Working Paper: NBER ID: w0714
Authors: A. Mitchell Polinsky
Abstract: This paper examines the sharing of risk under three different remedies for breach of contract. The risk considered arises from the possibility that, after a seller and buyer have entered into an agreement for the exchange of some (not generally available) good, a third party who values the good more than the original buyer may come along before delivery has occurred; the seller will want to breach. It is shown that this risk is optimally allocated by the expectation damage remedy if the seller is risk neutral and the buyer is risk averse, by the specific performance remedy if the opposite is true, and by a liquidated damage remedy if both parties are risk averse. The level of damages under the liquidated damage remedy is also shown to be bounded by the expectation measure of damages and a "damage equivalent" to the specific performance remedy. By means of a numerical example, it is shown that use of the prevailing remedy for breach of contract -- the expectation damage remedy -- may plausibly cause a welfare loss of as much as 20% due to inappropriate risk sharing.
Keywords: No keywords provided
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expectation damage remedy (D84) | risk allocation (G22) |
| seller is risk neutral and buyer is risk averse (D81) | expectation damage remedy optimally allocates risk (D84) |
| specific performance remedy (L14) | risk allocation (G22) |
| seller is risk averse and buyer is risk neutral (D81) | specific performance remedy optimally allocates risk (D61) |
| liquidated damage remedy (G33) | risk allocation (G22) |
| both parties are risk averse (D81) | liquidated damage remedy optimally allocates risks (G33) |
| expectation damage remedy used inappropriately (K13) | welfare loss (D69) |