Breach of Contract: An Economic Analysis of the Efficient Breach Scenario (International Law and Economics) [1st ed. 2021] 9783030625245, 9783030625252, 3030625249

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International Law and Economics

Oliver Hofmann

Breach of Contract An Economic Analysis of the Efficient Breach Scenario

International Law and Economics Series Editors Stefan Voigt, University of Hamburg, Hamburg, Germany Anne van Aaken, University of St. Gallen, St. Gallen, Switzerland Andrew T. Guzman, University of California at Berkley, Los Angeles, USA Stefan Oeter, University of Hamburg, Hamburg, Germany Joel P. Trachtman, Tufts University, Medford, USA Naigen Zhang, Fudan University, Shanghai, China

The world has been experiencing a long period of globalization. At the same time, ever more international law has been created to deal with the many consequences of globalization such as problems of coordination, spillover effects across countries, the protection of foreign direct investment or the prosecution of crimes against humanity. To date, the economic analysis of international law has been lagging behind this development. This series aims at changing this by contributing to the understanding of international law. It strives to be a forum for contributions on all aspects of the economic analysis of international law ranging from the analysis of the genesis of international law, its ratification, its effects on government behavior, the means to monitor compliance to sanctions against actors not complying with the law.

More information about this series at http://www.springer.com/series/13428

Oliver Hofmann

Breach of Contract An Economic Analysis of the Efficient Breach Scenario

Oliver Hofmann University of Hamburg Hamburg, Germany

ISSN 2364-1851 ISSN 2364-186X (electronic) International Law and Economics ISBN 978-3-030-62524-5 ISBN 978-3-030-62525-2 (eBook) https://doi.org/10.1007/978-3-030-62525-2 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG. The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Contents

1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Content of the Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.1 Scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.2 Method: Law and Economics . . . . . . . . . . . . . . . . . . . . 1.1.3 Remedies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Limits of the Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.1 Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.2 Enforcement of Contracts . . . . . . . . . . . . . . . . . . . . . . . 1.2.3 Optimal Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.4 Type of Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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1 2 2 4 7 9 9 9 10 11 11

2

Breach or Perform Decision: The Traditional Model of the Efficient Breach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Expectation Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Specific Performance and Renegotiating the Contract . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15 16 18 20

Distributional Effects and the Original Contract . . . . . . . . . . . . . . 3.1 Price Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Interaction Between Remedies and Bargaining Power . . . . . . . . 3.2.1 Determinants of Bargaining Power . . . . . . . . . . . . . . . . . 3.2.2 Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.3 Disagreement Points . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 Probability of an Increase in Costs . . . . . . . . . . . . . . . . . 3.3.2 Magnitude of Increase . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.3 Bargaining Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Unsuccessful Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 Expected Unsuccessful Renegotiation . . . . . . . . . . . . . . 3.4.2 Unexpected Unsuccessful Renegotiation . . . . . . . . . . . .

23 24 26 26 27 29 38 40 42 43 44 44 45

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3.5 Result . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

46 47

The Option to Cover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 When Does the Option to Cover Exist? . . . . . . . . . . . . . . . . . . . 4.1.1 Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.2 Subjective Perspective . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Consequences for Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 Homogenous, Fungible, and Other Goods of Equal Kind and Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.2 Differentiated Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Result . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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49 50 51 51 52

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52 59 65 66

5

Over- and Undercompensation . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 The Shortfall of Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.1 General Reasons for Shortfall . . . . . . . . . . . . . . . . . . . . 5.1.2 Shortfall of Damages Beyond the Money . . . . . . . . . . . . 5.1.3 Modeling the Shortfall . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.4 Shortfall of Damages and Bargaining Power . . . . . . . . . . 5.1.5 Shortfall Due to Litigation Costs . . . . . . . . . . . . . . . . . . 5.1.6 Keeping Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.7 Shortfall and Renegotiation . . . . . . . . . . . . . . . . . . . . . . 5.2 Overcompensatory Damages . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3 Result . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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67 67 68 71 74 78 83 87 93 96 97 98

6

Incomplete Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1 Buyer Having Private Information About His Valuation . . . . . . . 6.1.1 Effect of Seller’s Incomplete Information on Standard Model (Ex Post) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1.2 Ex Post Stage: Renegotiation . . . . . . . . . . . . . . . . . . . . . 6.1.3 Taking the Ex Ante View: Negotiation at the Contracting Stage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Seller Having Private Information About Her Costs . . . . . . . . . . 6.2.1 Ex Post Effects of Seller’s Private Information . . . . . . . . 6.2.2 Ex Ante Effects of Seller’s Private Information . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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101 101

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102 107

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140 205 206 210 220

Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1 Renegotiation Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1.1 Scale of Renegotiation Costs . . . . . . . . . . . . . . . . . . . . . 7.1.2 Renegotiation and Incomplete Information . . . . . . . . . . . 7.1.3 Renegotiation and Preferences for Fairness . . . . . . . . . . . 7.1.4 Prospect Theory and the Endowment Effect . . . . . . . . . .

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223 224 224 229 230 231

4

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Contents

7.2

Contracting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2.1 Difference in Contracting Costs . . . . . . . . . . . . . . . . . . . 7.2.2 Inefficient Contracting Due to Flawed Estimation of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3 Litigation Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3.1 Relationship of Assessment and Bargaining Costs . . . . . . 7.3.2 Constrains for Assessing Damages . . . . . . . . . . . . . . . . . 7.4 Enforcement Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5 Result . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8

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237 237

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239 246 248 254 255 256 257

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

261 268

Chapter 1

Introduction

It is an important topic in legal theory and law and economics how contracts and the law should protect the buyer’s entitlement to the performance of a contract. In my work, I analyze the so-called efficient breach scenario: After two parties have concluded a contract the circumstances change rendering the costs of performance higher than the buyer’s valuation. What should the remedy look like to resolve such situations? Different jurisdictions have provided different answers. In civil law countries, specific performance is the predominant remedy while common law countries have installed expectation damages as the remedy for most cases. In practice, those differences between jurisdictions may be rather in degree than in kind but remain to be of importance (Katz 2005, p. 384). In the international context, the CISG does not take a clear stand. It generally gives the parties a right to specific relief but at the discretion of the court if its domestic law would not grant specific relief.1 In the literature, the debates are vibrant when it comes to the stipulated idea of an efficient breach of contract.2 Early proponents of the efficient breach theory viewed expectation damages which set damages equal to the buyer’s valuation as the tool to achieve efficient decisions about whether to breach or to perform (Birmingham 1970; Barton 1972). At the same time, the buyer is made indifferent which allegedly suffices moral demands (Shavell 2006a). The early version of the efficient breach theory has been widely discussed and criticized (Klass 2014, p. 367). Some reject the idea for moral reasons3 while others point to economic caveats. Those economic shortcomings range from failing to account for transaction costs and the possibility of renegotiation, over assuming

1

See Art. 46, 28, 62 CISG. See for example: Markovits and Schwartz (2011), Eisenberg (2006, p. 562), Eisenberg (2005), Friedman (1989a), Shiffrin (2009), Shiffrin (2007), Brooks (2006). 3 See as an example Shiffrin (2009). 2

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 O. Hofmann, Breach of Contract, International Law and Economics, https://doi.org/10.1007/978-3-030-62525-2_1

1

2

1 Introduction

perfect information, to neglecting the effect on the original contract.4 Acknowledging the complexity if one takes into account those additional aspects and that the choice of remedy depends on the particular situation transforms the theory of efficient breach to a theory of efficient remedy.5 There is not one remedy that serves the parties best under all circumstances. It is necessary to assess what remedy is superior under what circumstances such that either the lawmaker or the parties themselves can make an informed choice. In this spirit, my work contributes by analyzing distributional effects and efficiency under specific performance and expectation damages. My work puts a focus on three topics that have not got the deserved attention so far: the influence of the market structure,6 the informational structure, and insights from behavioral economics about human behavior. This book is structured in seven parts. Subsequent to the introduction I depict the standard economic model of the efficient breach scenario in the second part. Chapter 3 takes a look at the formation of the original contract and focuses on distributional effects. Chapter 4 analyzes how the market structure interacts with the efficient breach scenario. In Chap. 5 we will assess the effects of damages being under- and overcompensation. Chapter 6 departs from the assumption of complete information. As Klass observes, the literature rarely mentions the importance of the standard model that the seller knows the buyer’s valuation (Klass 2014, p. 369, Fn. 20). In addition, the impact on the original contract is a main issue. Chapter 7 puts a new view on the impact of different kinds of transaction costs, renegotiation, contracting, litigation and assessment costs, and their relationship under both remedies.

1.1 1.1.1

Content of the Analysis Scenario

The classical depiction of the efficient breach scenario is as follows7: A “buyer”8 signs a sales contract with a “seller” to purchase a good or service and pay a certain price in exchange. The following analysis concentrates on contracts which concern the duty to give. This means a good already exists and needs to be transferred to the 4

See for an overview Klass (2014, p. 369); see for the importance to include the original contract formation into the analysis (Friedman 1989b, p. 303). 5 See for a similar point Klass (2014). 6 Already Friedman emphasized the importance of the market structure for the analysis, see Friedman (1989b, p. 284). 7 Early illustrations of the efficient breach scenario are given by Birmingham (1970) and Barton (1972). 8 In my analysis I will speak about buyers and sellers but it applies equivalently to other types promisees and promisors.

1.1 Content of the Analysis

3

Fig. 1.1 Timeline of efficient breach scenario

buyer.9 As events transpire the seller’s costs to perform the contract increase.10 This can be due to a rise of the costs to procure and deliver the sold item or of the seller’s opportunity costs (Riehm 2015, p. 173; Eisenberg 2005, p. 997). The former scenario is called “loss-avoiding” scenario or loss paradigm and the latter one “gain-seeking” scenario or overbidder paradigm.11 The latter scenario is typically illustrated by the seller’s opportunity to sell performance to a third party who offers to pay a higher prize (Riehm 2015 p. 173; Eisenberg 2005, p. 997). Beyond this classical scenario, the analysis applies to a wide bouquet of situations where the seller’s valuation increases after the conclusion of the contract. It is no different than an increase in her costs. Consider a Football club transferring their second goalkeeper to another club. But after the contract is signed their first goalkeeper gets injured. Now the club’s valuation of their second goalkeeper increases profoundly. Similarly, a shipping company sells one of its older ships. But due to an accident, one of its newer ships is wrecked. In consequence, the sold ship is important for the shipping company to fulfill its obligations. One can also find examples from M&A transactions. A company sells a subsidiary. A new board is elected which wants to steer the company in a different direction rendering its valuation of the subsidiary much higher. Think of a patent a company holds. The company transfers its exclusives rights to another company. But new research shows that the use of the patent will be of higher value to the former patent holder than she initially thought. All those scenarios are depicted by Fig. 1.1. My work analyzes how different remedies for a breach of contract affect the parties’ behavior and discusses what remedy leads to superior results. I focus on two types of remedies: specific performance and expectation damages. Other remedies will be discussed only if the respective issue demands for it; for instance, liquidated damages as a measure to overcome asymmetric information. The classical debate on

9

The alternative to the duty to give is the option to act, see Lando and Rose (2004, p. 475). Lando and Rose argue that the duty to act is barely enforced. In contrast, they presume that the duty to give is often enforced. 10 A rise in costs can occur do to a change of circumstances or because new information is received after the contract is signed. 11 Eisenberg (2005, p. 997); in my analysis I will use the terms “loss-avoiding” and “gain-seeking” scenarios.

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1 Introduction

efficient breach focused only on the decision about performance once the seller’s costs have increased (“ex post”). My analysis encompasses the effect the remedies have on the formation of the contract in the first place (“ex ante”). It is important to draw a clear distinction between those two situations because they differ fundamentally. Prior to the signing of the contract, the parties are free to walk away unboundedly. There can be many other potential sellers and buyers the parties can sign the contract about the same kind of performance with. Once the parties have entered into the contractual relationship, renegotiation takes place only between the two parties of the contract and they are not free to walk away but bounded by the contract. The applied method is the economic approach to law which I outline in the next section.

1.1.2

Method: Law and Economics

Law and economics sees law not as an end in itself but as a means to an end. The relevant factor that defines how the law should be designed is the result that one wants to achieve. In a broader picture, the economic analysis of law is part of a wider approach that comprehends law through its goals (Weinrib 2012, p. 3). This strand of thoughts sees law as a tool “to serve human needs” (Calabresi 1975, p. 105). It is called “functionalism.”12 In the eyes of law and economics, law sets incentives affecting people’s behavior to achieve the desired result. The same holds for the design of contracts. Building on that, the purpose of remedies for a breach of contract is to set the right incentives (Shavell 2006b, p. 868). Starting from the overall objective it needs to be assessed what behavior leads to the desired objective and what incentives lead to the desired behavior. The aim is to design the remedies such that the incentives the parties face are aligned with those that lead to the desired behavior. Against this benchmark, we compare the different outcomes produced by the remedies.13 The following section provides an overview of the overall objective of the economic approach to law stipulates and the tools which are applied to model and predict the parties’ behavior.14

12 Weinrib (2012, pp. 3, 5): the functional approach to private law is criticized for neglecting the internal “concepts, a distinctive institutional setting and a characteristic mode of reasoning.” The opposite concept is “legal formalism;” see Weinrib (2012, p. 19). 13 See for the general concept to compare the economic outcomes of different policies: Boadway (2016, p. 2). 14 See for that distinction: Bechthold (2010, p. 26).

1.1 Content of the Analysis

1.1.2.1

5

Welfare Economics

Law and economics conventionally builds on welfare economics (Parisi 2004, p. 266; Bechthold 2010, p. 27; Schäfer and Ott 2012, p. 38). The objective is to maximize social welfare (Mathis 2009, p. 96; Eidenmüller 2015, p. 173). Traditionally social welfare is the aggregation of the subjective welfare of individuals (Parisi 2004, p. 269; Boadway 2016, p. 49); their utility (Boadway 2016, p. 49; Piet al. 2014, p. 144; Bechthold 2010, p. 27; Schäfer and Ott 2012, pp. 3, 58; Kirchgässner 2013, pp. 11, 21). The utility an individual receives from a good or a service depends on their preferences (Bechthold 2010 p. 27). Since those are not observed we rely on individuals to reveal their preferences through their choice of action (Boadway 2016, p. 49). The individual’s utility is transferred to a money metric.15 This is done by using someone’s willingness to pay (WTP), i.e., the maximum amount one is willing to spend to make the expenditure, or to someone’s willingness to accept (WTA), i.e., the minimum amount one demands to give something up (Boadway 2016, p. 53; Bechthold 2010, p. 28). Having this one metric allows interpersonal comparisons.16 The comparison of two possible states is done by taking the sum of the individuals’ willingness to pay or to accept and applying the Kaldor-Hicks criterion: A state is superior to another if the total gains from moving to that state outweigh the total losses and thus the winners can potentially compensate the losers.17 In that and I follow this approach in my work, we determine and analyze distribution separately from efficiency (Boadway 2016, p. 57). Moreover, it is important to note that I assume that the parties are risk neutral.18

1.1.2.2

Homo Economicus

The traditional model to predict human behavior in law and economics is the homo economicus.19 The homo economicus maximizes his expected utility (Pi et al. 2014, p. 144). When he chooses between different alternatives, he chooses the one giving 15

Boadway (2016, p. 53), Bechthold (2010 p. 28); see for an overview of possible states that should be maximized according to different approaches: Parisi, Positive, Normative and Functional Schools in Law and Economics, 267. 16 Boadway (2016, p. 49); on the downside, possibly aspects might be included which are of a certain value but cannot be converted: Parisi, Positive, Normative and Functional Schools in Law and Economics, 269. 17 Schäfer and Ott (2012, p. 20). The main alternative criterion is the Pareto criterion: An optimal state of allocation is given if the well-being of no individual cannot be improved without negatively affecting the well-being of another individual (Bechthold 2010, p. 28; Schäfer and Ott 2012, p. 20; Parisi, Positive, Normative and Functional Schools in Law and Economics, p. 267). The KaldorHicks test is inter alia criticized on the basis that the sum of individual’s payoffs does not take into account the diminishing marginal utility of wealth. See for alternative approaches to derive the objective welfare function: Boadway (2016, p. 57). 18 See for risk attitudes: Schäfer and Ott (2012, p. 438). 19 See for an overview and critical views: Schäfer and Ott (2012, p. 95).

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1 Introduction

him the highest payoff (Pi et al. 2014, p. 144). In that he acts rational and selfinterested. The predicted behavior is determined by exogenous restrictions and individual preferences (Schäfer and Ott 2012, p. 95). Rationality requires the individual’s preferences about the available choice alternatives to be complete, transitive, and independent (Schäfer and Ott 2012, p. 95). Self-interest means that the actor does not take into account other’s preferences and outcomes are evaluated on the effects for himself (Schäfer and Ott 2012, p. 99). The assumption of self-interest-seeking does not necessarily imply myopic decision making (Williamson 1993, p. 459). It allows a farsighted understanding of economic actors and their consideration of long-term consequences of their actions (Williamson 1993, pp. 459, 460).

1.1.2.3

Behavioral Law and Economics

Economics in general and the economic analysis of law experience a fundamental change. The outlined model of the homo economicus has been challenged by an ever-growing number of empirical studies (Zamir and Teichman 2014, p. 2). Insights, originally from social and cognitive psychology (Ulen 2014, p. 177), show systematic deviations of human behavior from economic rationality and from the assumption of self-interest (Jolls et al. 1998; Tversky and Kahneman 1991; Kahneman and Tversky 1979; Kahneman et al. 1990; Bechthold 2010, p. 23; Zamir and Teichman 2014, p. 2; Schäfer and Ott 2012, p. 103). People are subjects to bounded rationality (Williamson 1993, p. 458). This means they intend to act rational, but due to cognitive limits they fail systematically. Those limitations prevent people from taking optimal choices. Bounded self-interest implies that people’s utility function does not only include to maximize one’s wealth, but that people have social preferences (Engel 2018; Fehr and Schmidt 2004); for instance treat others and being treated fairly (Jolls et al. 1998, p. 1479). Those findings gave rise to the field of behavioral law and economics.20 The systematic deviations from the homo economicus are integrated into the model and improve it.21 A widely discussed question is whether and to what extent behavioral law and economics applies to companies (Tor 2014, pp. 546, 547). It is argued that a company’s goal is to maximize profit and shareholders expect them to because they want to receive the maximum return of investment (Schwartz and Scott 2003, pp. 550, 551). Thus, even if managers take their social preference into consideration 20 There are alternative approaches to sketch human decision making which deviates from rational choice. See for an overview Mitchell (2014). 21 Zamir and Teichman (2014, p. 2), Bechthold (2010, p. 25); the opposing view argues that those anomalies depicted by behavioral economics cannot be accommodated by the rational choice model but have such weight that they will lead to a new paradigm; Ulen (2014, p. 112). See for an overview of the criticism, like questioning the external validity of laboratory experiments, of behavioral law and economics (Mitchell 2014, p. 177).

1.1 Content of the Analysis

7

they are controlled by shareholders (Schwartz and Scott 2003, p. 551). In contrast, Hart and Zingales recently argued that shareholders have social preferences and therefore maximization of shareholder welfare would not be the same as maximization of market value (Hart and Zingales 2017). Concerning bounded rationality, the market is argued to put pressure on firms and the employees to act rational. Otherwise the firms would lose market share and the employees are less likely to receive a position with responsibilities (Schwartz and Scott 2003, p. 551). However, the empirical evidence provides a more complex picture. It shows that business managers take decisions more rationally but often they make mistakes like other individuals (Tor 2014, pp. 546, 547). Therefore, even though behavioral law and economics does not apply to firms to the same extent the findings remain relevant. I do not provide a general discussion of behavioral law and economics and do not depict a general list of the deviations that have been determined.22 Instead, I will refer to behavioral law and economic findings throughout my work as they become relevant. I will assess the influence of behavioral insights on the analysis in general and not constrained to individuals. But one needs to be aware that those results do not simply apply to firm’s behavior.

1.1.3

Remedies

This chapter serves to clarify the meaning of the remedies for breach of contract.

1.1.3.1

Specific Performance

Specific performance allows the buyer to sue and coerce the seller to perform the duty specified in the contract (Riehm 2015, p. 8). In my analysis I presume an unconstrained form of specific performance, i.e., the buyer always has the option to claim performance even under extreme circumstances and extraordinary increases in seller’s costs. For instance, this is different in German law that endows the buyer with a right to specific performance. German law places limits on that right in case performance is impossible or the costs of performance are unproportionally high.23 But if the seller causes such situation with intent or neglectingly the law empowers the buyer to disgorge the seller from any profit made.24 As a result, the seller has no incentive to breach a contract willfully in the efficient breach scenario because the buyer would seize the profit.

22

See for an overview: Schäfer and Ott (2012, p. 104), Epstein (2006). See § 275 BGB (German Civil Code). 24 See § 285 BGB (German Civil Code). 23

8

1.1.3.2

1 Introduction

Expectation Damages

In contrast to specific performance, the remedy expectation damages do not require the seller to perform by delivering the good or service but to compensate the buyer in money (Eisenberg 2005, p. 979). Expectation damages are based on the indifference principle (Eisenberg 2005, p. 979; Riehm 2015, p. 171; Markovits and Schwartz 2011, p. 1939). The seller needs to put the buyer where he would have been if the contract had been performed.25 Emphasis needs to be drawn to the fact that the state of comparison is the hypothetical performance by the seller and not the buyer’s situation before the parties entered into the contract. In comparison, restoring the promisee to the position she was in before the contract was concluded would grant her so-called reliance damages. As the law and economics literature predominantly views expectation damages superior to reliance damages, I will not further discuss the latter in this book.26

1.1.3.3

Penalty Clauses

Penalty clauses impose the duty on the seller to pay a high amount of damages to the buyer in case of breach. The amount is unrelated to the buyer’s valuation and supposed to take such a high value that it prevents the seller from breaching without consent.27 In theory, specific performance and penalty clauses do not differ in respect of their results because it is assumed that also with the specific performance the buyer can make the seller perform. Therefore, I will not discuss penalty clauses separately.

1.1.3.4

Liquidated Damages

Liquidated damages for breach of the contract mean a sum of money due to be paid if the seller does not perform specified by the parties in the contract. In contrast to penalty clauses, the amount of damages approximates the buyer’s damages. I will not generally discuss liquidated damages but only refer to them when the issue demands for it.

See for example the German Civil Code § 249 Abs. 1 BGB and for the American Law Restatement (Second) of Contracts § 344(a) (1981); Restatement 1932 § 329; Ulen (1984, p. 360). Eisenberg (2005, p. 979); Craswell (1988, p. 636). 26 See Mathis (2009, p. 103). 27 German law explicitly regulates the possibility to agree on a penalty for not fulfilling one’s obligation, see § 340 BGB (German Civil Code). The amount shall generally not be unproportionally high. Otherwise a court can reduce the amount the penalty takes, see § 343 BGB (German Civil Code). In most common law countries, i.a. in US and English law punitive elements in contractual damage clauses are not enforceable. 25

1.2 Limits of the Analysis

1.1.3.5

9

Property and Liability Rules

Specific performance and expectation damages are part of a broader distinction of remedies in law: property and liability rules. A property rule is one that makes it necessary for a transfer of the entitlement that it is bought from the rightsholder leading to a voluntary transaction (Calabresi and Melamed 1972, p. 1092). The entitlement holder has the right to prevent an infringement (Schäfer and Ott 2012, p. 551; Bechthold 2010, p. 144 Fn. 585). Specific performance is a property rule (Markovits and Schwartz 2011, pp. 1939, 1941, 2017, p. 9; Kronman 1978, p. 352). The entitlement rightsholder can insist on specific performance (Depoorter and Tontrup 2012, p. 712 Fn. 170, 173). In contrast, a liability rule allows “infringing” the right and in return paying the price in the form of damages (Calabresi and Melamed 1972, p. 1092; Markovits and Schwartz 2011, p. 1941). The rightsholder cannot prevent the infringer from doing so “ex ante” but just get compensation “ex post” (Schäfer and Ott 2012, p. 551; Bechthold 2010, p. 144 Fn. 585). In contract law, a provision that allows the buyer to sue for expectation damages is a liability rule (Markovits and Schwartz 2011, pp. 1939, 1941, 2017, p. 9). The rule “expectation damages” grants the seller the option not to perform but to pay monetary compensation (Kronman 1978, p. 352; Depoorter and Tontrup 2012, p. 712 Fn. 170, 173).

1.2 1.2.1

Limits of the Analysis Method

My work does not discuss the value of an economic approach to law in general. This has been debated elsewhere and seems unnecessary to be repeated (Dworkin 1980; Mathis 2009; Eidenmüller 2015). Furthermore, I will not address the debate whether the economic approach is applicable when interpreting the law (Fezer 1986, p. 822; Fezer 1988, p. 224; Kirchner 1997; Schäfer and Ott 1988, p. 213; Eidenmüller 2015; Mathis 2009).

1.2.2

Enforcement of Contracts

Analyzing different remedies for breach of contract is related to the question, why should the state enforce contracts in general? Both issues need to be kept distinct.

10

1 Introduction

The question about which remedy should apply presupposes that the state enforces contracts.28 From an economic perspective, the enforcement increases the reliability of contracts. This enables the parties to make efficient relation specific investments.29 The buyer is protected against a breach of contract (Schwartz and Scott 2003, p. 562). Contracts allow people to agree on something today they will do tomorrow (Schwartz and Scott 2003, p. 557); and by being bound through the contract the promise is not only cheap talk but credible. In that, the seller can signal her ability to perform in the future because the inability to perform comes with costs. It follows that the enforcement of contracts plays a role if goods and services on the one hand and money on the other hand are not exchanged immediately like in a spot market. Nevertheless, this conclusion does not predetermine how to protect the buyer in a general way.

1.2.3

Optimal Investment

Another issue that concerns the choice of remedy is their effect on the parties’ investment. My analysis focuses on the scenario of efficient breach and concerns only the so-called exchange efficiency. I do not consider how the remedies influence investment decisions.30 28 Arguments that are concerned with the question why contracts should be enforceable cannot be simply used to argue for one or the other type of remedy. Thus, arguing for specific performance by raising the necessity to protect relation specific investment in a general form is beside the point as all remedies protect relation specific investment. The fallaciousness of such arguments comes out clear if it is alleged that the parties have to insure against non-performance under a remedy of expectation damages. This oversees that expectation damages function similarly to an insurance in particular because insurances involve monetary payments and not specific performance (Riehm 2015, p. 167; Unberath 2012, p. 148). On the same grounds, it cannot be argued that specific performance entails lower transaction costs compared to expectation damages due to the fact that the parties do not need to address the question whether the contract is obligatory or that the buyer would not have to purchase an insurance contract (Riehm 2015, pp. 167, 207; Weller 2012, p. 368). 29 Schwartz and Scott (2003, pp. 559–562); apart from economic reasoning other grounds have been have been proposed for state enforcement of contracts: From an induvial perspective, on the one hand it has been alleged that the parties’ autonomy is increased (see for example: Craswell 1989a, p. 514) and on the other hand the morality of promise keeping. From a society perspective, it has been argued that contracts and their enforcement create a relation of recognition and respect of the involved parties (see Markovits 2004). 30 The literature has identified several ways how the remedies affect investment decisions. First, Shavell shows that the seller would possibly make “wasteful preventive expenditures under specific performance, to avoid being held up by buyers when the seller faces high production cost.” Thereby the seller would strengthen his bargaining position. But those expenditures would decrease the joint surplus of the parties (See Shavell 2006b, p. 844). Secondly, there exists a problem of overinvestment. The buyer makes relation specific investments and increases the value of the seller’s performance to him. If expectation damages include

References

1.2.4

11

Type of Rules

My analysis does not discuss whether the remedy should be installed as a default and mandatory rule in the law.

References Barton, J. H. (1972). The economic basis of damages for breach of contract. The Journal of Legal Studies, 1(2), 277–304. Bebchuk, L. A. (2001). Property rights and liability rules: the ex ante view of the cathedral. Michigan Law Review, 100(3), 601–639. Bebchuk, L. A., & Ben-Shahar, O. (2001). Precontractual Reliance. The Journal of Legal Studies, 30(2), 423–457. Bechthold, S. (2010). Die Grenzen zwingenden Vertragsrechts. Ein rechtsökonomischer Beitrag zu einer Rechtsetzungslehre des Privatrechts. Mohr Siebeck: Tübingen. Birmingham, R. L. (1970). Breach of contract, damages measures, and economic efficiency. Rutgers Law Review, 24, 273–292. Boadway, R. W. (2016). Cost-benefit analysis. In The Oxford handbook of Well-being and public policy (pp. 47–81). New York, NY, USA: Oxford University Press. Brooks, R. R. W. (2006). The efficient performance hypothesis. The Yale Law Journal, 116(3), 568–596. Calabresi, G. (1975). Concerning cause and the law of torts. An essay for Harry Kalven, Jr. The University of Chicago Law Review, 43, 69–108. Calabresi, G., & Melamed, D. A. (1972). Property rules, liability rules, and inalienability: one view of the cathedral. Harvard Law Review, 85(6), 1089–1128. Craswell, R. (1988). Contract remedies, renegotiation, and the theory of efficient breach. Southern California Law Review, 61, 629–670. Craswell, R. (1989a). Contract law, default rules, and the philosophy of promising. Michigan Law Review, 88, 489. Craswell, R. (1989b). Performance, reliance, and one-sided information. The Journal of Legal Studies, 18(2), 365–401. Depoorter, B., & Tontrup, S. (2012). How law frames moral intuitions: the expressive effect of specific performance. Arizona Law Review, 54(3), 673–717. Dworkin, R. M. (1980). Is wealth a value? The Journal of Legal Studies, 9(2), 191–226.

such investments the buyer would invest so that his marginal costs of investments are equal to the marginal benefits of such an investment, but he would not take into account, the possibility that the performance becomes inefficient. The same can be true for specific performance. Shavell (1980), Rogerson (1984), Eisenberg (2005, p. 981), Shavell (1980, p. 472), Shavell (1984, p. 124), Listokin (2005), Bebchuk and Ben-Shahar (2001), Craswell (1989b), Eisenberg and Donnell (2003), Edlin (1996). Regarding liability and property rules: Bebchuk (2001). Thirdly, the Hart and Moore brought the problem of hold-ups to consideration which causes the parties to underinvest (See Hart and Moore 1988; Nöldeke and Schmidt 1995). Edlin and Reichelstein combined the two latter strings of literature and found that contracts with expectation damages can only induce one party to invest efficiently whereas specific performance can cause both parties to invest efficiently (Edlin and Reichelstein 1996).

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Edlin, A. S. (1996). Cadillac contracts and up-front payments: efficient investment under expectation damages. Journal of Law, Economics, and Organization, 12, 98–118. Edlin, A. S., & Reichelstein, S. (1996). Holdups, standard breach remedies, and optimal investment. The American Economic Review, 86(3), 478–501. Eidenmüller, H. (2015). Effizienz als Rechtsprinzip. Möglichkeiten und Grenzen der ökonomischen Analyse des Rechts. Mohr Siebeck: Tübingen. Eisenberg, M. A. (2005). Actual and virtual specific performance, the theory of efficient breach, and the indifference principle in contract law. California Law Review, 93(4), 975–1050. Eisenberg, M. A. (2006). The disgorgement interest in contract law. Michigan Law Review, 105(3), 559–602. Eisenberg, M. A., & Donnell, B. H. (2003). Expectation damages and the theory of overreliance. Hastings Law Journal, 54, 1335–1374. Engel, C. (January 2018). The proper scope of behavioral law and economics. Bonn: Max Planck Institute for Research on Collective Goods. Epstein, R. (2006). Behavioral economics: human errors and market corrections. The University of Chicago Law Review, 73(1), 111–132. Fehr, E., & Schmidt, K. M. (2004). The role of equality, efficiency, and Rawlsian motives in social preferences. In A reply to Engelmann and Strobel. Zürich: Inst. for Empirical Research in Economics. Fezer, K.-H. (1986). Aspekte einer Rechtskritik an der economic analysis of law und am property rights approach. Juristische Zeitung, 18, 817. Fezer, K.-H. (1988). Nochmals - Kritik an der ökonomischen Analyse des Rechts. Juristische Zeitung, 223–228. Friedman, D. (1989a). The efficient breach fallacy. The Journal of Legal Studies, 18(1), 1–24. Friedman, D. D. (1989b). An economic analysis of alternative damage rules for breach of contract. The journal of law & economics, 32, 281–310. Hart, O., & Moore, J. (1988). Incomplete contracts and renegotiation. Econometrica, 56, 755–785. Hart, O. D., & Zingales, L. (2017). Companies should maximize shareholders welfare not market value. London: Centre for Economic Policy Research. Jolls, C., Sunstein, C. R., & Thaler, R. H. (1998). A behavioral approach to law and economics. Stanford Law Review, 50(5), 1471–1481. Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental tests of the endowment effect and the Coase theorem. Journal of Political Economy, 98(6), 1325–1348. Kahneman, D., & Tversky, A. (1979). Prospect theory: an analysis of decision under risk. Econometrica, 47(2), 263–291. Katz, A. W. (2005). Remedies for breach of contract under the CISG. International Review of Law and Economics, 25(3), 378–396. Kirchgässner, G. (2013). Homo oeconomicus. Das ökonomische Modell individuellen Verhaltens und seine Anwendung in den Wirtschafts- und Sozialwissenschaften. Mohr Siebeck: Tübingen. Kirchner, C. (1997). Ökonomische Theorie des Rechts. Überarbeitete und ergänzte Fassung eines Vortrages gehalten vor der Juristischen Gesellschaft zu Berlin am 16. Oktober 1996. Berlin: de Gruyter. Klass, G. (2014). Efficient breach. In G. Klass, G. Letsas, & P. Saprai (Eds.), Philosophical foundations of contract law (pp. 362–387). Oxford: Oxford University Press. Kronman, A. T. (1978). Specific performance. The University of Chicago Law Review, 45(2), 351–382. Lando, H., & Rose, C. (2004). On the enforcement of specific performance in civil law countries. International Review of Law and Economics, 24(4), 473–487. Listokin, Y. (2005). The empirical case for specific performance: evidence from the IBP-Tyson litigation. Journal of Empirical Legal Studies, 2(3), 460–493. Markovits, D. (2004). Contract and collaboration. The Yale Law Journal, 113, 1420. Markovits, D., & Schwartz, A. (2011). The myth of efficient breach. New defenses of the expectation interest. Virginia Law Review, 97(8), 1939–2008.

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Markovits, D., & Schwartz, A. (2017). (in)efficient breach of contract. In The Oxford handbook of law and economics, ed. Francesco Parisi. Oxford, United Kingdom, New York, NY: Oxford University Press. Mathis, K. (2009). Effizienz statt Gerechtigkeit? Auf der Suche nach den philosophischen Grundlagen der Ökonomischen Analyse des Rechts. Dissertationsschrift--Universität Zürich (p. 2003). Berlin: Duncker & Humblot. Mitchell, G. (2014). Alternative behavioral law and economics. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 167–191). Oxford: Oxford Univ. Press. Nöldeke, G., & Schmidt, K. M. (1995). Option contracts and renegotiation: a solution to the hold-up problem. The Rand Journal of Economics, 26(2), 163–179. Parisi, F. (2004). Positive, normative and functional schools in law and economics. European Journal of Law and Economics, 18(3), 259–272. Pi, D., Parisi, F., & Luppi, B. (2014). Biasing, debiasing and the law. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 143–166). Oxford: Oxford Univ. Press. Riehm, T. (2015). Der Grundsatz der Naturalerfüllung. Tübingen: Mohr Siebeck. Rogerson, W. P. (1984). Efficient reliance and damage measures for breach of contract. The Rand Journal of Economics, 15(1), 39–53. Schäfer, H.-B., & Ott, C. (1988). Die ökonomische Analyse des Rechts - Irrweg oder Chance wissenschaftlicher Rechtserkenntnis. Juristische Zeitung, 213. Schäfer, H.-B., & Ott, C. (2012). Lehrbuch der ökonomischen Analyse des Zivilrechts. Berlin, Heidelberg: Springer. Schwartz, A., & Scott, R. E. (2003). Contract theory and the limits of contract law. The Yale Law Journal, 113(3), 541. Shavell, S. (1980). Damage measures for breach of contract. Bell Journal of Economics, 11(2), 466–490. Shavell, S. (1984). The Design of Contracts and Remedies for breach. Quarterly Journal of Economics, 99(1), 121–148. Shavell, S. (2006a). Is breach of contract immoral? The Emory Law Journal, 56(2), 439–460. Shavell, S. (2006b). Specific performance versus damages for breach of contract: an economic analysis. Texas Law Review, 84(4), 831–876. Shiffrin, S. (2007). The divergence of contract and promise. Harvard Law Review, 120(1), 708–753. Shiffrin, S. (2009). Could breach of contract be immoral? Michigan Law Review, 107(8), 1551–1568. Tor, A. (2014). The market, the firm and behavioral antitrust. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 539–567). Oxford: Oxford Univ. Press. Tversky, A., & Kahneman, D. (1991). Loss aversion in riskless choice: a reference-dependent model. Quarterly Journal of Economics, 106(4). Ulen, T. (1984). The efficiency of specific performance: toward a unified theory of contract remedies. Michigan Law Review, 83(2), 341–403. Ulen, T. S. (2014). The importance of behavioral law. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 93–124). Oxford: Oxford Univ. Press. Unberath, H. (2012). Die Vertragsverletzung. Tübingen: Mohr Siebeck. Weinrib, E. J. (2012). The idea of private law. Oxford: Oxford Univ. Press. Weller, M.-P. (2012). Die Vertragstreue. Vertragsbindung - Naturalerfüllungsgrundsatz Leistungstreue. Mohr Siebeck: Tübingen. Williamson, O. E. (1993). Calculativeness, trust, and economic organization. Journal of Law and Economics, 36(1, Part 2), 453–486. Zamir, E., & Teichman, D. (2014). Introduction. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law. Oxford: Oxford Univ. Press.

Chapter 2

Breach or Perform Decision: The Traditional Model of the Efficient Breach

This chapter outlines the standard model of efficient breach. Recall the scenario depicted in the introduction: A company B (Buyer) signs a sales contract with company S (Seller) to buy a certain kind of commodity and pay a certain price in exchange. As events transpire the seller’s costs to perform the contract increase.

In the moment the parties conclude the contract the seller expects to have certain costs to perform (co). The buyer has a valuation of performance which is denoted v. The parties agree on price P. The price will be above the seller’s costs of performance and below the buyer’s valuation such that both parties profit from trade; co
P
v. This is based on the observation that parties conclude contracts to profit from trade (Markovits and Schwartz 2017, p. 10). The trade is ought to create joint surplus (Markovits and Schwartz 2017, p. 10). The price functions as the intermediary and ensures that the buyer’s valuation is above the seller’s cost. The surplus of a contract is equal to the difference between the seller’s costs and the buyer’s valuation. The parties share that surplus according to their respective bargaining power. However, in the timeframe between the parties conclude the contract and the performance the seller’s costs can increase and attain a high value (denoted c) which lies above the price.1 The buyer remains to have the same valuation of performance. The price does not function as an intermediary anymore that guarantees that the buyer’s valuation is above the seller’s costs. From an overall efficiency perspective, performance should only take place if the seller’s costs do not exceed the buyer’s valuation. Thus, the seller should continue to perform if her costs remain below the buyer’s valuation. Otherwise the parties should terminate the contract and the seller should not perform. This goal is the same irrespective of the remedy and the discussion about the superior remedy is only which of them achieves this result

1

The reasons for the costs to attain a high value are exogenous and do not depend on the remedies.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 O. Hofmann, Breach of Contract, International Law and Economics, https://doi.org/10.1007/978-3-030-62525-2_2

15

16

2 Breach or Perform Decision: The Traditional Model of the Efficient Breach

Fig. 2.1 The two scenarios of increased costs

best. Figure 2.1 depicts the two possible scenarios with the seller’s costs either turning out to be below the buyer’s valuation or above. In the next sections, I illustrate the basic effects of the different remedies. They base on the assumptions of complete information, full compensation of the buyer, and behavior according to rational choice. In the sections to follow we address the changes of the analysis if one drops those assumptions.

2.1

Expectation Damages

Expectation damages give the seller the option to breach and pay damages. Put differently, the seller has a call option to purchase the right of performance from the buyer (Mahoney 1995, p. 143; Friedman 1989, p. 2). Expectation damages are argued to implement the optimal incentive from an efficiency perspective (Shavell 1980, 1984; Eisenberg 2005, p. 980). The advantage that is attributed to the remedy of expectation damages is that the seller breaches contracts if and only if it is efficient (Friedman 1989, p. 3). In that expectation, damages align the seller’s incentive with the incentive that generates the overall efficient outcome. The argument goes as follows: From an efficiency point of view, it is crucial that performance takes place if the buyer’s valuation exceeds the seller’s costs in the moment of performance (Polinsky and Shavell 2007, p. 102); v  c > 0.2 From the seller’s perspective, the consequences she faces if she breaches the contract depend on the remedy in place. Without any remedy, the seller is only affected by

2

In case the valuation is equal to the seller’s costs it is irrelevant from an efficiency perspective whether performance takes place. In the following I concentrate on strict inequalities between valuation and costs.

2.1 Expectation Damages

17

the price the buyer pays and her costs. The seller prefers to perform if the prize is not below her costs to maximize her profit. However, the increased costs possibly exceed the prize (P  c < 0). If that is the case the seller would make a loss by performing and thus prefers not to do so. But the buyer might value the performance of the contract more than what it would cost the seller to perform. Hence, performance might still be efficient. The remedy of expectation damages creates a link between the seller’s decision whether she breaches or performs and the overall efficiency. If the seller decides to breach she has to compensate the buyer by paying expectation damages (d). The seller performs to maximize her profit if expectation damages exceed her costs. Hence, the seller performs if P  c < P  d.3 This implies that the seller breaches if c > d. Under the assumption of full compensation expectation damages are equal to the buyer’s valuation (d ¼ v) (Markovits and Schwartz 2011, p. 1962). This allows the following inference: The seller breaches if c > v and performs if c
v.4 Hence, the seller internalizes the buyer’s valuation in her calculation whether to breach or to perform. As a result, she decides whether to perform or to breach like she represented both, the buyer and herself. 5 The formulas show that the seller’s incentive to breach is congruent with the overall efficiency.6 It becomes obvious that this only holds if the full value of performance is included in the seller’s calculation; this means expectation damages are equal to the buyer’s valuation. Otherwise the seller might breach too often.7 I will revert to this question in Part 5. 3 To allow easy comparisons between the payoffs under performance and breach expectation damages are constructed in the way that the buyer pays the prize and receives full damages for her valuation of performance throughout my work. As the price cancels out in the theoretical equations the parties, in reality, would set the price and damages off. It would not change the model if the buyer did not pay the prize and instead receives damages reduced by the amount of the prize. The difference in construction claims relevancy only in case the “buyer” is not obliged to pay money but to perform something himself in return; which is not part of my analysis. 4 To clarify: An increase in the seller’s costs that also causes the buyer’s valuation to increase would not lead to an efficient breach of contract because it is the relationship between the buyer’s valuation and the seller’s costs that determines the outcome. If both rise by the same amount, nothing changes. 5 Markovits and Schwartz (2017, p. 5); see for a similar application of a concept of internalization of costs in tort law: Cooter and Ulen (2008-2012, p. 310); more general thoughts that the person taking the decision should internalize all costs: Adams (2004, p. 788). 6 Posner (2014), Markovits and Schwartz (2017, p. 1), Depoorter and Tontrup (2012, pp. 675, 684), Eisenberg (2005, p. 978); reliance damages would not have the same effect. The seller would not have to internalize the buyer’s valuation but only his costs due to entering the contract. The seller is thereby incentivized to breach not only in those cases where her costs outweigh the buyer’s valuation but always if the opportunity costs outweigh the buyer’s costs; Eisenberg (2005, p. 980). See for a comprehensive comparison of the different incentives expectation damages and reliance damages impose (Mathis 2009, p. 102). 7 Craswell (1988, pp. 634, 635), Eisenberg (2005, p. 980).

18

2 Breach or Perform Decision: The Traditional Model of the Efficient Breach

An important aspect of this solution is that it is neither the parties together nor a judge who decides whether the performance of the contract is inefficient and therefore should not take place (Mathis 2009, p. 102). The driving factor is the interplay between the seller’s unilateral decision and the overall efficiency (Mathis 2009, p. 102). As a result, the buyer is indifferent between performance and compensation while the seller is better off; this outcome even suffices the so-called Pareto criterion (Friedman 1989, p. 3). Expectation damages have been contrasted to specific performance. It has been argued that under specific performance as the only remedy the buyer would claim performance. This would lead to inefficient performances if the seller’s costs exceed the buyer’s valuation (Birmingham 1970; Cooter 1985, pp. 29–37). As a result, the joint surplus is diminished. However, this assertion does not account for the parties renegotiating the contract; an option the next section turns to.

2.2

Specific Performance and Renegotiating the Contract

The result of the standard model for breach of the contract suggests that the buyer should not have the right to sue for specific performance but instead the seller should have the option to breach the contract and pay expectation damages. In support of specific performance it is argued that an efficient outcome would also be achieved if the seller is not granted the option to breach but the parties renegotiate their contract after they have learned that the costs of performance had changed (Craswell 1988, p. 631; Rogerson 1984). Hence, if the buyer has the right to claim specific performance the seller would make the buyer an offer to be freed from her obligation to perform (Markovits and Schwartz 2011, pp. 1963, 1964, 2017, p. 9; Faust 1996, p. 318). The seller purchases the option to claim performance (Mahoney 1995, p. 143). According to the Coase Theorem parties bargain to the efficient allocation of property rights given that transaction costs are zero.8 This means that if there is a gain from renegotiating the contract the parties would renegotiate so that the seller is excused from her obligation and pays an amount above the buyer’s valuation of performance (Markovits and Schwartz 2011, pp. 1944, 1964). Respectively, if there Markovits and Schwartz (2017, p. 4) argue that the notion of an efficient breach of contract is false because the parties of a contract maximize their payoff by creating the terms of the contract a breach of those terms is per se inefficient. Therefore, it is rather a question how to interpret the contract; i.e., do the terms of the contract oblige the seller to perform by transferring the good or the service or alternatively is the seller obliged to perform by either transferring the good or the service or transferring a sum that makes the buyer indifferent. The assumption that contracts would always imply that performance can only mean to transfer the good or the service is argued to be a mistake. Despite that objection I shall presume to use the term “breach of contract” as it is the notion used by the prevailing literature. The objection is not relevant for my work as I concentrate on the design of contracts and not on how to interpret them. 8 Coase (1960); the term “no transaction costs” is to be understood in a broad sense, including any costs of negotiating as no information asymmetries, see: Calabresi and Melamed (1972, p. 1095).

2.2 Specific Performance and Renegotiating the Contract

19

Fig. 2.2 Timeline including renegotiation

is no gain from renegotiating the seller would perform. To put this more formally first note the change to the timeline as shown in Fig. 2.2. Recall the situation that the costs of performance exceed the prize (c > p). The buyer’s valuation can be either above the costs (v > c) or below costs respectively (v < c). I assume that both, the seller and the buyer have knowledge in what state of the world they are in. The buyer has two options. Either he insists on specific performance9 or he agrees to a payment in the amount of x from the seller for which the seller is excused from her obligation to perform in return. If he insists on specific performance his payoff is equal to his valuation of performance minus the price (π ¼ v  P). By contrast, if he agrees to the payment his payoff is equal to the amount of that payment (π ¼ x). From the seller’s perspective performance by transferring the good or the service would imply a negative payoff of her costs of performance reduced by the price she gets (σ ¼  c + P). On the contrary, if the parties agree on a payment (x) the seller faces a negative payoff equal to the amount she pays (σ ¼  x). First consider the case in which the buyer’s valuation is above the seller’s costs (v > c). The seller will only accept agreements if the amount she would have to pay is below the costs she would incur otherwise (x >  c + P , x < c  P). At the same time, the buyer would only accept an agreement if the amount he receives is above his valuation of performance minus the price (x > v  P). It follows, that in the case v > c the parties do not find an agreement because both conditions cannot be fulfilled simultaneously: vP v > PED, SP. If the seller’s costs turn out to be high, under specific performance the buyer trades his right of specific performance to the seller. They will agree on a price for the trade of v
PSP + b whereby b  c
v. The factor b represents what the buyer gains

higher expectation damages (see Markovits and Schwartz 2017, 10, 2011, 1959–1970; Shavell 2006, 843; Craswell 1988). 2 The limited distributional effects of commercial contract rules, in addition, stems from the fact that commercial parties are regularly in both positions: seller and buyer. On an even broader level, firms are owned by shareholders. Those shareholders diversify their risk by owning shares from different firms. In order to diversify the risk optimally those firms are of both types: firms which are more likely to be sellers and those which are more likely to be buyers: Schwartz and Scott (2003, 555). 3 This part builds on Markovits and Schwartz (2011).

3.1 Price Mechanism

25

from the surplus that is generated by non-performance. Since this scenario arises with a probability of α it follows for the buyer’s gain: With a probability of α he gets v
PSP + b; otherwise v
PSP. αðv
PSP þ bÞ þ ð1
αÞðv
PSP Þ ¼ v
PSP þ αb

ð3:1Þ

In case of an expectation damages rule, in the moment the parties learn about the increase in costs the seller can extract the complete surplus. However, under complete information, the parties know when they conclude the contract that with a probability of α the seller’s costs will increase to c and that in this case, the surplus of non-performance will be c
v. It follows that this surplus and the question how to share will enter the negotiations ex ante. The parties bargain about the distribution of that possible surplus of non-performance whereby b represents the share the buyer gets. The parties adjust the price, i.e., reducing it by α times b compared to PSP. In other words, the expectation damages price equals the price under specific performance reduced by the amount the seller will pay to the buyer (b) ex post in case the costs increase (probability α): PED ¼ PSP
αb

ð3:2Þ

One can also put this the other way, saying that under expectation damages the parties agree to the price PED and adjust that price under specific performance to PSP ¼ PED + αb. It shows that the price reflects what the parties expect the surplus of non-performance to be under both regimes. Comparing the buyer’s payoffs under both regimes reveals that the choice of remedy does not affect them. Under expectation damages, the seller pays expectation damages equal to the buyer’s valuation (v) if she breaches and the buyer pays the price PED. The buyer’s payoffs under the two remedies are: Buyer’s payoff under expectation damages π ED ¼ v
PED

ð3:3Þ

Inserting PED ¼ PSP
αb we get π ED ¼ v
PSP
αb

ð3:4Þ

It shows that this is equal to the buyer’s payoff under specific performance π SP ¼ v
PSP þ αb

ð3:5Þ

The two remedies differ in that under expectation damages each party gets a fixed amount when both parties conclude the contract whereas under specific performance

26

3 Distributional Effects and the Original Contract

the payoffs depend on whether the costs attain a high value.4 Thus, there is less uncertainty under expectation damages.

3.2

Interaction Between Remedies and Bargaining Power

So far, we have seen that in the scenario of a bilateral monopoly the price mechanism makes it irrelevant which remedy enters the parties’ contract from a distributional perspective. This section looks at whether this result sustains if the bargaining power differs between the contracting and the renegotiation stage. The analysis requires some more general thoughts on what determines bargaining power. This is covered in the next section before delving into the deeper analysis.

3.2.1

Determinants of Bargaining Power

The price for performance as the result from contract negotiations depends on the parties’ bargaining power. The term bargaining power captures how patient the parties are and what alternatives each party has outside the contract (Markovits and Schwartz 2011, 1963). In economics, the parties’ patience is measured by their discount factor. The higher the discount factor the more a party values current money to future money and thus has a relatively weaker bargaining position (Schwartz and Scott 2003, 553). The outside options determine the parties’ “walk away” price; the maximum price the buyer is willing to pay and the minimum price the seller is willing to accept. The question is: What payoff does each party gain if they fail to come to an agreement. The “walk away” price is called disagreement point (Markovits and Schwartz 2011, 1963). It is influenced by the parties’ personal attributes, for example, her cost structure, and the outside options. The latter are affected by the market structure (Markovits and Schwartz 2011, 1963). For instance, a buyer who has the option to purchase the same good from another supplier for EUR 100 will not agree to a price above those EUR 100. A seller with only one potential customer will potentially agree to any price above her costs because her payoff if the negotiations fail is negative in the amount of her costs in case she has already acquired the product she wants to sell. Both aspects of bargaining power differ in how they affect the price and the distribution of the surplus. First, I analyze the effect of the discount rate and subsequently turn to outside options entering the assessment.

4

See for distributional effects if the parties are not risk neutral: Mahoney (1995, 142).

3.2 Interaction Between Remedies and Bargaining Power

3.2.2

27

Discount Factors

We first concentrate on the effect of discount factors. To that end, we assume that there is one buyer and one seller. When the parties negotiate the contract and fix the price they bargain about how to share the surplus which is generated by the surplus in a whole. This is the difference between the buyer’s maximum price and the seller’s minimum price. Under specific performance, bargaining takes place a second time if the seller’s costs have increased.5 In this second period, the parties negotiate how to share the surplus that is generated by non-performance because the costs have increased. Consider now the scenario that the seller has a higher discount factor ex ante than ex post and the seller’s discount factor remains constant. Thus, the seller has a stronger bargaining position ex post. Conversely, the buyer has a stronger bargaining position ex ante than ex post. This seems plausible for the following reason: ex ante the seller is keen on concluding the contract quickly as she receives the price in exchange for performance. Similarly, the buyer has an interest for a quick conclusion of the contract as he gets his valuation of performance. However, the sellers position changes once the parties learn that she will not perform due to high costs. Under specific performance, she will make a side payment to be excused from her obligation. Therefore, instead of receiving a surplus, she faces the duty to make a payment. She has no interest in making that payment soon. In contrast, the buyer still has the same interest in receiving his valuation of performance without delay. The seller’s elevated bargaining position ex post leads to a lower side payment. But as shown above, the parties account for the expected outcome of those second negotiations and adjust the price accordingly at the contracting stage. This means that in expectation the parties will agree on non-performance in the event that the seller’s costs increase, the surplus generated by non-performance enters the negotiations at the contracting stage. Already at that stage the parties bargain how to share it and the expected side payment the seller makes to the buyer increases the price according to the bargaining power ex ante. As the adjustment takes place when parties negotiate about the original contract the discount factors at that first stage determine what share of the surplus generated by the contract each party gets. This includes the surplus through non-performance. Since only the ex ante discount factor matters, even if the discount factor differs ex post the distribution is the same under both remedies. Take for example, a buyer with a valuation of performance of EUR 200 and the seller’s costs being EUR 100 but they increase to EUR 240 with a probability of 10%. Suppose that the parties’ discount factors are such that the buyer has a strong bargaining position ex ante providing him with a share of 80% of the surplus. Further, suppose that ex post both parties have the same discount factor implying

5

See the standard model in Chap. 2.

28

3 Distributional Effects and the Original Contract

that they share the surplus of non-performance equally in case the seller’s costs have increased.6 First, consider the situation under expectation damages. As we assume no outside options to exist, the buyer’s maximum price is equal to his valuation, i.e., EUR 200. The seller’s minimum price is equal to her expected costs: 0:9  100 EUR þ 0:1  200 EUR ¼ 110 EUR Thus, the surplus being shared is EUR 90 of which the buyer gets 80%. This means, the parties agree on a price of EUR 182. The buyer has an expected payoff of EUR 72 and the seller of EUR 18. Under specific performance, the parties foresee that in case of an increase in costs the seller will make an additional side payment of EUR 20 to be excused from her obligation to perform. It follows for the buyer’s maximum price to be at EUR 202 and for the seller’s minimum price to be at EUR 112. Thus, also under specific performance the surplus ex ante being shared between the parties amounts to EUR 90. The buyer gets 80% of that surplus due to the parties’ discount factors. The parties agree on a price of EUR 184. It follows that also under specific performance the buyer has an expected payoff of EUR 72 and the seller of EUR 18; thus, the distribution of the surplus is unaffected by the choice of remedy. The analysis even upholds in the extreme case that the buyer has no bargaining power ex post.7 In that case, the seller gets all the surplus generated by non-performance ex post. From an ex ante perspective this is not different from agreeing on expectation damages if renegotiation is granted to take place successfully without costs. The predicted future payoff enters the negotiation at the contracting stage. To see the equivalence, consider, as in the standard model, a seller whose costs of performance co increase with probability α attaining the value c. The buyer’s valuation is denoted v. Under specific performance, given that the seller has all the bargaining power ex post, the side payment the seller makes, takes the value of the buyer’s valuation. This is the minimum the buyer accepts because that is the amount he would also get otherwise if the seller performs. This means that the buyer does not gain anything from the surplus generated by non-performance; in the terms used in section A: b ¼ 0. Making further use of the analysis in Sect. 3.1, we have seen that PED ¼ PSP
αb. Under the given circumstances it follows that PED ¼ PSP. Thus, we can conclude that from an overall perspective it does not make a difference whether the buyer does not receive an additional payment ex post through 6 This change in discount factors is likely to occur. A seller for whom it is important to conclude the contract quickly ex ante in order to receive the payment faces a different situation once her costs have increased and she prefers not to perform. Because in that case she does not receive money but instead negotiations are about how much she pays to the buyer. 7 In contrast to my finding Markovits and Schwartz doubt that the parties are indifferent between sharing the surplus ex ante or renegotiating ex post if the buyer has no bargaining power ex post: Markovits and Schwartz (2011, 1968).

3.2 Interaction Between Remedies and Bargaining Power

29

bargaining or because the seller has the option to breach the contract in the first place.

3.2.3

Disagreement Points

Disagreement points influence the bargaining power in a different way than discounting. They determine the maximum and the minimum price and thus the range within which a price can lie. This section analyzes how the existence of third additional buyers or sellers with different valuation and costs affect the distribution of the surplus.8 To that end, I discuss two scenarios with either two sellers facing one buyer or one seller facing two buyers. Before delving into that deeper analysis, I explain how and under what circumstances the existence of additional buyers or sellers influence the disagreement points generally and thereby the price. As I analyze the impact of disagreement points, I assume that the seller’s and buyer’s discount rates are equal, i.e., each would get half of the surplus if no outside options exist that affect the disagreement points.9

3.2.3.1

Third Parties, Disagreement Points, and Prices

To see how disagreement points generally affect the bargaining outcome I exclude the possibility that the costs of performance might increase in this section. Consider a seller who bears costs to perform of co and a buyer A valuing this performance in the amount of vA, whereby vA > co. First suppose no outside options exist for both of the parties; if the parties fail to conclude the agreement both receive a payoff of zero. It follows that for the seller every price above c and for buyer A every price below vA is beneficial compared to not finding an agreement. As we assume equal discount factors both parties receive half of the surplus, denoted s, generated by concluding o the contract; s ¼ vA
co. Thus, the price the parties would agree on is: PH ¼ vA þc 2 .

Markovits and Schwartz confine their finding by saying that the parties are indifferent between sharing the surplus ex ante or renegotiating ex post if the seller’s ability to price ex ante is constrained by the existence of other potential suppliers: Markovits and Schwartz (2011, 1968). 9 This is based on “Nash Bargaining Solution.” See for more details regarding the concept Daughety and Reinganum (2012, pp. 403, 410). In short, the idea is to find a price that maximizes the total payoff: 8

ðv
pÞðp
co Þ max p 1 F:O:C: : v
2p þ co ¼ 0 , p ¼ ðv þ co Þ 2

30

3 Distributional Effects and the Original Contract

Fig. 3.1 Surplus of contract and price determination without outside options

Fig. 3.2 Second buyer and disagreement point

Figure 3.1 illustrates that situation: Now consider a second potential buyer B entering the market whose valuation of performance (vB) is below the valuation of the first buyer but above the seller’s costs of performance: vA > vB > co

ð3:6Þ

The existence of the second buyer changes the outside option for the seller. If she does not find an agreement with the buyer, she could conclude a contract with the second buyer. Figure 3.2 depicts the introduction of the second buyer (B). The range between vB and co is where the price between seller and buyer B could lie if buyer A did not exist. The price the seller and buyer B would agree on is the seller’s disagreement point.

