Contract Law: Efficient Breach

Efficient breach theory holds that a party should be allowed to breach a contract and pay damages if  breach would be more economically efficient than performance. This theory stems from the law-and-economics movement. Black’s Law Dictionary 9th Ed.

The most well known analysis of the theory of efficient breach is in Richard Posner’s book, Economic Analysis of the Law. In his book, Posner outlines the following scenario known as the Overbidder Paradigm.

“Suppose I sign a contract to deliver 100,000 custom-ground widgets at $.10 apiece to A, for use in his boiler factory. After I have delivered 10,000, B comes to me, explains that he desperately needs 25,000 custom-ground widgets at once since otherwise he will be forced to close his pianola factory at great cost, and offers me $.15 apiece for 25,000 widgets. I sell him the widgets and as a result do not complete timely delivery to A, who sustains $1000 in damages from my breach. Having obtained an additional profit of $1250 on the sale to B, I am better off even after reimbursing A for his loss. Society is also better off. Since B was willing to pay me $.15 per widget, it must mean that each widget was worth at least $.15 to him. But it was worth only $.14 to A – $.10, what he paid, plus $.04 ($1000 divided by 25,000), his expected profit. Thus the breach resulted in a transfer of the 25,000 widgets from a lower valued to a higher valued use.”

Basically if another party comes along and offers a higher enough value for each widget than the original party did, it will be in the sellers best interest to deliver those widgets to the highest bidder and pay damages to the original buyer. In the above situation, all parties will be better off (or the same) as a result of the breach.

As with any good economic model, we must make the following assumptions:

• The original buyer is indifferent between performance and damages
• The seller knows the value of the widgets to promisee before breach
• There are no court costs, attorney fees, or transaction costs

In conclusion, the theory of efficient breach is, in fact, inefficient for three reasons:

1. Both parties would search for an overbidder, in hopes of creating an efficient breach situation
2. Reduction in the rewards for planning and investing
3. Weaken one of the three legs of the contracting system, which are legal remedies, reputational constraints, and the internalization of moral norms. These three legs exist in a symbiotic relationship, in that legal rules rely on social norms, reputation effects rely on social norms, and moral norms are reinforced by both legal rules and reputational effects.

While the efficient breach theory can exist in certain isolated scenarios, it would be unsustainable if adopted by society as a whole.

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Tags: Contracts, Law School

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