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Chapter 9 Topics in the Economics of Contract Law I. Remedies As

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Chapter 9 Topics in the Economics of Contract Law I. Remedies As Chapter 9 Topics in the Economics of Contract Law I. Remedies as incentives A. Alternative remedies Different remedies create different incentives for the parties to a contract. Our focus is how different remedies affect the incentives each party has to act in an economically efficient manner. 1. Expectation damages Perfect expectation damages (PED) are meant to leave the promisee indifferent between performance and nonperformance of the contract. The baseline is value to promisee if contract was performed. Damages then are equal to the difference between the net value of performance of the contract and no contract . 2. Reliance damages In this case, the injury that is caused by breach focuses on the costs the promisee has incurred as a result of relying on the contract. As such, perfect reliance damages (PRD) are meant to leave the promisee indifferent between no contract and breach of the contract. The baseline is no contract. Damages then are equal to the promisee’s net reliance costs. 3. Opportunity cost damages In this case, the injury that is caused by breach focuses on the costs the promisee has incurred as a result of foregoing alternative contracts. As such, perfect opportunity cost damages (POCD) are meant to leave the promisee indifferent between breach of the contract and performance of the next best contract. The baseline is value to promisee of the next best contract. Damages then are equal to difference between the net value of performance of the next best contract and no contract. 4. The typical relationship between PED, POCD and PRD and the problem of subjective value a. Generally speaking, PED > POCD > PRD Why? Efficient reliance costs are included in PED and OCD. Best contract is at least as good as the next best contract. Next best contract is at least as good as no contract. Implications for efficiency? b. The difference between subjective values and market prices can distort the relationship between PED, POCD and PRD. 5. Restitution Restitution simply requires that, in the event of breach, the promisor must give back anything the promisee gave the promisor in exchange for the promise. As such, restitution is a minimal remedy. 6. Disgorgement Disgorgement damages are intended to eliminate the injurer’s profit from doing wrong. As such, if a promisor breaches a contract by doing something wrong and profits from the wrongdoing, perfect disgorgement damages would leave the promisor indifferent between performing the contract and breaching and paying damages equal to the gain from having breached. Compare this to perfect expectation damages. 7. Specific Performance This remedy simply requires the promisor to perform the contract. (In the event that the court orders specific performance, the parties to the contract can subsequently negotiate an alternative settlement, e.g., breach with damages paid to the promisee.) Note that an advantage it has over damages is that the court does not have to estimate the value of performance to the promisee. Availability of substitutes and the probability of errors by the courts when estimating damages are important considerations when deciding between damages and specific performance. Specific performance is especially attractive in cases involving special/unique goods and services. 8. Party-designed remedies: Liquidated damages i. The contract contains explicit terms specifying the remedy in the event of breach. ii. Courts are not overly fond of party-designed remedies that include punitive sanctions and generally refuse to enforce such clauses in a contract. However, this may discourage efficiency to the extent that the punitive clause represents an explicit ex ante allocation of risk. Penalty clauses can also convey information about a promisor’s reliability and thus facilitate the creation of efficient contracts. B. Models of Remedies: Damages versus Specific Performance 1. Efficient breach and performance: Unfortunate versus fortunate contingencies a. An unfortunate contingency increases the cost of performance and, thus, the incentive for breach. In choosing between damages and specific performance in this case, we have already shown that perfect expectation damages will create incentives for efficient breach. In the case of specific performance, the outcome will be efficient so long as the parties can subsequently negotiate an efficient solution to the dispute. All that changes under these circumstances is the distribution of wealth. In those instances where negotiation is not possible (due to high transactions costs) the result will be inefficient when the costs of performance exceed the value of performance to the promisee. Thus, damages dominate specific performance, but specific performance is viable when transactions costs are low. In addition, it is important to recognize that this assumes that the court can accurately estimate damages. Further explanation If we assume that the court can accurately measure expectation damages, damages dominate specific performance as remedy for breach. This is because perfect expectation damages will always result in the efficient outcome, regardless of the level of transactions costs between the parties to the contract. Specific performance, on the other hand, will also result in an efficient resolution of the dispute so long as transactions costs are low. However, if transactions costs between the parties are high, the court order of specific performance will result in an inefficient outcome if the costs of performance exceed the benefits of performance. This is because bargaining can’t take place and the promisor will therefore be forced to perform. (Recall that breach is efficient whenever the costs of performance exceed the benefits from performance.) The fact that damages dominate specific performance notwithstanding, if the subject of the contract is unique (e.g., a rare painting), the assumption that the court can accurately measure expectation damages may become untenable. This is because the court must ascertain the subjective value that the promisee attaches to performance of the contract, which is not an easy feat. Thus, when transactions costs are sufficiently low there is good reason for preferring specific performance to damages in the case of an unfortunate contingency. When transactions costs are high and we are dealing with a unique good or service, the court must balance the (likely) possibility of incorrectly estimating damages against the possibility that, in the event that the court orders specific performance, an inefficient outcome will result if the costs of performance exceed the benefits of performance because bargaining can’t take place. Obviously, the problem is not easily solved. b. A fortunate contingency makes nonperformance more profitable than performance. In this case, both remedies lead to the efficient outcome, only the distribution of income varies. However, specific performance may entail more transactions costs and, in this sense, may be less desirable than damages. At the same time, specific performance enables the court to avoid answering the question of how much value the promisee attaches to performance. Depending on how costly this latter process is, specific performance may entail lower overall costs. (Note this observation applies to the case of unfortunate contingencies as well.) Further explanation In this situation it is easy to show that, ignoring the costs of settling the dispute in the courts, perfect expectation damages and specific performance both result in the efficient outcome, regardless of the magnitude of the transactions costs incurred by the parties in the process of bargaining (see pp. 241-243 of the text for a discussion of this point). However, digging deeper, we need to consider the transactions costs incurred by the court in the process of settling the dispute. Once again, if we are dealing with a unique good, it may become very expensive for the court to determine the level of perfect expectation damages. Thus, even though the transactions costs incurred by the different parties in the process of moving the good or service to its most highly valued use may be higher under specific performance than they would be if the court awarded expectation damages, the savings realized by the court’s order of specific performance (because the court no longer has to estimate the subjective value the promisee attaches to performance) may outweigh the transactions costs incurred by the various parties. This is especially likely in the case of a unique good or service. C. Summary: Choosing Between Damages and Specific Performance Type of Contingency Unfortunate Contingency Fortunate Contingency PED always efficient Both remedies are efficient SP may or may not be efficient wrt the outcome, but may depending on TCs among the differ wrt TCs parties to the contract Need to consider · TCs between the two parties (bargaining) · Type of good (has implications for the court’s TCs) · Unique · Standard Unfortunate Fortunate Contingency Parties’ TCs Contingency Parties’ TCs Low High Low High Unique Unique Good Good Std. Std. D. Investment in performance and reliance: Skip this section II. Formation Defenses and Performance Excuses (What Promises Should Be Enforced? Revisited) A. Incompetence Competent people should protect the interests of incompetent contractual parties or assume the liability for failure to do so. Thus, the court should rule to the benefit of the incompetent party. This will give competent parties the correct incentives when dealing with incompetent parties.
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