Working Paper: NBER ID: w3696
Authors: Lucian Arye Bebchuk; Steven Shavell
Abstract: According to the contract law principle established in the famous nineteenth century English case of Hadley v. Baxendale, and followed ever since in the common law world, liability for a breach of contract is limited to losses "arising ... according to the usual course of things," or that may be reasonably supposed "to have been in the contemplation of both parties, at the time they made the contract, ..." Using a formal model, we attempt in this paper to analyze systematically the effects and the efficiency of this limitation on contract damages. We study two alternative rules: the limited liability rule of Hadley, and an unlimited liability rule. Our analysis focuses on the effects of the alternative rules on two types of decisions: buyers' decisions about communicating their valuations of performance to sellers; and sellers' decisions about their level of precautions to reduce the likelihood of nonperformance. We identify the efficient behavior of buyers and sellers. We then compare this efficient behavior with the decisions that buyers and sellers in fact make under the limited and unlimited liability rules. This analysis enables us to provide a full characterization of the conditions under which each of the rules induces, or fails to induce, efficient behavior, as well as the conditions under which each of the rules is superior to the other.
Keywords: contract law; liability; Hadley v. Baxendale
JEL Codes: K12; K13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| type of liability rule (K13) | decision-making processes of buyers (D91) |
| type of liability rule (K13) | decision-making processes of sellers (L14) |
| high valuation buyers communicate valuations (D46) | sellers take appropriate precautions (D18) |
| limited liability rule (K13) | high valuation buyers identify themselves (G24) |
| unlimited liability rule (K13) | high valuation buyers do not communicate valuations (G19) |
| communication costs exceed benefits (L96) | neither liability rule yields efficient behavior (K49) |