On Breach Remedies: Contracting with Bilateral Selfish Investment and Two-sided Private Information
Abstract: In this paper, a setting of bilateral selfish reliance investments and post contractual two-sided asymmetric information is explored. Since the pioneering work of Rogerson (1992) and Hermalin-Katz (1993), it is by now well known that comprehensive contracts can implement the first best even if the parties' valuations are private information and reliance investments are of selfish types (with quasi-linear utilities). However, real world contracts seem to be rather simple - fixed-price incomplete contracts which are sometimes renegotiated later. Hence, it is of interest to analyse whether breach remedies can introduce the first best in this set-up. Paper tries to fill this gap in the literature. Some interesting results are obtained: both the parties tend to over-invest under Restitution (i.e. no-damage) which is contrary to the conventional literature on hold up, also under Reliance damage. Further analysis of the Subjective Valuation and the Objective Valuation (Expected Expectation Damage) - two Court adopted methods of establishing a breach-victim's expectation interest under asymmetric information - shows that Expected Expectation damage is superior to the others but still falls short of what party-designed liquidated damage could achieve. Analysis also shows that it may be of the parties mutual interest to set a very high liquidated damage to protect their investment upfront, and Court should recognise this fact. However, first best is generally not achievable.
