Timing Problems in Contract Breach Decisions

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:
Breach of contract
Contract law
Contracts
Damage claims
Decision Making
Economic models
Efficiency
Expected values
Law
Options markets
Studies
United States
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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. It is shown 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. A study explores various responses to this problem, including vertical integration, changes in contract remedies, flexible price provisions, and the capital structure of each party.
ISSN:0022-2186
1537-5285
DOI:10.1086/467388