5. (15) Breach of Contract

This question runs through the various concepts associated with breach of contract. Jack and Jill sign a contract whereby Jill must supply Jack with his fall line of clothing, which will be displayed in a fashion show whose date has already been set. Jack and Jill are both risk neutral and therefore base their decisions on their expected returns.

state	probability	Jack	Jill
good	0.9	20,000	10,000
bad (no breach)	0.1	20,000	- 30,000

a) (3) Suppose that breach of contract is forbidden, and Jack demands specific performance. The penalties will be severe if Jill does not meet the terms of the contract, so in the bad state she has to pay top dollar for a replacement seamstress on short notice. The table above lists the outcomes of this contract. Will Jack sign the contract? Will Jill sign the contract? Is it socially desirable that contract be fulfilled in the bad state?

b) (3) Now suppose that breach of contract is permitted, with no penalties. In the bad state, Jill will breach and Jack will have to deal with the problem. He will decide to cancel the fashion show, at a loss to him of $5000. The table is therefore altered to the following:

state	probability	Jack	Jill
good	0.9	20,000	10,000
bad (breach)	0.1	- 5,000	0

Will Jack sign the contract? Will Jill sign the contract? Is it socially desirable that the contract be fulfilled in the bad state?

c) (3) Suppose again that breach of contract is permitted, and that expectations damages are awarded in the event of breach. If Jill's gain from breaching is more than that Jack's loss, Jill must pay Jack enough to give him "the result he expected from her performance". The result he expected from her performance is that he get a surplus of $20,000. Thus, if she breaches Jill must pay Jack $25,000. The table is therefore altered to the following:

state	probability	Jack	Jill
good	0.9	20,000	10,000
bad (breach)	0.1	20,000	- 25,000

Will Jack sign the contract? Will Jill sign the contract? Will the contract be fulfilled in the bad state? Is it socially desirable that it be fulfilled in the bad state?

d) (3) Suppose again that breach of contract is permitted, and that reliance damages are awarded. Under reliance damages, Jill must make Jack as well off as if the contract had never been signed. Jill must therefore pay Jack $5,000. The table is altered to the following:

state	probability	Jack	Jill
good	0.9	20,000	10,000
bad	0.1	0	- 5,000

Will Jack sign the contract? Will Jill sign the contract? Will the contract be fulfilled in the bad state? Is it socially desirable that it be fulfilled in the bad state?

e) (3) Now modify the example slightly. Suppose that Jill had the option of training a back-up seamstress. If she had, this would have raised her costs by $6000 in the good state, but saved her $20,000 in the bad state if she does not breach. The original table is altered as follows:

state	probability	Jack	Jill
good (with seamstress)	0.9	20,000	4,000
bad (with seamstress and no breach)	0.1	20,000	- 10,000

If Jill had hired the back-up seamstress, would breach of contract have been socially desirable in the bad state? Would it have been socially desirable for Jill to hire the back-up seamstress? Under reliance damages, would Jill have hired the back-up seamstress?