The Economics of Liquidated Damage Clauses in Contractual Environments with Private Information

Journal of Law, Economics, and Organization, October 1992, 8(3)

Posted: 21 Feb 2014

See all articles by Lars Stole

Lars Stole

University of Chicago - Booth School of Business

Date Written: October 1, 1992

Abstract

This paper considers trading environments in which buyers are privately informed about their valuations and sellers are privately informed about the expected value of outside trading opportunities. Outside opportunities are stochastic, however, and future realized shocks may make bilateral trade between a buyer and a seller inefficient. In this environment, there is a role for using liquidated damage clauses as a screening device in optimal contracts, whether designed by the seller, designed by the buyer or designed by a third-party. In all such design settings, liquidated damages are set below the buyer's valuation. Excessive liquidated damage clauses are never optimal in this trading environment and may be a symptom of another contracting distortion or failure. These findings provide a partial rationalization for why courts may strike down liquidated damage clauses when they are excessive, but not when they are insufficient to compensate the harmed party.

Keywords: Contract theory, Incentives

JEL Classification: C70, D82

Suggested Citation

Stole, Lars A., The Economics of Liquidated Damage Clauses in Contractual Environments with Private Information (October 1, 1992). Journal of Law, Economics, and Organization, October 1992, 8(3). Available at SSRN: https://ssrn.com/abstract=2398477

Lars A. Stole (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-7309 (Phone)
773-702-0458 (Fax)

Here is the Coronavirus
related research on SSRN

Paper statistics

Abstract Views
511
PlumX Metrics