ECON 1450 – Professor Berkowitz Lecture 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 homeowners 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 Sellers breach decision – sellers return w. breach = - D, sellers 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 = buyers 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 C h > C L, and C h > V > C L 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 - C L ) + (1-q)(-R) = q(V – R) - R

R^ - efficient reliance Max qV(R) – qC L – R Max qV(R) – R See Figure 5.2 – R^ buyer should invest less to account for losses when high costs are realized Show that dR^/d(1-q) 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 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, contd With unlimited damages, buyer get R and with expectation damages buyer gets R^ only Expectation damages and buyers 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 – contd 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

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?