Expectation Damages, Divisible Contracts, and Bilateral Investment

This paper examines the efficiency of expectation damages as a breach remedy in a bilateral trade setting with renegotiation and relationship-specific investment by the buyer and the seller. As demonstrated by Edlin and Reichelstein (1996), no contract that specifies only a fixed quantity and a fixed per-unit price can induce efficient investment if marginal cost is constant and deterministic. We show that this result does not extend to more general payoff functions. If both parties face the risk of breaching, the first best becomes attainable with a simple price-quantity contract. (JEL: K12, D86, L14) Real-world contracts sometimes look surprisingly simple given the complexity of the environment. A production contract between a buyer and a seller might specify only ∗Bonn Graduate School of Econonomics, University of Bonn, Adenauerallee 24-26, 53113 Bonn, Germany; email: [email protected]. Many people have helped to improve the paper with their comments and suggestions. In particular, I would like to thank the two anonymous referees, as well as Urs Schweizer and Patrick Schmitz. I am also grateful to Bastian Goldlücke, Martin Hellwig, John Moore, Timofiy Mylovanov, Stefan Reichelstein, Andreas Roider, Alexander Stremitzer, and seminar audiences in Bonn. Support by Deutsche Forschungsgemeinschaft through SFB TR 15 is gratefully acknowledged.