1. Econ 522 Economics of Law
Dan Quint
Spring 2010
Lecture 13

2. Last week… Formation defenses Performance excuses Concepts
Incompetence
Duress, necessity
Adhesion, unconscionability (lesion)
Fraud, failure to disclose
Mutual mistake
But not unilateral mistake
Performance excuses
Impossibility
Frustration of purpose
Concepts
Efficient bearer (low cost avoider) of a risk
Uniting knowledge and control

3. Remedies for breach of contract
That’s all for ways to invalidate a contract. Next, we’ll consider the remedies that are available when a contract is breached.

4. Three broad types of remedy for breach of contract
Party-designed remedies
Remedies specified in the contract
Court-imposed damages
Court may decide promisee entitled to some level of damages
Specific performance
Forces breaching party to live up to contract
There are three general types of remedies for breach of contract:
party-designed remedies
court-imposed damages
specific performance
Party-designed remedies are remedies specified in the contract for a particular scenario
for example, a construction contract might stipulate a particular daily fee if completion of the building is delayed
Court-imposed damages are what we’ve already been talking about
the court may rule that the promisee is entitled to some amount of money as compensation for the breach
The third alternative is for the court to require specific performance
This forces the breaching party to live up to the contract
This is what the dissenting opinion in Peevyhouse proposed
Rather than calculating money damages, they said the coal company should be required to actually carry out the restorative work as promised.
Remedies that are stipulated in the contract are fairly clear-cut
although we’ll come to an example of some that are often not enforced
Specific performance is also fairly clean, although we’ll discuss it a bit more later today
The difficult one is when the court has to step in and calculate the appropriate level of monetary damages
There are a number of different standards which can be used for this

5. Expectation damages
Compensate promisee for the amount he expected to benefit from performance
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
We’ve already seen one: expectation damages.
Expectation damages are meant to compensate the promisee for the amount he expected to benefit from performance of the promise
Recall the airplane example we did a while back
you contracted to buy an airplane from me for $350,000
you expected to derive $500,000 of benefit from it
under expectation damages, I would owe you that benefit
($500,000 if you had already paid me, or $500,000 - $350,000 = $150,000 if you had not.)
The civil law refers to these as positive damages, as they compensate you for the positive benefit you anticipated from the contract
When they are calculated correctly, expectation damages make the promisee indifferent about whether the promisor performs or breaches
Thus, under expectation damages, the promisor internalizes all the costs of breach, and therefore makes the efficient decision about breach.

6. 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
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
A second type of damages are reliance damages
These compensate the promisee for any investments he made in reliance on the promise, but not for the additional surplus he expected to gain
Reliance damages, therefore, restore the promisee to the level of well-being he would have had if he had not received the promise in the first place
In the airplane example, suppose I chose not to deliver the plane but you had built yourself a hangar
Reliance damages would require me to reimburse you the cost of the hangar, but not the surplus you expected to earn from owning the plane
In the rich uncle example – the rich uncle promises his nephew a trip around the world, then changes his mind – reliance damages would pay for whatever supplies the nephew had purchased in preparation for the trip, minus whatever price he could resell them for
Again, this puts the promisee back in the position he was in before the promise was made
The civil law tradition refers to these as negative damages, as they undo the negative (the harm) that actually occurred in response to the promise
If no investments were made in reliance on the promise, reliance damages would be 0 – sort of a “no harm, no foul” rule.

