ON THE EFFICIENCY OF PRIVATELY STIPULATED DAMAGES FOR BREACH OF CONTRACT - ENTRY BARRIERS, RELIANCE, AND RENEGOTIATION

Two roles for stipulated damage provisions have been debated in the li terature: protecting relationship-specific investments and inefficient ly excluding competitors. Aghion and Bolton (1987) formally demonstrat e the latter effect in a model without investment or renegotiation. Al though introducing renegotiation alone destroys their result, introduc ing both renegotiation and investment restores it. In particular, if t he entrant has market power and the seller's cost of production is obs ervable but not verifiable, then privately stipulated damages are set at a socially excessive level to facilitate the extraction of the entr ant's surplus. In contrast, if the entrant prices competitively (as ty pically is assumed in the law and economics literature on breach), the n private stipulation is efficient. Whereas a simple legal restriction on the contract corrects for any inefficiency, standard court-imposed remedies do not.