Risk Sharing through Breach of Contract Remedies

Abstract

This paper examines the sharing of risk under three different remedies for breach of contract. The risk considered arises from the possibility that, after a seller and buyer have entered into an agreement for the exchange of some (not generally available) good, a third party who values the good more than the original buyer may come along before delivery has occurred; the seller will want to breach. It is shown that this risk is optimally allocated by the expectation remedy if the seller is risk neutral and the buyer is risk averse, by the specific performance remedy if the opposite is true, and by a liquidated remedy if both parties are risk averse. The level of damages under the liquidated remedy is also shown to be bounded by the expectation measure of damages and a damage equivalent to the specific performance remedy. By means of a numerical example, it is shown that use of the prevailing remedy for breach of contract -- the expectation remedy -- may plausibly cause a welfare loss of as much as 20% due to inappropriate risk sharing.