Chapter 5

The Economics of Contract Law II: Remedies for Breach

Key Points

•        The efficient breach model says that it is efficient to breach a contract when the cost of performance exceeds the value of performance. Monetary compensation is the most common remedy for breach.

•        Expectation damages, which is equal to the value of performance to the promisee, induces the promisor to breach only when it is efficient to do so. However, it also induces the promisee to overinvest in reliance because it fully insures him or her against breach.

•        Limited expectation damages, defined to be expectation damages evaluated at the promisee’s efficient level of reliance, induces both efficient breach and reliance. This measure of damages corresponds to the remedy established in Hadley v. Baxendale.

•        The Hadley v. Baxendale rule also requires promisees who would incur unusual (unforeseeable) damages from a breach to communicate that information up front to promisors. Otherwise, they will not be able to recover those damages in the event of breach.

•        The doctrine of impossibility discharges performance without damages if performance would have been physically impossible. Because efficient breach is not an issue in this case, the economic theory of impossibility says that this doctrine should be applied so as to assign the risk of breach to the party best able to bear, or insure against, the risk.

•        Commercial impracticability discharges performance when performance is possible but would be economically burdensome. A proper economic interpretation of this doctrine shows that it functions like a threshold, or negligence, rule to induce efficient breach and reliance in “bilateral care” contract settings.

•        Specific performance is a court order requiring the promisor to perform the contract as written. According to the Coase Theorem, this will not lead to excessive performance because the promisor can always offer to buy-out the contract if that is the efficient outcome, provided transaction costs are low.

•        Compared to money damages, the main advantage of specific performance is that it protects the subjective value of performance for promisees. In so doing, it ensures that excessive breach will not occur.

•        Some contracts provide their own remedies for breach (liquidated damages), or failure of the product to perform as advertised (warranties).

•        Not all products carry express (explicit) warranties. Courts nevertheless often find an implied warranty of fitness, which holds manufacturers liable for damages caused by a defect in the product. Implied warranties represent the intersection of contract and tort (products liability) law.

•        Parties engaged in ongoing commercial relationships often employ long-term contracts to save on the costs of re-negotiating each transaction anew. Long-term contracts can also prevent strategic behavior by one or both parties. Merger of trading partners can serve the same purpose. Economic theory says that courts should generally enforce long-term contracts.