3.2 Interaction Between Remedies and Bargaining Power

31

Fig. 3.3 Disagreement point with an effect

It is essential to note that if buyer B’s valuation is below the one of buyer A, vB itself is the seller’s disagreement point. This is based on the following thought. vB is the maximum buyer B would offer.10 In a bargaining process, buyer B is willing to make offers up to the point of his valuation. As long as buyer A makes offers below vB buyer B would intervene by making a higher offer up until vB. It follows that buyer A would need to offer an amount at least equal to vB. A complex question is whether the effect of disagreement points on the price is constrained. In economic theory, it is put forward that disagreement points would only have an impact if the disagreement point of one party is above the share the party would receive without taking the disagreement point into account (Schwartz and Scott 2003, 553). In the given context that means that the existence of the second buyer (B) does not affect the price if his valuation is below the price the seller and buyer A would agree on anyway. The “threat” to conclude the contract with buyer B is not credible and thus not relevant. Because the seller and buyer A would agree on PH as the price and that lies above vB it follows that PH remains the price the parties agree on. In consequence, the existence of a second buyer would have no effect and thus no relevance for my analysis. Setting aside the economic argument I will concentrate on the alternative case; the second buyer’s valuation being above the hypothetical price. The result would be applicable if the impact of disagreement points is not constrained. Figure 3.3 describes a scenario where buyer B’s valuation exceeds the price the seller and buyer would agree on if buyer B did not exist. In that case, this hypothetical price between the seller and buyer A is not attainable in equilibrium because buyer B would make a higher offer. It follows that the price is pushed upwards by the existence of buyer B above the point vB. Given that the parties have equal discount factors the price would be in the middle between vA and vB.

10

In that case buyer B is indifferent between concluding the contract or not. One could also say that buyer B would only make offer that imply some profit for him. But theoretically that profit could be infinitely small represented by the term vB
ε. For the ease of illustration, I assume in case of indifference, buyer B prefers to conclude a contract.

32

3.2.3.2

3 Distributional Effects and the Original Contract

Two Buyers Scenario Under Different Remedies

So far, I have analyzed the effect of disagreement points without a possible increase in the seller’s costs. This section connects the findings about the impact of an additional buyer with the “efficient breach scenario.” Consider the situation as before with one seller and two buyers, A and B, whereby A has a higher valuation than B. The seller has costs of performance of co which are below both buyers’ valuations. All parties know that the seller’s costs increase and attain the value c with probability α, whereby c > vA > vB > co. As stated above all parties are assumed to have equal discount factors. Further I assume that buyer B’s valuation lies above the hypothetical price the seller and buyer A would agree on without a second buyer and the probability of an increase in the seller’s costs being zero. To analyze distributional effects, i.e., differences in payoffs, we first determine the price under each remedy which in turn depends on the parties’ willingness to pay and willingness to accept. Under expectation damages the seller’s willingness to accept is WTAED A ¼ (1
α)co + αvA when she contracts with buyer A. Buyer A’s willingness to pay is equal to his valuation: WTPED A ¼ vA because regardless whether performance occurs he gets the amount of his valuation. As I assume equal discount factors the hypothetical price between the seller and buyer A is PH ED ¼

ð1
αÞco þ αvA þ vA co þ vA þ αðvA
co Þ ¼ 2 2

ð3:7Þ

under expectation damages. As said for buyer A also buyer B’s willingness to pay is equal to his valuation under expectation damages, wtpED B ¼ vB. Recall that buyer B’s valuation is greater o o than the hypothetical price (vB > c þvA þα2ðvA
c ÞÞ.11 In that case, buyer B’s valuation is the seller’s disagreement point. The seller knows that she has the outside option to conclude the contract with buyer B and he is willing to pay the price equal to his valuation.12 It follows that the price the seller and buyer A agree on lies between buyer B’s valuation and buyer A’s valuation. Because we assume equal discount factors the B price will be PED ¼ vA þv 2 . Figure 3.4 shows how the price moves upwards indicated by the arrow: Next, consider the payoffs under expectation damages. The seller’s payoff:

11

As shown in Sect. 3.2.3.1, if the disagreement point (buyer B’s valuation) lies below the hypothetical price, it is argued to not affect the price. 12 This conclusion is based on the finding in Sect. 3.2.3.1 which provides a detailed explanation why buyer B will pay the price equal to his willingness to pay.

3.2 Interaction Between Remedies and Bargaining Power

33

Fig. 3.4 Two buyers scenario under expectation damages

σ ED ¼ ð1
αÞðPED
co Þ þ αðPED
vA Þ ¼

vA þ vB
ð1
αÞco
αvA 2

ð3:8Þ

The seller performs if her costs have not increased. In this case, she receives the price and bears her expected costs. In the formula, this is reflected by the term (1
α)(PED
co). Otherwise she breaches and pays expectation damages equal to buyer’s A valuation (represented by the term α(PED
vA)). The buyer A’s payoff is: π ED ¼ vA
PED ¼ vA


vA þ vB vA
vB ¼ 2 2

ð3:9Þ

B The buyer pays the expectation damages price (PED ¼ vA þv 2 ) and gets his valuation in return either through performance or as expectation damages. With specific performance, the parties account for the possibility that the performance costs increase and that the seller needs to make a side payment to the buyer to be excused from her obligation to perform. The side payment by the seller to buyer A A takes the value cþv 2 which consists of buyer A’s valuation, vA, plus half of the surplus A generated by non-performance, c
v 2 . Thus, the seller’s willingness to accept is:

c þ vA 2

ð3:10Þ

c þ vA c
vA ¼ vA þ α 2 2

ð3:11Þ

c þ vB c
vB ¼ vB þ α 2 2

ð3:12Þ

WTASP A ¼ ð1
αÞco þ α Buyer A’s willingness to pay is WTPSP A ¼ ð1
αÞvA þ α and Buyer B’s willingness to pay is WTPSP B ¼ ð1
αÞvB þ α

Figure 3.5 illustrates the scenario under specific performance: In the graph the arrows indicate the change in willingness to pay (willingness to accept) as one moves from expectation damages to specific performance. The arrow

34

3 Distributional Effects and the Original Contract

Fig. 3.5 Two buyers scenario under specific performance

is larger for buyer B as his willingness to pay rises more profound stemming from the larger potential surplus generated by non-performance if the seller’s costs increase. As before the seller has the outside option to conclude a contract with buyer B for a price equal to buyer B’s willingness to pay. However, one cannot simply derive the seller’s disagreement point from the buyer B’s willingness to pay. All parties know that under specific performance if the seller concludes the contract with buyer B she would have to make a side B payment of c
v 2 with probability α. For the disagreement point, one needs to look at the overall payoff the seller can expect to get if she concludes the contract with buyer A or buyer B. In consequence, to derive the disagreement point we need to adjust buyer B’s willingness to pay and B subtract the future side payment c
v 2 yielding a disagreement point of vB. But to determine the minimum price the seller asks for one also needs to account for the future payment she makes to buyer A. She is not accepting a payment that leaves her with a surplus below vB from an overall perspective. Therefore, we need to add the future side payment she makes to buyer A resulting in a minimum price of vB þ α

c
vA : 2

It follows for the price under specific performance: PSP ¼

vB þ α

c
vA 2

þ vA þ α 2

c
vA 2

¼

vB þ vA c
vA þα 2 2

ð3:13Þ

Next, consider the payoffs under specific performance. The seller’s payoff is:   c þ vA σ SP ¼ ð1
αÞðPSP
co Þ þ α PSP
2   c þ v A ¼ PSP
ð1
αÞco
α 2

ð3:14Þ

3.2 Interaction Between Remedies and Bargaining Power

35

The seller receives the specific performance price. If her costs do not increase she performs incurring her costs of performance. Otherwise she does not perform but makes a payment to the buyer equal to his valuation plus half of the surplus. c
vA A Inserting PSP ¼ vB þv 2 þ α 2 yields σ SP ¼

vA þ vB
ð1
αÞco
αvA 2

ð3:15Þ

Buyer A receives:     c
vA c
vA π SP ¼ ð1
αÞvA þ α vA þ
PSP ¼ vA þ α
PSP 2 2

ð3:16Þ

The buyer pays the specific performance price and gets his valuation plus his share of the surplus generated by non-performance if the seller’s costs increase. c
vA A Inserting PSP ¼ vB þv 2 þ α 2 yields π SP ¼

v A
vB 2

ð3:17Þ

Comparing the payoffs under each remedy shows that each party has the same expectation regardless of the remedy regime in place.

3.2.3.3

Two Sellers Scenario Under Different Remedies

This section analyzes the opposite a scenario with one buyer and two sellers. It concentrates on the situation that both sellers are affected by the increase in price such that if the increase in costs renders performance inefficient thus is true for both sellers. For the case that only the seller’s costs increase with whom the buyer has concluded the contract see Chap. 4. In a market two sellers and one buyer exist whereby the seller A’s expected costs of performance are lower than seller B’s Various scenarios are plausible how both seller’s costs increase. First, it can be that the ultimate costs both sellers face are the same. This would arise if a third party makes a higher offer to both sellers. Secondly, the costs increase by percentage points. Such scenario exists if the reason for the difference in costs is related to the increase in price. For example, seller A operates more efficiently and uses 10% less resources. An increase in price for those resources will affect seller A less (by 10%). Thirdly, the change in price is the same. This is the case if the difference in costs for performance is due to factors unrelated to the increase in price. For example, seller A has lower fixed costs of production and the rise in costs is due to an exogenous price shock regarding the commodities necessary to produce the good that is subject to the contract. For the analysis of a distributional effect, I concentrate on the last scenario. It serves as an example. The general argument is applicable to the other two situations.

36

3 Distributional Effects and the Original Contract

Suppose, seller A and B have costs of performance of coA and coB . The probability that those costs attain high values, cA or cB is α. Both seller’s costs increase by the same amount such that coB
cB ¼ coA
cA . The buyer has a valuation of v which is above both seller’s original costs but below both seller’s increased costs (coA < coB < v < cA < cB ). The parties have the same discount factors. To determine whether a distributional effect exists we first derive the price the parties agree and the payoffs they receive under each remedy before comparing them. We start with expectation damages. Under expectation damages seller A’s willingness to accept is wtaED A ¼ ð1
αÞcoA þ αv. whereas seller B’s willingness to accept is wtaED B ¼ ð1
αÞcoB þ αv: Because seller A’ willingness to accept is lower than seller B’s the buyer will conclude the contract with seller A. We further assume that seller B’s willingness to accept lies below the hypothetical price seller A and the buyer would agree on such that the existence of seller B influences the buyer’s disagreement point.13 It follows that the buyer has the outside option to purchase performance from seller B for the price equal to wtaED B ¼ ð1
αÞcoB þ αv .. Thus, the price seller A and the buyer agree on lies between seller A’s and seller B’s willingness to accept. As we assume equal discount factors the price will be in the middle: PED


ð1
αÞcoB þ αv þ ð1
αÞcoA þ αv ð1
αÞ coB þ coA þ αv ¼ ¼ 2 2

ð3:18Þ

This leads to the following payoffs under expectation damages. The seller gets a payoff of
σ ED ¼ ð1
αÞ PED
coA þ αðPED
vÞ ¼ PED
ð1
αÞcoA
αv

ð3:19Þ

If seller A performs she receives the expectation damages price. She performs only if her costs have not increased and then incurs costs of cA . She breaches if her performance costs exceed the buyer’s valuation and pay damages to him which are the buyer’s valuation and in turn receives the price. ð1
αÞðcoB þcoA Þ Inserting PED ¼ þ αv into the equation yields: 2 σ ED

ð1
αÞ coB
coA ¼ 2




The buyer receives

13

See Sect. 3.2.3.1 for the general analysis of the effect of disagreement points.

ð3:20Þ

3.2 Interaction Between Remedies and Bargaining Power

π ED ¼ v
PED

37



  ð1
αÞ coB þ coA coB þ coA
αv ¼ ð1
αÞ v
ð3:21Þ ¼v
2 2

The buyer pays the expectation damages price and gets his valuation either through performance or damages. Turning to specific performance, as stated before the parties account for the possibility that the performance costs increase and that the seller needs to make a side payment to the buyer to be excused from her obligation to perform. Seller A would have to make a side payment of cA2þv which consists of the buyer valuation, v plus half of the surplus generated by non-performance, cA2
v . The side payment anticipated by seller B reflects her increased costs and takes a value of cB2þv. This leads to the following willingness to accept and willingness to pay. Seller A’s willingness to accept is: wtaSP A ¼ ð1
αÞcoA þ α

cA þ v 2

ð3:22Þ

cB þ v 2

ð3:23Þ

and seller B’s willingness to accept is: wtaSP B ¼ ð1
αÞcoB þ α

The buyer’s willingness to pay when contracting with seller A is wtpSP A ¼ ð1
αÞv þ α

cA þ v c
v ¼vþα A 2 2

ð3:24Þ

As under expectation damages, the buyer has the outside option to conclude a contract with seller B for a price equal to buyer B’s willingness to pay. But like in the scenario with one seller and two buyers the disagreement point is not simply the price seller B offers. The buyer takes into account that he would receive a lower side payment ex post if he concludes the contract with seller B. Thus, we need to adjust the price seller B is willing to accept by the difference in the future payment the buyer receives to determine the buyer maximum price: α cA2
v
cB2
v). Therefore, the maximum price the buyer would pay when contracting with seller A on the basis that he has the option to conclude a contract with seller B for the price wtaSP B ¼ ð1
αÞcoB þ α cB2þv is: wtaSP B þ α



 cA
v cB
v c þv
¼ ð1
αÞcoB þ α A 2 2 2

It follows for the price under specific performance to be

ð3:25Þ

38

3 Distributional Effects and the Original Contract

PSP ¼

ð1
αÞcoA þ α

c þv

2

þ ð1
αÞcoB þ α 2

cA þv 2


ð1
αÞ coA þ coB c þv þα A ¼ 2 2

ð3:26Þ

Next, we analyze the payoffs under specific performance. Seller A’s payoff is  
c þv σ SP ¼ ð1
αÞ PSP
cA þ α PSP
A 2 c þ v ¼ PSP
ð1
αÞcoA
α A 2 Inserting PSP ¼

ð1
αÞðcoA þcoB Þ 2

þα

σ SP

cA þv 2

ð3:27Þ

gives us

ð1
αÞ coB
coA ¼ 2


ð3:28Þ

The buyer’s payoff is π SP ¼ ð1
αÞv þ α Because PSP ¼

ð1
αÞðcoA þcoB Þ 2

þα

cA þv 2

 cA þ v
PSP 2

ð3:29Þ

the buyer gets 

π SP



co þ coB ¼ ð1
αÞ v
A 2


 ð3:30Þ

Comparing the payoffs under both remedy regimes we can conclude that the choice of remedy does not have a distributional effect also if a second seller is in the market whose costs increase.

3.3

Uncertainty

The analysis has shown that the choice of remedy does not entail distributional effects if the parties can foresee what amount the seller will pay to the buyer under specific performance if her costs increase and with what probability that happens. In reality, predicting future payment can be a difficult task. This is true for all aspects which determine the expected amount of the side payment: the probability of an increase in costs, the magnitude of an increase in costs, and the bargaining power each party has in renegotiations.

3.3 Uncertainty

39

The challenge is not to predict with the exact number it will take in the future but to determine the correct amount in expectation. This requires the parties to attach probabilities to each possible scenario; how likely is it that the seller’s costs increase to a certain amount and with what probability do the parties have a certain bargaining power ex post. However, often the parties lack the information how probable a scenario is. In economic theory, one distinguishes between situations of “risk” and situations of “uncertainty.”14 Only in the former situations probabilities are known or can be derived by deduction or from the past (Gilboa et al. 2008). An example is, when somebody flips a coin, there is an objective probability that the head will occur. In a situation of uncertainty, the parties do not know “objective” probabilities (Gilboa et al. 2008). In economic modeling, the standard approach to such problems is to assume that the parties although lacking objective information about probabilities hold beliefs about how likely events are going to occur (Gilboa et al. 2008). Thus, in the absence of objective probabilities, the parties replace them with “subjective” ones.15 People are assumed to have such beliefs with respect to all sources of uncertainty (Gilboa et al. 2008). In the given scenario, the magnitude and the probability of an increase in costs as well as the future bargaining power base on multifaceted reasons. For many of them, no objective probabilities are available. For example, what is the likelihood that the price for certain raw materials skyrocket due to conflicts in the region where they exist? How likely is it that a new company enters the market supplying the same product and thereby affecting the bargaining power? What is the probability that one of the parties is confronted with liquidity constraints due to a financial crisis? For some questions, one could use data from the past to derive probabilities. However, depending on the kind of performance that is subject to the contract, the factors which determine the costs vary. For many of those factors either no data exists, or data of the past is of limited use to predict the future. Obviously, this is true for weather where, for example, the possibility to forecast droughts is bounded. Furthermore, as predictions are built on the past, they do not include events that appear for the first time. In consequence, that leads the parties to underestimate the respective probability. But also concerning events that have occurred but only seldomly estimation is difficult as data is scarce. In the end, it is an empirical question whether parties attach a too low or too high probability to the possibility that the costs of performance increase or bargaining power to change under specific circumstances. In the following we ask: How does the choice of remedy affect the distribution of the surplus if the parties do not correctly predict the size and likelihood of the side payment?16

14

Knight (2014) (reprint of the original version 1921). Gilboa et al. (2008); this approach is based on the work of Savage: Savage (2012) (reprint). 16 See Craswell (1988) for an analysis of the effect different risk attitudes: if buyers are risk-seeking he prefers specific performance because he pays a higher price but a chance for the extra side payment to excuse the seller. He further argues that specific performance is preferred by the seller if 15

40

3 Distributional Effects and the Original Contract

3.3.1

Probability of an Increase in Costs

Consider the scenario that the parties incorrectly predict the probability of an increase in the seller’s costs of performance. Recall from Sect. 3.1: the price the parties agree on under expectation damages is denoted PED. Because the parties account for the possibility of an increase in price when they agree on specific performance PSP ¼ PED + αb whereby b represents what the seller will pay to the buyer if the costs have increased and α represents the probability the parties predicted that this will happen. The seller’s original costs are denoted c and the increased costs are denoted c. The predicted probability for an increase in the seller’s costs, α, differs from the de facto probability, denoted β. We get the following payoffs for the parties under expectation damages: The seller’s payoff is σ ED ¼ ð1
βÞð PED
co Þ þ βðPED
vÞ ¼ PED
co þ βco
βv

ð3:31Þ

whereby the buyer’s gets π ED ¼ ð1
βÞðv
PED Þ þ βðv
PED Þ ¼ v
PED

ð3:32Þ

In case of specific performance, the payoffs are somewhat different: The seller’s payoff is σ SP ¼ ð1
βÞð PSP
c Þ þ βðPSP
v
bÞ ¼ PSP
co þ βco
βv
βb ð3:33Þ and the buyer receives π SP ¼ ð1
βÞð v
PSP Þ þ βðv þ b
PSP Þ ¼ v
PSP þ βb

ð3:34Þ

Comparing the seller’s payoffs, we see that if the parties have underestimated the probability the seller is better off under expectation damages. σ ED > σ SP

ð3:35Þ

PED
c þ βc
βv > PSP
c þ βc
βv
βb o

o

o

o

ð3:36Þ

Plugging in PSP ¼ PED + αb yields:

she is risk averse because she gets a higher price and give up the chance to receive extra money through breach. However, it needs to be noted that this only applies to the gain-seeking scenario. In the cost-avoiding scenario the risk-averse seller would prefer expectation damages. See also Klass (2014, p. 379).

3.3 Uncertainty

41

PED
co þ βco
βv > PED þ αb
co þ βco
βv
βb

ð3:37Þ

0 > αb
βb

ð3:38Þ

β>α

ð3:39Þ

It follows that in the opposite scenario, the parties overestimate the probability of an increase, the seller profits from the specific performance. From the buyer’s perspective, given that the parties underestimate the probability of an increase he benefits from the specific performance: π SP > π ED

ð3:40Þ

v
PSP þ βb > v
PED

ð3:41Þ

Plugging in PSP ¼ PED + αb: v
PED
αb þ βb > v
PED

ð3:42Þ

β>α

ð3:43Þ

Take the following example: The buyer has a valuation of performance of EUR 180. The seller’s costs are EUR 100 but increase with the probability 20% and take a value of EUR 200. The parties predicted the probability to be 10%. Both parties have equal bargaining power. Under expectation damages the seller’s willingness to accept is 0:9  100 EUR þ 0:1  180 EUR ¼ 108 EUR whereas the buyer’s willingness to pay is equal to his valuation, EUR 180. It follows that they will agree on a price of PED ¼ 144 EUR. With specific performance the seller’s willingness to accept is slightly higher because she will make a side payment of EUR 190 if her costs increase: 0:9  100 EUR þ 0:1  190 EUR ¼ 109 EUR Accordingly, the buyer’s willingness to pay is higher: 0:9  180 EUR þ 0:1  190 EUR ¼ 181 EUR Therefore, the price under specific performance will be PSP ¼ 145. Given that the probability of an increase is 20% the seller’s payoff under expectation damages is

42

3 Distributional Effects and the Original Contract

σ ED ¼ 144 EUR
0:8  100 EUR
0:2  180 EUR ¼ 28 EUR whereas the buyer receives a payoff of π ED ¼ 180 EUR
144 EUR ¼ 36 EUR Under specific performance the seller gets σ SP ¼ 145 EUR
0:8  100 EUR
0:2  180 EUR ¼ 27 EUR and the buyer has a payoff of π SP ¼ 0:8  180 EUR þ 0:2  190 EUR
145 EUR ¼ 37 EUR Thus, the seller benefits from expectation damages by EUR 1, and the buyer would benefit from the specific performance by EUR 1. The analysis shows that if the parties underestimate the probability of an increase the seller charges a too low price from the buyer for the option to claim specific performance. Putting it differently, the seller pays too much for the option to breach the contract. Conversely, if the parties overestimate the probability of an increase in costs the buyer overpays for the option to claim specific performance. A more complex situation exists if one of the parties, most likely the seller, has superior knowledge regarding the probability of an increase in price. I will discuss this issue as part of the broader topic of asymmetric information in Chap. 6.17

3.3.2

Magnitude of Increase

Next, we look at the effect if the parties make a false prediction about the magnitude of an increase. We can largely refer to the previous section. Overestimating the magnitude of an increase in costs has the same effect as overestimating the probability. Likewise, underestimating the magnitude of an increase in costs equals underestimating the probability of an increase. To see that first recall the relationship between the prices under specific performance and expectation damages: PSP ¼ PED + αb. It shows that the buyer pays a higher price under specific performance based on the probability of an increase, α, and on the amount of the side payment. Secondly, note that the side payment reflects the share of the surplus the buyer gets through renegotiations. That surplus increases as the magnitude of the increase

17 A distributional effect surely occurs if only one of the parties over- or underestimates the probability and the other party is aware of that mistake and can make use of it.

3.3 Uncertainty

43

expands. Thus, underestimating the magnitude entails a lower predicted side payment, denoted g. Therefore, the price is PSP ¼ PED + αg. The formulas for the payoffs remain the same as in Sect. 3.2.1 apart from that the parties correctly predict the probability of an increase, α. Thus, if we compare the seller’s payoffs under both remedies we see that she prefers expectation damages if the parties underestimate the magnitude of an increase in costs. σ ED > σ SP

ð3:44Þ

PED
c þ αc
αv > PSP
c þ αc
αv
αb o

o

o

o

ð3:45Þ

Plugging in PSP ¼ PED + αg yields: PED
co þ αco
αv > PED þ αg
co þ αco
αv
αb

ð3:46Þ

b>g

ð3:47Þ

From the buyer’s perspective, if the parties underestimate the magnitude of an increase in costs he is better off with specific performance: π SP > π ED

ð3:48Þ

v
PSP þ αb > v
PED

ð3:49Þ

v
PED
αg þ αb > v
PED

ð3:50Þ

b>g

ð3:51Þ

We can further infer that the converse result is gained if the parties overestimate the magnitude of an increase.

3.3.3

Bargaining Power

Making a false prediction about the parties’ future bargaining power during renegotiations entails a distributional effect. False predictions about the future bargaining power enter the formulas equally as mistakes about the magnitude of an increase in costs. Both affect the expectation about the future side payment, b. Thus, for the details, I refer to Sect. 3.2.2. In a nutshell, if the parties underestimate the buyer’s future bargaining power, he will get a greater share of the surplus than the price reflects. Correspondingly, the seller profits from the specific performance if the parties overestimate the buyer’s future bargaining power.

44

3.4

3 Distributional Effects and the Original Contract

Unsuccessful Renegotiation

So far, the analysis assumed that the parties will successfully renegotiate the contract under specific performance if the seller’s costs increase. Departing from this assumption I turn to the question who bears the loss that arises if the parties fail to renegotiate successfully. This can rationally be the case if the transaction costs outweigh the possible benefit from renegotiation, e.g., high attorney fees, or due to asymmetric information as will be discussed in Chap. 6. The loss stems from the seller performing although her costs have increased above the buyer’s valuation which is inefficient. Since expectation damages are unaffected by the failure of renegotiation, at least under the assumption of complete information, I concentrate on specific performance in this section. I distinguish between two cases: in the first scenario the parties expected that no successful renegotiation will take place. In the second scenario, the failure of renegotiation takes the parties by surprise. I use the same notation as in the previous sections.

3.4.1

Expected Unsuccessful Renegotiation

This section analyzes how the parties distribute the surplus under specific performance if they expect renegotiations to fail. In that case, the overall surplus shrinks. The buyer’s willingness to pay is equal to his valuation because without renegotiation the seller always performs, wtpSP ¼ v. The seller’s willingness to accept reflects that she will always perform even if the costs increase, wtaSP ¼ (1
α) co + αc. The price reflects the parties’ willingness to pay and willingness to accept. It lies somewhere in between depending on the respective bargaining power. PSP ¼ ð1
λÞðð1
αÞco þ αcÞ þ λv

ð3:52Þ

λ 2 [0, 1] represents the bargaining power ex ante. With λ ¼ 1 the seller has all the bargaining power leading to a price of PSP ¼ v; the seller captures all the surplus. If the buyer has all the bargaining power λ ¼ 0. The price would be the seller’s willingness to accept. We can further infer for the buyer’s payoff to be π SP ¼ v
PSP ¼ v
ð1
λÞðð1
αÞco þ αcÞ
λv ¼ ð1
λÞðv
ð1
αÞco
αcÞ and for the seller’s payoff to take the value

ð3:53Þ

3.4 Unsuccessful Renegotiation

45

σ SP ¼ PSP
ðð1
αÞco þ αcÞ ¼ ðλ
1Þðð1
αÞco þ αcÞ þ ð1
λÞv ¼ λðv
ð1
αÞco
αcÞ

ð3:54Þ

It shows that the overall surplus of the transaction, i.e., (v
(1
α)co
αc) is purely distributed based on the bargaining power λ. Therefore, the loss due to unsuccessful bargaining is shared according to the bargaining power ex ante: the higher the bargaining power, the greater the share of the surplus. Thus, the more powerful party also bears a greater part of the loss because she would have gained a greater share of the larger surplus. The analysis also shows the parties’ participation constraints. This is the cutoff such that a party prefers not to conclude a contract in the first place. Because it is assumed that no outside options exist that cutoff lies where the share of the surplus is below zero. For a contract to exist it is therefore necessary that v
ð1
αÞco
αc > 0

3.4.2

ð3:55Þ

Unexpected Unsuccessful Renegotiation

We saw that the parties determine the distribution of the overall surplus ex ante and account for the expectation that renegotiation will fail. However, that presumes that the parties foresee renegotiation to fail. This section assesses the allocation of the surplus if renegotiation fails contrary to the parties’ prediction. Recall from Sect. 3.2 the buyer’s willingness to pay being wtpSP ¼ (1
α)v + α(v + b) ¼ v + αb and the seller’s willingness to accept being wtaSP ¼ (1
α)co + α(v + b). Again, we further infer that the price the parties agree on lies somewhere in between: PSP ¼ ð1
λÞðð1
αÞco þ αðv þ bÞÞ þ λðv þ αbÞ

ð3:56Þ

whereby λ 2 [0, 1] represents the bargaining power ex ante. First, it is important to notice that in comparison to the scenario that the parties foresee renegotiations to fail the payoffs are constant apart from the price the buyer pays. Buyer’s payoff π SP ¼ v
PSP ¼ v
ð1
λÞðð1
αÞco þ αðv þ bÞÞ
λðv þ αbÞ Seller’s payoff

ð3:57Þ

46

3 Distributional Effects and the Original Contract

σ SP ¼ PSP
ð1
αÞco
αc ¼ ð1
λÞðð1
αÞco þ αðv þ bÞÞ þ λðv þ αbÞ
ð1
αÞco
αc ¼ αðv þ b
cÞ þ λðv
αv
ð1
αÞco Þ

ð3:58Þ

It follows that to see who bears the costs of the unexpected failure of renegotiation we can simply compare the prices and how they differ if the parties anticipated that renegotiation will fail. As the benchmark case we determine under what circumstances prices are equal: ð1
λÞðð1
αÞco þ αcÞ þ λv ¼ ð1
λÞðð1
αÞco þ αðv þ bÞÞ þ λðv þ αbÞ

ð3:59Þ

ð1
λÞðαcÞ ¼ ð1
λÞðαðv þ bÞÞ þ λðαbÞ

ð3:60Þ

ð1
λÞðαcÞ ¼ ð1
λÞðαvÞÞ þ αb

ð3:61Þ

ð1
λÞðαc
avÞ ¼ αb

ð3:62Þ

ð 1
λ Þ ð c
vÞ ¼ b

ð3:63Þ

Recall that the future side payment b is a share of the surplus that is generated by non-performance if the costs increase, i.e., c
v. The size of the share the buyer gets depends on his future bargaining power, b ¼ δ(c
v), whereby δ 2 [0, 1]. Thus, the prices are equal if (1
λ) ¼ δ, i.e., ex ante and ex post bargaining power are equal. In that case, the distribution of the surplus in case renegotiation fails unpredicted is the same as if the parties had foreseen it to happen. Once the parties’ bargaining power varies this is different. If the buyer’s expected bargaining power ex post is greater than his bargaining power ex ante the parties will account for a higher future side payment and increase the price respectively such that the distribution of the surplus remains constant. As a result, if renegotiation fails the buyer has paid a higher price than he would have if the parties had anticipated the failure of renegotiation. Conversely, if the buyer’s ex post bargaining power is below his ex ante bargaining power the parties lower the price. As a result, the seller receives a lower share of the surplus than what she would have gotten if the parties had predicted renegotiations to fail.

3.5

Result

The analysis has shown that as long as the parties correctly anticipate the future side payment the seller makes under specific performance the choice of remedy is irrelevant from a distributional perspective. The future payment enters the negotiation at the contacting stage as an expected payment for which the parties adjust the price. From this perspective, expectation damages do not differ from specific

References

47

performance structurally but represent the extreme case that the future payment above the buyer’s valuation the seller makes is zero. Therefore, the outcome is the same between expectation damages and specific performance if in the case the seller is assumed to have all the bargaining at the renegotiation stage. However, once the parties lack the information or fail to predict the expected value of the side payment various distributional effects occur. Who benefits depends on whether the parties over- or underestimate the value of the side payment. If the parties overestimate the future side payment the seller is better off under specific performance. In the opposite case that the parties underestimate the future side payment the buyer profits from choosing specific performance as the remedy. The effects that such mistakes have on efficiency will be analyzed in Chap. 7.

References Craswell, R. (1988). Contract remedies, renegotiation, and the theory of efficient breach. Southern California Law Review, 61, 629–670. Daughety, A. F., & Reinganum, J. F. (2012). Settlement. In C. W. Sanchirico & L. M. Froeb (Eds.), Procedural law and economics (pp. 386–471). Cheltenham, UK, Northampton, MA, USA: Edward Elgar. Faust, F. (1996). Die Vorhersehbarkeit des Schadens gemäß Art. 74 Satz 2 UN-Kaufrecht (CISG). Teilw. zugl.: Regensburg, Univ., Diss., 1995-1996. Tübingen: Mohr. Gilboa, I., Postlewaite, A. W., & Schmeidler, D. (2008). Probabilty and uncertainty in economic modeling. The Journal of Economic Perspectives, 22(3), 173–188. Klass, G. (2014). Efficient breach. In G. Klass, G. Letsas, & P. Saprai (Eds.), Philosophical foundations of contract law (pp. 362–387). Oxford: Oxford University Press. Knight, F. H. (2014). Risk, uncertainty and profit. Mansfield Center, CT: Martino Publishing. Kronman, A. T. (1978). Specific performance. The University of Chicago Law Review, 45(2), 351–382. Mahoney, P. G. (1995). Contract remedies and options pricing. The Journal of Legal Studies, 24(1), 139–163. Markovits, D., & Schwartz, A. (2011). The myth of efficient breach. New defenses of the expectation interest. Virginia Law Review, 97(8), 1939–2008. Markovits, D., & Schwartz, A. (2017). (in)efficient breach of contract. In The Oxford handbook of law and economics, ed. Francesco Parisi. Oxford, United Kingdom, New York, NY: Oxford University Press. Savage, L. J. (2012). The foundations of statistics. Newburyport: Dover Publications. Schwartz, A., & Scott, R. E. (2003). Contract theory and the limits of contract law. The Yale Law Journal, 113(3), 541. Shavell, S. (2006). Specific performance versus damages for breach of contract: an economic analysis. Texas Law Review, 84(4), 831–876. Shiffrin, S. (2007). The divergence of contract and promise. Harvard Law Review, 120(1), 708–753. Shiffrin, S. (2009). Could breach of contract be immoral? Michigan Law Review, 107(8), 1551–1568.

Chapter 4

The Option to Cover

Imagine the seller and buyer agreed on a sales contract and there exists a market for the good that is subject to the contract. If it turns out that the seller’s costs have increased either one can purchase the good from another provider and thereby kill two birds with one stone; the seller does not need to incur her high costs of performance in order that the buyer receives the performance. It is important to stress that if the option to cover exists it generally does so for both parties. The law and economics literature regarding the option to cover often concentrates on the buyer’s opportunity to purchase the substitute elsewhere. For example, Eisenberg makes the distinction between “actual specific performance” and “virtual specific performance” whereby he defines “virtual specific performance” as the possibility for the buyer to purchase a substitute in the market.1 Thereby Eisenberg automatically narrows his view to the possibility that the buyer purchases the substitute and not the seller. This comes out clear when he states that “actual specific performance should be awarded unless (. . .), or the promise [buyer] can accomplish virtual specific performance.” (Eisenberg 2005, 978). In the following, I compare the effect of the option to cover given that either the buyer can claim specific performance from the seller but not the difference in price or the seller can breach and pay expectation damages. In the former case, the seller can in principle purchase the substitute and perform. In the latter case, the buyer can purchase the substitute and claim damages if the seller breaches. We proceed in two steps. First, we determine when the option to cover exists. In the second step we analyze the effects on efficiency.

1

See for example Eisenberg (2005, 978).

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 O. Hofmann, Breach of Contract, International Law and Economics, https://doi.org/10.1007/978-3-030-62525-2_4

49

50

4.1

4 The Option to Cover

When Does the Option to Cover Exist?

Putting it plainly, the option to cover hinges on the presence of suppliers of substitutes. This implies two questions: what follows for the market structure and what requirements do such substitutes need to meet? Those two questions are interrelated because the market structure depends on whether substitutes exist. The questions even conflate into one if the existence of substitutes, as regularly done, is only assessed by categorizing the goods as unique and alternatively as homogenous or fungible goods (Eisenberg 2005, 989; Kronman 1978). However, the two questions stem from different perspectives. The market structure is analyzed in an objective way and provides a good starting point. But for the option to cover it is the individual buyer’s perspective and thus his subjective valuation that is crucial. When designing the contract, the buyer can insert his perspective and determine what kind of goods count as performance.2 Therefore, I will argue that it is not the category, unique good or fungible good, that determines the option to cover but that the good or service provides the same utility in kind, not just amount, to the buyer.3 On the contrary, seeing the parties’ agreement as the fundament of the option to cover widens the scope of its applicability since it does not require that products are homogenous, fungible, or undifferentiated, but the parties decide what goods or services represent substitutes. Furthermore, the option to cover depends on the reason for an increase in the costs of performance. If it grounds on a more general root that affects not only the seller but all alternative providers equally the option to cover does not exist.4 In the next section, I discuss the different market structures before turning to the subjective aspect of the definition.

2 I take an ex-ante perspective in my work focusing on the design of contracts. The corresponding ex-post view is how to interpret a contract. The primary question is whether to apply a textual, and thus less ambiguous approach or to take the context into account. See for a discussion: Faust (1996, p. 316); Depoorter and Tontrup (2012, 677); Schwartz and Scott (2003, 547). 3 Eisenberg defines the possibility to cover the following: “A promise [buyer] can accomplish virtual specific performance if he can readily find in the market a commodity that he could not in good faith reject as an equivalent of the breached performance, given his demonstrable preferences—by which I mean subjective preferences whose existence can be satisfactorily demonstrated.”(Eisenberg 2005, 978). See also Ulen who emphasizes the buyer’s valuation as the decisive criterion; Ulen (1984, 373, 374). 4 Shavell calls those risks “systematic risks.” He distinguishes those from “idiosyncratic risks”: Shavell (2006, 854).

4.1 When Does the Option to Cover Exist?

4.1.1

51

Market Structure

Generally, market structures are categorized based on their level of competition, with perfectly competitive markets on one side of the spectrum and monopolistic markets at the other end (Cooter and Ulen 2008, 2012, pp. 28–32). Perfectly competitive markets require large numbers of sellers and buyers, that the products are homogenous, all participants are price takers, and perfect information among consumers and producers, i.e., knowledge about all prices and utilities each person would get by having each product (Breyer 2015, 72, 73). A producer produces as many goods or provides as many services until his marginal costs equal the market price. All goods or services will be purchased by customers. All contracts show the same terms. Thus, if the seller had not concluded a contract with the buyer she would have concluded the same contract with another producer (Cooter and Eisenberg 1985, 1445). In a perfectly competitive market, it is possible to cover as there are plenty of suppliers and the goods are by definition homogenous. In contrast, in a monopolistic market only one supplier exists (Breyer 2015, 88); therefore to cover is impossible. Those extreme market structures rarely exist. Nevertheless, we can conclude that the more the market resembles a monopoly the less likely the option to cover exists. However, in principle, even with only one additional provider the option to cover can exist.

4.1.2

Subjective Perspective

As stated above, the parties can determine in their contract what counts as performance. Although not having the final say categories are a good starting point to assess whether other goods can represent substitutes. This is most unlikely the case if the good subject to the contract is unique like real property, art, or antiques. In contrast, the more the good is fungible or homogenous it will represent a substitute to the buyer. But whether a good is fungible is rather a matter of degree than of kind (Mahoney 1995, 144). Furthermore, the parties’ view might differ from such general classification.5 This is not to negate that in many cases the stated categories correspond to the parties’ view. However, this is not necessarily the case. For instance, if the buyer needs a certain good but it is irrelevant to him whether he gets it today or in sixth months the service to deliver that good by plane or by ship has the same value to the buyer. But if the buyer needs the good urgently those types of delivery highly influence the buyer’s valuation. Similarly, a buyer might want to use a certain good only for one time. 5 This aspect is, for example, discussed regarding the right to cover under German law, § 439 BGB (German Civil Code).

52

4 The Option to Cover

Thus, it does not matter to him whether the quality of the good allows to make use of it several times. Not specifying the good or service too precisely can give the seller more options and thereby reduce the price. Thus, it is also possible that the substitute does not provide the exact same value to the buyer, but he has deliberately chosen not to further specify the good.

4.2

Consequences for Efficiency

In this section, I assess the direct consequences of the option to cover efficiency. To that end, I assume that under no renegotiation takes place due to high transaction costs. This allows identify how the option to cover affects the remedy regimes differently because those would otherwise vanish due to bargaining as seen in Sect. 2.2. I will start by analyzing the situation with homogenous goods and, based on the widened scope of the applicability of the option to cover, turn to the effects if goods are differentiated. In this part of my work, I assume that expectation damages meet the goal to make the buyer indifferent between performance and breach, i.e., compensation includes expenses due to purchasing the cover. I will discuss the problem expectation damages to be over- or undercompensatory in Chap. 5.

4.2.1

Homogenous, Fungible, and Other Goods of Equal Kind and Value

Suppose a buyer has purchased a good from a seller. There exist substitutes and a market price on which basis the parties had concluded the contract. Both seller and buyer can purchase the substitute whereby each incurs transaction costs. The analysis speaks to all situations in which the substitutes suffices the buyer’s preferences equally as the original good. This is true for homogenous and fungible if the parties have not articulated otherwise. It also holds if the parties have only specified a group of products among which products vary slightly and the seller picks the product randomly. In that case, the buyer expects to get the average product from that group of products. It follows that he gets the same expected valuation if he receives the product from another seller who has the same distribution as that product.

4.2.1.1

Expectation Damages

First, consider the situation under the remedy of expectation damages. The buyer has a certain valuation v. The seller has costs of performance denoted co. They increase

4.2 Consequences for Efficiency

53

Fig. 4.1 Game tree with option to cover under expectation damages (first constraint)

with a certain probability and attain the value c. The parties agreed on the price P equal to the market price, whereby c > v > P ¼ PM > co. After the conclusion of the contract, the parties learn that the seller’s costs have increased. Under expectation damages, the parties face two subsequent decisions. First, the seller has three options. She can either continue to perform herself, purchase cover on the market or she decides to breach the contract, and pay expectation damages. Taking the buyer’s perspective, he only makes a decision when the seller had breached the contract. In case the seller performs, either herself or by cover, the buyer has no say. Given the seller has breached the contract the buyer decides whether he purchases performance on the market himself for the price PM. In that case, he has transaction costs tB. Through performance or covering he receives his valuation v. Expectation damages allow the buyer to demand compensation from the seller for his covering costs, the price he paid for covering, and the transaction costs. Alternatively, the buyer can demand compensation in the form of his valuation in case the seller breaches. Importantly the right to claim compensation is limited in two ways: First, compensation does not exceed the buyer’s valuation. Secondly, the costs of covering represent an upper ceiling to the amount of compensation. In the following, we analyze why those constraints are important. To see the importance of the first constraint, suppose that the buyer’s valuation is below his costs of covering, v < PM + tB ¼ P + tB. The game tree in Fig. 4.1 shows the flow of decisions: We derive the results by backward induction starting with the buyer’s decision. With damages not being limited to the buyer’s valuation, we see that the buyer always receives a payoff of v  P independent from the parties’ decisions. If he covers, he gets fully reimbursed for the costs of covering. As a result, when the seller breaches the buyer is indifferent between covering and not covering. In contrast, if damages are limited to the buyer’s valuation, he only gets a payoff of π ¼ 2v  2P  tb. This is a smaller payoff than without cover π ¼ v  P:

54

4 The Option to Cover

2v  2P  t b < v  P

ð4:1Þ

v < P þ tb

ð4:2Þ

This is true by assumption in the given scenario. Hence, the buyer does not cover if the seller breaches in the given scenario if damages are limited to the buyer’s valuation. Next, consider the seller’s perspective. If the seller performs, she receives the price but incurs her increased costs of performance, σ ¼ P  c. In case she decides to cover she gets the price but has to pay the market price and additionally incurs her transaction costs. Because the price she receives and the market price are equal her payoff is σ ¼  tS. If she decides to breach her payoff depends on the buyer’s choice and on whether damages are limited: If damages are not limited and the buyer covers she gets the price but pays the market price plus the buyer’s transaction costs; σ ¼ P  PM  tB ¼  tB. If the buyer does not cover she pays the buyer’s valuation as compensation for the price in exchange; σ ¼ P  v. In case damages are limited to the buyer’ valuation the seller’s payoff is σ ¼ P  v independent from the buyer’ decision. Depending on the size of transaction costs we get the following case distinction: Case 1: Seller’s and buyer’s transaction costs take a high value such that P  c >  ts and P  c >  tb. It remains true that P  c < P  v. Under both forms of damages, limited to the buyer’s valuation and not limited we find the equilibrium that the seller breaches and the buyer does not cover. With limited damages, the buyer does not cover if the seller breaches and the seller is better off with paying the buyer’s valuation as compensation. However, with unlimited damages, there is a second equilibrium because the buyer is indifferent between covering and not covering. If the buyer covers the seller prefers to perform under unlimited damages. This second equilibrium is not efficient. Case 2: The seller’s transaction costs are high and the buyer’s transaction costs are smaller such that P  c >  ts and P  c <  tb. It remains true that P  c < P  v. For limited damages, the outcome is the same as in case 1: An efficient equilibrium where the seller breaches and the buyer does not cover. With damages not being limited to the buyer’s valuation, the buyer is indifferent between the cover and not covering. In contrast to case 1, the seller always prefers to breach. As a result, we find two equilibria. One where the seller breaches and the buyer inefficiently covers and alternatively the efficient equilibrium where the seller breaches and the buyer does not cover. Case 3: The transaction costs are generally low. The buyer’s transaction costs are below the seller’s transaction costs: P  c <  ts <  tb. It remains true that P  c < P  v and v < P + tB. It follows that P  c <  ts <  tb < P  v, i.e., breach and no cover is efficient. That is the equilibrium we find with limited damages. But with unlimited damages another equilibrium allows the buyer to cover and the seller to breach.

4.2 Consequences for Efficiency

55

Fig. 4.2 Game tree with option to cover under expectation damages (second constraint)

Case 4: The seller’s transaction costs take a low value and are below the buyer’s transaction costs. In addition, the seller’s transaction costs are smaller than the buyer’s valuation minus the price. It follows: P  c <  tb < P  v <  ts.The seller prefers cover to performing and to breach regardless of the buyer’s decision and whether damages are limited. Thus, the only equilibrium we get is that the seller covers which is efficient. Case 5: This case differs from the previous one only in that the seller’s transaction costs are greater than the buyer’s valuation minus the price. We get P  c <  tb <  ts < P  v. With limited damages the seller breaches in equilibrium and the buyer does not cover. However, with unlimited damages there is a second equilibrium. The seller covers as she expects the buyer to cover. This is a possibility because the buyer is indifferent between cover and no cover. This second equilibrium is inefficient. As a result, we see that limiting damages to the buyer’s valuation is necessary to achieve efficient results in all cases.6 Now, we draw attention to the second constraint; compensation is limited to the costs of covering. Within legal doctrine, this is captured by the buyer’s duty to mitigate. According to the principle, the buyer is obliged to mitigate his losses. From this obligation, it is deduced that the buyer gets compensation for his lost valuation but only to the extent that he could not have prevented it by covering. This upper ceiling for compensation is relevant if the buyer’s valuation exceeds his costs for covering, v > PM + tB ¼ P + tB. We suppose we are in such situation for the following assessment of the importance of the constraint (Fig. 4.2). 6

For the sake of completeness, it needs to be said that outcomes in the given scenario are not necessarily first best from a welfare perspective. For example, if the seller takes the decision whether to perform or cover the market price enters into her calculation as costs. From a welfare perspective, it might be that covering would still yield a surplus although the price is plus transaction costs are higher than the seller’s increased of performance. This is based on the fact that the market price is possibly higher than the costs the other supplier bear to perform. Thus, paying the price would be the surplus of another supplier and thus part of the overall welfare calculation. However, this inefficiency is not related to the choice of remedy but a lack of competition in the market.

56

4 The Option to Cover

First of all, we can infer in the given situation that the seller would not perform. It is dominated by the seller’s option to breach with or without the duty to mitigate: v > PM þ t B ¼ P þ t B , t B > P  v > P  c

ð4:3Þ

Secondly, we can conclude that with the duty to mitigate the buyer covers if the seller breaches. We get the following three cases: Case 1: The seller’s transaction costs take a high value being above the buyer’s transaction costs and the buyer’s valuation minus the price: tB > P  v >  tS. With the duty to mitigate the seller breaches and the buyer covers efficiently. Without the duty to mitigate there is the second equilibrium that the seller breaches and the buyer does not cover because he is indifferent. Case 2: The seller’s transaction costs are above the buyer’s transaction costs, but below the buyer’s valuation minus the price: tB >  tS > P  v. With the duty to mitigate we find only one equilibrium where the seller breaches and the buyer covers. As in case 1 without the duty to mitigate we get a second inefficient equilibrium. Here, the seller covers herself if she expects the buyer not to cover if she breaches. This is a possibility because the buyer is indifferent. Case 3: The seller’s transaction costs are below the buyer’s transaction costs and the buyer’s valuation minus the price. tS >  tB > P  v. In this case the seller efficiently covers herself with and without the duty to mitigate. We can conclude that the imposition of the constraint on compensation provides efficient outcomes. So far, the law and economics literature when analyzing the duty to mitigate has concentrated on the buyer’s decision to cover. It is argued that the duty to mitigate has the advantage to incentivize the buyer to cover when it is preferable from a welfare perspective (Posner 2000, p. 170; Goetz and Scott 1983, 984). The argument goes as follows: Suppose the seller breaches a contract and the buyer has the option to mitigate the loss. It is said that the buyer has no incentive to mitigate if the seller has to fully compensate the buyer for all the loss. Therefore, the buyer should be obliged to mitigate, and if he fails he should bear that part of the loss that he could have prevented. However, the analysis has shown that the constraint is necessary not only to incentivize the buyer to take the efficient decision to cover but also empower the seller to foresee that the buyer will cover and based on knowledge to take the efficient decision herself. This is important in case 2 where the seller might opt for covering herself although it is less efficient than the cover by the buyer. Further, it is important to note that the constraint on compensation strikes a delicate balance. As Posner points out (Posner 2000, p. 170), the buyer would also take an efficient decision whether to cover if he does not get compensated. Thus, the amount of damages awarded need to fulfill two requirements: the buyer needs to take an efficient decision about covering and the seller needs to be incentivized to perform if it is efficient.

4.2 Consequences for Efficiency

4.2.1.2

57

Specific Performance

The situation under specific performance is quite simple. The seller decides whether she performs or purchases the cover. The buyer’s role is reduced to be the recipient of performance. It follows that the outcome is solely dependent on the seller’s decision. She will perform herself if her payoff from the performance is above her payoff if she covers; P  c >  tS. Putting it differently, the seller performs if her costs of covering exceed her costs of performance. Obviously, that cuts off two possibilities compared with expectation damages: the buyer covering himself and breach without covering (non-performance). First, consider that it is not the buyer who covers. From an efficiency perspective, this implies two possible negative scenarios. First, it might be that the seller is incentivized to cover although her transaction costs are above the buyers. Secondly, the seller might prefer performance to purchasing the cover because she faces high transaction costs. This would lead to a less efficient outcome if the buyer’s transaction costs would be lower such that the seller would prefer to simply compensate the buyer. In the first case, the loss the parties incur is the difference in transaction costs loss ¼ tS  tB. In the second scenario the parties lose the difference between the seller’s costs of performance and the costs of covering by the buyer; loss ¼ c  P  tB. The second result that is not reachable under specific performance is non-performance meaning the buyer receives performance neither from the seller nor through the cover. This reduces the parties’ total payoff if the buyer’s valuation is below all three options to achieve performance: performance by the seller herself, cover by the seller, and cover by the buyer; v < min (c, P + tB, P + tS). Basically, this is the same argument as the one generally put forward in favor of expectation damages shown in the standard model. However, it has less meaning in the given context with the option to cover for two reasons. To see the first reason, suppose that the transaction costs for covering are the same for buyer and seller. The parties agreed on a price equal to the market price.7 It is probable that the buyer’s transaction costs to purchase performance from the seller in the first place are the same as the transaction costs the buyer faces to make the cover purchase. Based on the fact that the buyer did acquire from the seller leads to the conclusion that his valuation is greater than the price the parties agreed on plus his transaction costs. We can further infer given that the market price is the same as the price the parties agreed on, the buyer’s transaction costs for cover are the same he had for the original purchase and they are equal to the seller’s transaction costs, the

7 It is possible that the market price increases because the seller drops out of the market due to her increase in costs. In that case the second reason for the lower meaning is even more relevant because this increase in price does not affect the other suppliers’ marginal cost and therefore not the social welfare.

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4 The Option to Cover

buyer’s valuation is still above the price plus the seller’s transaction costs: v > P + t B ¼ P M + t S. The fact that the buyer has already incurred the original transaction costs is irrelevant because they are sunk costs. If the seller’s transaction costs surpass the buyer’s this might imply inefficiencies but those are limited in scope to the difference in transaction costs. The second reason is more fundamental and bases on the distinction between total welfare and the parties’ total payoff. Suppose the buyer’s valuation is below the seller’s costs of performance and the costs for covering by either party. The seller’s costs for covering are below her costs of performance. Under specific performance, the seller purchases the cover on the market although it reduces the parties’ total payoff. The buyer gets a payoff of π ¼ v  P and the seller receives the negative payoff of σ ¼ P  PM  tS. The parties’ total payoff: π + σ ¼ v  P + P  PM  tS ¼ v  PM  tS is negative and could have been prevented by non-performance. However, from a welfare perspective, the market price paid by the seller to purchase the cover is not the social costs to enable performance. This would only be true in a perfectly competitive market where the market price is equal to the marginal costs of production. Thus, from a welfare perspective, the price paid is the benefit of another supplier. This supplier bears costs cB. It follows that cover by the seller remains efficient as long as the buyer’s valuation is greater than the transaction costs plus the supplier’s costs; v > cB + tS. It follows that the greater the difference between the market price and the marginal costs of performance the less likely it is that cover by the seller although the market price plus the transaction costs exceed the buyer’s valuation is inefficient.

4.2.1.3

Result

From an efficiency perspective, the decision who should purchase the substitute depends on for who of the parties it is cheaper to do so.8 The analysis shows that expectation damages, designed the way shown above, hold an advantage over specific performance if and to the extent that it is cheaper for the buyer to cover (Schwartz 1979, 286). If it is cheaper for the seller to cover she would do so under both regimes. Under expectation damages, she is incentivized to do so because she would compensate the buyer for his (higher) transaction costs (Yorio 1982, 1385). With specific performance, it is always the seller who makes the cover purchase regardless whether it is cheaper for her. Not to overstate this result, it is vital to remember that this bases on the additional assumption that the parties do not renegotiate. If they did they could also negotiate who of them makes the cover purchase. In case the buyer has lower transaction costs he could agree to do so in return for a side payment.

8

This resembles the concept of the cheapest cost avoider; see for that approach: Calabresi (1977).

4.2 Consequences for Efficiency

59

In addition, even if expectation damages lead to more efficient outcomes the magnitude of this advantage is merely the difference in transaction costs. Furthermore, there is no general reason to believe that it is cheaper for the buyer to cover because the seller needs to have knowledge about their competitors, and she is likely to have an advantage in assessing the quality of the cover performance.9 Another important assumption the result bases on is that expectation damages encompass the buyer’s transaction costs. Expectation damages have been criticized for making the buyer bearing transaction costs that arise from the necessity to conclude cover contracts (Weller 2012, p. 368). However, this argument is not discrete from the general discussion about the shortfall of expectation damages. As shown above in the standard model, it is generally important that the seller bears those costs that are caused by her decision whether to breach so that she internalizes those costs in her own cost-benefit analysis.10 This point will be assessed in Chap. 5.

4.2.2

Differentiated Goods

This section asks to what extent the findings about the impact of the option to cover given that the goods are homogenous carry over to the situation where the goods are not homogenous. Buyer and seller concluded a contract but learn that the seller’s costs have increased rendering performance inefficient. There exist alternative goods in the market. However, they provide a lower valuation to the buyer. The next sections analyze the scenario under expectation damages and specific performance. Subsequently, I compare the findings.

4.2.2.1

Expectation Damages

Recall the scenario from the previous chapter: Buyer and seller conclude a contract. The buyer has valuation v. The seller has costs of performance denoted co. They increase with a certain probability and attain the value c. The parties agreed on the price P whereby c > v > P > co. After the conclusion of the contract, the parties learn that the seller’s costs have increased. In

9

See for that argument and more details: Schwartz (1979, 287). This section only concerns cover contracts and transaction cost based on such. Thomas Riehm additionally alleged that expectation damages lead to higher transaction costs induced by the necessity to conclude back up contracts because the seller possibly does not perform but breaches (Riehm 2015, p. 179). He further argues that buyers would always have to conclude such back up contracts because they could never be sure to receive performance. However, it seems far-fetched that firms would conclude such back up contracts because of the possibility of the efficient breach scenario. The possibility that performance does not occur rather stems from other factors. As Riehm puts it, efficient breaches are of minor relevance compared too breaches of contract in general; (Riehm 2015, p. 180). 10

60

4 The Option to Cover

contrast, to the previous scenario there exists not the same product for the same price on the market but an alternative product for PAlt providing a reduced valuation vAlt to the buyer. Analyzing whether expectation damages set efficient incentives we distinguish again between two stages: at the first stage, the seller decides whether she perform herself, buys the alternative product, or breaches. On the second stage, the buyer decides whether he purchases the alternative product. We start with the second stage. As discussed above, expectation damages are constraint in two ways: expectation damages do not exceed the buyer’s valuation and he is obliged to mitigate his damages. This translates to the given scenario as follows: If the seller breaches and the buyer does not cover he generally gets damages in the form of his valuation for the original contract, v and pays the price to the seller. Those damages are limited if the buyer can mitigate his losses, i.e., if covering yields a positive payoff to him. This depends on the relation between the buyer’s valuation of the alternative good and its price. The limit therefore is v  vAlt + PAlt + tB which is below v if vAlt > PAlt + tB. In case the buyer covers he gets expectation damages in form of his incurred expenses for covering, PAlt + tB plus the difference in his valuation v  vAlt leading a total amount od PAlt + tB + v  vAlt. In that case expectation damages are limited to his valuation. It follows that similar to the case of equivalent goods the buyer covers after breach if it yields a positive payoff, vAlt > PAlt + tB. Otherwise the buyer refrains from covering and the seller pays the buyer his valuation as compensation. This provides us with two cases and the following payoffs: Case 1: Covering provides a surplus, i.e., vAlt > PAlt + tB. The seller compensates the buyer for his expenses due to covering and the difference in valuation. This gives the buyer a surplus of π ¼ v  P. The seller gets σ ¼ P  PAlt  tB  v + vAlt. Case 2: Covering does not provide a surplus, i.e., vAlt < PAlt + tB. The buyer does not cover. The seller compensates the buyer in the amount of his valuation yielding a payoff for the buyer of π ¼ v  P and for the seller of σ ¼ P  v. Turning to the first stage, we determine the parties’ payoffs based on the seller’s decision whether to perform herself, cover, and breach. This allows us to compare the private incentives with the social objective. If the seller performs she gets σ ¼ P  c and the buyer receives π ¼ v  P. Covering herself instead provides a payoff to the seller of σ ¼ P  PAlt  tS. The buyer would get π ¼ vAlt  P. With respect to breach we differentiate between the two cases and start by supposing that covering by the buyer yields a surplus (Fig. 4.3). Based on the fact that vAlt > PAlt + tB we can infer that P  PAlt  tB  v + vAlt > P  v. Combining this with the fact that c > v and therefore P  PAlt  tB  v + vAlt > P  c it shows that the seller’s option to breach the contract dominates the option to perform. To see whether the seller’s incentive is aligned with the parties’ objective to maximize their total payoff we first determine the parties’ total payoff if the seller

4.2 Consequences for Efficiency

61

Fig. 4.3 Game tree for the option to cover under expectation damages for differentiated goods given that cover by the buyer yields a surplus

cover and if she breaches. For the latter case, we have shown that the buyer covers himself. We receive the total payoff by adding the parties’ individual payoffs. This implies a total payoff if the seller covers of ΠCov S ¼ vAlt  P þ P  PAlt  t S ¼ vAlt  PAlt  t S

ð4:4Þ

With breach the total payoff is ΠBreach ¼ v  P þ P  PAlt  t B  v þ vAlt ¼ vAlt  PAlt  t B

ð4:5Þ

It follows that the seller should cover herself if her transaction costs for covering are below the buyer’s: ΠCov S > ΠBreach

ð4:6Þ

vAlt  PAlt  t S > vAlt  PAlt  t B

ð4:7Þ

tS < tB

ð4:8Þ

Looking at the seller’s incentive we see that it is not aligned with the given objective. The seller prefers cover to breach if P  PAlt  tS > P  PAlt  tB  v + vAlt , tS < tB + v  vAlt. Thus, the seller covers too often because with breach the seller also compensates for the difference in the buyer’s valuation. To align the seller with the parties’ objective to maximize the total payoff the price the buyer pays to the seller needs to reflect the lower valuation he gets if the seller covers. Thus, if the seller covers the price the buyer pays must be PCov ¼ P  v + vAlt. As a result, the parties are incentivized to generate the maximum total payoff.

