Preliminary －Do not cite without permission

Bounded Rationality: A Double-edged Sword in Regulating Standard Form
Contracts
Wataru Tanaka+I.

Introduction

Behavioral law and economics has grown up rapidly in the legal
scholarship for the past twenty years.1 In contrast to traditional economic
analysis of law that generally assumes full rationality of individuals,
behavioral law and economics, based on abundant empirical (experimental)
evidences of cognitive phycology,2 explicitly recognizes that humans are onlyboundedly rational and often make decisions relying more on heuristics thanon rigid computation of expected utilities. Arguably, the behavioral approachprovides more reliable basis of both positive (i.e., predicting how people would
behave under alternative legal systems) and normative (i.e., discussing whatsort of law would improve social welfare) analyses of law than the traditional
approach.
The law regulating standard form contracts in consumer transactions3 isamong the fields of law in which the behavioral approach seems mostpromising. It is plausible to presume that many consumers, suffering frombounded rationality, do not read form contract clauses or, even when they readthem, can barely estimate what costs and benefits those clauses will have,+ Professor of Commercial Law, Institute of Social Science, The University of Tokyo.
1

See generally Christine Jolls et al., A Behavioral Approach to Law and Economics, 50

STAN. L. REV. 1471(1998); Russell Korobkin & Thomas S. Ulen, Law and Behavioral

Science: Removing the Rationality Assumption from Law and Economics, 88 CALIF. L.
REV. 1051 (2000). These two articles are among the most cited law journal articles
since 1995. See Russel Korobkin, What Comes after Victory for Behavioral Law andEconomics, 2011 U. ILL. L. REV. 1653, 1654-55 (2011).
2 For a comprehensive and highly readable introduction of psychological studies ofhuman behaviors by one of the pioneering scholars of this field, see DANIEL KAHNEMAN,
THINKING, FAST & SLOW (2011).
3 Although standard form contracts are widely used in commercial transactions amongfirms too, I focus on standard form contracts used in consumer transactions. Arguably,
the latter type of transactions are more prone to problems caused by bounded
rationality and have a larger need for the legal intervention than the former ones.

1Preliminary －Do not cite without permission

and make decisions of purchasing goods or services from firms without taking
due consideration to those clauses. In his influential article, Russel Korobkinargues that such behaviors of consumers would lead to inefficient standard
form contracts, and judicial intervention to them (in particular, invalidating
form contract clauses that are proven to be inefficient) would potentially
improve efficiency as well as consumers’ interests.4
In this presentation, I also take a behavioral approach, but from adifferent perspective from Korobkin’s. I try to analyze how the law concerning
standard form contracts is (rather than should be) developed. It is natural topresume that, like any other individuals, lawyers, who are in charge ofdeveloping the law as government officials or judges, and legal scholars, who
advocate for and sometimes participate in the process of the legal reform, also
suffer from bounded rationality and make heuristic-oriented decision-making.
Therefore, the mechanism of legal development caused (at least in part) by
the behaviors of lawyers and legal scholars can be explained using theframework of behavioral economics.
In particular, I try to apply prospect theory5 to analyze the developmentof the Japanese law regulating standard form contracts in consumertransactions. The prospect theory predicts that humans’ decision-makings arevery much influenced by the change from the reference points. In short, they
dislike the change for worse from the reference points much more than they
like change for better from the reference points (“loss aversion”). I argue that,through the legal education they have received, lawyers and legal scholars
have a natural tendency to regard default rules as reference points. Thus,
when they see the firms use standard form contracts limiting the rights ofconsumers provided by default rules, in order to make profits, they tend toevaluate those firms’ conducts as unfair. Such tendency of lawyers and legal
scholars will eventually lead to the legal system which basically determines
whether to invalidate any form contract clauses by the degree of divergence
4

RusselKorobkin,

BoundedRationality,

Standard

Form

Contracts,

andUnconscionability, 70 U. Chi L. Rev. 1203 (2003). Korobkin’s analysis, as well as various
other economic analyses in the United States on regulation of consumer contracts has
recently been introduced in Japan by YASUHITO NISHIUCHI, SHOHISHA KEIYAKU HO NO
KEIZAI BUNSEKI [Economic Analysis of Consumer Contract] (2016).

See Daniel Kahneman & Amos Tversky, Prospect Theory: An Analysis of Decision
Under Risk, 47 ECONOMETRICA 263 (1979).

52Preliminary －Do not cite without permissionof these clauses from relevant default rules. I also discuss how the legal
system developed in such a way might fail to improve, or sometimes evenworsen, consumers’ interests as well as social welfare.6
The rest of this article is organized as follows. Part II explains the notionof rationality and standard form contracts that will be made if both parties(firms and consumers) are fully rational. Part III reviews existent literature
discussing how inefficient standard form contracts may be made if parties(especially consumers) are boundedly rational and regulating standard form
contracts may improve efficiency as well as consumers’ interests. Then Part
IV discusses on my own hypothesis that boundedly rational regulators andlegal scholars regard default rules as reference points, and tries to explain
the law regulating standard form contracts in consumer transactions andlegal scholarship in Japan with that hypothesis. Part V concludes the analysis.
II. Standard Form Contracts under the Assumption of Rationality
Before examining the case when parties (especially consumers) ofstandard form contracts are boundedly rational, I first explain the notion ofrationality and show what kind of standard form contracts will be made if
both parties (firms and consumers) are fully rational. Although this scenario
may appear unrealistic, it serves as a good benchmark with which the casewhen consumers are boundedly rational will be compared.
A. Notion of Rationality

In the standard economic modeling, rational actors make a decision thatwill maximize their expected utilities.7 More concretely, when rational actors
choose their action from multiple alternatives, they predict an outcome
resulting from choosing each alternative and attach a utility to each outcome.
6

