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Compensation and Incentives to Breach

Sven Hoeppner

Efficient breach theory recommends expectation damages as remedy for breach of contract, because this incentivizes contract parties to perform when that is efficient and breach when that is efficient. A broad stream of evidence shows, however, that people behave rather pro-socially and, in particular, tend to keep their promises and honor their agreements, which questions the heuristic value of efficient breach theory. I provide an experimental institution test that investigates the effect of compensatory damages and its two features (fine and recovery) on agent's willingness-to-breach. Second movers in a trust game receive a surprising incentive to act non-cooperatively and I elicit their reserve price to do so. Under compensatory damages and fines, agents demand a lower reserve price for non-cooperative play. The recovery procedure reduces the reserve price when the players did not agree to cooperative exchange, but increases the reserve price given agreement. Compensatory damages and the recovery procedure induce more (less) punishment of non-cooperative agents, when there was agreement (no agreement) between the players. These results imply that compensatory damages facilitate efficient breach and, therefore, contribute to overall social welfare generated from contracts.