The party to a potential contract makes a contract decision when it decides whether or not to enter into a proprosed contract now. An offer that seems lucra-tive now might lead to a counterproduclucra-tive, even disastrous, contract if the party’s circumstances or the market situation adversely change before the contract is to be performed. The higher the required level of commitment (the higher the de-commitment fee) and the higher the probability of such adverse changes occuring, the less inclined a rational agent should be to enter into a contract in the first place. From the society’s point of view, very risky, high cost contracts may well be inadvisable.32
To this end, Smith (2004) has argued that in relation to the contract decision the expectation damages are sometimes too high. Instead, reliance damages that include the foregone profits of other possible contracts (the profit that could have been achieved outside this particular contract) would cover the other party suf-ficiently (ensuring non-negative profit) and sometimes facilitate contracts that
31In case the Expectation Damages policy is used, he is even indifferent between the case in which the buyer wants the service and the case where he does not.
32Of course in some cases such contracts or projects might be in the society’s interest, if the payoffs for success are sufficently large. For example, trying to build the world’s first fusion reactor is going to take a long time and cost a huge amount of money and other resources even in the most optimistic scenarios. And still, the success is far from certain. But, on the other hand, a clean, almost unlimited source of energy would obviously be very useful for any society.
Given the costs and risks involved, some major governments (including European Union, USA and Russia) have decided to cooperate in a joint project in this area, see http://www.iter.org/.
would not be possible if full expectation damages were offered (Fuller and Pur-due 1936).33However, in an efficient market, the difference between the two is very small or even non-existent because in such a setting, there would be many providers selling a similar product for a similar price. Therefore by taking on one provider, the buyer has in effect lost an opportunity to make a very similar profit with some other provider. Therefore the loss is roughly equal to cost + profit (i.e.
the expectation damages). However, in a situation with fewer outside opportuni-ties, the second-best option can be much worse, in the extreme case, it might be zero (if there are no viable alternatives). This might happen, for example, if the provider has a lot of spare capacity that he would not have any use for outside this one particular contract.34 Compensating the expectation damages automatically does keep the seller’s risk to a minimum (any contract that will have a positive utility in case of success will have that also in case of the buyer failure) but it will also mean that sometimes the buyers will not enter into a contract even if it was in the seller’s and in the society’s interest. In other words, a potential buyer might in some cases be dissuaded from using the service if, in case of decommitment, he would have to pay for the seller’s profits that the seller would never have had a chance to get without the buyer in question.
A numerical example might better illustrate Smith’s idea. So, assume that the cost of providing a service, which has to be paid immediately, is 5, the price of the service is 7 (due to the low season) and the value of the service to the buyer is 13, and the probability of the buyer needing to decommit is 50%. Now, the buyer’s expected utility in the cases with reliance and expectation damages would be:
EUb(contract | reliance damages) = 0.5(13 − 7) + 0.5(−5) = 0.5 EUb(contract | expectation damages) = 0.5(13 − 7) + 0.5(−7) = −0.5
and for the seller:
33Smith’s proposition means compensating so called opportunity cost (or best alternative to negotiation agreement, BATNA) instead of expectation damages where the profit compensated is the one the victim expected to make from the existing contract. The legal rules are mostly interested in the performance decision and ignore these other decisions. Legally, entering into a contract means accepting a liability for the opponent’s reasonable profits from the contract also in case of non-performance. This holds also when substitute contracts are used. This has nothing to do with the opportunity cost.
34This might be for example because his business is very seasonal and outside the season there is very little demand.
EUs(contract | reliance damages) = 0.5(7 − 5) + 0.5 ∗ 0 = 1.0 EUs(contract | expectation damages) = 0.5(7 − 5) + 0.5 ∗ 2 = 2.0
So the seller would want this contract to happen. If we assume that the value of the buyer’s outside option is zero, he will choose to enter the contract when the reliance damages policy is used, but not enter into a contract when the expectation damages policy is used.35 For the society, the benefit of the contract would be in both cases 0.5(v − c) + 0.5(−c) = 0.5(13 − 5) + 0.5(−5) = 1.5 and therefore the contract would be also in the society’s interest.
However, this is not the whole story. It misses the important point that the contract price is a major risk allocation tool and if the decommitment policy is clear and all the relevant risks are known by both parties in advance, the parties can use the price to find a mutually acceptable balance of profits and risks with almost any policy (Goetz and Scott (1980)). To see how this works in practice consider the buyer in the numerical case above. In cases where the expectation damages policy is in use, he is unwilling to enter into a contract because the risk of decommitment and the fee are too high. Now, for the seller the high decommitment cost is a good thing: It increases his expected utility from 1.0 to 2.0 and, therefore, he may well be willing to offer a lower price. This lower price, in turn, increases the utility of the potential contract to the buyer and makes it more lucrative. So, in the numerical example above, under the expectation damages policy, the seller might offer a price 6 for a buyer that is unwilling to go for it with the price of 7. This would make the expected utility for the buyer equal to 0.5 · (13 − 6) + 0.5 · (−6) = 0.5, which would be enough to persuade the buyer to enter into the contract. The contract price can be used very efficiently in this way.
However, sometimes this mechanism is unable to find a good balance and sub-optimal contracts might be entered into or parties might not be able to agree on a price although a mutually acceptable price exists. For the price mechanism to work properly, the parties must be able to assess relatively accurately the probabilities that they or their opponent will perform. If no such information is available,
35Of course the buyer would be even more willing to get into these contracts if, for example, the fee would be zero and also the society might be better served in some lower level of damages, because there might be cases where a contract could be reached with a lower level of compensation when it is not possible with reliance damages. For example, if the probability of failure is 60%
instead of 50, the buyer would not enter under reliance damages (expected utility −0.6) but a compensation level of four would make the buyer indifferent between entering into the contract or not and the society would still benefit, its benefit from this would be 0.2. However, here, Smith seems to think that covering the ‘victim’s’ costs (ensuring him non-negative utility) is fair under the circumstances.
it may be impossible to find an optimal contract price. Also the probability of performance in many situations depends on the fee (the higher the fee the more probable the performance), which may make this assessment more difficult if the fee varies. We will investigate this price adjustion mechanism and what it means when we have none, one or both parties using it in different settings.
We will concentrate our efforts in this work (in chapter 6) in investigating this price adaptation to different decommitment policies. We will use different decom-mitment policies and allow none, one or both parties to take the risks of later decommitments into account and see how that affects the common good.