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WORK IN PROGRESS: Liquidated Damages and Efficient Breach: A Psychological Experiment

February 05, 2009
Tess Wilkinson-Ryan L’05, MA ’06, PhD ’06
Sharswood Fellow in Law and Psychology
University of Pennsylvania Law School

 

You’re worried that the builder you’re about to hire to renovate your kitchen won’t get the job done on time, so you specify in the contract that he will pay you $1,000 if he fails to meet the target date.

Feeling better? You shouldn’t. Research by a faculty fellow at the University of Pennsylvania Law School suggests that you’ve just increased the probability that your builder will finish behind schedule.
 
Why? Because for most people, moral objections to breach of contract can be stronger than financial disincentives, writes Tess Wilkinson-Ryan, who holds a law degree and a Ph.D. in psychology from Penn. 
 
“One person in our study wrote that ‘there is no amount of money to make it worth going back on your word,’” Wilkinson-Ryan said. “Participants routinely reported that a contract is a promise and that breaking a contract is immoral.”
 
But once an explicit penalty for breaking the contract is written into the agreement, people actually become more willing to break the contract if it’s in their self-interest to do so. 
 
For example, in Wilkinson-Ryan’s research, subjects were asked this: Imagine you own a small restaurant that the Wilson family is renting one evening for $1,000. Two weeks before the Wilsons’ party, a famous rock band calls to ask if they can rent your restaurant on the same night. How much would the band have to pay to get you to break you contract with the Wilsons?
 
The results show that if the Wilsons’ agreement did not have a breach of contract clause, the rock band would have to pay $4,000 for the space in order to entice the restaurant owners to break the contract with the Wilsons. If, however, the original contract included a clause stating that Mr. and Mrs. Wilson would be paid $1,000 if the restaurant became unavailable or unusable for any reason, subjects were willing to break that contract even if the rock band was only willing to pay $2,800 to rent the restaurant.
 
Even when there was no penalty clause in the Wilsons’ contract but the subjects were told that a general “law of contracts” would require them to pay the Wilsons $1,000, they were less likely to break the contract and rent to the rock band, even though the economic cost of doing so would be exactly the same as if a $1,000 penalty clause were written into the original contract.
 
The lesson for psychologists is that people are more willing to break a contract if doing so is part of  the contract and not a repudiation of it, Wilkinson-Ryan says. The lesson for lawyers is that writing contracts that include cancelation penalties can facilitate economically sound breaches that leave least one party better off and no one worse off.
 
And the lesson for homeowners with outdated kitchens  is that you might want to skip the penalty clause and take your chances.
 
[This research is being published as Paper No. 09-03 by the Institute for Law and Economics at the University of Pennsylvania. Available at SSRN:  http://ssrn.com/abstract=1299817.]