an economic analysis of buyer's breach: a comment on sadanand

An Economic Analysis of Buyer's Breach: A Comment on SadanandAuthor(s): Samuel A. Rea, JrSource: The Canadian Journal of Economics / Revue canadienne d'Economique, Vol. 22, No. 4(Nov., 1989), pp. 904-909Published by: Wiley on behalf of the Canadian Economics AssociationStable URL: http://www.jstor.org/stable/135506 .

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An economic analysis of buyer's breach: a comment on Sadanand S A M U E L A. R E A, J R University of Toronto

Abstract. This paper examines legal remedies for breach of a contract to buy from a monopolistic seller. Rational parties will prefer lost profits damages for buyer breach. The lost profits can be measured as the contract price minus the costs not yet incurred minus the seller's value of the unsold goods at the time of breach. If the buyer prefers to resell the goods in the market despite the resale cost, the monopolistic seller will prefer to breach and pay lost profits damages. The law tends to provide the remedies that would be included in efficient contracts.

Une analyse economique du bris de contrat par l'acheteur: un commentaire sur l'analyse de Sadanand. Ce memoire examine les dedommagements legaux pour bris de contrat de la part d'un acheteur quand il fait face a un vendeur qui est monopoleur. Les parties en presence vont rationnellement preferer un dedommagement egal aux profits perdus a cause du bris de contrat. On peut mesurer les profits perdus comme la diff6rence entre le prix indique au contrat moins les coiuts non encore encourus moins la valeur des biens non vendus pour le vendeur au moment du bris de contrat. Si l'acheteur prefere revendre les biens sur le marche, meme s'il y a couts de revente, le vendeur monopoleur va pref6rer lui meme briser le contrat et payer des dddommagements egaux aux profits perdus. La loi tend a fournir des dedommagements qui seraient contenus dans des contrats efficients.

INTRODUCTION

In a recent article in this journal, Sadanand (1987) compares alternative legal remedies for buyer's breach. These are: (1) Lost profits (contract price less marginal cost), (2) Market Damages (contract price less market price), and (3) Specific Performance (the buyer is forced to purchase the goods). She concludes that 'each remedy performs well under different circumstances' (Sadanand, 1987, 766-7), and that the choice between the market damages remedy and the lost profits remedy 'rests upon the buyer's ease of entry in the reselling market' (767). This note demonstrates that the lost profits remedy provides Pareto-efficient contracts, regardless of the buyer's cost of reselling. Further, and contrary to the impression created by Sadanand, the lost profits remedy prevails in Canadian law.

Sadanand's model assumes that a monopolist is contracting with a buyer for future

Canadian Journal of Economics Revue canadienne d'Economique, XXII, No. 4 November novembre 1989. Printed in Canada Imprime au Canada

0008-4085 / 89 / 904-9 $1.50 ? Canadian Economics Association



Comment on Sadanand 905

production and delivery. The value of the goods to the buyer depends on future demand. At some time prior to production, the state of the world becomes known and the seller makes his production decision, correctly anticipating the quantity that the buyer purchases and the amount the buyer resells. 1 The buyer's decision depends on his or her valuation of the goods, the cost of resale, and the damages that must be paid for failing to purchase the quantity specified in the contract. The seller is assumed to have no cost of reselling the goods (Sadanand, 1987, 755). The only information problem that prevents complete contracts is the inability of the seller to prevent the buyer from reselling goods in the market. Sadanand assumes that performance of the contract is the point of reference (the 'base case') with which to compare the seller's profits under market damages and lost profit damages. She states and proves numerous theorems that relate the seller's undercompensation or overcompensation to the cost of reselling the goods.

Unfortunately, the theorems in the paper are irrelevant, because performance of the contract is inefficient in the situations that are described. The inefficiency arises if the buyer is unduced to overconsume or underconsume the good or if resale costs are needlessly incurred. Rational agents would never agree ex ante to a contract in which there is a possibility that the buyer consumes goods valued below the seller's cost of production. Ex post the parties would attempt to negotiate around the inefficient remedy. There is an additional source of inefficiency in Sadanand's model. Given that the buyer must incur a cost of reselling the goods and the seller has no such cost, the seller should not provide goods to the buyer when the buyer is known to be reselling the goods. In the absence of an ability to monitor resale, it will be efficient for the seller to breach whenever the buyer is reselling the goods in the market. If damages are specified to equal lost profits, the buyer and seller will breach when it is efficient to do so. The next section indicates that lost profits are the legal remedy employed in Canada.2

LEGAL REMEDIES FOR BREACH OF CONTRACT

The potential inefficiencies of specific performance are recognized in the law. The presumptive remedy for breach of contract is lost profits, not specific performance.3 Specific performance is an exceptional remedy which is granted only when damages are inadequate (Sharpe, 1983, 5). If the buyer breaches a contract, he or she is liable

1 Sadanand's basic model will be used for the discussion. The paper contains some extensions of this model.

2 The law is similar in the United States and England. 3 Sadanand is unclear on this point. She states that lost profits are 'generally used on [sic] connection

with buyer's breach' Sadanand (1987, 751, n3), yet also suggests that specific performance achieves the objective of the law Sadanand (1987, 752-3). She claims that protecting the expectation interest is 'weakly Pareto improving' (Sadanand, 1987, 751) and links expectation to specific performance. This note demonstrates that specific performance and market damages are not Pareto- efficient remedies.