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4 The Option to Cover

Fig. 4.4 Game tree for the option to cover under expectation damages for differentiated goods given that cover by the buyer yields no surplus

Suppose now that covering by the buyer does not yield a surplus, vAlt < PAlt + tB. In that case, the game tree looks as shown in Fig. 4.4: As before, the seller’s option to breach dominates performing herself because P  v > P  c. To assess whether the seller’s incentive is aligned with the parties’ overall objective we determine the total payoff. The total payoff for covering by the seller is the same as before. ΠCov S ¼ vAlt  P þ P  PAlt  t S ¼ vAlt  PAlt  t S

ð4:9Þ

For breach we get a total payoff of ΠBreach ¼ v  P þ P  v ¼ 0

ð4:10Þ

This implies that the seller should cover herself if the buyer’s valuation of the alternative good exceeds her costs for covering ΠCov S > ΠBreach

ð4:11Þ

vAlt  PAlt  t S > 0

ð4:12Þ

The seller would be incentivized to cover not only if the buyer’s valuation of the alternative product is above the costs of covering but even if the buyer’s valuation of the original good exceeds her costs of covering: P  PAlt  t S > P  v

ð4:13Þ

v  PAlt  t S > 0

ð4:14Þ

4.2 Consequences for Efficiency

63

As before, the seller’s incentive is aligned with parties’ overall objective if the price the buyer pays if the seller covers reflect the buyer’s difference in valuation, PCov ¼ P  v + vAlt.

4.2.2.2

PCov  PAlt  t S > P  v

ð4:15Þ

P  v þ vAlt  PAlt  t S > P  v

ð4:16Þ

vAlt  PAlt  t S > 0

ð4:17Þ

Specific Performance

Turning now to the effects under specific performance we can build what we derived for equivalent goods and for differentiated goods under expectation damages. Compared to the situation under expectation damages, the seller does not have the option to breach and thus the buyer does not take any decision. For the analysis we can apply the result we derived for expectation damages that the price the buyer pays if the seller covers need to reflect the difference in the buyer’s valuation: PCov ¼ P  v þ vAlt

ð4:18Þ

Table 4.1 shows the parties’ payoffs. We see that the seller’s incentive when to cover is aligned with the overall objective of the parties with respect to her decision whether to perform or to cover. The total payoff for covering by the seller is the same as before. ΠCov S ¼ vAlt  PCov þ PCov  PAlt  t S ¼ vAlt  PAlt  t S

ð4:19Þ

For perform we get a total payoff of ΠPerform ¼ v  P þ P  c ¼ v  c

ð4:20Þ

This implies that the seller should cover if covering yields a positive payoff or the loss from performing is below the loss generated by cover ΠCov S > ΠPerform

Table 4.1 Payoffs for the option to cover under specific for differentiated goods

Buyer

Seller Perform v  P, P  c

ð4:21Þ

Cover vAlt  PCov, PCov  PAlt  tS

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4 The Option to Cover

vAlt  PAlt  t S > v  c

ð4:22Þ

The seller is incentivized to act in accordance to that objective. We see that when we compare the seller’s payoffs: PCov  PAlt  t S > P  c

ð4:23Þ

P  v þ vAlt  PAlt  t S > P  c

ð4:24Þ

vAlt  PAlt  t S > v  c

ð4:25Þ

However, even though the seller is incentivized to maximize the total parties’ payoff within the boundaries of the given options specific performance lacks the opportunity that the buyer performs or neither of the parties performs nor covers.

4.2.2.3

Result

First, we can conclude that expectation damages imply efficient incentives for both parties. Specific performance on the other hand does not include the options that the buyer covers or neither party performs nor covers as a possible outcome. This is a problem if covering by the seller does not yield a positive total payoff for the parties, vAlt  PAlt  tS < 0. In that case, either the buyer’s transaction costs are lower such that covering by him is efficient (vAlt  PAlt  tB > 0) or non-performance, neither by performance nor cover, maximizes the parties’ payoff. In contrast to situations with homogenous goods, it is less likely that covering has a positive payoff. For homogenous goods, we argued that the prices are the same and also the buyer’s valuation. This is not the case here. Thus, the problem of specific performance if renegotiation does not occur is more relevant the more differentiated possible substitutes are. Furthermore, even if covering by the seller implies a surplus it might be that the buyer’s transaction costs are still below the seller. With differentiated goods, it is more likely that the costs for covering differ. In the given context of differentiated goods, the buyer’s informational advantage to know best which product satisfy his preferences the best is of more value than in the case of homogenous goods. However, the parties have specified performance in the contract so that the seller has gained information about the buyer’s needs (Schwartz 1979, 287). In addition, also the seller’s superior knowledge of the market is of more relevance in the case of differentiated goods. In the end, this question is an empirical one and depends on the specific circumstances.11

11

Yorio (1982, 1384), alleges that the buyer will be the cheaper coverer because he is likely to have ongoing business arrangements and if seller and buyer are far apart the seller has high delivery costs which outweigh the buyer’s costs to obtain the good. However, the good could be bought by the

4.3 Result

65

Regarding both remedies, I find that it is vital that the price for covering by the seller reflects the difference in the buyer’s valuation between the original good and the substitute. Otherwise the seller is incentivized to cover too often because the seller would not take into account the reduction of the buyer’s utility.12

4.3

Result

The analysis shows that the remedy of expectation damages sets the seller incentives to take an efficient decision unilaterally about performing and who covers. Nevertheless, the option to cover ameliorates inefficiencies that would arise under specific performance without renegotiation according to the standard model. If the buyer has lower costs to cover both remedies lead to the same outcome. If it is more expensive for the seller to cover the advantage of expectation damages exists only in the amount of the differences in costs for covering both parties face. The more the market resembles a perfectly competitive market with homogenous goods the easier it is for both parties to cover. We can infer that under such circumstances the choice of remedy and also the debate about the efficient breach scenario has little relevance. For the remainder of the analysis, I focus on scenarios where the choice of remedy does not only determine whether it is the buyer or the seller who covers. Thus, I assume for the following that there is no option to cover unless indicated otherwise. The parties do not act in an environment of perfectly competitive markets but rather in markets with one or few suppliers. This implies another important inference for the following analysis. In the efficient breach scenario damages cannot be calculated based on a market price. Thus, so-called “market damages” which have been proposed elsewhere are no solution in the efficient breach scenario.13 If there is no substitute there is no market. Thus, damages cannot be calculated on basis of a comparison between the contract price and market price.14

seller and delivered to the buyer directly. Whether the buyer has ongoing business arrangements cannot be discussed in a general way. 12 Such price adjustment is not necessarily easy to install. It is based on the buyer’s valuation which is likely to be private information, a general aspect that will we discussed in Part III. Nevertheless, the problem is the same under both remedies and thus does not give them an edge over the other. 13 For example, Schwartz and Scott propose “market damages” as the best remedy for a default if parties trade in thick markets. See Schwartz and Scott (2008). They explicitly limit their analysis by assuming considerable homogeneity in supply, Schwartz and Scott (2008, 1637 Fn. 80): “Market damages presupposes a market. Thus, we analyze market performance. When there is considerable heterogeneity in supply, controversy can exist as to whether a buyer’s substitute purchase would be sufficiently “like” the contract service so that the contract-price/market-price formula is appropriate. In such cases, direct expectation damages or specific performance may be more apt.” 14 To see the importance of that result consider among others Markovits and Schwartz (2011, 1977 Fn. 58) and Schwartz (1979, 271, 275–277) who argue specific performance is preferred if the value is unverifiable and no close substitutes exist and therefore expectation damages cannot be derived from a market price.

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References Breyer, F. (2015). Mikroökonomik. Eine Einführung. Springer Gabler: Berlin. Calabresi, G. (1977). The costs of accidents. New Haven: Yale Univ. Pr. Cooter, R., & Eisenberg, M. A. (1985). Damages for breach of contract. California Law Review, 73 (5), 1432–1481. Cooter, R., & Ulen, T. (2008–2012). Law and economics//law & economics. Pearson AddisonWesley; Addison-Wesley, Boston MA Depoorter, B., & Tontrup, S. (2012). How law frames moral intuitions: the expressive effect of specific performance. Arizona Law Review, 54(3), 673–717. Eisenberg, M. A. (2005). Actual and virtual specific performance, the theory of efficient breach, and the indifference principle in contract law. California Law Review, 93(4), 975–1050. Faust, F. (1996). Die Vorhersehbarkeit des Schadens gemäß Art. 74 Satz 2 UN-Kaufrecht (CISG). Teilw. zugl.: Regensburg, Univ., Diss., 1995-1996. Tübingen: Mohr. Goetz, C. J., & Scott, R. E. (1983). The mitigation principle: toward a general theory of contractual obligation. Virginia Law Review, 69(6), 967–1024. Kronman, A. T. (1978). Specific performance. The University of Chicago Law Review, 45(2), 351–382. Mahoney, P. G. (1995). Contract remedies and options pricing. The Journal of Legal Studies, 24(1), 139–163. Markovits, D., & Schwartz, A. (2011). The myth of efficient breach. New defenses of the expectation interest. Virginia Law Review, 97(8), 1939–2008. Posner, E. A. (2000). Contract remedies: foreseeability, precaution, causation and mitigation. In B. Bouckaert & G. de Geest (Eds.), Encyclopedia of law and economics (pp. 162–178). Elgar: Cheltenham. Riehm, T. (2015). Der Grundsatz der Naturalerfüllung. Tübingen: Mohr Siebeck. Schwartz, A. (1979). The case for specific performance. The Yale Law Journal, 89(2), 271–306. Schwartz, A., & Scott, R. E. (2003). Contract theory and the limits of contract law. The Yale Law Journal, 113(3), 541. Schwartz, A., & Scott, R. E. (2008). Market damages, efficient contracting, and the economic waste fallacy. Columbia Law Review, 108(7), 1610–1669. Shavell, S. (2006). Specific performance versus damages for breach of contract: an economic analysis. Texas Law Review, 84(4), 831–876. Ulen, T. (1984). The efficiency of specific performance: toward a unified theory of contract remedies. Michigan Law Review, 83(2), 341–403. Weller, M.-P. (2012). Die Vertragstreue. Vertragsbindung - Naturalerfüllungsgrundsatz Leistungstreue. Mohr Siebeck: Tübingen. Yorio, E. (1982). In defense of money damages for breach of contract. Columbia Law Review, 82 (7), 1365–1424.

Chapter 5

Over- and Undercompensation

This chapter discusses the consequences if expectation damages do not make the buyer indifferent but are either over- or undercompensatory. The specific performance gives the buyer the power to gain at least his valuation by claiming performance. The buyer would not excuse the seller from her obligation for a side payment less than his valuation (Depoorter and Tontrup 2012, p. 677). This part of the analysis concentrates on expectation damages and refers to specific performance only to highlight differences or similarities. The analysis starts with undercompensatory damages, i.e., a shortfall, proceeds with overcompensatory damages, and concludes with the results.

5.1

The Shortfall of Damages

A shortfall of damages is seen as one major impediment for expectation damages to provide efficient incentives (Eisenberg 2005, p. 989). As said above expectation damages are based on the idea to put the buyer in the same position as if the contract was performed (Eisenberg 2005, p. 989). It is said that if this aim was achieved fully, in theory, the reasons to promote specific performance as an alternative remedy dwindle (Eisenberg 2005, p. 989). However, there is a gap between the aforementioned aim and the buyer actually being indifferent between performance and expectation damages, if the latter ones might fall short (Eisenberg 2005, p. 989). In the following, I first describe what factors contribute to a shortfall of damages. I discuss their likelihood and the size of the impact they have. The second section outlines literature which argues that damages fall short even if damages are fully compensatory. In a third step, I model the effect of a shortfall of damages and discuss the consequences on efficiency. Thirdly, I analyze how the bargaining power of the parties affects the consequences of a shortfall of damages. This is followed by a section on the special issue that litigation costs preventing the buyer from going to court. Penultimately we will delve into behavioral insights on the value of keeping © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 O. Hofmann, Breach of Contract, International Law and Economics, https://doi.org/10.1007/978-3-030-62525-2_5

67

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contracts and reciprocity caused by a breach of contract. The last section analyzes whether renegotiation can reinstall efficient results in case of a shortfall.

5.1.1

General Reasons for Shortfall

Various reasons have been discussed in the literature as reasons for a shortfall of damages. They arise either from difficulties proving incurred damages or limits of compensation the law implies (Eisenberg 2005, p. 990; Depoorter and Tontrup 2012, p. 677, 687; Schwartz 1979).1 Eisenberg even alleges that “(. . .), damages under the expectation measure always fall short of making a promisee indifferent between performance and legal relief” (Eisenberg 2005, p. 977). Taking the seller’s perspective, as the decisive one, she takes her decision about the breach in the light of the future court decision. Thus, if courts set damages too low this translates into the seller’s cost-benefit calculation about breaching or performing. What matters for the seller’s decision is not that the court eventually sets the damages equal to the buyer’s valuation but that the seller expects the court to do so. Thus, the question is about systematic differences between damages and valuation rather than random mistakes by individual judges. Those systematic differences put the seller into the position to anticipate a shortfall due to specific circumstances of the situation like that the buyer has no proof of certain losses he would incur due to a breach of contract. Importantly, a shortfall of damages does not require asymmetric information about the buyer’s valuation and costs.2 Both parties can be informed about all aspects, but the buyer is limited in verifying his costs imposed by the breach to the court. The problem is the need to meet certain requirements how to measure certain kinds of damages, to prove damages, and predict them if they lie in the future (Schwartz 1979, p. 278; Faust 1996, p. 317). The difficulty to measure damages is salient if the buyer’s valuation of performance is primarily subjective. In cases where performance is about unique items that draw value from personal affection, it is said that courts face an insurmountable challenge to determine the buyer’s valuation (Kronman 1978, p. 368). For that reason, it is argued that at least under such circumstances specific performance is superior to expectation damages (Kronman 1978, pp. 355–365, 366–369). However, the problem of measuring and quantifying damages is not constrained to unique 1

See for an experimental approach to the shortfall of damages (Lewinsohn-Zamir 2012). A more general thought on monetary damages concerns the functionality of money itself. Monetary damages can only represent a functioning remedy as an alternative to specific performance if the money the buyer receives is valuable to the buyer. Hence, in situations of high inflation or in countries where money alone does not help to get the desired good a claim to damages is no valid substitute to performance. 2 I will take a closer look at the distinction between observable and verifiable information in Chap. 6.

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69

items but of a more general kind whenever the subjective value and intangible interests in performance are relevant (Riehm 2015, p. 23, 172; Ulen 1984, p. 361).3 By contrast, specific performance protects the subjective value of performance (Ulen 1984, p. 365). Intertwined with the problem to measure and monetize certain kinds of damages is the limit law imposes on such costs to be recoverable. For example, many jurisdictions do not protect the consumer surplus but would only grant damages in the amount of the market price. Furthermore, costs as frustration and anger are not recoverable (Schwartz 1979, p. 271). For instance, in German law immaterial damages are in principle not recoverable but only if the law states explicitly otherwise.4 When large companies contract, they only pursue economic aims. Thus, the shortfall is less likely to arise due to the difficulty to quantify subjective value but stems rather from the difficulty to prove and predict damages. Potential future earnings and losses can be challenging to predict and verify in court (Schwartz 1979, p. 271). The buyer needs to show sufficient certainty (See Eisenberg 2005, p. 992 for more details in regards to the application of that standard in the USA. But see also § 287 BGB (German Civil Code) as an example for the reduction of the burden of proof regarding the amount of damages if the investigation would require disproportionate effort; BGH 26.7.2005).5 Also, negative reputative effects the buyer suffers from do not get compensated because they are difficult to measure and negative effects on future earnings are complicated to predict (Riehm 2015, p. 176). Another potential source for a shortfall of damages is the buyer’s interest in keeping his valuation of performance and what it determines private (Ben-Shahar and Bernstein 2000). Such information can affect the bargaining position between the parties for future and parallel contracts but also if the information spreads it might affect the buyer’s bargaining position with other companies or, for example, banks (Ben-Shahar and Bernstein 2000, p. 1886).6 To establish and proof lost profits in court the buyer might be forced to reveal valuable information. This implies a loss to him he is not compensated for. Alternatively, the buyer could decide not to go to court. This would likewise entail a shortfall of damages, in fact zero damages. Similar to the buyer’s problem to monetize damages, the issue of the buyer’s secrecy interest is most salient with subjective damages which require firm-specific information in contrast to objective damages (Ben-Shahar and Bernstein 2000, p. 1886).

3

Some scholars take a very subjective viewpoint. They argue that only the parties themselves can know their costs and valuations in all cases. A third party cannot determine them. Thus, this strand of literature argues that expectation damages can never be an adequate response to a breach of contract. See for an overview Schäfer and Ott (2012, p. 504, 505). 4 See § 253 Abs. 1 BGB (German Civil Code). 5 See Eisenberg (2005, 992) for more details in regards to the application of that standard in the U.S.A. But see also § 287 BGB (German Civil Code) as an example for the reduction of the burden of proof regarding the amount of damages if the investigation would require disproportionate effort; BGH 26.7.2005. 6 The effect on the buyer’s bargaining position will be discussed in more detail in Sect. 6.1.3.4.

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A shortfall can also occur to the extent that the seller does not have to compensate third parties for damages that arise due to the seller’s breach. In that damages can fail to internalize external effects into the seller’s cost-benefit analysis. Misaligned incentives due to systematic undercompensation are attenuated if substitutes exist and the parties can cover. In particular, if goods are homogenous or fungible and can be readily purchased on the market, paying damages derived from the comparison between the agreed price and the market price often puts the buyer in an (almost) as good position as if it was performed (Eisenberg 2005, p. 990; Riehm 2015, p. 172). The buyer eventually gets performance and therefore his subjective valuation. Nevertheless, if the option to cover exists it remains difficult to monetize certain costs like costs of finding and making a second deal (Schwartz 1979). Limits to claim damages for expenses made to cover exist (Riehm 2015, p. 176). Even if identical goods exist but are not readily available on the market damages are likely to fall short. It is said that the existence of identical goods and a market price simplify to compensate by granting the buyer the difference between the market price and the price the parties agreed upon (Eisenberg 2005, p. 990). However, if the good cannot be purchased by the buyer he will not get his personal valuation. It is likely that his valuation will be above the market price (Eisenberg 2005, p. 990). In case homogenous goods do not exist, one cannot determine one common price, but rather an estimation or extrapolation (Eisenberg 2005, p. 990). A fictitious market price by extrapolation and comparison with comparable goods contains an even higher probability not to represent the buyer’s valuation correctly (Eisenberg 2005, p. 990). Another topic that is discussed within the context of undercompensatory damages is the foreseeability doctrine (Eisenberg 2005, p. 990). This doctrine is a center part of common law and also entered the United Nations Convention on Contracts for the International Sale of Goods, Art. 74 CISG. According to the foreseeability doctrine, the seller’s liability is restricted to such damages that were foreseeable for her at the moment the parties conclude the contract (Bebchuk and Shavell 1991). It is argued that the application of the doctrine leads to a shortfall of damages (Riehm 2015, p. 61). However, what makes this different from other reasons for a shortfall of damages is that the buyer can, in principle, prevent such shortfall by providing the seller with the necessary information at the contracting stage. Thus, limiting damages to such that were foreseeable by the seller is not simply a shortfall of damages that occurs but raises the more complex question whether the buyer should be forced to convey information about his valuation. The second question is whether it should be the moment the parties conclude the contract as the reference point that determines damages as foreseeable or alternatively the moment the seller decides whether to breach (Faust 1996, p. 318). Those questions are related to the asymmetry of information and will be discussed in Chap. 6.

5.1 The Shortfall of Damages

5.1.2

71

Shortfall of Damages Beyond the Money

Beyond the abound reasons for why damages fall short several papers argue that even if damages reflect the buyer’s valuation, they would not be fully compensatory. For example, Lewinsohn-Zamir alleges, based on experimental findings, that “people have a strong preference for in-kind entitlements and remedies over monetary ones. They prefer to obtain or recover the very thing they were entitled to rather than receive a monetary substitute, however accurately calculated.” (Lewinsohn-Zamir 2012) Thus, damages were undercompensatory if they do not include a premium that reflects the losses from not receiving performance itself (Lewinsohn-Zamir 2012, p. 23). In her study, she gave the participants a questionnaire with six different scenarios (Lewinsohn-Zamir 2013). For example, one of them concerned a transaction of iron and looked as follows (Lewinsohn-Zamir 2012, p. 16): Imagine that you are the owner of a factory that uses iron to manufacture its products. You are negotiating the purchase of a certain quantity of iron from an importer. The price the factory will pay the importer for the iron is $200,000. A quarter of this sum ($50,000) will be paid up front, at the time of contracting. The importer has offered you a choice between two contracts for purchasing the iron: According to contract M, the iron will be delivered to the factory within two months, but the importer reserves the right to sell the iron to another buyer if, after the formation of the contract, another buyer offers him a higher price. In that case, the importer will repay the advance payment ($50,000) without delay, and will also pay you monetary damages. The damages will fully compensate you for your losses due to the delay in supplying the iron, the inconvenience of purchasing substitute iron from another importer, and the increase (in the event that there is one) in the market price of iron. A. Which contract would you prefer to sign? (Please mark X beside your chosen answer.) I would sign contract I I would sign contract M I have no preference between the two contracts B. If you chose contract I, would you agree to sign contract M if the importer offered you a discount in the price of the iron? Yes/No (circle the correct answer) If yes, what would be the price discount (in dollars) required for you to choose contract M?

She finds that 74% chose specific performance. Only 34% of them were willing to switch to expectation damages for a discount. 30% demanded an unrealistically high discount, between 20% and 50% of the contract price (Lewinsohn-Zamir 2012, pp. 17–19, 2013, p. 162). Lewinsohn-Zamir claims that both contracts are of equal value. But she also admits that the right to claim specific performance gives the buyer the option to renegotiate and capture part of the additional payoff generated by selling to the third party (Lewinsohn-Zamir 2012, p. 18). Hence, all should have decided to take specific performance. However, she argues that the participants were not sophisticated enough to take into account the possibility of post-contractual negotiations (Lewinsohn-Zamir 2012, p. 18).

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In a second experiment, Lewinsohn-Zamir adjusts the questionnaire, now informing the participants that with the specific performance the seller needs to renegotiate to sell to the third party and the price would be lower under expectation damages (Lewinsohn-Zamir 2013, p. 170). Furthermore, the subjects are businessmen not Hebrew students which led Schwartz to raise external validity concerns (Schwartz 2012). But the result did not change. The percentage of subjects which chose specific performance even went up to 82.5%. Of those who chose specific performance 40% were willing to switch for a higher discount (Lewinsohn-Zamir 2013, p. 171).7 Apart from further conceptual concerns,8 there remain strong doubts that the study allows an inference that expectation damages are undercompensatory even if compensation reflects the buyer’s monetary loss.9 The results tell that the majority of the subjects think that the specific performance contract is the better decision and they are not willing to switch. But the study does not tell why they think that the specific performance contract is better. It could be that the subjects introduced their real-life experience into the study that damages are sometimes not even realized or can be difficult to proof (Schwartz 2012, p. 30, Fn. 2). In addition, though Lewinsohn-Zamir claims to measure people’s perceptions of outcomes it is possible that the subjects decided for specific performance because they reject the idea that a contract is not kept. In that people would have a deontological approach to decision-making. They judge the contract and its associated act, performance, or breach, not based on its outcome but whether it is in line with a moral norm of contract keeping (Zamir and Medina 2010, p. 41). But the economic analysis as consequentialist theory takes only outcomes into consideration. The process to reach a certain outcome has no influence on the evaluation (Schweizer and Lewinsohn-Zamir 2012). The traditional law and economics analysis focused on wealth as the outcome measure (Cooter and Ulen 2008–2012). But the utility function is generally open to other outcome measures. Based on behavioral law and economics, in particular, social preferences like inequality aversion enters the utility function (Engel 2018; Fehr and Schmidt 2006). Thus, Lewinsohn-Zamir’s demand that the economic analysis should include preferences for in-kind remedies and not only wealth (Lewinsohn-Zamir 2012), can be accounted for. However, her 7

The high amounts participants demanded to switch to expectation damages might partly be explained by a status quo bias. 8 First, Schwartz argues that the questionnaire suggests in-kind remedies to be the preferred choice. It creates an entitlement to the participant. In addition, it frames the expectation damages contract to be of lower value due to the second question: would you switch for a discount. Second, the specific performance contract suggests that the participants opt for actual performance and not a remedy which allows to sue for performance. See Schwartz (2012, 29, 30). 9 Schwartz puts forward an argument against Lewinsohn-Zamir’s conclusion that the buyer should receive a premium additional to expectation damages in case the parties are firms. He points out that firms are supposed to maximize the profit. If a manager prefers specific performance due to reasons beyond wealth this preference should not be relevant for the firm’s compensation. Nevertheless, such compensation would be lower than the overall loss created by the breach since the loss is not confined to the company.

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73

data does not substantiate the claim that people’s utility function puts a higher value on performance than on its monetary equivalent. Instead, she found that a large proportion subjects were not willing to switch for any discount. But if people simply put a greater value on performance there should be some discount that would lead them to opt for expectation damages. Hence, the study does not allow to infer that people have a preference for performance overcompensation. In the same vein, other studies that try to determine subjects’ moral understanding of a breach of contract, for instance by Wilkinson-Ryan or Mittlaender (WilkinsonRyan and Baron 2009; Mittlaender 2019), do not speak to whether people value performance more than their monetary equivalent. Instead, those studies presuppose that if subjects view a breach as immoral though the buyer being compensated, they apply deontological decision-making. Hence, those studies do not allow an inference whether the participants’ attitude about the breach enters their utility function or whether their decision is not based on an underlying utility function, i.e., they reject cost-benefit analysis from the start (Lewinsohn-Zamir 2012, p. 10). To the extent that those studies concern people’s inequality aversion, they are relevant to determine the buyer’s utility, i.e., if he experiences inequality aversion it means a loss to him. Inequality aversion might be on hand in the gain-seeking scenario. The seller makes an additional benefit without sharing it with the buyer. However, Mittlaender finds in a study that people do not show sign of inequality aversion in the gain-seeking scenario if the buyer gets fully compensated (Mittlaender 2019). Other studies by Wilkinson-Ryan and Baron (Wilkinson-Ryan and Baron 2009),10 and by Wilkinson-Ryan and Hoffman (Wilkinson-Ryan and Hoffman 2010), exist which find that people put in the buyer’s position would decree higher damages in a gain-seeking scenario than in a loss-avoiding scenario. But those studies do not allow to infer that people incur a loss due to inequality aversion. They just show a relative difference between the scenarios. No conclusion can be made why people perceive both scenarios differently. It might also be possible that the subjects empathized with the seller in the loss-avoiding scenario and thus decreed a lower amount of damages. For a specific set of transactions and aspects of transactions, a more precise study exists. Freund and Engel provide an experiment alleging that buyers are not indifferent between receiving performance and compensation if their preferences for the specific good is sufficiently strong (Engel and Freund 2017). In the experiment, they give the subjects the option to donate money to a charity organization. They provide the subjects with a list of ten organizations and let them pick their favorite. In the specific performance treatment, the money certainly goes to the picked organization. In the expectation damages treatment, there is a risk of 25% that the money will go to one of the other nine organizations. In that case, the subject receives an amount of money equal to their willingness to pay to secure that the money will end up at their preferred organization. This amount functions like expectation damages to make the

10 Furthermore, those experiments do not inform participants that giving the seller the option to breach leads to a lower price as we discussed in Chap. 3.

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subject indifferent through monetary compensation. They elicit the subject’s willingness to pay to ensure that their preferred organization gets the money at a previous stage of the experiment. The result shows that less people donate if an uncertainty exists that the money goes to the preferred organization. The authors infer receiving performance is different to some subjects than being compensated. To them performance, the organization receiving the money, means more than they state to be willing to pay for it. Since life is never certain, it would be interesting to see whether those findings persist if specific performance does not generate certain performance but only makes the performance more probable. It might be that subjects perceive a relative change in certainty different than absolute certainty. Engel and Freund conducted the experiment also with chocolate bars but did not find a difference in the subjects’ behavior between the specific performance and the expectation damages treatment. In contrast, donating money to a charity accentuates the subject’s social preferences. The results suggest that subjects find it difficult to put a price on the valuation the donation has to them. Hence, not only the preference needs to be sufficiently pronounced, as the authors say, but also the good in question needs to be intangible. In that this result is congruent with the above-mentioned problem courts face to put prices on the loss of intangible items. It shows that it is not simply an inability of the court, but that people face the same difficulty themselves.

5.1.3

Modeling the Shortfall

The shortfall of damages can have an effect on the seller’s decision about the breach and induce her to breach too often (Depoorter and Tontrup 2012, p. 278; Faust 1996, p. 317). In addition it might affect the parties when contracting in the first place. I start with the last stage, the seller’s decision whether to perform or breach, working my way backwards.

5.1.3.1

Deciding About Performance or Breach

Consider the following situation. The buyer has the valuation v. The seller has costs of performance of co which increase above the price with a certain probability. The increased costs attain either the value cα, cβ or cγ . The seller has the option to breach the contract and pay damages instead. Those damages take the value d which lie below v. We assume the price to lie between the seller’s original costs of performance co and damages d or c depending on which one is lower.11 The seller is incentivized to breach the contract if the damages are below her costs of performance. A breach is inefficient if the buyer’s valuation is above the increased costs.

11

We will discuss the influence of the price on the decision to breach in the next section.

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75

Fig. 5.1 Three ex post scenarios with a shortfall of expectation damages

Depending on what value the increased costs attain we see one of the three scenarios in Fig. 5.1: In the first scenario of Fig. 5.1, compensation falls so short that although the buyer’s valuation is above the seller’s costs of performance the seller is incentivized to breach which is inefficient. In the second and third scenarios, compensation is below the buyer’s valuation, but the shortfall does not have an impact on the seller’s decision. In the second scenario the seller breaches which she would have done also if she had to pay the full amount of compensation. Thus, it does not imply an efficiency loss but only changes the amount that is transferred. In the third scenario, the seller performs because her costs of performance are below the amount of compensation she expects to pay with the breach. In that case, the shortfall shows no impact at all. We can conclude that from an efficiency perspective a shortfall of damages entails a problem if and only if the buyer’s valuation exceeds the seller’s increased costs and the shortfall of damages takes a size which renders damages to be below the seller’s costs. Furthermore, it is important to note that the seller’s decision exclusively depends on the amount she expects to pay as damages compared to her costs of performance. Thus, to incentivize her efficiently it is not necessary that the buyer gets the respective amount of damages but only that the seller expects to pay them.

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5.1.3.2

Contracting Stage

This section analyzes whether the shortfall of damages hinders the parties to contract efficiently. Seller and buyer conclude a contract agreeing on the price P. Suppose that seller and buyer know at the contracting stage that when the seller’s costs increase those costs can attain the three different values cα, cβ or cγ . With probability α the costs increase such that the parties find themselves in the first scenario: “inefficient breach.” With probability β the parties will be in scenario two: “efficient breach.” Last, with probability γ the parties face scenario three: “performance.” Accordingly, with probability 1
α
β
γ the costs stay at their original level and the seller performs. The following equations show the parties’ payoffs. The buyer’s expected payoff is   E π sf ¼ ð1
α
β
γ Þv þ γv þ αd þ βd
P ¼ ð1
α
β Þv þ ðα þ βÞd
P

ð5:1Þ

The seller performs if there is no increase in costs or if costs increase to cγ . The buyer then receives his valuation. Otherwise the seller breaches and pays damages. The buyer always pays the price. The seller’s expected payoff is   E σ sf ¼ P
ð1
α
β
γ Þco
γcγ
αd
βd:

ð5:2Þ

The seller receives the price, incurs costs of co without an increase in costs, and cγ in the third scenario. Otherwise she pays damages. The total payoff is     Πsf ¼ E π sf þ E σ sf ¼ ð1
α
β Þv þ ðα þ βÞd
P þ P
ð1
α
β
γ Þco
γcγ
ðα þ βÞd ¼ ð1
α
β Þv
ð1
α
β
γ Þco
γcγ
¼ ð 1
α
β Þ ð v
co Þ
γ cγ
co ð5:3Þ Next, we analyze whether the shortfall has an impact on the parties’ contracting behavior. First suppose that the parties have no outside options to invest their money, i.e., their payoff is zero if they do not find an agreement. In that case, the parties will always conclude a contract as the following consideration shows. The buyer’s willingness to pay is WTPsf ¼ (1
α
β )v + (α + β)d and the seller’s willingness to accept takes a value of WTAsf ¼ (1
α
β
γ)co + γcγ + d (α + β). As long as the buyer’s willingness to pay is above the seller’s willingness to accept the parties can find a price to agree on:

5.1 The Shortfall of Damages

77

WTPsf > WTAsf

ð5:4Þ

ð1
α
β Þv þ ðα þ βÞd > ð1
α
β
γ Þco þ γcγ þ d ðα þ βÞ ð1
α
β Þv > ð1
α
β
γ Þc þ γcγ o

ð5:5Þ ð5:6Þ

We can rewrite the inequality as ð1
α
β
γ Þv þ γv > ð1
α
β
γ Þco þ γcγ

ð5:7Þ

The inequality always holds because ð1
α
β
γ Þv > ð1
α
β
γ Þco

ð5:8Þ

v > co

ð5:9Þ

γv > γcγ

ð5:10Þ

v > cγ

ð5:11Þ

and

Both are true by assumption. Hence, under such circumstances, the shortfall of damages has no effect on the bargaining behavior. This potentially changes if the parties have outside options. Suppose the buyer has two options: Either he concludes the contract with the seller or he invests his money differently providing him a payoff of π I. This outside option represents the buyer’s disagreement point.12 The buyer will not agree to a price with the seller that would push his payoff below his disagreement point. The existence of an outside option does not necessarily mean that the parties do not conclude a contract. Furthermore, if the parties do not conclude a contract that does not necessarily imply an inefficiency. We need to distinguish the cases where the buyer’s alternative payoff is below or above the total surplus (Πsf) which both parties share when they conclude a contract. Case 1: π I < Πsf In this case, the disagreement point can affect the price, but it does not prevent the parties from concluding the contract. The higher the disagreement point the greater the buyer’s share of the surplus the parties generate by concluding the contract. Case 2: π I > Πsf Once the disagreement point exceeds the parties’ total payoff the parties cannot find an agreement. This does not necessarily imply that the failure to conclude a contract is due to the shortfall. To determine when this is actually based on the shortfall itself we need to make a comparison to the situation where damages do not fall short. 12

See for the effects of disagreement points in general, Sect. 3.2.3.1.

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5 Over- and Undercompensation

If expectation damages did not fall short the seller would compensate the buyer for his complete losses. The parties’ payoffs would be as follows: The buyer’s expected payoff is E ½π  ¼ v
P

ð5:12Þ

E ½σ  ¼ P
ð1
α
β
γ Þco
αcα
βv
γcγ

ð5:13Þ

The seller expects to receive

It follows for their total payoff without a shortfall to be Π ¼ E ½π  þ E ½σ  ¼ v
ð1
α
β
γ Þco
αcα
βv
γcγ

ð5:14Þ

Comparing this to the total payoff with a shortfall we see that it is greater: v
ð1
α
β
γ Þco
αcα
βv
γc
γ > ð 1
α
β Þ ð v
co Þ
γ cγ
co

ð5:15Þ

αðv
cα Þ > 0

ð5:16Þ

The shortfall has a negative impact on the parties’ contracting behavior and thereby on their total payoff under two conditions: First, they would conclude a contract given that damages would not fall short. Second, they do not conclude the contract because damages fall short. This is on hand if the parties’ total payoff without a shortfall exceeds the buyer’s disagreement point while the parties’ total payoff with a shortfall does not: Πsf < π I < Π

ð5:17Þ

Figure 5.2 summarizes the result whether the shortfall has an impact at the contracting stage graphically:

5.1.4

Shortfall of Damages and Bargaining Power

This section analyzes how the division of the bargaining power between seller and buyer affects the impact of the shortfall of damages. So far, the analysis tacitly presumed that if the seller costs increase, they increase above the price. This can be true. However, there is an intimate relationship between the bargaining power, the price, and the impact a shortfall of damages can have. In the following, I focus on the relevant case that a shortfall of damages supposedly leads to inefficient breaches (first scenario in Fig. 5.1). For simplicity I will denote the increased costs c instead of cα. We shall quickly recall the scenario by considering Fig. 5.3:

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79

Fig. 5.2 Three ex ante scenarios with and without a shortfall of expectation damages

Fig. 5.3 Inefficient breach due to shortfall of expectation damages

For the analysis, I first suppose that the seller has all the bargaining power before deriving a general theory. In addition, I assume throughout that both parties have no outside options.

5.1.4.1

Seller Has All the Bargaining Power

This section asks whether the seller would ever breach the contract given that she has all the bargaining power. The seller takes two decisions. She sets the price because she has all the bargaining power and ex post, she can either perform or breach if her costs increase. Since damages fall short, the buyer’s payoff differs depending on what action the seller chooses ex post after an increase in costs. In consequence his willingness to pay depends on the seller’s post action. Thus, the price the seller can charge from the buyer is related to her future ex post action.

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5 Over- and Undercompensation

To analyze what price the seller sets and what action she chooses in case of an increase in costs I start by determining her payoffs subject to the ex post action and the price. In a second step, I compare the payoffs. The seller chooses the combination of price and ex post action which maximizes her payoff. First, suppose the seller performs ex post. In that case, the buyer’s ex ante willingness to pay is WTP ¼ v. The seller’s ex ante willingness to accept is WTA ¼ (1
α)co + αc. Since the seller has all the bargaining power the price is equal to the buyer’s willingness to pay: P ¼ v. For this to be a possible equilibrium it needs to be that the seller has no incentive to deviate from her strategy, i.e., if the price increases the seller does not prefer to breach the contract. The seller’s payoff if she performs is σ perform ¼ P
c ¼ v
c. If the seller breaches the buyer has two options. Either she claims compensation and pays the price, or she rescinds from the contract and does not have to pay the price. In the given case he would not claim compensation because damages are below the price, d < P ¼ v. The seller would get a payoff of zero. Comparing those payoffs, we see that the seller prefers to perform because σ perform ¼ v
c > 0. We can conclude that setting the price equal to P ¼ v and performing ex post is a possible candidate for an equilibrium strategy. Alternatively, suppose the seller breaches and the buyer does not claim damages if the seller’s costs increase. In that case, the buyer’s ex ante willingness to pay is WTP ¼ (1
α)v which also represents the price, P ¼ (1
α)v, because the seller has all the bargaining power. As before, for this to be an equilibrium strategy we need to check whether the seller would not deviate from her strategy to breach if her costs increase. The seller breaches ex post if σ breach > σ perform

ð5:18Þ

0>P
c

ð5:19Þ

c > ð1
αÞv

ð5:20Þ

In addition, the assumption that the buyer prefers not to go to court needs to hold. This is true if d < P ¼ (1
α)v. Therefore, it must hold that d < (1
α)v < c. The last candidate for an equilibrium is that the seller breaches and the buyer claims damages. The buyer’s ex ante willingness to pay is WTP ¼ (1
α)v + αd which represents the price, P ¼ (1
α)v + αd. However, this cannot be in equilibrium because the assumption that the buyer claims damages does not hold. The buyer would only claim damages if they exceed the price. However, this cannot be the case as the following inequality shows: d > P ¼ ð1
αÞv þ αd , d > v This inequality is false by assumption.

ð5:21Þ

5.1 The Shortfall of Damages

81

For the second stage of the analysis, it remains to compare the payoffs of the two candidates for an equilibrium. This will provide us with the price the seller will set and her according ex post action if her costs increase. We found that the seller either charges a price equal to the buyer’s valuation P ¼ v which entails that the seller always prefers to perform. The seller’s expected payoff is σ P¼v ¼ ð1
αÞðv
co Þ þ αðv
cÞ

ð5:22Þ

Alternatively, the seller charges P ¼ (1
α)v implying that she breaches if her costs increase and the buyer does not go to court.13 The seller’s expected payoff is σ P ¼ αv ¼ (1
α)(v
co). Comparing those two payoffs shows that the seller is better off with charging a price P ¼ v: σ P¼v > σ P¼αv

ð5:23Þ

ð1
αÞðv
c Þ þ αðv
cÞ > ð1
αÞðv
c Þ

ð5:24Þ

αðv
cÞ > 0

ð5:25Þ

o

o

Hence, the seller charging a price P ¼ v and perform if her costs increase is the equilibrium outcome. Therefore, even if a shortfall of damages is on hand no inefficient breach occurs if the seller has all the bargaining power. The intuition of the result is that if the seller captures all the gains from trade, then the seller prefers to perform if there are gains from trade to breaching the contract. The next section will further develop the relationship between the bargaining power and the shortfall of damages allowing for more variation with respect to the bargaining power.

5.1.4.2

General Relationship Between Bargaining Power, Price, and Shortfall

The previous section showed that if the seller has all the bargaining power a shortfall of damages does not lead to inefficient breaches. This section provides a more general picture of the relationship between the bargaining power, the price, and the shortfall. The analysis consists of two stages. First, I assess the parties’ strategies if costs have increased and determine the respective payoffs as a function of the price the parties agreed upon. In a second step, I analyze the price determination stage and show the effects the bargaining power has on the likelihood that the seller will breach inefficiently via the price. Consider first the stage once the seller’s costs have increased. The seller has two options: perform or breach. The buyer has the option to go to court and claim damages if the seller has breached. The following figure shows the respective 13

This alternative additionally hinges on the condition that d < (1
α)v < c as shown above.

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5 Over- and Undercompensation

Fig. 5.4 Shortfall of expectation damages and increase in costs

game tree whereby the two decisions made by the parties are depicted on the right. The payoffs are shown at the end nodes of the game tree in Fig. 5.4. Starting with the buyer’s last decision, we see that he prefers to sue if d
P>0

ð5:26Þ

d>P

ð5:27Þ

and would not sue otherwise. Now consider the seller’s decision about breach and performance. Suppose d > P. Therefore, the buyer sues upon breach. The seller would prefer breach to performance. By assumption d < c. Thus, P
d > P
c. If P > d and the buyer not going to court the seller does not pay compensation if she breaches. The seller prefers to breach if 0>P
c

ð5:28Þ

c>P

ð5:29Þ

Next, consider the price determination stage. First, I determine the upper and lower bound for the price before I discuss the relationship between the price and the parties’ ex post actions. The maximum the buyer would be willing to pay is given if the seller always performs, WTPmax ¼ v. The minimum the seller would be willing to

5.1 The Shortfall of Damages

83

Fig. 5.5 Bargaining power, price, and shortfall of damages

accept is, WTAmin ¼ (1
α)co + αd.14 The price lies somewhere in between those bounds. The buyer’s and seller’s relative bargaining power determines where in between those bounds the price eventually lies. Figure 5.5 shows how this interrelates with the seller’s and buyer’s decisions ex post. The price takes a value between (1
α)co + αd and v. The brackets above the line indicate the buyer’s reaction to an increase in price with respect to where the price lies. The brackets below the line refer to the seller’s decision if the price increases with respect to the price. The picture allows us to conclude as follows: The greater the seller’s bargaining power the higher will be the price. Once the seller’s bargaining power is such that the price exceeds the increased seller’s costs of performance the seller would perform. Putting it general, the greater the seller’s bargaining power the less likely it is that a shortfall leads to inefficient breaches.

5.1.5

Shortfall Due to Litigation Costs

Another reason which potentially leads to a shortfall of damages is litigation or enforcement costs which take a value that prevents the buyer from going to court. In fact, this is not just a shortfall of damages but renders them to be zero. If the buyer is not reimbursed for litigation costs he will not be indifferent and might be prevented to pursue his claim (Eisenberg 2005, p. 995). A seller expecting the buyer not to enforce his claim or not going to court would be incentivized to breach if her costs increase above the price. Based on that reason it has been argued that specific performance would hold an advantage over expectation damages because the buyer might face problems to

14

This assumes that the seller performs if her costs do not increase. Also note that the buyer claims damages if d > P. Since by assumption d > co, the minimum price arises if the buyer claims damages.

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5 Over- and Undercompensation

enforce her claim of damages (Riehm 2015, p. 177). It is argued that this disadvantage is salient if the seller has her place of business abroad or the magnitude of a single claim is small (Riehm 2015, p. 177). However, what distinguishes a shortfall due to litigation or enforcement costs from the reasons for a shortfall of damages discussed in the previous section, Sect. 5.1, is that enforcement and litigation costs also arise if the buyer sues for specific performance. If the buyer cannot enforce his claim of specific performance, it has no more bite than expectation damages. Nevertheless, the incentives to pursue a claim might differ between the remedies; which is analyzed in the following. Consider the Following Scenario: Seller and buyer conclude a contract. The seller’s costs of performance are co and the buyer’s valuation v. The parties agree on a price P. I assume the parties have equal bargaining power at the contracting stage. Hence, as in Chap. 3 I assume that the parties reach a price that splits the difference of the expected profit. The seller’s costs increase above the price with probability α.15 The increased costs c attain either a value below the buyer’s valuation c1 or above the buyer’s valuation c2, whereby the probability of c1 is φ and the probability of c2 is 1
φ; φ 2 (0, 1). Both parties know the probabilities and observe whether the costs increase and if so, what value they take. If the buyer goes to court and enforces his claim, his expected litigation and enforcement costs are l;16 it denotes expected litigation and enforcement costs under both remedies. We will relate the litigation costs to the remedies at a later stage of the analysis. The damages d are equal to the buyer’s valuation v because the shortfall discussed is based solely on litigation or enforcement costs. The scenario is depicted in Fig. 5.6. Consider that the seller’s costs have increased attaining a value of c1. In this case, performance is efficient because v > c1. However, if the seller expects the buyer not to go to court she prefers not to perform. She would not get the price but also not incur her increased costs of performance which exceed the price. If the seller’s costs of performance attain the value c2 non-performance is efficient. Under expectation damages, the seller could breach and pay damages. But if she expects the buyer not to sue she would not pay damages. Similarly, under specific performance, the parties could agree on non-performance for a side payment paid to the buyer. But in case the seller expects the buyer not to sue she would not perform without renegotiation. Nevertheless, such non-performance is efficient regardless of whether the seller pays some form of compensation to the buyer.

15 Another question is whether a difference in price due to the different remedies affects the probability that the increased costs are above the price. For the given scenario I assume that the costs increase by such an amount that they always lie above the original price regardless of the respective remedy in place. 16 For the model the litigation costs the seller pays are not relevant. In my work I do not address the question who pays what share of litigation costs but focus on the differences between specific performance and expectation damages supposing expected litigation costs. The assumption is that expected litigation and enforcement costs are the same between the remedies. Chapter 7 deals with the question whether those costs differ between the remedies.

5.1 The Shortfall of Damages

85

Fig. 5.6 Increased costs take value above or below buyer’s valuation

Putting those two findings together, we see that an efficient outcome is obtained if the seller’s costs attain the value c2 or as long as the seller expects the buyer to go to court if her costs increase attaining a value c1. Thus, we need to consider the buyer’s incentive to go to court if c ¼ c1. The crucial question is whether the buyer’s incentive differs between the remedies. Going to court provides the buyer with the following payoff: π ¼v
P
l

ð5:30Þ

Once the buyer goes to court the seller performs regardless of the remedy. There through the buyer gets his valuation and pays the price. He incurs litigation costs of l. The buyer sues as long as v
P > l. Note that if the seller expects the buyer to go to court, she would perform under both remedies. Breaching the contract and being sued just lowers her payoff. Next, consider the price determination on the basis that the buyer would sue if the seller does not perform. As said, in that case, the seller would perform without litigation to occur. First suppose the remedy in the place is expectation damages. The seller’s willingness to accept is WTAED ¼ ð1
αÞco þ αðφc1 þ ð1
φÞvÞ

ð5:31Þ

The buyer’s willingness to pay is WTPED ¼ v

ð5:32Þ

It follows for the price to be PED ¼

ð1
αÞco þ αðφc1 þ ð1
φÞvÞ þ v 2

ð5:33Þ

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5 Over- and Undercompensation

We can conclude that under expectation damages the equilibrium that the buyer would always sue if the seller’s costs increase to c1 can be sustained as long as v
PED > l v


ð1
αÞc þ αðφc1 þ ð1
φÞvÞ þ v >l 2 o

v
ð1
αÞco
αðφc1 þ ð1
φÞvÞ >l 2

ð5:34Þ ð5:35Þ ð5:36Þ

Next, I suppose that the remedy governing the contract is specific performance. In addition, I assume that in case the seller’s costs increase to c2 the parties renegotiate the contract. The seller is excused from her obligation to perform and the buyer gets a side payment of v + b. The seller’s willingness to accept is WTASP ¼ ð1
αÞco þ αðφc1 þ ð1
φÞðv þ bÞÞ

ð5:37Þ

The buyer’s willingness to pay is WTPSP ¼ v þ αð1
φÞb

ð5:38Þ

Thus, the price under specific performance is PSP ¼

ð1
αÞco þ αðφc1 þ ð1
φÞðv þ bÞÞ þ v þ αð1
φÞb 2

ð5:39Þ

In consequence, the buyer is incentivized to sue under specific performance given that the seller costs increased to c1 if v
PSP > l v


ð1
αÞc þ αðφc1 þ ð1
φÞðv þ bÞÞ þ v þ αð1
φÞb >l 2 o

v
ð1
αÞco
αðφc1 þ ð1
φÞðv þ bÞÞ
αð1
φÞb >l 2

ð5:40Þ ð5:41Þ ð5:42Þ

We compare the outcomes under both remedies. It shows that the equilibrium of the buyer suing if the seller’s costs increase to c1 exists for a greater range of litigation costs under expectation damages:

5.1 The Shortfall of Damages

87

v
ð1
αÞco
αðφc1 þ ð1
φÞðv þ bÞÞ
αð1
φÞb φc1 þ ð1
φÞv

ð5:45Þ

b>0

ð5:46Þ

The inequality shows that under specific performance the buyer is prevented to proceed with legal steps for lower litigation costs than under expectation damages. This is an effect of the higher price the buyer has to pay under specific performance because the parties expect the buyer to get a side payment if the costs increase to c2. As a result, the buyer’s expected profit from eventually receiving performance is lower under specific performance than under expectation damages. This effect hinges on the side payment the parties expect the buyer to get in the future, b. In case the parties expect the buyer to get no side payment but just his valuation specific performance leads to the same result as expectation damages. As the side payment increases the impact on the buyer’s likelihood to sues increases.17

5.1.6

Keeping Contracts

We have seen that the shortfall of damages can cause the seller to breach too often. However, the consequences might be less severe. Experimental studies suggest that people would keep their contracts even if they are better off breaching. This claim has potentially two channels. First, it is proposed that sellers have a social preference to keep a contract. Secondly, buyers retaliate if the seller breaches although it causes a loss to him. The seller foreseeing such behavior decides not to breach. Alternatively, both channels could have the effect that the seller pays fully compensatory damages to the buyer.

17 One aspect which could counteract this effect of specific performance would be if the expected litigation costs reflect the lower interest the buyer has in suing for performance due to the higher price. This can be the case, if litigation and enforcement costs the buyer expects to pay vary with value of the claim the buyer has. However, the variation of the litigation costs would have to reflect the full difference in price, and it seems difficult to calculate the reference value on the buyer’s subjective valuation of performance.

88

5.1.6.1

5 Over- and Undercompensation

Seller Performs Based on Moral Duty

The situation is as follows: The seller’s costs have increased. She can breach and pay damages. Those damages are below her costs but do not reflect the buyer’s valuation. The buyer’s valuation is above the seller’s increased costs. The seller would benefit from a breach because damages are lower than her costs. But now imagine, the seller takes morality into consideration and that morality would demand to keep contracts (Eisenberg 2014, p. 460). She performs. People’s decisions are to some degree based on moral judgment (Mitchell 2014, p. 183).18 Those judgments are based on moral heuristics (Sunstein 2005). In our case the moral heuristic would be: You shall not breach contracts. This heuristic is said to govern contract law (Feldman and Teichman 2011, p. 15; Bernstein 1992).19 From an efficiency perspective, people behaving according to moral heuristic is not necessarily positive (Mitchell 2014, p. 172).20 Let us alter the situation slightly: The seller’s costs have increased, and the buyer’s valuation is below her costs. Due to the moral norm the seller performs. In such a situation it is said that people trade efficiency off against other values (Mitchell 2014, p. 184). For our analysis, the important questions are: Do people act according to a moral heuristic which demands to keep contracts or promises as a broader concept? Is that still true in the efficient breach scenario? Here circumstances have changed, and they can breach according to their contract and pay damages. By answering those two questions we can form an idea whether people keep contracts inefficiently and whether they efficiently perform despite a shortfall of damages. We start with the general topic of promise keeping. Several studies suggest that people keep their promises without enforcement; even if it means a loss to them (Charness and Dufwenberg 2006, 2010, 2011). Those studies make use of versions of the so-called trust game (Berg et al. 1995): In the trust game Player A is given an endowment and has the option to send part of the endowment to Payer B. The amount he sends is tripled. Player B decides whether he shares with Player A. If one played the trust game according to homo economicus model Player B would not send anything back and as a result Player A would not give part of his endowment to Player B. But the studies found that people share. To test the effect of promises

18

See the following differentiation by Pi, Parisi and Luppi 2014, p. 145: such behavior is not in line with rational choice in the sense that the actor does not try to maximize their utility. But it is different than bounded rationality where the actor tries to maximize utility but due to mistakes, he does not achieve that goal. People still apply a costs-benefit analysis: the higher the costs for behaving according to moral heuristics the less likely people follow them, see: Stout (2014, p. 202). 19 See for a theoretical illustration: Shiffrin (2009). 20 Two opposing views exist with regards to heuristics: In standard behavioral law and economics heuristics are usually seen as impediments to optimal decision-making. This has its basis in the work by Kahneman and Tversky. In contrast, Gigerenzer sees heuristics as a tool to arrive at superior solutions when optimization is either not possible or the optimal strategy is unknowable. See Mitchell (2014, p. 172).

5.1 The Shortfall of Damages

89

Player B can send a costless, non-binding message beforehand, that she promises to be cooperative (Charness et al. 2013). Commonly such behavior is either explained by guilt aversion, i.e., the actor feels guilt if she believes to fail the other side’s expectations and to cause her a loss of utility (Charness and Dufwenberg 2006, p. 1583), or by moral commitment, i.e., the actor has a mere preference to keep a promise (Ellingsen and Johannesson 2004; Vanberg 2008). But despite that promises are kept without enforcement it can be that sellers breach in the efficient breach scenario. Taking an opposite view, Wilkinson-Ryan and Baron conjecture that more people would keep contracts than efficient (Wilkinson-Ryan and Baron 2009, p. 422). They base their view on findings from questionnaires. They showed subjects different situations reflecting the efficient breach scenario, for instance, the loss-avoiding and gain-seeking scenario, and one torts scenario. They asked the subjects to indicate what amount of damages they would set. A similar study was conducted by Wilkinson-Ryan and Hoffman (Wilkinson-Ryan and Hoffman 2010). But the studies are unsuited to provide insights about how a seller would behave because the subjects did not take a seller’s position (Eisenberg 2014, p. 461). Avoiding such objections, Wilkinson-Ryan modified the trust game to examine the seller’s willingness to breach in an efficient breach scenario (Wilkinson-Ryan 2015). Two steps are added to the experiment. First, Player B indicates prior to Player A’s decision whether he is going to share. Second, after Player A transferred an amount to Player B, Player B was given the opportunity to achieve a higher payoff but implying that he could not keep his promise to share with Player A (Wilkinson-Ryan 2015). She reports that 18.6% of the participants indicated to breach for any amount of profit. 27.9% were unwilling to breach even when offered almost triple the initial payout. For the remaining subjects, she identified a breakpoint somewhere in between. Wilkinson-Ryan concludes that a large fraction of sellers has a tendency to keep the contract even if it comes at cost (WilkinsonRyan 2015). However, drawing inferences from such trust games to the efficient breach scenario is a far stretch. Here, the seller compensates the buyer. Thus, the seller could believe that the buyer suffers no harm and thus she does not feel guilt. Furthermore, the seller could perceive her action as no breach of the contract because the contract allows her to breach (See for the debate about the double performance hypothesis: Markovits and Schwartz 2011; Shiffrin 2009).21 Furthermore, in the efficient breach scenario, the contingency that the costs increase exists with some probability. Most of the time the seller performs which generates the higher payoff. In the trust game, breach always implies a higher payoff (Mittlaender 2015, p. 7). Addressing those structural differences Mittlaender provides an experiment that includes compensation and both contingencies: an increase in costs and no increase

21

See for the debate about the double performance hypothesis: Markovits and Schwartz (2011), Shiffrin (2009).

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5 Over- and Undercompensation

in costs. His experiment showed support for his hypothesis that “expectation damages induce performance if and only if performance is socially efficient” (Mittlaender 2015, p. 39). The results indicate that sellers do not out of principle keep a contract if they pay compensation. More than 90% of the subjects in the seller’s role breached a contract given that it was efficient when they had to pay compensation and did not have to fear retaliation (Mittlaender 2015, p. 25). This allows us to infer that overperformance is no problem with efficiency. Our setting slightly deviates because compensation does not make the buyer whole. But even without compensation Mittlaender found no evidence that promises alone would induce the seller to perform in the efficient breach scenario (Mittlaender 2015, p. 39). More than 96% breached the promise if it was efficient (Mittlaender 2015, p. 25). Importantly, in the case of a shortfall of damages the seller has the option to fully compensate the buyer. This might be a way for the seller if she feels wrong about undercompensating the buyer to behave efficiently. Thus, we can conclude that there is no empirical study yet, which specifically addresses whether sellers keep a contract when damages fall short. Mittlaender’s findings allow to conjecture that the seller generally would not. This is adequate because Mittlaender’s experimental design represents the efficient breach scenario more accurately. But further research is necessary.

5.1.6.2

Reciprocity

The second channel that potentially leads the seller to perform is her expectation that the buyer might retaliate. In contrast to the rational choice model experiments have shown that people’s actions are influenced by reciprocity (Gächter 2014, p. 31. See for a detailed discussion of the reasons for why people show reciprocity: Gächter 2014, p. 35)22; negative reciprocity, i.e., they are willing to pay to retaliate in case of unfair behavior (Fehr and Schmidt 2003), positive reciprocity, i.e., they reward kind acts (Gächter 2014, p. 53). As an example, the ultimatum game is commonly named (Camerer and Thaler 1995). The “proposer” gets an amount of money and decides how he wants to share it with his counterparty, called responder. The counterparty needs to agree to the proposition. If she rejects both get no money (Stout 2014, p. 199). In contrast to the rational choice prediction that the proposer would offer the minimum amount which is accepted by the responder because it is better than nothing, in the typical ultimatum game experiment, the proposer usually offers half of the amount (Stout 2014, p. 199). Otherwise the responder rejects (Camerer and Thaler 1995). The influence of reciprocity differs among people. Some show stronger reciprocity, others act more according to rational choice (Gächter 2014, p. 25).