The possibility that default rules work as default rules has already been recognized byliteratures. See, e.g., Russel B. Korobkin, The Status Quo Bias and Contract Default
Rules, 83 CORNELL. L. REV. 608 (1998). Existing literatures, however, are mainlyinterested whether default rules work as reference points for contracting parties. In
contrast, this article discusses on the possibility that default rules work as reference
points for regulators.
7 See Korobkin, supra note 4, at 1218.
3

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If there are more than one (say, N) possible outcomes (O1, O2, …, ON) and it isuncertain which outcome will result from one alternative, then the rational
actors predict a probability each of possible outcomes will happen (p1 for O1,
p2 for O2,…, pN for ON, where p1 + p2 +･･･+ pN =1), and attach a utility to eachpossible outcome (U(O1), U(O2) …, U(ON)). Then they compute an expectedutility from the alternative by weigh-averaging these utilities withprobabilities:
Expected utility from one alternative
U
U

⋯

U

.

Rational actors compute an expected utility coming from each alternative,
and choose the alternative that will produce the largest expected utility.8
In modeling decision-making of rational actors, standard economic theory
does not set any limit on the actors’ cognitive abilities. In other words, it is(implicitly) assumed rational actors have unlimited abilities to compute
expected utilities. For example, when a rational consumer chooses to buy
some goods from one of different sellers, he or she compares all the attributesof the goods, including prices and other contract terms, and chooses the onethat will maximize his or her expected utility.9
B. Standard Form Contracts Made by Rational Parties

If we assume that both parties (firms and consumers) of standard form
contracts are fully rational, it is easy to see these contracts generally become
efficient and improve the interests of both parties.
This point can be illustrated by a simple example.10 Suppose one seller(Firm) is going to supply some good to a consumer (Consumer) and9

See Korobkin & Ulen, supra note 1, at 1062-63.
See Korobkin, supra note 4, at 1219.

10

The analysis in this section is based on Korobkin, supra note 4, at 1209-11. For a8

more thorough analysis, see Richard Craswell, Passing on the Costs of Legal Rules:

Efficiency and Distribution in Buyer-Seller Relationships, 43 STAN. L. REV. 361 (1991).
Also, the analysis in this section is just one application of a theory predicting that
contracts made by rational parties will be mutually beneficial. See STEVEN SHAVELL,
FOUNDATIONS OF ECONOMIC ANALYSIS OF LAW 293 (2004).
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considering which clause it should offer in a standard form contract. One
alternative is Liability Clause, in which Firm promises to compensate
Consumer for damages if the good causes an accident. The other alternative
is Exemption Clause, which exempts Firm from any liability to Consumer.
Liability Clause has its benefits and costs compared with Exemption
Clause. Benefits of Liability Clause include preventing an accident by giving
Firm an incentive to take precaution, and insuring Consumer against the riskof suffering damages from the accident (as long as Consumer is risk averseand for some reason it is difficult or costly for Consumer to buy insurance
him/herself). Costs of Liability Clause, on the other hand, include costs ofprecaution of Firm induced by the clause and various administrative costs toenforce liability. If Firm and Consumer are both fully rational and canaccurately estimate benefits and costs of alternative clauses, they will agree
on whichever clause more efficient than the other in order to maximize theirown expected utilities. Let me illustrate this point by two cases.
Case1:
Suppose first that Liability Clause gives Consumer benefits worth $15
and costs $10 for Firm, compared with Exemption Clause. In other words,
Liability Clause is more efficient than Exemption Clause. In this case, Firm
will offer Liability Clause and Consumer accepts it.11 Too see this, suppose
that, if Firm offered Exemption Clause, it would offer price $X.12 Then Firm
will be better off if it offers (a) Liability Clause instead of Exemption Clauseand (b) the price that is higher than $X by the range from $10 to $15.13 Firm
will be better off because the price increase ($10-$15) will more thancompensate the cost increase ($10). Consumer will also be better off to accept
Firm’s offer because Liability Clause will give Consumer benefits ($15) morethan the price increase ($10-15).
Provided that Consumer evaluates the good higher than the price Firm offers. If not,Consumer will not purchase the good no matter which clause Firm offers. The same istrue in Case 2 below.
12 The specific amount of X is determined by such factors as shapes of supply anddemands curves and the market condition (i.e. whether Firm faces the competition or
enjoys monopoly) of the goods, which are not specified in this example.
13 The specific amount of price increase under Liability Clause compared with
Exemption Clause is also determined by the market condition. If Firm faces the perfectcompetition, it will increase the price by $10, just to compensate the cost increase
under Liability Clause. Alternatively, if Firm enjoys monopoly, it will increase the priceby $15 in order to exploit all the benefits of Liability Clause.
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Case 2:
Suppose next that Liability Clause gives Consumer benefits worth only
$10 and costs $15 for Firm, compared with Exemption Clause. That is,
Liability Clause is less efficient than Exemption Clause.14 In this case, Firm
will offer Exemption Clause at the price $X and Consumer will accept it, andboth parties will be better off than when Firm offers Liability Clause. If Firm
offered Liability Clause instead of Exemption Clause, it would have toincrease price by at least $15 to compensate the cost increase, and Consumer
would not like such an offer because he or she evaluates Liability Clause only
$10, which is less than the price increase.
C. Regulating Standard Form Contracts Will Be No Use

The point of the example in the last section can be generalized. As long as
both parties are rational and can accurately estimate costs and benefits ofalternative clauses, parties agree on the most efficient clause, that is, theclause producing the largest amount of benefits minus costs, no matter whichparty enjoys the benefits or bears the costs. If one party bears the costs morethan it enjoys benefits, then the party can be compensated by priceadjustment (increase or decrease of price, depending on whether the party isa firm or a consumer). Regulating standard form contracts, especiallyinvalidating some “bad” contract clauses in order to “protect” consumers’interests, will be no good in such a situation. If such a regulation invalids aclause (e.g., Exemption Clause in our example) when the clause is inefficient(like in Case 1), the regulation makes no change, since parties do not agree
on the clause any way. If, on the other hand, such a regulation invalids aclause when the clause is efficient (like in Case 2), it forces parties to be boundby an inefficient clause (Liability Clause). Such a result is not only inefficient(decreases social welfare) but also is inconsistent with consumers’ interests.

