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Dynamic Contract Breach

  • Fan Zhang

    (Economic Analysis Group, Antitrust Division, Department of Justice)

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    This paper studies the design of optimal, privately-stipulated damages when breach of contract is possible at more than one point in time. It offers an intuitive explanation for why cancellation fees for some services (e.g., hotel reservations) increase as the time for performance approaches. If the seller makes investments over time to improve her value from trade, she will protect the value of her investments by demanding a higher compensation when the buyer breaches their contract at a time closer to when contract performance is due. Furthermore, it is shown that if the seller may be able to find an alternate buyer when breach occurs early but not when breach occurs late, the amount by which the damage for late breach exceeds the damage for early breach is increasing in the probability of finding an alternate buyer. (This result may explain why some hotels impose larger penalties for last-minute cancellations during the high season than during the low season.) When the probability of finding an alternate buyer is endogenized, the seller's private incentive to mitigate breach damages is shown to be socially insufficient whenever she does not have complete bargaining power with the alternate buyer. Finally, if renegotiation is possible after the arrival of each perfectly competitive entrant, the efficient breach and investment decisions are shown to be implementable with the same efficient expectation damages that implement the efficient outcomes absent renegotiation.

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    Paper provided by Department of Justice, Antitrust Division in its series EAG Discussions Papers with number 200803.

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    Length: 29 pages
    Date of creation: Mar 2008
    Date of revision:
    Handle: RePEc:doj:eagpap:200803
    Contact details of provider: Postal: Department of Justice Antitrust Division 450 Fifth Street NW Washington, DC 20530
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    1. Tai-Yeong Chung & Alan Chan, 2004. "Contract Damages and Investment Dynamics," Econometric Society 2004 Far Eastern Meetings 683, Econometric Society.
    2. Stole, Lars A, 1992. "The Economics of Liquidated Damage Clauses in Contractual Environments with Private Information," Journal of Law, Economics and Organization, Oxford University Press, vol. 8(3), pages 582-606, October.
    3. Chung, T.Y., 1991. "On the Social Optimality of Liquidated Damage Clauses: An Economic Analysis," UWO Department of Economics Working Papers 9102, University of Western Ontario, Department of Economics.
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