7. Opportunity cost damages
Give promisee benefit he would have gotten from his next-best option
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
A third type of damages are opportunity cost damages
If you agree to buy a plane from me, you may pass up another chance to buy a plane from someone else
But if I breach our contract, that other option may no longer be available
Opportunity cost damages are set to restore the promisee to the level of well-being he would have had if he had not contracted with this promisor, and instead had gone with his “next-best option”
Opportunity cost damages can be seen as an extension of reliance damages, where now turning down another opportunity is seen as a form of reliance, that is, as an investment you make in reliance on the promise that was made
Thus, opportunity cost damages leave the promisee indifferent between breach of the contract that was signed and fulfillment of the best alternative contract
In the airplane example, you contracted to buy a plane worth $500,000 for $350,000
Suppose someone else had an equally attractive airplane for sale at $400,000
If I breach our contract, opportunity cost damages would be $100,000, since this is the surplus you would have realized by foregoing the contract with me and instead buying the other plane

8. Example: expectation, reliance, and opportunity cost damages
You agree to sell me ticket to Wisconsin-Michigan football game for $50
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
An example
I decide I want to go to the Michigan game in a few weeks
One of you has a roommate with an extra ticket, and so you agree to sell it to me for $50
At the last minute, your roommate decides to go to the game, and you breach your promise.
Expectation damages are supposed to make me as well-off as if you had indeed sold me the ticket for $50
It may be hard to measure exactly how well-off the football game would have made me
But once you tell me my ticket is gone, I could show up at the stadium before the game and buy a ticket from a scalper
Say this costs $150
This gives us an easy way to compute expectation damages
If you had lived up to your promise, I’d be $100 better off, because I’d have gotten the same good (a ticket) for $50 instead of for $150
So expectation damages might be set at $100.
Now consider reliance damages for the same contract
Going to a football game doesn’t involve a lot of substantial investments
It’s possible reliance damages would be 0
If I had already gone out and bought red-and-white face paint and a big foam finger, reliance damages might reimburse me for these purchases
But reliance damages would not compensate me for the benefit I expected to get.

9. Example: expectation, reliance, and opportunity cost damages
You agree to sell me ticket to Wisconsin-Michigan football game for $50
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)
Finally, suppose when we made the deal, there were lots of people offering tickets on Craigslist for $70
By the time you breach, these tickets were gone, so all I could do was pay a scalper $150 for a ticket
The actual payoff I got was G – 150, where G is the value of attending the game
If I had signed the best alternative contract, my payoff would have been G – 70
So while the contract we signed would have made me $100 better off, the best alternative would have made me $80 better off
Opportunity cost damages, then, would be set at $80, to compensate me for having passed on that opportunity.
Also note that these are all remedies for seller breach
We could calculate what I would owe you if I changed my mind and decided not to go to the game – that is, the remedy for buyer breach – in the analogous way.
In this example, a ticket to a football game is a good with many substitutes
That is, there are lots of tickets to the game, and they’re all worth about the same amount
So it made sense to calculate damages based on the market price of a replacement ticket
When a contract is for a unique good, this doesn’t always work; but conceptually, the analysis is almost the same.

10. ³ ³ = = = ³ ³ ³ ³ Ranking damages $100 $80 $0-20 Contract I Sign
Best Alternative
Do Nothing = = =
Breach + Expectation Damages
Breach + Opportunity Cost Damages
Breach + Reliance Damages
In this example,
Expectation Damages >= Opportunity Cost Damages >= Reliance Damages
It turns out, as long as all three are computed correctly, this should always be true
The reason is simple.
If I am rational and choose to sign a particular contract, it must be because that contract is at least as good for me as my best alternative
Of course, doing nothing is always an option, so it stands to reason that both the contract I sign, and the next best alternative, are at least as good as doing nothing
So from the point of view of my utility,
Contract I sign >= Best Alternative >= Doing Nothing
Following breach,
expectation damages restore me to the value of performance of the contract I signed
opportunity cost damages restore me to the value of performance of the next-best alternative
reliance damages restore me to the value of having done nothing So
Breach + Expectation Damages >= Breach + Opp Cost Damages >= Breach + Reliance D
If we subtract off the value of the breached contract in each case, we see that
(Of course, damages are not always calculated perfectly, so there may be instances in which this is violated. We’ll see examples of this next time.)
Expectation Damages
Opportunity Cost Damages
Reliance Damages
$100
$80
$0-20