This can happen when (1) administrative costs to enforce liability is high, (2)benefits of giving Firm incentives to take precaution is small (probably because
consideration of reputation has already given Firm pretty much incentives to takeprecaution) and/ or (3) benefits of insuring Consumer against the risk of the damages issmall (probably because damage insurances against the kind of the risk the good willcause are easily available to consumers).
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III. Standard Form Contracts under the Assumption of Bounded Rationality
As is discussed in the last Part, it is difficult to justify regulations ofstandard form contracts (especially regulations invalidating form contract
clauses apparently disadvantageous to consumers) if parties are fully rationaland can accurately estimate costs and benefits of the contracts.15 Standard
economic theory with the assumption of full rationality, however, has been
under serious attack because it is not consistent with empirical(experimental) evidences. Behavioral economics, based on abundant
experimental evidences of cognitive phycology, explicitly recognizes thathumans are only boundedly rational and often make decisions relying more
on heuristics than on rigid computation of expected utilities. This Part
introduces the theory how humans with bounded rationality make theirdecisions (only to the extent it is relevant with the theme of this article) anddiscusses how bounded rationality of consumers may lead them to agreeing
on standard form contracts that are inefficient as well as detrimental to theirown interests.
A. Decision-making by Humans with Bounded Rationality

According to the knowledge of phycologists, humans have two systems of

15

It should be noted, however, that even fully rational parties may inaccurately estimate

costs and benefits of contract clauses, since rationality does not mean having perfect
information. Even rational consumers may over- or under-estimate benefits or costs
because of lack of information, and such misperception can lead the consumers to making
inefficient contracts. Indeed, this possibility had been analyzed in economics long before
behavioral economics became popular. See Micheal A. Spence, Consumer Misperceptions,

Product Failure and Producer Liability, 44 REV. ECON. STUD. 561 (1977). Contracting
problems being discussed in this Part will be understood by some economists (andeconomically oriented legal scholars) as matters of misperception caused by lack of
information, rather than matters of bounded rationality. I prefer understanding the
problems in term of bounded rationality, however, since it enables us better tounderstand how consumers suffer from such misperception and better to predict in which
direction such misperception is likely happen (e.g., whether consumers over- or underestimate the risk of getting involved in accidents) in given circumstances.
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thinking in mind. Sytem 1 operates automatically and quickly, with little orno effort and no sense of self-control. System 2 allocates attention to effortful
mental activities such as complex computations.16
When humans have to make some judgement, System 1 operates
automatically and suggests an intuitive answer. Though this intuitive
thinking operates pretty well, it is prone to errors. System 2 functions to checkand controls System1’s thinking but, since operation of system 2 requires
costly efforts, it sometimes fails to function well and accepts System 1’s wrong
answer.17
A characteristic way of operation of System 1 is, when it faces a hardquestion, it will (unintentionally) replace the question with a related questionthat is easier and will answer it. This function is called substitution and theeasier question that substitutes the original question is called heuristic
question.18
For example, if people want to estimate the frequency of instances of one
category, they judge the frequency by the ease with which those instances
come to mind. In other words, they replace the original question “howfrequent some instances happen?” with the easier heuristic question “howeasy those instances come to our mind?” This way of thinking is famously
named “availability heuristics.”19 If the objective frequency of those instances
and their easiness to come to our minds are diverge, this heuristic can cause
serious bias in our judgment. For instance, experimental studies have foundpeople tend to overestimate the frequency of deaths caused by accidents.20
Since fatal accidents occupy more media coverage than deaths from ordinary
causes such as strokes or cancers, they come to people’s minds more easily,
which make most people believe deaths caused by accidents happen more
often than they really do.
B. Standard Form Contracts Made by Boundedly Rational Parties Can be Inefficient16
17

See Kahneman, supra note 2, at 20.
See id. at 43-46.

See id. at 97-98.
See id at 129; Amos Tversky & Daniel Kahneman, Availability: A Heuristic for
Judging Frequency and Probability in JUDGMENT UNDER UNCERTAINTY: HEURISTICS
AND BIASES 163-78 (Daniel Kahneman et al., eds, 1982).
20 Kahneman, supra note 2, at 137-38.
18
19

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If parties of standard form contracts – especially consumers – are onlyboundedly rational and make heuristic-oriented decisions, it is possible thatthey agree on form contract clauses that are inefficient as well as detrimental
to consumers’ interests. This section briefly illustrates this point, following
Korobkin’s analysis.21
As was discussed in section II.B, when fully rational consumers having
unlimited cognitive abilities choose to buy some goods from one of different
sellers, they compare all the attributes of the goods that will affect theirutilities, including prices and other contract terms, and choose one that will
maximize their expected utilities. Considering all the attributes of goods tocompute expected utilities, however, are beyond abilities of ordinary,
boundedly rational consumers. Instead, typical consumers use a simpler
method – they replace a hard question with easier one—. They focus on
limited number of “salient” attributes that are easily called on their attention,such as price, functionality and physical appearance, and they makepurchasing decisions based only on these attributes, without consideringother, “non-salient” attributes.22
Arguably, many (if not all) matters provided by standard form contracts
belong to the category of non-salient attributes. First, in many transactions,form contract clauses are not disclosed to consumers when they makecontracts,23 so consumers simply have no chance to pay attention to them.
Second, even when form contract clauses are disclosed to consumers, they areoften so long, detailed and written in such tiny points that few (if any)
consumers try to read and understand them.24 Third, even when form terms
21
22

