5. Over- and Undercompensation

See for an experimental approach to the shortfall of damages (Lewinsohn-Zamir 2012).

A more general thought on monetary damages concerns the functionality of money itself. Monetary damages can only represent a functioning remedy as an alternative to specific performance if the money the buyer receives is valuable to the buyer. Hence, in situations of high inflation or in countries where money alone does not help to get the desired good a claim to damages is no valid substitute to performance.

I will take a closer look at the distinction between observable and verifiable information in Chap. 6.

Some scholars take a very subjective viewpoint. They argue that only the parties themselves can know their costs and valuations in all cases. A third party cannot determine them. Thus, this strand of literature argues that expectation damages can never be an adequate response to a breach of contract. See for an overview Schäfer and Ott (2012, p. 504, 505).

See § 253 Abs. 1 BGB (German Civil Code).

See Eisenberg (2005, 992) for more details in regards to the application of that standard in the U.S.A. But see also § 287 BGB (German Civil Code) as an example for the reduction of the burden of proof regarding the amount of damages if the investigation would require disproportionate effort; BGH 26.7.2005.

The effect on the buyer’s bargaining position will be discussed in more detail in Sect. 6.​1.​3.​4.

The high amounts participants demanded to switch to expectation damages might partly be explained by a status quo bias.

First, Schwartz argues that the questionnaire suggests in-kind remedies to be the preferred choice. It creates an entitlement to the participant. In addition, it frames the expectation damages contract to be of lower value due to the second question: would you switch for a discount. Second, the specific performance contract suggests that the participants opt for actual performance and not a remedy which allows to sue for performance. See Schwartz (2012, 29, 30).

Schwartz puts forward an argument against Lewinsohn-Zamir’s conclusion that the buyer should receive a premium additional to expectation damages in case the parties are firms. He points out that firms are supposed to maximize the profit. If a manager prefers specific performance due to reasons beyond wealth this preference should not be relevant for the firm’s compensation. Nevertheless, such compensation would be lower than the overall loss created by the breach since the loss is not confined to the company.

Furthermore, those experiments do not inform participants that giving the seller the option to breach leads to a lower price as we discussed in Chap. 3.

We will discuss the influence of the price on the decision to breach in the next section.

See for the effects of disagreement points in general, Sect. 3.​2.​3.​1.

This alternative additionally hinges on the condition that d < (1 − α)v < c as shown above.

This assumes that the seller performs if her costs do not increase. Also note that the buyer claims damages if d > P. Since by assumption d > c^o, the minimum price arises if the buyer claims damages.

Another question is whether a difference in price due to the different remedies affects the probability that the increased costs are above the price. For the given scenario I assume that the costs increase by such an amount that they always lie above the original price regardless of the respective remedy in place.

For the model the litigation costs the seller pays are not relevant. In my work I do not address the question who pays what share of litigation costs but focus on the differences between specific performance and expectation damages supposing expected litigation costs. The assumption is that expected litigation and enforcement costs are the same between the remedies. Chapter 7 deals with the question whether those costs differ between the remedies.

One aspect which could counteract this effect of specific performance would be if the expected litigation costs reflect the lower interest the buyer has in suing for performance due to the higher price. This can be the case, if litigation and enforcement costs the buyer expects to pay vary with value of the claim the buyer has. However, the variation of the litigation costs would have to reflect the full difference in price, and it seems difficult to calculate the reference value on the buyer’s subjective valuation of performance.

See the following differentiation by Pi, Parisi and Luppi 2014, p. 145: such behavior is not in line with rational choice in the sense that the actor does not try to maximize their utility. But it is different than bounded rationality where the actor tries to maximize utility but due to mistakes, he does not achieve that goal. People still apply a costs-benefit analysis: the higher the costs for behaving according to moral heuristics the less likely people follow them, see: Stout (2014, p. 202).

See for a theoretical illustration: Shiffrin (2009).

