Optimal Penalties in Contracts

Aaron Edlin () and Alan Schwartz

Law and Economics from EconWPA

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.

JEL-codes: K12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-law
Date: 2003-03-27
Note: 29 pages, Adobe.pdf
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwple:0303002

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