ECON 1450 * Professor Berkowitz Lectures on Chapter 1

ECON 1450 – Professor Berkowitz
Lecture Notes -Chapter 5
• Remedies for Breach of Contract
• Efficient Breach Model
• Previous lectures – what promises should be legally
• 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
• Uncertainty about offers from alternative
• 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 homeowner’s 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
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
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
• 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
• Seller’s breach decision – seller’s return w.
breach = - D, seller’s 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 = buyer’s 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
• Ch > CL, and Ch > V > CL
• 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 - CL) + (1-q)(-R) =
• q(V – R) - R
R^ - efficient reliance
• Max qV(R) – qCL – R
• Max qV(R) – R
• See Figure 5.2 – R^ < R* (case of no
uncertainty) => buyer should invest less to
account for losses when high costs are realized
• Show that dR^/d(1-q) < 0 (or dR^/dq > 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
• 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.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!
Hadley v. Baxendale, cont’d
• With unlimited damages, buyer get R’ and
with expectation damages buyer gets R^ only
• Expectation damages and buyer’s 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
Mitigation of Damages
• Example – owner of duplex agrees to rent an
apt to a student for 12 months at $300 per
• 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 – cont’d
• Landlord refuses to take on new lease holder
• Student admits to breaching contract
• Student also argues landlord should only get
• 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
Commercial impracticability
• Courts discharge contracts when performance
is feasible but economically burdensome
• Conditional rule that discharges performance
without penalty when costs are sufficiently
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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