Optimal Penalties in Contracts

Abstract

Contract law protects the promisee's expectation interest by requiring a breaching promisor to pay as damages a sum that would put the promisee in the same position that performance would have. When the expectation is difficult to monetize, the promisor must render the contractual performance. The law also permits parties to specify in their contract the sum the promisor must pay on breach: the specified sum is permitted to fall below, but cannot exceed, a reasonable ex ante estimation of the promisee's expectation interest. The rules regulating contractual damage measures, denoted here as the "liquidated damage rules," thus prohibit penalties.