Regulating Damage Clauses in (Labor) Contracts
31 Pages Posted: 27 Oct 2006
Date Written: October 2006
We analyze the role of damage clauses in labor contracts using a model in which a worker may want to terminate his current employment relationship and work for another firm. We show that the initial parties to a contract have an incentive to stipulate excessive damage clauses, which leads to ex post inefficiencies. This result is due to rent seeking motives a) between the contracting parties vis-à-vis third parties and b) among the contracting parties themselves. We then show that, by imposing an upper bound on the amount of enforceable damages, a regulator can induce a Pareto improvement; in some cases even the first best can be achieved.
Keywords: damage clauses, penalty doctrine, breach of contract, asymmetric information, labor contracts
JEL Classification: K12, K31, M12
Suggested Citation: Suggested Citation