Abstract:

According to the contract law principle established in the famous nineteenth century English case of Hadley v. Baxendale, and followed ever since in the common law world, liability for a breach of contract is limited to losses "arising ... according to the usual course of things," or that may be reasonably supposed "to have been in the contemplation of both parties, at the time they made the contract, ..." Using a formal model, we attempt in this paper to analyze systematically the effects and the social desirability of this limitation on contract damages. We study two alternative rules: the limited liability rule of Hadley, and an unlimited liability rule. Our analysis focuses on the effects of the alternative rules on two types of decisions: buyers' decisions about communicating their valuations of performance to sellers; and sellers' decisions about their level of precautions to reduce the likelihood of nonperformance. We identify the socially desirable behavior of buyers and sellers. We then compare this socially optimal behavior with the decisions that buyers and sellers in fact make under the limited and unlimited liability rules. This analysis enables us to provide a full characterization of the conditions under which each of the rules induces, or fails to induce, socially desirable behavior, as well as the conditions under which each of the rules is superior to the other.