11. 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
In the examples so far – the airplane, and the football ticket – we could use market prices to calculate damages
In some situations, the value of a contract is subjective, making things a bit harder
Still, the principle is the same, it’s just a question of how to actually do the calculation.
A dramatic example of this is a 1929 case from New Hampshire, Hawkins v McGee, “the hairy hand case.”
George Hawkins had a scar on his hand from touching an electrical wire when he was young
A local doctor, McGee, approached him about having the scar removed, and promised to “make the hand a hundred percent perfect hand.”
Skin from Hawkins’ chest was grafted onto his hand
But the surgery was a disaster: the scar ended up bigger than before, and covered with hair
Hawkins successfully sued McGee; the issue on appeal was how high to set the damages.
To get a view of what’s going on, consider Hawkins’ preferences over two types of goods: his hand, and money. (Indifference curves.)

12. Hawkins v McGee (“hairy hand case”)$
+ Expectation Damages
+ Opp Cost Damages
Expectation Damages
Reliance Damages
Opp Cost Damages
+ Reliance Damages
Initial Wealth
To get a view of what’s going on, consider Hawkins’ preferences over two types of goods: his hand, and money. He could have a scar on his hand; a perfect hand; he could have gone to a different doctor who promised him improvement but not perfection; and he could have the hairy hand he had after surgery. Indifference curves.
Hawkins started out at the red dot – with a scarred hand, and some initial amount of money.
The doctor promised him the green dot – a perfect hand (but less money, since he would have to pay for the surgery)
Now he’s stuck with a hairy hand. And about to get more money (damages).
Reliance damages would get him back to the same level of well-being as before
The next-best doctor might have gotten him to the orange dot – a pretty good hand.
Opportunity cost damages would get him to the level of well-being he would have had by going to the next-best-doctor
Expectation damages would get him to the level of well-being he expected from the successful operation.
(Of course, there is still the question of how to calculate these indifference curves, since they are clearly subjective
There is also the question of whether it even makes sense to think that money can compensate for something like a disfiguring injury
But this is at least the principle.)
Once again, we see that the promised benefit (performance) is better than the next-best option, which is better than doing nothing
So expectation damages are bigger than opportunity cost damages, which are bigger than reliance damages
This ranking should hold whenever all three damage levels are calculated correctly
Hand
Hairy
Scarred
Next best doctor
100% Perfect

13. Recapping different types of damages
Expectation damages
Give promisee benefit he would have had from performance
Opportunity cost damages
Give promisee benefit he would have had from next-best contract
Reliance damages
Give promisee benefit he would have had from doing nothing
Expectation Dam ³ Opp Cost Dam ³ Reliance Dam
But order can be reversed when calculated incorrectly
We saw that the promised benefit (performance) is better than the next-best option which is better than doing nothing
So expectation damages are bigger than opportunity cost damages, which are bigger than reliance damages
This ranking should hold whenever all three damage levels are calculated correctly
However, there are instances when this may not occur, leading to a different ranking
The book gives an example where someone promises to deliver to me a tiny diamond from my great-grandmother’s engagement ring
The diamond is very small, and worth very little objectively, but it has a great sentimental value to me
In anticipation of receiving it, I commission a very expensive setting for the stone
I’m motivated by sentimental value, but the market value of the ring, even with the stone, is less than its cost
Now, after I’ve bought and paid for the setting, the promisor breaches.
Expectation damages should get me back to the level of well-being I expected to be at with the diamond
But that level is based on a high subjective valuation
A court could refuse to enforce that level of damages, and instead base expectation damages on the market value of the ring in its setting
But this could be less than the price I paid for the setting
On the other hand, reliance damages would at least reimburse me the cost of the setting
In a sense, this is what happened in Peevyhouse
The Peevyhouses’ subjective valuation for their farm, in its original condition, appeared to be very high
The court refused to base damages on this subjective value, instead limiting damages to the reduction in market value, which was only $300