906 Samuel A. Rea, Jr

for the seller's lost profits on the transaction.4 Market damages are the starting point for the measurement of damages when there is an 'available market,' but this method is applied only when it is consistent with the lost profits measure (Waddams, 1983, 83, 380). The market damages measure is intended to apply to homogeneous goods with relatively low selling costs, such as securities. Courts would not use the market damages remedy when there is a monopolistic seller and the buyer has high costs of resale.5

Similarly, damages for seller's breach equal the difference between the value of goods to the buyer and the contract price.6 It could be argued that the damages should reflect the resale value when it exceeds the buyer's own valuation, but both measures give the same result in the situation described below.

PARETO-EFFICIENT CONTRACTS

The usual approach to contracting problems is to consider the ex ante decision that the parties face, subject to the type of imperfect information that has been specified. The remedies for breach of contract that maximize the value of the contract are then determined. Sadanand has restricted the problem by pre-determining the number of units sold in the contract. Given this assumption, several economic questions arise: first, what remedies would the parties specify ex ante; second, given a particular legal remedy (including no remedy), how would the parties behave; and third, what legal remedy leads to Pareto-efficient contracts?7 Sadanand does not address these questions. Instead, she compares the buyer's profits under specific performance with the profits under alternative remedies. It is shown below that specific performance and market damages lead to Pareto-inferior outcomes in the absence of renegotiation and that the lost profits remedy induces Pareto-efficient behaviour without renegotiation.

The inefficiency of specific performance is obvious because it forces the buyer to acquire goods which he or she values less than the seller. This is a classic example of inefficient exchange. If the buyer's valuation of the goods is below the seller's cost of

4 '(2) The measure of damages is the estimated loss directly and naturally resulting in the ordinary course of events form the buyer's breach of contract. (3) Where there is an available market for the goods in question, the measure of damages is prima facie to be ascertained by the difference between the contract price and the market or current price at the time or times when the goods ought to have been accepted ...' (Sale of Goods Act, R.S.O. 1970, c. 421, s. 48).

See Waddams (1983, 381) for references to cases that provide for lost profits under common law as well as the Sale of Goods Act.

5 Charter v. Sullivan [ 1957] 2 Q.B. 117 at 125 (c.A.). In this case the seller had a limited supply of automobiles because of rationing by the manufacturer. The court measured the damages with lost profits but found that there were no lost profits: 'But it was for the plaintiff to prove that he did in fact sustain the loss of profit claimed, and this to my mind he wholly failed to do' (132). In economic terms, the marginal cost of a rationed automobile is the opportunity cost of selling it to someone else.

6 'Where, as is usual, the price has not been paid, the measure of damages is the difference between price and value' Waddams (1983, 81). The statutory statement occurs in the Sale of Goods Act, R.S.O. 1970, c. 421, s. 49.

7 The impact of the rules on the welfare of other consumers in the marketplace is not considered.




production, the parties would be better off by having the buyer breach and pay the seller's lost profits. The market damages remedy also leads to inefficient consumption. The efficient outcome could be obtained by negotiation if the legal remedy were specific performance or market damages,8 but the lost profits remedy leads to the efficient outcome without costly negotiation.

Inefficiency also occurs when the buyer is reselling in the market. If the buyer's marginal valuation of the goods falls below the market price less his resale costs, the seller should breach on a portion of the contract and pay the buyer's lost profits in order to prevent the waste associated with the buyer's resale costs. These points are easily demonstrated.

The parties will wish to have a Pareto-efficient outcome, given the seller's decision on the quantity to supply in the spot market (which is conditional on the state of the world). This supply decision determines the spot market price, subject to modification if the buyer resells in the market. It will be shown that the buyer will not resell in the market if the contract is efficient.

Sadanand's model contains the following terms:

P = spot market price per unit K = contract price per unit c = marginal cost of production r = buyer's cost of resale per unit Z = quantity specified in the contract X = quantity consumed by buyer

T(X) = Buyer's gross valuation of the goods.

There are two types of efficient breach. In the first situation the buyer's marginal valuation is less than the marginal cost of production,

T'(Z) < c, (1) and the proceeds from resale are less than the marginal cost,

P - r < c. (2)

Specific performance forces the buyer to take goods that will cost more than their value to the buyer. 9 The buyer could be made better off without harming the seller if the goods were sold back to the seller for a price c until T'(X) = c.

