Timing Problems in Contract Breach Decisions1

In contracts susceptible to efficient breach, each party has an American option to breach and pay damages rather than perform. She will repudiate early if the expected decrease in damages liability resulting from her partner's mitigation exceeds the expected value of the terminated contract, in...

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Bibliographic Details
Published in:The Journal of law & economics 1998-04, Vol.41 (1), p.163-208
Main Authors: Triantis, Alexander J., Triantis, George G.
Format: Article
Language:English
Subjects:
Business orders
Contract breaches
Contract law
Contracts
Cost efficiency
Executory contracts
Legal liability
Mitigation of damages
Options contracts
Specific performance
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Summary:In contracts susceptible to efficient breach, each party has an American option to breach and pay damages rather than perform. She will repudiate early if the expected decrease in damages liability resulting from her partner's mitigation exceeds the expected value of the terminated contract, including the option to breach in the future. We show that each party has the incentive to repudiate earlier than socially optimal because expectation damages compensate the nonrepudiating party only for the loss of the completed exchange and not the value of its lost breach option. This inefficiency is particularly acute in long‐term, fixed‐price contracts in which the cost of performance to the promisor and the value to the promisee are volatile and uncorrelated. We explore various responses to this problem, including vertical integration, changes in contract remedies (including specific performance), flexible price provisions, and the capital structure of each party.
ISSN:0022-2186
1537-5285
DOI:10.1086/467388