14. Other court-ordered remedies
Restitution
Return money that was already received
Disgorgement
Give up wrongfully-gained profits
There are three other types of damages that are sometimes ordered, which aren’t all that interesting, but are worth knowing.
Restitution is basically just forcing someone to pay back whatever money they’ve already received
I contract to buy a house and make a down payment
The seller breaches
If nothing else, he is required to return my down payment
This is sort of a minimal remedy, but it at least is very easy to implement.
Disgorgement is a similar concept, requiring someone to give up whatever profits they have wrongfully gained
Directors of a corporation have a duty to stockholders to act in a certain way
This is a very vague duty, not a list of specific things they are required to do
Suppose a director acts in a disloyal way, which is costly to the company but profitable to himself
Disgorgement damages would require the director to give up whatever profits he earned to the victim, in this case, the stockholders
Perfect disgorgement damages take away the director’s incentive to commit fraud

15. Other court-ordered remedies
Restitution
Return money that was already received
Disgorgement
Give up wrongfully-gained profits
Specific Performance
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
Specific Performance is when, instead of ordering money damages, the court orders the promisor to live up to the promise
I contract to buy a particular house from you
It’s a beautiful house, in a historical neighborhood, and there are no others like it available
After we sign an agreement, you find a more eager buyer, and try to breach our agreement
The court might order you to follow through with the sale to me – this would be specific performance
In some civil law countries, specific performance rather than monetary damages is the traditional remedy for breach of contract
In common law, when a good has substitutes, money damages are traditionally the remedy, since the promisee can use that money to buy a substitute good if he so chooses
Specific performance is sometimes ruled for sale of goods without any substitutes
Specific performance can also be seen as an analog to injunctive relief in property law – your promise now belongs to me, so you’re not allowed to get out of it unless I choose to release you

16. Other court-ordered remedies
Restitution
Return money that was already received
Disgorgement
Give up wrongfully-gained profits
Specific Performance
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
Specific performance is also a sensible remedy choice when it is very difficult for the court to compute the appropriate level of damages
For example, when the valuation of the good is very subjective
This is what the dissenting opinion in Peevyhouse suggested
The Peevyhouses’ subjective valuation for their property in its original condition was clearly high, and hard to assess
Rather than take a stab at computing damages, the dissent would have ordered the coal company to clean up its mess as promised
As always, the two sides could have then negotiated around the ruling if transaction costs were low
Of course, specific performance is sometimes impossible
In the Hawkins case, it was impossible for the doctor to undo the damage to Hawkins’ hand, much less restore it to the promised level
So only monetary damages were sensible

17. Party-designed remedies
Remedy for breach could be written directly into contract
But common law courts don’t always enforce remedy terms
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
We mentioned that in some cases, the remedy for breach can be built directly into the contract
Some contracts stipulate an amount of money that a party would have to pay if he were to breach the contract
Others might specify a “performance bond” – an amount of money deposited with a third party, that would be paid to the promisee upon breach
Or a contract might specify a different process for resolving any disputes, such as agreeing to submit to binding arbitration or some other process
(This is what happens with disputes among diamond merchants, which are never resolved in court.)
For some reason, courts are often hesitant to enforce remedy terms in contracts
Rather than enforce the contract as written, courts sometimes set aside remedy clauses and impose their own remedies
One type of remedy that courts will often refuse to enforce is penalty damages
Penalty damages are damages that are greater than the actual harm that occurred
(“Liquidated damages” refer to party-specified damages that are a reasonable estimate of the actual harm done by the breach; penalty damages are any damages that are greater than that)
Civil law courts generally enforce penalty damages
But common law courts often set aside penalty damages, and only enforce liquidated damages