See Korobkin, supra note 4, at 1216-44.
See id. at 1226-29 (collecting empirical studies supporting the observation describedin the text).
Like when consumers buy train tickets or stay at hotel rooms.
24 When reading form contract clauses is costly, even fully rational consumers would not23

read them in order to save transaction costs, and such consumers’ behaviors could leadto inefficiency of standard form contracts. Indeed, Avery Katz shows in his model ofdynamic games with incomplete information, even small costs to read form contract
clauses can lead to significant inefficiency through strategic behaviors of firms andconsumers. See Avery Katz, Your Terms or Mine? The Duty to Read the Fine Print inContracts, 21 RAND J. ECON. 518 (1990). Though elegant as it was, his model’s
prediction of behaviors of consumers who rationally foresee what firms will offer in form
contract clauses and choose their action to maximize their expected utility makes me
9Preliminary －Do not cite without permission

are disclosed and consumers read (some of) them, they will not necessarily
become “salient” attributes based on which consumers make their purchasing
decision. Many of form contract clauses govern matters that will not happen
in the ordinary course of transactions, such as whether or to what extent
firms are liable to consumers for damages if the purchased goods have caused
accidents, or whether disputes between firms and consumers will be solved in
the litigation or arbitration. Since those rare events hardly come to consumers’
minds (unless similar events have recently been reported sensationally),
consumers may well underestimate the risk such events will happen or may
even treat the risk is virtually non-existent.25 In such cases, consumers haveno reason to make their purchasing decision based on the form contract
clauses that govern those events.
If form contract clauses are non-salient to consumers, it is straightforward
to show the possibility that these clauses will become inefficient anddetrimental to consumers. Let us consider again the example in section II.B.
In Case 1 of the example, Liability Clause gives Consumer benefits ($15)
larger than the costs ($10) born by Firm. If Consumer properly estimates thebenefits, he or she prefers Firm’s offer of Liability Clause and the price higher
by the range from $10 to $15 than the price that would be offered under
Exemption Clause ($X). However, if Consumer is boundedly rational and does
not think of the risk the good he or she purchases will cause an accident, thenConsumer finds no benefit in accepting Liability Clause with the higher price($X + 10~15), and prefers Exemption Clause with the lower price ($X). In thiscase, Firm also has no incentive to offer Liability Clause.26 The end result is
Consumer purchases the good under Exemption Clause, which is inefficient
as well as inconsistent with Consumer’s interest.

wonder how relevant such an analysis is with reality. Although the end results may not
be so different, I prefer modeling of consumers’ behaviors with an assumption of bounded
rationality as better description of consumer transactions.
25 See Korobkin, supra note 4, at 1232-33.
26 If Firm offers Liability Clause, it must offer price higher than $X by at least $10.
Then Firm will lose competition against other firms that offer Exemption Clause at theprice $X. See Korobkin, supra note 4, at 1235-36.Even if Firm enjoys monopoly, offering
Liability Clause is not in Firm’s interest because fewer consumers will accept such anoffer and Firm’s profit will be smaller than the case when Firm offers Exemption
Clause with the lower price.
10Preliminary －Do not cite without permission

C. Regulating Standard Form Contracts Is Not an Easy Task

When standard form contracts are inefficient because of consumers’
bounded rationality, it is possible to improve efficiency as well as consumers’interests by regulating standard form contracts. For example, in Case 1
described in section II.B, the law (a statutory regulation or judge-made law)
can invalid Exemption Clause and force Firm to offer Liability Clause, which
is more efficient and beneficial to consumers. Indeed, Korobkin advocates forregulation of standard form contracts in which courts invalidate form contract
clauses that are proven to be both non-salient and inefficient.27
Improving the situation by regulating standard form contracts is notalways an easy task, however. It is important to note that, even non-salient
form contract clauses can be efficient, and if so, invalidating those clauses andreplacing them with less efficient clauses would not serve consumers’interests. For example, in Case 2 in section II.B, Exemption Clause is more
efficient than Liability Clause. 28 In this case, if the law invalidates
Exemption Clause, Firm will offer Liability Clause and the price higher by
the range from $10 to $15 than the price it would offer under Exemption
Clause. That will not be Consumer’s interest, since Liability Clause in Case
2 will give Consumer benefits worth only $10, which is less than the priceincrease.
To determine whether some contract form clause is inefficient or not is acomplicated task, since it requires regulators to estimate costs and benefits
the clause will produce. To do this, regulators must compare the situation thatwill result in the clause in question with another, hypothetical situation thatwould occur if the law invalidated the clause. For instance, in order todetermine efficiency or inefficiency of Exemption Clause, regulators must
estimate how much administrative costs of enforcing liability the clause will
save, or how much incentives for Firm to take precaution the clause will cut
back. Estimating such benefits or costs is not a simple task, no matter which
regulatory bodies, administrative offices or courts, will do it.
IV. How Lawyers and Legal Scholars Make Decisions on Regulating Standard

