Do Liquidated Damages Encourage Breach? A Psychological Experiment

This Article offers experimental evidence that parties are more willing to exploit efficient-breach opportunities when the contract in question includes a liquidated-damages clause. Economists claim that the theory of efficient breach allows us to predict when parties will choose to breach a contract if the legal remedy for breach is expectation damages. However, the economic assumption of rational wealth-maximizing actors fails to capture important, shared, nonmonetary values and incentives that shape behavior in predictable ways. When interpersonal obligations are informal or underspecified, people act in accordance with shared community norms, like the moral norm of keeping promises. However, when sanctions for uncooperative behavior are specified or otherwise formalized between the parties, behavior becomes more strategic and more self-interested. A liquidated-damages clause makes the remedy for breach explicit. Using a series of web-based questionnaires, I asked participants to indicate the lowest financial incentive that they would accept to breach a hypothetical contract, showing some subjects a contract with a liquidated-damages clause and others an otherwise identical scenario in which damages were determined by “the law of contracts.” Subjects were more willing to breach a contract-an action normally dictated against by social and moral norms-when damages were stipulated. I argue that even when the law of contracts is clear itself on the legal remedy for breach, moral intuition differentiates between a background law like the rule of expectation damages and an obligation to pay damages included as a clause in the body of the contract. When parties stipulate damages, they clarify the respective expectations of the parties, permitting efficient breach without repudiation of the mutual understanding.