The Moral-Hazard Effect of Liquidated Damages: An Experiment on Contract Remedies

Abstract

Recent evidence suggests that liquidated-damages clauses provide efficiencyadvantages by crowding out contracting parties' deontological concerns about efficient breach. In this paper we highlight an important downside to damage stipulations by parties. Based on findings obtained in a controlled laboratory experiment, we suggest that express damage stipulations trigger negative reciprocity and moral hazard, reducing performance by contract promisors. Such negative effects are absent when damages are exogenously imposed. Moreover, our results indicate that when stipulating damages, contract parties attain less cooperative surplus than when they are subject to an exogenously imposed remedy. Principals, not agents, bear this loss.