Timing Problems in Contract Breach Decisions

Under a regime of expectation damages, each party has the option to breach and pay damages, rather than incur the cost of performance. This paper concerns the timing of breach or repudiation. The benefit to the repudiating party from early repudiation is the decrease in damages liability due to the prospective mitigation activity of the nonrepudiating party. The loss is the sum of the expected value of the contracted exchange and the value of the option to breach in the future. Where efficient breach is meaningful (i.e. the cost of performance to the promisor is not correlated with the value of performance to the promissee), repudiation is the contract analog to the decision of a single firm to abandon a project. We show that, because the abandonment decision is split between two parties when the project is exploited by contract rather than in an integrated firm, each party may have the incentive to repudiate too early, which causes the premature abandonment of their project. This results from the fact that expectation damages compensate the nonrepudiating party only for the loss of the completed exchange and not the value of its lost breach option. This problem is particularly acute in long term, fixed price contracts in which the cost of performance to the promisor and the value to the promisee are volatile and uncorrelated. We explore various responses to this problem including vertical integration, changes in contract remedies (including specific performance), flexible price provisions and the capital structure of each party