THE ECONOMICS OF CONTRACT
In a world of perfect certainty and costless contracting, the parties to a contract will specify as part of the contract the manner in which they will react to all possible contingencies. That is, they will write fully contingent contracts. In reality, however, the parties will not be able to provide for all contingencies. Thus, there will occasionally arise circumstances in which one of the parties no longer values performance of the contract under the original terms. In this case, a dispute arises. Contract law provides rules for resolving disputes over nonperformance (or modified performance) that the parties are not able to resolve on their own. The two basic questions contract law addresses are: What contracts should be enforceable? and, What should be the remedies available to victims of broken but enforceable promises? ( Cooter and Ulen, 1988, p. 213).
In this chapter, I focus on the second question by examining remedies for breach of contract. I begin by analyzing the impact that various court-imposed damage measures have on the breach decision, the decision of how much the parties invest in transaction-specific assets (i.e., "reliance"), and risk sharing. Although efficient breach requires that "victims" of breach receive full compensation for their expected gain from the contract (their expectation interest), other considerations argue for limiting damages in particular ways. For example, I show that the latter provide economic justifications for the famous Hadley v. Baxendale rule.
I next turn to the question of whether courts should enforce liquidated damages specified by the parties as part of the contract. The refusal of courts to enforce contract terms that both parties agreed to at first seems puzzling, but I will suggest reasons why it may sometimes be efficient to do so. Finally, I examine the merits of specific performance, or enforcement of the contract as written, as an alternative to money damages.