Price Discrimination with Contract Terms: The Lost-Volume Problem

The "lost-volume" problem in contract law poses a problem of contract design. A seller with market power who faces buyers with private valuations for the subject of sale solves the problem with a combination of a required positive down payment and a later transaction price above cost. This combination maximizes the surplus the seller can capture from the buyers, but the contract is inefficient: the positive down payment cuts off contracting and a price above cost induces breach by buyers who value the product above its cost. The lost-volume question, then, is whether a court should enforce the inefficient contract the seller prefers or should instead impose one of two mandatory rules: permitting the seller to recover full lost-profit damages or no damages at all. These mandatory rules produce inefficiencies of their own. This paper's contribution is (a) to clarify the lost-volume problem; (b) to show that the three judicially implementable solutions cannot be Pareto-ranked abstractly: which outcome best turns on the distribution of buyer valuations in particular markets; (c) to show which value distributions likely would yield efficiency under each of the solutions; and (d) to argue, for second-order reasons, that courts should enforce the consensual contract rather than impose either mandatory rule. Copyright 2010, Oxford University Press.