18. Penalty Damages Peevyhouse v Garland Coal
Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000
Penalty Damages
Peevyhouse v Garland Coal
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
It’s unfortunate that penalty clauses are often not enforced, because they could be useful in some instances
In particular, they could be helpful when one party to a contract places a high subjective value on performance
Go back to coal mining example we saw earlier, Peevyhouse v Garland Coal
The Peevyhouses only wanted their farm strip-mined if the land could be restored to its original condition
They seemed to value the condition of their farm much more highly than “market value”
Had they known the coal company would refuse to perform the restoration work, and instead only pay them damages, they might have refused to agree to the contract in the first place
We can illustrate this with a simple dynamic game
Suppose the coal extracted was worth $70,000 (net of costs), and Garland Coal agreed to pay $25,000 to mine it
Recall that restoration work would have cost around $30,000, but damages for refusing to do it were assessed at $300
Suppose that the Peevyhouses got $40,000 of disutility from the land not being restored

19. Liquidated damages If damages limited to 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
Liquidated damages
Peevyhouses
Sign
Don’t
Garland Coal
(0, 0)
Restore property
Don’t, pay damages
(25,000, 15,000)
(-14,700, 44,700)
If damages limited to liquidated damages…
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

20. Penalty damages If penalty clauses in contracts enforceable…
Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000
Penalty damages
Peevyhouses
Sign
Don’t
Garland Coal
(0, 0)
Restore property
Don’t, pay penalty
One way to address this in a contract would have been to write into the contract a $40,000 penalty in the event that the restorative work was not completed
If this was enforceable, it would ensure that the mining company followed through with the restorative work
That is, it would change the game to this:
Now, the Peevyhouses are assured of getting their land restored
So they’re happy to agree to the contract
But, if common law courts don’t uphold penalty clauses, this won’t work
Another example: suppose you’re hiring a contractor to build a house, and you place a very high value on its being completed by a particular date
You are happy to pay $200,000 to get the house built, but insist on a $50,000 penalty if it’s not ready on that date
Now suppose there are lots of contractors who could potentially build the house
If you offer this deal to lots of them, the ones who accept are likely the ones who are most confident in their ability to finish the house on time
Since you value this highly, this may be efficient
And this may be the easiest (or the only) way for you to elicit this information
If there is no penalty clause, every contractor will try to convince you he’s 100% certain he’ll finish on time
But if someone accepts the $50,000 penalty clause, they’re probably pretty sure
(25,000, 15,000)
(25,000, 5,000)
If penalty clauses in contracts enforceable…
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

21. Penalty clauses
Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus
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!
So in some instances, penalty damages seem beneficial
Especially if one party would not agree to a mutually beneficial contract without them
So it seems like the fact that they’re not enforced is a problem
However, it turns out, most things you could accomplish with penalties, you could restate in a different way with a performance bonus
Go back to the house-building example
I’m happy to pay $200,000 to get the house built by a certain date
But I insist on a $50,000 penalty if it’s not ready on time
We could alternatively write the contract this way:
I pay $150,000 for the building of the house
And I pay an additional $50,000 performance bonus if the house is completed by a certain date
Courts generally have no problem enforcing contracts with bonuses in them, so this would likely be enforced as written
But it has the same effect as the contract with the penalty
(Under either contract, the builder gets $200,000 for finishing the house on time, and $150,000 for finishing it late.)

22. Penalty clauses
Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus
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
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
Similarly, go back to the Peevyhouse example
Instead of a $40,000 penalty that might not be upheld, the Peevyhouse contract also could have been rewritten as a bonus
We imagined that Garland paid $25,000 to mine the coal
Suppose the contract were written in this way:
Garland pays the Peevyhouses $65,000 to mine the coal
The Peevyhouses pay Garland a $40,000 bonus if the resoration work is completed
This would create exactly the same incentives as a $40,000 penalty clause
(In this case, though, the intent of the contract might have been so transparent that it still might not have been enforced)

23. Effects of different remedies on…. decision to perform or breach
Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

