Expectation Damages and the Theory of Overreliance

Abstract:     
The basic remedy for breach of a bargain contract is expectation damages, which puts the injured party where she would have been had the contract been performed. It is generally accepted that the expectation measure provides efficient incentives to a bargain-promisor. Beginning about twenty years ago, however, law-and-economics scholars developed a model of damages which showed that the expectation measure can provide inefficient incentives to a bargain-promisee. The theory is that the expectation measure insures the promisee's reliance, and may thereby cause the promisee to overrely - that is, to invest more heavily in reliance than efficiency requires. The theory of overreliance is not limited in its application to the expectation measure, but it is most salient to that measure, just because the expectation measure is the gold standard in a bargain context.

The model upon which the theory of overreliance is based provides an extremely important insight into damages. As time went on, however, law-and-economics scholars started to lose sight of the fact that the model was just that, a model, and began to widely assume, explicitly or implicitly, that the expectation measure not only can but does provide inefficient incentives to promisees. The objective of this Article is to rehabilitate the expectation measure of damages, by showing that when institutional considerations are taken into account the theory of overreliance has virtually no real-world application. In the great majority of cases, overreliance normally cannot occur, because of the way in which the expectation measure is applied in specific contexts, because of the economics of transactions, or both. Overreliance is also unlikely to occur even in most of the residual cases, because as a result of litigation risks and litigation costs the standard expectation measure does not insure the promisee's reliance. There are a few remaining real-world cases in which overreliance might occur. In principle, the standard expectation measure could be modified to prevent overreliance in those few cases. However, the benefits of such a modification would be very low, partly because overreliance is so unlikely occur, and partly because where overreliance does occur it is likely to involve only small, marginal increments. In contrast, the costs of a modified expectation measure would be very high, because of the direct costs that would be entailed in applying the theory of overreliance to actual cases, and the indirect effect of those costs on the behavior of contracting parties.

Working Paper Series