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Cadillac Contracts and Up-Front Payments: Efficient Investment Under Expectation Damages

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Aaron S. Edlin

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Abstract

This paper shows that up-front payments can play a crucial role in providing efficient investment incentives when contracts are incomplete. They can eliminate the overinvestment effect identified by Rogerson [1984] and Shavell [1980] when courts use an expectation damage remedy. This method extends to complex contracting situations if parties combine up-front payments with what we call 'Cadillac' contracts (contracts for a very high quality or quantity). This combination provides efficient investment incentives in complex contracting problems when an expectation damage remedy is accompanied by a broad duty to mitigate damages. This indicates that an expectation remedy is well-suited to multidimensional, but one-sided, investment problems, in contrast to specific performance, which Edlin and Reichelstein [1993] showed is well-suited to two-sided, but unidimensional, investment problems.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4915.

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Date of creation: Nov 1994
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Handle: RePEc:nbr:nberwo:4915

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K - Law and Economics
L - Industrial Organization

References listed on IDEAS
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  1. David Cutler, 1994. "Market Failure in Small Group Health Insurance," NBER Working Papers 4879, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  1. Alexander Stremitzer, 2008. "Standard Breach Remedies, Quality Thresholds, and Cooperative Investments," Discussion Papers 242, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
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  2. Patrick W. Schmitz, 2005. "Should Contractual Clauses that Forbid Renegotiation Always be Enforced?," Bonn Econ Discussion Papers bgse26_2005, University of Bonn, Germany. [Downloadable!]
    Other versions:
  3. Charles North, 2001. "Remedies for misrepresentation in applications in the presence of fraudulent intent," Atlantic Economic Journal, International Atlantic Economic Society, vol. 29(2), pages 162-176, June. [Downloadable!] (restricted)
  4. Plambeck, Erica L. & Taylor, Terry A., 2004. "Implications of Breach Remedy and Renegotiation for Design of Supply Contracts," Research Papers 1888, Stanford University, Graduate School of Business. [Downloadable!]
  5. C. Manuel Willington, 2004. "Hold-Up under Costly Litigation and Imperfect Courts of Law," Econometric Society 2004 Latin American Meetings 231, Econometric Society. [Downloadable!]
    Other versions:
  6. Schmitz, Patrick W., 2002. "On simple contracts, renegotiation under asymmetric information, and the hold-up problem," MPRA Paper 12530, University Library of Munich, Germany. [Downloadable!]
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