Damage measures for breach of contract

Despite the results of Klein and Leffler, buyers and sellers do breach contractual agreements, and there is a well-developed body of legal rules pertaining to contractual agreements. In this section we examine how parties who are harmed by such breaches of contract ('victims' of breaches of contract) should be compensated, and whether measures that are frequently employed by courts induce efficient behaviour.

Consider the following situation. There are two parties: a buyer (B) and a seller (S). They sign an agreement or contract which specifies that S deliver a good, in exchange for a payment P. This payment is paid up front by B. After the contract is signed, the parties expect that the seller will produce the good and will deliver it at some future date.

In general, the purpose of enforceable agreements between firms or individuals is to provide an environment in which the parties to the agreement can take certain economic investments or actions, based on the expectation or knowledge that the terms of the agreement will carried out. To allow for this possibility, suppose that the buyer makes a reliance investment of xB at a marginal cost of wB. The value of performance to the buyer is V(xB), with V'(xB) > 0 and V"(xB) < 0. For example, suppose that based on the expectation that the seller will deliver the good, the buyer purchases other goods that are complementary and which enhance the value of the good which the seller is supposed to deliver.

The seller can take actions to increase the probability that he will be able to perform the contract, and reduce the probability that he will not be able to perform. Suppose that the seller takes an action xs, with a marginal cost of wS which increases the probability that the seller will be able to deliver the good.

If all possible contingencies or states of the world could be anticipated costlessly and with complete certainty, parties to a contract could simply write down these contingencies in the contract and specify what happens in each state of the world. Such an agreement is called a fully contingent contract.

However, future states of the world are not known with certainty, and circumstances will arise in which one of the parties no longer values performance of the contract under the original terms. When such circumstances are not anticipated by either party, disputes arise. Contract law provides rules for resolving such disputes.

The probability of breach is assumed to be p(xS), and the probability of performance is 1 - p(xS). We assume that p'(xS) < 0, and p"(xS) > 0. Thus, xS here can be thought of as the seller's precaution or care to ensure that he puts himself in a position to perform the contract. The situation is therefore exactly analogous to the bilateral model of accident law that was examined in Chapter 6. We assume that the level of care taken by the seller is non-contractible, and that no renegotiation is possible. These are important assumptions.

Ideally, as discussed above, the parties would like to specify a price schedule, which would give a different price for every possible level of care that the seller could take. We assume that the parties cannot write such contracts here, because it is too costly for them to do so. On the other hand, we also assume that agreements are enforceable in a court of law, and that the buyer is awarded damages in the event of a breach. In the event of a breach of the contract by the seller, the court awards damages of d to the buyer, which are meant to compensate the buyer for the harm caused by the breach. In principle, d could depend on the actions taken by both the buyer and the seller as well as the price, so we write:

Suppose that both parties know that if the contract is breached, damages of d will be awarded. To summarise, the sequence of events is as follows:

  • • The parties sign a contract and specify the delivery price P. The buyer pays this price to the seller.
  • • The buyer makes a reliance investment of xB > 0, at a cost of wB xB.
  • • The seller takes an action xS > 0, at a cost of wSxS, which affects the likelihood that the contract is performed.
  • • Given xS, the seller is either able to perform the contract (which happens with probability 1 - p(xS), or cannot perform, in which case he breaches the contract, which happens with probability p(xS).
  • • If the seller breaches, the buyer files a lawsuit at no cost.
  • • The court awards damages of d.

Throughout the analysis we assume that the parties are risk neutral. The expected benefit of the contract to the buyer is then:

and the expected benefit of the contract to the seller is:

Adding these two gives the joint expected benefits of the contract:

Note that under the assumption of risk neutrality, neither the price nor the damage measure enter this expression, since both are simply a transfer between the seller and the buyer.

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