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On the Efficiency of Privately Stipulated Damages for Breach of Contract: Entry Barriers, Reliance, and Renegotiation

Kathryn E. Spier and Michael D. Whinston
The RAND Journal of Economics
Vol. 26, No. 2 (Summer, 1995), pp. 180-202
Published by: Wiley on behalf of RAND Corporation
Stable URL: http://www.jstor.org/stable/2555912
Page Count: 23
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Since scans are not currently available to screen readers, please contact JSTOR User Support for access. We'll provide a PDF copy for your screen reader.
On the Efficiency of Privately Stipulated Damages for Breach of Contract: Entry Barriers, Reliance, and Renegotiation
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Abstract

Two roles for stipulated damage provisions have been debated in the literature: protecting relationship-specific investments and inefficiently excluding competitors. Aghion and Bolton (1987) formally demonstrate the latter effect in a model without investment or renegotiation. Although introducing renegotiation alone destroys their result, introducing both renegotiation and investment restores it. In particular, if the entrant has market power and the seller's cost of production is observable but not verifiable, then privately stipulated damages are set at a socially excessive level to facilitate the extraction of the entrant's surplus. In contrast, if the entrant prices competitively (as typically is assumed in the law and economics literature on breach), then private stipulation is efficient. Whereas a simple legal restriction on the contract corrects for any inefficiency, standard court-imposed remedies do not.

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