Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 13
Last week…
 Formation defenses
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Incompetence
Duress, necessity
Adhesion, unconscionability (lesion)
Fraud, failure to disclose
Mutual mistake
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But not unilateral mistake
 Performance excuses
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Impossibility
Frustration of purpose
 Concepts
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Efficient bearer (low cost avoider) of a risk
Uniting knowledge and control
1
Remedies for breach
of contract
2
Three broad types of remedy for breach of
contract
 Party-designed remedies
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Remedies specified in the contract
 Court-imposed damages
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Court may decide promisee entitled to some level of damages
 Specific performance
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Forces breaching party to live up to contract
3
Expectation damages
 Compensate promisee for the amount he expected to
benefit from performance
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You agreed to buy an airplane for $350,000
You expected $500,000 of benefit from it
Expectation damages: if I breach, I owe you that benefit
($500,000 if you already paid, $150,000 if you didn’t)
 “Positive damages”
 Make promisee indifferent between performance and breach
4
Reliance damages
 Reimburse promisee for cost of any reliance investments
made, but not for additional surplus he expected to gain
 Restore promisee to level of well-being before he signed
the contract
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You contracted to buy the plane and built a hangar
If I breach, I owe you what you spent on the hangar, nothing else
 “Negative damages” – undo the negative (harm) that
occurred
5
Opportunity cost damages
 Give promisee benefit he would have gotten from his
next-best option
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Make promisee indifferent between breach of the contract that
was signed, and performance of best alternative contract
You value plane at $500,000
You contract to buy plane from me for $350,000
Someone else was selling similar plane for $400,000
By the time I breach, that plane is no longer available
I owe you $100,000 – the benefit you would have gotten from
buying the other seller’s plane
6
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Michigan football
game for $50
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Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of face paint and giant foam
finger
7
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Michigan football
game for $50
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Expectation damages: you owe me value of game minus $50
If I pay scalper $150, then expectation damages = $100
Reliance damages: maybe 0, or cost of face paint and giant foam
finger
When you agreed to sell me ticket, other tickets available for $70
Opportunity cost damages: $80
(I paid a scalper $150 to get in; I would have been $80 better off if
I’d ignored your offer and paid someone else $70)
8
Ranking damages
Contract
I Sign

Best
Alternative

Do Nothing
=
=
=
Breach +
Expectation
Damages

Breach +
Opportunity Cost
Damages

Breach +
Reliance
Damages

Opportunity Cost
Damages

Reliance
Damages
Expectation
Damages
$100
$80
$0-20
9
Hawkins v McGee (“hairy hand case”)
 Hawkins had a scar on his hand
 McGee promised surgery to “make the hand a hundred
percent perfect”
 Surgery was a disaster, left scar bigger and covered with
hair
10
Hawkins v McGee (“hairy hand case”)
+ Opp Cost
Damages
+ Reliance
Damages
Initial Wealth
Opp Cost Damages
Reliance Damages
+ Expectation
Damages
Expectation Damages
$
Hand
Hairy Scarred
Next
best
doctor
100%
Perfect
11
Recapping different types of damages
 Expectation damages
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Give promisee benefit he would have had from performance
 Opportunity cost damages
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Give promisee benefit he would have had from next-best contract
 Reliance damages
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Give promisee benefit he would have had from doing nothing
 Expectation Dam  Opp Cost Dam  Reliance Dam
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But order can be reversed when calculated incorrectly
12
Other court-ordered remedies
 Restitution
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Return money that was already received
 Disgorgement
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Give up wrongfully-gained profits
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Other court-ordered remedies
 Restitution
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Return money that was already received
 Disgorgement
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Give up wrongfully-gained profits
 Specific Performance
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Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
14
Other court-ordered remedies
 Restitution
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Return money that was already received
 Disgorgement
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Give up wrongfully-gained profits
 Specific Performance
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Promisor is forced to honor promise
Civil law: often ordered instead of money damages
Common law: money damages more common; S.P. sometimes
used when seller breaches contract to sell a unique good
Like injunctive relief
15
Party-designed remedies
 Remedy for breach could be written directly into contract
 But common law courts don’t always enforce remedy terms
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Liquidated damages – party-specified damages that reasonably
approximate actual harm done by breach
Penalty damages – damages greater than actual harm done
Civil law courts are generally willing to enforce penalty damages
But common law courts often do not
16
Penalty Damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
 Peevyhouse v Garland Coal
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Peevyhouses only wanted farm strip-mined if it would be restored to
original condition after
Suppose coal extracted worth $70,000
Garland paid $25,000 for rights to mine it
Restoration work would cost $30,000
Diminution of value was $300
So liquidated damages would be $300
Suppose Peevyhouses got $40,000 of disutility from land being left
in poor condition
17
Liquidated damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay damages
(-14,700, 44,700)
 If damages limited to liquidated damages…
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Peevyhouses have no reason to believe restorative work will get done
So Peevyhouses better off refusing to sign
Even though mining and restoring Pareto-dominates
18
Penalty damages
Coal worth $70,000
Garland to pay $25,000
Restoration would cost $30,000
Liquidated damages are $300
Peevyhouses value restoration at $40,000
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay penalty
(25,000, 5,000)
 If penalty clauses in contracts enforceable…
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Write contract with $40,000 penalty for leaving land unrestored
Now restoration work would get done, so Peevyhouses willing to sign
But if courts won’t enforce penalty damages, this won’t work
19
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus
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I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
20
Penalty clauses
 Whatever you can accomplish with penalty clause, you
could also accomplish with performance bonus
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I agree to pay $200,000 to get house built, but I want you to pay a
$50,000 penalty if it’s late
Alternatively: I agree to pay $150,000 for house, plus a $50,000
performance bonus if it’s completed on time
Either way, you get $150,000 if house is late, $200,000 if on time
Courts generally enforce bonus clauses, so no problem!
Similarly, Peevyhouse example
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Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is
not restored
Equivalently, get $65,000 for mining rights, pay $40,000 bonus if
restoration is completed
But, if intent of contract is too transparent, still might not be enforced
21
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
22
Plane worth $500,000 to you
Price $350,000
Cost: either $250,000 or $1,000,000
Remedies and breach
Expectation Damages
Specific Performance
Costs
Low –
Perform
Costs
High –
Perform
Costs
High –
Breach
I get
100,000
-650,000
-150,000
You get
150,000
150,000
150,000
Total
250,000
-500,000
0
Costs
Low –
Perform
Costs
High –
Perform
Costs
High –
Renegotiate
I get
100,000 -650,000
-400,000
You get
150,000
150,000
400,000
Total
250,000 -500,000
0
 Transaction costs low  either leads to efficient breach, but
seller prefers “weaker” remedy
 Transaction costs high  S.P. leads to ineff. performance
23
Remedies and breach
 Opportunity cost damages, or reliance damages
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Inefficient breach when transaction costs are high
Renegotiate contract to get efficient performance when transaction
costs are low
Like nuisance law: any remedy leads to efficient breach with low TC
But only expectation damages do when TC are high
 Unfortunate contingency and fortunate contingency
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Efficient signing
 Specific Performance
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If costs stay low, I get $350,000 - $250,000 = $100,000 profit
If costs rise, I take $400,000 loss
Am I willing to sign this contract?
 Even expectation damages face this problem
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Expectation damages: costs stay low, same $100,000 profit
Costs rise, $150,000 loss
If probability of high costs is ½, I won’t sign contract
 Expectation damages lead to efficient breach, but may
not lead to efficient signing
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Suggests expectation damages might be good default rule,
but not good mandatory rule
25
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
26
Paradox of compensation
 Remedy for breach sets incentive for both promisor and
promisee
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Promisor: perform or breach
Promisee: how much to rely
 Generally impossible to set both incentives efficiently at the
same time
 Example: should anticipated benefit from reliance be
included in expectation damages?
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Incentives for reliance
(airplane example)
Plane worth $500,000 to you
Price $350,000
Cost: either $250,000 or $1,000,000
$x investment  600x increase in
value of performance
Additional
value of
plane
y = 600 x
Designer hangar with Starbucks - $480,000
Functional heating - $240,000
Metal poles, rigid roof - $120,000
Plywood frame, canvas roof - $60,000
Tarp and rope - $6,000 benefit
Investment in hangar
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Three questions
Plane worth $500,000 to you
Price $350,000
Cost: either $250,000 or $1,000,000
$x investment  600x increase in
value of performance
 Let p be probability of breach
 Three questions
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What is the efficient level of reliance?
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What will promisee do if expectation damages include anticipated
benefit from reliance?
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What will promisee do if expectation damages exclude anticipated
benefit from reliance?
29
Three questions
Plane worth $500,000 to you
Price $350,000
Cost: either $250,000 or $1,000,000
$x investment  600x increase in
value of performance
 Let p be probability of breach
 Three questions