22 See for a detailed discussion of the reasons for why people show reciprocity: Gächter (2014, p. 35).

5.1 The Shortfall of Damages

91

For our purpose, the question is whether negative reciprocity can prevent the seller from breaching too often when damages are undercompensatory. Regarding the functioning of incomplete contracts Stout argues: Even if a party to a breached contract cannot rely on the judicial system to enforce the contract correctly, being able to drag one’s faithless counterparty into litigation, especially under the American rule where each party must pay its own attorney’s fees, is itself a form of punishment. Thus the behavioral phenomenon of spite can play a useful role in promoting prosocial behavior in relational contracting, if the parties to relational contracts anticipate that were they to indulge in opportunistic behavior, their disappointed counterparty might spitefully incur the cost of a suit merely for the personal satisfaction of knowing they have managed to impose a cost on the breaching party (Stout 2014, p. 207).

The relevance of the buyer’s willingness to incur costs is most evident when litigation costs would stop him from claiming damages. This would cause undercompensation as discussed. Regarding torts, Stout alleges that prosocial behavior can prompt the tortfeasor to behave negligently despite there is undercompensation of damages (Stout 2014, p. 205). A way that allows reciprocity between the parties to get an impact across the market is reputation. To keep a good reputation the seller might perform although benefitting from the breach in short term (Reputation has also been formulated as a substitute to legal rules: see Kornhauser 1983).23 It is said that “all other things being equal, a business prefers to contract with a partner known to have completed his promises promptly and without contentiousness.” (Ulen 1984, p. 347) Two ways how reputation affects the business is via the spread of information and repeated interaction of the parties (Ulen 1984, p. 347). It is rational for companies not to breach a contract although beneficial to them if that would cause to lower their reputation, implying lower future profits and thereby outweigh the benefits (Ulen 1984, p. 348). However, even though the seller is incentivized to perform when she anticipates the buyer’s retaliation the question remains whether we observe a net benefit. Sellers might inefficiently perform to avoid retaliation. If some sellers fail to anticipate retaliation they breach and the buyers retaliate. Thus, we observe an efficiency loss due to the inefficient breach, and in addition costs accrue to the parties due to retaliation. In his aforementioned experiment, Mittlaender tests retaliation by buyer’s and its anticipation by the seller’s in the efficient breach scenario (Mittlaender 2015): He finds that buyers very often retaliate in the absence of expectation damages irrationally when the seller’s decision was inefficient (Mittlaender 2015, p. 39). Sellers anticipated that behavior mostly when performance was efficient and performed. They performed more often when retaliation was possible to the buyer. This conclusion suggests that retaliation contributes to efficiency when there is no compensation. Arguably, those findings can be applied to undercompensatory

23

Reputation has also been formulated as a substitute to legal rules: see Kornhauser (1983).

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5 Over- and Undercompensation

damages; the buyer reacts similarly to the breach if he is undercompensated. This is likely to depend on the size of the shortfall. But the data of the experiment also reveal the downside to retaliation. Though retaliation is anticipated by a large fraction of sellers without damages the data shows that still 50% breach inefficiently; only 30% with damages and around 10% with damages and retaliation (Mittlaender 2015, p. 26). As Mittlaender rightly concludes, fully compensatory damages are much more effective in avoiding inefficient breaches than retaliation. The experiment, in addition, indicates that the introduction of expectation damages reduces retaliation (Mittlaender 2015, p. 39). Interestingly, the data shows that retaliation does not prevent the seller from breach when it is efficient; this suggests that the seller does not anticipate retaliation given that the breach is efficient (Mittlaender 2015, p. 26). The data from the experiment tells that when the breach was efficient still in more than 20% of the cases buyers responded with retaliation; with fully compensatory damages and even more without damages. This result goes hand in hand with a finding Mittlaender made in another study (Mittlaender 2019). He showed that around 20% of people viewed a breach of contract to be immoral even when the buyer is fully compensated (Mittlaender 2019, p. 131). The retaliation by those 20% leads to a substantial efficiency loss. However, it is less than other studies had predicted. Wilkinson-Ryan and Baron as well as Wilkinson-Ryan and Hoffman interpreted their findings asserting that people generally find a breach of contract to be immoral (Wilkinson-Ryan and Baron 2009; Wilkinson-Ryan and Hoffman 2010); also when the seller compensates the buyer (Wilkinson-Ryan and Baron 2009, p. 417). Thus, people would react punitive.24 Both studies use questionnaires. Subjects read different scenarios of breaching behavior or torts and had to indicate what amount of damages they would set. The study functioned on a relative basis, i.e., it compared the difference in damage the subjects assigned in either a loss or gain-seeking scenario; torts or breach case; a scenario that differed in timing: before the breach, negotiated prior to the breach and decided by an impartial party after the breach. They found that people are more punitive in a gain-seeking scenario than in a loss-avoiding scenario;25 people are more punitive in a breach of contract case than a torts case; people set a higher fee

24

Depoorter and Tontrup argue that it is the law that shapes the parties’ preferences about a breach of contract; Depoorter and Tontrup (2012). “(. . .) the endogenous nature of moral intuitions suggests that individuals are not principally opposed to contract breach. Rather, the default remedy influences the moral acceptability of contract breach. As an empirical matter, it appears that the ethical norm of promise keeping is highly context-dependent.” (p. 689) Based on their experimental result they argue that a default rule of specific performance causes the parties to reject a breach of contract. But their result does not only show that a significant number of people change their attitude towards a breach of contract. It also shows that around 75% do not change their attitude (p. 700). 25 Interestingly, Mittlaender did not find a difference in the retaliation behavior between the lossavoiding and the gain-seeking scenario if the seller compensates the buyer: Mittlaender (2015, 28).

5.1 The Shortfall of Damages

93

when damages are determined by a third party after the breach than when they are negotiated or determined prior to the breach. Those studies come with several caveats. They only allow to observe the relative difference between scenarios (Mittlaender 2019). Furthermore, the external validity is doubtful because the participants do not sign real contracts and do not face the monetary consequences of their decisions (Depoorter and Tontrup 2012, p. 690). The studies do not include how changes affect for example prices (Eisenberg 2014, p. 462; Schweizer and Lewinsohn-Zamir 2012). Also the questionnaires framed the seller’s behavior as a breach of contract. This suggested to the subjects that the seller was not allowed to breach and pay damages (Markovits and Schwartz, The Myth of Efficient Breach 1955). The importance of that aspect is highlighted by the finding that people did not set different fees when the contract was renegotiated, or the compensation was determined prior to the breach. Overall, the findings provide a mixed result regarding the effect of retaliation on efficiency. Retaliation prevents a large fraction of sellers from inefficient breaches. But it comes at a cost. In cases where sellers inefficiently breach buyers retaliate. The overall loss is threefold: the inefficient breach, the seller’s costs from retaliation, and the buyer’s cost from retaliation. In addition, buyers retaliate even when the breach is efficient. Thus, it is difficult to predict whether retaliation provides a net benefit.26 But we can conclude that the shortfall of damages leads to costs one way or another.

5.1.7

Shortfall and Renegotiation

As shown above, the shortfall of damages can result in inefficient breaches by the seller. However, this disadvantage can be overcome by renegotiation.27 Craswell asserted that point verbally (Craswell 1988, p. 635). We analyze it formally. I repeat the scenario from Sect. 5.1.3 but shall concentrate on the situation where the shortfall leads to inefficient breaches. The idea of renegotiation is closely related to the relationship between the bargaining power and the impact of the shortfall discussed above. For the following to be relevant, I assume that the seller does not have all the bargaining power because otherwise, as shown above, no inefficient breaches occur and there is no need for renegotiations. Buyer and seller conclude a contract and agree on the price P. The seller’s costs of performance increase with probability α and attain the value c (for the ease of illustration I denote those costs c instead of cα) that remains below the buyer’s valuation but above the price. The seller has the option to breach the contract and pay damages instead. Those damages take the value d and lie below both, the buyer’s

26

See for a study which suggests that retaliation does not lead to a net benefit to welfare: Sefton et al. 2007. For a study that shows a positive effect on social welfare see Gächter et al. 2008. 27 See for an analysis regarding the related topic of liability rules, undercompensatory damages and the influence of bargaining Kaplow and Shavell (1996, 761, 764).

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5 Over- and Undercompensation

valuation and the seller’s increased costs but above the price; P < d < c < v.28 The seller is incentivized to breach the contract because the damages she would have to pay are below her costs of performance. But this might change if the buyer offers an additional payment/higher price and thereby induces the seller to perform.29 To solve the question whether the parties find an efficient agreement we distinguish between two stages both after the parties have learned that the seller’s costs have increased: At the first stage the parties negotiate about the higher price. At the second stage, the seller decides whether she performs or breaches. As said, in the given situation without further payments the seller would breach. We start by determining the payoffs in the second stage and work our way back to the renegotiation stage. If the parties do not find an agreement the seller will breach the contract and pay damages. This provides the buyer with a payoff of π Breach ¼ d
P and the seller receives σ Breach ¼ P
d. This implies a total payoff of ΠBreach ¼ 0. Next, we analyze the renegotiation stage. The buyer has the option to make an additional payment to the seller x. This increases the price the seller receives. The question is whether the parties can always agree on such a payment that leads the seller to perform. To answer the question, we determine the parties’ payoffs given that the buyer makes an additional payment and check whether both parties’ payoff increases. The payoffs with renegotiation causing the seller to perform are as follows: The buyer’s payoff is π Rene ¼ v
P
x. He receives his full valuation pays the price plus the additional payment. The seller receives the price plus the additional payment and incurs her costs of performance; σ Rene ¼ P + x
c. This leads to a total payoff ΠRene ¼ v
c. This shows that the seller’s willingness to accept a payment to perform lies where she is indifferent between getting the additional payment and perform on the one hand and breach on the other hand: σ Rene ¼ σ Breach

ð5:47Þ

Pþx
c¼P
d

ð5:48Þ

x¼c
d

ð5:49Þ

Thus, the payment x needs to be at least x ¼ c
d. The buyer’s willingness to pay for the additional payment lies where he is indifferent between inducing performance with an extra payment and breach.

28 Having P < d ensures that the buyer would claim damages. If P > d the payoffs would be different but the underlying argument for renegotiation remains unaffected. 29 In case that the shortfall occurs because expectation damages do not include the valuation of third parties (also not via the buyer’s valuation) who share an interest in performance renegotiation would be different in that also those third parties would contribute to the additional payment.

5.1 The Shortfall of Damages

95

π Rene ¼ π Breach

ð5:50Þ

v
P
x¼d
P

ð5:51Þ

x¼v
d

ð5:52Þ

It follows that the maximum value payment x can take is x ¼ v
d. For an agreement to be reachable it must be that: WTP > WTA

ð5:53Þ

v
d >c
d

ð5:54Þ

v>c

ð5:55Þ

which is true by assumption.30 It follows that the parties can always find an agreement such that the buyer makes an extra payment and the seller performs.31 An important aspect of this agreement is that the payment needs to be conditional on performance. Put differently, the seller cannot get the additional payment and simply pay damages. The amount of damages d does not change. Thus, the seller 30 In the given bilateral contractual setting the problem of multiple takings as discussed for liability rules in general does not apply. The problem of multiple takings is as follows: If ownership rights are protected by liability rules which do not compensate the proprietor completely, others find it beneficial to them to take the property from the original proprietor, even if their valuation of the good is lower than the original proprietor ones. In a two-agent scenario the original proprietor would offer the potential taker money for foregoing the opportunity to take. However, in a multi-party scenario the original proprietor would face not only one potential taker who needs to be bought off. Hence, the original proprietor would not pay money to any potential taker and therefore, the first potential taker might take the property even if his valuation is lower. The inference is drawn, that if damages are set too low, bargaining by owners would not be viable and inefficient takings would be the consequence. See for the problems of undercompensation and multiple takings: Kaplow and Shavell (1996, 765, 766). In a bilateral contractual relationship only the parties of the contract can breach the contract. No third party can unilaterally “take” and decide not to perform. Thus, the buyer cannot face multiple parties he would need to bribe. 31 A distinct question is, how that agreement looks like. Being more specific, how much does the buyer pay extra to the seller. In turn, this can also depend on the shortfall of damages and how the shortfall of damages affects the discount factor. To see this, consider the situation that seller and buyer negotiate about the size of the extra payment. The longer the negotiation takes the more time elapses until the buyer receives performance. The mere delay of performance can lead to damages. First, think about damages that affect the buyer’s valuation. For instance, due to the delay the buyer himself loses customers. In such scenario, even if the seller does not compensate the buyer for such damages she is affected by the time delay indirectly. The buyer’s valuation decreases and therefore also the potential amount the extra payment takes. In case the seller would fully compensate the buyer for such losses the buyer has a very strong bargaining position because the seller bears all the damages that arise as negotiation takes place. Second, consider damages that do not affect the buyer’s valuation. In such scenario, the seller’s bargaining position highly depends on whether she has to compensate the seller for those damages. If the seller does not compensate the buyer, the seller has negative leverage over the buyer as she can await the buyer’s offers whereby the buyer loses money as negotiation takes place.

96

5 Over- and Undercompensation

Fig. 5.7 Three ex post scenarios with overcompensatory expectation damages

would still be better off to breach than to perform if she could keep the full payment including the additional amount. In comparison to the renegotiation under specific performance, here renegotiation takes place if the buyer’s valuation is still above the seller’s increased costs. The renegotiation under specific performance occurs if the seller’s costs of performance exceed the buyer’s valuation. The result that the parties always find an efficient agreement that induces the seller to perform claims validity only in case of complete information. I will analyze how asymmetric information about the seller’s costs impedes bargaining and finding efficient agreements in the given scenario in Sect. 6.2.

5.2

Overcompensatory Damages

This section looks at the effects if expectation damages are overcompensatory. As already argued analogously for the shortfall of damages, we see an effect on the seller’s decision if she anticipates that the court would grant damages above the buyer’s valuation. Expectation damages being overcompensatory provides the converse result as derived for the shortfall. We distinguish three scenarios and assume that the price lies between the original costs of performance and the buyer’s valuation or the increased costs depending on which of them is lower (see Fig. 5.7). In scenario one, the buyer’s valuation is below the seller’s costs of performance. However, expectation damages lie above the seller’s costs of performance. In that

5.3 Result

97

case, the seller would prefer performance over breach although it is inefficient. In the second scenario, the buyer’s valuation and also expectation damages lie below the seller’s costs of performance. The seller breaches which is efficient. In the third scenario, both the buyer’s valuation and expectation damages exceed the seller’s increased costs of performance. The seller is incentivized to perform which is efficient. The analysis shows that only in the first scenario, expectation damages being overcompensatory has an effect on the seller’s decision; implying the seller to perform too often. Under such circumstances, expectation damages lead to the same outcome as specific performance. More generally, if expectation damages would be set at an amount always exceeding the seller costs of performance, they function the same way as specific performance does because the seller always prefers to perform.32 Hence, for the first scenario, we can refer to the effects under specific performance in general. As breach is no option for the seller, the parties renegotiate the contract equally as under specific performance. It also follows that expectation damages being overcompensatory is no disadvantage in comparison to specific performance.

5.3

Result

As a result, we can conclude that overcompensatory damages are not a downside in comparison to specific performance as it shows the same theoretical outcome. Furthermore, the analysis outlined the inefficient incentives expectation damages set if they fall short of representing the buyer’s full valuation. However, we also found that the impact of the shortfall does not always lead to inefficient breaching but is limited to scenarios where damages are below the seller’s costs of performance, but the buyer’s valuation is above those costs. In addition, inefficient breaches require that the original price is below the increased costs which depend on the bargaining power, and furthermore, that the parties fail to renegotiate the contract. Generally, the problem of undercompensatory damages is most relevant if the buyer’s valuation is based on subjective grounds that are difficult to measure and to verify. Nevertheless, we also saw that in such circumstances renegotiating solves the problem if the information is complete and transaction costs are zero. Thus, the shortfall of damages does not lead to inefficient breaching under the same conditions specific performance does not lead to inefficient performances. Hence, a decisive question is how both remedies perform once the information is not complete. This is the topic of the next chapter.

32

See for the parallel finding regarding property and liability rules Kaplow and Shavell (1996, 761).

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5 Over- and Undercompensation

References Bebchuk, L. A., & Shavell, S. (1991). Information and the scope of liability for breach of contract. The rule of Hadley v. Cambridge, MA: Baxendale. Ben-Shahar, O., & Bernstein, L. (2000). The secrecy interest in contract law. The Yale Law Journal, 109(8), 1885–1925. Berg, J., Dickhaut, J. M., & Cabe, K. (1995). Trust, reciprocity, and social history. Games and Economic Behavior, 10(1), 122–142. Bernstein, L. (1992). Opting out of the legal system. Extralegal contractual relations in the diamond industry. The Journal of Legal Studies, 21, 115. Camerer, C., & Thaler, R. H. (1995). Anomalies. Ultimatums, dictators and manners. The Journal of Economic Perspectives: EP: a journal of the American Economic Association. Charness, G., Du, N., Yang, C.-l., & Yao, L. (2013). Promises in contract design. European Economic Review: EER, 64(2013), 194–208. Charness, G., & Dufwenberg, M. (2006). Promises and partnership. Econometrica: journal of the Econometric Society, an internat society for the advancement of economic theory in its relation to statistics and mathematics, 74(6), 1579–1601. Charness, G., & Dufwenberg, M. (2010). Bare Promises, An experiment. Economics Letters, 107 (2), 281–283. Charness, G., & Dufwenberg, M. (2011). Participation. The American Economic Review, 101(4), 1211–1237. Cooter, R., & Ulen, T. (2008–2012). Law and economics//law & economics. Pearson AddisonWesley; Addison-Wesley, Boston MA Craswell, R. (1988). Contract remedies, renegotiation, and the theory of efficient breach. Southern California Law Review, 61, 629–670. Depoorter, B., & Tontrup, S. (2012). How law frames moral intuitions: the expressive effect of specific performance. Arizona Law Review, 54(3), 673–717. Eisenberg, M. A. (2005). Actual and virtual specific performance, the theory of efficient breach, and the indifference principle in contract law. California Law Review, 93(4), 975–1050. Eisenberg, M. A. (2014). Behavioral economics and contract law. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 438–464). Oxford: Oxford Univ. Press. Ellingsen, T., & Johannesson, M. (2004). Promises, threats and fairness. The economic journal: the journal of the Royal Economic Society, 114(495), 397–420. Engel, C. (January 2018). The proper scope of behavioral law and economics. Bonn: Max Planck Institute for Research on Collective Goods. Engel, C., & Freund, L. (2017). Behaviorally efficient remedies. An experiment. Bonn: Max Planck Institute for Research on Collective Goods. Faust, F. (1996). Die Vorhersehbarkeit des Schadens gemäß Art. 74 Satz 2 UN-Kaufrecht (CISG). Teilw. zugl.: Regensburg, Univ., Diss., 1995-1996. Tübingen: Mohr. Fehr, E., & Schmidt, K. M. (2003). Theories of fairness and reciprocity – evidence and economic applications. In M. Dewatripont, L. P. Hansen, & S. J. Turnovsky (Eds.), Advances in economics and econometrics. Theory and applications; eighth world congress (pp. 208–257). Cambridge: Cambridge Univ. Press. Fehr, E., & Schmidt, K. M. (2006). The economics of fairness, reciprocity and altruism. Experimental evidence and new theories. In Handbook of the economics of giving, altruism and reciprocity (pp. 615–691). Amsterdam [u.a.]: North-Holland. Feldman, Y., & Teichman, D. (2011). Are all contractual obligations created equal? The Georgetown Law Journal, 100(1), 5–52. Gächter, S. (2014). Human prosocial motivation and the maintenance of social order. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 28–60). Oxford: Oxford Univ. Press.

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Gächter, S., Renner, E., & Sefton, M. (2008). The long-run benefits of punishment. Science, 322, 1510. Kaplow, L., & Shavell, S. (1996). Property rules versus liability rules. An economic analysis. Harvard Law Review, 109(4), 713. Kornhauser, L. A. (1983). Reliance, reputation, and breach of contract. Journal of Law and Economics, 26(3), 691–706. Kronman, A. T. (1978). Specific performance. The University of Chicago Law Review, 45(2), 351–382. Lewinsohn-Zamir, D. (2012). The questionable efficiency of the efficient-breach doctrine. Journal of institutional and theoretical economics: JITE, 168(1), 5–26. Lewinsohn-Zamir, D. (2013). Can’t buy me love: monetary versus in-kind remedies. Illinois Law Review, 1, 151. Markovits, D., & Schwartz, A. (2011). The myth of efficient breach. New defenses of the expectation interest. Virginia Law Review, 97(8), 1939–2008. Mitchell, G. (2014). Alternative behavioral law and economics. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 167–191). Oxford: Oxford Univ. Press. Mittlaender, Sergio. 2015. Retaliation, remedies, and contracts Mittlaender, S. (2019). Morality, compensation, and the contractual obligation. Journal of Empirical Legal Studies, 16(1), 119–142. Pi, D., Parisi, F., & Luppi, B. (2014). Biasing, debiasing and the law. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 143–166). Oxford: Oxford Univ. Press. Riehm, T. (2015). Der Grundsatz der Naturalerfüllung. Tübingen: Mohr Siebeck. Schäfer, H.-B., & Ott, C. (2012). Lehrbuch der ökonomischen Analyse des Zivilrechts. Berlin, Heidelberg: Springer. Schwartz, A. (1979). The case for specific performance. The Yale Law Journal, 89(2), 271–306. Schwartz, A. (2012). The questionable efficiency of the efficient-breach doctrine, Comment. Journal of institutional and theoretical economics: JITE, 168(1), 27–31. Schweizer, U., & Lewinsohn-Zamir, D. (2012). The questionable efficiency of the efficient-breach doctrine. Comment. Journal of institutional and theoretical economics: JITE, 168(1), 32–37. Sefton, M., Shupp, R., & Walker, J. (2007). The effect of rewards and sanctions in provision of public goods. Economic inquiry: journal of the Western Economic Association International, 45 (4), 671–690. Shiffrin, S. (2009). Could breach of contract be immoral? Michigan Law Review, 107(8), 1551–1568. Stout, L. A. (2014). Law and prosocial behavior. In E. Zamir & D. Teichman (Eds.), The Oxford handbook of behavioral economics and the law (pp. 195–212). Oxford: Oxford Univ. Press. Sunstein, C. R. (2005). Moral heuristics. The Behavioral and Brain Sciences, 28, 531–573. Ulen, T. (1984). The efficiency of specific performance: toward a unified theory of contract remedies. Michigan Law Review, 83(2), 341–403. Vanberg, C. (2008). Why do people keep their promises? An experimental test of two explanations. Econometrica: journal of the Econometric Society, an internat. society for the advancement of economic theory in its relation to statistics and mathematics, 76(6), 1467–1480. Wilkinson-Ryan, T. (2015). Incentives to breach. American Law and Economics Review, 290–311. Wilkinson-Ryan, T., & Baron, J. (2009). Moral judgment and moral heuristics in breach of contract. Journal of Empirical Legal Studies, 6(2), 405–423. Wilkinson-Ryan, T., & Hoffman, D. A. (2010). Breach is for suckers. Vanderbilt Law Review, 63, 1003. Zamir, E., & Medina, B. (2010). Law, economics, and morality. Oxford: Oxford Univ. Press.

Chapter 6

Incomplete Information

Uncertainty entering the analysis has a deep impact. It can affect the seller’s unilateral decision whether to breach the contract under expectation damages as well as the renegotiation of the contract under both remedies. In the given setting, the important pieces of information are the buyer’s valuation and the seller’s costs. I start by assessing incomplete information regarding the buyer’s valuation: the buyer having private information regarding his valuation. Subsequently, I turn to the effects of the seller having superior knowledge about her costs and the probability of an increase in costs.1

6.1

Buyer Having Private Information About His Valuation

This section addresses the scenario that the buyer’s valuation is unobservable to the seller;2 the buyer has private information about his valuation; for instance, the buyer’s expected profit he makes based on using a good the seller’s delivers

1 Both situations concern so-called one-sided asymmetric information. This means one of the parties has more information in respect of at least one relevant piece of information (Daughety and Reinganum 2012, p. 394). This needs to be distinguished from two-sided asymmetric information, where both parties have private information in respect of a relevant aspect (Daughety and Reinganum 2014, 86 Fn.6). If the relevant piece of information concerns one of the players, i.e., their payoff, valuation, or their costs of performance it is called a game of incomplete information (Mas-Colell et al. 1995, p. 253). We transform the game of incomplete information to a game of imperfect information by adding a so-called first move by nature choosing the realization of the parties’ respective attributes like his valuation or costs of performance with a certain probability distribution. This approach originates from John Harsanyi. See for more details Mas-Colell et al. (1995, p. 254). 2 Note that observable does not imply that the piece of information is verifiable (Schwartz and Scott 2003, 605). For a party to verify a piece of information it is a necessary condition that the piece of information is observable to that party. In addition, the party needs to be able to demonstrate the

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 O. Hofmann, Breach of Contract, International Law and Economics, https://doi.org/10.1007/978-3-030-62525-2_6

101

102

6 Incomplete Information

(Ben-Shahar and Bernstein 2000, 1898). The seller’s costs are common knowledge. Further we assume for now, and relief that assumption later, that the buyer can verify his valuation in court. We will first introduce the asymmetry of information to the standard model of the efficient breach scenario, i.e., at the ex post stage. This implies that the buyer did either not reveal his valuation to the seller at the contracting stage or that he only learned his valuation after the conclusion of the contract. In Sect. 6.1.3 we will discuss the buyer’s incentive to reveal his valuation under the different remedies at the contracting stage and also analyze reasons for not doing so. The change, from a setting of complete information to one-sided asymmetric information, has a tremendous impact on the standard model of the efficient breach scenario. Eisenberg stated that the theory of efficient breach relies on the condition that the promisor (seller) knows the promisee’s (buyer) valuation of performance at the time she takes the decision to perform or to breach the contract (Eisenberg 2005, 1000, 1019). Without this knowledge, the promisor’s opportunity to breach the contract unilaterally would be of no benefit and no argument exists in favor of such an assumption in the real world (Eisenberg 2005, 1019). The seller can derive that the buyer’s valuation is above the agreed price, as otherwise she would not have agreed to it (Eisenberg 2005, 1000). However, apart from that inference, the seller is unlikely to know the buyer’s valuation; in particular what profits the buyer intends to make based on the seller’s performance. In addition, the time between the conclusion of the contract and the moment the seller takes the decision to breach or perform contributes to the uncertainty the seller faces in respect of the buyer’s valuation of performance (Eisenberg 2005, 1000). The next chapter analyzes the impact of the seller’s constrained knowledge about the buyer’s valuation on the efficiency of her unilateral decision in more detail.

6.1.1

Effect of Seller’s Incomplete Information on Standard Model (Ex Post)

6.1.1.1

Analysis

Consider the following situation. A buyer and a seller conclude a contract. The parties agree on price P. The buyer’s valuation is unobservable to the seller and he does not provide information to the seller about his valuation. The seller’s costs (co) increase and attain a value above the price (c). The seller infers that also the buyer’s valuation lies above the price because otherwise the buyer would not have agreed to

piece of information. This ability is not only limited by the mere power to do so but also by the costs it entails. Verifying the piece of information can be of interest regarding both the opposite party or a third party, in particular a court (Schwartz and Scott 2003, 605).

6.1 Buyer Having Private Information About His Valuation

103

Fig. 6.1 Scenario of incomplete information with two types of buyers

that price. We assume that the court would learn the buyer’s valuation if the buyer sues. Under expectation damages, the seller has the option to breach the contract and pay damages to the buyer equal to his valuation. Alternatively, the seller can perform. Under specific performance, the seller always performs. For this part of the analysis, showing the effect of the seller’s reduced knowledge, it is assumed that no renegotiation of the contract takes place. Thus, for the analysis, it is decisive that the seller does not know the buyer’s valuation. Whether the buyer has that information is irrelevant for the efficiency of the seller’s decision as we assume that no exchange of information or bargaining occurs. Suppose the buyer’s valuation can take two values; a low value ðvÞ and a high value (
vÞ. The low value lies below the seller’s increased costs whereas the high value lies above those costs. We refer to those values as two types of buyers. The probability that the buyer is a high type is δ and the probability that he is a low type is 1  δ, whereby δ 2 [0, 1]. The buyer knows his type and the seller only knows the distribution of types, i.e., δ. Figure 6.1 illustrates the scenario. In order to assess the efficiency of the remedies, we first determine the first-best solution. This is achieved if the seller only performs given that she faces a buyer with a valuation above her costs. Thus, the total payoff under the first-best solution is ΠFB ¼ δð
v  cÞ

ð6:1Þ

Under specific performance, the seller always performs implying a total payoff of ΠSP ¼ δð
v  cÞ þ ð1  δÞðv  cÞ

ð6:2Þ

The total payoff under specific performance is less than the total payoff under the first best: ΠFB > Π SP

ð6:3Þ

δð
v  cÞ > δð
v  cÞ þ ð1  δÞðv  cÞ

ð6:4Þ

ð 1  δ Þ ð v  cÞ < 0

ð6:5Þ

This is true because 1  δ is positive and v  c is always negative providing an overall negative result.

104

6 Incomplete Information

Consider now the situation under expectation damages. The seller breaches the contract if her payoff is greater than with performance. Her payoff from breach depends on the buyer’s valuation. As damages are equal to the buyer’s valuation the expected compensation the seller pays is equal to the buyer’s average valuation. Consider the seller’s decision whether to breach without any further negotiations. Suppose the law requires the seller to pay damages equal to the average overall buyers’ valuations. Alternatively, the law deems damages to be tailored to the specific individual buyer’s valuation, but the seller only knows the average of damages she will have to pay.3 In that case, the decision the seller faces is the same. Tailoring expectation damages to the buyer’s valuation and its accuracy of assessing them by the court later has no effect on the seller’s decision if the seller does not have this information when taking the decision herself (Kaplow 1994; Kaplow and Shavell 1996a). The seller’s payoff with breach is σ breach ¼ P  δ
v  ð1  δÞv

ð6:6Þ

The seller’s payoff with performance is σ perform ¼ P  c

ð6:7Þ

σ breach > σ perform

ð6:8Þ

P  δ
v  ð1  δÞv > P  c

ð6:9Þ

δ
v þ ð1  δÞv < c

ð6:10Þ

Thus, the seller breaches if

The total payoff of the parties under expectation damages depends on the seller’s decision. With breach it is Πbreach ¼ 0 and with the performance it is Πperform ¼ δð
v  cÞ þ ð1  δÞðv  cÞ. This finding implies that the total payoff under both remedies is the same if the average valuation is above the seller’s increased costs causing the seller to perform: ΠSP ¼ δð
v  cÞ þ ð1  δÞðv  cÞ ¼ Πperform

ð6:11Þ

In case the average valuation lies below the seller’s costs expectation damages remain to have an advantage over specific performance: 3 Ben-Shahar and Bernstein (2000); this statement holds as long as all buyers would sue upon breach of contract: see Avraham and Liu (2012) for an analysis if not all buyers would sue. In their model new information about the buyer’s valuation and the seller’s costs arises after the conclusion of the contract. The information is two sided-asymmetric. They find that the court should not include the new information about the valuation into its assessment of damages; in particular if the parties can renegotiate.

6.1 Buyer Having Private Information About His Valuation

105

Πbreach > ΠSP

ð6:12Þ

δð
v  cÞ þ ð1  δÞðv  cÞ < 0

ð6:13Þ

Rearranging the equation, we get c > δ
v þ ð1  δÞv

ð6:14Þ

This always holds because only given that condition the seller breaches under expectation damages. Nevertheless, although expectation damages remain to be more efficient than specific performance given that the buyer’s average valuation is below the seller’s costs of performance the gap in efficiency is reduced. Under complete information expectation damages lead to the first-best outcome. Under incomplete information this is not true; in particular for the case that the buyer’s average valuation is below the seller’s costs leading her to breach: ΠFB > Πbreach

ð6:15Þ

δð
v  cÞ > 0

ð6:16Þ

The seller inefficiently breaches if she faces a high type. The more high type buyers exist or generally the greater the buyer’s average valuation the smaller the advantage of expectation damages. Once, the average reaches the seller’s increased costs expectation damages and specific performance lead to the same outcome.4

4 It has been argued that the importance of incomplete information is less relevant under expectation damages because compensation could be calculated on the basis of the difference between the contract price and the market price, see Schwartz (1979, 285). But, the difference between the contract price and the market price is unlikely to make the buyer indifferent. If there is a market price the buyer is likely to have paid the market price. Even if the buyer paid less than the market price his valuation is nevertheless likely to exceed the market price. Most notably, as outlined above, the efficient breach scenario and the discussion about remedies claims the more importance the less the good subject to the contract is fungible or homogenous. It follows that in the most relevant cases there would be no market that could function as the benchmark to come up with some market price. On a general basis it is true that the problem of incomplete information is alleviated if a market exists. Consider a seller and a buyer operating in a market with homogenous goods. The seller and buyer concluded a contract based on the market price. In case the seller’s costs of performance increase above the market price she does not necessarily know whether her costs have increased above the buyer’s valuation, but she can infer that covering is the cheapest option because the buyer’s valuation will be above the market price.

106

6.1.1.2

6 Incomplete Information

Result and Further Questions

The analysis shows that the seller’s option to breach the contract and pay damages has not lost its complete advantage under incomplete information. Nevertheless, its value is reduced as incomplete information impedes the seller’s ability to decide unilaterally in an efficient way whether to breach the contract. Thus, the proclaimed advantage of expectation damages that the seller takes the efficient decision without the necessity to bargain fades under incomplete information. Potentially, efficiency can be attained if either the seller receives the necessary information to take an informed decision under expectation damages or through bargaining, if the parties reach the efficient decision whether performance shall take place with mutual consent; the latter is possible under both remedies (Eisenberg 2005, 1000). As shown above, renegotiation leads to efficient outcomes under specific performance in the setting of complete information. It has been argued that specific performance would lead to communication between the parties and thus makes it easier for them to reach efficient outcomes under asymmetric information (Eisenberg 2005, 1000).5 Mutual consent, it is contended, is the way to assure that only in the case that the buyer’s valuation is below the seller’s costs the contract is terminated because the buyer would only agree to the termination of the contract in return for a payment made by the seller which is his valuation (Eisenberg 2005, 1000). But the exchange of information and bargaining can also take place under expectation damages. Renegotiating the contract is not only an option under specific performance but also under expectation damages. Due to the efficiency of the seller’s unilateral decision under complete information, it was just not relevant. However, now as the seller’s ability to decide unilaterally in an efficient way is diminished renegotiating the contract claims importance also under expectation damages. Thus, the next section is not only about assessing the process of renegotiation and its outcome under specific performance but also under expectation damages. The important question is whether and to what extent the incentives within the process of renegotiation differ among remedies and whether that leads to different outcomes. The analysis of the renegotiation under one-sided asymmetric information is followed by a section that takes the ex ante view. The remedies for breach of contract might not only influence the process of renegotiation but also affect the parties’ behavior at the contracting stage. It is important to assess what impact the choice of remedy has on the parties when concluding the contract in the light that an efficient breach scenario might arise in the future. This includes the question whether the buyer is incentivized to reveal his private information about his valuation at that stage in time.

5

Eisenberg calls it “efficient termination.”

6.1 Buyer Having Private Information About His Valuation

6.1.2

107

Ex Post Stage: Renegotiation

This section addresses the question: Does the parties’ ability to reach efficient outcomes given that the seller has incomplete information regarding the buyer’s valuation differ among remedies if they can renegotiate the contract? As it concerns renegotiation taking place ex post it is assumed that the buyer has not revealed his valuation at the contracting stage or the buyer’s valuation evolved after the contract had been concluded. On the general level of property and liability rules, it is a contentious subject whether the property (specific performance) or liability rules (expectation damages) facilitate bargaining more and are superior in case of asymmetric information (Bar-Gill and Persico 2016, 253; Kaplow and Shavell 1995; Ayres and Talley 1995a, b). Following Calabresi and Melamed property rules are said to be market encouraging bargaining while liability would be market mimicking (Calabresi and Melamed 1972). Thus, property rules are preferred with low transaction costs (Cooter and Ulen 2008, 2012, p. 100). In contrast, Ayres and Talley argued that liability rules facilitate bargaining (Ayres and Talley 1995b); but they speak to liquidated damages. Kaplow and Shavell posited that asymmetric information lead to inefficient outcomes independent from the form the protection of rights takes (Kaplow and Shavell 1996b, 764). They conjecture that property rules are superior in promoting bargaining, but liability rules start ahead in the race before bargaining occurs (Kaplow and Shavell 1995). They argue (Kaplow and Shavell 1996b, 737): . . . it is formally indeterminate which type of rule is superior given imperfect bargaining (. . .) The reason that the liability rule does not necessarily perform better is that bargaining may not be equally successful under the two types of rules. Indeed, just because property rules are behind in the race with the liability rule before any bargaining occurs—that is, just because the parties have more to gain from bargaining successfully—they will be more likely to conclude beneficial bargain. In addition, because imperfect bargaining involves subtle and complex elements, it is hard to predict the effect of this or that starting point for bargaining—here, a property rule or a liability rule.

Engert and Hofmann provide a model with one-sided asymmetric information and conflict costs which arise if the defendant (seller) takes the entitlement (breaches the contract) into consideration.6 They find that property rules promote bargaining and lead to more efficient outcomes overall. In the following, we will use simple models to explore the underlying difference which expectation damages and specific performance set for renegotiations. We will relate our findings to the just outlined literature where applicable.

6

See for a richer model on bargaining under property and liability rules with one-sided asymmetric information (Engert and Hofmann 2019). Their model contains a continuous type space for the owner of an entitlement (buyer).

108

6.1.2.1

6 Incomplete Information

Bargaining Under Incomplete Information

In order to answer the question whether renegotiation of the contract leads to efficient outcomes, it is necessary to predict the outcome of the bargaining between the parties. To that end one needs to model the bargaining process. Albeit, such model cannot perfectly predict the outcome in the real world it can provide evidence what outcomes can be expected. In particular for my analysis, the goal is not to perfectly predict on what the parties finally agree and how they behave but to identify the differences in incentives set by the two remedies, expectation damages and specific performance. To focus on those differences the model is kept simple. The general concept on which the predictions are based is the idea of the “Nash equilibrium” (Mas-Colell et al. 1995, p. 246; Daughety and Reinganum 2012, p. 401). A set of strategies consisting of one strategy for each player is a Nash equilibrium if no player can unilaterally move to another set of strategies and thereby increase her payoffs (Mas-Colell et al. 1995, p. 246; Daughety and Reinganum 2012, p. 401). Commonly two kinds of situations are distinguished in the realm of bargaining under incomplete information (Ausubel et al. 2002). On the one hand, there are scenarios in which any agreement is efficient. For example, take settlement bargaining. Any agreement between the parties which prevents a lawsuit is efficient regardless of the sum of money that is paid. A lawsuit would lead to costs and the payment is merely distributive. On the other hand, there are scenarios in which it is not clear whether an agreement is efficient, i.e., in all cases there is a surplus and the parties only need to decide how to share the surplus. This is true for the given case of the efficient breach scenario. An agreement between the seller and the buyer that excuses the seller from her obligation to perform only provides a surplus if the seller’s costs are above the buyer’s valuation.7 The parties not knowing whether there is room for an agreement affects the bargaining incentives as we will discuss. When modeling the bargaining process under incomplete information various aspects need to be considered; above all the bargaining process itself and how to model the incompleteness of information. With respect to the bargaining process, the critical aspect is to define the possible actions the parties can take (Daughety and Reinganum 2012, pp. 386, 388). Generally, models of a bargaining process suppose that one party makes an offer that can either be accepted or rejected by the other party (Daughety and Reinganum 2012, p. 414). This procedure can be repeated if the offer is rejected, i.e., there can be up to infinite number of rounds. If there is more than one round of offers models usually assume that the party making the offer alternates (Daughety and Reinganum 2012, p. 414).8

7 Ausubel, Cramton and Deneckere refer to the former kind as the “gap cases” and call the latter ones “no gap cases,” see Ausubel et al. (2002). 8 See for an exception: Spier (1992).

6.1 Buyer Having Private Information About His Valuation

109

In the following analysis, I allow the parties to make offers that can be either accepted or rejected by the recipient. One concentrates on one round of offers. This means that the first player makes a take-it-or-leave-it offer. The other player moves second and is left with the decision whether to accept the offer or not.9 This set up of the bargaining process gives the party making the offer the maximum bargaining power. Note that modeling the bargaining process with more than one but a finite number of rounds would not necessarily lead to different outcomes. If there is a finite number of rounds and both parties know that there will be a last round giving one party all the bargaining power this party can wait until this last round to make a take-it-or-leave-it offer. The second important aspect to model is the incompleteness of information. Incompleteness of information is not modeled such that the party does not have any information. Instead the interesting piece of information is modeled such that it can take various values. The uninformed party knows the possible values and the probability with which they occur. With respect to the given scenario, this means that the buyer’s valuation can take different values and the seller only knows the probability with which the buyer’s value is of a specific amount. One says that the buyer can be of different types. Each type refers to a different valuation. Respectively the seller knows the distribution of buyer types. Generally, the incompleteness of information can be structured with a continuum of different types. For the ease of illustration, my analysis focuses on discrete types; either two or three types of buyers. Regarding the party who makes the offer, my analysis encompasses both possibilities: The seller making an offer to the buyer or reversely. Those two scenarios are called “screening” and “signaling” (Mas-Colell et al. 1995, pp. 450, 460). Screening means that the uninformed party, in the given setting the seller, makes the offer (Mas-Colell et al. 1995, p. 460). Signaling on the other hand refers to the situation that the informed party, the buyer, makes the offer (Mas-Colell et al. 1995, p. 450; Daughety and Reinganum 2012, p. 420; 2014, p. 88; Bebchuk 1984). With respect to the actions taken by the different types, it is differentiated between the following equilibria depending on how much information is conveyed to the uninformed party. In a separating equilibrium, the different types choose different actions (Mas-Colell et al. 1995, p. 453). In consequence, the uninformed party can infer the type she faces. It is a revealing strategy (Daughety and Reinganum 2012, p. 422). In contrast, in a pooling equilibrium, different types take the same action, and thus the informed party cannot infer whom she faces (Mas-Colell et al. 1995, p. 453; Daughety and Reinganum 2012, p. 422). The analysis assumes litigation to be costless and that the buyer sues if the seller breaches.10 Furthermore, bargaining costs are considered to be zero if not explicitly

9

A model that allows an infinite time horizon and also for alternating offers is the Rubinstein bargaining model. To keep it simple I concentrate on one round of offers. 10 This would be different if the buyer’s valuation turns out to be lower than the price after the seller has breached. See for an analysis focusing on the effect that buyers do not sue Avraham and Liu

110

6 Incomplete Information

stated otherwise.11 A standard assumption of game-theoretic models analyzing uncertainty is that the court will have all the information in case a party pursues a lawsuit (Daughety and Reinganum 2012, pp. 386, 388; 2014, p. 86). The first part of the analysis assumes, in that line, that the buyer can verify his valuation to a court and therefore the court has all information when making a judgment. Subsequently I analyze the situation if the buyer cannot fully verify his valuation to the court implying a shortfall of damages. The court itself is not modeled as a strategic player.12

6.1.2.2

Fully Compensatory Damages: Verifiable to Court

In this section, I assume that the buyer can verify his valuation to court if the seller breaches the contract. The buyer receives his full valuation as damages in case the seller breaches under expectation damages.

Two Buyer Types Setting A seller and a buyer conclude a contract. The seller had costs of performance of co but they have increased and taken the value c. The buyer can either be a low type buyer with valuation v or a high type with
v, whereby v < c <
v. The buyer knows his type and the seller’s costs, but the seller only knows her costs and the distribution of types. At this stage, the parties have the option to renegotiate their contract. Thus, the seller knowing only the distribution of buyer types, she can update her believe about the type of buyer she is facing based on the buyer’s action. There are δ high types and 1  δ low types, whereby δ 2 [0, 1]. The analysis considers a signaling game, the buyer as the informed party makes a take-it-or-leave-it offer, and a screening game, the seller as the uninformed party makes a take-it-or-leave-it offer. Both offers, by the buyer or the seller, are denoted x. It is the amount the buyer demands in return for being excusing the seller from her obligation to perform or the amount the seller offers for being excused. Before digging deeper into the bargaining situation, consider the expected payoffs for each scenario shown in Table 6.1. The buyer knows his type. From his perspective regardless whether the seller performs or breaches he gets his valuation minus the price. In contrast, the seller does not know the buyer’s type. If she breaches her expected payoff depends on the (2009). In their model new information about the buyer’s valuation and the seller’s costs arises after the conclusion of the contract. The information is two sided-asymmetric. They find that the court should not include the new information about the valuation into its assessment of damages; in particular if the parties can renegotiate. In addition, they find that if low valuing buyers do not sue under specific performance it can foster efficiency. 11 This is a common assumption, see Daughety and Reinganum (2012, p. 391). 12 This is a common assumption, see Daughety and Reinganum (2012, pp. 386, 388).

6.1 Buyer Having Private Information About His Valuation

111

Table 6.1 Overview of the possible expected payoffs under both remedies Specific performance Expectation damages

Seller Buyer Seller Buyer

Agreement σ accept ¼  x π accept ¼ x σ accept ¼  x π accept ¼ x

Performance σ perform ¼ P  c π perform ¼ v  P σ perform ¼ P  c π perform ¼ v  P

Breach

σ breach ¼ P  E(v) π breach ¼ v  P

Fig. 6.2 Two buyer types setting signaling game under specific performance

expectation about the amount of damages, she needs to pay which depends on the buyer’s type. Thus, her expectation depends on her belief about what type of buyer she is facing.

Specific Performance This section analyzes the bargaining situation under specific performance. Consider Fig. 6.2 for the signaling game. The game starts with a so-called move by nature choosing the realization of the random variable whether the buyer is a high or a low type. This first move is introduced to capture the situation of incomplete information. After that, it is the buyer’s move to make a demand x followed by the seller’s decision whether she accepts the offer or rejects and performs. The dotted line indicates that the seller, when taking her decision is in one information set. This means that the seller does not observe the move by nature determining the buyer’s type. Thus, she does not know the buyer’s type but only holds a belief about what type she is facing. This belief is based on the distribution of types and is updated upon the inferences she makes based on the buyer’s offer. For the analysis, first take the seller’s position. The seller will accept demands only if she is at least as well off as if she rejects the offer and performs; σ perform ¼ P  c. This determines the seller’s so-called participation constraint. The buyer’s payoff with performance is the lower bound for offers he makes, π perform ¼ v  P. Thus, the high type buyer will make a demand x >
v  P which the seller does not accept because P  c > x > P 
v since
v > c.

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6 Incomplete Information

Fig. 6.3 Two buyer types setting screening game under specific performance

The low type buyer makes a demand x > v  P. The seller accepts that demand if it does not exceed her payoff with performance, σ perform ¼ P  c. To maximize his payoff the low type buyer makes a demand x ¼ c  P.13 It shows that we get a separating equilibrium, each type of buyer making a different offer. It leads to the efficient outcome: The seller performs facing a high type and does not perform facing a low type buyer. Next, consider the screening game under specific performance (Fig. 6.3). Like before, the game starts with a move by nature determining the buyer’s type. This time the seller makes an offer x to the buyer. When deciding what offer to make the seller does not know the buyer’s type; i.e., she is within the same so-called information set. This is indicated by the dotted line. Receiving the seller’s offer the buyer decides to accept or reject the offer. In case of rejection, it is the seller’s turn to perform. Since the seller has no leeway in doing so and does not take an additional decision this move is omitted in the game tree. First note that the buyer does not accept offers below his payoff with performance, π perform ¼ v  P. The seller makes only offers that render her better off than performance, x > P  c , x < c  P. It follows as for the signaling game that there is no room for agreements with the high type,
v  P  x < c  P is an inequality for which no x exists. This is different for the low type since x exist for the inequality v  P  x < c  P. To maximize her payoff the seller will make an offer as small as possible. Thus, she offers x ¼ v  P.14 The low type accepts the offer whereas the high type rejects. In case of rejection the seller performs, which is her only option anyway. Thus, as with the signaling game, we get the efficient result that the seller performs facing a high type and she does not perform facing a low type.

13 As said before, in such situation it is plausible to assume that the buyer accepts the offer equal to his valuation and is therefore indifferent. The seller could increase the offer by an incremental amount and the buyer prefers to accept. The incremental amount tends towards zero because the smaller it is the greater the seller’s payoff. 14 See Footnote 13.

6.1 Buyer Having Private Information About His Valuation

113

Fig. 6.4 Two buyer types setting signaling game under expectation damages

Expectation Damages Now, consider both bargaining games under expectation damages, starting with the buyer making an offer (Fig. 6.4). As with specific performance, the game starts with the move by nature determining the buyer’s type. In the signaling game, the buyer makes the offer x followed by the seller’s decision whether she accepts or rejects the offer. In contrast to specific performance, the seller’s decision is followed by a second decision she takes, whether she performs or alternatively breaches the contract and pays expectation damages. As shown for the remedy of specific performance the high type buyer makes a demand x >
v  P. The seller will not accept this demand because she is better off with performance, σ perform ¼ P  c >  x. Turning to the low type buyer, he will make a demand at least equal to his payoff with performance or breach which are the same: π breach ¼ π perform ¼ v  P. As under specific performance, if he makes a demand above the seller’s payoff with the performance he knows the seller is not accepting that. Consider that the buyer makes a demand equal to the inverse of the seller’s payoff with performance such that the seller is indifferent between making the side payment or performing. That is the strategy we found for the low type buyer under specific performance. However, with expectation damages, the seller has the option to breach. The seller’s payoff with breach depends on the buyer’s type. The seller does not know what type she faces. However, she can update her belief about the buyer’s type according to the buyer’s action. As said the high type makes demand above x >
v  P . Thus, receiving a demand x ¼ c  P the seller can infer that she receives that demand from the low type buyer. As a result, she prefers to breach the contract and pay expectation damages to accepting that demand because P  v > x ¼ P  c. This inference holds for any demand greater than the low type buyer’s payoffs with performance or breach, x ¼ v  P ) x ¼ P  v. The buyer is indifferent between making a demand equal to his payoff with breach or performance or making a high

114

6 Incomplete Information

demand followed by either breach or performance. Thus, the low type buyer can also make a demand greater than the high type’s payoff. It follows that we get several equilibria of two different kinds. The first kind of equilibria are so-called separating equilibria; different types of buyers make different demands. There are three different cases. Case 1: The high type makes a demand x >
v  P. The low type demands v  P < x <
v  P . The seller performs upon receiving a demand x >
v  P and breaches if she receives a demand v  P < x <
v  P. Case 2: The high type makes a demand x >
v  P. The low type demands x ¼ v  P. The seller performs upon receiving a demand x >
v  P and breaches if she receives a demand x ¼ v  P. Case 3: The high type makes a demand x >
v  P. The low type demands x ¼ v  P. The seller performs upon receiving a demand x >
v  P and accepts demands x ¼ v  P. Though these three equilibria might differ in the kind of outcome they are equal with respect to the seller’s and buyer’s payoffs. The seller pays her increased costs if she faces a high type and pays the low type his valuation either as compensation after she breaches or as a side payment. Both, the high type and low type get their respective valuations. The second kind of equilibrium we see is a pooling equilibrium; all types make the same demand. In our scenario this is, both types make demands x >
v  P. Upon receiving such offer, the seller’s decision whether to perform or breach depends on her believe what type of buyer she is facing. In the given pooling equilibrium this belief merely stems from her knowledge about the buyer types’ distribution. The seller’s payoff with performance is σ perform ¼ P  c. If she breaches her δ
vþð1δÞv . If we set those payoffs in relation, we see that the payoff is σ breach ¼ P  2 seller breaches if σ breach > σ perform

ð6:17Þ

P  δ
v þ ð1  δÞv > P  c

ð6:18Þ

δ
v þ ð1  δÞv < c

ð6:19Þ

δ
v þ ð1  δÞv < δc þ ð1  δÞc

ð6:20Þ

δð
v  cÞ < ð1  δÞðc  vÞ

ð6:21Þ

δ cv < 1  δ
v  c

ð6:22Þ

The formulas emphasize that the seller faces two potential losses: Breaching although she faces a high type and thus, she would have been better off with performance; this implies a loss of
v  c. The second loss occurs if she performs although she faces a low type buyer; implying a loss of c  v. Her decision bases on which of those losses is of greater significance. In turn, this depends on the ratio of high and low type buyers and the ratio of magnitudes of each kind of loss. This

6.1 Buyer Having Private Information About His Valuation

115

Fig. 6.5 Two buyer types setting screening game under expectation damages

comparison is shown by the last formula, showing the ratio of high types on the lefthand side and the ratio of the magnitudes of losses on the right-hand side. It follows, depending on the ratio of low and high types relative to the difference between the seller’s costs on the one hand and both buyer types’ valuations on the other hand, that the seller breaches or performs in the pooling equilibrium. Next, we turn to the last scenario. The seller makes a take-it-or-leave-it offer to the buyer under expectation damages (Fig. 6.5). The screening game differs from the signaling game only in that the seller makes the offer x to the buyer subsequent to the move by nature. The seller does not know the buyer’s type when making the offer, indicated by the dotted line. The buyer can either accept or reject the offer. Upon rejection, the seller takes the second decision, whether she breaches or performs. Again, the dotted line indicates that the seller does not know the buyer’s type when taking that second decision. The screening game under expectation damages provides the same outcome as the screening game under specific performance. The seller offers x ¼ v  P. The low type buyer accepts that offer. The high type rejects the offer. The seller infers that only high types reject her offer. Facing a high type her payoff is greater with performance than with breach; thus, she performs. σ perform > σ breach

ð6:23Þ

P  c > P 
v

ð6:24Þ

c <
v

ð6:25Þ

It follows that in the screening game under expectation damages and two buyer types the seller’s option to breach is irrelevant. Efficiency To evaluate the outcome more accurately we compare the outcomes to the first best, i.e., the parties’ maximum total payoff. As we already saw before, this is achieved if

116

6 Incomplete Information

the performance takes place in case the buyer’s valuation is above the seller’s costs and no performance takes place otherwise. ΠFB ¼ δð
v  cÞ

ð6:26Þ

The analysis shows that specific performance provides this first-best outcomes for both scenarios, the buyer or the seller making the offer. Expectation damages lead to efficient outcomes if the seller makes the offer. For the alternative scenario, expectation damages provide a more complex picture. We found two kinds of equilibria. A separating equilibrium in which the low type reveals his type by making a low demand. In that case, we saw that either the seller accepts or breaches. Both lead to non-performance which is efficient. In the separating equilibrium, the seller performs facing a high type. It follows that the first-best outcome is reached. The second kind of equilibrium we found is a pooling equilibrium, both types make indistinguishable offers. The seller bases her decision whether to breach or perform on her belief what type of buyer she is facing. But with a pooling demand, she cannot draw any further inference about the buyer’s type. We found that she breaches if δ
v þ ð1  δÞv < c and performs otherwise. In order to assess the efficiency loss, we determine the parties’ total payoff and compare it to the firstbest outcome. First, suppose the seller breaches in the pooling equilibrium; δ
v þ ð1  δÞv < c. It follows for the parties’ total payoff: Πbreach ¼ 0

ð6:27Þ

Thus, we observe an efficiency loss of ΠFB  Πbreach ¼ δð
v  cÞ

ð6:28Þ

Second, consider that the seller performs in the pooling equilibrium. The parties total payoff would be Πperform ¼ δð
v  cÞ þ ð1  δÞðv  cÞ

ð6:29Þ

The loss accumulates to ΠFB  Πperform ¼ δð
v  cÞ  δð
v  cÞ  ð1  δÞðv  cÞ ¼ ð1  δÞðv  cÞ ð6:30Þ which is a loss because v < c.

6.1 Buyer Having Private Information About His Valuation

117

Result The problem under expectation damages leading to the efficiency loss stems from that the buyer is not incentivized to participate in the bargaining process. In the broader framework of liability rules Ayres and Talley compared liability rules with damages tailored to the plaintiff’s valuation (in the given context the buyer), untailored damages, and property rules (Ayres and Talley 1995b). They posit that tailoring damages to the plaintiff’s (buyer’s) valuation impedes efficient bargaining because it gives the plaintiff (buyer) a “perfect insurance” against the breakdown of negotiations and prevents him from revealing his type (Ayres and Talley 1995b, 1066). On the contrary to this argument that a “perfect insurance” would have a negative effect on bargaining, we saw that specific performance leads to efficient results in our simple bargaining game. The buyer was incentivized to make an offer revealing his type. Thus, the problem of expectation damages is not necessarily that the buyer is overly protected because specific performance provides an even stronger protection. Instead the buyer is not incentivized to make an offer under expectation damages like under specific performance because he would not profit from any renegotiation. If the low type reveals his type and makes a low demand the seller has the option to capture all the available surplus from non-performance which is uncovered by the low type’s offer. The seller can simply breach the contract and pay damages. Thus, the buyer never receives more than his valuation even if he participates in renegotiations and reveals his type. We need to distinguish our finding from an argument made inter alia by Ayres and Talley and picked up by Kaplow and Shavell. They argue that setting damages equal to the victims’ harm is detrimental to bargaining because it introduces further asymmetric information:15 (. . .), suppose victims know their harms and anticipate receiving damages equal to true harm from courts, but that injurers do not know victims’ level of harm. Then bargains will tend not to be struck between victims and injurers: the only offer a victim would accept would be more than his true loss, yet injurers would know that victims would accept only such offers and thus would not want to make offers that victims would accept.

This is different from our scenario in that the seller can still perform. In Kaplow and Shavell’s example, the parties only bargain about the amount of money transferred. But negotiation does not involve a decision that can be efficient or inefficient. Kaplow and Shavell looked at the injurer offer. We saw in the screening model that in our context this was efficient; but we will revisit that finding with more buyers. We found that the outcome differed in the signaling model. Interesting to note is that also under specific performance the asymmetry of information exists. The option to breach simply provides the seller with an additional

15 Kaplow and Shavell (1996b, 737 Fn. 711). They refer to Johnston (1995) and Spier (1992) for earlier versions of that argument.

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6 Incomplete Information

option. The option to perform exists under both remedies. But giving the seller the second option has negative effects on bargaining. Our result corresponds to the findings by Engert and Hofmann (2019). Their model contains a continuous type setting and litigation costs which accrue if the buyer sues for damages. They find that the signaling game provides efficient outcomes for all types under the property rule (specific performance). In contrast to our result, they find for the liability rule (expectation damages) in the signaling game equilibria where some types of rightsholders (buyers) reveal their valuation allowing for efficient outcomes. This difference results from the existence of litigation costs. Those allow for some types of rightsholders (buyers) to reveal their type by making demands which render the taker (seller) better with the agreement than with unilateral taking (breaching). The looming litigation costs for unilateral taking (breach) make such takings (breaches) less attractive. Nevertheless, their findings also show that this possibility does not exist for all types of buyers unless litigation costs are extremely high (Engert and Hofmann 2019).

