Strategic Interactions Regarding Contractual Penalties

Abstract

We review some thoughts on the value of liquidated damages and penalty clauses using a simple game-theoretic model to illustrate the strategic situation. In our model we develop a sequential game in which different types of sellers and buyers are matched randomly and have to decide either to ask for a penalty agreement or not and which level of diligence to take. Sellers differ in the amount of extra costs for higher levels of care and buyers differ in the potential loss they suffer from defective goods. We show that an increase in the achievable amount of penalty leads to more sellers providing high levels of care and to more buyers asking for such a clause whereas an increase in indemnities granted by court leads to more sellers providing high care anyway but to fewer buyer opting for a contractual penalty. These results provide the basis for criticism of current legal positions which are skeptical towards penalty clauses despite their risk-allocating and signaling properties.