Principles of Contract Damages

Possible remedies when a contract is breached:

1) the promisee’s reliance loss (the cost incurred in reasonable reliance on the promisor’s performing the contract)

2) the expected loss (loss of the anticipated profit of the contract)

3) liquidated damages (damages actually specified in the contract as a money remedy for a breach)

4) consequential damages (ripple effects on the promisee’s business from the breach)

5) restitution (to the promisee of the promisor’s profits from the breach)

6) specific performance (ordering the promisor to perform on the penalty of being found in contempt of court)

7) a money penalty specified in the contract, or punitive damages.

The first question to ask is, is the breach opportunistic? Example, A contracts to deliver goods to B in the future while taking immediate payment, A then uses the money for something else, and of course, never delivers the goods. It is economically efficient to always deter this type of behavior. Minimum penalty—promisor turns over all profits derived from the breach.

We want to consider the vast majority of breaches that could be construed as efficient. These breaches may be involuntary because performance has become impossible (at least at a reasonable cost). The breach may also be voluntary but efficient.

Two individuals A and B enter into a contractual agreement. Let EP A and EP B be the expect profits that will result from the contractual arrangement, for A and B respectively.

Ex ante, an economically efficient contract is one in which:

                                                                               EP A + EP B > 0

Suppose sometime after the contract was signed but before its completion an unexpected event (why must it be unexpected?) makes it unprofitable for B to fulfill her part of the agreement. Further suppose that if the contract was actually completed the actual joint profits would be negative:

                                                                                P A + P B < 0

In this case the breach of contract is efficient.

Consider in this context Holmes’s dictum: It is not the policy of the law to compel adherence to contracts but only to require each party to choose between performing in accordance with the contract and compensating the other party for injury resulting from failure to perform.

Example, I order 100, 000 custom ground widgets for my factory. After taking delivery of 10,000, the market for my final product collapses and I cancel delivery of the remaining 90,000 widgets. My suppler, who has not yet begun to produce the additional widgets, informs me that he intends to produce the remainder of the widgets and expects me to pay the price specified by the contract. Would it be efficient for the supplier to manufacture the remainder of widgets? If the court applies Holmes’s dictum do this case what remedy would it impose? Would this remedy result in efficient behavior on the part of both parties?

Query: Since there are only two parties to this disagreement won’t the Coase theorem apply so that the parties will reach an efficient solution to their problem without the necessity of contract law?

What if in the above case all 100,000 widgets have been manufactured but are still in the possession of the seller? What if possession has been transferred to the buyer?

Suppose the contract is broken by the suppler. After producing 50,000 widgets he has a mechanical breakdown and is unable to continue production. Suppose there are alternative sources of supply, who should be responsible for securing the widgets from an alternative source, the seller or the buyer? What is the efficient remedy in this case?

Suppose I sign a contract to sell 100,000 custom widgets to A for 10 a piece. Suppose after I have produced and delivered 10,000 to A, B comes to me with an emergency request for 25,000 custom widgets that are necessary to keep his pionola factory from being forced to close down, further, suppose he offers to pay 15 per widget. Suppose my failure to deliver to A in a timely manner causes him to lose $1000 in lost profit but that I make an additional profit of $1200 by selling to B (this sum is over and above what I would have made selling to A in a timely manner).

What if:

                                                                                  P A <0   But  P A + P B > 0

In this case A will lose money if he completes the contract, but the profit, from completion to B is large enough so that in total the contractual relationship is profitable. Is performance in this case economically efficient? Would use of Holmes’s dictum result in performance?

Suppose A agrees to sell B a machine for $100,000. Before A begins production of the machine she realizes that she will lose $5000 on the transaction and she defaults on the contract. In this case B has born no reliance costs, suppose however it would cost him $112,000 to buy a machine from an alternative manufacturer. Is there any important additional information in this example?

In Groves v. John Wunder Co., as part of a larger job the plaintiff contracted to have some land leveled. The cost of leveling the land was $60,000, but the value of the land after leveling would have been no more then $12,000—since the signing of the contract the depression had intervened lowering the value of the land. The defendant did not level the land. The court awarded the plaintiff the $60,000, the plaintiff did not have the land leveled with the money he received. Was the loss imposed on the plaintiff $60,000? Was this an efficient breach? What potential problems could this damage award create?

Measurement of expectations: 1) A tenant defaults, and the landlord promptly rents the apartment to a new tenant at a slightly lower rental rate. 2) A manufacturer receives an order for 1,000 widgets from X, but X refuses to take delivery. The manufacturer resells the widgets at a slightly lower price. Should the landlord be required to deduct the rent received from the new tenant? Yes. Should the manufacture be required to deduct the price he receives from the alternative buyer? No. Explain why these cases are different. What are the potential problems associated with measuring profits and costs in these types of cases?

Consequential damages: Cases like Hadley v. Baxendale involve asymmetric knowledge of risk. Only one party knows the extent of potential harm resulting from a loss, that party should take precautions or if the other party (the second party) can avoid the loss at a lower cost the first party should reveal the consequences of the loss to the second party to induce increased care and precaution. The term used in these cases is foreseeability of the risk. Why might economists question the value of the foreseeability concept?

Why don’t the courts generally enforce penalty clauses in contracts?

In general court imposed specific performance is not economically efficient. Why? Why does specific performance violate Holmes’s dictum.

When there is a breach self-help is sometimes cheaper (and thus more efficient) than a suit. For example, a car dealer may simply reposes a car rather than take a buyer who defaults on the car loan to court. But the self-help remedy must not be significantly out of line with the actual damages.