The economics of breach of contract

Antony Dnes, University of Hull
Put online February 2010

This text is extracted from The Economic Analysis of Law: An Introduction, one of the resources shared through the TRUE wiki for The Economic Analysis of Law. Available under a Creative Commons license, some rights reserved.

Economic efficiency is based on voluntary and informed trading, which is supported by a law of contract that enforces terms of trade and may plug gaps in agreements that would otherwise be too costly to cover. Contract law enables resources to be transferred to their most valuable uses, as people come to know what promises are enforceable and how enforcement may occur.

Suppose a company does not wish to complete a service it has promised to undertake. Should it be forced to perform? Both economics and law suggest that it is unnecessary to require specific performance, except in special cases. It is not the business of the law to force people to carry out tasks for which the economic justification may have disappeared, but only to ensure they compensate the 'victims' of breach. There can be such a thing as efficient breach of contract, when the party breaching is able to compensate the victim for non-performance. Compensation is usually defined by the courts: although some economists have argued that enforcing specific performance of the original contract would ensure that the would-be breaching party is forced to pay accurate compensation to obtain the victim's consent to breach.

In Tsakiroglou v. Noblee Thorl (1962), a company in the Sudan undertook to sell peanuts to a German firm on standard terms - in particular, at a price including insurance and freight. The Suez war erupted in 1956 and the company had claimed delivery was impossible. The buyer claimed delivery was just more expensive (around the Cape) and won compensation from the seller for the cost of arranging a new delivery. The case also draws attention to the insurance function of contracts.

The court concentrated upon the issue of whether performance was physically possible, which is not how an economist would examine the case. The economist sees a contract as an attempt to increase efficiency by allocating future contingencies between the parties: as performing an insurance function. In Tsakiroglou, it seems the seller was in the best position - at the time the contract was written - to cover the contingency of blockage of the canal. It is also relevant that the price included insurance and freight, suggesting these costs were the responsibility of the seller. Efficient contracts would indeed assign risks to those able to bear them at least cost.

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