27
28

Korobkin, supra note 4, at 1278-90.
When such a situation can happen is discussed in footnote 14, supra.
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Form Contracts
Having reviewed existent literature analyzing how problems may arise instandard form contracts when consumers are boundedly rational and how thelaw should deal with these problems, I would like to move to the question in
my interest: How is the law regulating standard form contracts actually being
developed?
As was discussed in Part III, though it is possible for the law to improve
efficiency as well as consumers’ interests by invalidating inefficient form
contract clauses, it is not easy for regulators to tell what are inefficientclauses and what are not. It is no wonder such investigation will often face
the problem of indeterminacy. Nevertheless, regulators (government officials
or courts) in the real world seem to make decisions. There are substantial
number of statutes and rules that regulate standard form contracts, andsubstantial number of courts’ decisions that have struck down, or at least
limited application of, some form contract terms. Regulators do not hesitate
to intervene standard form contracts just because they are not sure ofinefficiency of those contracts. To begin with, regulators do not (at least not
explicitly) inquire into whether form contract clauses in question are efficient
or inefficient before deciding to invalid those clauses.29 If efficiency does notdetermine their decision, on what ground regulators decide whether or not tointervene standard form contracts? This Part tries to answer this question,with a help of one theory of behavioral economics – prospect theory.
A. Prospect Theory and Its Implication to Normative Judgement

1.

What is Prospect Theory

Prospect theory is a theory advocated by two phycologists who pioneered
behavioral economics, Amos Tversky and Daniel Kahneman.30 Like expectedutility theory adopted by standard economics, prospect theory is a descriptive
theory predicting how people make their decisions (choices). Prospect theory
Korobkin reports that courts in the United States generally do not inquire into
efficiency of form terms before deciding whether those terms should be viewed
unconscionable and void. See Korobkin, supra note 4, at 1255 -78 (discussing cases).
Japanese courts do not conduct such inquiry, either.
30 See Tversky & Kahneman, supra note 5; Kahneman, supra note 2, Part IV.
29

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is very different from expect utility theory in one respect: it recognizes a
special role of states called reference points.
According to expect utility theory described in section II.A., when a person
makes a choice from alternative actions, he or she predicts what states(outcomes) will result from each of alternative actions, attaches a utility toeach of those states, and chooses an action that will result in the largest
expected utility. In so doing, the status quo – the state in which the actor now
stands – has no special meaning. It is only one of those states that can happen
and to which the actor attaches a utility. According to prospect theory, incontrast, the status quo is very important. People tend to regard their statusquos as reference points, and their judgement about how happy they are islargely determined by the change from the reference points.
For example, suppose one person owns $5 million dollars today. Expectedutility theory will predict that this person has the same utility (i.e., is happy
to the same extent) no matter whether he or she owned $1 million dollars (inCase 1) or $9 million dollars (in Case 2) yesterday. In contrast, prospect theory
will predict – persuasively, in my own judgement –, that the person is muchhappier today in Case 1 than in Case 2, since his or her situation has changed
better in Case 1, while it has changed worse in Case 2, from the reference
point (i.e., the wealth s/he owned yesterday).31
2.

Loss Aversion

Prospect theory maintains, with empirical supports, that people tend to
dislike losses (i.e., changes for worse from the reference point) than they likegains (changes for better from the reference point). This propensity is called“loss aversion.” Most people decline a gamble in which there is 50% chance of
winning $150 and 50% chance of losing $100. For many people, to offset 50%
chance of losing $100, the gain must be at least $200. In other words, the “lossaversion rate” is 2.32 Psychological values people attach to gains and losses
from the reference point according to prospect theory can be illustrated in
Figure 1 (the reference point is represented by the origin of the graph).
< Insert Figure 1 (in the last page of this article) here>
31
32

See Kahneman, supra note 2, at 274-5.
See id., at 283-4.
13Preliminary －Do not cite without permission

People’s propensity of loss aversion can be seen as a product of System 1
thinking (described in section III.A),33 and presumably has an evolutionary
origin. In most of evolutionary history, our ancestors had survived their lives
in which even one wrongful choice could often lead to death directly. In suchsevere conditions, organisms that treat threats as more urgent thanopportunities have a better chance to survive and reproduce.34
3. Prospect Theory Also Predicts Humans’ Moral Judgment

What is important for our analysis on the regulation of standard form
contracts is that prospect theory seems to have a power to predict not only
people’s day-to-day-life judgements that will affect only their own utilities,
but also their moral judgements --, that is, how people evaluate other people’s
conducts as fair or unfair. Generally speaking, people tend to consider it
unfair for firms to make profits by imposing losses on their customers or
workers relative to reference transactions (i.e., transactions functioned as
reference points).35 Such tendency has been well reported in the research (aseries of telephone surveys in Canadian metropolitan areas) conducted by
Kahneman, Jack Knetsch and Richard Thaler.36
In their survey, respondents were asked to judge various actions as
acceptable or unfair. One example was as follows:“A hardware store has been selling snow shovels for $15. The morning
after a large snowstorm, the store raises the price to $20. “Although the store has acted rationally according to standard economic
theory (raises its price in response to increase in demand), most respondents(82%) rated its conduct as unfair. They evidently viewed the pre-blizzard priceas a reference point and the store’s conduct imposing a loss on customers totake advantage of short-time increase in demand as unfair.37
See id., at 281-2.
See id., at 282.
35 See id., at 305.
36 Daniel Kahneman et al., Fairness as a Constraint on Profit Seeking: Entitlements in
33
34

