Private Information and the Option to Not Sue: A Reevaluation of Contract Remedies

Abstract

In this paper we study contracts with two-sided incomplete information. Prior literature on contract remedies does not formally account for the non-breaching party's option to not sue for damages upon breach, when her expected payoff from suing is negative, given the contractual terms and her private information about her post breach loss. With this option incorporated into the analysis, we show that: First, courts should commit to awarding fixed damages, because awarding flexible damages based on ex post information will distort the incentives to breach. This result is not driven by the information forcing effect of basing damages on ex ante expectations, ̀ la Hadley vs. Baxendale. Second, the option of acquiescing to the breach expands the breach set under specific performance, which can be more efficient than other remedies. Third, the efficiency advantage of ex ante expectation damages over ex post actual damages is further enhanced when we account for the possibility of renegotiation. The main results are robust when we account for verification cost of plaintiff's damages and for parties' litigation cost.