What is the efficient level of reliance?
x = $90,000 (1 – p)2
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What will promisee do if expectation damages include anticipated
benefit from reliance?
x = $90,000
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What will promisee do if expectation damages exclude anticipated
benefit from reliance?
x = $90,000 (1 – p)2
30
So…
 To get efficient reliance, we need to exclude gains from
reliance in calculation of expectation damages
 But then promisor’s liability < promisee’s benefit, leading to
inefficient breach
 With low transaction costs, we can fix this through
renegotiation
 But what about unobservable actions the promisor needs
to take, to make breach less likely?

Investment in performance
31
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
32
Investment in performance
(continuing with airplane example)
 Some investment I can make to reduce likelihood that
breach becomes necessary
 Suppose probability of breach is initially ½…
but for every $27,726 I invest, I cut the probability in half
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Invest nothing  probability of breach is 1/2
Invest $27,726  probability is 1/4
Invest $55,452  probability is 1/8
Any investment z  probability is .5 * (.5) z / 27,726
 Wrote it this way so p = .5 e – z / 40,000
33
Investment in performance
(continuing with airplane example)
 Suppose you’ve built a $90,000 hangar
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Increases value of performance by $180,000…
…so value of performance is $150,000 + $180,000 = $330,000
Probability of breach = .5 e – z/40,000
Let D = damages I owe if I breach
 Same questions as before:

What is efficient level of investment in performance?
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How much will I choose to invest in performance?
34
Investment in performance
(continuing with airplane example)
 Suppose you’ve built a $90,000 hangar




Increases value of performance by $180,000…
…so value of performance is $150,000 + $180,000 = $330,000
Probability of breach = .5 e – z/40,000
Let D = damages I owe if I breach
 Same questions as before:

What is efficient level of investment in performance?
Enough to reduce probability of breach to 40,000/430,000

How much will I choose to invest in performance?
Enough to reduce probability of breach to 40,000/(100,000 + D)
35
What do these results mean?
 What is the efficient level of investment in performance?
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Enough so that p(z) = 40,000/430,000
 What will promisor do under various rules for damages?
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Enough so that p(z) = 40,000/(100,000 + D)
 So if D = 330,000, efficient investment in performance
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D = 330,000 is promisee’s benefit, including reliance
So expectation damages, with benefit of reliance, leads to
efficient investment in performance
If D < 330,000, too little investment in performance
If D > 330,000, too much
Makes sense – think about externalities
36
Effects of different remedies on…
decision to perform or breach
decision to sign or not sign
investment in performing
investment in reliance
37