Market damages would be zero if P 2 K and would equal K - P per unit otherwise. The marginal cost of consumption for the buyer is the contract price less the per unit damages, K - (K - P) = P. Therefore, the buyer will consume the good until T'(X) = P. At this level of consumption the buyer and seller could be made better off if they could agree to the sale of additional units for some price between P and C.10 Therefore, market damages lead to a Pareto-inferior outcome unless the parties can negotiate around the legal remedy.

8 Sadanand (1987, 752, n4) mentions the possibility of negotiation but does not pursue the implic- ations.

9 Sadanand assumes that the production occurs after the state of the world becomes known. 10 The seller would not agree to this if it affected the price paid by all the other customers.



908 Samuel A. Rea, Jr

The Pareto efficient outcome (T'(X) = c) can be induced by making the buyer pay the seller's lost profits as damages for failure to purchase the entire amount specified in the contract. Lost profits are K - c for each unit.11 The buyer's net cost of consumption is K - (K - c) = c when damages equal lost profits. Therefore, the lost profits remedy provides efficient breach of contract by buyers and would generally be the ex ante negotiated remedy for risk neutral parties.

The second case in which breach is efficient occurs when the buyer can profitably resell in the market,

T'(Z) < P - r, (3)

and the proceeds of resale exceed the marginal cost,

P - r ' c. (4)

In this situation Sadanand concludes that the buyer will honour the contract and sell in the market until T'(X) = P - r. This is clearly inefficient, since the original seller has no selling costs. It will be efficient for the seller to breach by withholding enough units from the buyer so that the buyer does not wish to resell in the market. The seller will have the appropriate incentives whether the damages payable by the seller equal the buyer's loss without resale,

T(Z)- T(X)-K(Z-X), (5)

or with resale,

(P- r- K) (Z-X). (6)

These damages will lead the seller to supply an amount such that T'(X) = P - r, and the buyer will not resell in the market. 12 This can be shown by examining the change in profit for a change in the amount delivered to the buyer. At the level of supply where T'(X) P - r, a one-unit decrease in supply would cost the seller K - c in lost profits plus damages. A one-unit increase in supply would provide profits on that unit equal to K - c and would reduce damages by T'(X) - K = P - r - K, using either concept of damages. The additional unit would be resold, reducing the original seller's marginal revenue by P - c. The net change in the seller's profits for the additional unit is

(K- c) + (P- r-K)-(P- c) -r < O (7)

Profits fall by the resale cost if the seller provides the additional unit. Therefore, damages equal to the buyer's lost profit will lead to efficient breach by the seller when equations (3) and (4) hold. 13

The seller must choose a quantity for sale in the spot market (Q) that will maximize

11 I have used the same measure of profits as Sadanand (1987, 758). The law generally defines lost profits in this way (See Rea, 1987).

12 Sadanand assumes that the seller knows the buyer's demand. 13 Note that there is underconsumption of the good, relative to a complete information world, because

T'(X) = P -r > c. This cannot be avoided as long as the buyer and seller cannot write a contract that prevents resale.




profits. Since the seller never resells any goods in the spot market, the spot market production decision determines the spot market price directly. Given the buyer's valuation T(j), the quantity chosen will maximize the profits (XT) over the three ranges of price:

T'(Z) < c and P - r < c: (buyer breach) = (P(Q) - c)Q + (K - c)Z

T'(Z) < P -r and P - r > c: (seller breach) r= (P(Q) - c)Q + (K - c)X - T(Z) + T(X) + K(Z - X)

T'(Z) P - r and T'(Z) ? c: (no breach) I= (P(Q) - c)Q + (K - c)Z

where X is a function of the spot market price and T'(X) = P - r.

CONCLUDING COMMENTS

Sadanand describes the buyer breach problem in such a way that the only information problem that the parties face is that they cannot directly prevent resale by the buyer. If they could prevent resale, the ex ante efficient contract for risk-neutral parties would be one in which the buyer consumed until the buyer's marginal valuation equaled the marginal cost of production.

A more reasonable description of the problem of buyer breach is that the seller cannot observe the buyer's valuation of the goods. Furthermore, it seems likely that the seller incurs some costs that cannot be recovered after a breach of contract. Rea (1986) examines this contracting problem (assuming among other things that the spot price is exogenous) and concludes that the buyer will breach efficiently when damages equal the seller's lost profits. The lost profit can be measured as the contract price minus the costs not yet incurred minus the seller's value of the unsold goods at the time of breach. Without explicitly recognizing economic objectives, the law tends to be generally consistent with efficient contracts.

REFERENCES

Rea, Samuel A. Jr (1986) 'Damages for buyer breach,' International Review of Law and Economics 6, 77-86

Sadanand, Asha (1987) 'Lost profits, market damages, and specific performance: an economic analysis of buyer's breach.' This JOURNAL 20, 750-73

Sharpe, Robert J. (1983) Injunctions and Specific Performance (Toronto: Canada Law Book) Waddams, Stephen M. (1983) The Law of Damages (Toronto: Canada Law Book)



an economic analysis of buyer's breach: a comment on sadanand

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