Two opposing views exist with regards to heuristics: In standard behavioral law and economics heuristics are usually seen as impediments to optimal decision-making. This has its basis in the work by Kahneman and Tversky. In contrast, Gigerenzer sees heuristics as a tool to arrive at superior solutions when optimization is either not possible or the optimal strategy is unknowable. See Mitchell (2014, p. 172).

See for the debate about the double performance hypothesis: Markovits and Schwartz (2011), Shiffrin (2009).

See for a detailed discussion of the reasons for why people show reciprocity: Gächter (2014, p. 35).

Reputation has also been formulated as a substitute to legal rules: see Kornhauser (1983).

Depoorter and Tontrup argue that it is the law that shapes the parties’ preferences about a breach of contract; Depoorter and Tontrup (2012). “(…) the endogenous nature of moral intuitions suggests that individuals are not principally opposed to contract breach. Rather, the default remedy influences the moral acceptability of contract breach. As an empirical matter, it appears that the ethical norm of promise keeping is highly context-dependent.” (p. 689) Based on their experimental result they argue that a default rule of specific performance causes the parties to reject a breach of contract. But their result does not only show that a significant number of people change their attitude towards a breach of contract. It also shows that around 75% do not change their attitude (p. 700).

Interestingly, Mittlaender did not find a difference in the retaliation behavior between the loss-avoiding and the gain-seeking scenario if the seller compensates the buyer: Mittlaender (2015, 28).

See for a study which suggests that retaliation does not lead to a net benefit to welfare: Sefton et al. 2007. For a study that shows a positive effect on social welfare see Gächter et al. 2008.

See for an analysis regarding the related topic of liability rules, undercompensatory damages and the influence of bargaining Kaplow and Shavell (1996, 761, 764).

Having P < d ensures that the buyer would claim damages. If P > d the payoffs would be different but the underlying argument for renegotiation remains unaffected.

In case that the shortfall occurs because expectation damages do not include the valuation of third parties (also not via the buyer’s valuation) who share an interest in performance renegotiation would be different in that also those third parties would contribute to the additional payment.

In the given bilateral contractual setting the problem of multiple takings as discussed for liability rules in general does not apply. The problem of multiple takings is as follows:

If ownership rights are protected by liability rules which do not compensate the proprietor completely, others find it beneficial to them to take the property from the original proprietor, even if their valuation of the good is lower than the original proprietor ones. In a two-agent scenario the original proprietor would offer the potential taker money for foregoing the opportunity to take. However, in a multi-party scenario the original proprietor would face not only one potential taker who needs to be bought off. Hence, the original proprietor would not pay money to any potential taker and therefore, the first potential taker might take the property even if his valuation is lower. The inference is drawn, that if damages are set too low, bargaining by owners would not be viable and inefficient takings would be the consequence. See for the problems of undercompensation and multiple takings: Kaplow and Shavell (1996, 765, 766).

In a bilateral contractual relationship only the parties of the contract can breach the contract. No third party can unilaterally “take” and decide not to perform. Thus, the buyer cannot face multiple parties he would need to bribe.

A distinct question is, how that agreement looks like. Being more specific, how much does the buyer pay extra to the seller. In turn, this can also depend on the shortfall of damages and how the shortfall of damages affects the discount factor. To see this, consider the situation that seller and buyer negotiate about the size of the extra payment. The longer the negotiation takes the more time elapses until the buyer receives performance. The mere delay of performance can lead to damages. First, think about damages that affect the buyer’s valuation. For instance, due to the delay the buyer himself loses customers. In such scenario, even if the seller does not compensate the buyer for such damages she is affected by the time delay indirectly. The buyer’s valuation decreases and therefore also the potential amount the extra payment takes. In case the seller would fully compensate the buyer for such losses the buyer has a very strong bargaining position because the seller bears all the damages that arise as negotiation takes place.

Second, consider damages that do not affect the buyer’s valuation. In such scenario, the seller’s bargaining position highly depends on whether she has to compensate the seller for those damages. If the seller does not compensate the buyer, the seller has negative leverage over the buyer as she can await the buyer’s offers whereby the buyer loses money as negotiation takes place.

See for the parallel finding regarding property and liability rules Kaplow and Shavell (1996, 761).