Do Liquidated Damages Encourage Efficient Breach? A Psychological Experiment

Abstract:     
This paper offers experimental evidence that parties are more willing to exploit efficient breach opportunities when the contract in question includes a liquidated damages clause. The moral obligations entailed by a contractual promise implicate unusually robust moral intuitions, which may deter parties from breaching even when there is an economic incentive to do so. However, those intuitions are not immutable. Decision researchers have found experimental evidence that, when social norms are in conflict with efficiency incentives, a more explicit incentive structure leads to more self-interested behavior. Liquidated damages are a means of making the sanction for breach explicit within a contract. The hypothesis of this research is that parties will be less resistant to breaching a contract that includes a liquidated damages clause. In a series of web-based questionnaires, subjects read contracts scenarios involving efficient breach opportunities. Subjects were asked to imagine themselves in the position of the promisor, and to indicate in each case the lowest offer that they would accept (from a hypothetical third-party offeror) to breach each contract. Subjects were randomly assigned to read either that their contract had a liquidated damages clause specifying damages for breach, or they were assigned to read an identical scenario in which the same damages were said to be "required by the law of contracts." Subjects in the liquidated damages condition gave much lower willingness-to-accept responses; they were willing to breach for less money. This was true even when the liquidated damages clause included a slight penalty on top of the promisee's expected loss. I argue that a liquidated damages clause clarifies the respective normative expectations of the parties, permitting efficient breach without repudiation of the mutual understanding.

Keywords: contracts, damages, moral intuitions, behavioral economics

JEL Classifications: K12

Accepted Paper Series