Answer to Question #163979 in Economics for Vineet Kumar

Question

Consider an investor and an entrepreneur that can enter a business relationship where the investoninvests 110 and where the joint profit of the investment amounts to 60 each in case the entrepreneur performs. In case the entrepreneur breaches the contract the investor gets - 110 and the entrepreneur gets 110 (without damages). To increase profits our investor can make an additional investment with a third party of 100. If the entrepreneur performs our investor will increase the profit from 60 to 70 and our entrepreneur still receives 60. In case of breach the initial investment and the extra investment yields a payoff of -210 to the investor and 110 to the entrepreneur (without a contract). Will naïve or simple expectation damages give the Investor optimal incentives to invest in reliance? Explain and show, with the help of relevant calculations, how a correct interpretation of perfect expectation damages can solve the problem of optimal reliance in this case. (20p) Will no damages give efficient incentives to invest in reliance in this case? Motivate your answer with relevant calculations. Explain briefly why no damages cannot lead to an efficient contractual outcome and why perfect expectation damages will, even if optimal incentives to invest in reliance is achieved by no damages. (5 p)

Answer 1

Naive or simple expectation damages won't give the Investor optimal incentives to invest in reliance.

But no damages may give inefficient incentives too to invest in reliance in this case.

Only perfect expectation damages will lead to an efficient contractual outcome.