Money damages is by far the most common form of court-imposed remedy for breach, but in cases where money damages are thought to provide inade- quate compensation—generally, contracts involving land or “unique goods” —the court will order specific performance. That is, the court will order the promisor to perform the contract as written. The attractiveness of specific performance in these cases is apparent, but, given the centrality of efficient breach to the economic theory of contract law, one might suppose that econ- omists would support its limited use, fearing excessive performance. To the contrary, some economists have argued for the wider use of the remedy.20This
section lays out the economic arguments in favor of specific performance over money damages in the context of the efficient breach model.
The first point to emphasize is that specific performance is not inconsistent with efficient breach of contract. Consider a contract for the sale of a parcel of land for $50,000. Suppose that the buyer values the land at $60,000, but before closing, another buyer arrives and offers $65,000. It is efficient for the second buyer to acquire the land because she is the highest valuer, and this outcome will be achieved under expectation damages. Specifically, the seller will breach the contract with the first buyer, pay damages of $10,000 (! $60,000 " $50,000), then sell to the second buyer for $65,000, producing a net gain of $5,000 for the seller.
What will happen under specific performance? First, the court will order the seller to honor his promise to sell to the first buyer. Then, one of two things will happen. If the first buyer is aware of the second offer, she will likely enforce the original sale, but then resell to the second buyer for a net gain of $5,000. If she is not aware of the offer, the seller will offer some amount of money greater than $10,000 (the first buyer’s surplus) and less than $15,000 (the premium above the original price offered by the second buyer) to cancel the contract. The first buyer will accept, and the seller will then sell the land to the second buyer.
scenarios; the only difference is how it is achieved. Under expectation dam- ages, the court sets the price that the seller must pay to breach the original deal; the original buyer can only accept the damages. In contrast, specific per- formance allows the original buyer to participate in setting the terms of the breach, either by enforcing the original deal and reselling, or by bargaining with the seller over the price of a “buyout.” In general, it will always be true (according to the Coase Theorem) that when breach is efficient, bargaining between the original contractors can yield the same result. This basic insight is the starting point for our evaluation of specific performance.
EXERCISE5.2
Return to the construction contract from Exercise 5.1 where
V ! $100,000 P ! $75,000
Suppose the builder’s cost of production turns out to be $125,000. De- scribe the bargaining between the buyer and the builder under a specific performance remedy. Will performance occur?
2.1 Transaction Costs
One criticism of specific performance is that transaction costs might inhibit the sort of renegotiation that needs to take place to achieve the efficient dis- position of the contract. Such costs are not required under money damages because the court sets the terms of breach. But in their place are the litigation costs involved in court determination of the correct amount of damages. As- suming that both methods (money damages and specific performance) reach the efficient outcome (an assumption that we question below), the choice de- pends on a comparison of these costs.
Let’s tally the likely transaction costs under the two remedies to see which is lower. If the above transaction for sale of land is governed by a damage remedy, a breach by the seller will entail two further “transactions”: (1) liti- gation over damages owed to the first buyer, and (2) resale to the second buyer. Although the transaction costs of resale are probably low, the costs in- volved in determining damages for the first buyer may be quite high. Recall that it requires measurement of the value of performance, which is the buyer’s private information and is therefore subject to misrepresentation. (See the discussion of the Peevyhouse case below.) Measuring it accurately could be a difficult factual inquiry.
the land to the second buyer: (1) a court proceeding, initiated by the first buyer, to enforce the contract, followed by (2) the sale from the original buyer to the new buyer. There seems no good reason to believe that the transaction costs of resale will be any higher in this case, but there is reason to think that the litigation costs will be lower under specific performance because of the absence of factual issues. (It is the same argument that we used to claim that litigation costs would be lower per case under strict liability compared to neg- ligence in torts.) Further, the seller may be less inclined to breach in the first place under specific performance because he expects to realize no gains from doing so, whereas he realizes all of the gains from breach under expectation damages (see Section 2.3 below). In this case, the litigation costs involved in enforcement are replaced by the transaction costs of the original sale, almost certainly a savings.
What if breach involves nonperformance, as in the production cost model? In this case, there is no resale following breach; there is only the litigation costs of determining the amount of damages under a damage remedy com- pared to the negotiation of a buyout price under specific performance (plus the enforcement costs, if any) (see Exercise 5.2 above). While the compari- son is an empirical question, one supposes that the costs of renegotiation will generally be low because the parties have already demonstrated the ability to bargain with one another when they first negotiated the contract.
2.2 Subjective Value and Efficient Breach
The preceding discussion focused on the transaction costs of money dam- ages compared to specific performance while assuming that efficient breach would occur under both remedies. But there is reason to believe that in some cases specific performance will also result in more efficient breach deci- sions. This point is best made in the context of the well-known case Peevy-
house v. Garland Coal & Mining Co. (382 P.2d 109, cert. denied, 375 U.S.
906, Okla. 1962).
