Efficient Material Breach of Contract

Abstract

In an environment in which sellers can reduce the probability of defective delivery through cooperative investment, and in which enforcement of default remedies for breach of contract is imperfect, an optimal performance standard grants buyers the option to reject goods for some but not all defects, in other words, when the delivery is sufficiently defective and the seller is said to be in “material breach” of contract. This optimal performance standard implements efficient cooperative investment more often under a policy that, in addition, allows buyers to collect compensation for nondelivery of the good (upon rightful rejection) than a policy that limits buyers’ compensation to the recovery of the price. Although contracts with liquidated damages (i.e. a customized compensation function) can solve the investment problem as long as court enforcement is not too imperfect (in which case optimal liquidated damages are excessive and likely not enforced), the doctrine of material breach with an option to reject performs well as a default rule.