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Optimal Penalties in Contracts

Author

Listed:
  • Aaron S. Edlin

    (University of California, Berkeley)

  • Alan Schwartz

    (Yale University)

Abstract

Contract law's liquidated damage rules prevent enforcement of contractual damage measures that require the promisor, if it breaches, to transfer to the promisee a sum that exceeds the net gain the promisee expected to make from performance; but these rules permit the promisor to transfer less than the promisee's expectation. We define a contractual damage multiplier as any number between zero and infinity by which the promisee's expected gain -- its expectation interest -- is multiplied. Multipliers of one or less thus comply with the liquidated damage rules while multipliers that exceed one do not; the high multipliers are unenforceable penalties. This paper shows that multipliers of any size can be efficient or inefficient, depending on the parties' purposes in creating them. For example, a multiplier that exceeds one will decrease welfare if used by a seller with market power to deter entry; but will increase welfare if used by parties to induce efficient relation specific investment. As a consequence, a court should inquire, not into the size of the multiplier, but into the purpose the multiplier serves for the parties.

Suggested Citation

  • Aaron S. Edlin & Alan Schwartz, 2003. "Optimal Penalties in Contracts," Law and Economics 0303002, EconWPA.
  • Handle: RePEc:wpa:wuwple:0303002 Note: 29 pages, Adobe.pdf
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    File URL: http://econwpa.repec.org/eps/le/papers/0303/0303002.pdf
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    References listed on IDEAS

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    Cited by:

    1. Liu, Zhiyong & Avraham, Ronen, 2012. "Ex ante versus ex post expectation damages," International Review of Law and Economics, Elsevier, vol. 32(4), pages 339-355.
    2. Alexander Stremitzer, 2012. "Standard Breach Remedies, Quality Thresholds, and Cooperative Investments," Journal of Law, Economics, and Organization, Oxford University Press, vol. 28(2), pages 337-359.
    3. Comino, Stefano & Manenti, Fabio M. & Nicolò, Antonio, 2011. "Ex-ante licensing in sequential innovations," Games and Economic Behavior, Elsevier, vol. 73(2), pages 388-401.
    4. Alexander, Corinne & Ivanic, Rasto & Rosch, Stephanie & Tyner, Wallace & Wu, Steven Y. & Yoder, Joshua R., 2012. "Contract theory and implications for perennial energy crop contracting," Energy Economics, Elsevier, vol. 34(4), pages 970-979.
    5. Ronen Avraham & Zhiyong Liu, 2006. "Incomplete Contracts with Asymmetric Information: Exclusive Versus Optional Remedies," American Law and Economics Review, Oxford University Press, vol. 8(3), pages 523-561.
    6. Sugata Bag, 2010. "Whither Contract Damages: Contracts with Bilateral Reliance, One-sided Private Information," REVISTA DE LA MAESTRIA DE DERECHO ECONÓMICO, UNIVERSIDAD JAVERIANA - DERECHO ECONOMICO, December.

    More about this item

    JEL classification:

    • K12 - Law and Economics - - Basic Areas of Law - - - Contract Law

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