Optimal Penalties in Contracts

29 Pages Posted: 12 Dec 2002

See all articles by Aaron S. Edlin

Aaron S. Edlin

University of California at Berkeley; National Bureau of Economic Research (NBER)

Alan Schwartz

Yale Law School


Contract law's liquidated damage rules prevent enforcement of contractual damage measures that require the promisor, if it breaches, to transfer to the promisee a sum that exceeds the net gain the promisee expected to make from performance; but these rules permit the promisor to transfer less than the promisee's expectation. We define a contractual damage multiplier as any number between zero and infinity by which the promisee's expected gain - its expectation interest - is multiplied. Multipliers of one or less thus comply with the liquidated damage rules while multipliers that exceed one do not; the high multipliers are unenforceable penalties. This paper shows that multipliers of any size can be efficient or inefficient, depending on the parties' purposes in creating them. For example, a multiplier that exceeds one will decrease welfare if used by a seller with market power to deter entry, but will increase welfare if used by parties to induce efficient relation specific investment. As a consequence, a court should inquire, not into the size of the multiplier, but into the purpose the multiplier serves for the parties. The practical implication of this view is that it no longer should be a sufficient defense to an action to enforce a contractual damage measure that the parties' multiplier exceeded one.

Suggested Citation

Edlin, Aaron S. and Schwartz, Alan, Optimal Penalties in Contracts. Chicago-Kent Law Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=354781 or http://dx.doi.org/10.2139/ssrn.354781

Aaron S. Edlin

University of California at Berkeley ( email )

Dept of Economics 549 Evans Hall #3880
Berkeley, CA 94720
United States
510-642-4719 (Phone)
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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Alan Schwartz (Contact Author)

Yale Law School ( email )

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New Haven, CT 06520-8215
United States
203-432-4030 (Phone)
203-432-8260 (Fax)

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