24. Costs High – Renegotiate
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
Costs Low – Perform
Costs High – Perform
Costs High – Renegotiate
I get
100,000
-650,000
-150,000
I get
100,000
-650,000
-400,000
You get
150,000
150,000
150,000
You get
150,000
150,000
400,000
For example, let’s compare a contract enforced by specific performance – the promisor is not allowed to breach unless the promisee agrees – versus a promise enforced by expectation damages
Let’s stick with the example of the airplane I agreed to build for you
The plane will give you a value of $500,000; we agree on a price of $350,000
I expect the plane to cost me $250,000 to build, but there is some chance it will instead cost me $1,000,000
Expectation damages
Specific performance
by renegotiating the contract, we create a total surplus of $500,000 (beyond our outside options if you forced me to build the plane)
Suppose that our negotiations lead us to divide this additional surplus evenly
This would lead you to get $250,000 beyond your outside option, which was $150,000, so your payoff would be $400,000
I would get $250,000 beyond my outside option, which was -650,000, which would be -400,000
(So this means, in return for getting out of the contract, I pay you $400,000)
As long as transaction costs are low, either remedy will lead to the same outcome
When it is efficient to breach, expectation damages lead me to breach without permission
Under specific performance, when it is efficient to breach, renegotiation will lead us to some sort of agreement to let me off the hook.
But when the transaction costs of renegotiating our contract are too high…
Expectation damages still allow me to breach
Specific performance would lead to inefficient performance
I would have to build you the plane, even though it costs me more than your benefit
Total
250,000
-500,000
Total
250,000
-500,000
Transaction costs low  either leads to efficient breach, but seller prefers “weaker” remedy
Transaction costs high  S.P. leads to ineff. performance

25. Remedies and breach Opportunity cost damages, or reliance damages
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
We can do the same type of analysis with other types of damages – opportunity cost damages, or reliance damages
With high transaction costs, either of these would lead to inefficient breach – sometimes, I would choose to breach, even when that’s inefficient
With low transaction costs, when performance is efficient but I would otherwise choose to breach, we can simply renegotiate the contract and get performance
So just like in nuisance law, any remedy leads to efficient performance when transaction costs are low
But only expectation damages do it without renegotiation; and only expectation damages get efficient breach even when transaction costs are high
An increase in the cost of performance is referred to as an unfortunate contingency
On the other hand, I may want to break my promise because I discover another buyer who values my product more than you do
This is referred to as a fortunate contingency
Earlier, we saw the example where you contracted to buy my painting, but my rich cousin appeared and valued it much more highly than you did
We can do the same exercise as before with the different remedies, and see the same thing
With low transaction costs, any remedy will lead to efficient breach, but with different allocations of surplus
An example of this is done in the textbook (p. 267)
Once again, specific performance is the most advantageous to the buyer, and higher damages are better for the buyer than lower damages.

26. Efficient signing Specific Performance
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
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
Suggests expectation damages might be good default rule, but not good mandatory rule
One further point that we mentioned earlier but didn’t talk much about: efficient signing.
With specific performance, in the example above, we saw that when costs stay low and I perform, I get a profit of $100,000 (the price you pay, $350, minus the costs I incur, $250)
When costs rise and I need to renegotiate to get out of the contract, if gains from trade were split evenly, I would take a $400,000 loss
Which begs the question: would I have been willing to sign this contract in the first place?
It turns out, expectation damages face this problem too
When my costs remain low and I perform, I get the same profit of $100,000
And when my costs jump up and I breach, I owe $150,000 (expectation damages)
If the probability my costs rise is small enough, that’s no big deal
I take the risk of owing you expectation damages, because my profits in the cases where I don’t breach are large enough that it’s worth the risk.
But if the probability my costs rise is high, then my expected profit from this contract is negative
For example, suppose the probability of a dramatic rise in costs is ½
Then my expected payoffs from agreeing to build you the airplane are
½ (100,000) + ½ (-150,000) = -25,000
So now there’s no way I’d agree to the contract in the first place
This is the point we mentioned before:
Expectation damages lead to efficient breach, but they may lead to inefficient signing
(If I’m the only airplane manufacturer available, it’s still efficient for us to sign this contract – it generates positive expected surplus – but under expectation damages, I would not sign this contract.)
This suggests that, even if expectation damages make a sensible default rule, it’s efficient for parties to be able to specify a different damages rule in the contract
That is, even if expectation damages are often efficient, they are not always efficient, so there’s no reason for them to be mandatory

27. Effects of different remedies on…. decision to perform or breach
Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

28. Paradox of compensation
Remedy for breach sets incentive for both promisor and promisee
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?