the Market, 76 (4) AM. ECON. REV. 728 (1986).
37 See Kahneman et al., supra note 36, at 729; Kahneman, supra note 4, at 305.
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Another interesting example was about a store cutting down the wage of
its employee.38 Some respondents were asked to evaluate the case below.
“A small photocopying shop has one employee who has worked in the shop
for six months and earns $9 per hour. Business continues to be satisfactory,
but a factory in the area has closed and unemployment has increased. Other
small shops have now hired reliable workers at $7 an hour to perform jobs
similar to those done by the photocopy shop employee. The owner of thephotocopying shop reduces the employee’s wage to $7.”
Most (83%) of the respondents rated the shop-owner’s conduct as unfair.
Other respondents were shown the same case, except that the last sentence
was changed into: “The current employee leaves, and the owner decides to
pay a replacement $7 an hour.” Now a large majority (73%) of the respondents
rated the shop-owner’s conduct as acceptable.
The current wage of an employee serves as a reference for evaluating thefairness of the adjustments of that employee’s wage, but not for evaluating
the fairness of the wage paid to a replacement. 39 These examples may
suggest that evaluating fairness relying on reference points (transactions)will tend to protect existing interests, without due consideration into whether
a person having such an existing interest really deserves it. Kahneman,
Knetsch and Thaler point out:
“It should perhaps be emphasized that the reference transaction provides
a basis for fairness judgments because it is normal, not necessarily because itis just. Psychological studies of adaptation suggest that any stable state ofaffairs tends to become accepted eventually, at least in the sense thatalternatives to it no longer readily come to mind.”40
B. Default Rules as Reference Points

1. Why Lawyers and Legal Scholars Regard Default Rules as Reference Points

Since lawyers, who are engaged in regulation (as government officials
See Kahneman et al., supra note 36, at 730.
See id.
40 See id., at 730-1.
38
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drafting statutes or establishing rules, or as judges interpreting andsometimes invalidating contracts), and legal scholars, who discuss what are
better law and sometimes participate in the legal reform, are also humans, it
is natural to assume that their decision-makings are also influenced byheuristics and their normative judgements can be explained by prospect
theory at least to some extent. If lawyers and legal scholars make normative
judgements about validity of form contract terms – determine whether someform terms should be valid or invalid – as prospect theory predicts, what arereference points they use?
I believe that default rules are good candidates of the reference points.
Through legal education they took at law schools and/or colleges and throughstudies to pass bar exams, they made a lot of efforts to memorize default rules
and to learn how to interpret them and apply them to particular cases. As aresult, they arguably have a natural tendency to regard default rules asreference points, and when they see firms, in order to make profits, include
form clauses in consumer contracts that limit rights or expand duties ofconsumers compared with those provided by default rules, they tend to view
such firms’ conducts as unfair.
Of course, to regard default rules as reference points does not mean toinvalidate automatically any form contract clauses that are different fromdefault rules in any respects. To do so would make all default rules mandatory,
which would be inconsistent with a widely accepted view that most rules incontract law are default (discretionary), not mandatory. 41 Rather, lawyers
and legal scholars inquire how far form contract clauses in question diverge
from relevant default rules. If the form contract clauses give consumers by
far smaller rights or impose on consumers by far larger duties than rights orduties provided by default rules, they are likely to be viewed as unfair andmade invalid. Such an attitude can be illustrated by articles of Consumer
Contract Act, the main body of law in Japan regulating consumer contracts(that usually, if not always, take the form of standard form contracts).
2. Statutory Provisions Determining Validity of Contract Clauses Based on Default
Rules as Reference Points

In Japan, default rules are usually called nin’i-hoki (discretionary rules), whichmeans contracting parties have a discretion to modify those rules by agreements.
41

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According to the Civil Code of Japan, a contracting party who hasbreached the contract will be liable to the counterparty for damages causedby the breach.42 In principle, breaching parties must compensate what thecounterparties would have gained if contracts were performed, though theprinciple is subject to the rule of “foreseeability”, that is, only damages thatwere foreseeable to breaching parties should be compensated.43
These are basically default rules, so parties have a discretion to modify
those rules by agreements, such as to limit the liability to the specified
amount (liquidated damages). 44 However, a contract clause that totally
exempts the firm from liability to consumers arising from breach of thecontract is so significantly diverged from the default rules, that Article 8(1)(i)of Consumer Contract Act invalids such a clause.45
Also, while limiting liability to the specific amount is not itself prohibited,a contract clause limiting the liability of the firm from breach due to an
intentional act or gross negligence is so significantly diverged from the default
rules that Article 8(1)(ii) of Consumer Contract Act invalids such a clause,
too.46 In this respect, it should be noted that Supreme Court of Japan has
decided, even in a transaction between firms, a form contract clause limiting
liability arising from breach of a contract should not be applicable when thebreach was due to an intentional act or gross negligence of the breaching party.
47

In addition to these and other specific provisions, Consumer Contract Act
has a general provision determining validity of a consumer contract bycomparing it with a relevant provision of default rules. Article 10 of Consumer
Contract Act provides that any consumer contract clause that restricts the
See Minpo (Civil Code), art.415 (cited in Appendix).
See Minpo (Civil Code), art.416 (cited in Appendix).
44 See Minpo (Civil Code), art. 419, para.(1) (cited in Appendix).
45 See Shohisha keiyaku ho (Consumer Contract Act) art.8, para.(1), no.(i) (cited in
42
43