Two Buyer Types Setting and Costs for Offers Building on the results of the previous section, this section enriches the analysis by supposing that making an offer is not for free but imposes the costs of k on the party who make the offer. Prior to making an offer, the respective party decides if she does so at all. It is generally argued that if property rules (specific performance) are introduced and bargaining costs are on hand, efficient transactions would be prevented, as the only way to transfer goods is by bargaining (Bar-Gill and Persico 2016, 253). The following assesses this assertion. Specific Performance First, consider the buyer making an offer. As shown above, the high type knows that he cannot make an offer above his payoff with the performance the seller would accept. Therefore, the high type decides not to make an offer. The low type gets a payoff of π perform ¼ v  P with performance. As seen above the low type would make a demand x ¼ c  P. This provides a payoff to him of π accept ¼ c  P  k. Thus, the low type demands x ¼ c  P if the costs for an offer are below the difference between the seller costs and his valuation. π accept > π perform

ð6:31Þ

cPk >vP

ð6:32Þ

k σ no offer

ð6:36Þ

δ ð P  cÞ þ ð 1  δ Þ ð P  vÞ  k > P  c

ð6:37Þ

k < ð1  δÞðc  vÞ

ð6:38Þ

In words, the seller makes an offer if the costs of making an offer to all buyers are below the benefit she gains from making offers to low type buyers. The buyer’s payoff is the same as without the costs for offers, π ¼ v  P; π
¼
v  P. This shows that the screening game provides a less efficient result than the signaling game because the seller needs to make offers to all buyers implying costs k in all cases. Expectation Damages Under expectation damages in the signaling game, the high type behaves the same as under specific performance, making no demands because he would incur costs but never profit from an agreement. In contrast to specific performance, the low type would not make a demand. As shown above, without costs for making an offer low types were indifferent between making a demand or not under expectation damages. But now the buyer faces costs of k if she makes a demand. The low type would not make demands below x  v þ k because otherwise he would be better off with no agreement implying performance or breach. Taking the seller’s perspective, she would not accept any demand x > v because she knows it comes from the low type. In such case she would always prefer to reject the demand and breach. As a result, we only find a pooling equilibrium; both types of buyers making no demand. The seller’s decision whether she breaches or performs depends on the ratio of the different types of buyers and the potential losses from either performing although the seller faces a low type and breach although it is a high type; see for

120

6 Incomplete Information

the details for this decision the analysis without costs for offering in the section “Two Buyer Types Setting—Expectation Damages.” Consider now the screening game. As under specific performance, the seller could make an offer x ¼ v  P knowing that high types always reject. This would provide her with a payoff of σ offer ¼ δðP  cÞ þ ð1  δÞðP  vÞ  k

ð6:39Þ

Unlike under specific performance, her payoff from making no offer depends on her second decision, breaching or performance. With performance her payoff is σ perform ¼ P  c. If she breaches she gets an expected payoff of σ breach ¼ P  E ðvÞ ¼ P  ðδ
v þ ð1  δÞvÞ. Thus, she prefers to breach if σ breach > σ perform

ð6:40Þ

P  ðδ
v þ ð1  δÞvÞ > P  c

ð6:41Þ

δ
v þ ð1  δÞv < c

ð6:42Þ

Suppose the seller prefers performance to breach we get the same result as under specific performance. The seller prefers to make an offer given that σ offer > σ perform

ð6:43Þ

δ ð P  cÞ þ ð 1  δ Þ ð P  vÞ  k > P  c

ð6:44Þ

k < ð1  δÞðc  vÞ

ð6:45Þ

If the seller prefers breach to the performance she would make an offer if σ offer > σ breach

ð6:46Þ

δðP  cÞ þ ð1  δÞðP  vÞ  k > P  ðδ
v þ ð1  δÞvÞ

ð6:47Þ

k < δð
v  cÞ

ð6:48Þ

In words, she makes an offer if the costs for making an offer are below the loss she would incur from breaching if she faces a high type.

Efficiency To assess the efficiency of each remedy with both screening and signaling we first determine the first-best outcome and use this as a reference point. The first-best solution is achieved if the performance takes place with high types and non-performance occurs with low types without the necessity to make offers and thereby incurring costs.

6.1 Buyer Having Private Information About His Valuation

ΠFirst Best ¼ δð
v  cÞ þ ð1  δÞ0 ¼ δð
v  cÞ

121

ð6:49Þ

First, consider the different total payoffs under each remedy in the signaling game. For specific performance, we need to differentiate between different cases depending on the amount of costs for making offers. Suppose that the costs the buyer incurs for making an offer are not prohibitively high, k < c  v . Under specific performance we found a separating equilibrium providing a total payoff of ΠSP Signaling small k ¼ δð
v  cÞ þ ð1  δÞðk Þ

ð6:50Þ

This overall payoff is close to the first-best outcome. The difference is only that the low type buyers incur costs of k. ΠFirst Best  ΠSP Signaling large k ¼ ð1  δÞk

ð6:51Þ

Second, if the costs for making an offer are prohibitively high, k > c  v, we do not observe offers and the seller always performs. This is the outcome proposed by the standard model discussed in Chap. 2 for specific performance without renegotiation. The total payoff is ΠSP Signaling large k ¼ δ
v þ ð1  δÞv  c ¼ δð
v  cÞ  ð1  δÞðc  vÞ

ð6:52Þ

This implies an overall loss compared to the first best of ΠFirst Best  ΠSP Signaling large k ¼ ð1  δÞðc  vÞ

ð6:53Þ

Turning to expectation damages we found that the seller always breaches if δð
v  cÞ < ð1  δÞðc  vÞ

ð6:54Þ

This provides a total payoff of ΠED Signaling breach ¼ 0. Thus, the difference to the first best is ΠFirst Best  ΠED Signaling breach ¼ δð
v  cÞ

ð6:55Þ

Otherwise she always performs leading to a payoff of ΠED Signaling perform ¼ δ
v þ ð1  δÞðvÞ  c

ð6:56Þ

which is the same as under specific performance and prohibitively high costs for making an offer. Table 6.2 provides an overview of the difference in outcomes to the first best; the loss in the total payoff. First, we can easily observe that specific performance is

122

6 Incomplete Information

Table 6.2 Overview of loss in total payoff in two type setting signaling game with costs for offers

k cv

Specific performance (1  δ)k ð1  δÞðc  vÞ

Expectation damages Perform ð1  δÞðc  vÞ ð1  δÞðc  vÞ

Breach δð
v  cÞ δð
v  cÞ

superior if costs for making an offer are not prohibitively high and the seller performs under expectation damages; ð1  δÞk < ð1  δÞðc  vÞ . Furthermore, both remedies provide the same outcome if the costs for the offering are prohibitively high and the seller performs under expectation damages. In case the seller breaches under expectation damages this leads to a smaller loss of total payoff than specific performance if k > c  v . This is true because the seller’s cost-benefit analysis about breaching is the same as the comparison of the two payoffs: δð
v  cÞ < ð1  δÞðc  vÞ

ð6:57Þ

Less clear is the comparison if costs for making an offer are not prohibitively high and the seller would breach under expectation damages. Specific performance is superior if the costs for making offers by the low buyer type are outweighed by the loss created under expectation damages based on that high type buyers do not receive performance. ð1  δÞk < δð
v  cÞ

ð6:58Þ

Next, consider the efficiency in the screening game. Under specific performance, if the seller makes a separating offer the total payoff is ΠSP Screening small k ¼ δð
v  cÞ  k

ð6:59Þ

Thus, the loss in total payoff compared to the first-best scenario is ΠFirst Best  ΠSP Screening small k ¼ k

ð6:60Þ

Given that the costs for making an offer are prohibitively high we gain the same result with respect to the total payoff as in the signaling game: ΠFirst Best  ΠSP Screening large k ¼ ð1  δÞðc  vÞ

ð6:61Þ

Under expectation damages, the seller can make an offer causing the buyer types to separate and alternatively either breach or perform. Making an offer provides the same result as under specific performance. Likewise performing leads to the same outcome as under specific performance if the seller does not make an offer.

6.1 Buyer Having Private Information About His Valuation Table 6.3 Overview of loss in total payoff in two type setting screening game with costs for offers

Offer No offer

Specific performance k ð1  δÞðc  vÞ

123 Expectation damages Perform Breach k k ð1  δÞðc  vÞ δð
v  cÞ

If the seller decides to breach, this provides a total payoff of ΠED Signaling breach ¼ 0. Thus, the difference to the first best is ΠFirst Best  ΠED Signaling breach ¼ δð
v  cÞ . Table 6.3 provides an overview of the loss in total payoff. To further assess the efficiency, we need to make a case distinction like in the signaling game depending on the amount of costs for making an offer. Under specific performance, the seller makes an offer if k < ð1  δÞðc  vÞ. In comparison to the signaling game, the costs for making an offer reach the limit to be prohibitively high earlier because the seller needs to make that offer to both types of buyers. Under expectation damages, if the seller prefers performance to breach we get the same distinction. Therefore, we observe that both remedies lead to the same outcome if the seller prefers performance to breach under expectation damages. Consider next the scenario that the seller favors breach over performance; δ
v þ ð1  δÞv < c. In that case, she makes a separating offer if k < δð
v  cÞ. Combining those two equations, we can infer that in case the seller makes an offer, k < δð
v  cÞ, this also happens under specific performance: δ
v þ ð1  δÞv < c

ð6:62Þ

δð
v  cÞ < ð1  δÞðc  vÞ

ð6:63Þ

Inserting this into the equation k < δð
v  cÞ yields k < δð
v  cÞ < ð1  δÞðc  vÞ

ð6:64Þ

This implies that both remedies entail the same total payoff if k < δð
v  cÞ. Further we can observe that if k > δð
v  cÞ expectation damages are superior to specific performance. The seller does not make an offer leading to smaller loss in total payoff regardless what the seller does under specific performance. First compare the loss in total payoff with breach to making an offer under specific performance: δð
v  cÞ < k

ð6:65Þ

This is true as it is the same inequality that needs to hold for the seller to breach under expectation damages and not make an offer. Compare next the loss of total payoff with breach to performance:

124

6 Incomplete Information

δð
v  cÞ < ð1  δÞðc  vÞ

ð6:66Þ

That inequality holds because it reflects the seller’s decision whether she prefers performance or breach. Result Overall the analysis shows that also with small costs for making an offer specific performance does not only catch up with expectation damages but is superior. In the signaling game with low costs for making offers, specific performance leads to more efficient results because expectation damages cause the seller to perform and breach inefficiently. In the screening game and low costs, we see that both remedies imply the same result. However, the outcome regarding the total payoff in the signaling game under specific performance trumps the total payoff received in the screening game regardless of the remedy. This is easy to see if we compare the loss in total payoff: The loss under specific performance in signaling game is (1  δ)k which is smaller than k, the loss under specific performance and expectation damages in the screening game. On the contrary, if the costs for an offer are prohibitively high, the analysis reasserts the finding of the standard model that expectation damages yield an advantage over specific performance.

Three Buyer Types Setting So far, we saw some evidence that renegotiations are less successful under expectation damages since the buyer has no incentive to reveal his type. But in a setting with two types of buyers and the seller making a take-it-or-leave-it offer the first-best outcome is achieved under both remedies. This raises the question whether the seller making the offer can ensure efficient outcomes. To assess that question, this section analyzes a setting with three types of buyers and no costs for making an offer.16 The scenario is as follows. A seller and a buyer conclude a contract. The seller had costs of performance of co but they have increased and taken the value c. The buyer’s valuation can either be vα, vβ or vγ , whereby vα < vβ < c < vγ . The buyer is type α with probability α, type β with probability β, and type γ otherwise. The buyer knows his type and his valuation whereas the seller only knows her costs and the distribution of the different types of buyers. Figure 6.6 illustrates the scenario.

16 See for a model on bargaining under property and liability rules with one-sided asymmetric information with a continuous type space Engert and Hofmann (2019).

6.1 Buyer Having Private Information About His Valuation

125

Fig. 6.6 Three-type setting

Specific Performance First consider the situation under specific performance if the buyer makes the demand. Like in the two types setting the types with a valuation below the seller’s costs (vα, vβ) demand x ¼ c  P. The seller accepts those demands as before. The high type (vγ ) makes a demand above his valuation. The seller rejects followed by performance. Thus, we get the same outcome as with two types of buyers. It changes in the case of screening. In the scenario, with two types the seller makes an offer just enough such that the low type accepts it. Now being confronted with two low types the first option is to make an offer x ¼ vα  P which is only accepted by type α. Types β and γ reject the offer and the seller performs. Alternatively, the seller offers x ¼ vβ  P.17 In that case, both type α and type β accept the offer and only type γ rejects. To determine the seller’s strategy, consider her payoffs for each scenario. If she offers x ¼ vα  P she makes that payment with probability α and performs otherwise: σ x¼vα P ¼ αðP  vα Þ þ ð1  αÞðP  cÞ

ð6:67Þ

In contrast, if she offers x ¼ vβ  P she pays that amount with the probability α + β and performs otherwise.
 σ x¼vβ P ¼ ðα þ βÞ P  vβ þ ð1  α  βÞðP  cÞ

ð6:68Þ

The seller prefers to make the offer x ¼ vα  P if σ x¼vα P > σ x¼vβ P
 αðP  vα Þ þ ð1  αÞðP  cÞ > ðα þ βÞ P  vβ þ ð1  α  βÞðP  cÞ

 α vβ  vα > β c  vβ

ð6:69Þ ð6:70Þ ð6:71Þ

The formula shows the balancing the seller needs to make. The left-hand side reflects that making the offer x ¼ vα  P saves the seller costs because she does not pay x ¼ vβ  P to type α but only x ¼ vα  P. The right-hand side represents that the seller performs facing a type β although an agreement would be possible. However,

Making offers between vα  P and vβ  P is not in equilibrium because β types would still not agree and the seller makes a higher payments to type α.

17

126

6 Incomplete Information

only if the seller decides to make an offer x ¼ vβ  P an efficient result is achieved; no performance if the buyer’s valuation is below the seller’s costs.

Expectation Damages Under expectation damages, the result for signaling is similar to the one we saw for the two buyer types setting. The high type (γ) makes demands x > vγ  P. Both types α and β are indifferent between making a low demand and thereby revealing to have a valuation below the seller’s costs, or a pooling demand x > vγ  P. In the former case, the seller’s response is to breach. In the latter case, the seller’s response depends on her belief from whom she receives the demand. Since the seller cannot draw an inference from the demand to the buyer’s type, she bases her decision on her knowledge about the distribution of buyers. Thus, the seller breaches if σ breach > σ perform


P  E ð vÞ > P  c

ð6:72Þ 

αvα þ βvβ þ ð1  α  βÞvγ < c

ð6:73Þ ð6:74Þ

In words, the seller breaches in case the expected valuation of the buyer is below her costs of performance. Breaching implies an inefficient result for the cases that the seller faces a buyer of type γ. In case she performs this would be inefficient for α and β types. This is the same outcome as we found in the two buyers type setting just that v has two values, vα and vβ. To see this we exchange those values and the respective probabilities: α + β ¼ (1  δ) , δ ¼ (1  α  β); vγ ¼
v and vα þ vβ ¼ v.


 αvα þ βvβ þ ð1  α  βÞvγ ¼ ð1  δÞv þ δ
v < c

ð6:75Þ

In the screening game, the seller faces the same options as under specific performance. Either she makes an offer x ¼ vα  P or x ¼ vβ  P. In the latter case, both α and β types accept and only γ type buyers reject. Thus, the seller performs after rejection because she can infer to face a γ type. Thus, making an offer x ¼ vβ  P provides the seller with a payoff of
 σ x¼vβ P ¼ ðα þ βÞ P  vβ þ ð1  α  βÞðP  cÞ

ð6:76Þ

In the former case, only α type buyers accept whereas buyers of type β and γ reject. Therefore, in that case, the seller does not always perform after rejection. Her decision depends on her belief about the buyer’s type. She updates her belief in that she infers that buyers of type α would have accepted the offer. Thus, she faces either a β or a γ type.

6.1 Buyer Having Private Information About His Valuation

P

127

σ breach > σ perform

ð6:77Þ

P  E ð vÞ > P  c

ð6:78Þ

βvβ þ ð1  α  βÞvγ >Pc 1α

βvβ þ ð1  α  βÞvγ < ð1  αÞc

ð6:79Þ ð6:80Þ

To determine whether the seller makes an offer of x ¼ vα  P or x ¼ vβ  P we need to compare her payoffs for each option. Suppose the seller prefers performance to breach if she made an offer x ¼ vα  P. In that case, we compare her payoff from making the offer x ¼ vα  P followed by performance if the buyer rejects to her payoff from making an offer x ¼ vβ  P. The seller prefers to make the low offer x ¼ vα  P if σ x¼vα P; perform > σ x¼vβ P
 αðP  vα Þ þ ð1  αÞðP  cÞ > ðα þ βÞ P  vβ þ ð1  α  βÞðP  cÞ

 α vβ  vα > β c  vβ

ð6:81Þ ð6:82Þ ð6:83Þ

which is the same finding as under specific performance. Suppose that the seller prefers breach over performance if she made an offer x ¼ vα  P. The seller’s cost-benefit analysis looks as follows: σ x¼vα P; breach > σ x¼vβ P

 αðP  vα Þ þ
β P  vβ þ ð1  α  β
Þ P  vγ > ð α þ β Þ P  vβ þ ð 1  α  β Þ P  v γ
 αðP  vα Þ > α P  vβ

ð6:86Þ

vβ > vα

ð6:87Þ

ð6:84Þ ð6:85Þ

This is true by assumption. Therefore, the seller always prefers to make a small offer x ¼ vα  P.

Efficiency First, we observe that in the signaling game-specific performance provides an efficient outcome. In contrast, under expectation damages the signaling game does not provide a single equilibrium but encompasses such that lead to efficient but also such implying inefficient outcomes. This is equivalent to the outcome in the two buyers type setting above only that the low type buyer takes two different values. Therefore, we can focus on the screening game. As before, we first determine the first best. This is given if no performance occurs with buyers of type α and β because

128

6 Incomplete Information

their valuation is below the seller’s costs. With buyers of type γ performance should take place. This gives a first-best outcome of
 ΠFirst Best ¼ ð1  α  βÞ vγ  c

ð6:88Þ

First note, the first-best outcome for the total payoff is achieved in case the seller makes the offer x ¼ vβ  P. Both types with a valuation below the seller’s costs accept the offer. After rejection, the seller performs.
 Πx¼vβ P ¼ ð1  α  βÞ vγ  c

ð6:89Þ

If the seller makes an offer x ¼ vα  P the total payoff depends on whether the seller performs or breaches after rejection. The total payoff with performance after rejection is

 Πx¼vα P,perform ¼ β vβ  c þ ð1  α  βÞ vγ  c

ð6:90Þ

The total payoff with breach after rejection is Πx¼vα P,breach ¼ 0.
Under specific
performance, 
the seller  makes the offer x ¼ vβ  P if α vβ  vα < β c  vβ , c > αβ vβ  vα þ vβ . Otherwise she offers x ¼ vα  P and breaches after rejection. With expectation damages, the same condition applies but in addition it needs to hold that βvβ + (1  α  β)vγ > (1  α)c for the seller to offer x ¼ vβ  P. This provides us with the following cases:
 βv þð1αβÞv Case 1: c < αβ vβ  vα þ vβ and c < β 1α γ The seller offers x ¼ vα  P and performs if the buyer rejects the offer under both remedies. This implies a welfare loss of

 ΠFirst Best  Πx¼vα P,perform ¼ ð1  α  βÞ vγ
 c  β vβ  c 
ð1  α βÞ vγ  c ¼ β c  vβ

ð6:91Þ


 βv þð1αβÞv Case 2: β 1α γ < c < αβ vβ  vα þ vβ The seller offers x ¼ vα  P under both remedies. With the specific performance the seller responds with performance to a rejection of the offer whereas with expectation damages the seller breaches upon rejection. This implies the following welfare loss under specific performance:

 ΠFirst Best  Πx¼vα P,perform ¼ ð1  α  βÞ vγ
 c  β vβ  c 
ð1  α βÞ vγ  c ¼ β c  vβ Under expectation damages the welfare loss is

ð6:92Þ

6.1 Buyer Having Private Information About His Valuation


 ΠFirst Best  Πx¼vα P,breach ¼ ð1  α  βÞ vγ  c

129

ð6:93Þ

Comparing the losses under each remedy, we see that specific performance leads to a greater loss: ΠFirst Best  Πx¼vα P,perform > ΠFirst Best  Πx¼vα P,breach

 β c  vβ > ð 1  α  β Þ vγ  c

ð6:95Þ

ð1  αÞc > βvβ þ ð1  α  βÞvγ

ð6:96Þ

c>

βvβ þ ð1  α  βÞvγ 1α

ð6:94Þ

ð6:97Þ

which is true because it is a lower bound for c in case 2.
 βv þð1αβÞvγ Case 3: αβ vβ  vα þ vβ < c < β 1α The seller offers x ¼ vβ  P under both remedies leading to the first-best outcome.
 βv þð1αβÞv Case 4: c > αβ vβ  vα þ vβ and c > β 1α γ The seller offers x ¼ vβ  P under specific performance but x ¼ vα  P under expectation damages followed by breach implying a welfare loss of
 ΠFirst Best  Πx¼vα P,breach ¼ ð1  α  βÞ vγ  c

ð6:98Þ

Result The key message of this section concerns the screening game. With two buyer types, the screening game led to efficient outcomes. Thus, it might have seemed that the problem of expectation damages to find efficient agreements in the signaling game is less relevant. Introducing a third type of buyer showed that the screening game does not necessarily provide efficient outcomes. Only in case 3 both remedies lead to the first-best outcome. But the existence of case 3 hinges on a very specific ratio of the seller’s costs and also the buyer’s types. The more types of buyers exist the less likely it is that screening leads to the firstbest outcome. The first-best outcome is only reached if the seller makes an offer all buyers with a valuation below the seller’s costs accept. In turn this means if the seller wants to achieve all buyers to accept she needs to pay the least valuing buyer the same amount as the highest valuing buyer with a valuation below her costs. This becomes less attractive the greater the gap between those two types of buyers and the lower the proportion of the highest valuing type with a valuation below the seller’s costs is. This problem of the seller bases on the fact that she does not know the buyer’s type. The more types there are the less the seller knows about the buyer’s type. When the seller makes the offer, she acts like a monopolist maximizing her profit. As we

130

6 Incomplete Information

know from monopolist pricing, this causes inefficiencies if the monopolist does not know the buyers’ valuations. In contrast, with signaling the informed party makes the offer. Thus, only signaling has the potential to lead to first-best outcomes in all cases. All the more important is it that the buyer is incentivized to make offers himself. The analysis showed that the outcome under specific performance playing the signaling game is unaffected by the introduction of a third type. Under expectation damages, the buyer has no reason to participate in renegotiations.

6.1.2.3

Shortfall of Damages: Constraints of Verifiability to Court

The previous sections discussed the effect of asymmetric information regarding the buyer’s valuation on the outcome of renegotiations. This section builds upon those findings and takes the analysis further by asking how incentives change if damages are not fully compensatory. We have already seen in Sect. 5.1.6 that renegotiation can overcome misaligned incentives which would cause the seller to breach too often if expectation damages are undercompensatory. The renegotiation looked differently than the one discussed so far for asymmetric information in that it was not the seller making a side payment to be excused from her obligation to perform but the buyer to induce the seller to keep performing. This section assesses how those two processes of renegotiation merge. As the shortfall only concerns expectation damages I concentrate on that remedy. I will refer to specific performance only to compare the outcomes. Depicting the situation more formally, the low type buyer has a valuation of v and the high type of
v. The seller’s costs of performance are c. If the seller breaches she compensates the low type buyer by paying an amount of d and the high type by paying d
whereby d < v and d
<
v . The buyer knows the seller’s costs of performance. The buyer’s valuation is private information. The seller knows the distribution of types of buyers; δ high types and 1  δ low types. Taking the basic two buyers type setting in section in “Two Buyer Types Setting” as the starting point, there are three scenarios in which the shortfall of damages potentially changes the outcome. First, the shortfall of damages causes the high type’s amount of compensation to drop below the seller’s increased costs of performance. Second, despite the shortfall the high type’s compensation remains above the seller’s increased costs of performance. And thirdly, the analysis considers the scenario that both types of buyers have a greater valuation than the seller’s costs but due to the shortfall the low type’s compensation falls below the seller’s increased costs of performance.

6.1 Buyer Having Private Information About His Valuation

131

Fig. 6.7 Two buyer types setting with shortfall; low type’s valuation below increased costs and high type’s damages below increased costs

Low Type’s Valuation Below Increased Costs and High Type’s Damages Below Costs In the first scenario, the low type’s valuation is below the seller’s costs of performance and the high type’s valuation is above the seller’s increased costs of performance. The amount of expectation damages the seller would pay to the buyer lies below the increased costs of performance for both types of buyers; d < v < d
< c <
v. Figure 6.7 depicts the situation graphically: Signaling First, consider the buyer making a take-it-or-leave-it offer. Recall that in the basic two buyer types setting we found a separating equilibrium under specific performance; the low type making a revealing offer x ¼ c  P and the high type making an uninformative high offer. Under expectation damages such separating equilibrium is not the unique outcome but the low type could also make uninformative offers such that the seller could not infer the buyer’s type. The reason for renegotiation was limited to the question whether the seller should be excused from her obligation to perform. Only the low type had the possibility to profit from such renegotiation. Recall that as damages are undercompensatory the renegotiation can also be about whether the seller should continue to perform and not breach as shown in Sect. 5.1.6. This is a possibility if the buyer’s valuation is above the seller’s increased costs of performance because only in that case the buyer’s willingness to pay is above the seller’s willingness to accept as shown above. It is important to note that in the given scenario the seller has no reason to agree to any demand by any type of buyer to be excused from her obligation to perform. Regarding both types, the seller is better off breaching compared to performance. The buyers would not make a demand below their respective payoff with expectation damages. Because expectation damages for both types lie below her costs of performance the seller would not profit from agreeing to any demand even though it would reveal the buyer’s type. This is different from the basic setting above where the seller profits if the buyer reveals his type. Instead in the given scenario the high type might offer the seller an extra payment and induce her thereby to perform. The low type would not make such offer because his valuation is below the seller’s increased costs of performance. Thus, for the low

132

6 Incomplete Information

type, there is no feasible payment below his valuation that induces the seller to perform. Receiving an offer for an additional payment the seller can infer that it is a high type whom she faces. The high type’s payoff given that the seller breaches is π
breach; shortfall ¼ d
 P. With performance his payoff is π
perform ¼
v  P. The seller’s payoff if she performs
is σ perform ¼ P  c and if she breaches facing a high type it is σ breach ¼ P  d. To induce the seller to perform the payment needs to take an amount such that the seller does not prefer to breach: P  c þ x  P  d


ð6:99Þ

x  c  d


ð6:100Þ

If the buyer makes such extra payment his payoff is π
perform ¼
v  P  x . To
maximize his payoff, he will offer the lowest amount necessary which is x ¼ c  d.
Thus, his payoff is π
perform; side payment ¼
v  P  c þ d. The high type is incentivized to make such offer because this payoff is still above the payoff if the seller breaches: π
perform; side payment > π
breach; shortfall

ð6:101Þ


v  P  c þ d
> d
 P

ð6:102Þ


v > c

ð6:103Þ

which is true by assumption.

Screening Turning to the screening game, we can build on the finding for the signaling game. The seller has no reason to make an offer to be excused from her obligation to perform because regardless of the buyer’s type she prefers to breach. Instead, the seller can make an offer demanding an additional payment that makes her better off with performance than with breach. As shown above, the seller knows that an agreement is only possible with the high type. To maximize her payoff the seller makes a demand as high as possible that the high type still accepts. This is when the high type is indifferent between making an extra payment inducing the seller to perform and not making an extra payment and the seller breaches: π
perform; side payment ¼ π
breach; shortfall

ð6:104Þ


v  P  x ¼ d
 P

ð6:105Þ

x ¼
v  d


ð6:106Þ

6.1 Buyer Having Private Information About His Valuation

133

The high type accepts the demand whereas the low type rejects. The seller responds with breach to a rejection of the demand. The seller prefers to make the demand and perform to breaching facing a high type: σ perform; side payment > σ breach

ð6:107Þ

P þ x  c > P  d


ð6:108Þ


v  d
 c > d


ð6:109Þ


v > c

ð6:110Þ

which is true by assumption.

Result We find that the high type reveals his type by offering an extra payment. The low type does not make such offer. In other words, in the given setting, the shortfall of damages impels the high type to reveal his type. This allows the seller to make an informed decision leading to an efficient outcome.

Low Type’s Valuation Below Increased Costs and High Type’s Damages Above Increased Costs In contrast, to the previous section the high type’s damages do not fall below the seller’s costs of performance but remain above; d < v < c < d
<
v. Figure 6.8 represents the situation: The decisive difference to the last scenario is that it is not clear that the seller prefers to breach absent any renegotiation. Whether she expects to gain a higher payoff from breach depends on her belief of what buyer she is facing. Prior to any offers being made her belief stems merely from her knowledge about the distribution of types; δ high types and 1  δ low types. The seller updates her belief upon the actions and reaction she observes during renegotiation. We can infer that the seller prefers breaching to performance without any further information through the renegotiation process if

Fig. 6.8 Two buyer types setting with shortfall; low type’s valuation below increased costs and high type’s damages above increased costs

134

6 Incomplete Information

σ breach > σ perform

ð6:111Þ

P  E ðd Þ > P  c

ð6:112Þ

The expectation about damages reflects the seller’s belief about the buyer’s type. It follows that without further information this is based on the distribution of types: P  δd
 ð1  δÞd > P  c

ð6:113Þ

δd
þ ð1  δÞd < c

ð6:114Þ

Signaling We start by analyzing the buyer making a take-it-or-leave-it offer. Suppose first that the seller performs without any further information; δd
þ ð1  δÞd > c . Take the high type’s perspective. He makes a demand above his valuation. He knows that the seller performs receiving such demand: If the low type reveals his type by making a low demand and thus the seller updates her belief receiving a high demand that she faces a high type her expectation about damages
Breach becomes even less attractive. increases further because δd
þ ð1  δÞd < d. In the alternative scenario that the low type mimics the high type making a high demand, the seller would also perform as we suppose that the seller performs without any further information; δd
þ ð1  δÞd > c. Turning to the low type. The low type has two options. Either he mimics the high type and makes a pooling demand or he makes a low separating demand which reveals his type. In the latter case the seller would prefer to breach if she receives such separating demand: σ breach > σ perform

ð6:115Þ

P  E ðd Þ > P  c

ð6:116Þ

Pd >Pc

ð6:117Þ

d σ perform

ð6:119Þ

P  E ðd Þ > P  c

ð6:120Þ

Pd >Pc

ð6:121Þ

d c

ð6:126Þ

However, this is not an equilibrium because in consequence the low type would prefer to mimic the high type and make a high demand in order to induce performance. Next, consider both types to make a pooling demand. The seller breaches upon receiving a pooling demand. As a result, the high type is incentivized to signal his type by making an offer for an extra payment to induce the seller to perform. In fact, this is the same strategic situation as in the previous section where the high type makes an offer to induce the seller to perform. Thus, I refer to that section for the details.

Screening Consider next, the seller making a take-it-or-leave-it offer to the buyer. The seller has generally two options. Either she demands an extra payment to perform or she makes an offer to be excused from her obligation to perform. Suppose the seller performs if both types reject and therefore the seller gets no further information regarding the buyer’s type. This is the case, as above, if δd
þ ð1  δÞd > c. In that case, both buyer types would reject a demand for an extra payment because they expect the seller to perform anyway. Instead, the seller can make an offer to be excused from her obligation to perform. As in the basic setting without a shortfall in damages, the seller offers x ¼ v  P. The low type accepts such offer. The high type rejects the offer and the seller performs. For the details see section “Two Buyer Types Setting.” Note that the low type would not accept a lower offer, in particular not x ¼ d  P, because with the rejection he would receive performance.

136

6 Incomplete Information

Given that the seller breaches without any further information regarding the buyer’s type the seller has two options. Either she makes an offer to be excused from her obligation to perform as just discussed or she demands a payment to continue to perform as seen in section “Screening—Low Type’s Valuation Below Increased Costs and High Type’s Damages Below Costs.” To compare her payoffs under the two options we can build on the previous findings. We saw that if she makes an offer to be excused from her obligation to perform, she offers x ¼ v  P. The low type accepts the offer. The high type rejects and the seller performs. This provides her with a payoff of: σ offer excused ¼ δðP  cÞ þ ð1  δÞðv þ PÞ

ð6:127Þ


This In case she decides to make a demand to perform she demands x ¼
v  d. leads to a payoff of: σ demand to perform ¼ δðP þ x  cÞ þ ð1  δÞðP  E ðdÞÞ ¼ δðP þ
v  d
 cÞ þ ð1  δÞðP  d Þ

ð6:128Þ

It follows that the seller prefers to make a demand for an extra payment to continue to perform: σ demand to perform > σ offer excused δðP þ
v  d
 cÞ þ ð1  δÞðP  dÞ > δðP  cÞ þ ð1  δÞðv þ PÞ δð
v  d
Þ þ ð1  δÞðv  d Þ > 0

ð6:129Þ ð6:130Þ ð6:131Þ

which always holds because
v  d
> 0 and v  d > 0. Result This section has shown that the impact of the shortfall of damages on the buyer to reveal his type is limited. Only in scenarios where the seller would breach without further information about the buyer’s type given the a priori distribution of types of buyers and their respective claims for compensation the seller will be informed about the buyer’s type. If not, she takes an uninformed decision whether to breach implying inefficient outcomes.

Low Type’s and High Type’s Valuation Above Seller’s Increased Costs But Low Type’s Damages Below Seller’s Increased Costs In the following section, the high type’s damages remain above the seller’s costs of performance. The low type’s valuation is above the increased costs of performance, but his damages fall below them; d < c < v < d
<
v.

6.1 Buyer Having Private Information About His Valuation

137

Fig. 6.9 Two buyer types setting with shortfall; low type’s valuation above and his damages below increased costs

Consider Fig. 6.9 for a graphical depiction: Based on the previous findings we can infer that in the given situation there is no room for agreements between the seller and the buyer excusing the seller from her obligation to perform. In addition, we distinguish the two scenarios whether the seller would breach or perform without further information. As shown, this depends on the following relation causing the seller to breach if δd
þ ð1  δÞd < c. Signaling First, suppose the seller would perform without further information. As in the previous section, we find a pooling outcome. The low type prefers not to separate himself from the high type because otherwise the seller would breach. Both types have no reason to make an offer for an additional payment to induce the seller to perform since she performs anyway. Suppose next, that the seller would breach without renegotiation. Both types have an incentive to induce the seller to perform by making an additional offer. Both types offer the minimum amount x necessary to induce the seller to perform. This is given if P  ðδd
þ ð1  δÞdÞ  P þ x  c

ð6:132Þ

x  c  ðδd
þ ð1  δÞdÞ

ð6:133Þ

Thus, the minimum amount is: x ¼ c  ðδd
þ ð1  δÞdÞ Screening As said, there exists no room for an agreement between the parties which includes a side payment from the seller to the buyer in return for excusing her from her obligation to perform. The only option remaining is that the buyer makes an additional payment to induce the seller to perform. In case the seller would perform without further information both types would reject any demand by the seller. If the seller breaches without further information both types would generally be willing to make an additional payment. There exist two candidates for demands the seller could make. Either she demands x ¼ v  P which would be accepted by both

138

6 Incomplete Information

Fig. 6.10 Two buyer types setting with average damages

types or she demands x ¼
v  P and only the high type accepts it. The seller’s decision depends on the ratio of types and the value the buyer’s valuations take. The seller’s payoff from making a high demand is σ x¼
vP ¼ δð
v  cÞ þ ð1  δÞðP  dÞ

ð6:134Þ

Her payoff if she makes a low demand shows to be σ x¼vP ¼ v  c

ð6:135Þ

Hence, she makes a low demand if v  c > δð
v  cÞ þ ð1  δÞðP  d Þ

ð6:136Þ

Result The signaling game provides efficient results in both scenarios, that the seller would breach or perform without further exchange of information. The screening game does not always provide an efficient outcome but only if the seller prefers to make a low demand.

Average Damages In this part, we will consider the case that the court does not try to determine the buyer’s individual valuation but specifies the same amount of damages for all buyers. For illustration, we consider that the court awards average damages.18 For us, two interesting cases exist. One where the seller costs lie between the low type’s valuation and average damages (c1) and the case where the seller’s costs lie between average damages and the high type’s valuation (c2). Consider Fig. 6.10:

18

For example, in a case concerning lost earnings, the German Federal Court decided that to determine damages one can assume that the plaintiff would have earned at least an amount he would have received with average success in his job; BGH 6.2.2001.

6.1 Buyer Having Private Information About His Valuation

139

Consider c1. The seller would perform with renegotiation. Building on what we have established so far, we see that the seller would make an offer to be excused from her obligation to perform equal to the low type’s valuation and the low type would accept. The high type would refuse, and the seller performs. The buyer making a demand would lead the low type to demand an amount equal to the seller’s costs of performance. The seller would make that payment because she is still better off than paying average damages.19 Now consider c2. The seller would breach without renegotiation. This would imply a shortfall for the high type. Building on our result we can ascertain that the high type is incentivized to make an offer to the seller. Alternatively, the seller demands an additional payment and only the high type accepts. Either way, the high type reveals his type and the seller breaches only when she faces the low type. In both scenarios, we get efficient results.

Result This section provides us with the interesting result that a shortfall of damages can in fact enhance renegotiations. The buyer whose valuation lies above the seller’s costs is incentivized to make an offer if the seller would breach otherwise. That was also the case with average damages which meant a shortfall to the high type. A similar information forcing effect has been described regarding liquidated damages by Ayres and Talley (1995a, b).20 They argue that untailored damages force those plaintiffs (buyers) with a valuation above the amount of damages to reveal their type and bribe the defendant (seller) not to exercise her option to breach. Ayres and Talley assert liquidated damages to facilitate the exchange of information and to be superior to property rules (specific performance) and to liability rules with tailored damages (expectation damages) (See also Ayres 2005, p. 143). But we observed that also with specific performance the parties achieved efficient outcomes. The effect shows to be more than simply a reduction of the asymmetry of information as Kaplow and Shavell argue (Kaplow and Shavell 1996b, 764, Fn. 163). We saw the effect with a shortfall of damages also in case that both types of buyers still got different amounts of damages.

19

Importantly, we assume that the court would still decree average damages and not swop to award damages based on the low type’s valuation. 20 A situation similar to a shortfall of damages but concerning both kind of remedies arises if the contractual entitlement itself is uncertain to be granted. Johnston (1995) finds that such uncertainty has a positive effect on the efficiency of bargaining with asymmetric information. Croson and Johnston (2000) find positive evidence for the predictions in an experiment.

140

6.1.2.4

6 Incomplete Information

Result

The analysis showed that the incentives driving renegotiations differ fundamentally between remedies. Under specific performance buyer and seller share the gain which is created by non-performance. The signaling game as one polar case illustrated that the buyer has an incentive to find an agreement on non-performance to receive a side payment. Even if his share of the surplus which is generated by non-performance is smaller as the seller’s bargaining power increases, he is still incentivized to signal that there is room for an agreement. This is different under expectation damages because once the seller can infer that the buyer is of a type with a valuation below the seller’s increased costs of performance the seller can breach the contract capturing all the gain from non-performance. As a result, the buyer is not incentivized to signal his type implying inefficient outcomes due to the seller’s incomplete information. Interestingly the analysis also showed that a shortfall of damages can further efficiency under incomplete information. In case the seller would breach due to a shortfall of damages the buyer with a valuation above the increased costs is incentivized to reveal his type and offer an additional payment to induce the seller to perform. We further saw that designing damages not tailored to the buyer’s valuation, but as average damages imply a shortfall to the higher valuing buyer enhancing the renegotiation.

6.1.3

Taking the Ex Ante View: Negotiation at the Contracting Stage

This section takes the ex ante view, i.e., concentrating on the situation when the parties negotiate the contract in the first place. They do so in the shadow that an efficient breach scenario might arise after the conclusion of the contract. This section asks how the possibility of such course of events affects the parties’ ability to file a contract given that the buyer’s valuation is private information and assesses whether it differs among remedies. Generally, private information can be an impediment for parties to achieve mutually beneficial exchanges. In the analysis we will address the following questions: • How does the incomplete information affect the efficiency of bargaining over a contract and what role do remedies for the breach of contract play in that respect. • Is the buyer incentivized to reveal his private information. • Does the result change and if so, how does it change if there is a potential efficiency gain at the ex post stage from exchanging information ex ante? This means, without further exchange of information the seller would, to some proportion, inefficiently perform or not perform ex post which is avoided if the seller knows the buyer’s type.

6.1 Buyer Having Private Information About His Valuation

141

• The last part of the analysis addresses the question whether limiting compensation by applying the foreseeability doctrine furthers the efficiency of bargaining and the exchange of information.

6.1.3.1

The Problem of Cross-Subsidization

Consider the seller’s perspective at the contracting stage under expectation damages being aware that her costs of performance increase with a certain probability. The possible occurrence of an efficient breach scenario reduces her expected payoff by an amount either of the damages the seller pays or the future side payment she makes to be excused from the obligation.21 The exceptional feature of expectation damages is that the amount of compensation is tailored to the buyer’s valuation to make him indifferent. Thus, buyers with different valuations get different amounts of compensation in case the seller breaches. Regarding the seller’s expected payoff, the effect comes threefold: Firstly, higher valuing buyers will be paid a larger amount of compensation; secondly, they might ask for a higher side payment and finally, it will be more probable that their valuation exceeds the seller’s increased costs such that she is more likely to incur highperformance costs. It follows that to get the same payoff contracting with buyers having different valuations the seller would have to charge different prices. But under asymmetric information, the seller is constrained with respect to pricing. Increasing the price rather repels low valuing buyers than high valuing buyers. Higher valuing buyers, who will ask for a higher compensation, are the ones who are willing to pay a higher price; this is called a situation of adverse selection (Bolton and Dewatripont 2015, p. 47). It can lead to cross-subsidization if lower valuing buyers pay a higher price than they had to if the price was adjusted to them personally. The higher price follows from the seller paying compensation based on the buyers’ average valuation.22 Conversely, higher valuing buyers pay a lower price. This is an issue of expectation damages not only in case of the efficient breach scenario but in general as courts compensate on an individual basis though sellers cannot price discriminate (Eisenberg 2005, 986). Putting this in a more general context, such problems arise if the promisor’s (seller’s) expected costs depend on the promisee’s (buyer’s) specific attributes and the price does not reflect them. Consider, for instance, insurance contracts where the risk of the individual insuree determines the insurer’s cost function. If all insurees pay the same price for the insurance those with low risks subsidize those with high

21 This relationship was already discussed in Chap. 3 with the focus on distributional effects and complete information. 22 See for the argument in the context of defective toasters: Craswell (2003, 1158, 1159).

142

6 Incomplete Information

risks.23 The issue of cross-subsidization in case of expectation damages is based on the same fundamental/rationale. The scenario for the analysis is as follows: A seller and a buyer negotiate a contract. The buyer can be of two types: a low type with valuation v and a high type with valuation
v. The buyer knows his type, but the seller only knows the distribution of types. The probability that the buyer is a high type is δ. Otherwise he is a low type; the according probability is (1  δ). The seller has costs of performance of co but both parties are aware that these costs can increase and take a high value of c with probability α. Both v and
v lie below the seller’s increased costs of performance; co < v 0

ð6:188Þ

This always holds because v > co : It follows that we can say on a general basis that an inefficiency exists if the seller makes a high offer, which she does if σ P¼
v > σ P¼v

ð6:189Þ

δ ð1  αÞð
v  c Þ > ð1  αÞðv  c Þ  αδð
v  vÞ o

o

ð6:190Þ

Figure 6.13 illustrates this graphically: The graph in Fig. 6.13 depicts the two scenarios that on the one hand, the seller charges a high price,
v, and contracts only with high types and on the other hand, the seller charges a low price, v, and contracts with both types. In the former case, we see contracts only in δ cases which is shown on the left side. The gray area represents the seller’s costs of contracting with the high type whereas the white area above shows the profit she makes. Moving towards a low price and contracting with both types causes the seller to miss out on the profit represented by the white area. Instead, she receives the lower revenue from both types. Regarding the high type, all the revenue she gets is eaten up by costs. The gray area overlaps any potential profit area. In

154

6 Incomplete Information

addition, the seller incurs costs stemming from contracting with the low type which is lower than with the high type due to the lower compensation she would have to pay. The seller prefers to charge a low price if the area of the expected profit from a low price is greater than the area representing the expected profit from a high price. The areas translate to marginal benefits and costs shown on the right. Those marginal effects show the difference for the seller if she moves from charging a high to a low price. The picture shows that in the example the seller prefers to charge a high price because the marginal costs exceed the marginal benefits. Furthermore, Fig. 6.13 allows us to determine the difference in total payoffs. First, consider the first-best scenario. In that case, the seller charges the high type a high price and the low type a low price. It follows that the seller captures both areas that represent possible profit. In case the seller charges a low price, the seller can only capture the area representing a profit from charging a low price on the right side. However, the profit from charging a low price is not lost. Instead, the high type seizes that profit. This is different if the seller charges a high price. In this case, the seller receives the profit represented by the white area but the profit from charging a low price is not captured by either party and lost. In a second step, we need to determine whether we can attribute the inefficiency to the necessity to pay compensation on an individual basis without a reflection in the individual’s price. To that end, we rearrange and take a closer look at the inequality that determines whether the seller charges a high or small price: δð1  αÞð
v  co Þ þ δαð
v 
vÞ > ð1  αÞðv  co Þ þ αðv  δ
v  ð1  δÞvÞ ð6:191Þ δð1  αÞð
v  co Þ  ð1  αÞðv  co Þ > αðv  δ
v  ð1  δÞvÞ  δαð
v 
vÞ ð6:192Þ ð1  αÞðδð
v  co Þ  ðv  co ÞÞ > α δð
v  vÞ

ð6:193Þ

The left-hand side of the inequality represents the seller’s advantage from charging a high price given that her costs do not increase. The right-hand side shows the loss the seller incurs if her costs increase from charging a low price although she compensates the high type according to his valuation. If the left-hand side is positive the seller always charges a high price and contracts only with high types. This reflects the inefficiency loss occurring because the seller charges a price as a monopolist maximizing her payoff without the opportunity to price discriminate. Such efficiency loss is independent of the duty to pay damages. In case the left-hand side is negative the seller would charge a low price and contract with both types if there was no duty to compensate the buyer. But if the loss the seller faces due to compensating the high type according to his valuation though charging a low price represented on the right-hand side exceeds the benefit from charging a low price, the seller is incentivized to contract only with high types. This effect is caused by that the price does not reflect the future amount of compensation the seller has to pay. Figure 6.14 allows us to see the effect if the price is adjusted to future compensation:

6.1 Buyer Having Private Information About His Valuation

155

Fig. 6.14 Seller’s payoffs contracting with high or both types under expectation damages if compensation is adjusted. Parameters: c ¼ 120,
v ¼ 100, v ¼ 60, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%

The difference to Fig. 6.13 lies in the shaded area. It reflects that the seller is not limited to charge either a high or low price but has the ability to charge a low price and add an additional amount which captures her higher costs due to higher compensation if she faces a high type. This price she charges from the high types takes the value P ¼ v þ α
v . In consequence, the seller receives the payoff represented by the shaded area not only if she charges a high price but also if she charges a low price which is adjusted if she faces a high type. Because the seller gets this profit regardless of what price she charges, we only compare the payoff represented by the white area and the profit she only makes if she asks for a low price on the right side. It shows that the adjustment of the price leads to higher marginal benefits for the seller from moving to a low price. In the given example we see that adjusting the price for high types to the higher compensation would cause marginal benefits from contracting with both types to rise above marginal costs. This means, that the seller does not contract with both types due to his inability to price in the possible future compensation. We also see that the white area representing profits from contracting only with the high type for a high price can generally be greater than the area from contracting with both on the right side. This remains true if the price with the high type is adjusted to the future amount of compensation. The inefficiency arising from that does not result from the chosen remedy for breach of

156

6 Incomplete Information

contract but from “market failure” because the seller has all the market power and makes a take-it-or-leave-it offer.

Specific Performance Under specific performance, the possible ex post outcomes encompass a whole range. Like in the signaling model we will analyze two polar cases where the side payment is equal to the seller’s increased costs or to the high type’s valuation. Subsequently, we look at the general effects if the different types of buyers receive a payment between their valuation and the seller’s costs.

Side Payment in the Amount of the Seller’s Increased Costs This section supposes that the seller will make a side payment in the amount of her increased costs to both buyers. This is the outcome received in the signaling game in section “Two Buyer Types Setting—Specific Performance.” Based on the assumption that the seller cannot price discriminate the seller has a single payoff function. Contracting with both types this would be σ ¼ P  ð1  αÞco  αc

ð6:194Þ

She performs in case her costs do not increase and makes a side payment to the buyer in the amount of her increased costs if her costs increase. Importantly, due to the side payment the buyer’s payoff and thus his participation constraints are different than under expectation damages: π ¼ αc þ ð1  αÞv  P  0

ð6:195Þ

π
¼ αc þ ð1  αÞ
v  P  0

ð6:196Þ

It follows that the two candidates for a price to maximize the seller’s payoff are P ¼ αc þ ð1  αÞv and P ¼ αc þ ð1  αÞ
v . For the same argument as depicted under expectation damages, asking for any other price would be a dominated strategy. The seller’s payoff from charging a high price implies contracts only with the high type: σ P¼αcþð1αÞ
v ¼ δðαc þ ð1  αÞ
v  ð1  αÞco  αc Þ ¼ δ ð1  αÞð
v  co Þ ð6:197Þ The seller’s payoff from charging a low price differs in that she gets a lower price but contracts with both types: σ P¼αcþð1αÞv ¼ αc þ ð1  αÞv  ð1  αÞco  αc ¼ ð1  αÞðv  co Þ

ð6:198Þ

6.1 Buyer Having Private Information About His Valuation

157

Comparing this payoff to the one under expectation damages shows that we do not observe a shift of profit to the high type for the scenario that the seller’s costs increase. This is also shown in the high type’s payoff function as shown next. Turn to the buyer’s payoffs. If the seller charges a low price, she seizes all the gains from trading with the low type. Thus, the low type gets a payoff of zero. In contrast, the high type’s payoff is π
P¼v ¼ αc þ ð1  αÞ
v  αc  ð1  αÞv ¼ ð1  αÞð
v  vÞ

ð6:199Þ

This provides the following total payoff given that the seller charges a low price: ΠP¼v ¼ ð1  αÞðv  co Þ þ δð1  αÞð
v  vÞ ¼ ð1  αÞðð1  δÞv þ δ
v  co Þ

ð6:200Þ

It is the same total payoff as is generated under the first-best outcome. If the seller charges a high price, the low type does not contract at all and receives a payoff of zero. The seller seizes all the gains from trading with the high type such that also the high type has a payoff of zero. This leads to a total payoff of: ΠP¼αcþð1αÞ
v ¼ δ ð1  αÞð
v  co Þ

ð6:201Þ

It follows that charging a high price leads to a lower total payoff. The proof presented for expectation damages carries over to this case. Thus, the interesting questions are: When does the seller charge a high price, and does it differ from the finding under expectation damages? Again, we compare the seller’s payoffs: σ P¼αcþð1αÞ
v > σ P¼αcþð1αÞv

ð6:202Þ

δ ð1  αÞð
v  co Þ > ð1  αÞðv  co Þ

ð6:203Þ

δ ð
v  c Þ > ðv  c Þ

ð6:204Þ

o

o

It shows that the seller bases her decision solely on comparing her payoffs, if her costs do not increase. This results from the fact that in the scenario where her costs increase the different valuations have no impact on the seller’s payoff function because both types of buyers receive the same side payment. No shift of profit from the seller to the high type occurs. In consequence, the seller is more likely to maximize her payoff by charging a low price under specific performance leading to a higher overall payoff. Figure 6.15 depicts that the price the seller charges is elevated. This is based on the buyer’s higher willingness to pay due to the future payment he gets if the seller’s costs increase. At the same time, the seller’s costs increase. Importantly, the seller’s costs are the same facing a high type or low type. Furthermore, it shows that the low

158

6 Incomplete Information

Fig. 6.15 Seller’s payoffs contracting with high or both types under specific performance and a side payment equal to the seller’s increased costs. Parameters: c ¼ 120,
v ¼ 100, v ¼ 60, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%

type’s willingness to pay increased relatively more than the high type’s willingness to pay by such an amount that we retain the same shaded area that we saw in Fig. 6.14. In a nutshell, there is no shift in profit for the scenario that the seller’s costs increase implying that she is more likely to contract with both types.

Side Payment in the Amount of the High Type’s Valuation Suppose the seller makes a side payment in the amount of the high type’s valuation to both types ex post to be excused from the obligation to perform. This section differs from the previous one in the size of the side payment that both types of buyer get. Thus, the question is, does the mere size of the payment influence whether the seller charges a high or low price and how does it affect the total payoff. We have assessed those questions for the buyer making a take-it-or-leave-it offer but it remains to show that the result is equivalent once it is the seller who makes the offer. The side payment made by the seller if her costs of performance increase translate to her single payoff function as follows when she contracts with both types: σ ¼ P  ð1  αÞco  α
v

ð6:205Þ

As the side payment is equal to the high type’s valuation, the high type’s payoff, and thus his participation constraint is the same as under expectation damages. The low type’s payoff and participation constraint are greater than under expectation

6.1 Buyer Having Private Information About His Valuation

159

damages and below the one with a side payment being equal to the seller’s increased costs. π
¼ α
v þ ð1  αÞ
v  P ¼
v  P  0

ð6:206Þ

π ¼ α
v þ ð1  αÞv  P  0

ð6:207Þ

It follows as before that there are the two candidates for a price; a low price P ¼ α
v þ ð1  αÞv and a high price P ¼
v. The seller’s payoff from charging a high price is σ P¼
v ¼ δð
v  ð1  αÞco  α
v Þ ¼ δ ð1  αÞð
v  co Þ

ð6:208Þ

whereas she receives σ P¼α
vþð1αÞv ¼ α
v þ ð1  αÞv  ð1  αÞc  α
v ¼ ð1  αÞðv  co Þ

ð6:209Þ

given that she charges a low price. Both buyers receive a payoff of zero if the seller charges a high price. Given a low price the low type still gets a payoff of zero, but the high type’s payoff is: π
P¼α
vþð1αÞv ¼
v  α
v  ð1  αÞv ¼ ð1  αÞð
v  vÞ

ð6:210Þ

Comparing the payoffs with the ones found in the previous section, we see that they do not differ. This allows us to infer that the size of the side payment does not affect the seller’s decision what price she charges if it is on her to make a take-it-orleave-it offer and hence, also does not affect the total payoff. Different Side Payments for Different Buyers The section takes the general approach and supposes that the side payment takes a value between the buyer type’s individual valuation and the seller’s increased costs. The seller’s single payoff function contracting with both types is: σ ¼ P  ð1  αÞco  αðδð
v þ μðc 
vÞÞ þ ð1  δÞðv þ μðc  vÞÞÞ

ð6:211Þ

This reflects that the seller’s payoff ex post depends on which type she faces. If she faces a high type she makes a payment x ¼
v þ μðc 
vÞ and facing a low type the side payment takes a value of x ¼ v þ μðc  vÞ.28 The buyer’s payoff and participation constraint depending on his type are:

28

μ could also be modeled to take on different values depending on the type of buyer.

160

6 Incomplete Information

π ¼ αðv þ μðc  vÞÞ þ ð1  αÞv  P ¼ v þ αμðc  vÞ  P  0

ð6:212Þ

π
¼ αð
v þ μðc 
vÞÞ þ ð1  αÞ
v  P ¼
v þ αμðc 
vÞ  P  0

ð6:213Þ

It follows that the two candidates for a price are P ¼ v þ αμðc  vÞ and P ¼
v þ αμðc 
vÞ. The seller’s payoff from charging a high price is: σ P¼
vþαμðc
vÞ ¼ δð
v þ αμðc 
vÞ  ð1  αÞco  αð
v þ μðc 
vÞÞÞ ¼ δ ð1  αÞð
v  co Þ

ð6:214Þ

Her payoff from charging a low price takes the following form: σ P¼vþαμðcvÞ ¼ v þ αμðc  vÞ  ð1  αÞco  αðδð
v þ μðc 
vÞÞ þ ð1  δÞðv þ μðc  vÞÞÞ

ð6:215Þ

Simplifying yields: σ P¼vþαμðcvÞ ¼ ð1  αÞðv  co Þ  αδð
v  v  μð
v  vÞÞ

ð6:216Þ

Next, consider the buyer’s payoff. As before, given that the seller charges a high price, both types’ payoffs are zero. This remains to be true for the low type if the seller asks for a low price but the high type’s payoff changes. He gets π
P¼vþαμðcvÞ ¼
v þ αμðc 
vÞ  v  αμðc  vÞ ¼
v  v  αμð
v  vÞ

ð6:217Þ

This equation shows the effect of the side payment on the high type’s profit quite illustratively. The greater μ the lower is the shift of the profit from the seller to the high type. This yields the same total payoffs as in the previous sections: ΠP¼
vþαμðc
vÞ ¼ δ ð1  αÞð
v  co Þ

ð6:218Þ

ΠP¼vþαμðcvÞ ¼ ð1  αÞðv  co Þ  αδð
v  v  μð
v  vÞÞ þ δð
v  v  αμð
v  vÞÞ ¼ ð1  αÞðv  co þ δð
v  vÞÞ

ð6:219Þ

The seller will charge a high price if σ P¼
vþαμðc
vÞ > σ P¼vþαμðcvÞ

ð6:220Þ

6.1 Buyer Having Private Information About His Valuation

161

δ ð1  αÞð
v  co Þ > ð1  αÞðv  co Þ  αδð
v  v  μð
v  vÞÞ

ð6:221Þ

ð1  αÞðδð
v  c Þ  ðv  c ÞÞ > α δð
v  v  μð
v  vÞÞ

ð6:222Þ

o

o

The left-hand side of the inequality depicts the seller’s cost-benefit analysis in the event that her costs of performance remain stable. It is the same as shown in the previous sections concerning specific performance as well as under expectation damages. Of more interest is the right-hand side of the inequality which illustrates the situation that the seller’s costs of performance increase. Recall that μ takes a value between zero and one, whereby if μ ¼ 1 both buyers get the seller’s increased costs as a side payment and if μ ¼ 0 both buyers get their valuation as the side payment. The equation shows that if μ ¼ 1 there is shift in profit. In contrast, if μ ¼ 0 the right-hand side takes the same form as under expectation damages implying the problem that the seller subsidizes the high type causing the seller to be more likely to charge a high price.

Result The analysis has shown that cross-subsidization among buyers as well as the seller subsidizing the high type can lead to inefficient contracting behavior under expectation damages. This is the case if the seller’s inability to price discriminate with respect to the amount of future compensation results in a higher price which leads the parties to miss out on profitable contracts (See also Craswell 2003, 1159). We also saw the importance to distinguish between on the one hand the effects on efficiency based on the general inability to price discriminate facing buyers with various valuations and on the other hand the impact of an unadjusted price to future payments causing cross-subsidization. The former one is a general concern of market failure and depends on the market structure and the parties’ bargaining power. The latter one is independent of the structure of the market but a concern of a general kind. Even if the buyer had all the bargaining power, cross-subsidization would potentially lead to inefficiencies the same way. It is not based on the seller’s aim to maximize her payoff but that the various buyers’ valuations enter the seller’s payoff function at the same time as costs and thereby affecting the price. In contrast, under specific performance we found that preventing inefficient performances through renegotiation can at the same time alleviate the problem of cross-subsidization. In fact, the more equal the different buyers’ side payments are the less cross-subsidization occurs. It follows that if the buyer has all the bargaining power ex post all buyers’ side payments converge to the seller’s increased costs of performance eliminating the problem of cross-subsidization. The effect of the price not reflecting the future payment in case of an increase in costs exists regardless of whether the buyer or the seller has more bargaining power in the contracting stage. The buyer having the bargaining power leads to crosssubsidization among the buyers and the seller having bargaining power leads to a

162

6 Incomplete Information

Fig. 6.16 Effect of the price not reflecting the future compensation under expectation damages with respect to buyer’s or seller’s bargaining behavior. v ranges from 20 to 100. All other parameters are constant: c ¼ 120,
v ¼ 100, co ¼ 20, δ ¼ 0:5 and a probability that the seller’s costs increase of 50%

shift of profit from the seller to the high type. Nevertheless, the size of the effects differs. Figure 6.16 shows how the shift of the profit to the high type affects the contracting behavior differently with respect to who has the bargaining power. First, consider the dotted line representing the low type’s profit from contracting if he makes a take-it-or-leave-it offer. Once it crosses the x-axis the low type would make a profit from a contract under the first-best scenario because his valuation is above the seller’s costs of performance. However, due to cross-subsidization, the price the low type would have to pay is greater than his benefit up until that point where his profit function meets the function representing the costs of crosssubsidization; which is defined by: ð1  αÞðv  co Þ ¼ αδð
v  vÞ

ð6:223Þ

The shaded area below the dotted line represents the total payoff which is lost due to cross-subsidization if the buyer has all the bargaining power.

