Two-Sided Informational Asymmetry, Bilateral Selfish Investment, Simple Incomplete Contract and the Legal Remedies

Abstract

In this paper, a setting of bilateral selfish reliance investments and post contractual two-sided asymmetric information is explored. Since the pioneering work of Rogerson (1992) and Hermalin-Katz (1993), it is by now well known that the comprehensive contracts can implement the first best even if the parties' valuations are private information and reliance investments are of selfish types (with quasi-linear utilities). However, surprisingly real world contracts seem to be rather simple. Most often parties come up with fixed-price incomplete contracts which are generally renegotiated later (if not prohibited by court). Hence, it is an interesting to analyse whether breach remedies can introduce the first best in this set-up. Some interestingly results are obtained: Both the parties tend to over-invest both under Reliance damage and Restitution (i.e. no-damage) damage remedies. Courts usually adopt two disctinct methods - subjective and objective valuation - to establish breach - victim's expectation interest under asymmetric information. I conclude that the performance of expectation damages falls short of what party-designed liquidated damage could achieve; however, first best is generally not achievable.