Appendix).
46 See Shohisha keiyaku ho (Consumer Contract Act), art.8, para.(1), no.(ii) (cited inAppendix).
47 See Y.K. Jewelry Yamaya v. KK. Kobe Portopia Hotel, 209 SAIBANSHU MINJI 143(Sup. Ct., Feb. 23, 2003). It should also be noted that in Japanese law, statutory
limitations of liability arising from breach of some types of contracts generally are notapplicable when the breach is due to an intentional act or gross negligence (or “recklessact,” which is interpreted to have the same meaning as gross negligence). See, e.g,
Shoho (Commercial Code), art. 581 (liability of land carriers of goods); Kokusai kaijo
buppin unso ho (International Carriage of Goods by Sea Act), art. 13-2 (liability ofinternational sea carriers of goods).
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rights or expands the duties of consumers more than the application of default
provisions in the Civil Code, the Commercial Code and any other laws andregulations, and that unilaterally impairs the interests of consumers inviolation of the fundamental principle of good faith, is void.48 The new Article548-2 (2) of the Civil Code under deliberation provides the same rule todetermine the validity of standard form contracts.49
3. Legal Theories Determining Validity of Contract Clauses Based on Default Rules
as Reference Points

It should be noted that statutory provisions, as were explained in the lastsection, that determines validity of contract clauses based on default rules asreference points come from a long tradition of discourse in jurisprudence. In
particular, there are legal theories in Germany that argue for“Ordnungsfunktion (ordering function)” or “Leitbildfunktion (leading
function)” of default rules. 50 According to these theories, default rules
represent the “objective order” set up by the nation, and contracting parties
do not have an unlimited freedom to diverge from the objective order even bymutual consents. Rather, to modify default rules, parties must demonstrate a“reason” to justify divergence from those rules. In other words, they must
demonstrate why the order given by the nation is not appropriate in a specificcircumstance they are in. These theories have had a significant influence on
the legal scholarship in Japan, especially in the area of regulation on
standard form contracts.51
C. Benefits and Costs Using Default Rules as Reference Points

What I have argued in this Part – that judgement by lawyers and legal
See Shohisha keiyakusho (Consumer Contract Act), art.10 (cited in Appendix).
See Draft of the New Civil Code Art. 548-2(2) (cited in Appendix).
50 Two most influential theorists are Ludwig Raiser and Hans Carl Nipperdey. See
LUDWIG RAISER, DAS RECHT DER ALLGEMEINEN GESCHÄFTSBEDINGUNGEN, 1935;
LUDWIG ENNECCERUS/ HANS CARL NIPPERDEY, ALLGEMEINER TEIL DES BÜRGERLICHENRECHTS, Halbband 1, 15 Aufl., 1959. For a review of their theories and how muchinfluence they have on the jurisprudence in Japan, see Takafumi Matsuda, Nin’i hoki
wo meguru jiritsu to chitsujo (2) [Autonomy and Order Concerning Default Rules, Part2], 148 MINSHO HO ZASSHI [Journal of Civil and Commercial Law] 117, 128-44 (2013).
51 See Matsuda, supra note 50, at133 n.127 (citing Japanese articles that introduce
and discuss Raiser’s theory).
48
49

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scholars can be explained by prospect theory and that they use default rules
as reference points in evaluating form contract terms and determining
whether to invalid them – is just a hypothesis at this stage, and much efforts
should be needed to collect evidences to show its power to explain the way
how the laws regulating standard form contracts have been developed. Evenat this stage, however, it is worth considering what benefits and costs legal
development in such a way as I hypothesize might have.
1. Positive Sides of Using Default Rules as Reference Points

One of possible benefits of regulating standard form contracts based on
default rules as reference points will be to bring (at least some degree of)certainty or predictability in regulation of standard form contracts. If courts
decide whether to invalid form contract clauses in question based on their
judgment of efficiency or inefficiency of those clauses, as is proposed by
Korobkin,52 courts must compare estimated benefits and costs arising fromthose clauses. Such estimation and comparison may well become speculative,
and the results of cases will often be difficult to predict. Determining whether
to invalidate form clauses based on the degree of divergence from default
rules is also speculative, of course, but it will at least give courts someguidelines (i.e., default rules) that are familiar to them than the notion ofefficiency. Also, to the extent that attorneys who give advices to parties thinkin ways similar to judges, the results of cases will be easier to predict.
Another possible benefit is that determining validity of form contract
clauses using default rules as reference points may be a convenient rule ofthumb (or heuristic, so to speak) that can substitute directly inquiring into
inefficiency of those form clauses. To the extent default rules have beendeveloped to strike appropriate balance of interests of parties, they may be
fairly efficient rules in many circumstances. If so, form clauses that are
significantly diverge from default rules are also likely to be inefficient andshould be invalid.
2. Negative Sides of Using Default Rules as Reference Points

Regulating standard form contracts based on default rules as reference52

See supra note 27 and accompanying text.
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points can be costly, however, if relevant default rules are actually inefficient.
Regulators do not necessarily have incentives to establish efficient default
rules, and even if they do, they may fail to find what efficient rules are. In
addition, even if regulators succeed in establishing default rules that are
efficient in most circumstances, these rules may not be efficient for somecategory of transactions or some category of parties. If some default rule isinefficient, a form contract clause that appears significantly disadvantageous
to consumers compared with the default rule may actually be efficient. In thiscase, invalidating that clause will be not only inefficient but also detrimental
to consumers, as was discussed in section III.C.
Of course, the risk of invalidating efficient form contract clauses exists
even when regulators determine whether to invalid form contract clauses
based on efficiency analysis, since efficiency analysis is difficult and subject
to errors, as was discussed in section III.C. As long as regulators (and legal
scholars who suggest better regulations to regulators) are concerned withefficiency analysis, however, such errors can be corrected through theoreticaland empirical studies that reveal benefits of contract clauses apparently
disadvantageous to consumers or costs of relevant default rules. In contrast,
if regulators make regulatory decisions (and legal scholars make suggestions
to regulators) based on default rules as reference points, they may be satisfied
with a belief that they have made a “fair” decision and may not be interested
in any theoretical or empirical studies on efficiency of form contract clauses
or relevant default rules. In this case, there is little chance for regulatory
errors to be corrected.
V. Conclusion
Behavioral approach to law has persuasively demonstrated the possibility
that consumers with bounded rationality agree on form contract clauses thatare both inefficient and detrimental to their own interests, and that legal
intervention to standard form contracts can improve the situation. As was
discussed in this article, however, this approach can also identify thepossibility that regulators and legal scholars with bounded rationality maketheir decisions based on default rules as reference points, which may lead toregulatory errors that are difficult to be corrected. In this respect, bounded
rationality can be said to be a double-edged sword in regulating standard form
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contracts – it clarifies both potentials and riskiness of legal intervention tocontract form clauses.
I believe behavioral economics is promising. Though somewhat
complicated it is compared with standard economic theory, it stands on more
realistic assumptions on human behaviors and enriches both positive andnormative analyses of law. I hope the analysis in this article will help readers
appreciate the power of behavioral approach to law.
Appendix: Excerpts of Statutes
1. Shohisha keiyaku ho (Consumer Contract Act of Japan)
2. Minpo (Civil Code of Japan)
3. Draft Articles of Minpo (Civil Code) Regarding Standard Form Contracts
1. Shohisha keiyaku ho (Consumer Contract Act of Japan)

