The John M. Olin Center

Paper Abstract

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24. Yuval Procaccia, Information Acquisition and Damages for Breach of Contract: An Economics Analysis, 9/2008.

Abstract: An early, but crucial decision one often makes in a contractual setting is whether to undertake an obligation, although the ultimate cost of performing it is yet uncertain. Two options present themselves in such a context: one is to assume the commitment nevertheless, knowing that with some probability it would engender a loss; another is to acquire information, and then proceed to contract only if the commitment is indeed advantageous. This paper examines the socially optimal choice in that regard, and compares it to the privately optimal choice, derived as a function of the legal consequence of breach. It is initially shown that the party’s private incentive to invest in information essentially always departs from the social optimum. If the acquired information is observed by his counterpart, then his incentive to acquire it will be too weak regardless of the applicable damage measure; and if he can withhold the information from his counterpart, his incentive to acquire it will generally be excessive under the expectation measure, but might also remain inadequate under measures of lesser magnitude.

It is further shown that parties will often fail to select the welfare-maximizing measure, even though they are rational by assumption, and act under complete freedom of contract. Moreover, in some cases, the very capacity to alleviate uncertainty will generate a welfare loss, relative to a setting in which there is no such capacity. The source of these failures is rooted in strategic behavior, which is endemic to the information-gathering process (and therefore does not appear in models where uncertainty is exogenous.) The paper identifies these failures and characterizes their overall impact. In a limited set of cases, it is shown that the parties may overcome them by entering into a "hands-tying" agreement, in which they commit to select a particular measure in a future contract. The proposed solution is argued to have theoretical appeal, albeit only limited practical viability.