6.1 Buyer Having Private Information About His Valuation

163

Next, consider the gray line representing the seller’s profit from making a low offer such that she contracts not only with the high but also with the low type. We see that this line crosses the x-axis only where the low type’s valuation attains a substantially greater value. Before that, the seller prefers just to contract with the high type also in the absence of a shift in profit due to seller’s inability to price in the amount of future compensation. The gray line meets the x-axis at the point defined by: ð1  αÞðδð
v  co Þ  ðv  co ÞÞ ¼ 0

ð6:224Þ

Though the seller would profit from contracting with both types; as the low type’s valuation exceeds this point, his inability to price in the future amount of compensation prevents such contracts. Only once the seller’s profit from contracting with both outweighs her costs of paying the high type a high compensation, though receiving a low price; she contracts with both types as determined by the following inequality: ð1  αÞððv  co Þ  δð
v  co ÞÞ > α δð
v  vÞ

ð6:225Þ

The area below the gray line depicts the loss in total payoff due to the seller’s inability to price in the amount of compensation given that the seller has all the bargaining power. It shows that this has a weaker impact on missing out on possible profits than cross-subsidization if the buyer has all the bargaining power. However, an important caveat to that finding is that it depends on the distribution of types and does not hold in general. Besides the impact the asymmetry of information has on the total payoff, it is worth paying some more attention to who profits at whose expenses from crosssubsidization? One might think that in line with the term “cross-subsidization” it would be clear that it is the high type who gains at the expense of the low type. However, as already mentioned this is only half the truth and depends on who has the bargaining power ex ante. Consider the buyer making the take-it-or-leave-it offer under expectation damages or specific performance with the buyer having zero bargaining power ex post (μ ¼ 0); this implies cross-subsidization. If both buyer types contract with the seller the high type profits from the asymmetry of information at the expense of the low type. To see this, compare the payoffs each type gets under the first best and with asymmetric information. In the first-best scenario the payoffs are: π FB ¼ v  P ¼ v  ð1  αÞco  αv

ð6:226Þ

π
FB ¼
v  P ¼
v  ð1  αÞco  α
v

ð6:227Þ

With asymmetric information the buyer gets:

164

6 Incomplete Information

π ¼ v  P ¼ v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

ð6:228Þ

o

π
¼
v  P ¼
v  ð1  αÞc  αðδ
v þ ð1  δÞvÞ

ð6:229Þ

π FB > π

ð6:230Þ

Thus, the low type prefers the first best:

v  ð1  αÞco  αv > v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

ð6:231Þ

v > ðδ
v þ ð1  δÞvÞ

ð6:232Þ


v  v > 0

ð6:233Þ

which is true by assumption. The high type receives a high payoff with asymmetric information: π
> π
FB

ð6:234Þ


v  ð1  αÞc  αðδ
v þ ð1  δÞvÞ >
v  ð1  αÞc  α
v o

o

ð6:235Þ

ðδ
v þ ð1  δÞvÞ > 
v

ð6:236Þ


v  v > 0

ð6:237Þ

The seller has a payoff of zero in all cases and is therefore indifferent. In case the low type does not contract as a result of cross-subsidization, both the buyer and the seller have a payoff of zero. The high type gets the same payoff as in the first best because he is the only one contracting and thus the seller knows his type. Hence, the low type’s loss from not contracting is not transferred to the high type but lost. Now consider the seller to make the take-it-or-leave-it offer. The low type gets a payoff of zero in the first-best scenario as well as with asymmetric information. The high type receives the following payoffs: First best: π
FB ¼ 0

ð6:238Þ

π
P¼v ¼
v  v

ð6:239Þ

π
P¼
v ¼ 0

ð6:240Þ

Contract with both types:

Contract only with high type:

The seller’s payoffs are. First best:

6.1 Buyer Having Private Information About His Valuation

σFB ¼ ð1  αÞðð1  δÞv þ δ
v  co Þ

165

ð6:241Þ

Contract with both types: σ P¼v ¼ v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

ð6:242Þ

Contract only with high type: σ P¼
v ¼ δ ð1  αÞð
v  co Þ

ð6:243Þ

The summary of those payoffs shows that the high type profits from asymmetric information if the seller contracts with both types. The high type gains that profit at the expense of the seller. The difference between the seller’s payoff in the first best and contracting with both types is the flipside of the high type’s profit: σ FB  σ P¼v ¼ ð1  αÞðð1  δÞv þ δ
v  co Þ  v þ ð1  αÞco þ αðδ
v þ ð1  δÞvÞ ¼ δð
v  vÞ

ð6:244Þ

In case the seller contracts only with the high type it is the seller who bears all the lost profit in comparison to the first-best scenario. Overall, this shows that only the high type profits from asymmetric information. But he does so not necessarily at the expense of the low type. Rather at whose expenses he profits, depends on the bargaining power. The bargaining power determines how the parties share the profit from the trade. The high type can extract some part of the profit regardless of the buyer’s bargaining power if the seller contracts with both types. The seller and the low type share the respective burden of the extracted profit according to the proportional bargaining power seller and buyer have. This means if the seller has all the bargaining power she bears all the burden of the high type’s profit. In contrast, if the buyer has all the bargaining power the low type is the one who cross-subsidizes the high type. If the bargaining power is equal the seller and the low type share the burden equally.

6.1.3.2

Information Unraveling and Price Discrimination

Up to now we have analyzed the contracting stage tacitly assuming that the buyer does not disclose his type. In this part, we ask whether and under what conditions the buyer would be incentivized to do so. To be able to disclose his type the piece of information needs to be verifiable as defined in this chapter. Insofar as the buyer’s valuation and thus his type depends on things like his personal preferences, tastes, etc. and is therefore not objectively measurable, it is not verifiable (Bolton and Dewatripont 2015, p. 171).

166

6 Incomplete Information

For the following, we will focus on cases where the buyer can generally verify his type which also seems plausible for companies as their valuation tends to be objectively measurable. I suppose the company can get a certificate from a rating agency or an accounting firm which certifies the buyer’s type (Bolton and Dewatripont 2015, p. 173). This section begins by analyzing the incentives for the buyer to disclose his type under the assumption that the costs for verification are zero; K ¼ 0.29 Subsequently I discuss reasons which might impede disclosure.

Unraveling and Full Disclosure To see the unraveling of information, first consider the signaling game; the buyer making a take-it-or-leave-it offer. With respect to specific performance, I suppose that the buyer has no bargaining power ex post, μ ¼ 0, which renders specific performance to imply the same effect of cross-subsidization like expectation damages as we found above. This allows me not to distinguish between the two remedies but to focus on whether the buyer verifies his valuation to the seller. By revealing his type, the buyer moves from the scenario of asymmetric information to the first-best scenario. Recall the buyer’s payoffs in both scenarios: π ¼ v  P ¼ v  ð1  αÞco  αv

ð6:139Þ

π
¼
v  P ¼
v  ð1  αÞc  α
v

ð6:140Þ

o

The buyer’s payoff in the case of asymmetric information is: π ¼ v  P ¼ v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

ð6:144Þ

π
¼
v  P ¼
v  ð1  αÞc  αðδ
v þ ð1  δÞvÞ

ð6:145Þ

o

As already said above this comparison emphasizes that the high type profits from asymmetric information whereas the low type gets a lower payoff. Therefore, through revealing his type, the low type can overcome the problem that he pays a price that reflects the compensation only the high type receives (Bolton and Dewatripont 2015, p. 174). Importantly, this is not only relevant if the low type would not contract due to cross-subsidization but allows him in all cases to pay a lower price. For the high type, it is not profitable to disclose his type which therefore will not occur (Johnston 1990, 623). Nevertheless, the seller can infer as much information

29

Besides verification costs to be zero it is an important assumption that the buyer knows his type and the seller being aware of that. See for more details and to what the given conditions do not only sufficient but also necessary conditions: Bolton and Dewatripont (2015, pp. 176, 178).

6.1 Buyer Having Private Information About His Valuation

167

from non-disclosure as from disclosure in a two types setting (Bolton and Dewatripont 2015, p. 174). If verification is costless our result of full disclosure is not limited to a two types setting but extends to any number of types.30 The induction argument rests on the information which is sent by non-disclosure: If you do not disclose your valuation, it is above of those who disclose their valuation. The least valuing type discloses as in the two type setting, because otherwise he is pooled in the same group as all higher valuing types implying a higher price. Once the least valuing type reveals his type the same argument applies to the second least valuing type and so on (Bolton and Dewatripont 2015, p. 175).31 A slightly shifted picture is provided by the screening game. The low type’s payoff is zero in both scenarios, the first best and under asymmetric information. This is the result from giving the seller all the bargaining power. However, this does not show that the low type would not verify his type if the seller has all the bargaining power, because such extreme case is more theoretical in nature. It rather points to the issue that the low type’s incentive to reveal his type hinges on the payoff he would get in return. This becomes relevant if the costs of verification are not zero which is discussed in the next section.

Impediments to Disclosure The low type’s incentive to reveal his type rests on the profit he thereby gains. A profit is not guaranteed once the costs for verification are greater than zero; K > 0. Such costs can stem from the mere costs of verification like paying the accounting firm. The relevance of such costs depends on whether the buyer would have purchased the service anyway. The low type prefers not to disclose his valuation once his costs of verification exceed his gain from contracting. However, one can also imagine that under certain circumstances the seller offers the low type to bear part of the verification costs to induce him to reveal his type. The intuition behind this thought is that the high type profits from asymmetric information at the expense of the low type and the seller as shown above. How the seller and the low type share those expenses depends on their respective bargaining power. In consequence both, seller and low type, benefit from the disclosure of the buyer’s type. The seller could make an offer conditional on the buyer’s type such that the low type would accept such offer. In addition, the unraveling of information is limited by the value the buyer attaches to keeping his expected profit secret (Ben-Shahar and Bernstein 2000, 1898). Ben-Shahar and Bernstein name knowledge about business information like

30

See also for the full unraveling effect under expectation damages: Bebchuk and Shavell (1991, 284), Faust (1996, p. 231). 31 The full disclosure theorem was established by Grossman and Hart (1980), Grossman and Leland (1981), Milgrom (1981).

168

6 Incomplete Information

material and labor costs, availability of alternative suppliers, the identity of customers. They argue that this information not only can affect the bargaining position between the parties for future and parallel contracts, but also if the information spreads it might affect the buyer’s bargaining position with other companies or banks for instance (Ben-Shahar and Bernstein 2000, 1885, 1886). Concerning the unraveling of information in the current negotiations, the buyer’s secrecy interest with respect to his bargaining position is of less importance; because as we have seen the low type does not benefit from asymmetric information, and it is the low type that potentially reveals his type. Generally, it might be possible that the buyer verifies his type without providing details about customers, etc. and still reveal his type through a trustful mediator who certifies the type. Furthermore, the parties can sign a confidentiality agreement to prevent third parties from receiving information about the buyer’s valuation. Another possibility would be that the seller guarantees the low type a certain price for a long period of time such that the low type is assured that the seller cannot abuse his knowledge in future negotiations. Likewise, the seller might offer similar securities with respect to parallel contracts.32

Efficiency This section asks whether the disclosure of the buyer’s type is efficient. It can have a positive effect on efficiency at the contracting stage if it leads to contracts between the low type and the seller which would not have been concluded otherwise. At a first glance, it seems that the spread of information would always further efficiency. However, verifying the low type’s information does not increase the total payoff if the low type had contracted anyway. Rather it just leads to a different distribution of the gains from trade. Thus, if the verification of the type only has a distributional effect but produces costs, the disclosure is inefficient (Bolton and Dewatripont 2015, p. 174). Besides affecting efficiency at the contracting stage, the disclosure can have a positive impact on the ex post stage after the seller’s costs have increased. This can be either by improving the seller’s ability to take the efficient decision under expectation damages or render renegotiations more successful under both remedies. In the given context, this has no value because we have assumed that the parties reach efficient outcomes ex post. Within the next sections, we will depart from that assumption and discuss how this affects the buyer’s incentive to reveal his type.

32 Another potential limit to disclosure is law prohibiting price discrimination. However, this seems little relevant for the topic of the efficient breach scenario and a company on both sides of the contract. For instance, this is more important regarding insurance contracts and anti-discrimination law; see ECJ 1. March 2011.

6.1 Buyer Having Private Information About His Valuation

6.1.3.3

169

The Specific Case of the Efficient Breach Scenario

We have seen that expectation damages and to a lower degree-specific performance cause cross-subsidization if the seller’s costs increase above all buyer’s valuation and the seller does not perform. In that scenario, it was clear that non-performance is efficient ex post. This section is about what changes if it is unclear whether it is efficient to perform once the seller’s costs have increased. The focus of this section is not on the differences between the remedies. To account for uncertainty whether performance is efficient once the seller’s costs increase the following analysis takes the scenario that the buyer can exist of the following two types: On the one hand a low type with a valuation between the original costs and the increased costs and on the other hand a high type whose valuation exceeds the increased costs; co < v < c <
v: Thus, efficiency demands that the seller performs facing a high type but does not perform facing a low type if the seller’s costs have increased. The analysis encompasses both scenarios, the parties either expect to find the efficient outcome ex post or not. We determine the result of the two polar bargaining cases, the buyer or the seller making a take-it-or-leave-it offer, to allow for inferences what impact the parties’ bargaining power has. This is particularly important with respect to the buyer’s incentive to disclose his valuation. We start with outlining the first-best scenario as the benchmark for what follows.

First-Best Scenario First consider the ex post decision. Under the first best the seller performs facing the high type and does not perform facing the low type. For the ease of illustration, I assume that the seller pays the low type his valuation as either a side payment or as compensation. Against that background, consider the contracting stage. We can build on the findings of cross-subsidization in general in Sect. 6.1.3.1. We see that there is an additional payoff generated by the seller performing after an increase in costs facing a high type. This additional payoff takes an expected amount of δαð
v  cÞ. In the signaling game the high type captures that gain in the first best whereas the seller receives that gain if it were on her to make a take-it-or-leave-it offer.33

33

The following outlines the detailed deduction. First consider the seller to make the take-it-orleave-it offer. The buyers’ payoff which constitutes the participation constraints allow us the derive the prices the seller offers: π ¼vP0)P¼v

170

6 Incomplete Information

The Seller’s Costs as a Ceiling to Cross-Subsidization This section supposes that the parties find an efficient outcome ex post: The seller performs ex post if she faces a high type and pays the low type his valuation either as a side payment or as compensation. I do not explicitly distinguish between the different remedies but just refer to the differences and how the outcome alters if the seller makes a higher side payment.34

π
¼
v  P  0 ) P ¼
v The seller’s payoff function depends on the type of buyer she faces. σ low type ¼ P  ð1  αÞco  αv σ high type ¼ P  ð1  αÞco  αc We derive the seller’s payoff facing a low type σ low type ¼ v  ð1  αÞco  αv ¼ ð1  αÞðv  co Þ The seller’s payoff facing a high type is σ high type ¼
v  ð1  αÞco  α
v ¼ ð1  αÞð
v  co Þ þ αð
v  cÞ In both cases the seller captures all gains from trade. The seller’s payoff also representing the total payoff is ΠFB ¼ ð1  δÞð1  αÞðv  co Þ þ δðð1  αÞð
v  co Þ þ αð
v  cÞÞ

 ¼ ð1  αÞ ð1  δÞðv  co Þ þ δ
v  c0 þ αδð
v  cÞ Next, consider the buyer to make the take-it-or-leave-it offer: σ low type ¼ P  ð1  αÞco  αv  0 Thus, the price the low type offer is P ¼ ð1  αÞco þ αv. σ high type ¼ P  ð1  αÞco  αc  0 The high type offers a price P ¼ (1  α)co + αc. This provides the following payoffs to the buyer: π ¼ v  P ¼ v  ð1  αÞco  αv π
¼
v  P ¼
v  ð1  αÞco  αc This provides us with the following total payoff

 ΠFB ¼ ð1  αÞ ð1  δÞðv  co Þ þ δ
v  c0 þ αδð
v  cÞ

34 If one supposes that under specific performance the seller makes a side payment to the buyer equal to her increased costs, we would not observe cross-subsidization in the first place as shown above.

6.1 Buyer Having Private Information About His Valuation

171

The following illustrates one particularity of the efficient breach scenario compared to the case of cross-subsidization seen in the previous section where the seller always pays damages: The seller’s option to perform. This provides an upper ceiling for cross-subsidization because if the buyer’s valuation lies above the seller’s costs of performance the seller would prefer to perform and does not pay damages. In the following, I will start by analyzing the signaling model and subsequently combine the findings with those from Sect. 6.1.3.1: “Buyer Makes a Take-It-or-Leave-It Offer—Expectation Damages” to draw an inference for the screening model.

Buyer Makes a Take-It-or-Leave-It Offer Suppose the buyer makes a take-it-or-leave-it offer at the contracting stage. The seller has the following single payoff function which allows us to derive the lowest price the seller would accept: σ ¼ P  ð1  αÞco  αðδc þ ð1  δÞvÞ  0 ) P ¼ ð1  αÞco þ αðδc þ ð1  δÞvÞ

ð6:245Þ

The buyer’s payoff dependent on his type is π ¼ v  P ¼ v  ð1  αÞco  αðδc þ ð1  δÞvÞ

ð6:246Þ

π
¼
v  P ¼
v  ð1  αÞc  αðδc þ ð1  δÞvÞ

ð6:247Þ

o

The high type captures the additional payoff which is generated if the seller performs facing a high type. In the previous section, we saw that the low type incurs additional costs due to cross-subsidization as the price is elevated not only representing his but also the high type’s valuation. Under expectation damages and the seller paying compensation to both buyers, the low type prefers not to contract if ð1  αÞðv  co Þ  αδðv  vÞ < 0 |fflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflffl} |fflfflfflfflffl{zfflfflfflfflffl} Cross‐ Low type’ s profit subsidization from contracting if

ð6:248Þ

seller performs We compare this result to the current scenario. Here, the low type prefers not to contract given that v  ð1  αÞco  αðδc þ ð1  δÞvÞ < 0

ð6:249Þ

172

6 Incomplete Information

ð1  αÞðv  co Þ  |fflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflffl} Low type’ s profit from contracting if seller performs

αδðc  vÞ < 0 |fflfflfflfflffl{zfflfflfflfflffl} Cross‐ subsidization

ð6:250Þ

The decisive difference is seen regarding cross-subsidization. In the given case that the seller performs facing a high type, the high type’s valuation does not affect the impact of cross-subsidization. Thus, regardless of how much the high type’s valuation exceeds the low type’s valuation, the effect of cross-subsidization does not increase; because it is limited to the difference between the low type’s valuation and the seller’s increased costs of performance. Furthermore, we can infer, based on the findings of the previous section, that if the low type does not only get his valuation but a higher side payment ex post under specific performance, the smaller is the effect of cross-subsidization. In the extreme case, the low type gets a payment equal to the seller’s increased costs, and we observe no cross-subsidization to arise. Based on the same consideration as in Sect. 6.1.3.1—Result, comparing the buyer’s payoffs to the first best, it shows that the low type is incentivized to reveal his type if cross-subsidization is on hand. Nevertheless, the size of crosssubsidization is slightly different because in the given context it bases on the difference between the seller’s costs and the low type’s valuation. In contrast, the high type has no such incentive because he profits from cross-subsidization.

Seller Makes a Take-It-or-Leave-It Offer This section examines whether the effect, that the seller’s increased costs function as a limit to cross-subsidization, translates analogously to the screening model. To that end consider the following: If the seller contracts with both types, her payoff function is: σ ¼ P  ð1  αÞco  αðδc þ ð1  δÞvÞ

ð6:251Þ

The seller has costs of co with probability 1  α. We assume ex post efficiency and the seller performing the contract facing a high type implying costs c and breaching/making a side payment implying costs v if she faces a low type. In all cases, the seller receives the price P. In case she contracts only with the high type she gets: σ ¼ δðP  ð1  αÞco  αc Þ

ð6:252Þ

The buyer’s participation constraints based on his payoff function depending on his type are as follows:

6.1 Buyer Having Private Information About His Valuation

173

π ¼vP0

ð6:253Þ

π
¼
v  P  0

ð6:254Þ

As discussed in Sect. 6.1.3.1: “Buyer Makes a Take-It-or-Leave-It Offer— Expectation Damages,” the only two candidates for an offer that maximize her payoff are P ¼ v on the one hand and P ¼
v on the other hand. Making an offer above
v would imply that no contracts will be signed. Making an offer below v means that every type accepts but this would also be true for the higher price P ¼ v providing a higher payoff to the seller. The same argument applies to offers in between v and
v; only the high type accepts those offers but he also accepts offers P ¼
v providing the seller with a higher payoff. The seller’s payoffs from each respective offer are: σ P¼
v ¼ δð
v  ð1  αÞco  αc Þ

ð6:255Þ

σ P¼v ¼ v  ð1  αÞco  αðδc þ ð1  δÞvÞ

ð6:256Þ

The equations show that the seller’s increased costs replaced the high type’s valuation in comparison to the finding in Sect. 6.1.3.1: “Buyer Makes a Take-It-orLeave-It Offer—Expectation Damages.” Taking the buyer’s perspective: The low type always gets a payoff of zero. The high type gets a payoff of zero with a high price and π
P¼v ¼
v  P ¼
v  v if the seller contracts with both types charging a low price. Hence, the high type’s situation does not change compared to what we have seen if his valuation lies below the seller’s costs in Sect. 6.1.3.1: “Buyer Makes a Take-It-or-Leave-It Offer—Expectation Damages.” Also, whether the seller prefers to contract with both types or only the high type is unaffected by her performing facing a high type. To see this, consider when she prefers to contract only with high types in the given setting σ P¼
v > σ P¼v

ð6:257Þ

δð
v  ð1  αÞco  αc Þ > v  ð1  αÞco  αðδc þ ð1  δÞvÞ

ð6:258Þ

δð1  αÞð
v  c Þ þ δαð
v  cÞ > ð1  αÞðv  c Þ  αδðc  vÞ

ð6:259Þ

δð1  αÞðv  co Þ  ð1  αÞðv  co Þ þ >0 αδðv  vÞ |fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl} |fflfflfflfflffl{zfflfflfflfflffl} High type’ s profit Seller’ s general cost‐benefit analysis if seller contracts contracting with high or both types

ð6:260Þ

o

o

with both and costs increase This is the same cost-benefit analysis the seller sees herself in, when she does not perform ex post but always breaches as shown in Sect. 6.1.3.1: “Buyer Makes a

174

6 Incomplete Information

Take-It-or-Leave-It Offer—Expectation Damages.” This results from the additional gain from performing ex post facing a high type instead of paying damages in the amount of the high type’s valuation. This gain enters her payoff function regardless whether she contracts with both types or only with the high type. As we learned in Sect. 6.1.3.1: “Buyer Makes a Take-It-or-Leave-It Offer— Expectation Damages,” if the seller makes the take-it-or-leave-it offer, the high type profits from the asymmetry of information at the expense of the seller given that she contracts with both types. The high type pays the low type’s valuation as the price but still gets his valuation. This does not change in the given scenario. We found in this section that the seller captures all the additional gain that is created through her performing if her costs have increased facing a high type. In addition, the seller’s decision whether to contract with both types or only with the high type is unaffected by her performing facing a high type because this happens in both scenarios.

Expected Ex Post Inefficiency Next, we analyze the consequences if the parties expect an inefficient outcome ex post due to asymmetric information. This inefficiency is prevented if the buyer discloses his type at the contracting stage. In that, this section assesses how it affects the buyer’s incentive to reveal his type at the contracting stage if that would increase the surplus which is shared.35 We need to distinguish between the scenarios that the parties expect that the seller would breach or perform ex post not knowing what type she faces. The seller breaching presuppose that the remedy is expectation damages and not specific performance. Thus, the next section only speaks to expectation damages. Seller Would Always Breach Under Expectation Damages The analysis starts with the signaling game, the buyer making a take-it-or-leave-it offer. Buyer Makes a Take-It-or-Leave-It Offer The seller breaching at the ex post stage implies besides that the remedy in place is expectation damages also that c > δ
v þ ð1  δÞv. The seller’s payoff if she contracts with both types:

35

Similarly Ayres and Gertner as well as Bebchuk and Shavell make the distinction whether it is desirable that the seller can distinguish between buyers with a high or a low valuation to take the efficient decision, see Ayres and Gertner (1989, 101), Bebchuk and Shavell (1999, 1617).

6.1 Buyer Having Private Information About His Valuation

σ ¼ P  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

175

ð6:261Þ

Which provide us with her participation constraint to be P  ð1  αÞco  αðδ
v þ ð1  δÞvÞ  0

ð6:262Þ

This leads to the price P ¼ ð1  αÞco þ αðδ
v þ ð1  δÞvÞ. The buyer’s payoff depends on his type and turns out to be as follows under asymmetric information π ¼ v  P ¼ v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

ð6:263Þ

π
¼
v  P ¼
v  ð1  αÞc  αðδ
v þ ð1  δÞvÞ

ð6:264Þ

o

The low type prefers not to contract at all if her payoff is below zero. π ¼ v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ < 0

ð6:265Þ

We can distinguish between the two aspects that prevent the low type from contracting: cross-subsidization and the ex post inefficiency. The low type pays a higher price than what he would pay adjusted to his valuation. In addition, the price is even higher because the seller does not perform but breach facing a high type. ð1  αÞðv  co Þ  |fflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflffl} Low type’ s profit from contracting if seller performs

αδðc  vÞ  αδðv  cÞ < 0 |fflfflfflfflffl{zfflfflfflfflffl} |fflfflfflfflffl{zfflfflfflfflffl} Cross‐ Ex‐post subsidization inefficiency

ð6:266Þ

The buyer dropping out as a potential contractual candidate on the one hand has a negative effect on efficiency. On the other hand, the seller now knows that he contracts with a high type. Thus, ex post efficiency is restored because she will perform. However, this comes at the expense of not contracting with the low type. The high type will capture all the efficiency gain. Before dropping out completely the low type might want to disclose his type; which is discussed in the following. Figure 6.17 shows the different aspects affecting the low type’s payoffs: Figure 6.17 shows that under expectation damages and given that the seller always breaches ex post there occur two forms of cross-subsidization. The first form of cross-subsidization is shown in Pane (b) neglecting the ex post inefficiency. In that it depicts the scenario of the section “The Seller’s Costs as a Ceiling to CrossSubsidization—Buyer Makes a Take-It-or-Leave-It Offer” where the seller performed ex post if she faces a high type. The low type pays a higher price subsidizing the high type receiving performance ex post. The price the low type pays reflects the seller’s higher costs if she performs ex post. The second form of cross-subsidization is shown in Pane (d). It comprises asymmetry of information and

176

6 Incomplete Information

Fig. 6.17 Effect of cross-subsidization under expectation damages in signaling game with potentially inefficient breaching facing the high type. All Panes are based on the following parameters: v ¼ 50,
v ¼ 100, c ¼ 80, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%. Pane (a) shows the first-best scenario. Pane (b) shows the effect of asymmetric information if both buyer’s contract. Pane (c) is exclusively a theoretical case for the illustrative purpose. It shows the effect of the ex post inefficiency, breach facing a high type, on the first best. Pane (d) combines asymmetry of information and the ex post inefficiency

the additional inefficiency ex post arising from the fact that the seller does not perform facing a high type but breaches if her costs increase (Pane c). This second form of cross-subsidization is distinct in that the low type does not make an extra payment from which the high type would benefit. Rather the low type pays something extra due to the inefficiency. Nevertheless, it is a form of cross-subsidization because the low type shares the burden of paying a higher price though the inefficiency arises only with respect to the high type. To analyze the buyer’s incentive to disclose his valuation, we need to compare his payoff to what he would get if he reveals his type; putting it differently, to his payoff in the first best we derived above. Recall that in the first best the price is adjusted to the buyer’s type. The high type pays P ¼ (1  α)co + αc and the low type offers a price of P ¼ ð1  αÞco þ αv which provides us with the following payoffs:

6.1 Buyer Having Private Information About His Valuation

177

π FB ¼ v  P ¼ v  ð1  αÞco  αv

ð6:267Þ

π
FB ¼
v  P ¼
v  ð1  αÞc  αc

ð6:268Þ

o

The following comparison shows that the high type prefers not to reveal his type despite him capturing all the gain from a greater efficiency ex post: π
> π
FB
v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ >
v  ð1  αÞco  αc

ð6:269Þ ð6:270Þ

δ
v  ð1  δÞv > c

ð6:271Þ

c > δ
v þ ð1  δÞv

ð6:272Þ

which holds by assumption. In the case of ex post efficiency, the high type would pay a lower price, P ¼ ð1  αÞco þ αðδc þ ð1  δÞvÞ, because the seller would perform facing a high type. However, by revealing his type the high type would also forego his benefit from cross-subsidization. It shows that the high type has no incentive to reveal his type because he profits more from cross-subsidization than from achieving efficiency. This can also be seen in Fig. 6.17 if we compare the high type’s payoff in Pane (a) and Pane (d). It shows that the price the high type pays is greater in Pane (a), the first-best scenario. The shaded and dotted area depict the cross-subsidization that adds on to the high type’s profit in Pane (d) and thus render not revealing his type as more profitable. The low type has an incentive to reveal his type encountering cross-subsidization similar as in the previous sections. In the given context, the low type revealing his valuation does not only have a distributional effect at the expense of the high type. It also leads to an efficiency gain ex post which is captured by the high type.

Seller Makes a Take-It-or-Leave-It Offer This section turns to the opposite scenario. The seller makes the take-it-or-leave-it offer. This gives her all the bargaining power. The seller’s payoff if she contracts with both types is σ Screening BT ¼ ð1  αÞðP  co Þ þ αðP  δ
v  ð1  δÞvÞ

ð6:273Þ

The buyer gets a payoff depending on his type: π ¼vP

ð6:274Þ

π
¼
v  P

ð6:275Þ

As before the two candidates for a price are P ¼
v and P ¼ v. But different from Sect. 6.1.3.1: “Buyer Makes a Take-It-or-Leave-It Offer—Expectation Damages”

178

6 Incomplete Information

the seller changes her behavior ex post if she contracts only with the high type. As said in the previous section for signaling, the seller will be aware that she faces a high type if she charges a high price. Thus, she prefers to perform ex post. In contrast to the signaling game, when the seller makes the take-it-or-leave-it offer, she captures such efficiency gain. Thus, it affects her decision whether to contract with both types. In the signaling game, it was the low type who decided whether to contract; but he did not profit from the efficiency gain. First consider the buyer’s payoff from the different prices. With a low price and both contracting we get the following payoffs: π Screening P¼v ¼ 0

ð6:276Þ

π
Screening P¼v ¼
v  v

ð6:277Þ

Like with the general form of cross-subsidization (Sect. 6.1.3.1: “Buyer Makes a Take-It-or-Leave-It Offer—Expectation Damages”) the high type profits from asymmetric information. If the seller charges a high price both types get a payoff of zero. Next, consider the seller’s payoffs. We start with the payoff she receives charging a low price. σ Screening P¼v ¼ ð1  αÞðv  co Þ  αδð
v  vÞ

ð6:278Þ

On the contrary, if the seller contracts only with the high type she performs ex post providing her with a payoff of: σ Screening P¼
v ¼ δðð1  αÞð
v  co Þ þ αð
v  cÞÞ

ð6:279Þ

The seller prefers to contract only with the high type if σ Screening P¼
v > σ Screening P¼v

ð6:280Þ

δðð1  αÞð
v  co Þ þ αð
v  cÞÞ > ð1  αÞðv  co Þ  αδð
v  vÞ

ð6:281Þ

δð1αÞðvc Þ ð1αÞðvc Þ þ >0 ð6:282Þ þ αδðvcÞ αδðvvÞ |fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl} |fflfflfflfflffl{zfflfflfflfflffl} |fflfflfflfflffl{zfflfflfflfflffl} Additional Seller’ sgeneral cost‐benefit analysis Hightype’ sprofit efficiency gain if seller contracts contracting with highor bothtypes fromperforming withboth and o

o

costsincrease

ex‐post facing hightype

The inequality reflects that in the given scenario the seller has additional incentives to charge a high price in addition to her general cost-benefit analysis. She

6.1 Buyer Having Private Information About His Valuation

179

Fig. 6.18 Effect of asymmetric under expectation damages in screening game with potentially inefficient breaching facing the high type. All Panes are based on the following parameters: v ¼ 50,
v ¼ 100, c ¼ 80, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%. Pane (a) shows the first-best scenario. Pane (b) shows the seller contracting only with the high type. Pane (c) shows the seller contracting with both types under asymmetric information

captures the additional gain which is reached ex post and prevents the high type cashing in on the asymmetry of information.36 The various costs the seller faces are shown in Fig. 6.18. Pane (a) shows the firstbest scenario where the seller performs ex post when she faces a high type but breaches facing a low type. In case she contracts only with the high type, depicted in Pane (b), she would also perform ex post, but no contract exists with the low type. Considering Pane (c), we can distinguish the effects described by the inequality above. The high type profits in the amount of the full difference between his valuation and the price not only if the seller’s costs remain stable but also if the costs increase. Thus, the high type’s profit is the white area but also the shaded area. In sum, this is the area between the price, the low type’s valuation, and the high type’s valuation. The shaded area furthermore indicates that it is the seller who bears all the costs stemming from the inefficiency that she breaches facing a high type.

36

Recall that the assumption is that the parties do not reach an efficient outcome ex post.

180

6 Incomplete Information

Concerning the buyer’s incentive to disclose his type, in the given extreme scenario that the seller has all the bargaining power and makes a take-it-or-leave-it offer, the seller would capture all the additional surplus if she knew what type she faces. This is also shown in Fig. 6.18 if one moves from Pane (c) to Pane (a). The high type would not reveal his type since he could only lose in particular if the seller prefers to contract with both types. The low type’s incentive to reveal his type is reduced because he would not benefit under the first best in the screening game. Seller Always Performs Now suppose that the seller would perform at the ex post stage without receiving further information at the contracting stage. This is the case if the remedy in the place is specific performance but also under expectation damages given that c < δ
v þ ð1  δÞv. If the seller learns the buyer’s type I assume that the seller pays the low type his valuation either as compensation or side payment and performs facing a high type. Thus, by construction, the outcome is the same under both remedies. The result would not change if the low type gets a higher side payment in the first best because the price would completely reflect such change as the low type gets all the surplus generated anyway. Buyer Makes a Take-It-or-Leave-It Offer The buyer making a take-it-or-leave-it offer under asymmetric information provides us with the following payoff and participation constraint for the seller which also gives us the minimum price: σ ¼ P  ð1  αÞco  αc  0 ) P ¼ ð1  αÞco þ αc

ð6:283Þ

The buyer’s payoff is given by π ¼ v  P ¼ v  ð1  αÞco  αc

ð6:284Þ

π
¼
v  P ¼
v  ð1  αÞco  αc

ð6:285Þ

The low type prefers not to contract if π ¼ v  ð1  αÞco  αc < 0

ð6:286Þ

ð1  αÞðv  c Þ þ αðv  cÞ < 0

ð6:287Þ

o

At a first glance, the equation seems to tell that there is no cross-subsidization happening but simply inefficient performances facing the low type. The seller has the same costs regardless whether she faces the high or the low type. However, this is just half the truth. Despite the fact that the seller has the same costs the types profit differently. Being specific, if the seller’s costs increase the low type would prefer non-performance and a lower price. There are two aspects that cause the low type to

6.1 Buyer Having Private Information About His Valuation

181

pay for the performance even if the costs increase: He pays partly for the high type to get the performance and partly for himself to get performance because the seller does not differentiate between the two types. Even if there was no ex post inefficiency, i.e., non-performance facing the low type, the low type would pay partly for the high type receiving performance ex post. The price would be P ¼ ð1  αÞco þ αðδc þ ð1  δÞvÞ which is smaller than P ¼ (1  α)co + αc because v < c. It shows that the cross-subsidization is hidden in the given case because both types pay the same price, and both get the same treatment, i.e., performance. We can infer that cross-subsidization consists of two parts: Not only receiving the same performance but also how they value the treatment they receive in case costs increase. Thus, we can break up the equation to accentuate both aspects that prevent the low type to contract: ð1  αÞðv  co Þ  αδðc  vÞ  αð1  δÞðc  vÞ < 0 |fflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflffl} |fflfflfflfflffl{zfflfflfflfflffl} |fflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflffl} Cross‐ Ex‐post Low type’ s profit subsidization inefficiency from contracting if

ð6:288Þ

seller performs Consider the following figure for a graphical depiction: Putting Fig. 6.19 and the inequality into relation, consider first Pane (c). It shows in comparison to the first best, Pane (a), that the low type bears the costs of the inefficiency. Hence, Pane (c) can be understood as the basic inequality ð1  αÞ  ðv  co Þ þ αðv  cÞ < 0. Looking deeper at the sources of the seller’s costs facing the low type brings us next to Pane (b). It assumes no ex post inefficiency but asymmetric information. Given such circumstances we would observe crosssubsidization like in section “The Seller’s Costs as a Ceiling to Cross-Subsidization—Buyer Makes a Take-It-or-Leave-It Offer.” The price decreases and both types receive a greater payoff. But the rise of the high type’s profit comes at the expense of the low type due to cross-subsidization because both pay the same price. Pane (d) shows the reason why the cross-subsidization is hidden. All the benefit the high type gains from cross-subsidization are consumed by the inefficiency which makes both types paying a higher price depicted as the black area with white dots. In that we only see the negative effect of cross-subsidization affecting the low type but not the corresponding benefit on the high type’s side. It is generally true that the higher price the high type pays due to the inefficiency is equal to the high type’s benefits from cross-subsidization. To see this, consider the price the high type would pay without the inefficiency: P ¼ ð1  αÞco þ αðδc þ ð1  δÞvÞ

ð6:289Þ

Comparing this to the price he eventually pays we get the high type’s loss from the inefficiency:

182

6 Incomplete Information

Fig. 6.19 Effect of cross-subsidization if seller potentially always performs in signaling game implying an inefficiency. All Panes are based on the following parameters: v ¼ 50,
v ¼ 100, c ¼ 80, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%. Pane (a) shows the first-best scenario. Pane (b) shows the effect of asymmetric information without the seller inefficiently performing facing a low type after an increase. Pane (c) shows the seller’s costs given asymmetry of information and the inefficiency without relating it to its sources. Pane (d) relates the costs the seller faces to its different sources given asymmetry of information and ex post inefficiency

ð1  αÞco þ αc  ð1  αÞco  αðδc þ ð1  δÞvÞ ¼ αð1  δÞðc  vÞ

ð6:290Þ

Hence, multiplied with the proportion of high types this provides us with the total expected loss of the high type: δαð1  δÞðc  vÞ. Contrast this now to the effect of cross-subsidization. We saw in the above inequality that the low type transfers a sum of αδðc  vÞ to the high type. Multiplying this with the proportion of low types gives us the total expected sum transferred to the high type; which is δαð1  δÞðc  vÞ and thus the same as the high type expects to lose. To analyze the buyer’s incentive about disclosing his type recall the buyer’s payoff in the first best: π FB ¼ v  P ¼ v  ð1  αÞco  αv

ð6:291Þ

6.1 Buyer Having Private Information About His Valuation

183

π
FB ¼
v  P ¼
v  ð1  αÞco  αc

ð6:292Þ

Comparing the buyer’s payoffs with his payoffs in the first-best points out that the high type does not profit from revealing his type. Though there would be an efficiency gain, the price he had to pay would increase. In the situation of asymmetric information, the high type profits from cross-subsidization. Only the low type would capture the efficiency gain moving towards the first best, because his price is adjusted downwards. On the contrary, the price the high type pays remains constant, because the seller would perform anyway facing a high type. From the low type’s perspective, the incentive to disclose his type rests on encountering cross-subsidization and additionally to achieve the efficient ex post outcome, because he is the one who captures the respective generated profit.

Seller Makes a Take-It-or-Leave-It Offer In the given scenario that the seller always performs ex post and she contracts with both types her payoff is: σ Screening BT ¼ ð1  αÞðP  co Þ þ αðP  cÞ

ð6:293Þ

The buyer’s payoff depending on his type is: π ¼vP

ð6:294Þ

π
¼
v  P

ð6:295Þ

As before the two candidates for a price are P ¼
v and P ¼ v. The seller’s respective payoffs are: σ Screening P¼
v ¼ δðð1  αÞð
v  co Þ þ αð
v  cÞÞ

ð6:296Þ

σ Screening P¼v ¼ ð1  αÞðv  c Þ þ αðv  cÞ

ð6:297Þ

o

The seller prefers to contract only with the high type if σ Screening P¼
v > σ Screening P¼v δðð1  αÞð
v  c Þ þ αð
v  cÞÞ > ð1  αÞðv  c Þ þ αðv  cÞ o

o

ð6:298Þ ð6:299Þ

184

6 Incomplete Information

þ αð1δÞðcvÞ >0 δð1αÞðvco Þ ð1αÞðvco Þ þ αδðvvÞ |fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl} |fflfflfflfflffl{zfflfflfflfflffl} |fflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflffl} ’ ’ Additional Seller sgeneral cost‐benefit analysis Hightype sprofit efficiency gain if seller contracts contracting with high or both types from notperforming with bothand ex‐post facing costs increase lowtype

ð6:300Þ

Like in the scenario that the seller always breaches ex post, the seller has an additional advantage from contracting only with the high type. In the given case that the seller performs ex post this additional advantage translates to not inefficiently performing facing a low type when her costs increase. Consider Fig. 6.20 for a graphical depiction: The graphs illustrate that if the seller contracts with both types, the high type profits at the seller’s expense. The low type profits in both situations, if the seller’s costs increase or remain the same. Pane (c) also depicts that the seller bears all the costs of the inefficient ex post outcome that she performs facing a low type. Pane (a) shows that the seller would profit from disclosure in two ways: She captures the high type’s profit if the costs increase or not and additionally profits from the efficient outcome that she does not perform ex post. If she contracts only with the high type as shown in Pane (b) she only captures the high type’s profit but misses out on the profit facing the low type. The findings from the signaling game about the buyer’s incentive to disclose his type translate equivalently to the screening game. As we do not observe crosssubsidization, the only incentive to reveal his type is given by the efficiency gain potentially directed at the low type. But since the seller captures that gain in the first best, the low type’s incentive to reveal his valuation is reduced.

Result This section built on the previous finding that expectation damages and to a lower degree also specific performance lead to cross-subsidization. It showed that the seller’s option to perform functioned as a ceiling to cross-subsidization if the seller efficiently performs ex post given that her costs remain below the buyer’s valuation. Furthermore, we explored the effect of a potential inefficient outcome ex post. We found that the low type can be even more incentivized to reveal his type. This is the case where the seller would inefficiently perform. In this case by revealing his type the low type does not only reduce the price he by preventing cross-subsidization but also inducing the efficient outcome ex post. This incentive is most pronounced in the signaling game where the buyer has the bargaining power and the least if the seller has all the bargaining power.

6.1 Buyer Having Private Information About His Valuation

185

Fig. 6.20 Effect of asymmetric information if seller potentially always performs in screening game implying an inefficiency. All Panes are based on the following parameters: v ¼ 50,
v ¼ 100, c ¼ 80, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%. Pane (a) shows the first-best scenario. Pane (b) shows the seller contracting only with the high type. Pane (c) shows the seller contracting with both types under asymmetric information

The high type profits from cross-subsidization by more than the surplus generated through an efficient decision ex post. Thus, he will prefer not to disclose his type. Furthermore, the analysis provided the insight that the expectation of an inefficient outcome ex post intensifies the seller’s incentive to contract only with the high type eliminating the ex post inefficiency. It is important to emphasize that in the given context, revealing one’s type is eponymous with verifying one’s type; i.e., not simply declaring the type with the possibility to misrepresent one’s type. Throughout all the cases we saw that only the low type is incentivized to disclose his type. Such disclosure implies a lower price for the low type. However, the high type would also prefer a low price and therefore mimic the low type if a simple statement would be enough to signal to be a low type. This is possible for the high type because regardless of the remedy, unlimited liability, or specific performance, his ex post outcome is not connected to the signal he makes at the contracting stage. Even if he declares to be a low type he would still

186

6 Incomplete Information

get fully compensated at the ex post stage or get a side payment that is unrelated to his statement. Thus, we can conclude that revelation requires verification which entails the respective costs discussed in Sect. 6.1.3.2.

6.1.3.4

Limited Compensation

The analysis so far has assumed the compensation the seller pays under expectation damages to be tailored to the buyer’s valuation. This section discusses the effects if compensation is limited either based on the foreseeability doctrine or contractually. The foreseeability doctrine is, as already mentioned in Chap. 5 I, a legal concept in common law originating from the case Hadley v. Baxendale in 1854.37 It states that damages cannot be recovered unless they are foreseeable and reasonably certain at the time of the conclusion of the contract. The buyer can communicate his particular circumstances to the seller. Otherwise liability is limited to the ordinary level of losses (Bebchuk and Shavell 1991; Unberath 2012, p. 319). The doctrine also entered the Convention on international sales for goods in Art 74 CISG saying: Damages for breach of contract by one party consist of a sum equal to the loss, including loss of profit, suffered by the other party as a consequence of the breach. Such damages may not exceed the loss which the party in breach foresaw or ought to have foreseen at the time of the conclusion of the contract, in the light of the facts and matters of which he then knew or ought to have known, as a possible consequence of the breach of contract.

Allegedly the foreseeability doctrine leads to a revelation of the buyer’s type. The buyer is said to be incentivized to disclose his valuation because thereby it becomes foreseeable and part of a damages claim (Johnston 1990, 616; Faust 1996, p. 223; Riehm 2015, p. 520). It is asserted that this mechanism would further accurate pricing (Eisenberg 2005, 985; Schwartz and Scott 2003, 598 Fn. 116; Bebchuk and Shavell 1991).38 In addition, the seller knowing the buyer’s valuation decides

37

9 Ex. 341, 156 Eng. Rep. 145 (1854). Classic nineteenth century English case where a mill owner, Hadley, engaged the company Pickford & Co. to deliver an engine shaft to another city for replacement. Pickford and Co. belonged to Baxendale (the defendant). The performance of that contract was of high value to Hadley because he did not have a spare shaft and without a new shaft his mill could not operate. Baxendale did not deliver the shaft on the agreed date and Hadley incurred damages because he could not operate his mill. The court ruled that Baxendale did not have to compensate Hadley for his loss because Baxendale could not foresee them. Hadley would have had to have communicate the particular circumstances to Baxendale at the time the contract was concluded. 38 Bebchuk and Shavell compare limited (no damages for unforeseeable losses) and unlimited liability for damages. In their model the seller can take precautions in order to be able to perform. In their model two types of buyers exist: Few high valuing buyers and many low valuing buyers. The seller cannot observe the buyer’s valuation. Bebchuk and Shavell assume that the buyers can identify themselves either as high or low valuing buyers. If a buyer reveals his type, he incurs communication costs. Adler extended this model by adding that high types do not only suffer higher damages but also that they are more likely to suffer damages [See Adler (1999) and the response by

6.1 Buyer Having Private Information About His Valuation

187

more efficiently about the effort to perform the contract (Johnston 1990, 616; Riehm 2015, p. 520). Originally, the doctrine arose for cases of negligence, i.e., what level of precaution should be exercised. In the context of the efficient breach scenario, it is not about precaution but willful breaches. Nevertheless, it is said that the same arguments apply (Bebchuk and Shavell 1991, 303, 304).39 In the next sections, I put those assertions to a test in the given context of the efficient breach scenario. I proceed as follows: First I analyze whether and how the incentives change in comparison to the general setting analyzed in Sect. 6.1.3.1 at the contracting stage once the seller pays only foreseeable damages. In this part, the breach is always the efficient outcome if the seller’s costs increase. Starting with such scenario allows the direct comparison to Sect. 6.1.3.1 and focuses on the effect of limiting liability on cross-subsidization. I model the foreseeability doctrine the way that it limits compensation to the low type’s valuation unless the seller has informed the party to be a high type at the contracting stage. In that case, compensation is tailored to the buyer’s valuation. Subsequently, I further develop the model discussing the case that revealing the type has a positive effect on efficiency ex post. Thirdly, I discuss why it is crucial that the moment of contracting is the relevant point in time when damages need to be foreseeable. In this respect, I analyze what problems such construction brings along. A section on effects if the parties are given the option to specify damages either to be limited or unlimited in their contract concludes.

Effect of Foreseeability Doctrine on Contracting Breach Efficient Ex Post Recall the scenario from Sect. 6.1.3.1. Seller and buyer conclude a contract. The seller has costs of performance equal to co which increase with probability α attaining a value c. The buyer can be of two types, v and
v , whereby v <
v < c. The proportion of high types is δ and 1  δ low types. In case the seller breaches the contract and pays damages those damages are limited to the low type’s valuation unless the seller is informed about the seller being a high type at the contracting stage.

Bebchuk and Shavell (1999)]. However, in the context of the efficient breach scenario it seems not convincing that a buyer who does not receive performance would not suffer damages regardless of his valuation. 39 See also Bigoni et al. (2017, 28), who state that the option to breach would lead to an exchange of information in the scenario that the buyer has superior information about the seller’s costs of performance or the converse setting that the seller has superior information about the buyer’s valuation if damages are undercompensatory. But they do not provide a closer assessment. In particular they do not discuss to what extent damages need to be undercompensatory in relation to the profit the informed makes on having superior information.

188

6 Incomplete Information

First, I analyze the model without the buyer informing the seller about his type and subsequently discuss whether the buyer is incentivized to reveal that information. I make use of the signaling model, the buyer making a take-it-or-leave-it offer because it allows to focus on the effect of the foreseeability doctrine on pricing and cross-subsidization without the impact of the seller maximizing his profit through pricing. The seller’s payoff function with the foreseeability doctrine is as follows: σ LL Signaling ¼ P  ð1  αÞco  αðδv þ ð1  δÞvÞ ¼ P  ð1  αÞco  αv ð6:301Þ The seller performs if her costs remain stable but breaches in case her costs increase. The second part of the function shows the difference due to the foreseeability doctrine; without limiting the liability the seller expected to pay the average of the buyer’s valuation providing the following payoff function: σ ¼ P  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

ð6:302Þ

To maximize his payoff the buyer offers the lowest possible price which is P ¼ ð1  αÞc þ αv. It follows for the buyer’s payoff to take the following form for the low type: π LL Signaling ¼ v  P ¼ v  ð1  αÞco  αv ¼ ð1  αÞðv  co Þ

ð6:303Þ

The low type gets his valuation either through performance or compensation. The high type gets his valuation if the seller performs or compensation in the amount of the low type’s valuation. The high type’s payoff is π
LL Signaling ¼ ð1  αÞ
v þ αv  P ¼ ð1  αÞ
v þ αv  ð1  αÞco  αv ¼ ð1  αÞð
v  co Þ

ð6:304Þ

We compare those payoffs with once for the first best which we have already derived in Sect. 6.1.3.1. The price in the first-best scenario is adjusted to the buyer’s valuation. The high type pays a price P ¼ ð1  αÞco þ α
v whereas the low type pays P ¼ ð1  αÞco þ αv. In contrast to the given scenario of limited liability the seller pays compensation to the high type equal to his valuation: π FB Signaling ¼ v  P ¼ v  ð1  αÞco  αv ¼ ð1  αÞðv  co Þ

ð6:305Þ

π
FB Signaling ¼
v  P ¼
v  ð1  αÞco  α
v ¼ ð1  αÞð
v  co Þ

ð6:306Þ

It shows that the buyer’s expected payoffs are the same in the first best, i.e., the seller knowing the buyer’s type. It follows that no type of buyer is incentivized to signal his type to the seller. The high type gets a higher compensation in the first best

6.1 Buyer Having Private Information About His Valuation

189

than without informing the seller about his type. Compensation is equal to his valuation. But the price he pays fully reflects this in the first best. It leads to a higher price. Hence, signaling his type would not increase his payoff. Rather, it would be like an insurance. But since the buyer is assumed to be risk neutral this does not affect the expected payoff. This result stems from the fact that the buyer receives the same compensation regardless of his type. This prevents cross-subsidization as we have already seen in Sect. 6.1.3.1: “Buyer Makes a Take-It-or-Leave-It Offer—Specific Performance” under specific performance conditional on that the buyer gets a side payment equal to the seller’s increased costs.40 To emphasize this, limiting liability prevents cross-subsidization without the need that the buyer reveals his type. Ex Post Inefficiency This section takes the slightly altered scenario that the high type’s valuation exceeds the increased costs such that co < v < c <
v ; equal to the scenario discussed in section “Expected Ex Post Inefficiency.” There are gains gesnat stake from making the efficient decision ex post which I assume would not be generated if the information is not exchanged ex ante. The seller should perform if she faces a high type and not if she faces a low type. This scenario is the “efficient breach equivalent” to the standard scenario where the foreseeability doctrine is discussed; i.e., a damages scenario where an exchange of information can improve the seller’s decision about taking precautions (Johnston 1990, 622). As before, the analysis supposes in a first step that the buyer does not reveal his type and asks in a second step whether the buyer has the incentive to disclose his type. I start by analyzing the signaling model and subsequently I discuss the differences in the screening model. This allows to see the different incentives based on different divisions of the bargaining power. Note that once the seller’s costs increase, she would breach the contract if the buyer did not reveal his type at the contracting stage. She only pays damages in the amount of the low type’s valuation and by assumption c > v. I assume that there is no successful renegotiation with the high type as discussed in section “Low Type’s Valuation Below Increased Costs and High Type’s Damages Above Increased Costs.” Buyer Makes a Take-It-or-Leave-It Offer The seller has the following single payoff function:

40

Johnston (1990, 631) arrives at the same conclusion for the standard case of the foreseeability doctrine assuming a fixed standard of precaution. In such case more information about the buyer’s valuation does not lead to more efficient precautions.

190

6 Incomplete Information

σ LL Signaling ¼ ð1  αÞðP  co Þ þ αðP  vÞ

ð6:307Þ

The buyer offers the lowest possible price the seller can still accept to maximize in order to his payoff: P ¼ ð1  αÞco þ αv

ð6:308Þ

This results in the following payoff for the buyer: π
LL ¼ ð1  αÞ
v þ αv  P ¼ ð1  αÞð
v  co Þ

ð6:309Þ

π LL ¼ v  P ¼ ð1  αÞðv  c Þ

ð6:310Þ

o

The equations show the important finding, that not only the high type but also the low type always contracts. This results from the absence of cross-subsidization combined with that the low type does not bear the costs of the efficiency loss. The low type pays the price adjusted to his valuation. Next, it remains to analyze whether the buyer would reveal his type. Importantly and in contrast to the analysis before, it is not about verifying the type but simply declaring whether he is a high or a low type without further proof. If the buyer signals that he is a high type compensation is not limited to the low type’s valuation, i.e., the high type gets his valuation as compensation and the low type gets his valuation but for the latter this does not change anything. We need to assess whether it is in equilibrium that the high type signals his type, but the low type does not mimic the high type. To that end, suppose that the buyer signals his type only if he is a high type. In such case the seller would perform if she gets the respective signal and breach otherwise. This yields two payoff functions for the seller depending on the type she faces: σ High type ¼ ð1  αÞðP  co Þ þ αðP  cÞ

ð6:311Þ

σ Low type ¼ ð1  αÞðP  co Þ þ αðP  vÞ

ð6:312Þ

Thus, the high type offers the price P ¼ (1  α)co + αc providing him with a payoff of π
¼
v  P ¼ ð1  αÞð
v  co Þ þ αð
v  cÞ

ð6:313Þ

The low type’s offers a price P ¼ ð1  αÞco þ αv implying the following payoff: π ¼ v  P ¼ ð1  αÞðv  co Þ

ð6:314Þ

For this to be an equilibrium it remains to show that no type has the incentive to deviate from the given strategy. The high type prefers this payoff to what he gets without signaling the type because

6.1 Buyer Having Private Information About His Valuation

191

Fig. 6.21 Effect of asymmetric information and disclosure on payoffs in signaling game under limited liability rule. c ¼ 80,
v ¼ 100, v ¼ 50, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%. c > δ
v þ ð1  δÞv. Pane (a) shows the scenario under asymmetric information. Pane (b) depicts the first-best scenario

π
LL < π


ð6:315Þ

ð1  αÞð
v  co Þ < ð1  αÞð
v  co Þ þ αð
v  cÞ

ð6:316Þ

c <
v

ð6:317Þ

The low type does not deviate from his strategy and mimic the high type because otherwise he had to pay the high price without any benefit in return. Consider the low type’s payoff deviating from the equilibrium and signaling to be a high type: π ¼ v  P ¼ v  ð1  αÞco  αc ¼ ð1  αÞðv  co Þ  αðc  vÞ

ð6:318Þ

Furthermore, we see that the high type signaling his type and the low type remaining silent is the only equilibrium. The two other candidates are first, both types remaining silent and second both types signaling to be a high type. Notice that both types remaining silent cannot be an equilibrium, because the high type would prefer to deviate and signal his type. Both types of signaling to be a high type is also shown not to be an equilibrium. The seller’s participation constraint and thus the minimum price would reflect the average valuation of the buyer as compensation. Therefore, the low type prefers to remain silent and pay the price adjusted to his valuation. We conclude that in the given scenario the high type reveals his type.41 This leads to an efficient outcome. Figure 6.21 allows to see the effect of disclosure under the limited liability rule. In comparison to unlimited damages depicted in Fig. 6.17 and specific performance

41 Bebchuck and Shavell (1991) reach the analogous result for the scenario that the seller exercises a certain level of precaution instead of willful breach in a perfectly competitive market.

192

6 Incomplete Information

shown in Fig. 6.19 we see that there is no cross-subsidization. Thus, the high type bears all the loss from the inefficiency. The seller’s costs facing the high type are reduced to the costs facing the low type because she pays damages limited to the amount of the low type’s valuation. This results in a change in the incentives to disclose. The low type does not profit from disclosure. The high type profits in the full amount of the greater efficiency. He gets the efficiency gain which is generated by disclosure combined with the absence of cross-subsidization. Under the unlimited liability rule, the high type profited from the higher efficiency through disclosure, but cross-subsidization prevented the high type from disclosure as it entailed an even greater profit. Comparing limited liability to the specific performance we see the similarity that only one type profits from disclosure but the incentive to disclose addresses different types. Limited liability addresses the high type whereas specific performance addresses the low type. This shows to be a decisive difference because the high type does not need to verify his type but simply indicate it without further proof. His signal is credible because only the high type profits from signaling to be a high type. The low type would pay a higher price but gets nothing extra in return through performance in comparison to being compensated.

