Market Damages, Efficient Contracting, and the Economic Waste Fallacy
Market damages are the best default rule when parties trade in thick markets: They induce parties to contract efficiently and to trade if and only if trade is efficient, and they do not create ex ante inefficiencies. Courts commonly overlook these virtues, however, when promisors bundle services that are not separately priced. For example, a promisor may agree to pay royalties on a mining lease and later to restore the promisee's property. When the cost of completion is large relative to the "market delta" -- the increase in market value -- courts concerned with avoiding "economic waste" limit the buyer to the market value increase. This concern is misguided. Since the buyer commonly prepays for the service, a cost-of-completion award actually has a restitution element -- the prepaid price -- and an expectation interest element -- the market damages. Courts fail to see the restitution issue and thus deny these damages more frequently than they should. We argue first that the rule denying buyers market damages induces excessive entry into these service markets. Second, buyers are undercompensated when they prepay and cannot recover the price paid for the breached services. Finally, sellers often can take actions in the interim between making the contract and the time for performance of the service that would reduce the service cost to manageable proportions. Sellers are less likely to take these precautions if they are required to pay buyers only the market delta, rather than the full performance cost that their actions could have avoided.
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- December 18, 2015