Law number: Act No. 61 of 2000
(Definitions)
Article 2(1) The term "Consumer" as used inthis Act means an individual (however, the same shall not apply in cases
where said individual becomes a party to a contract asa business enterprise or for the purposes of a business enterprise).
(2) The term "Business Operator" as used inthis Act (excluding Article 43, paragraph (2), item (ii)) means acorporation or association, or an individual who becomes a party toa contract as a business enterprise or for the purposes ofa business enterprise.
(3) The term "Consumer Contract" as used inthis Act means a contract concluded between a Consumer and a Business
Operator.
(Nullity of Clauses which Exempt a Business Operator from Liability for
Damages)
Article 821

Preliminary －Do not cite without permission(1) The following Consumer Contract clauses are void:(i) Clauses which totally exempt a Business Operator
from liability to compensate a Consumer for damages arisingfrom default by the Business Operator;(ii)
Clauses which partially exempt a Business Operator
from liability for damages arising from default by the Business Operator(limited to default which arises due to an intentional act or grossnegligence on the part of the Business Operator, the Business
Operator's representative or employee);(iii) Clauses which totally exempt a Business Operator
from liability for damages to a Consumer which arise from a tort pursuant
to the provisions of the Civil Code committed during the Business
Operator's performance of a Consumer Contract;(iv) Clauses which partially exempt a Business Operator
from liability for damages to a Consumer arising from a tort (limited
to cases in which the same arises due to an intentional act or grossnegligence on the part of the Business Operator, the Business
Operator's representative or employee) pursuant to the provisionsof the Civil Code committed during the Business Operator's performance ofa Consumer Contract; and(v) Where a Consumer Contract is a contract for value, and there exists a
latent defect in the subject matter of the Consumer Contract (including
where a Consumer Contract is a contract for work, and there exists
a defect in the subject matter of a Consumer
Contract for work; the same shall apply in the following paragraph):
Clauses which totally exclude a Business Operator
from liability to compensate a Consumer for damages caused by such defect.
(Nullity of Clauses that Impair the Interests of Consumers Unilaterally)
Article 10
Any Consumer
contract clause that restricts the rights or expands the dutiesof the Consumer more than the application of provisions unrelated
to public order in the Civil Code, the Commercial Code (Act No. 48
of 1899) and any other laws andregulations, and that unilaterally impairs the interests of the Consumer,
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Preliminary －Do not cite without permissionin violation of the fundamental principle provided
in the second paragraph of Article 1 of the Civil Code, is void.
2. Civil Code in JapanLaw number: Act No. 89 of 1896
Amendment : Act No. 78 of 2006
(Fundamental Principles)
Article 1(2) The exercise of rights and performance of duties must be done in goodfaith.
(Damages due to Default)
Article 415
If an obligor fails to perform consistent with the purpose of
its obligation, the obligee shall be entitled to demand damages arisingfrom such failure. The same shall apply in cases it has become impossible
to perform due to reasons attributable to the obligor.
(Scope of Damages)
Article 416(1) The purpose of the demand for the damages for failure to perform an
obligation shall be to demand the compensation for damages which would
ordinarily arise from such failure.
(2) The obligee may also demand the compensation for damages which arise
from any special circumstances if the party did foresee, or should haveforeseen, such circumstances.
(Liquidated Damages)
Article 420(1) The parties may agree on the amount of the liquidated
damages with respect to the failure to perform the obligation.
In such case, the court may not increase or decrease the amount thereof.
(3) Any penalty is presumed to constitute liquidated damages.

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3. New Articles of Minpo (Civil Code) of Japan regarding Standard Form Transaction
Agreements (under Deliberation)(Agreement Based on Standard Clauses)
Article 548-2(2) Notwithstanding the preceding paragraph, the other party will not be
deemed (under the provisions of the preceding paragraph) to have agreed toa contract term that restricts its rights, or places an obligation upon it, if, inlight of the aspects and the actual circumstances of the standard transaction
as well as socially accepted ideas with regards to standard transactions, theterm is deemed unilaterally detrimental to the interests of the other party,
in contravention of the basic principles set forth in Article 1, paragraph
Note:

English translations of articles of the Consumer Contract Act and the Civil
Code are based on Japanese Law Translation Database System operated by
Ministry of Justice ofJapan(http://www.japaneselawtranslation.go.jp/?re=02), while English
translation of new Article 548-2 was made by David Litt.

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Figure 1: Psychological of values of gains and losses according to prospect
theorySource: Kahneman, supra note 2, Chap.26.

25