Seller Makes a Take-It-or-Leave-It Offer In the previous scenario, the high type captured all the gain that is created through revealing his type. This is based on the construction that the buyer makes a take-itor-leave-it offer which gives him all the bargaining power like in a perfectly competitive market. This section analyzes the consequences if it is the seller who makes the take-it-or-leave-it offer and has all the bargaining power. The seller’s payoff if she contracts with both types is σ LL Screening BT ¼ ð1  αÞðP  co Þ þ αðP  vÞ

ð6:319Þ

The buyer gets a payoff depending on his type: π
LL ¼ ð1  αÞ
v þ αv  P

ð6:320Þ

π LL ¼ v  P

ð6:321Þ

Contracting with both types implies that the seller charges the highest price possible that both the high and the low type are willing to pay. This implies a price P ¼ v. This leads to the following payoffs: σ LL Screening BT ¼ ð1  αÞðv  co Þ

ð6:322Þ

6.1 Buyer Having Private Information About His Valuation

193

π
LL Screening BT ¼ ð1  αÞð
v  vÞ

ð6:323Þ

π LL Screening BT ¼ 0

ð6:324Þ

Now consider the alternative scenario that the seller contracts only with the high type. In this scenario, the seller charges a price knowing that only the high type will accept that price. In consequence, the high type’s valuation changes to be foreseeable damages. It follows that if she contracts only with the high type the seller performs ex post because c < v. This translates to the following payoffs: σ LL Screening HT ¼ δðð1  αÞðP  co Þ þ αðP  cÞÞ

ð6:325Þ

π
LL ¼ ð1  αÞ
v þ α
v  P ¼
v  P

ð6:326Þ

The seller charges the maximum price, P ¼
v leading to the following payoffs: σ LL Screening HT ¼ δðð1  αÞð
v  co Þ þ αð
v  cÞÞ

ð6:327Þ

π
LL Screening HT ¼
v 
v ¼ 0

ð6:328Þ

π LL Screening HT ¼ 0

ð6:329Þ

The seller prefers to charge a high price and only contracts with the high type if σ LL Screening HT > σ LL Screening BT

ð6:330Þ

δðð1  αÞð
v  c Þ þ αð
v  cÞÞ > ð1  αÞðv  c Þ o

δð1  αÞðv  co Þ  ð1  αÞðv  co Þ þ |fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl} Seller’ s general cost‐benefit analysis contracting with high or both types

o

>0 αδðv  cÞ |fflfflfflfflffl{zfflfflfflfflffl} Additional efficiency gain

ð6:331Þ ð6:332Þ

from performing ex‐post facing high type Note that the seller is less likely to contract only with the high type if the liability is limited. This rests on the fact that the high type does not get the extra profit if the seller’s costs increase and the seller contracts with both types charging a low price. Reconsider the high type’s payoff if the seller contracts with both types: π
LL Screening BT ¼ ð1  αÞð
v  vÞ

ð6:333Þ

It shows that the high type only profits in case the costs do not increase. This finding also resonates in the seller’s payoff if she contracts with both types. Thus, the seller’s cost-benefit analysis whether to contract with both or only the high type does

194

6 Incomplete Information

Fig. 6.22 Effect of asymmetric information and disclosure on payoffs in screening game under limited liability rule. All Panes are based on the following parameters: v ¼ 50,
v ¼ 100, c ¼ 80, co ¼ 20, δ ¼ 0:4 and a probability that the seller’s costs increase of 50%. Pane (a) shows the first-best scenario. Pane (b) shows the seller contracting only with the high type. Pane (c) shows the seller contracting with both types under asymmetric information

not include an extra profit for the high type the seller can avoid by contracting only with the high type and charging a high price. The histograms in Fig. 6.22 show that in comparison to specific performance and unlimited liability, the high type profits less from asymmetric information. Pane (c) reflects that the high type makes only a profit when the seller’s costs do not increase. In turn, this means that the seller gets a greater payoff contracting with both types, because she does not bear the efficiency loss generated if she performs facing a high type. Thus, she is more likely to contract with both types. The graph also shows that the buyer does not profit from revealing his type. The low type’s payoff remains zero. The high type would even lose out when she discloses her type, because the seller captures all the gain. In summary, in a monopoly market structure and the buyer revealing his valuation, this will lead to

6.1 Buyer Having Private Information About His Valuation

195

price discrimination and the seller as the monopolist will capture all the gain (Johnston 1990, 626–38).42

Conclusion of Contract as the Reference Point in Time According to the foreseeability doctrine and also Art. 74 CISG the reference point in time, when damages are to be foreseeable, is when the parties conclude the contract. It has been discussed whether this should also be upheld for willful breaches.43 In the following, we shall consider what speaks in favor of having the moment of contracting as the reference and subsequently analyze what negative side effects this entails. Why Conclusion of the Contract In the efficient breach scenario, the seller decides at some point in time whether she breaches or performs if her costs of performance have increased. This is a distinct moment in time and could be an alternative reference point to determine whether damages are foreseeable. However, if the buyer’s valuation becomes foreseeable in the time between the conclusion of the contract and the decision about breach, the seller pays damages tailored to the buyer’s type. The price does not account for the difference of compensation, i.e., the problem of cross-subsidization arises (Faust 1996, pp. 318–320). But as we have seen, to prevent cross-subsidization the buyer does not necessarily need to reveal his type as long as compensation is paid equally to both types. Crosssubsidization occurs if the seller learns the buyer’s valuation in the time between concluding the contract and the decision about performance or breach. No crosssubsidization exists if the seller never learns the buyer’s valuation. Nevertheless, such construction would incentivize the high type to reveal his valuation after the contract has been concluded and before the decision about performance or breach has been taken (Faust 1996, pp. 318–320). This would distort the intention of limiting damages to prevent cross-subsidization. Negative Side Effect So far, we have seen the positive effect of limiting liability to foreseeable damages by preventing cross-subsidization. However, there is a side effect that potentially causes inefficiencies. Consider the scenario that the high type did not reveal his

42

See for a simple model which shows price discrimination by the seller if she learns about the buyer’s valuation but neglecting the effects of remedies: Ben-Shahar and Bernstein (2000, 1890 Fn. 13). 43 See for an overview of this discussion: Faust (1996, pp. 318–320).

196

6 Incomplete Information

valuation at the contracting stage either because he did not know his type at that moment or an extra profit arose in the meanwhile (Riehm 2015, p. 520).44 Given that the moment of contracting decides whether damages are foreseeable, the high type will only receive compensation in the amount of the low type’s valuation if the seller breaches contract. This remains unchanged if he informs the seller about his new information. Hence, in such a scenario we see a shortfall of damages (Riehm 2015, p. 520). As shown in Sect. 5.1 a shortfall can lead to inefficient breaches. This is particularly relevant in the scenario where the high type’s valuation lies above the increased costs and the low type’s valuation is below the increased costs; v < c <
v . The seller prefers breach because she only pays damages in the amount of the low type’s valuation. Nevertheless, as discussed in Sects. 5.1.6 and 6.1.2.3 the high type and the seller can renegotiate the contract and the high type pays a higher price to induce the seller to perform. Such renegotiation can be difficult if the buyer has incomplete information about the seller’s costs which will be analyzed in the next section. Such shortfall of damages could be prevented if the reference point would be the moment the seller takes the decision. The buyer could indicate whether he is a high type. But as said, this distorts the buyer’s incentive to reveal his type only after the contract is concluded causing cross-subsidization.45 One important difference between signaling to be a high type after the contract and doing so when concluding the contract is that it does not come at a price. At the contracting stage, we saw that the high type pays a higher price than the low type in both the signaling and the screening game. He accepts that loss because his profit outweighs the higher price. In case the buyer informs the seller after the conclusion of the contract, he has paid the same price as the low type which does not change. But if such signal does not come at a cost it has not the same credibility. Any buyer could send the message to be a high type if no costs are associated with such a message like paying a higher price. This potentially leads to the necessity that the high type not only signals but verifies his type.

Contractually Limiting Liability Until here, we concentrated on the seller and buyer negotiating about the price. In that we neglected so far, the possibility that the seller and buyer do not only agree

44 In case the high type did not inform the seller about his type because he prefers to keep that information secret this would not change after the conclusion of the contract with respect to future contracts and third parties. 45 Cross-subsidization is not such a problem if the all buyers learn their true valuation only after the conclusion of the contract. Low buyers still subsidize high types. But because the buyer does not know what type he is when he concludes the contract this would not cause buyers deciding not to contract at all. To have a law differentiating between the case that the buyer only learned his valuation after the conclusion of the contract seems impractical due to problems how to proof not having this knowledge prior to a certain point in time.

6.1 Buyer Having Private Information About His Valuation

197

about the price but in connection determine whether liability should be limited. This means that either the seller offers two contracts with two different prices whereby in one of the contracts the liability is limited to foreseeable damages, the low type’s valuation, or alternatively the buyer offers a contract which does not only include the price but also determines whether liability is limited. The following analysis fills this gap.46 We distinguish between the scenarios whether the default rule imposes unlimited or limited liability starting with the former. For the analysis we pick up the scenario of sections “Expected Ex post Inefficiency” and “Ex post Inefficiency.” The low type’s valuation lies between the seller’s costs whereas the high type’s valuation exceeds the seller’s increased costs; co < v < c <
v . Furthermore, the parties expect not to find an efficient outcome ex post. Thus, revealing the type ex ante enhances efficiency. Default Rule: Unlimited Liability Buyer Makes Take-It-or-Leave-It Offer We start with the seller’s payoff and her participation constraint. We found that if she breaches47 ex post her payoff is σ ¼ P  ð1  αÞco  αðδ
v þ ð1  δÞvÞ

ð6:334Þ

As that is also the participation constraint her minimum price is P ¼ ð1  αÞco þ αðδ
v þ ð1  δÞvÞ

ð6:335Þ

Consider now the low type’s perspective. As we determined above, under those circumstances, he would offer P ¼ ð1  αÞco þ αðδ
v þ ð1  δÞvÞ implying a payoff of π ¼ v  ð1  αÞco  αðδ
v þ ð1  δÞvÞ. If the low type combines his offer with limiting liability to foreseeable damages, i.e., to his valuation, this alters the seller’s participation constraint and allows the low type to pay a lower price. For that inference, we can build on our findings with respect to the foreseeability doctrine in Sect. 6.1.3.4: “Effect of Foreseeability Doctrine on Contracting—Buyer Makes a Take-It-or-Leave-It Offer”: σ ¼ ð1  αÞðP  co Þ þ αðP  vÞ

ð6:336Þ

The buyer offers the lowest possible price the seller can still accept to maximize his payoff:

46 The thought has been expressed by Ayres and Gertner (1989, 102 Fn. 66) with regards to the situation that the seller takes a certain level of precautions and without analyzing it in more detail; Johnston (1990, 636) further developed this point. 47 We would arrive at the same conclusions if we suppose that the seller performs under unlimited liability.

198

6 Incomplete Information

P ¼ ð1  αÞco þ αv

ð6:337Þ

This implies the following elevated payoff to the low type: π ¼ ð 1  α Þ ð v  co Þ

ð6:338Þ

Thus, we can conclude that limiting liability is a strictly dominant strategy to the low type. From the aforementioned, the seller can infer that the low type would always make an offer with limited liability and an offer without such clause would mean that she faces a high type. As a result, her participation constraint is P  ð1  αÞco  αc  0

ð6:339Þ

She would perform ex post because liability is unlimited and
v > c. The high type could offer a price P ¼ (1  α)co + αc leading to a payoff of π
¼
v  ð1  αÞco  αc. But it remains to show that he does not prefer to mimic the low type by offering a low price combined with limited liability. His payoff would be π
LL ¼ ð1  αÞð
v  co Þ. It shows that the high type prefers to pay a higher price combined with unlimited liability to mimic the low type: π
< π
LL

ð6:340Þ


v  ð1  αÞc  αc > ð1  αÞð
v  c Þ

ð6:341Þ

αð
v  cÞ > 0

ð6:342Þ

o

o

This results from the higher efficiency the high type captures due to the fact that the seller performs if her costs increase. Hence, we find that the buyer’s ability to limit liability contractually leads to a separating equilibrium where the seller performs ex post only facing a high type and thus the efficient outcome. Seller Makes Take-It-or-Leave-It Offer This section analysis the converse setting, that the seller makes the offer.
and a low price P. The high price The seller charges two prices: A high price P implies that the seller pays compensation tailored to the buyer’s valuation.48 If only

48

This could either be because the foreseeability doctrine is interpreted in the sense that paying a high price signals to be a high type. Alternatively, the seller could include such clause in the contract with the high price.

6.1 Buyer Having Private Information About His Valuation

199

high types pay the high price the seller performs in case her costs increase. This gives provides us with the following payoff function for the seller:49 σ ¼ ð1  δÞðð1  αÞðP  co Þ þ αðP  vÞÞ
 co Þ þ αðP
 cÞ Þ þ δðð1  αÞðP

ð6:343Þ

The seller wants to maximize her payoff but faces four constraints with respect to pricing: Both types need to participate which means that the price cannot put them in a worse position than not contracting.50 In addition, neither type must be incentivized to mimic the other. In other words, the low type must prefer the low price and the high type must prefer the high price.51 We start with the participation constraints. The high type’s payoff with a high price is
π
¼ ð1  αÞ
v þ α
v  P

ð6:344Þ

The seller always performs and the buyer pays a high price. The buyer’s payoff from not concluding a contract is assumed to be zero, the high type’s participation constraint is given by:
 0 ,
v  P
ð1  αÞ
v þ α
v  P

ð6:345Þ

Accordingly, the low type’s payoff and participation constraints are π ¼vP

ð6:346Þ

vP0,vP

ð6:347Þ

The high type needs to prefer the high price shown by the following inequality (high type’s incentive constraint):
 ð1  αÞ
v þ αv  P , α
v  P
 αv  P ð1  αÞ
v þ α
v  P

ð6:348Þ

The low type prefers the low price if (low type’s incentive constraint):
,PP
ð1  αÞv þ αv  P  ð1  αÞv þ αv  P

ð6:349Þ

Starting with the last inequality, we see that it always holds, and thus the low type’s incentive constraint does not have an impact on the seller’s ability of pricing. Since the low type’s incentive constraint is not binding the seller can charge a low

49 I focus on the interesting case that the seller prefers to contract with both types and not only the high type. 50 So-called participation constraints which we have encountered before. 51 So-called incentive constraints.

200

6 Incomplete Information

price which is equal to the low type’s valuation; this is the maximum based on the low type’s participation constraint; P ¼ v. Inserting this into the high type’s incentive constraint yields:
 αv  v α
v  P

ð6:350Þ


 v þ αð
v  vÞ P

ð6:351Þ

This allows us to further deduce that the high type’s participation constraint is slack, i.e., if his participation constraint is fulfilled the participation constraint is
 v þ αð
v  vÞ it must also hold that, automatically met. Putting it differently, if P

v because P v þ αð
v  vÞ 
v

ð6:352Þ

ð1  αÞv  ð1  αÞ
v

ð6:353Þ

v 
v

ð6:354Þ

Hence, we can conclude that the maximum high price the seller can charge is
¼ v þ αð
v  vÞ. We can further deduce the seller’s and the buyer’s payoffs: P π
¼
v  αð
v  vÞ  v ¼ ð1  αÞð
v  vÞ

ð6:355Þ

π ¼vv¼0

ð6:356Þ

σ Two contracts ¼ ð1  δÞðð1  αÞðv  c ÞÞ þ δðð1  αÞðv  c Þ þ αð
v  cÞÞ o

o

¼ ð1  αÞðv  co Þ þ δαð
v  cÞ

ð6:357Þ

This shows that the seller’s payoff contracting with two types is greater than her payoff contracting with two types under the limited liability rule which we determined above; σ LL Screening BT ¼ ð1  αÞðv  co Þ. This greater payoff results from the additional efficiency gain generated by performance ex post facing a high type which is captured by the seller. Therefore, the seller is more inclined to contract with both types. We find a total payoff of ΠLL Screening ¼ ð1  αÞðv  co Þ þ δαð
v  cÞ þ δð1  αÞð
v  vÞ ¼ ð1  αÞðv  co þ δð
v  vÞÞ þ δαð
v  cÞ

ð6:358Þ

At this point, we can make a few observations. The total payoff is the first-best outcome. The left part of the equation shows the profit which is generated if the seller’s costs do not increase and the seller performs regardless of the type she faces. The right part of the equation represents the profit from the seller performing if her costs have increased and she faces a high type.

6.1 Buyer Having Private Information About His Valuation

201

The high type has no incentive to reveal his type prior to concluding the contract because if he did the seller would adjust the price to the high type’s valuation providing the high type with a payoff of zero (Johnston 1990, 638). The equations show that the seller profits from the efficient outcome ex post. She gets all profit generated by performing after an increase in costs facing a high type in the amount of δαð
v  cÞ . The high type himself receives a profit based on the asymmetry of information and the seller contracting with both types amounting to ð1  αÞð
v  vÞ. Hence, limiting liability contractually preserves the high type’s profit gained if the seller’s costs do not increase, and though the seller has all the bargaining power. Default Rule: Limited Liability Taking the opposite starting point, that the liability is limited does not alter the outcome. This is clear in the case that the seller makes the offer, because she would simply offer the same two contracts. In case that the buyer makes the offer, it is not the low type who offers to limit liability but the high type separating himself from the low type by offering a higher price combined with unlimited damages. Result Providing the parties in the given scenario of expected ex post inefficiency with the option to specify the liability in their contract results in a separating equilibrium. This implies an exchange of information and the ex post efficient outcome. The analysis showed that we generally attain this result regardless of the default rule for damages. A difference persists in who is incentivized to include a clause into the contract which deviates from the default rule. If the default rule is unlimited damages, the low type would make an offer including a clause that limits the seller’s liability. This reveals that from the low type’s perspective limiting liability contractually is nothing but a cheap way of verifying to be a low type. If the default rule is limited damages and the buyer makes the offer it is the high type who is interested to separate himself from the low type paying a higher price and installing unlimited damages which leads to ex post performance. However, as shown above, the high type separating himself does not need to do this via the contract but can simply state his type which is credible. A substantial difference exists with respect to the situation that the seller has the bargaining power and makes the offer. By offering two contracts the seller can contract with both types and induce the high type to reveal his type by preserving his profit from information asymmetry.52 In that she reaches a more efficient outcome ex post, performing facing a high type, which she benefits from because she captures all the respective gain. Nevertheless, depending on the distribution of types it can still

52

See Johnston (1990, 628) for an analysis if the seller can charge only a single price.

202

6 Incomplete Information

be true that the seller prefers to contract only with the high type (Johnston 1990, 638). Nevertheless, the high type’s interest to keep his valuation secret with respect to future contracts and third parties is unprotected. Thus, he still might prefer not to reveal his type. But the seller could try to accommodate the high type’s wants by offering long term contracts and non-disclosure agreements. Specifying liability contractually as either limited or unlimited liability fosters the exchange of information about the buyer’s type. However, it is confined in that it only provides two alternatives: limited or unlimited damages. Therefore, such clauses can only help to indicate two different types. Once we see more types the alternative clauses will indicate two different groups of types but not each type individually. This is sufficient to provide efficient ex post results as long as there is only one possible value that the increased costs can take. If the seller’s costs always take on the value c in case they increase there will be the following two groups of buyers: those whose valuation lies above and those whose valuation lies below the increased costs. But once the increased costs can take more values with a certain probability, two groups of buyers are not enough to convey the necessary information to the seller to achieve efficient outcomes ex post under all circumstances. In consequence, the parties would not only be incentivized to determine whether liability should be limited or unlimited; but also specify an amount for damages; in other words, liquidated damages. This allows to differentiate between more types. The price reflects the different amounts of liquidated damages the seller will have to pay in the event of non-performance. The seller would only perform if the liquidated damages exceed the costs. It follows, if the liquidated damages are equal to the buyer’s valuation the seller would always take the efficient ex post decision regardless of what value the increased costs take.

6.1.3.5

Result

The analysis of incomplete information about the buyer’s valuation at the contracting stage provides several findings. Essentially, we saw that such incomplete information impedes efficient contracting. To some degree, this is independent from the remedy. More important for our analysis is the core finding that also the remedy has an impact. Expectation damages causes cross-subsidization, i.e., the low type pays a higher price and thereby subsidizes the high type who pays the same price but gets higher compensation. This is a source for inefficient contracting. We also saw that this form of cross-subsidization hinges on the buyer having a substantial part of bargaining power ex ante. The seller being in a strong bargaining position changes the situation. Not the low type subsidizes the high type but the high type profits at the expense of the seller. This form of cross-subsidization can also have similar detrimental effects on contracting. Here it is important to note that we established in Chap. 4 that the efficient breach scenario is most relevant in markets with few suppliers. Thus, the seller is likely to have substantial bargaining power.

6.1 Buyer Having Private Information About His Valuation

203

Cross-subsidization in either form can also exist under specific performance. But the greater the buyer’s bargaining power at the ex post stage the lower is the impact of cross-subsidization under specific performance. Thus, we can say that specific performance runs at a lower risk to cause cross-subsidization. A revelation of the type prevents cross-subsidization under specific performance and tailored damages. The low type is incentivized to reveal his type; the greater the buyer’s bargaining power the greater his incentive. In the particular situation that buyer types exist under which performance is or is not efficient ex post the costs for performance function as a ceiling to crosssubsidization. This is always true under specific performance while under expectation damages this only holds as long as the seller performs efficiently ex post. Revelation of one’s types has an additional efficiency advantage if it leads to the efficient decision ex post given that it would be missed otherwise. In such case, this provides a surplus implying an additional incentive to reveal the type. The size of the incentive depends on the bargaining power the buyer has. Designing damages in the way not to make the buyer indifferent but limiting them to foreseeable damages prevents cross-subsidization among the buyer types and also between the seller and the high type.53 But it comes at the expense of a possible shortfall of damages with the associated potential inefficiencies or necessary transaction costs discussed in Chap. 5 and which will be further discussed in Chap. 7. Such shortfall does not occur if the buyer reveals his type. With limited liability, neither type has an incentive to reveal his type if it does not affect the ex post decision providing an additional surplus. But in such scenario where it makes the ex post decision more efficient, the high type has the incentive to reveal his type. Note that under limited damages it is the high and not the low type who is potentially incentivized to reveal his type. As said, under specific performance and tailored damages, it is the low type who profits from revelation. This difference is substantial in two ways: First, the high type is less encouraged to disclose, the greater the seller’s bargaining power is (Ben-Shahar and Bernstein 2000, 1890). Without disclosure the high type profits from asymmetric information at the expense of the seller given that the seller has a relevant share of the bargaining power. The high type would give up that advantage to profit from the more efficient outcome and the greater surplus (Ben-Shahar and Bernstein 2000, 1886; Faust 1996, p. 258). But if his share of the additional surplus is smaller than his profit due to asymmetric information he prefers not to disclose.54 Under specific performance and unlimited damages the low type does not face such opposed incentives because he does not profit from asymmetric information.

53 An alleged disadvantage of the foreseeability doctrine is the information costs created due to its ambiguity which we will not further discuss in this context: Bebchuk and Shavell (1991, 284, 308), Faust (1996, p. 237). 54 As said above, additionally the high type might put a value on not disclosing his valuation in the light of future contracts. See also for this point Ben-Shahar and Bernstein (2000).

204

6 Incomplete Information

Secondly, the high type disclosing his valuation works without the necessity that the high type costly verifies his valuation. He can simply declare to be a high type. Such a statement is credible. Overall, we can infer that the choice to limit liability by the foreseeability doctrine does not create an incentive to the high type to reveal his type that would not exist otherwise. The question is not whether such an incentive to reveal one’s type is created but only at whom it is directed. Thus, it is misleading, as has been argued elsewhere, that limiting liability would infringe the buyer’s value to keep his valuation private.55 Limiting damages just shifts the incentive from the low type to the high type. In contrast, unlimited liability is directed at the low type’s value to keep his valuation private. One could think that limiting liability protects the low type’s value to keep his valuation private and unlimited damages protect the high type interest to keep his valuation private. But once either type discloses his valuation the seller can infer the other’s valuation as well.56 Regarding the secrecy interest, it is important to note that in contrast to simply declaring one’s type verifying one’s costs implies that the low type provides the certifying party with detailed information about his valuation, i.e., his costs structure and expected future profit, allowing the certifying party to assess the validity of the information. Albeit the certifying party is obligated to treat such information confidential, the risk that the information spreads cannot be denied. Hence, we see a deeper impact on the low type’s secrecy interest than what we observe if the buyer states his type. Nevertheless, since the low type does not profit from asymmetric information, we do not see an immediate implication regarding the low type’s payoff if we only look at the specific contractual relationship at hand. But being the low type in the given scenario does not necessarily mean that this is also the case concerning parallel and future contractual relationships between the parties and also with third parties where the information might also be relevant. Once the low type verifies his type also the high type’s valuation is known by the seller so that also the high type’s secrecy interest remains unprotected. In particular, the low type does not include the high type’s secrecy interest into his costs-benefit analysis about verifying his type.

55

See for such argument: Ben-Shahar and Bernstein (2000, 1893). The related underlying question is: Why should the buyer’s interest to keep his valuation private be protected; and if yes of which type of buyer? Shahar and Bernstein argue that from a social welfare perspective, taking the buyer’s interest to keep information private into account bases on the incentive it creates to acquire information or invest in innovation (Ben-Shahar and Bernstein 2000, 1893 Fn. 21). In the given context, the argument would be that the high type was more innovative and therefore has a greater valuation. If he could not fully profit from having the greater valuation he would not be incentivized efficiently to invest in innovation. However, it is far from clear that the high type’s greater valuation stems from innovation. It could simply be that the high type is less prepared for a certain situation and therefore needs the specific good more urgently leading to greater valuation in that moment. Putting it generally, whether the buyer’s private information about his valuation should be protected is a complex question which depends on context and cannot be answered on a general basis. See for an law and economics approach to the question what kind of information should be protected: Hirshleifer (1971). 56

6.2 Seller Having Private Information About Her Costs

205

Overall, not only expectation damages but also specific performance if it leads to cross-subsidization and causes the low type to verify his type does not always protect the buyer’s secrecy interest.57 We also saw that disclosure does not need to further efficiency. This is the case when disclosure involves costs that exceed the benefits from a more efficient outcome. This can particularly be the case if the incentive to disclose stems not from a greater profit due to a more efficient outcome but from the opportunity to redistribute the profit. The presented analysis on limited liability differs from the one outlined by Bebchuk and Shavell (1991)58 in two respects. Firstly, they assume communication costs as an exogenously given amount which does not differ between what type reveals his valuation. Secondly, their result bases on the assumption that the high type represents the minority which then leads to lower communication costs if only the high types communicate their valuation.59 But in contrast to their assumptions, the analysis showed that communication costs are endogenous and differ depending on what type reveals his valuation. Furthermore, we saw that the parties can indicate their type via contracting into limited or unlimited liability. In particular, if we consider the seller to make the offer and presenting two contracts, the costs would be the same (Johnston 1990, 627). But also, when the buyer makes the offer it seems unlikely that deviating from the default rule with respect to limited or unlimited liability would be a decisive cost factor when drafting the contract. Thus, it is questionable whether the proportion of types should be the determining factor rendering the one or the other rule efficient under the assumption of rational choice.60

6.2

Seller Having Private Information About Her Costs

In this section, we turn the asymmetry of information upside down. Not the buyer has private information about his valuation, but the seller about her costs of performance. We will analyze the effects at two different points in time. First, how does the seller having private information about her costs influence the ex post stage if the seller’s costs have increased. Secondly, how are the contract negotiations affected if the seller has private information about the probability that her costs increase and attain a value above the buyer’s valuation. 57

This result differs from the assertion by Ben-Shahar and Bernstein that specific performance would preserve the buyer’s secrecy interest; see Ben-Shahar and Bernstein (2000, 1904). In addition, at the renegotiation stage the seller would learn the buyer’s type if renegotiation is successful. 58 A similar point is made by Ayres and Gertner (1989, 110–111). 59 Those assumptions have been critically viewed by Johnston (1990, 623). 60 This result potentially differs once we depart from rational choice in the light that research has shown that default rules are “sticky.”

206

6 Incomplete Information

Fig. 6.23 Seller’s private information about her increased costs under specific performance

6.2.1

Ex Post Effects of Seller’s Private Information

Consider the seller having superior information about her costs in the standard model of the efficient breach scenario under expectation damages. The seller takes the decision whether to perform or to breach the contract. She breaches if her costs exceed the buyer’s valuation and perform otherwise. In such a case of one-sided asymmetric information the model for expectation damages is not affected. The seller still has the relevant information for her decision about the breach and decides efficiently. Since the standard model is not affected, the following analysis focuses on the renegotiation process under specific performance and the effects if expectation damages are not fully compensatory.

6.2.1.1

Specific Performance

The scenario is as follows. A seller and a buyer conclude a contract agreeing on a price P. The buyer’s valuation is v. The seller’s costs originally have the value co but increase taking on a value above the price. The increased costs can either be below the buyer’s valuation, cL or above the buyer’s valuation, cH. P lies between coand cL. Figure 6.23 depicts the scenario. Like for the analysis of renegotiation with the buyer having private information about his valuation, I apply a screening and a signaling game to model the bargaining situation.

Signaling First, consider the signaling game which means in the given context that the seller as the informed party makes a take-it-or-leave-it offer. The seller can offer a side payment in the amount x. If the buyer accepts the offer, the seller is excused from her obligation to perform. Otherwise she performs. The buyer’s payoff from performance is π perf ¼ v  P. This represents the buyer’s participation constraint; he does not accept a side payment implying a payoff below that value. The seller’s payoff from performance depends on her type:

6.2 Seller Having Private Information About Her Costs

207

σ L perf ¼ P  cL

ð6:359Þ

σ H perf ¼ P  cH

ð6:360Þ

To maximize her payoff the seller makes the lowest side payment possible that the buyer still accepts, x ¼ v  P. This implies a payoff to the seller of σ agree ¼ P  v regardless of her type. Comparing the payoffs allows us to see that only the high type will make such offer because the low type prefers to perform: σ L perf > σ agree

ð6:361Þ

P  cL > P  v

ð6:362Þ

cL < v

ð6:363Þ

This inequality always holds. We can conclude that the signaling game provides the efficient outcome.

Screening Now, the buyer as the uninformed party makes a take-it-or-leave-it offer. Building on our findings for the signaling game we can infer that the buyer will make a demand leading to a payoff greater than his payoff with performance x > π perf ¼ v  P

ð6:364Þ

and the low type will not accept such demands but prefer to perform. To maximize his payoff the buyer makes a demand equal to the high type’s participation constraint x ¼ σ H perf ¼ P  cH

ð6:365Þ

and the high type accepts. This provides the efficient outcome.

Result The analysis shows that the renegotiation with two types of sellers, one with increased costs below and one above the buyer’s valuation, lead to efficient outcomes regardless who makes the take-it-or-leave-it offer. This is similar to the result we derived for renegotiating the contract under specific performance and the buyer having private information about his valuation in section “Two Buyer Types Setting—Specific Performance.” Drawing on the result for the model regarding three types of buyers in section “Three Buyer Types Setting—Specific Performance” we can further infer that the efficiency of the screening model hinges on the existence of more seller types with

208

6 Incomplete Information

Fig. 6.24 Seller’s private information about her increased costs given a shortfall of damages

costs above the buyer’s valuation and their distribution. It can be that the buyer makes a demand which is not accepted by all types above his valuation. In that case, specific performance leads to an inefficient outcome. It follows that to this extent expectation damages provide an advantage over specific performance.

6.2.1.2

Seller’s Private Information and the Shortfall of Damages

We saw that incomplete information about the seller’s costs does not affect the unilateral decision of the seller under expectation damages and leads to efficient outcomes. But what if damages fall short? As hinted in Sect. 5.1.6, I take up the scenario of a shortfall of damages under asymmetric information with respect to the seller’s costs of performance. Recall our finding from Sect. 5.1.6 that under complete information and a shortfall of damages the seller does not breach inefficiently but the buyer makes an additional payment inducing the seller to perform. The scenario of Sect. 5.1.6 supposes that the seller’s costs increase and take a value which is below the buyer’s valuation but above the undercompensatory damages the seller would have to pay if she breaches the contract. I further develop this scenario by introducing some uncertainty regarding the seller costs. The buyer does not observe the seller’s costs. This gives rise to the seller’s opportunity to misrepresent her costs of performance which might impede the success of the renegotiation.61 The following explores what determines the likelihood that those renegotiations fail. The scenario shown in Fig. 6.24 captures two aspects about which the seller could bluff. First, it can be the magnitude of the increase in costs which is depicted by the two values cL and cH. Second, the seller can also bluff about the increase itself. The model encompasses this case by setting cL ¼ co. The seller knows her increased costs, but the buyer only knows the probability that the costs take a low or a high value. Suppose the buyer knows that the seller’s costs are cH with probability τ and cL otherwise.

This point has originally been made by Shavell (1980, 468 Fn. 6) without further inspection: “. . . the seller might wish to renegotiate owing to an increase in production costs, and let us assume that the increase is such that the total costs are still below the value of the machine to the buyer. If the buyer does not know what the production costs really are and he thinks the seller is bluffing he might refuse to accommodate the seller, (. . .).” 61

6.2 Seller Having Private Information About Her Costs

209

Next, to analyze whether there could be an agreement involving a payment from the buyer to the seller that induces the seller to perform, we need to determine the payoffs for the alternative outcome that the parties do not find an agreement. The buyer’s payoff depends on what type of seller he faces. If he faces a low type, the seller performs given that the parties do not find an agreement implying a payoff π L perf ¼ v  P for him and σ L perf ¼ P  cL for the seller. If he faces a high type, the seller breaches absent an agreement leading to payoff for the buyer of π H breach ¼ d  P and of σ H breach ¼ P  d for the seller. To assess the possibility of a payment, first take the buyer’s perspective. The maximum the buyer would be willing to pay to induce the seller to perform lies where he is indifferent between making a payment and refraining from doing so: π agree ¼ π not agree

ð6:366Þ

v  P  x ¼ τðd  PÞ þ ð1  τÞðv  PÞ

ð6:367Þ

x ¼ τ ðv  d Þ

ð6:368Þ

Next, take the seller’s perspective. The low type accepts any amount because she would perform anyway. In contrast, for the high type to be induced to perform such payment would need to take a value at least equal to her alternative payoff with breach: σ H agree ¼ σ H breach

ð6:369Þ

P þ x  cH ¼ P  d

ð6:370Þ

x ¼ cH  d

ð6:371Þ

We can infer that the payment needs to be between cH  d < x < τ(v  d ). Thus, an agreement is impossible if τ ð v  d Þ < cH  d τ
co. The second part of the equation is also positive because μðc  vÞðδα þ ð1  δÞβ  αÞ > 0

ð6:391Þ

δα þ ð1  δÞβ  α > 0

ð6:392Þ

ð1  δÞβ > ð1  δÞα

ð6:393Þ

β>α

ð6:394Þ

Next, turn to the high type. Her expected payoff is σ β ¼ P  ð1  βÞco  βðv þ μðc  vÞÞ

ð6:395Þ

σ β ¼ v þ μðc  vÞðδα þ ð1  δÞβÞ  ð1  βÞco  βðv þ μðc  vÞÞ

ð6:396Þ

σ β ¼ ð1  βÞðv  c Þ þ μðc  vÞðδα þ ð1  δÞβ  βÞ

ð6:397Þ

o

It follows that the high type prefers not to contract with the buyer if ð1  βÞðv  co Þ þ μðc  vÞðδα þ ð1  δÞβ  βÞ < 0

ð6:398Þ

ð1  βÞðv  c Þ þ μðc  vÞδðα  βÞ < 0

ð6:399Þ

ð1  βÞðv  c Þ < μðc  vÞδðβ  αÞ

ð6:400Þ

o

o

The right-hand side of the inequality is positive because β > α. It shows that the high type can only charge the same price as the low type but will make a side payment more often. Hence, we observe cross-subsidization under specific performance if the seller has private information about her costs. The seller with a high probability of an increase in costs subsidizes the seller with the low probability. We can further derive, that the cross-subsidization rests on the side payment the buyer receives which elevates his willingness to pay. Contracting with the high type elevates his willingness due to the future side payments and leads to a higher price. The low type of profits from this higher price. Thus, if the side payment takes a low value equal to the buyer’s valuation which is reflected in the formula by setting μ ¼ 0, we do not see such cross-subsidization. The high type seller prefers not to contract once the negative effect of crosssubsidization is greater than her benefits from contracting. If she does not contract this implies a lower total payoff compared to the first best and also compared to expectation damages:

214

6 Incomplete Information

Fig. 6.25 Effect of cross-subsidization in signaling game with the seller having private information under specific performance. Parameters: v ¼ 100, co ¼ 60, c ¼ 200 δ ¼ 0.1, α ¼ 0.1, β ¼ 0.5

ΠSP Signaling only low type < ΠFB Signaling

ð6:401Þ

δðð1  αÞðv  c ÞÞ < δðð1  αÞðv  c ÞÞ þ ð1  δÞð1  βÞðv  c ÞÞ o

o

ð1  δÞð1  βÞðv  c ÞÞ > 0

o

ð6:402Þ ð6:403Þ

which always holds. Consider Fig. 6.25 to see the impact of cross-subsidization on the high type’s decision to contract: Figure 6.25 allows us to see the impact of the side payment on the seller’s willingness to accept and the buyer’s willingness to pay. The greater the buyer’s bargaining power is at the renegotiation stage, represented by μ, the greater is the side payment. The influence on the seller’s willingness to accept differs across types since the high type will have to make such side payment more often. The graph depicts this effect in that the line representing the high type’s willingness to accept is steeper than the low type’s willingness to accept. The buyer’s willingness to pay increases faster than the low type’s willingness to accept, admittedly the difference is rather small in the given scenario and substantially slower than the high type’s willingness to accept. The point where the dotted and the black line meet depicts where the buyer’s willingness to pay is equal to the high type’s willingness to accept. As one moves further to the right, the high type prefers not to contract.

6.2 Seller Having Private Information About Her Costs

6.2.2.2

215

Buyer Making a Take-It-or-Leave-It Offer

First-Best Scenario As before, to model the first-best scenario I apply expectation damages as the remedy in place. In the first-best scenario, the buyer knows the seller’s type. The buyer’s possibility to offer a price is limited by the seller’s participation constraint. Those are depending on the seller’s type σ α ¼ P  ð1  αÞco  αv  0

ð6:404Þ

σ β ¼ P  ð1  βÞc  βv  0

ð6:405Þ

o

The buyer offers the minimum price. Thus, the price depends on the seller’s type. Facing a low type, the buyer offers P ¼ (1  α)co + αv and P ¼ (1  β)co + βv facing a high type. The buyer captures all the gain and the seller receives a payoff of zero. The buyer’s payoff depends on the type he faces: π α ¼ v  P ¼ v  ð1  αÞco  αv ¼ ð1  αÞðv  co Þ

ð6:406Þ

σ β ¼ v  P ¼ v  ð1  βÞco  βv ¼ ð1  βÞðv  co Þ

ð6:407Þ

This provides us with the following total payoff ΠFB Screening ¼ δð1  αÞðv  co Þ þ ð1  δÞð1  βÞðv  co Þ

ð6:408Þ

Expectation Damages Next, I turn to expectation damages. The buyer can only offer a single price. The two candidates for a price are P ¼ (1  α)co + αv and P ¼ (1  β)co + βv. As in the case that the buyer has private information about his valuation, we find a similar situation of adverse selection in the given case of the seller having private information about the probability of an increase in costs. The buyer needs to weigh the benefits from contracting with both types against the benefits from offering a lower price but contract only with the low type. The buyer’s payoff depends on the price he offers. The buyer’s payoff paying a price P ¼ (1  α)co + αv is π ð1αÞco þαv ¼ δðv  PÞ ¼ δðv  ð1  αÞco  αvÞ ¼ δð1  αÞðv  co Þ

ð6:409Þ

In contrast, if he pays a price of P ¼ (1  β)co + βv he contracts with both types leading to a payoff of

216

6 Incomplete Information

π P¼ð1βÞco þβv ¼ v  P ¼ v  ð1  βÞco  βv ¼ ð1  βÞðv  co Þ

ð6:410Þ

As we have seen above, contracting only with the low type implies loss in the total payoff. In comparison to the first-best scenario, the total payoff would be smaller by the payoff generated through contracts between the buyer and the high type if the contract is performed. This is given by ΠFB Screening  ΠContracts low types ¼ ð1  δÞð1  βÞðv  co Þ

ð6:411Þ

Consider the following inequality to see whom the buyer prefers to contract with: π P¼ð1βÞco þβv > π ð1αÞco þαv

ð6:412Þ

ð1  βÞðv  co Þ > δð1  αÞðv  co Þ

ð6:413Þ

1  β > δð1  αÞ

ð6:414Þ

In words: The buyer prefers to contract with both types if the probability that the high type performs is greater than the probability that the low type performs adjusted by the proportion of low types. Thus, the smaller the proportion of low types and the more equal the probability of performance is, the more likely the buyer prefers to contract with both types.

Specific Performance Under specific performance, the buyer expects to receive a side payment in the future if the seller’s costs increase. This means for the price that it can take the two following forms: P ¼ ð1  αÞco þ αðv þ μðc  vÞÞ

ð6:415Þ

P ¼ ð1  βÞc þ βðv þ μðc  vÞ

ð6:416Þ

o

The buyer’s payoff depends on the price he offers. If he offers a low price, he contracts only with low types leading to a payoff of π P¼ð1αÞco þαðvþμðcvÞÞ ¼ δðv þ αðv þ μðc  vÞÞ  ð1  αÞco  αðv þ μðc  vÞÞÞ ð6:417Þ π P¼ð1αÞco þαðvþμðcvÞÞ ¼ δð1  αÞðv  co Þ whereas he gets

ð6:418Þ

6.2 Seller Having Private Information About Her Costs

217

Fig. 6.26 Comparison of buyer’s decision what price to offer under specific performance and expectation damages when the seller has private information in screening game. Parameters: v ¼ 100, co ¼ 60, c ¼ 200, α ¼ 0.1, β ¼ 0.5, μ ¼ 0.5

π P¼ð1βÞco þβðvþμðcvÞÞ ¼ ð1  δÞðð1  βÞv þ βðv þ μðc  vÞÞÞ þ δðð1  αÞv þ αðv þ μðc  vÞÞÞ  ð1  βÞco  β ð v þ μ ð c  vÞ Þ π P¼ð1βÞco þβðvþμðcvÞÞ ¼ ð1  βÞðv  co Þ  ðβ  αÞδμðc  vÞ

ð6:419Þ ð6:420Þ

if he offers a high price. The buyer prefers to contract with both types if π P¼ð1βÞco þβðvþμðcvÞÞ > π P¼ð1αÞco þαðvþμðcvÞÞ ð1  βÞðv  c Þ  ðβ  αÞδμðc  vÞ > δð1  αÞðv  c Þ o

o

ð6:421Þ ð6:422Þ

Comparing the inequality with the one we have derived under expectation damages we see that the buyer bears additional costs of (β  α)δμ(c  v) if he contracts with both types. This effect stems from cross-subsidization, i.e., the low type getting a higher price although she pays the side payment less often than the high type. We also observe that this effect depends on the bargaining power ex post, μ; we saw this dependency equally if the seller makes the take-it-or-leave-it offer.

218

6 Incomplete Information

Figure 6.26 contrasts the buyer’s weighing costs and benefits of offering a high price and thus contracting with both types under specific performance and expectation damages: Considering Fig. 6.26 we see the effect of cross-subsidization under specific performance. It is assumed that buyer and seller have equal bargaining power ex post; μ ¼ 0.5. The gray line shows the buyer’s payoff if he offers a low price contracting only with low types; π low type ¼ δ(1  α)(v  co). The payoff does not differ between the remedies. The greater the proportion of the low types the more beneficial it is for the buyer to offer the low price. The black line represents the buyer’s payoff under expectation damages contracting with both types; π ED both o types ¼ (1  β)(v  c ). Under expectation damage the buyer’s payoff from offering a high price is not affected by the proportion of low types. He makes the same profit irrespective whether he faces a high or a low type. This is different under specific performance because facing a high type she gets the side payment less often; π SP both o types ¼ (1  β)(v  c )  (β  α)δμ(c  v). It follows that his payoff falls as the proportion of high types increases. As a result, the gray line meets the dotted line “earlier” than the black line does. Until the lines meet, i.e., a certain proportion of low types is reached, the buyer contracts only with high types. This difference is the consequence of cross-subsidization. We can further infer that if the bargaining power of the buyer (μ) increases, the dotted line decreases more rapidly, i.e., is steeper, and therefore meets the gray line even earlier meaning a greater effect of cross-subsidization. In case the probability of an increase for the low type (α) is greater, we observe two effects. First, it lowers the impact of cross-subsidization causing the dotted line to flatten. Second, it lowers the payoff from contracting only with low types, i.e., the gray line flattens. Last, look at the seller’s increased costs. They influence the buyer’s payoff only if she contracts with both types and only under specific performance. The smaller the seller’s costs and thus the closer they lie to the buyer’s valuation the greater is the buyer’s payoff. This may seem counterintuitive at a first glance, because the greater the seller’s increased costs the greater the side payment. However, in fact it just increases the effect of cross-subsidization.

6.2.2.3

Result

First, we notice that the cross-subsidization only occurs under specific performance in case the seller has private information about the probability that her costs increase. Inversely, to what we observed given that the buyer has private information, the side payment is not a way to encounter cross-subsidization but rather the source of crosssubsidization. The greater the buyer’s bargaining power ex post and thus the more the side payment reflects the seller’s increased costs, the more impact crosssubsidization has. Hence, we can infer on a more general basis, any form of compensation is a potential source of cross-subsidization if the variable which imposes asymmetric information also determines the amount of compensation.

6.2 Seller Having Private Information About Her Costs

219

Fig. 6.27 Comparison of the impact cross-subsidization has under specific performance in the screening or signaling game. Parameters: v ¼ 100, co ¼ 60, c ¼ 200, α ¼ 0.1, β ¼ 0.5, μ ¼ 0.7

We can pinpoint several factors that determine the size of cross-subsidization if the seller has private information about the probability of an increase in costs. Crosssubsidization increases with the proportion of low types, the buyer’s bargaining power ex post, the magnitude of the seller’s increased costs, and the difference in probabilities of an increase in costs. Next, consider the differences between the signaling and the screening game under specific performance. Figure 6.27 allows us to detect how the impact of cross-subsidization differs depending on who makes the take-it-or-leave-it offer under specific performance. The gross dotted line shows the insulated effect of cross-subsidization ((β  α)δμ (c  v)). The black line represents the payoff the high type gets if she contracts with the seller in the signaling game and at the same time the buyer’s payoff if he contracts with both types in the screening game; (1  β)(v  co). Thus, it indicates the decisive payoff; if surpassed by any alternative only the low type contracts with the buyer. In the signaling game, the high type seizes all the gains from a transaction. The only aspect that stops him from contracting is cross-subsidization. Thus, in the signaling game both types contract until the proportion of low types is so high that the gross dotted line crosses the black line; (1  β)(v  co) ¼ μ(c  v)δ(β  α).

220

6 Incomplete Information

In contrast, in the screening game, the buyer has a general benefit from contracting only with the low type. This corresponds to our finding for the buyer having private information and the seller making a take-it-or-leave-it offer in this chapter. It stems from giving the uninformed all the bargaining power at the contracting stage like a monopoly. It is shown by the gray line. The fine dotted line provides the accumulated effect of cross-subsidization and the buyer acting like a monopoly in the screening game. From the point on where the fine dotted line crosses the black line, the buyer prefers to contract only with the low type. The point where the gray line meets the black line indicates that if the proportion of low types exceeds the respective value then the buyer prefers to contract with the low type only regardless of cross-subsidization. Overall, it shows that cross-subsidization has an impact in both cases. In the screening case it arises already at a lower proportion of low types than in the signaling game; but at the same time once a certain proportion of low types is met, the cross-subsidization losses its relevance in the screening game. For the analysis, I have assumed that the seller cannot verify his type. Departing from this assumption the high type could reveal the probability that her costs of performance increase in order to contract with the buyer at a high price. We saw the inverse unraveling effect if the buyer has private information about his valuation discussed in Sect. 6.1.3.2. Due to its equivalence, I simply refer to the respective section above.

References Adler, B. E. (1999). The questionable ascent of Hadley v. Baxendale. Stanford Law Review, 51(6), 1547–1589. Ausubel, L. M., Cramton, P., & Deneckere, R. J. (2002). Bargaining with incomplete information. In Handbook of game theory with economic applications (Vol. 3, pp. 1897–1941). Avraham, R., & Liu, Z. (2009). Private information and the option to not sue: a reevaluation of contract remedies. Journal of Law, Economics, and Organization, 28(1), 77–102. Avraham, R., & Liu, Z. (2012). Private information and the option to not sue. A reevaluation of contract remedies. Journal of Law, Economics, and Organization, 28(1), 77–102. Ayres, I. (2005). Optional law. The structure of legal entitlements. Chicago: The University of Chicago Press. Ayres, I., & Gertner, R. (1989). Filling gaps in incomplete contracts: an economic theory of default rules. The Yale Law Journal, 99, 87–130. Ayres, I., & Talley, E. (1995a). Distinguishing between consensual and nonconsensual advantages of liability rules. The Yale Law Journal, 105(1), 235–253. Ayres, I., & Talley, E. (1995b). Solomonic bargaining: dividing a legal entitlement to facilitate Coasean trade. The Yale Law Journal, 104(5), 1027–1117. Bar-Gill, O., & Persico, N. (2016). Exchange efficiency with weak ownership rights. American Econ J / Microeconomics, 8(4), 230–267. Bebchuk, L. A., & Shavell, S. (1991). Information and the scope of liability for breach of contract. The rule of Hadley v. Cambridge, MA: Baxendale. Bebchuk, L. A. (1984). Litigation and settlement under imperfect information. The Rand Journal of Economics, 15, 404–415.

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Bebchuk, L. A., & Shavell, S. (1999). Reconsidering contractual liability and the incentive to reveal information. Stanford Law Review, 51, 1615–1627. Ben-Shahar, O., & Bernstein, L. (2000). The secrecy interest in contract law. The Yale Law Journal, 109(8), 1885–1925. BGH. 6.2. (2001). NJW, 2001, 1640. Bigoni, M., Bortolotti, S., Parisi, F., & Porat, A. (2017). Unbundling efficient breach. An experiment. Journal of Empirical Legal Studies, 14(3), 527–547. Bolton, P., & Dewatripont, M. (2015). Contract theory. Cambridge, MA, Londin, England: MIT Press. Calabresi, G., & Melamed, D. A. (1972). Property rules, liability rules, and inalienability: one view of the cathedral. Harvard Law Review, 85(6), 1089–1128. Cooter, R., & Ulen, T. (2008–2012). Law and economics//law & economics. Pearson AddisonWesley; Addison-Wesley, Boston MA Craswell, R. (2003). Instrumental theories of compensation: a survey. San Diego Law Review, 40, 1135–1180. Croson, R., & Johnston, J. S. (2000). Experimental results on bargaining under alternative property rights regimes. Journal of Law, Economics, and Organization, 16(1), 50–73. Daughety, A. F., & Reinganum, J. F. (2012). Settlement. In C. W. Sanchirico & L. M. Froeb (Eds.), Procedural law and economics (pp. 386–471). Cheltenham, UK, Northampton, MA, USA: Edward Elgar. Daughety, A. F., & Reinganum, J. F. (2014). Revelation and suppression of private information in settlement-bargaining models. The University of Chicago Law Review, 81(1), 83–108. ECJ. (2011, 1 March). Test-Achats Eisenberg, M. A. (2005). Actual and virtual specific performance, the theory of efficient breach, and the indifference principle in contract law. California Law Review, 93(4), 975–1050. Engert, A., & Hofmann, O. (2019). Ask, don't just take. Unpublished manuscript with author. Faust, F. (1996). Die Vorhersehbarkeit des Schadens gemäß Art. 74 Satz 2 UN-Kaufrecht (CISG). Teilw. zugl.: Regensburg, Univ., Diss., 1995-1996. Tübingen: Mohr. Grossman, S. J., & Hart, O. D. (1980). Disclosure laws and takeover bids. The journal of finance: the journal of the American Finance Association, 35(2), 323–334. Grossman, S. J., & Leland, H. E. (1981). The informational role of warranties and private disclosure about product quality. The journal of law & economics, 24(3), 461–483. Hirshleifer, J. (1971). The private and social value of information and the reward to inventive activity. The American Economic Review, 61(4), 561–574. Johnston, J. S. (1990). Strategic bargaining and the economic theory of contract default rules. The Yale Law Journal, 100(3), 615. Johnston, J. S. (1995). Bargaining under rules versus standards. The Journal of Law Economics, 11 (2), 256–281. Kaplow, L. (1994). The value of accuracy in adjudication: an economic analysis. The Journal of Legal Studies, 23(1), 307. Kaplow, L., & Shavell, S. (1995). Do liability rules facilitate bargaining? A reply to Ayres and Talley. The Yale Law Journal, 105(1), 221. Kaplow, L., & Shavell, S. (1996a). Accuracy in the assessment of damages. Journal of Law and Economics, 39, 191. Kaplow, L., & Shavell, S. (1996b). Property rules versus liability rules. An economic analysis. Harvard Law Review, 109(4), 713. Mas-Colell, A., Whinston, M. D., & Green, J. R. (1995). Microeconomic theory. New York, NY: Oxford Univ. Press. Milgrom, P. R. (1981). Good news and bad news. Representation theorems and applications. Bell Journal of Economics, 12(2), 380–391. Riehm, T. (2015). Der Grundsatz der Naturalerfüllung. Tübingen: Mohr Siebeck. Rothschild, M., & Stiglitz, J. (1976). Equilibrium in competitive insurance markets. An essay on the economics of imperfect information. Quarterly Journal of Economics, 90(1976), 629–649.

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Schwartz, A. (1979). The case for specific performance. The Yale Law Journal, 89(2), 271–306. Schwartz, A., & Scott, R. E. (2003). Contract theory and the limits of contract law. The Yale Law Journal, 113(3), 541. Shavell, S. (1980). Damage measures for breach of contract. Bell Journal of Economics, 11(2), 466–490. Spier, K. E. (1992). Incomplete contracts and signaling. The Rand Journal of Economics, 23(3), 432–443. Unberath, H. (2012). Die Vertragsverletzung. Tübingen: Mohr Siebeck.

Chapter 7

Transaction Costs

As we have seen in the standard model for the efficient breach scenario (Chap. 2), under the assumption of full compensation of the buyer and zero transaction costs, both specific performance and expectation damages lead to efficient results ex post (Bishop 1985; Kornhauser 1986, 716–717). Chapter 5 covered the effects if damages are not fully compensatory. This part examines transaction costs. The alleged main advantage of expectation damages over specific performance is to avoid transaction costs which accrue under specific performance due to the necessity to renegotiate the contract (Markovits and Schwartz 2011, 1945; 2017, 13; Shavell 2006, 843; Cooter and Ulen 2008–2012, pp. 240, 241; Kronman 1978, 365–369). Besides transaction costs due to renegotiation, this section addresses whether the costs for bargaining the contract in the first place differ between the remedies entering the contract. Intimately related are litigation costs which are covered with the focus on costs assessing damages. Those costs are usually seen as the counterpart to renegotiation costs under specific performance. This section also discusses the costs of enforcing claims. In the following I critically discuss the arguments which have been raised in support of either expectation damages or specific performance; i.e., bargaining costs to be high under specific performance or litigation costs to be high under expectation damages. However, the main goal of this chapter is to provide a different perspective based on a different approach. Instead of weighing bargaining costs, which are associated with specific performance, against assessment costs, which are attributed to expectation damages, I analyze their inner relationship and ask: Do greater assessment costs substitute for the necessity to renegotiate on a general basis?

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 O. Hofmann, Breach of Contract, International Law and Economics, https://doi.org/10.1007/978-3-030-62525-2_7

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224

7.1

7 Transaction Costs

Renegotiation Costs

The mere existence of renegotiation costs causes an inefficiency under specific performance if the same efficient outcome can be achieved for free through expectation damages. The effects of renegotiation costs can also take a second form. They might even render renegotiating inefficient if the bargaining costs exceed the potential gain from agreeing on non-performance. In that case, renegotiation should not take place at all implying an inefficient outcome. In the following, I first discuss the scale those renegotiation costs take and secondly analyze to what extent the assertion that such transaction costs only arise under specific performance holds.

7.1.1

Scale of Renegotiation Costs

Discussing the scale of renegotiation costs, it helps to put them into perspective starting with the general framework of property and liability rules. As outlined in Sect. 1.1.3.5 specific performance represents a property rule and expectation a liability rule. Calabresi and Melamed argued that transaction costs can justify protecting entitlement with a liability rule instead of a property rule allowing unilateral takings combined with paying compensation (Calabresi and Melamed 1972, 1108). The example they provide for high transaction costs is a scenario of accidents and negotiations before the activity that might harm somebody else takes place (Calabresi and Melamed 1972, 1108). Transaction costs for negotiations taking place before an accident happens are said to be prohibitively high, in particular, if the potentially harmed parties are unknown prior to the activities.1 In the light of this benchmark renegotiation costs seem likely to be low and not preventing efficient outcomes because only two parties are involved, and they know each other (Ulen 1984, 369).2 This argument is supported by the fact that the parties have negotiated before (Ulen 1984, 380). It might be that the parties conclude contracts frequently and renegotiations possibly coincide with other negotiations. Nevertheless, several arguments have been put forward contending that “property-rule-triggered” renegotiation, i.e., renegotiation under specific performance, is even more costly than average renegotiation (Markovits and Schwartz 2017, 13). The following outlines and assesses those arguments.

1 Another example of high transaction costs is a scenario where the hold-out problem exists. This can arise if a potential buyer needs to acquire complementary entitlements from several rightsholders. This is not the case when parties of a contract renegotiate. See for the hold-out problem concerning eminent domain (Calabresi and Melamed 1972, 1107; Cooter and Ulen 2008– 2012, p. 177). This is issue is not present in the given context, Friedman, Daniel (1989, 2). 2 It is important to note that the parties do not need to go to court to renegotiate. Ulen seems to presume that the parties renegotiate in front of the court, see Ulen (1984, 380).

7.1 Renegotiation Costs

7.1.1.1

225

Bilateral Monopoly

First of all, it is stressed that renegotiation of a contract under specific performance is structured like a bilateral monopoly (Devlin 2015, p. 167), i.e., there is no viable substitute for either of the parties (Devlin 2015, p. 167). No outside offers exist that could discipline the parties’ bargaining behavior (Markovits and Schwartz 2011, 1951). It is alleged that that the seller would drive a harder bargain and act less ethically, to avoid paying the buyer under specific performance (Markovits and Schwartz 2011, 1951). However, the premises of the argument need closer attention. Is it necessarily true that bargaining in a setting of a bilateral monopoly implies higher transaction costs? And, does renegotiating the contract and specific performance always imply a bilateral monopoly setting by precluding any outside options?

Bargaining and Bilateral Monopoly The argument that bargaining costs are particularly high in a setting of a bilateral monopoly emphasizes that it less than clear what the benchmark is. Comparing it to situations where the parties do not even know each makes it seem that a bilateral monopoly is not a bad environment. But even comparing it to a sales situation with several actors on the potential buyer’s side and one seller selling one object, it seems not clear that a bilateral monopoly implies higher transaction costs. Take for an example the acquisition of a company with several potential buyers. Not only one buyer but all of them prepare a tender and at least some will enter into a bargaining stage with the seller. This means that such costs of preparation and bargaining do not arise once but several times. Thus, even if bargaining itself might be more cumbersome it takes place only between two parties in a bilateral monopoly. Nevertheless, compared to bargaining in a competitive market it is more prone to failure. Furthermore, if the parties’ contract was not a one-shot event but they maintain constant business relations it is likely that even in a bilateral monopoly the parties negotiate productively in the light of future contracts and based on the experience of bargaining with each in the past. Hence, I conclude that no general inference can be drawn whether bargaining in a bilateral monopoly is particularly expensive, but it depends on the specific circumstances and the benchmark.

Renegotiating the Contract Under Specific Performance and Outside Options The following analyzes the second premise: Renegotiating a contract under specific performance takes place in the absence of outside options. Admittedly, additional buyers would make not influence the renegotiation process under specific performance, but the question is whether the presumption overlooks the influence existing

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7 Transaction Costs

Fig. 7.1 Game tree for the option to cover under specific performance and renegotiation

substitutes might have. This is assessed in the following sections. For this analysis, we need to assume that the parties do operate in a functioning market such that substitutes exist. If that is not the case renegotiation takes place in the setting of a bilateral monopoly. For the ease of exposition, it is assumed that the buyer’s valuation is the same for the purchased good and the substitute. Furthermore, the price agreed on between the parties equals the market price for the good. Contract Allows Seller to Cover This section supposes that the seller is allowed to cover by purchasing a substitute.3 Two decisions need to be made: The parties negotiate about whether the seller gets excused from her obligation to perform and if they do not find an agreement the seller decides whether she performs or covers. The game tree in Fig. 7.1 depicts those two stages: First consider the second stage, i.e., the seller’s decision whether she performs or covers. If the seller performs, she gets the price (P) the parties agreed on and incurs her increased costs of performance (c). If she covers, she gets the price from the buyer (P) and bears her expenses for covering, the market price (PM ¼ P) plus the costs for purchasing the cover denoted tS. Turning to the buyer, he gets his valuation (v) minus the price if the seller performs and his valuation for the substitute minus the price if the seller covers. We see that the seller covers if tS > P  c , c  P > tS and performs otherwise. Next, consider the first stage, the renegotiation of the contract. The parties bargain in the shadow of the subsequent decision taken by the seller. Suppose the seller performs without an agreement. The side payment x lies between the buyer’s payoff from performance and the amount the seller saves from non-performance,

3 In principle another possible scenario would be that the buyer accepts ex post the cover (see for this option for example § 364 BGB (German Civil Code)).

