ECON 1450 – Professor BerkowitzLecture Notes -Chapter 5

• Remedies for Breach of Contract• Efficient Breach Model • Previous lectures – what promises should be legally

enforceable?• Enforce contracts that are mutually beneficial• Suppose conditions change and a contract that was

mutually beneficial is no longer mutually beneficial

Efficient Breach Model

• Contract: buyer is a rock band• Contract: seller is music store• V = value of contract to buyer• C = cost of contract to seller – where C

includes variable costs • Contract is socially efficient if V > C• Contract is socially inefficient if V < C

Uncertainty and Social Efficiency

• Uncertainty over production costs • Uncertainty over value of performance to

buyer• Uncertainty about offers from alternative

buyers• Efficient breach rule versus individual

incentives to breach

Money damages and efficient breach

• Suppose there is uncertainty over production costs (C)

• Buyer is homeowner, seller is contractor who is fixing homeowner’s kitchen

• V = value of house is additional resale value after kitchen is fixed, P = price

• Expected that V > P and P > C => then both parties go ahead with contract and contract is efficient

Reliance investment

• R = reliance investment – example, homeowner hires moving company to deliver cabinets for kitchen on a particular day

• R – an upfront investment by owner that is not salvageable – enhances investment for homeowner, but is a pure loss if the investment (kitchen repair) does not go through

Breach of contract

• D = court imposed damage that contractor (seller) must pay buyer if there is a breach

• What D incentivizes the contractor to breach “efficiently”?

• Efficient contract: Joint return from contract is (V – P – R) + (P – C) = V – R – C, Joint return from breach is –R => efficient breach holds when – R > V – R – C or C > V!

Using D to get efficiency

• Seller’s breach decision – seller’s return w. breach = - D, seller’s return w. contract is P – C

• Seller breaches when C > P + D (interpret)• Efficient breach by seller occurs when C > V

and C > P + D => D = V – P • Interpretation – D = buyer’s surplus

Efficient breach and actual rules

• Expectation damages – money that leaves promissee (homeowner) just as well off as if contract had been performed: D = V – P

• Reliance damages – money that leaves promissee as well off as if the contract had never been made: D = R

• Under reliance damages sellers breach when C>P+D = P+R, where V > P+R, so seller breaches too much!

Actual rules – continued

• Breach when D=0• Seller breaches when C > P + D = P, and since V

> P, the seller breaches too frequently!• See figure 5.1• Check exercise 5.1

Incentives for Efficient Reliance

• Suppose the homeowner can choose R• R is chosen to enhance resale value if contract

goes through: V’(R) > 0 and V”(R) < 0• R* chosen to maximize V(R) – R• Therefore, V’(R*) – 1 = 0

Realism – seller is uncertain about costs

• Ch > CL, and Ch > V > CL • Contract is only efficient when costs are low• Probability that costs are low = q; probability

costs are high = 1 – q• Efficient R: maximizes expected joint return

which is q(V – R - CL) + (1-q)(-R) = • q(V – R) - R

R^ - efficient reliance

• Max qV(R) – qCL – R • Max qV(R) – R• See Figure 5.2 – R^ < R* (case of no

uncertainty) => buyer should invest less to account for losses when high costs are realized

• Show that dR^/d(1-q) < 0 (or dR^/dq > 0)

Expect Damages and Uncertainty

• Expectation damages D = V(R) – P• We want the buyer to invest efficiently in R

and we want the buyer to efficiently honor or breach the contract

• Seller efficiently breaches (we have already shown this!)

• Buyer chooses R: max q(V(R)–R–P) + (1-q)(D-R)

Expectation damages continued

• Since D = V(R) – P, then• Max q(V(R) – R – P) + (1-q)(V(R) – R – P) or• Max V(R) – R – P, or you get R* > R~, so buyer

over-invests!• Expectation creates a moral hazard problem

for the buyer!• Similar to under-investment of victim in tort

model with strict liability!

Solution to problem

• Efficient contract enforcement by seller and over-investment by buyer (moral hazard)

• Analogy to negligence in contract law – set a due standard for buyer (R-due standard)… if buyer meets this and does not exceed it, then the seller pays for full damages for breach

• There is no such remedy in contract law

Hadley v. Baxendale Rule

• Read case on pp.114-115• Damages for breech of contract are limited to

a “reasonable level”• Interpretation – reasonable level = R^ (the

efficient level under uncertainty) • Thus, D = V(R^) – P and• D = V(R^) – P < V(R’) – P, R’ is unlimited

expectation damages!

Hadley v. Baxendale, cont’d

• With unlimited damages, buyer get R’ and with expectation damages buyer gets R^ only

• Expectation damages and buyer’s behavior • Choose R: Max qV(R) – R – P + (1-q)V(R^) or

drop constants and max qV(R) – R • Under this rule, seller breaches or honors

contract efficiently and buyer invests efficiently!

Mitigation of Damages

• Example – owner of duplex agrees to rent an apt to a student for 12 months at $300 per month

• After 6 months the student abandons apt• After 12 months, landlord files for $1,800

unpaid rent• Student notes that friend offered landlord

$200 per month for remaining 6 months

Mitigation – cont’d

• Landlord refuses to take on new lease holder• Student admits to breaching contract• Student also argues landlord should only get

$600• Court sides with student – “contractors have a

duty to take on any reasonable (cost-effective) efforts to mitigate damages from breach!

Impossibility and related excuses

• Impossibility• Frustration of purpose• Commercial impracticability

Commercial impracticability

• Courts discharge contracts when performance is feasible but economically burdensome

• Conditional rule that discharges performance without penalty when costs are sufficiently high

Specific performance

• When is it efficient for the court to forego monetary damages (D) and, instead, order the promisor to perform the contract as written?