This case concerned a contract between the Peevyhouses, owners of a farm containing coal deposits, and a mining company. The contract allowed the mining company to conduct a strip mining operation for a period of five years, after which it was required to perform “certain restorative and reme- dial work . . . at a cost estimated by expert witnesses at about $29,000.” When the mining company failed to repair the land, the Peevyhouses sued for dam- ages. At trial, the mining company admitted to having breached the contract, arguing that the cost of performance was substantially larger than the mere $300 reduction in the market value of the farm resulting from the failure to do the repairs. The court agreed and awarded the Peevyhouses $300 in damages. According to our efficient breach model, breach appears to have been the efficient outcome in this case since the cost of performance, $29,000, far ex-
ceeded the value of performance, $300. And, by setting damages equal to the value of performance, the court established the correct incentives. So what’s wrong with this decision?
The problem is that the measure of damages is based on the market value of the repairs rather than the value to the Peevyhouses. To see the difference, note that market value measures the maximum amount that someone would
offer for a piece of property, while the value to the owner is the minimum
amount he or she would accept. You often hear the expression that “everyone has their price.” The value to the owner is that price, and the owner will only sell when the market value is greater. Refusal to sell is therefore a signal that the owner’s value exceeds the market value. This difference is sometimes re- ferred to as the owner’s subjective value.21
It seems likely that in this case the Peevyhouses attached a significant sub- jective value to repairs. (Some evidence is that this case was an appeal of an earlier damage award of $5,000.) What does that have to do with efficient breach? The answer is that economic exchange, voluntary or involuntary, should respect subjective value. The whole point of voluntary exchange is that owners are free to turn down offers that they find unacceptable for any
reason. And since market exchange is the paradigm for efficient breach (an
involuntary exchange), remedies for breach should account for subjective value. If they do not, there will be too many breaches.
To illustrate, suppose that the true value of performance to a promisee is
V, which is greater than the market value of M. If the court sets damages equal
to M, then promisors will breach when C ! M rather than when C ! V. Thus, inefficient breach will occur over the range where M " C " V.
The argument to this point suggests that the problem of excessive breach can be solved by setting damages equal to V rather than M. How is this an ar- gument for specific performance? The problem with setting damages equal to
V is that subjective value is unobservable to the court. Further, the court can-
not simply ask the Peevyhouses how much they value performance because they would have an incentive to overstate it. Specific performance overcomes this problem by placing the breach decision back in the hands of the parties where they will resolve it through negotiation (assuming that bargaining costs are low). If the cost of performance is truly greater than V, then the mining company will be able to offer an amount between V and $29,000 to breach the contract, and both parties will be better off (recall Exercise 5.2). In contrast, if
V exceeds the cost of performance, then performance will occur, as it should.
2.3 The Value of Consent
The final argument in favor of specific performance is not based on efficiency but instead on fairness. Return to the above example of a contract for the sale of land from seller S to buyer B1 for a price of $50,000. Before closing,
TABLE5.2 Money Damages Compared to Specific Performance
Remedy S’s return B1’s return Joint return
Damages $65,000 ! $10,000 ! $50,000 " $5,000 $0 $5,000
Specific performance $0 $65,000 ! $60,000 " $5,000 $5,000
buyer B2 arrives and offers $65,000, which exceeds B1’s value of $60,000. Table 5.2 summarizes the returns to S and B1 under money damages and spe- cific performance. First, under money damages, S breaches the contract with B1, pays damages of $10,000 (assuming that the court can observe V ), and then sells to B2 for $65,000. S thus receives a net gain of $5,000 compared to the original contract with B1. B1, in contrast, receives a net gain of zero; she is no better or worse off as a result of the breach. In this case, S receives all of the gains from the arrival of the second buyer.22
Now consider specific performance. If B1 knows about B2’s offer, she will enforce the original contract and resell to B2 herself. In this case, B1 receives the gain of $5,000, while S receives no gain. Both remedies therefore achieve the efficient outcome, but differ in the distribution of the net gains. The ad- vantage of specific performance is that it does not allow S to benefit from his breach, which is a legal wrong. This sentiment is expressed by the dissenting judge in the Peevyhouse case, who argued for specific performance because damages “would be taking from the plaintiffs the benefits of the contract and placing those benefits in defendant which has failed to perform its obligations.” Let us consider the difference between the two remedies further. Buyer B1 receives no gain under money damages because she cannot object to the breach; she can merely sue for expectation damages. Thus, she cannot obtain any portion of the $5,000 net gain created by B2’s arrival. In contrast, she obtains all of the gain under specific performance because she has the right to enforce the original contract; the seller must obtain B1’s consent before breaching. In this example, the $5,000 net gain represents the “value of con- sent” to B1.
More generally, the value of consent will depend on the bargaining abili- ties of the parties. For example, suppose that the value of performance to the Peevyhouses is $15,000. If the court employs specific performance, the mining company must obtain the Peevyhouse’s consent to breach. Thus, de- pending on the bargaining abilities of the parties, it will pay a price between $29,000, the cost of performance, and $15,000, the value of performance. If they split the difference, then the mining company will pay the Peevyhouses $15,000 # $7,000 " $22,000. In contrast, the mining company will only have to pay $15,000 under money damages (assuming again that V is observ- able). Thus, $7,000 is value of consent in this case.
shall see in the next chapter, it is central to the fundamental problem of de- signing an efficient framework for exchanging legal entitlements.