29. Incentives for reliance (airplane example)
Plane worth $500,000 to you Price $350,000 Cost: either $250,000 or $1,000,000 $x investment  600Öx increase in value of performance
Incentives for reliance (airplane example)
Additional value of plane
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
$100
$10,000
$40,000
$160,000
$640,000

30. Three questions Let p be probability of breach Three questions
Plane worth $500,000 to you Price $350,000 Cost: either $250,000 or $1,000,000 $x investment  600Öx increase in value of performance
Three questions
Let p be probability of breach
Three questions
What is the efficient level of reliance?
What will promisee do if expectation damages include anticipated benefit from reliance?
What will promisee do if expectation damages exclude anticipated benefit from reliance?

31. Three questions Let p be probability of breach Three questions
Plane worth $500,000 to you Price $350,000 Cost: either $250,000 or $1,000,000 $x investment  600Öx increase in value of performance
Three questions
Let p be probability of breach
Three questions
What is the efficient level of reliance?
x = $90,000 (1 – p)2
What will promisee do if expectation damages include anticipated benefit from reliance?
x = $90,000
What will promisee do if expectation damages exclude anticipated benefit from reliance?
Total social gain when costs stay low: 500, sqrt(x) – 250,000 – x
Total social gain when costs go up: – x
If probability costs rise is p, expected total social gain is
(1-p) (250, sqrt(x) – x) + p (-x)
250,000 (1-p) (1-p) sqrt(x) – x
Choose x to maximize this: derivative is
600 (1-p) /(2sqrt(x)) – 1 = 0
x = 90,000 (1 – p)2
x = 90,000 (1 – p)2 is the efficient level of reliance
When expectation damages include anticipated benefit,
private gain to promisee when costs stay low: 500, sqrt(x) – 350,000 – x = 150, sqrt(x) – x
Private gain to promisee when costs go up: 150, sqrt(x) – x
Expected private gain to promisee is 150, sqrt(x) – x
Choose x to maximize this: derivative is 600/(2Öx) – 1 = 0
x = 90,000
So promisee would invest x = $90,000 in reliance
When expectation damages exclude anticipated benefit,
Private gain to promisee when costs stay low: 500, sqrt(x) – 350,000 – x = 150, sqrt(x) – x
Private gain to promisee when costs go up: 150,000 – x
Expected private gain to promisee is 150,000 + (1 – p) 600 sqrt(x) – x
Choose x to maximize this: derivative is 600 (1 – p)/(2sqrt(x)) – 1 = 0
So promisee would invest x = $90,000 (1-p)2 in reliance

32. 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
So if damages include the gains from reliance, this leads to overreliance
But if the level of damages excludes the gains from reliance, this leads to efficient reliance
But we also know that if the level of damages exclude the gains from reliance, and the buyer relies anyway, that this will lead to inefficient breach
That is, since the seller’s liability from breach is lower than the buyer’s gain from performance, there will be some instances where the seller breaches even though efficiency requires performance
We said before that with no transaction costs, this problem can be solved
When breach would be inefficient, the parties can contract around it
Since it’s generally very clear whether a party has breached a contract or not, this shouldn’t be a particular problem.
However, there are situations in which a promisor can take actions to make performance less costly
Or, to put it another way, to lessen the probability that breach is necessary
A contractor could buy raw materials ahead of time, to avoid the risk of changing prices
A manufacturer could start a project earlier and frontload the labor to avoid the risk of a strike
If a project were to require a building permit or zoning easement, he could lobby the local government (or bribe someone) to decrease the chances of hitting a snag.
This sort of investment in performance, however, may be unobservable, or unverifiable
So even when this sort of investment is efficient, it may be very hard to build it into the contract
(It’s very hard to enforce a contract specifying “how hard I have to try” to convince the zoning board to approve your project.)
So investment in performance may only occur when it is in the promisor’s best interest

