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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

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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

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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

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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

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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

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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!

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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

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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!

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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

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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

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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

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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)

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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)

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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!

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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

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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!

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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!

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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

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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!

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Impossibility and related excuses Impossibility Frustration of purpose Commercial impracticability

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Courts discharge contracts when performance is feasible but economically burdensome Conditional rule that discharges performance without penalty when costs are sufficiently high

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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?

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Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre Recht und Ökonomie (Law and Economics) LVA-Nr.: 239.203.

Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre Recht und Ökonomie (Law and Economics) LVA-Nr.: 239.203.

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