Contract Damages and Cooperative Investments

Abstract

We study alternative breach remedies in the presence of specific investments that generate a direct benefit to the investor's trading partner (referred to as investments.). We find that (i) expectation damages perform very poorly, inducing no cooperative investment; (ii) privately stipulated liquidated damages can achieve a better, albeit inefficient, outcome; and (iii) the reliance damages perform the best, achieving the efficient outcome if ex post renegotiation is possible. These rankings stand in contrast to those found in the existing literature, but they explain many observed contracting practices.