33. Effects of different remedies on…. decision to perform or breach
Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance

34. 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
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
We’ll stick with the airplane example
Suppose there is some investment I can take that reduces the chance that my costs go up
I can buy some of my supplies ahead of time
This will reduce the risk of having to breach
But I can’t completely insulate myself from risk
Suppose that for each $27,726 I invest, I can reduce the probability I will need to breach by ½
That is, if I invest $27,726, the probability of breach goes from ½ to ¼
If I invest another $27,726, it goes down to 1/8
And so on
For any investment z, then, we can write the probability that breach is still required as ½ * ½ ^(z / 27,726)
The reason I chose the number 27,726 is that we can rewrite this probability as
½ e^{- z/40,000)
which makes it much easier to work with.

35. 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?
How much will I choose to invest in performance?

36. 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)
Efficient level?
Social surplus is 330, ,000 if costs stay low, 0 if costs rise
So expected social surplus is (1 – p(z)) (430,000) – z
430,000 – 430,000 * 0.5 * e–z/40,000 – z
Take derivative to maximize this:
– 430,000 * 0.5 * (–1/40,000) e– z/40,000 – 1 = 0
Could solve for z, but simpler to solve for p(z)
0.5 * e– z/40,000 = 40,000 / 430,000 = p(z)
Efficient level of investment in performance is enough to reduce probability of breach to 40,000/430,000
What will promisor actually do?
Private gain to promisor is 100,000 when costs stay low, -D when costs go up, minus whatever he invests in performance
Expected private gain is
(1 – p(z)) 100,000 + p(z) (-D) – z
100,000 – p(z) (100,000 + D) – z
100,000 – (100,000 + D) * 0.5 * e–z/40,000 – z
– (100,000 + D) * 0.5 * (–1/40,000) e– z/40,000 – 1 = 0
Again, solve for p(z)
0.5 * e– z/40,000 = 40,000 / (100,000 + D) = p(z)
For any level of liability D, promisor invests enough to reduce probability of breach to 40,000/(100,000+D)

37. What do these results mean?
What is the efficient level of investment in performance?
Enough so that p(z) = 40,000/430,000
What will promisor do under various rules for damages?
Enough so that p(z) = 40,000/(100,000 + D)
So if D = 330,000, efficient investment in performance
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
The efficient level of investment leads to a 40,000/430,000 chance of breach
Damages which are set equal to D lead to a self-interested promisor to allow a probability of breach of 40,000/(D + 100,000)
So when damages are set to 330,000 – damages include the benefit from reliance – the investment in performance is efficient
When damages are lower than that, the seller will underinvest in performance, leaving the risk of breach inefficiently high
When damages are higher than this, the seller will overinvest in performance
And what’s the overall lesson?
Making the seller liable for reliance – that is, increasing expectation damages to include benefit due to reliance – leads the seller to invest efficiently in performance; just like it led to efficient breach
But it leads the buyer to overinvest in reliance
On the other hand, making the seller not liable for reliance – leaving expectation damages where they were without reliance – leads to underinvestment in performance
But it leads to the efficient level of reliance
So like we saw last week with the sailboat example from Friedman:
The level of damages leads to multiple different incentives
And it’s impossible to come up with a level of damages that makes everyone behave efficiently
We already saw one attempt to get around this problem:
limit damages to the efficient level of reliance, not the actual level of reliance
that way, the promisee has no incentive to overinvest in reliance, so he invests the efficient amount
but the promisor still internalizes the full cost of breach
so he invests the efficient amount in performance
Textbook gives another clever, if unrealistic, solution, which is where we’ll start on Thursday

38. Effects of different remedies on…. decision to perform or breach
Effects of different remedies on… decision to perform or breach decision to sign or not sign investment in performing investment in reliance
That’s it for today
Wednesday, we’ll finish up contract law