An Economic Approach to Contract Interpretation

Contract interpretation determines the meaning of contractual language when disputes arise. Economic analysis provides guidance on interpretive methodology that courts and practitioners should consider.

The Objective

Hypothetical Bargain

Interpretation should identify the meaning that parties would have agreed to had they anticipated the dispute. This hypothetical bargain approach respects party autonomy while filling gaps that incomplete contracts inevitably contain.

Transaction Cost Minimization

Interpretive rules should minimize the sum of drafting costs, litigation costs, and error costs. Rules that are easy to apply reduce litigation costs; rules that match party expectations reduce error costs.

Interpretive Approaches

Plain Meaning

Plain meaning rules reduce litigation costs by limiting interpretive inquiry. However, they may increase error costs when plain meaning diverges from actual intent.

Contextual Interpretation

Contextual approaches consider extrinsic evidence of meaning. They reduce error costs but increase litigation costs by expanding the scope of relevant evidence.

The Optimal Balance

The optimal approach depends on context. Sophisticated parties who can draft precisely benefit from plain meaning rules; less sophisticated parties may benefit from contextual interpretation that corrects drafting errors.

Specific Doctrines

Contra Proferentem

Interpreting ambiguities against the drafter creates incentives for clear drafting. This rule is most appropriate when one party controls drafting and the other lacks bargaining power to demand clarification.

Course of Dealing

Prior dealings between parties provide evidence of meaning. This evidence is particularly valuable when parties have developed specialized terminology or practices.

Trade Usage

Industry customs inform interpretation when parties are industry participants. This approach reduces drafting costs by incorporating shared understandings without explicit statement.

International Considerations

CISG Interpretation

The CISG directs interpretation toward party intent, considering negotiations, practices, and usages. This approach reflects the difficulty of applying domestic interpretive conventions to international contracts.

Choice of Law

Interpretive methodology varies across jurisdictions. Choice of law provisions should consider not only substantive rules but also interpretive approaches that will govern disputes.

Conclusion

Contract interpretation is not merely a technical exercise but a policy choice with economic consequences. Courts and practitioners should consider the incentive effects of interpretive approaches and select methods that minimize total contracting costs.