7.1 Renegotiation Costs

227

v  P < x < c  P. Since tS > c  P the option to cover does not affect the bargaining. Suppose c  P > tS and the seller would cover. In such scenario the side payment would take a value v  P < x < tS. The seller’s option to cover constrains the buyer’s bargaining behavior. Hence, we can conclude that if the seller’s transaction costs to cover are not too high an existing substitute provides an outside option to the seller. Contract Excludes Possibility to Cover This section supposes that the seller is not allowed to fulfill her contract by the cover. Nevertheless, that does not withhold the buyer to purchase the substitute himself and thereby gain his valuation to a certain extent. The question is, does this still influence the renegotiation process. The buyer’s costs for covering are denoted tB. Suppose that covering by the buyer yields a positive payoff, v > P + tB. In that case, the buyer would buy the substitute himself if the parties agree on non-performance. It follows for the buyer’s payoff to be π ¼ v + x  tB  P and the seller would get σ ¼  x. For the buyer to accept a side payment it needs to be that v + x  tB  P > v  P , x > tB. From the seller’s perspective, without an agreement, her payoff would be σ ¼ P  c. Therefore, her willingness to pay during renegotiation is wtp ¼ c  P. Thus, the side payment will lie somewhere between the following: tB < x < c  P. Next, comparing the situation to one without the substitute where the side payment lies between v  P < x < c  P we see that the existence of the substitute lowers the buyer’s willingness to accept and widened the scope for a potential agreement since v > P + tB , tB < v  P. Thus, the existence of the substitute has the potential to influence the side payment if the seller transaction costs for making the cover are not higher than his profit from making that cover.4 In contrast to one’s intuition, this does not necessarily improve the buyer’s bargaining position. Instead, it makes his threat to claim performance less credible and the seller profits from the buyer’s option to cover.5

7.1.1.2

Zero-Sum Game

The second argument put forward supporting the assertion that renegotiations are a costly endeavor is that they represent a zero-sum game (Markovits and Schwartz 2011, 1951). It is said that “strategic bargaining behavior is most frequently associated with negotiations over the division of the surplus from an exchange, not with whether an exchange should take place” (Ulen 1984, 383).

4 If his transaction costs for the cover exceed the profit from purchasing the cover the bargaining process is unaffected. 5 To clarify, the model assumes prefect information.

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7 Transaction Costs

Fig. 7.2 Efficient breach scenario with inefficient performance

Notwithstanding whether that latter claim holds, the assumption that renegotiations are a zero-sum game requires some attention. First, consider the situation where the seller costs of performance increase by such an amount that they exceed the buyer’s valuation and both parties are aware of that. The situation is captured by Fig. 7.2: In this scenario, the performance would be inefficient. Both parties being aware of this, renegotiations would only be a matter of the sum the seller needs to pay to the buyer for being excused from her obligation to perform. In fact, given this situation, it is true that renegotiations are only about the division of the surplus. However, as pointed out it hinges on the fact that both parties know that an agreement is possible and has in prospect a surplus which is shared. But applying this assumption any negotiation becomes a zero-sum game. For example, if a potential buyer and a potential seller know that a sales contract provides a surplus the negotiations boil down to how to share that surplus. Renegotiations that take place under incomplete information such that neither party knows whether the seller’s costs have increased above the buyer’s valuation do not only take place against the question how to share the surplus but first of all whether the seller should be excused from her obligation. In such not unrealistic case, renegotiation will be about finding out whether a mutual gain from non-performance exists and in that do not differ from the original sales contract just with reversed roles. Seller and buyer negotiate about the seller re-purchasing the right to performance.

7.1.1.3

Urgency

An important advantage of expectation damages can be timing. If decisions need to be made quickly bargaining has the downside to take longer than a unilateral decision (Markovits and Schwartz 2011, 1974). Thus, inefficient outcomes can be the result under specific performance if non-performance is the efficient outcome but due to urgency cannot be reached quickly enough because the seller needs the buyer’s consent. However, since the buyer and seller know each other and not only the seller but also the buyer has an interest in non-performance if it is efficient because he participates partly through the side payment he gets cases where bargaining is impossible to seem rather rare.

7.1 Renegotiation Costs

7.1.2

229

Renegotiation and Incomplete Information

So far, we have discussed the scale of renegotiation costs under specific performance seen individually. Another argument asserting renegotiation costs under specific performance to be high puts renegotiation under expectation damages in the spotlight. It has been purported that renegotiations involve particularly high bargaining costs because they are prone to strategic behavior like misrepresentation of costs and valuation which can cause them to be unsuccessful (Ulen 1984, 381, 382; Depoorter and Tontrup 2012, 685; Shavell 2006, 838, 843). Such misrepresentation can only take place in the setting of incomplete information. As we saw in the previous chapter the seller having incomplete information about the buyer’s valuation can eliminate her capability to make the efficient decision about performing unilaterally. Hence, incomplete information cannot simply be seen as some kind of transaction cost but potentially changes the ground on which expectation damages’ superiority is based on.6 In the case that the seller has incomplete information about the buyer’s valuation bargaining can provide the opportunity to the parties to reach the efficient solution also under expectation damages but at the expense of bargaining costs as discussed in Sect. 6.1. We can conclude that under such circumstances renegotiation costs accrue under both remedies. In question remains, whether bargaining costs differ in size between the remedies given that renegotiations take place under both. As we have seen in Sect. 6.1 renegotiations under specific performance and expectation damages differ structurally. Under specific performance, neither the buyer nor the seller is not constrained in demanding a high or low price, respectively. In contrast, under expectation damages, the buyer is impeded to demand a price. This results from that once the seller knows that a surplus exists she prefers to breach the contract unilaterally and pay the buyer his valuation which will be below the buyer’s demand. We saw that the bargaining structure under expectation damages can prevent the exchange of information and eventually successful bargaining. But even if the parties achieve the efficient bargaining outcome such bargaining procedure will be more difficult rendering bargaining more expensive than under specific performance. Under specific performance there exists the common goal to find an agreement if possible also if both parties have opposite interests when it comes to the amount that is being paid. Under expectation damages, the seller’s interest is not necessarily to find an agreement but only to find out whether the buyer’s valuation is below her costs. Once she knows that she breaches the contract. This implies that the parties cannot openly discuss their positions in negotiations. One possibility to achieve efficient outcomes would be that only the seller makes offers that can be accepted by the buyer and the seller cannot revoke her offer. Alternatively, the parties could employ an independent third party who receives the 6 In the literature private information is mostly classified as transaction costs. See for example: Ben-Shahar and Bernstein (2000, 1892).

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7 Transaction Costs

parties’ offers in secret. A deal is automatically executed if the seller’s offer exceeds the buyer’s demand.7 Employing a trustee to allow for such more sophisticated mechanisms involves higher costs. Likewise, having only the seller making offer also seems like is more cumbersome procedure to find out whether a surplus exists that can be captured through an agreement. Hence, we can conclude that even if the buyer and seller manage to reach efficient bargaining solutions bargaining costs are likely to be greater than under specific performance.

7.1.3

Renegotiation and Preferences for Fairness

The traditional argument in favor of expectation damages is that it avoids costly and unsuccessful renegotiations. Lewinsohn-Zamir rejected such allegation. She suggested that negotiations that are necessary due to a property rule protection, like specific performance, would be more successful than predicted by rational choice models (Lewinsohn-Zamir 2012, 2014, p. 391). She bases her argument on findings gained in experiments on the ultimatum game. In those experiments, the participants play in pairs. One of them is the proposer. He gets a certain amount of money and divides it between him and the responder (Lewinsohn-Zamir 2014, p. 391). Only if the responder accepts the division both parties get their share. In contrast to the rational choice prediction, participating responders do not accept any amount. Instead most participants reject a proposed division below an amount they regard as “fair” (Lewinsohn-Zamir 2014, p. 391). Proposers do to a large number propose not only minimum offers and participants often find agreements (Lewinsohn-Zamir 2014, p. 391). Lewinsohn-Zamir regards those findings as evidence that people would be more successful in negotiations than it is worried because people show that they are not greedy (Lewinsohn-Zamir 2014, p. 391). However, Lewinsohn-Zamir’s argument is flawed. Suggesting that people would negotiate more efficiently because they do not act according to rational choice is wrong for the scenario of the ultimatum game. According to rational choice, the responder accepts any small amount and the proposer would propose the minimum amount. As a result, the parties would always find an agreement, i.e., being perfectly efficient. In contrast, people in those experiments sometimes reject offers. But every rejected offer implies an inefficiency. Therefore, findings from experiments on the ultimatum game cannot serve as an indicator that people would negotiate more

7 See for such mechanism called sealed bid auction: Jehle and Reny (2011, pp. 428, 429). See for the application to bargaining under incomplete information: Chatterjee and Samuelson (1983).

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efficiently than under the rational choice model. Those experiments do not provide evidence in favor of such assertion.8 Instead experimental findings by Bigoni et al. suggest that the successfulness of renegotiations depends to some degree on whether the parties find themselves in a loss-avoiding or gain-seeking scenario (Bigoni et al. 2017). In their experiment buyers and sellers sign a binding contract. Afterwards a shock might occur simulating either a loss-avoiding and gain-seeking scenario. With specific performance, the promisee can force the promisor to perform as stated in the contract. Both parties could agree on compensation and cancel the contract (Bigoni et al. 2017). They found evidence that participants were less willing to renegotiate when facing gain-seeking than loss-avoiding breaches (Bigoni et al. 2017). In addition, the buyer was paid more to excuse the seller in a gain-seeking scenario (Bigoni et al. 2017). The outcome depended to a great extent on the participant’s preference for equality (Bigoni et al. 2017). Depoorter and Tontrup infer from their experimental results that specific performance as a default rule triggers aversion against a breach of contract and compensation which would “negatively affect bargaining conditions” (Depoorter and Tontrup 2012, 689). The experimental finding was that in a gain-seeking scenario participants enforced inefficient performance more often if they had a right to claim specific performance instead of the mere factual power after the seller had breached the contract (Depoorter and Tontrup 2012). From that finding, they infer that to renegotiate the seller “must compensate the promisee not only for the material losses, but they must also obtain forgiveness for violating the statutory entitlement to performance” (Depoorter and Tontrup 2012, 689). However, it seems difficult to draw the inference from the experimental results that the buyer has a lower willingness to renegotiate. The experiment potentially causes that result by first having the seller to breach first before they renegotiate. Deeporter and Tontrup themselves argue that the buyer sees the breach as an insult. But in reality, the seller can offer to renegotiate without breaching in the first place. In that the seller does not commit an insult. Furthermore, it seems possible that the result found by Deeporter and Tontrup hinges on representing a gain-seeking scenario which is of importance as the findings from Bigoni et al. suggest.

7.1.4

Prospect Theory and the Endowment Effect

A center part of behavioral law and economics is the prospect theory established by Kahneman and Tversky (Tversky and Kahneman 1991, 1992). A key part of the prospect theory is loss aversion (Tversky and Kahneman 1991). Experimental and

It might be argued that experimental findings about people sharing the gains from trade weakens the hold-up problem under specific performance. However, this is a matter of precontractual investment. This is not part of this analysis. 8

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field evidence suggests that “people evaluate outcomes not (only) in absolute terms but (also) relative to a reference point, and that losses (in comparison to this reference point) loom larger than gains of equal size” (Zamir 2014, p. 268). This finding departs from the expected utility theory commonly applied to decision making where outcomes are treated independently from a reference point.9 Losing EUR 1000 would be the same as gaining EUR 1000; but real people experience a greater disutility by losing than utility by gaining the identical amount.10 The second feature of loss aversion concerns the parties’ risk attitude. Prospect theory suggests that people are rather risk averse with gains and tend to be riskseeking with losses (Zamir 2014, p. 270). Whether a party sees that payment as a gain or a loss depends on their reference points: An individual’s reference point determines whether the individual perceives changes as gains or losses (Zamir 2014, p. 268). Often the status quo is the reference point but in the case, a contract has been concluded it is assumed that the contract sets the reference point (Hart and Moore 2008. Tversky and Kahneman 1991, p. 1057; Herweg and Schmidt 2014). Alternatively, it has been asserted that it is the parties’ expectations that provide the reference point (Kőszegi and Rabin 2006, Nov, 2007). A particular form of appearance loss aversion can take is the endowment effect.11 This describes that people systematically value objects and entitlements more if they already have them compared to those they do not have; the person’s willingness to accept exceeds their willingness to pay (Kahneman et al. 1990; Thaler 1980; Pi et al. 2014, p. 149; Bechthold 2010, p. 227). As a result, the existence of an endowment effect challenges the Coase theorem: Even without transaction costs transfers are not reached in situations where the bidder’s willingness to pay for an entitlement exceeds holder’s willingness for the entitlement. For our analysis, the two questions are: First, does the contractual right to receive an item or an entitlement already create an endowment effect? Second, does it matter how the right is protected? The prevalent view answers both questions affirmatively. It is said that generally also rights can exhibit an endowment effect (Jolls et al. 1998, 1497–1501). Furthermore, it is predominantly contended that whether an endowment effect is on hand depends on how the property or the entitlement is protected; the endowment effect would exist only with a property rule but not with a liability rule (Jolls and Sunstein

Zamir (2014, p. 269); this is said to flip with very small probabilities. Then people tend to be risk averse with losses and risk-seeking with gains. See Kahneman and Tversky (1979). 10 Eisenberg (2014, 448), Zamir (2014, p. 270); the next section will deal with the second feature of loss aversion that people are risk-seeking when it is about losing something and risk averse in the light of a possible gain. 11 Korobkin (2003, 1227, 1242 ff.); see for an overview: Korobkin (2014) who also discusses the proposed underlying reasons for the existence of an endowment effect (attachment to items, regret avoidance, transactional disutility and attention); Some scholars doubt that loss aversion is the right explanation for the gap between the willingness to pay and the willingness to accept and suggest that the endowment effect exists in laboratory but not the outside world: Plott and Zeiler (2005), Plott and Kathryn Zeiler (2007). 9

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2006, 199, 220; Korobkin 2003, 1227, 1283 ff.; Ayres and Talley 1995, 1101, 1102).12 In our context, this suggests that specific performance but not expectation damages would cause the buyer to have a greater willingness to accept than the willingness to pay. Deeporter and Tontrup assert that their experiment, which we have mentioned in the previous section and in Chap. 5 with respect to social preferences, provides some empirical evidence suggesting that specific performance leads to an endowment effect (Depoorter and Tontrup 2012, 712). Recall that in their experiment participants found themselves in a gain-seeking scenario of efficient breach. After the seller has breached the contract buyers could either claim compensation or stop the breach: but only in the treatment group, the law gave the buyers the right to claim specific performance. Deeporter and Tontrup find that more people prevented the breach implying a lower payoff if the buyer had the right to claim specific performance. However, it seems doubtful that this result provides evidence for the existence of an endowment effect. Instead it seems more likely that, as Deeporter and Tontrup argue themselves, providing the buyer with the right to claim specific performance shapes their moral understanding. As a result, they are more likely to perceive a breach as an insult and retaliate. The experimental setting does not allow to draw further inferences about an endowment effect because the seller breaches first and in that commits an insult. The enforcement can only be interpreted as a reaction to the breach itself. It does not allow to draw conclusions whether the buyer has a greater valuation of his right to claim specific performance. Further research seems necessary to determine whether specific performance creates an endowment effect while expectation damages do not. Even if that is generally the case, research suggests that whether an endowment effect would be on hand depends on the good being subject to the contract and other circumstances. The effect is accentuated the greater the uncertainty about the good’s value (Korobkin 1998, 659; Bechthold 2010, p. 233). In contrast, the effect is of limited importance in case the goods are held in exchange and if the parties show market experience (Ulen 2014, p. 114; Bechthold 2010, p. 233; List 2003, 43). Hence, in the following we will assess both cases: Specific performance leads or does not lead to an endowment effect.

12 Rachlinski and Jourdan found in experiments concerning environmental protection that an endowment effect exists for property rules but not for liability rules, see Rachlinski and Jourdan 1998, 1545. However, it has been questioned whether those findings apply to the outside world and other cases: Korobkin (2014, p. 327), Lewinsohn-Zamir (2014, pp. 392, 392). See for the opposite view, however without empirical evidence, that liability rules but not property rules lead to an endowment effect: Lewinsohn-Zamir (2001, 2014, p. 393).

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7.1.4.1

7 Transaction Costs

Loss Aversion and the Endowment Effect in the Efficient Breach Scenario

First, consider the efficient breach scenario under specific performance. The seller’s costs have increased. Now the parties renegotiate the contract. Suppose specific performance creates no endowment effect; i.e., the buyer has the same willingness to accept (WTA) to give up his right to claim performance as he is willing to pay (WTP) for that right. Secondly, suppose the seller’s costs of production have increased to c; we are in a loss-avoiding scenario. The parties negotiate about the amount x the seller pays to the buyer to be excused from her obligation to perform. We get the following payoffs for the parties. If the parties find an agreement the seller pays x to the buyer but avoids costs c. The buyer gets the amount x and gives up his right to claim performance. Recall that the reference point to determine losses and gains is the parties’ expectations or the contract, respectively. The seller expects to receive the price and incur her costs of performance prior to an increase.13 The buyer expects to receive performance and pay the price. It follows that in a loss-avoiding scenario the seller feels about the increased costs she faces to pay as a loss. But also, the amount she pays to the buyer to be excused from her obligation to perform represents a loss from her perspective. Now consider the buyer’s perspective. As we suppose that the entitlement does not produce an endowment effect, the buyer perceives the extra payment as a gain. He does not have a feeling about losing the entitlement. Instead he sees the surplus, i.e., the amount by which the payment from the seller exceeds the value he attaches to the entitlement. Those findings allow us to make the following inferences. In a loss-avoiding scenario without an endowment effect, the renegotiation of the contract provides a greater disutility than the utility. The seller feels about the payment she makes to the buyer as a loss whereas the buyer perceives it as a gain.14 Given that losses imply a greater disutility than gains provide utility we see a net utility loss.15 This would not be the case if the seller finds herself in a gain-seeking scenario. Here the seller tries to make an extra gain; the difference between the payment she receives from a third party and the payment she makes to the buyer. Both, seller and buyer, are in a “gain

13 Also Wilkinson-Ryan and Baron take the expected payoff from the contract as the reference point. But they do not discuss the impact of loss aversion on the parties ‘payoffs or bargaining behavior but on their punitive behavior. See Wilkinson-Ryan and Baron (2009, 413). 14 There is no additional endowment effect working on the seller when making the payment. Research has shown that money does not create an endowment effect: Kahneman et al. (1990, 1325, 1328), Tversky and Kahneman (1991, 1039, 1055), Bechthold (2010, p. 233). 15 Similarly, Schmidt and Herweg regarding renegotiations of contract but not in the context of the efficient breach scenario. Considering the differences of utility due to loss aversion as inefficiencies presupposes that the objective welfare function takes loss aversion into account. This is generally answered affirmatively; see Zamir (2014, p. 288).

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position.” Thus, there is no difference between the utility each receives from the payments according to the concept of loss aversion. Furthermore, in the loss-avoiding scenario, we expect the seller to be risk-seeking and the buyer to be risk averse. Failure of negotiations are more likely when parties are risk-seeking (Lewinsohn-Zamir 2014, p. 392). In negotiations to be risk averse implies to be more concessionary and willing to compromise, risk-seeking is associated with holding out longer for a higher future payoff (Lewinsohn-Zamir 2014, p. 392). Since only one of the parties is risk-seeking we can infer that there is no special risk that renegotiations fail. One can be even more optimistic in a gainseeking scenario because not only the buyer but also the seller would be risk averse. Suppose now that specific performance creates an endowment effect; i.e., the buyer has a higher willingness to accept (WTA) to give up his right to claim performance than he is willing to pay (WTP) for that right. The difference is that the buyer when giving up his right to performance does not simply see the difference between the payment he receives and his valuation as a gain. Instead he feels about giving up the entitlement separately as a loss. This feeling is represented by the difference in WTP and WTA. In consequence, if the parties agree on non-performance the buyer still receives x. But now he gives up WTA which is greater than WTP. The seller’s payoff does not change. Eventually, the greater WTA can prevent the parties from finding an agreement in case WTP < c < WTA (Depoorter and Tontrup 2012). Furthermore, since the buyer perceives giving up the entitlement as a loss, we can expect him to be risk-seeking when he bargains. As a result, in a loss-avoiding scenario, both parties are risk-seeking causing failure of the renegotiations to be more likely. Next, we compare those findings to expectation damages. Suppose that the seller breaches the contract after the costs have increased and that expectation damages do not exhibit an endowment effect.16 In that case, we see the following differences under expectation damages. First, the payment the seller makes to the buyer is equal to the buyer’s valuation, i.e., smaller than under specific performance. From the buyer’s perspective, the payment is neither an additional gain nor a loss because he receives his valuation. Thus, there is no extra payment from the seller to the buyer the buyer regards as a gain while the seller sees it as a loss in the loss-avoiding scenario. Hence, we do not observe the disutility we saw in the loss-avoiding scenario under specific performance created by the extra payment, i.e., the difference in disutility the loss causes to the seller and the utility the gain implies for the buyer. Secondly, without the endowment effect non-performance is more likely to happen. The seller compensates the buyer for his valuation which is equal to his willingness to pay.17 In addition, we can make the following inference: If the parties renegotiate under expectation damages about excusing the seller from her obligation to perform those

16

The next section addresses the existence of an endowment effect under the different remedies. Another general question is whether damages should be based on the plaintiff’s willingness to pay or willingness to accept. See for an overview of the discussion Korobkin (2014, pp. 328).

17

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7 Transaction Costs

negotiations are more likely to be successful because the buyer is risk averse if expectation damages do not create an endowment effect. Now, consider that expectation damages fall short. In Chap. 5 we found that in such case the seller breaches if her increased costs exceed the buyer’s valuation. Alternative if those costs remain below the buyer’s valuation but above damages, the parties renegotiate about the seller performing for a higher price. In the former scenario, the buyer incurs a loss in that he receives less than expected: the difference between his valuation and damages. Hence, in the gain-seeking scenario the buyer’s loss of not being fully compensated provides the seller with a gain and therefore leads to an overall greater disutility. In the latter scenario, the buyer experiences a loss in that he pays a higher price than expected. Again, in the gain-seeking scenario, the buyer’s loss is the flipside of the seller’s additional gain. Thus, it creates a disutility overall. Furthermore, the buyer is risk-seeking in those renegotiations because he tries to avoid a loss which causes those renegotiations to be more prone to failure.

7.1.4.2

Conclusion

Expectation damages have an advantage over specific performance in the lossavoiding scenario if the buyer is made indifferent. On the contrary, in case of a shortfall of damages under expectation damages specific performance is advantageous in a gain-seeking scenario. Both findings base on the two features of loss aversion: First, the greater disutility the loss of an amount creates to one party compared to the utility the equivalent amount means to the other party. The second feature is the different risk attitudes depending on whether one faces a gain or a loss. Furthermore, it has been argued that liability rules (expectation damages) show an advantage over property rules (specific performance) because they avoid the creation of an endowment effect; moving from a property rule to a liability rule would be debiasing (Jolls and Sunstein 2006). This inference is questionable not only because it is doubtful that specific performance leads to an endowment effect at all. Korobkin argues that the assumption that the endowment effect is undesirable would depend on its cause (Korobkin 2014, p. 327). If it is based on true attachment to the entitlement, “a rule that prevents owners from developing such attachment arguably reduces potential social welfare” (Korobkin 2014, p. 327). Admittedly, it also possible that the buyer develops the same attachment to the entitlement he purchases with the money he receives as compensation after a while (Korobkin 2014, p. 322). Lewinshohn-Zamir holds a more general view: “WTP and WTA both constitute real and true measure of people’s valuation of entitlements. Neither measure is invariably superior to the other, and thus neither valuation can be ignored” (LewinsohnZamir 2001, 251). Arlen and Tontrup further argue that there is no need to debias through the law with respect to the endowment effect (Arlen and Tontrup 2015). People would

7.2 Contracting

237

debias themselves if necessary, by employing institutions like agencies (Arlen and Tontrup 2015). Overall, those findings indicate that an alleged endowment effect should not be an argument in favor of expectation damages.

7.2 7.2.1

Contracting Difference in Contracting Costs

Is contracting costlier under specific performance than it would be under expectation damages?18 Markovits and Schwartz answer that question affirmatively providing two arguments. First, they argue in order to determine the price with a rule of specific performance it would be necessary to predict not only how likely it is that the seller’s costs increase but also the exact extent in order to adjust the price (Markovits and Schwartz 2011, 1974). The more variables exist for which need to be accounted for during negotiations the higher is probability that the parties disagree about their value, the more aspects that need to be discussed and the more likely is the failure of negotiations. To see their point, consider the situation where the seller’s costs of performance do not increase as the benchmark. The buyer has a certain valuation of the good and the seller has certain costs. The difference represents the surplus created by the contract. The price the parties agree on determines how they share the surplus. In case a certain probability exists that the seller’s costs increase above the buyer’s valuation the seller’s expected costs and therefore her willingness to accept increases. In contrast, the buyer’s willingness to pay remains constant under expectation damages as we have seen in Chap. 3. Thus, the adjustment of the price reflects the probability of an increase and the size of the payment the seller needs to make to compensate the buyer equal to the buyer’s valuation. In comparison, under specific performance, the seller will need to make a side payment which lies

18

A related question is how the law should be designed such that the default rule reflects the preferences of the majority of the addressees. This is linked to contracting costs in that the fewer parties need to opt out of the default rule the lower will be the overall contracting costs; see for such argument: Ulen (1984, 376), Weller (2012, p. 369). However, in combination with an analytical approach to determine what remedy the parties prefer does not provide an additional substantial argument. The arguments for an analytical analysis determining what remedy is preferred by the parties would be congruent with those raised in favor of the remedies in general. Hence, the preferred remedy will be the one which is seen to be superior based on the theoretical arguments. The contracting costs aspect does not contribute an independent factor but only reinforces the theoretical finding. Take for instance the law and economics approach modeling the parties as rational agents. The agents prefer the remedy providing the more efficient outcome. This is determined by economic reasoning. As a result, law that departs from the efficient outcome would be designated even less efficient because it involves higher contracting costs. For that reason, an empirical assessment is required to add some substance. This goes beyond the scope of this book. See for an empirical approach Listokin (2005).

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somewhere between the buyer’s valuation and the seller’s increased costs. This side payment needs to be taken into account when making the adjustment to the price. Hence, for the adjustment under specific performance, it is not only the probability of an increase and the buyer’s valuation that play a role but also the value of the increased costs. However, the probability of an increase in costs and the extent of such increase are intimately related. Even more importantly, the extent of an increase is also relevant for expectation damages. Only if the increase takes such amount that the costs exceed the buyer’s valuation performance is deemed inefficient. An aspect Markovits and Schwartz do not mention but supports their argument is that the parties need to predict the future bargaining power of the parties to have an estimation of the future side payment. But note that in case of incomplete information about the buyer’s valuation and the parties expecting to renegotiate the contract also under expectation damages this difference in contracting costs between the remedies vanishes. The second argument Markovits and Schwartz raise is that under specific performance contracting costs would be higher because the contract would need to account for more contingencies (Markovits and Schwartz 2011, 1973–74; 2017, p. 14). Under specific performance, the contract does not only need to govern the consequences of no trade and trade but also account for the scenario that the seller sold the good, as the subject of the contract, to a third party which makes disgorgement necessary (Markovits and Schwartz 2011, 1973–74; 2017, p. 14). However, several objections need to be raised. First, if it is the case, as Markovits and Schwartz argue, that selling the good to a third party always triggers disgorgement, it is unclear whether the contracting costs would significantly rise. If specific performance necessarily implies the consequence just mentioned the parties would not need to explicitly bargain about it. Secondly, admitted that additional bargaining is necessary one could say that also under expectation damages the parties need to agree that expectation damages also applies if the seller transfers the good to a third party and not some other rule. Thirdly, under specific performance, the parties do not need to define another form of performance. How performance looks like is specified anyway. Under expectation damages, the parties need to agree on the design of damages. For example, they need to determine whether the seller pays damages in case of a breach of contract if those damages were unforeseeable. Hence, it is unclear under what remedy more contingencies need to be accounted for. It will depend on the specific circumstances of the particular case. Overall, it seems not convincing to attribute lower contracting to either remedy on a general basis.

7.2 Contracting

7.2.2

239

Inefficient Contracting Due to Flawed Estimation of Risk

In Chap. 3 we saw that under the assumptions of rational choice with perfect information and zero transaction costs seller and buyer contract efficiently under both remedies. We have discussed how contracting is affected if the information is imperfect and whether contracting costs differ between the remedies. Chapter 3 also covered the distributional effects of people fail to predict future events. This chapter analyzes the efficiency of contracting if the parties are not perfectly rational and underestimate the risk of an increase in the seller’s costs.19 The first section illustrates the research on people underestimating risks. The section to follow assesses how it affects contracting under both remedies if either the seller or the buyer, or both underestimate the risk of an increase in costs.

7.2.2.1

Behavioral Insights on People Failing to Predict Probabilities

Behavioral law and economics have identified several reasons for people to falsely estimate the occurrence of future events. In the given context a phenomenon most relevant is the so-called overoptimism bias (Pi et al. 2014); it “causes people to underestimate the likelihood of negative events, to overestimate the likelihood of positive events, and to be overly confident in each of these erroneous judgments”.20One form it can take is above-average-effect (Williams 2014, p. 336). This is exemplified by a study showing that most people perceive their driving skills to be above average (Williams 2014, p. 336). But also overoptimism can cause an underestimation of risks (Williams 2014, p. 340; Pi et al. 2014, p. 147). Camerer and Lovallo provided evidence that the overoptimism bias is reduced only if people are assured that the occurrence of the event is completely outside of their control (Camerer and Lovallo 1999). More generally, a systematic underestimation of risk has been described (Eisenberg 2014, p. 449). Arrow suggested that people tend not to be aware of future surprises and underestimate uncertainties (Arrow 1982, 9). Similarly, Krantz and Kunreuther observe that people would ignore probabilities below a certain threshold (Krantz and Kunreuther 2006). Regarding the efficient breach scenario in particular the seller seems susceptible to be overly optimistic about her ability to perform and underestimate the risk of an increase in costs. But also the buyer might be overoptimistic about the successfulness of the contract.21 Furthermore, the risk that the costs of performance increase might be quite small. As a result, the parties might put zero weight on the probability 19 Similar issues arise if the parties overestimate the risk of an increase in costs. As will be discussed, in the given context underestimation of risk seems more relevant. 20 Williams (2014, p. 335); see also for an overview of the literature Eisenberg (2014, p. 147). 21 Eisenberg made the same argument regarding liquidated damages Eisenberg (2014, p. 152).

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that the costs increase. Admittedly, the empirical and experimental findings cannot necessarily be applied to all situations. But they provide some evidence that seller and buyer tend to underestimate the risk of an increase in costs.

7.2.2.2

Seller Underestimates Risk

Consider the seller underestimating the risk of an increase in costs while the buyer makes a correct prediction. The true probability that an increase occurs is denoted αtrue. The probability due to overoptimism is αbias: αtrue > αbias. co denotes the seller’s costs of performance without an increase and c are her increased costs. v is the buyer’s valuation. We assume that under specific performance the parties successfully renegotiate the contract if the costs increase and share the benefits equally. We further assume the increased costs of performance exceed the buyer’s valuation; c > v. First, we analyze the situation under expectation damages. We see that the seller’s willingness to accept depends on the probability of an increase: WTAED TRUE ¼ ð1  αtrue Þco þ αtrue v

ð7:1Þ

WTAED BIAS ¼ ð1  αbias Þc þ αbias v

ð7:2Þ

o

The buyer’s willingness to pay is WTPED ¼ v. An inefficiency would arise if due to the underestimation of an increase in costs the parties contract although the seller’s costs exceed the buyer’s valuation; co > v.22 The analysis shows that the seller’s biased willingness to accept is smaller than the true willingness to accept if the seller’s costs of performance are below the valuation. Inversely, the biased willingness to accept is smaller than the true willingness to accept if the costs exceed the buyer’s valuation. There is no difference if costs and valuation are equal. WTAED BIAS < WTAED TRUE

ð7:3Þ

ð1  αbias Þc þ αbias v < ð1  αtrue Þc þ αtrue v

ð7:4Þ

ðαtrue  αbias Þco < vðαtrue  αbias Þ

ð7:5Þ

c v this always holds, i.e., the buyer’s biased willingness to pay is distorted in that it is smaller than his true willingness to pay (Fig. 7.6). The buyer puts a too low value on the right to claim performance and his expected payment from the seller in the future. As a result, the parties might not find a contract though the buyer’s valuation exceeds the seller’s cost. The figure shows the buyer’s

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245

valuation where such inefficiencies arise. It is the area between the two points where the dotted and the gray line meet and where the dotted and the black line meet.

7.2.2.4

Seller and Buyer, Underestimate Risk

In this third step, we examine how the underestimation of risk affects efficiency if both parties have a biased perception. First, consider the effect on the buyer’s willingness to pay and the seller’s willingness to accept. We can infer them from the previous section. WTPED TRUE ¼ WTPED BIAS ¼ v

ð7:14Þ

WTAED TRUE ¼ ð1  αtrue Þco þ αtrue v

ð7:23Þ

WTAED BIAS ¼ ð1  αbias Þc þ αbias v

ð7:24Þ

o

Since the buyer’s willingness to pay is unaffected this scenario is the same as when only the seller underestimates the risk. Thus, we can refer to them according to the result that no inefficiency is on hand. Also, for specific performance, we can infer the determination of the buyer’s willingness to pay and the seller’s willingness to accept from the previous section. We get:   vþc 2   vþc WTPSP BIAS ¼ ð1  αbias Þv þ αbias 2   vþc WTASP TRUE ¼ ð1  αtrue Þco þ αtrue 2   v þ c WTASP BIAS ¼ ð1  αbias Þco þ αbias 2 WTPSP TRUE ¼ ð1  αtrue Þv þ αtrue

ð7:16Þ ð7:17Þ ð7:25Þ ð7:26Þ

If we now concentrate on the biased versions, we see that the bias does not lead to an efficiency loss. Instead, the seller’s willingness to accept is equal to the buyer’s willingness to pay where the seller’s costs are equal to the buyer’s valuation (Fig. 7.7). Both biases cancel each other out if they take the same size. Graphically spoken, both, the willingness to pay and the willingness to accept curve, shifted downwards. Both undervalue the right to specific performance. This only has a distributional effect.

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Fig. 7.7 Effect of both, seller and buyer, underestimating risk on contracting under specific performance. Figure 7.7 bases on the following parameters: co ¼ 60, c ¼ 200, αtrue ¼ 0.3, αbias ¼ 0.1

7.2.2.5

Result

The analysis has shown that a flawed estimation of risk can lead to an efficiency loss under specific performance if the flawed perception is not the same for both parties. Expectation damages avoids that the bias has a negative effect on efficiency. Expectation damages is not debiasing. The actor remains to judge wrongly.23 Instead expectation damages is used to circumvent the bias which is called “insulation” (Pi et al. 2014, p. 150; Jolls and Sunstein 2006). It is important to keep in mind that this finding rests on the occurrence of the bias which does not need to hold in all situations.

7.3

Litigation Costs

Within the topic of the efficient breach scenario the literature has characterized litigation costs as the counterpart to bargaining costs (Devlin 2015, p. 169): Litigation costs exist under expectation damages to determine the amount of compensation. Bargaining costs arise under specific performance when renegotiation of the contract takes place and the parties agree on the side payment.

23

See for that difference: Pi et al. (2014, p. 147).

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247

The relationship between expectation damages and specific performance is illustrated as a tradeoff between litigation costs and bargaining costs (Devlin 2015, p. 169; Klass 2014, p. 374). Such approach treats the court simply as a price setter and litigation as the mechanism to determine the “price” for not performing the contract under expectation damages. This is not to say that with specific performance no litigation costs would ever exist. Under both remedies, the court needs to determine whether an obligation exists and whether a breach occurred (Ulen 1984, 384). However, with the specific performance the courts only need to identify the ownership right but with expectation damages the court, in addition, needs to assess damages (Devlin 2015, p. 162). On that basis, it is said that litigation is more likely under expectation damages and furthermore that such litigation would be more expensive due to the high costs of computing damages (Riehm 2015, p. 60; Ulen 1984, 363, 364).24 Computing damages becomes more costly if the buyer has an idiosyncratic value because information costs are high.25 Similarly, if the buyer’s valuation is private information he would be inclined to exaggerate his valuation in court (Ulen 1984, 384). Ulen further argues that under such circumstances, renegotiation under specific performance is cheaper than litigating under expectation damages because the parties themselves determine the price (Ulen 1984, 365, 366). But as Krier and Schwab rightly observe, those factors which render information costs and in consequence litigation costs to be high also lead to high bargaining costs (Krier and Schwab 1995, 459). The simple tradeoff described so far assumes that renegotiation does not take place under expectation damages. However, as we have seen in Chap. 5 for under- or overcompensatory damages and Chap. 6 for incomplete information, efficiency can demand renegotiation also under expectation damages. In addition, assessing damages is not a question in kind but rather in degree. There are not only the options to assess damages perfectly accurate or not at all (Krier and Schwab 1995, 463). Instead it needs to be decided what amount and resources (costs) should be spent (Krier and Schwab 1995, 463). But not tailoring the buyer’s compensation to his valuation on efficiency grounds would mean that the two goals expectation damages tries to achieve, efficiency and making the buyer indifferent, were not aligned but in contrast. For those reasons, I ask more generally: Under what circumstances and to what degree does assessing damages make renegotiation unnecessary? To answer this question, the following section analyzes the relationship between assessment costs and bargaining costs more closely.

24

Litigation costs vary extremely across countries, see Hodges et al. (2010, p. 57), Kaplow and Shavell also mention the costs to make the payment of damages, see Kaplow and Shavell (1996b, 741). 25 See Michael Krauss (2001, p. 788) in the context of property and liability rules.

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Relationship of Assessment and Bargaining Costs

Expectation damages aim to make the buyer whole in case the seller breaches. This aim needs to be balanced against the costs for assessing the buyer’s valuation. Consider the case where the emphasis is put on minimizing the assessment costs. There are two theoretical extreme cases depending on the legal standard of proof. First, the legal standard for proofing one’s valuation could be so high that the court rejects any evidence suggesting that the buyer’s valuation is greater than the price the parties agreed on. In case of a breach, the buyer would only get excused to pay the price or have a claim to receive an amount equal to the price if he had paid already. Alternatively, the legal standard of proof could be very low such that the court accepts any number the buyer demands as his valuation. In theory, this would lead to an infinite amount of damages. Consider the consequences in a scenario where the parties have perfect information. If the seller expects damages to be infinite the result mirrors the one under specific performance26: In case the seller’s costs of performance exceed the buyer’s valuation she will perform. Otherwise the parties would renegotiate the contract. Importantly, breach and paying damages is not an option for the seller. If damages are set equal to the price by the court the seller would be inclined to breach once her costs of performance exceed the price. We would observe a shortfall of damages. As discussed in Chap. 5, a shortfall of damages does not necessarily imply inefficient breaching if the buyer’s valuation exceeds the seller’s costs. Rather we expect the parties to renegotiate in the form that the buyer offers an additional amount to induce the seller to perform. Consider the opposite case. The court spares no costs and efforts to determine the buyer’s valuation. It sets damages equal to the specific buyer’s valuation. We saw that in the standard efficient breach model under expectation damages and perfect information: With perfect assessment and the court setting damages equal to the buyer’s valuation renegotiation is unnecessary to reach the efficient outcome. This outcome suggests that the more precise the assessment of damages is the less need remains to renegotiate the contract to reach efficient outcomes. In the following, we study the process of how a more accurate assessment of the buyer’s valuation affects the necessity to renegotiate. We contrast the result to the outcome under specific performance. We start by assuming that the court minimizes assessment costs and sets damages equal to the price. Take the following example: A buyer loses out on future sales because the seller breaches a contract. The seller did not deliver a certain product that was necessary to produce. The parties had agreed on the price P. Suppose that the profits of companies from selling those products are uniformly distributed over [vL, vH]. The seller’s increased costs take the value c which lies between vL and vH. We assume perfect information from both parties. 26 We determined this outcome for overestimated damages in Part 5 in general; see also for this inference in the sphere of property and liability rules Kaplow and Shavell (1996b, 730, 756).

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Fig. 7.8 Renegotiation necessity with minimized damages equal the price

Figure 7.8 illustrates the situation graphically. We see on the left that with damages set equal to the price the seller would always breach. But buyers with a valuation above the seller’s increased costs are induced to make an offer to induce the seller to perform. See for the details of renegotiation with a shortfall of damages Chap. 5. Under specific performance we get the opposite outcome: The seller renegotiates the contract with buyers who have a valuation below her increased costs. It follows that the number of cases in which renegotiation is necessary depends on where the increased costs are located. If they take a rather low value as they do in Fig. 7.8 expectation damages require renegotiation more often. If the costs tend to be rather high specific performance would require more renegotiations. Putting it differently, which of those two rules would produce greater renegotiation costs depends on the distribution of the increased costs of the seller. For the next step we allow higher assessment costs. Suppose that the court tries to approximate the buyer’s valuation by using the average of a certain comparison group. In our example: To estimate the buyer’s damages the court uses the average amount of profit other companies made by selling the product.27 The average profit and therefore damages take the value d. The buyer’s expected profit is between vL and vH which represents his type. As a result, there exist two kinds of buyers. Those who expect that their profit lies below average damages and those who expect that their profit lies above average damages. This means that the former kind of buyers expects an underestimation of damages. The latter expect overestimation of damages. Figure 7.9 illustrates that situation: Next, we assess how such measurement of damages affects the necessity to renegotiate the contract in order to achieve efficient outcomes. For the assessment, we consider two possible values the seller’s increased costs can take: One which is below d denoted c1 and one above d which is denoted c2. Again, we discuss the

27 I assume that it is impossible to cover. The German federal court decided in a case similar to the presented example: if a buyer is prevented to sell a new product due to a breach of contract damages it seems evident to predict the lost profit on the basis of usual course of events; BGH 26.7.2005, p. 3349. In a case concerning lost earnings, the German Federal Court decided to determine damages one can assume that the plaintiff would have earned at least an amount he would have received with average success in his job; BGH 6.2.2001. Kaplow and Shavell state that to avoid administrative costs courts would face when determining damages justifies estimating the harm and limit evidence. See Kaplow and Shavell (1996b, 731).

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Fig. 7.9 Scenario with average damages

Fig. 7.10 Renegotiation with average damages

results under specific performance as a benchmark. Figure 7.10 provides an illustration. First consider that the seller’s increased costs take the value below the average damages, c1. In that case, the seller would perform under either remedy. To achieve efficient outcomes the parties need to renegotiate the contract if the buyer’s valuation is below the seller’s costs. This does not change under specific performance if the seller’s increased costs attain the high value c2. It follows that regarding this scenario the spending resources on assessing damages is inefficient. Under expectation damages, the seller would breach with high costs c2. In consequence, the parties need to renegotiate when the buyer’s valuation exceeds the seller’s costs. Combining those two findings we see the effect of having a more precise estimate of damages: Under expectation damages renegotiation takes place with those types of buyers who represent the smaller group. This means that fewer renegotiations need to take place. Again, to what extent this reduces necessary renegotiations overall depends on the expected distribution of the increased costs. The number of necessary renegotiations cannot higher under expectation damages. However, if the seller’s increased costs lie always below the average valuation the assessment of damages does not lead to fewer renegotiations but only creates assessment costs. The greater the seller’s expected costs and lie above the average valuation the more renegotiations are avoided. Taking one more step, the court takes an even more precise assessment of the amount of damages. Instead of using the average damages of all companies, it divides the companies in two groups: Low valuing and high valuing buyers. In

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Fig. 7.11 Scenario with average damages and two groups of buyers

practice it could be that a court differentiates between companies that operate on a national or international basis. Alternatively, it might be that one can divide the companies into two groups depending on their annual turnover.28 The court determines two different amounts of average damages for each group: d1 and d2. vc represents the center which separates the two groups. Figure 7.11 depicts the scenario. Consider Fig. 7.12 to see the effect on the necessity to renegotiate. For that we assume that the seller’s increased costs can take four different values. Figure 7.12 shows that with small seller’s costs c1 the greater precision of the estimated damages does not affect the necessity to renegotiate. Nevertheless, once the increased costs take a value above the lower average damages (d1) the effect of tailoring damages becomes evident. If the seller’s costs take the value c2 she still performs facing high valuing buyers. Only if she faces low valuing buyers she would breach. Within that group of low valuing buyer those with a valuation above the seller’s costs are incentivized to renegotiate and make an offer to induce the seller to keep performing. Similarly, when the seller’s costs take the value c2 she breaches facing low valuing buyers. Only concerning those buyers within the high valuing group but with a valuation below the seller’s costs the seller needs to renegotiate the contract. If the seller’s costs increase to c3 and therefore above both average damages amounts the seller would always breach. Those buyers who have a valuation above the seller’s costs need to renegotiate. In contrast, under specific performance, the seller needs to renegotiate with all buyers who have a valuation below her costs. This group is larger than under expectation damages if the costs do not increase to an amount below d1. We could keep on iterating the process of approaching the buyer’s valuation until we determine for each buyer his individual damages. Similarly, the more aspects of a case a court takes into consideration the closer it tailors damages to the buyer’s valuation. A court could differentiate between the companies on the basis of more and more grounds until it determines for each company its individual lost profit.

28

In practice it is possible that the two groups one established do not perfectly reflect the expected profit as shown in the example. The court should choose which are best suited to represent a proxy for the expected profit.

Fig. 7.12 Renegotiation with average damages and two groups of buyers

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Fig. 7.13 Scenario with minimum damages and two groups of buyers

Fig. 7.14 Renegotiation with minimum damages and two groups of buyers

Importantly, this positive effect of assessing damages more closely on the necessity to renegotiate is not limited in that the court needs to take average damages. Consider the scenario that the court does not allow evidence for showing that one value performance more than the least valuing buyer. The outcome for the necessity to renegotiate is the same as with damages equal to the price shown in Fig. 7.8. But now the court also starts differentiating between two groups of buyers. In contrast to our analysis with average damages the court decrees minimum damages equal to the least valuing buyer; this time within his group. Figure 7.13 illustrates the scenario and emphasizes that the two groups do not need to represent equal proportions. Differentiating between the two groups reduces renegotiations as shown in Fig. 7.14. We see that with low costs the number of renegotiations is still higher under expectation damages compared to specific performance. However, comparing it to damages with two groups the effect becomes clear. Where the seller breaches renegotiation would have been necessary under expectation damages. For the high cost scenario expectation keeps its advantage to specific performance. It is the same outcome for expectation damages with or without two groups of buyers.

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Constrains for Assessing Damages

The previous section showed that the more effort and costs one spends on the assessment of the buyer’s valuation the better one can prevent the necessity to renegotiate under the assumption of perfect information.29 To specify the optimal level of accuracy there are two constraints. First, higher accuracy comes with higher assessment costs. Renegotiation costs and assessment costs function as substitutes not only with respect to the decision between expectation damages and specific performance. Rather also within expectation damages the question to what degree the court should assess, and tailor damages is a matter of balancing assessment costs and renegotiation costs. The more precise the court estimates damages the greater are the assessment costs. Furthermore, assessment costs are lower if damages are based on rather objective criteria and not such that are specifically attributed to the buyer.30 We saw that the degree of such accurate assessment helps to make renegotiation unnecessary depends on where the seller’s increased costs are located. The smaller the seller’s increased costs are the less more accurate assessment of damages prevents renegotiations.31 The second constraint to assessing damages precisely arrives from informational limitations. The positive impact of tailoring damages more accurately and making renegotiations unnecessary is limited by imperfect information.32 Increasing the accuracy of such assessment fails to have a positive impact on efficiency if the parties lack the necessary information when taking the decision to adjust their behavior (Kaplow 1994; Kaplow and Shavell 1996a, 192, b, 742). In our context, suppose the seller does not know the buyer’s valuation but only knows the expected value over a distribution of buyers. Then, the seller’s incentive about breaching or performing does not change whether the court determines the valuation more precisely or sets damages equal to the expected value. Thus, assessing damages Concerning tort cases Kaplow finds equivalently that accurate damage determination may improve the individuals’ incentives to decide whether to act when this is potentially harmful if the tortfeasor knows the size of the harm, see Kaplow (1994, 309, 312, 313). Kaplow and Shavell prove a formal model regarding the accuracy of damages and the level of precaution; see Kaplow and Shavell (1996a). 30 Ben-Shahar and Bernstein (2000, 1893, 1884); with incomplete information assessment costs also encompasses costs which arise due to tailoring and assessment as it goes at the expense of the buyer’s secrecy interest. Ulen argues that assessment costs are low with fungible goods (Ulen 1984, 384). But in such case the efficient breach is not an issue as shown above. 31 Kaplow and Shavell conclude that property rules would be superior based on their assumption that owner place a higher value on the entitlement and that the court will decree damages equal to average damages over all owners, see Kaplow and Shavell (1996b, 764). 32 Kaplow puts it as follows regarding torts cases: “In contrast if at the time I act I am unaware whether my act will cause an atypically high harm or low level harm, knowledge that an adjudicator will determine harm precisely ex post will not cause my behavior to adjust my behavior accordingly. (. . .) Thus, greater accuracy is valuable only to the extent it involves dimensions about which individuals are informed at the time they act.” See Kaplow (1994), Kaplow and Shavell (1996a, 192, 1996b, 730 Fn. 52, 742). 29

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more closely than the seller’s knowledge about the buyer’s valuation only causes inefficient assessment costs.33 In addition, it is important to recall that tailoring damages under incomplete information even has a detrimental effect on renegotiation as we analyzed in Chap. 6.34 Using average damages leads to more efficient renegotiations. This thought brings us back to the case Hadley vs. Baxendale and unforeseeable damages. As we discussed above, limiting damages to such that were foreseeable was based on the information forcing in the economic literature. It shows that avoiding inefficient assessment costs is another reason to limit damages to such the seller is able to foresee. Concerning the comparison between tailored expectation damages and specific performance, this finding means that the less information the seller has about the buyer’s valuation the more speaks in favor of either a simple damage rule with for example damages equal to the price or specific performance. An additional constraint for assessing damages exists but does not speak against tailoring damages in general. I mean uncertainty and informational costs. They arise if a damage rule provides the court with the task to determine damages more accurately than simply the price and less than tailored to the buyer’s valuation. A contract clause or a legal rule that demands an assessment of damages implies some uncertainty what circumstances the court includes in its consideration when tailoring damages. For example, a clause that the court should grant average damages causes uncertainty regarding the question: Average damages of what cohort? As a result of that lower predictability parties would renegotiate though it would not have been necessary, or they do not renegotiate though it would have been necessary. This argues in favor of a simple rule. May it be a simple damage rule or specific performance.

7.4

Enforcement Costs

While litigation costs render expectation damages less attractive it is argued that specific performance entails high enforcement costs due to the necessity to supervise performance (Ulen 1984, 398). This is said to be particularly true if the assessment of the performance is complex, i.e., the buyer and the court cannot easily observe whether the seller has exercised performance accurately (Schwartz 1979, 277, 293; Shavell 2006, 846). The seller might be reluctant to perform quickly, accurately, and

33

Avraham and Liu provide an analysis showing that the court should not take into account new information about the buyer’s valuation that has arisen after the parties signed the contract. Their analysis basis on the idea that the buyer’s decision to litigate is endogenous and low valuing buyer will not sue. As a result the seller’s breach decision is distorted, see Avraham and Liu (2012a, b). 34 Craswell is right when argues that “(. . .) the remedy that is closest to exact compensation will be the remedy that most often leads to the right result without requiring renegotiation (. . .).” See Craswell (1988, 663). But in that he fails to account for assessment costs and does not see the difference in the efficiency of renegotiations.

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carefully if she is coerced. Further lawsuits might be the result. In contrast, a payment of compensation can be easily observed. Albeit those assertions might be true, it seems necessary to assess the importance of the argument. Suppose the seller’s costs increase but performance remains efficient. In that case, performance should take place regardless of the remedy. Whether the seller performs quickly, accurately, and carefully needs to be supervised by the buyer under both remedies and if he does not accept the kind of performance rendered a court needs to evaluate the performance. Alternatively, if the seller’s costs rise above the buyer’s valuation, we expect the parties to renegotiate under specific performance. Enforcing an inefficient performance becomes only relevant if bargaining costs prevent the parties from renegotiating successfully. Hence, higher enforcement costs can only be relevant in two cases: 1. The seller inefficiently does not perform but is coerced under specific performance while she would breach under expectation damages. The efficiency advantage of specific performance would be diminished by the costly means of coercion to reach that result. 2. The seller breaches efficiently under expectation damages but would be coerced to perform under specific performance. In that case, the inefficiency caused by inefficiently performing under specific performance is aggravated. Hence, ultimately the argument about expensive enforcement under specific performance only suggests that inefficient performance under specific performance is more severe than inefficient breaches under expectation damages.

7.5

Result

The foregoing analysis comes with several findings. First, we looked at the scale of renegotiation costs. We established that they range rather at the low end with the framework provided by Calabresi and Melamed regarding property and liability rules in general. We found that the arguments proposed to deem renegotiate under specific performance costly are not convincing. Rather with tailored damages and incomplete information, it is plausible that bargaining is comparatively costly under expectation damages to specific performance. Behavioral insights of the prospect theory suggest an advantage of expectation damages in the loss-avoiding scenario if damages are fully compensatory. But we found the opposite result in a gain seekingscenario when damages fall short. Secondly, we saw that it is unclear whether specific performance or expectation damages imply higher contracting costs. It depends on the specific circumstances. In particular in the case the parties underestimate the risk of an increase the analysis revealed an advantage for expectation damages. Thirdly, the analysis showed that the alleged high enforcement costs specific performance are said to bring along do not represent an independent factor. Instead it

References

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only contributes to the severance of inefficient performances under specific performance; this might render them more severe than inefficient breaches under expectation damages. Fourthly, we took a different perspective on damages and assessment costs. It allowed us to see that theoretically specific performance is not an opposite remedy to damages an extreme end on a continues space. This space is determined by the accuracy to which damages are tailored to the buyer’s valuation. In addition, we established that assessing damages and renegotiating contracts function as substitutes. Based on this altered vantage point the optimal remedy demands to strike right balance between the renegotiation costs and the assessment costs. We saw that the optimal remedy depends on the scale of renegotiation and assessment costs, the degree how informed parties are, the uncertainty created by the ambiguity of damages clause and the distribution of the buyer’s valuation and the seller’s costs. The optimal remedy may be specific performance or expectation damages tailored to the buyer’s valuation. But the optimal remedy may also lie in between. Once there exists imperfect information about the buyer’s valuation tailored damages will not be the optimal remedy. There will be some other level of accuracy regarding damages that will be more efficient.

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Chapter 8

Conclusion

My work sets out to contribute to a more complex theory of remedies. There is not one superior remedy but context matters. The subject of the analysis is the efficient breach scenario. We started at well-known ground and introduced more advanced informational structures, discussing market structures and bargaining power, and eventually adding behavioral insights about human behavior to the analysis. The analysis goes beyond simplifying debates like whether the greater problem is undercompensatory damages which would incentivize the seller to breach too often or whether bargaining costs render specific performance inefficient.1 It takes a more generalizable approach than using factors like the type of contract to build categories and making assumptions what kind of inefficiency would be more prominent in the respective category.2 Figure 8.4 provides an overview of the results under the assumption of the homo economicus. The figure highlights two findings. Firstly, the importance whether an option to cover exists. In such case, the debate about the remedies is of less relevance. Furthermore, we inferred that the concept of market damages does not apply when the debate about the remedies is of relevance. Secondly, it shows that the informational structure is a key factor. If the seller knows the buyer’s valuation expectation damages is superior. But if the buyer’s valuation is his private information expectation damages shows a number of traits that are detrimental to efficient outcomes and render specific performance to be preferable. Admittedly, expectation damages can be altered by concepts like the foreseeability doctrine to reduce the negative effects. But those alterations do not come without negative side effects and also change the core idea, which is to make the buyer indifferent and thereby sufficing alleged moral demands (Fig. 8.1).

1 2

Mahoney 1995, 142; Schwartz 1979, 284–287; Kronman 1978, 363. Bishop 1985, 306.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 O. Hofmann, Breach of Contract, International Law and Economics, https://doi.org/10.1007/978-3-030-62525-2_8

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Fig. 8.1 Overview of analysis under homo economicus assumptions

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Fig. 8.2 Overview of analysis of transaction costs

The work, in addition, contributes by thoroughly analyzing the different kinds of transaction costs. A key aspect is a new view regarding the relationship between litigation and renegotiation costs (Fig. 8.2). The work proposes that the relationship should not simply be thought of as attributing renegotiation costs to specific performance and litigation costs for assessing damages to expectation damages. Rather both types of costs are substitutes and specific performance can be theorized as a remedy with low assessment and high renegotiation costs. Expectation damages aiming to make the buyer indifferent leads to high assessment costs. Deviating from its original form expectation damages can be designed in different ways to either cause higher assessment or renegotiation costs depending on how accurate compensation should reflect the buyer’s valuation. Importantly this possibility is limited if the seller has incomplete information about the buyer’s valuation. One factor that is crucial at several points of the analysis is the bargaining power each party has. The most important ones are illustrated in Fig. 8.3.

Fig. 8.3 Impact of bargaining power

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Introducing behavioral insights shows various effects. In most cases, the effects are an impediment to reach efficient outcomes. Both remedies suffer from inefficiencies based on human deviations from the homo economicus. Some aspects like reciprocity and a shortfall beyond money concern expectation damages while overoptimism and underestimation of risk are a greater problem under specific performance (Fig. 8.4). The behavioral literature about remedies is increasing but with respect to many questions no clear answers exist yet. For some of the arguments like the application of the prospect theory in renegotiations, there has not been conducted an experiment but is based on the theoretical application from other settings. Thus, there is no warranty that the behavioral findings fully transfer to the setting of contractual remedies. Hence, more research is necessary to get a more profound understanding of what effects remedies have on human behavior. Generally, one needs to be aware that experimental results should be tested for their external validity. Behavioral traits do not affect all people the same but are somehow distributed among society. The distribution within the society can be different than the one of the subjects to the experiment which mostly consists of students. More generally we found distributional effects if the parties make mistakes in predicting the future. The distributional effects of those mistakes are intimate to the remedy in place (Fig. 8.5). Overall, the analysis shows that the advantages and disadvantages of either remedy depend on the context. My work provides guidance under what circumstances which of the remedies performs better. Thereby this research helps contracting parties and the regulator to design remedies in an efficient way.

Fig. 8.4 Insights from behavioral law and economics

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Fig. 8.5 Distributional effects of mistakes in predicting the future

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References Bishop, W. (1985). The choice of remedy for breach of contract. The Journal of Legal Studies, 14 (2), 299–320. Kronman, A. T. (1978). Specific performance. The University of Chicago Law Review, 45(2), 351–382. Mahoney, P. G. (1995). Contract remedies and options pricing. The Journal of Legal Studies, 24(1), 139–163. Schwartz, A. (1979). The case for specific performance. The Yale Law Journal, 89(2), 271–306.