a competitor would refuse to deal with him.  } 


 In Illustration 18, on the other hand, $T$'s motive is 
redistributive.  $T$'s utility from holding the goods himself is 
less  than    his utility from  the sale price to $P$, and he would 
prefer the agreed sale price to not selling the goods at all. $T$ is 
dissatisfied, but that is only because he   could have received an 
even higher price if he had known that $P$ was the ultimate  buyer. 
Thus, the transfer of the goods from $T$ to $P$ is allocatively 
efficient, and there is no reason to invalidate the agreement. 



 

\bigskip
\noindent
 {\bf 6.   Concluding Remarks}

   This  paper has tried to sort out various aspects of agency law 
involving the  power of agents to bind their principals by contracts 
with third parties.  A unifying theme has been the view  of  the 
agent  as   a  means to reduce the  transaction cost, a role in which 
he  is   useful     to both  parties in the transaction,  the 
principal and the  third party. Issues of liability should be related 
to providing each of the two transactors with incentive to monitor 
the agent. After constructing a model of the interaction between 
principal, agent, and third party,  the   least-cost-avoider 
principle   was applied  to a variety of topics in agency law, 
including   the   categories of authority for the agent to act on 
behalf of the principal,   the undisclosed principal problem, 
bribery, criminal agents, negotiable instruments. 


  Many topics in agency   still await explanation.     This article 
has only attempted to analyze the main problems that arise, and 
scholars will find the {\it Restatement of Agency}  a  stimulating 
source of further difficulties that arise when one person acts for 
another.   This analysis may also be useful for analyzing two other 
areas of the law: partnerships, and criminal conspiracies. In both 
areas,  one person bears responsibility for the actions of another, 
and  the methods used here may be helpful in understanding and 
improving the law. 





%-----------------------------%--------------------------------------- 
---
\newpage
\bigskip
  \noindent
 {\bf References }


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 Ayres, Ian  and Robert Gertner (1989) ``Filling Gaps in Incomplete 
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Barnett, Randy (1987)  ``Squaring Undisclosed Agency Law with 
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Black, Henry (1990) {\it Black's Law Dictionary}, 6th edition,  St. 
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  Chu, Cyrus  \& Yingyi Qian (1992)   ``Vicarious Liability Under a 
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   Cooter, Robert (1985)  ``Unity in Tort, Contract, and Property: 
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 Cooter, Robert  \& Bradley Freedman (1991) ``The Fiduciary 
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Holmstrom, Bengt (1982) ``Moral Hazard in Teams'' {\it
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 Landes, Richard \& Richard Posner (1987) {\it The Economic Structure 
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Polinsky, A. Mitchell (1989) {\it An Introduction to Law and 
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 Posner, Richard (1986) {\it The Economic Analysis of Law}, 3rd 
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Rasmusen, Eric \& Ian Ayres (1993) ``Mutual Versus Unilateral Mistake 
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Schiff, Martin  (1983) ``The Undisclosed Principal: An Anomaly in the 
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 Spier, Kathryn  (1992) ``Incomplete Contracts and Signalling,'' {\it 
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Steffen, Roscoe  (1977) {\it Agency-Partnership in a Nutshell}, West
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Sykes, Alan (1984) ``The Economics of Vicarious Liability,'' {\it 
Yale Law Journal }, June 1984, 93: 1231-1280.
 

Sykes, Alan (1988) ``The Boundaries of Vicarious Liability: An 
Economic Analysis of the Scope of Employment Rule and Related Legal 
Doctrines,'' {\it Harvard Law Review}, January 1988,  101: 563-609. 

 




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