Material Breach of Contract and Rejection with Imperfect Expectation Damages

Abstract:     
An extensive theoretical literature on the efficiency properties of breach remedies, in particular, expectation damages, assumes that these remedies are perfect and exclusive. However, it has been widely accepted that in practice expectation damages are under-compensatory, and victims of breach are often given the choice between different breach remedies. In this article, I study a seller's incentive to breach a contract when expectation damages are under-compensatory, i.e., imperfect, and the buyer can reject a defective delivery by the seller. I argue that the buyer's right of rejection, elsewhere critized for giving rise to opportunistic behavior, corrects for a distortive effect of under-compensatory expectation damages. Moreover, I show that restricting the buyer's right of rejection to sufficiently defective deliveries is necessary for welfare maximization as long as the buyer is allowed to collect damages for rejected deliveries.

Number of Pages in PDF File: 36

Keywords: efficient breach of contract, expectation damages, material breach, rejection, restitution damages, substantial impairment, under-compensation

JEL Classification: D23, D86, K12

working papers series