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Jiujitsu Behavioral Economics: Incentivizing the Holy Grail of Efficient Breach through Liquidated Damages

24 Feb

Dear legal doctrine, Please untie me! Best, efficient breach.

It is undoubtedly a familiar scene from many 1L Contracts classrooms. The Professor introduces the concept of efficient breach; specifically the notion that contracts should be engineered, through the amount of damages awarded, to incentivize breach in the name of efficiency. The proposal provokes gasps of indignation from the class, who protest that breaking a contract ‘just feels wrong’. Ah, the professor will say, you must think we’re in a morality classroom, but we’re actually in law school. Through a variety of models, based on rational actors, the professor will demonstrate that damages which encourage efficient breach, generally expectation damages, will produce overall gains in societal wealth by encouraging contracting partners to breach their contracts when it will maximize overall wealth. (The larger question of whether wealth is a value worth pursuing through legal engineering will be carefully delineated as a separate question.) The professor may support his case with a quotation from the Restatement of Contracts, which empahsizes that breaking a contract is a morally neutral event. The professor may contrast expectation damages against the problematic concept of liquidated damages. Liquidated damages specify, in advance, the amount that a contracting partner must pay if they breach a contract. Liquidated damages clauses, especially those that seem punitive, are often not enforced by courts. A professor may demonstrate that liquidated damages clauses might deter efficient breach and therefore are economically unjustified. The students, standing in awe before the sacred models, are generally cowed into silence. They’ve learned an important lesson about attempting to apply their moral intuitions to economic analysis of legal doctrines. But is the professor actually right? Continue reading

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