Market Damages, Efficient Contracting and the Economic Waste Fallacy

 is the title of a new paper by Alan Schwartz and Robert E. Scott (Columbia) posted on SSRN.  Here's the paper and here's the abstract:

Market damages - the difference between the market price for goods or services at the time of breach and the contract price - are the best default rule whenever parties trade in thick markets: they induce parties to contract efficiently and to trade if and only if trade is efficient, and they do not create ex ante inefficiencies. Courts commonly overlook these virtues, however, when promisors offer a set of services some of which are not separately priced. For example, a promisor may agree to pay royalties on a mining lease and later to restore the promisee's property. In these cases, courts compare the cost to the promisor of providing the service that was not supplied to the increase in the market value of the promisee/buyer's property had the promisor/seller performed. When the cost of completion is large relative to the "market delta"- the increase in market value - courts concerned to avoid "economic waste" limit the buyer to the market value increase. This concern is misguided. Since the buyer commonly prepays for the service at the ex ante market price, a cost of completion award actually has a restitution element - the prepaid price - and an expectation interest element - the market damages. The failure to recognize the joint nature of cost of completion damages causes courts to deny these damages more frequently than they should. In this paper, we argue that the unappreciated virtues of market based damages justify removing the courts' discretion to deny them no matter how high they appear to be. The rule that denies buyers market damages induces excessive entry into these service markets. Moreover, buyers are under-compensated when they prepay and cannot recover the price paid for the breached services but instead are restricted to the market delta. As a result, too few buyers contract ex ante for the relevant service and surplus maximizing contracts are forgone. Finally, sellers often can take actions in the interim between making the contract and the time for performance of the service that would reduce the service cost to manageable proportions. Sellers are less likely to take these precautions if they are required to pay buyers only the market delta rather than the full performance cost that their actions could have avoided.

 

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